A Nation of Moochers

by Sykes, Charles J.

  The deals were possible because the mortgages were not held by the loan originators, but were instead quickly off-loaded. They were abetted by both the federally backed Fannie Mae and Freddie Mac, which bought many of the dicey loans, and by Wall Street, which developed an avaricious craving for more mortgages to slice, bundle, and sell as securities. Wall Street, recalls economics writer Arnold Kling, “made riskier and riskier bets, but as long as home prices kept increasing, defaults were rare and market participants enjoyed nice profits.”3

  In the days before the affordability bubble, it was understood that traditional borrowers would put down large down payments (preferably 20 percent), had good income and credit histories, and could service the mortgage debt easily. These were the so-called prime borrowers and they were prudent bets for lenders. They were also thirty-year deals, so the focus was always on the long-term stability of the lender-borrower relationship. That all changed in the brave new world in which salesmen, paid on the volume of mortgages they could sell, quickly sold them off to whatever greater fool would have them. In other words, notes Ritholtz, the industry underwent an “enormous paradigm shift.” Volume—and the pressure to make the sale—replaced prudence, which led to a “radical change in lending standards.” Lenders no longer needed to find buyers who would be a good risk for thirty years; “they needed only to find someone who wouldn’t default before the securitization process was completed,” or about ninety days.4

  The clamor for the exotic and lucrative mortgages meant that numbers were fudged and standards were bent—incomes were invented or inflated, appraisals massaged, piggy bank loans juggled, value-to-loan ratios ignored, and the money flowed. “If you could fog a mirror, you qualified for a mortgage,” quips Ritholtz, noting that a strawberry picker with an annual income of $14,000 was deemed qualified for a mortgage to buy a $720,000 home.5

  Let’s consider that strawberry picker and his $720,000 house for a moment. On one level, the loan was pure madness, but on another, it represented the triumph of the “affordability” crusade. A man making $14,000 a year was able to afford a house valued at three quarters of a million dollars. What could be more affordable than that? Of course, this required a great deal of Other People’s Money, but that was always implied in the whole frenzy.

  Some of these loans were undoubtedly what could be described as “predatory” (although it is a strange form of predation in which money is pressed on the victim rather than taken from him)—written by unscrupulous lenders anxious to score quick fees and the long-term risks be damned. But even if this is true, there was also predatory borrowing, as homeowners leveraged massive increases in their square footage and financed their lifestyles with meager investments of their own money.

  Meanwhile the mortgage securities—known as collateralized debt obligations or CDOs—seemed to be paying off handsomely. High ratings and decreasing transparency created the illusion of safety and prudence. Even though many of the mortgages were based on hinky subprime loans, ratings agencies gave them stellar AAA ratings and investors across the globe snapped them up. They became so popular that Wall Street created ultra-exotic CDOs that were backed by other CDOs, each step more complex and less transparent. In other words, nobody really understood what they had or how chancy the whole scheme had become.

  All that was left to complete this abdication of common sense was the support of the federal government. Support? The feds were cheerleading the process and bankrolling the march of folly.

  As mortgage madness spread, the federal government actively stoked the flames. Far from reining in the spread of questionable loans, Washington pressured Fannie and Freddie to buy increasingly risky loans. “Once,” reported The New York Times, “a high-ranking Democrat telephoned executives and screamed at them to purchase more loans from low-income borrowers, according to a Congressional source.” At the same time, “Shareholders attacked the executives for missing profitable opportunities by being too cautious.”6

  The CEOs of the two federally backed companies “eventually yielded to those pressures, effectively wagering that if things got too bad, the government would bail them out.”7

  This is where moral hazard goes to die.

  Bipartisan Madness

  While greed undoubtedly drove much of the mortgage mess, politics constantly provided the spur. History will record that the mortgage madness and subsequent bailouts occurred under both Democratic and Republican presidents and that many of the policies and practices that led to the crisis were advanced by both conservatives and progressives (albeit with different motives and agendas).

