Bailout Nation

by Barry Ritholtz

  What was their impact on lending? In 2004, 2/28 adjustable-rate mortgages (ARMs) accounted for almost 46 percent of new loans in dollar value and were about a third of total mortgages made, according to the Mortgage Bankers Association (MBA). That was up from 29 percent and 19 percent, respectively, in 2003. Subprime mortgage lending was one out of five mortgage loans in 2004, up from less than one out of 10 the year before.

  Why would ARMs make up so much lending when mortgage rates were at their lowest levels in 50 years? The only possible answer was to sell more—and bigger—loans. Getting people into teaser-rate mortgages, regardless of suitability, would get them past that default period covered by the initial warranty. This was the sub-prime mortgage industry’s primary raison d’etre.

  Ivy Zelman, the well-regarded housing analyst at Credit Suisse First Boston, noted the absurdity as early as 2006:• In 2005, 32.6 percent of new mortgages and home equity loans were interest only, up from 0.6 percent in 2000.

  • Forty-three percent of first-time home buyers in 2005 put no money down.

  • In 2006, 15.2 percent of 2005 buyers owed at least 10 percent more than their home was worth (negative equity).

  • Ten percent of all homeowners with mortgages had no equity in their homes (zero equity).

  • Fully $2.7 trillion in loans were scheduled to adjust to higher rates in 2006 and 2007.

  And those borrowers who convinced themselves an ARM would help them get into a bigger house until they could refinance (or flip the house) at a higher price? They were lying to themselves as they financially engineered their way into homes they couldn’t afford.

  Mortgage brokers were big fans of refinancing. Those buyers who couldn’t afford the mortgage in the first place were potential repeat customers down the road. As a house went up in value, you could always pull out the increase in equity to pay for the shortfall in monthly payments. Commission-driven real estate agents, along with the commission-driven mortgage brokers, liked to remind reluctant buyers that the longer they dithered, the higher prices were going. Best to get in now before the next leg up in real estate values!

  It is no surprise that these were the first mortgages to default. Disproportionately, subprime adjustable-rate mortgages have had the highest foreclosure rates of all mortgages. Rather than being “contained,” as Ben Bernanke and Henry Paulson (among other so-called experts) claimed throughout 2007, the subprime mortgage caused a cascade reaction all the way through the entire financial system.

  And the mortgage-based fun was only just beginning.

  INTERMEZZO

  A Memo Found in the Street: Uncle Sam the Enabler

  To: Washington, D.C.

  From: Wall Street

  Re: Credit Crisis

  Dear D.C.,

  Wow, we’ve made quite a mess of things here on Wall Street: Fannie and Freddie in conservatorship, investment banks in the tank, AIG nationalized. Thanks for sending us your new trillion-dollar bailout.

  We on Wall Street feel somewhat compelled to take at least some responsibility. We used excessive leverage, failed to maintain adequate capital, engaged in reckless speculation, and created new complex derivatives. We focused on short-term profits at the expense of sustainability. We not only undermined our own firms, we destabilized the financial sector and roiled the global economy, to boot. And we got huge bonuses.

  But here’s a news flash for you, D.C.: We could not have done it without you. We may be drunks, but you were our enablers. Your legislative, executive, and administrative decisions made possible all that we did. Our recklessness would not have reached its soaring heights but for your governmental incompetence.

  This memo provides a brief history of your actions that helped create this crisis.

  1997: Federal Reserve Chairman Alan Greenspan’s famous “irrational exuberance” speech in 1996 was somehow ignored by, um, Fed Chairman Greenspan. The Fed missed the opportunity to change margin requirements. Had the Fed acted, the bubble would not have inflated as much, and the subsequent crash would not have been as severe.

  1998: Long-Term Capital Management was undercapitalized, and used enormous amounts of leverage to purchase all manner of thinly traded, hard-to-value paper. It failed, and under the authority of the Federal Reserve a private-sector rescue plan by banks was cobbled together. Had these bankers suffered big losses from LTCM, they might have thought twice before jumping into the exact same business model of undercapitalized, overleveraged, thinly traded, hard-to-value paper. Instead, they reaffirmed Benjamin Disraeli’s famous aphorism: “What we learn from history is that we do not learn from history.”

  1999: The Financial Services Modernization Act repealed Glass-Steagall, a law that had separated the commercial banking industry from Wall Street, and the two industries, plus insurance, came together again. Banks became bigger, clumsier, and harder to manage. Apparently, risk management became all but impossible, even as banks had greater access to larger pools of capital.