  Even amid warnings that many of the subprime loans were unsustainable, the Bush administration ratcheted up the pressure for riskier loans, in pursuit of what Bush called the “ownership society.” Reported The Washington Post: “Eager to put more low-income and minority families into their own homes, [the Department of Housing and Urban Development] required that two government-chartered mortgage finance firms purchase far more ‘affordable’ loans made to these borrowers. Administration officials publicly complained that Fannie and Freddie were not being as aggressive as the private market and must do more.”8 Bush’s goal was to create 10 million new homeowners, largely backed by low-interest loans and the implicit government guarantees. To make that possible, Bush’s Department of Housing and Urban Development let Fannie and Freddie count the billions of dollars vanishing down the subprime hole as “a public good that would foster affordable housing.”9

  In 2003, Fannie and Freddie bought $81 billion in subprime securities; the next year, they had purchased $175 billion, fully 44 percent of the market. By 2006, Fannie and Freddie had backed off a bit, buying only $90 billion in subprime securities. But the damage had been done: From 2004 to 2006, Fannie and Freddie bought $434 billion in securities backed by subprime loans, fueling the lending frenzy by creating a huge taxpayer-backed market for the funny money loans.10 “Every dollar they pumped into subprime securities made the real estate bubble worse,” declared the conservative Heritage Foundation.11

  Even as the market began to unravel, Freddie’s defenders rationalized the failures. “It’s like a kid who gets straight A’s and then gets a DUI. Is the kid [messed] up?” one lobbyist for Freddie argued. “No, he made a mistake.… You can’t just get rid of Fannie and Freddie.”12

  By this point, though, the support for the risky lending was solidly bipartisan.

  Laying the Fire

  Long before there were subprime, no-down-payment, interest-only mortgages, before the rise of collateralized debt obligations and NINJA mortgages, there was the Community Reinvestment Act, a Carter-era law given teeth under President Bill Clinton. The law was originally designed to encourage banks to make loans in “disadvantaged” neighborhoods. While its role in the housing meltdown has been both downplayed and exaggerated by partisans, the CRA clearly laid the ground for much of what was to follow, including the underlying push for “affordability,” the political mantra that drove and rationalized the flight from financial sanity that eventually resulted in the housing crash.

  Defenders of the Community Reinvestment Act frequently cite a study from Harvard’s Joint Center for Housing Studies that concluded that loans covered by the CRA accounted for just 9 percent of the mortgages given to low-income individuals and neighborhoods. In contrast, independent mortgage companies accounted for the majority of such loans.13 But this understates the groundbreaking significance of CRA. While Fannie and Freddie and Wall Street recklessness provided the blowtorch that set off the bonfire, it was the CRA that laid the kindling.

  Hindsight, of course, is convenient in the wake of the bursting of a bubble, but there were warnings before the deluge gathered force. In 2000, Howard Husock, writing in City Journal, sounded the alarm for what he called “The Trillion-Dollar Bank Shakedown That Bodes Ill for Cities,” and explained how the CRA changed the political and financial dynamics of mortgage lending.14

  For the first decade or so of its regulatory lif
e, Husock noted, the CRA was generally ineffectual. But in the 1990s, the Clinton administration transformed it into “one of the most powerful mandates” shaping the nation’s financial system.

  Under Clinton, new CRA regulations gave advocacy groups greater clout in pressuring banks to make marginal loans. The new rules required bank regulators to evaluate how well banks responded to such pressure. “The old CRA evaluation process had allowed advocacy groups a chance to express their views on individual banks, and publicly available data on the lending patterns of individual banks allowed activist groups to target institutions considered vulnerable to protest,” wrote Husock. But the Clinton administration’s formal invitation was a “clarion call” for activists like the National Community Reinvestment Coalition and community groups to mobilize to pressure banks to make more low-income loans.

  The impact was swiftly felt. Merely by threatening to complain, activist groups were able to “gain control over eye-popping pools of bank capital, which they in turn parcel out to individual low-income mortgage seekers,” observed Husock. Notably, the now-notorious activist group ACORN Housing snagged a $760 million commitment from the Bank of New York. Another group, the Neighborhood Assistance Corporation of America, scored a $3 billion agreement with the Bank of America, and on and on it went, with similar deals in virtually every major city. Husock quoted one “affordable housing” activist who had landed $220 million in mortgage cash to parcel out saying: “CRA is the backbone of everything we do.”15

  Clinton also subtly shifted the focus of the law from poor neighborhoods to low-income individuals, significantly expanding its mandate and ultimately its effect on lending. For Husock, however, the new culture was personified by one activist in particular: Bruce Marks, the CEO of the Neighborhood Assistance Corporation of America. “Bruce Marks has set out to become the Wal-Mart of home mortgages for lower-income households,” wrote Husock, with offices in twenty-one states, an annual budget of more than $10 million, and delegated underwriting authority from banks. A self-described “bank terrorist,” Marks openly recruited homeowners as activists for his political agenda.

  Years before the housing meltdown, Husock predicted that activists like Marks “may well reshape urban and suburban neighborhoods,” because they pushed the envelope on the sorts of loans they issued. Because Marks believed that low-income borrowers were oppressed, disadvantaged victims, he regarded requiring down payments from low-income minority buyers as “patronizing and almost racist.’”16

  An Open Checkbook

  So the political stars were aligned for a transformation of the home mortgage industry. Even before the Bush-era “ownership society,” Democrat Bill Clinton pushed to expand the number of Americans who owned homes, and the CRA and Fannie and Freddie were key weapons in the battle. In 1995 the Clinton administration gave a green light to Fannie and Freddie to start buying subprime securities, including those backed by mortgages given to low-income borrowers. By 1996 the feds required that fully 40 percent of the loans backed by Fannie and Freddie had to come from buyers with “below median incomes.”17

  “We began to stress homeownership as an explicit goal for this period of American history,” Henry Cisneros, then Secretary of Housing and Urban Development, later told The Washington Post. “Fannie and Freddie became part of that equation.” Noted the Post: “The result was a period of unrestrained growth for the companies.… The companies increasingly were seen as the engine of the housing boom. They were increasingly impervious to calls for even modest reforms.”18

  Critics lacked the clout to restrain the mortgage giants or their rush to financial recklessness. Defenders like Congressman Barney Frank insisted that the companies with their virtually limitless checkbook served a public purpose because they made mortgages cheaper.19

  Fannie and Freddie effectively wrapped themselves in the cloak of homeownership, which was recast as an indispensable part of the American Dream, as indeed it was. But a key distinction was overlooked: The opportunity to one day own a home was a far cry from a mad rush to provide everyone—even those who couldn’t afford one—the means to purchase a sprawling suburban ranch right now. Once seen as the end result of a series of choices, sacrifices, and prudent decisions, homeowners now had to be instantly gratified. Artificially cheap loans were what economists call “signal noise,” distorting the market and blinding politicians and investors alike to the peril of the expansion of the unaffordable loans.

  As long as the music played—and the housing market continued to go up—the game worked: Homeowners got their bigger homes; the originators got their fees; Wall Street was able to reap fat yields; and taxpayers were assured they would never have to pay a nickel for any of this. Fannie and Freddie lubricated friendly politicians with generous campaign donations and kept fueling the subprime market even after it was caught cooking its own books. But when the music did, in fact, stop, the realization set in that the housing bubble had been fueled by funny money and that the dubious mortgages had been quickly shuffled from one hand to another, like a stick of dynamite with a slowly burning wick.

  In September 2008, the federal government seized control of Fannie and Freddie and the taxpayer bailouts could amount to hundreds of billions of dollars.* The total price tag for bailing out the financial system could run into the trillions of dollars.

  Chapter 11

  * * *

  BAILOUTS FOR IDIOTS (HOW TO MAKE OUT BIG BY SCREWING UP)

  * * *

  The Great Bailout of 2008–09 can be summed up simply:

  Never have so few mooched so much off so many.*

  The numbers are mind-bending—tens of billions of dollars for badly run car companies; hundreds of billions for reckless financiers; trillions to bail out the mortgage insanity of the previous decade. Spurred by dire warnings of financial Armageddon, the bailouts rewrote the rules of finance, exemplified crony capitalism, and transformed the landscape of the free market. Losing large amounts of money is the essence of market discipline; the prospect of failure is precisely what deters businesses from running imprudent risks. But in the Great Bailout the laws of financial gravity were suspended, if not repealed: Some well-connected companies were protected from their losses by the generosity of taxpayers, many of whom were watching their life savings devastated by the financial turmoil.

  As shocking as the bailouts seemed at the time, history is likely to be far less kind. The Congressional Oversight Panel’s review of the bailout of supermoocher AIG is a withering critique of cronyism, conflicts of interest, favoritism, and profligacy.

  The government’s actions in rescuing AIG continue to have a poisonous effect on the marketplace. By providing a complete rescue that called for no shared sacrifice among AIG’s creditors, the Federal Reserve and Treasury fundamentally changed the relationship between the government and the country’s most sophisticated financial players.… Even more significantly, markets have interpreted the government’s willingness to rescue AIG as a sign of a broader implicit guarantee of “too big to fail” firms. That is, the AIG rescue demonstrated that Treasury and the Federal Reserve would commit taxpayers to pay any price and bear any burden to prevent the collapse of America’s largest financial institutions, and to assure repayment to the creditors doing business with them. So long as this remains the case, the worst effects of AIG’s rescue on the marketplace will linger.1

  Even though taxpayers will recoup some of the original cost of the bailouts, the consequences as well as the costs will be paid not over years, but over generations.

  Bailouts, like corporate welfare, are not new. The federal government bailed out Chrysler in 1980, the S&Ls in the 1990s, Penn Central in 1974, and Lockheed in 1971. The Lockheed bailout set a precedent, but even so, that taxpayer rescue cost a mere $250 million, a small fraction of the money laid out to save Wall Street firms like Bear Stearns, Goldman Sachs, Citigroup, and AIG from their own excesses.

  Beginning with the rescue of Bear Stearns for $29 billion, the $700 billi
on Troubled Asset Relief Program (TARP), the takeover of Fannie Mae and Freddie Mac (which put taxpayers on the hook for $5.5 trillion in debt), the loan guarantees for Citigroup and injection of cash into Bank of America, the $182 billion rescue of insurance giant AIG, and the tens of billions of dollars for Chrysler and General Motors, the bailouts marked a massive transfer of wealth from productive America to a new class of supermoochers.

  As details have emerged, questions have multiplied: Were the bailouts really necessary? Were there alternatives to government takeovers? And was there any pattern to the winners and losers? The randomness of the bailouts is perhaps the most puzzling. Bear Stearns was rescued; Lehman Brothers was allowed to die; Citigroup got a stunningly generous bailout. Referring to Citi’s sweet deal, author Barry Ritholtz in Bailout Nation wrote: “One might assume the government would cut a hard bargain with the biggest, stupidest, most irresponsible bank in the country.… Instead, the Treasury essentially handed over the keys to the kingdom for a mere song.”2 By guaranteeing nearly $250 billion in toxic assets, “the liabilities for a full decade of terrible decision making were transferred from Citi’s bond-shareholders to the taxpayers—a terrible deal for Uncle Sam, but a fantastic score for Citi.”*

  The taxpayers were essentially required to underwrite a decade of recklessness made possible by a mad fever of Wall Street greed abetted by misguided deregulation. A caveat here: On balance I support freeing markets from unnecessary rules, mandates, and forest-killing make-work regulations. But some libertarians (and I use this word respectfully) took a Panglossian attitude that sound ethics and prudent common sense would prevent the worst abuses if the government simply got out of the way. As it turned out, they were naïve in assuming that “deregulation” itself would make markets more efficient. As Richard Posner and others have noted, it is one thing to ease the burden of dysfunctional overregulation; it is quite another to use it as a cover for Wall Street to invent bogus new securities that were so lacking in transparency and so fragilely connected to reality that they bordered on the fraudulent. “If you’re worried that lions are eating too many zebras, you don’t say to the lions, ‘You’re eating too many zebras,’” said Posner. “You have to build a fence around the lions. They’re not going to build it.”3