  2000: The Commodity Futures Modernization Act defined financial commodities such as “interest rates, currency prices, and stock indexes” as “excluded commodities.” They could trade off the futures exchanges, with minimal oversight by the Commodity Futures Trading Commission. Neither the Securities and Exchange Commission (SEC) nor the Federal Reserve, nor any state insurance regulators, had the ability to supervise or regulate the writing of credit default swaps by hedge funds, investment banks, or insurance companies.

  2001-2003: Alan Greenspan’s Fed dropped federal funds rates to 1 percent. Lulled into a false belief that inflation was not a problem, the Fed then kept rates at 1 percent for more than a year. This set off an inflationary spiral in housing, as well as a desperate hunt for yield by fixed-income managers.

  2003-2007: The Federal Reserve failed to use its supervisory and regulatory authority over banks, mortgage underwriters, and other lenders, who abandoned such standards as employment history, income, down payments, credit rating, assets, property loan-to-value ratio, and debt-servicing ability. The borrower’s ability to repay these mortgages was replaced with the lender’s ability to securitize and repackage them.

  2004: The SEC waived its leverage rules. Previously, broker-dealer net capital rules limited firms to a maximum debt-to-net-capital ratio of 12 to 1. This 2004 exemption allowed them to exceed this leverage rule. Only five firms—Goldman Sachs, Merrill Lynch, Lehman Brothers, Bear Stearns, and Morgan Stanley—were granted this exemption; they promptly leveraged up 20, 30, and even 40 to 1.

  2005-2007: Unscrupulous home appraisers found that they could attract more business by inflating appraisals. Intrinsic value was ignored, so referrals kept coming in. This helped borrowers obtain financing at prices that were increasingly unsupportable. When honest appraisers petitioned both Congress and the bureaucracy to intervene in the widespread fraud, neither branch of government acted.

  There’s actually a lot more we could add to these items. We could mention impotent supervision of Fannie and Freddie by the Office of Federal Housing Enterprise Oversight, the negligent oversight on rating agencies, the Boskin Commission’s monkeying around with how inflation gets measured, the Greenspan put, and so on.

  We could mention former Fed Governor Edward Gramlich, who warned about making home loans to people who could not afford them, and who said the runaway subprime mortgage industry would create problems in housing and the credit markets. But Gramlich was up against a Fed chairman who apparently believed that markets can regulate themselves. (Gramlich died in 2007, three months after the housing bubble started to deflate.)

  We on Wall Street do not deny our part. We created these securities, we rated them triple-A, and we traded them without understanding them. Now that they have gone bad, we are really close to getting the rest of the country to take them off our hands.

  Thanks, D.C. None of this would have been possible without you.

  Very truly yours,

  Wall Street

  Chapter 11

  Ra
dical Deregulation, Nonfeasance

  Those of us who have looked to the self-interest of lending institutions to protect shareholders’ equity, myself included, are in a state of shocked disbelief.

  —Alan Greenspan, Senate testimony, October 22, 2008

  How the United States ended up a Bailout Nation is more than the work of just one man. Sure, Alan Greenspan looms large in this story, and in more ways than one. But it took the creative irresponsibility and misguided philosophy of many players to create the massive debacle that has enveloped the global economy. Presidents, senators, Securities and Exchange Commission (SEC) chairmen, Treasury secretaries, and members of Congress all contributed.

  A brief review of modern U.S. regulatory history shows where the United States made its wrong turn, and the consequences of those errors.

  Following World War II, the world set about righting itself. The Marshall Plan was helping to rebuild Europe; Japan became a cheap source of industrial manufacturing. Millions of GIs returned home to the land of opportunity. Returning veterans had the benefit of the GI Bill, which meant free college or vocational school and low-cost loans to buy homes or start businesses. The nascent growth of suburbia also contributed to economic activity. The U.S. economy was expanding, and it led the rest of the world into a period of rapid growth.

  Along the way, the government’s bureaucracy also began expanding. Twenty years after the war, complying with U.S. regulatory oversight was increasingly complex, time-consuming, and expensive for American businesses. By the late 1960s, the many rules and regulations were a costly part of doing business. It wasn’t too much later when politicians seized on the concept of reducing costly regulations. It soon became a political rallying cry.

  Deregulation found an enthusiastic advocate in President Ronald Reagan. In many ways, Reagan is the intellectual father of the modern radical deregulatory movement. At first, expensive, onerous provisions were targeted. But it wasn’t long before all regulation became viewed as inherently evil. In this worldview, government was the source of problems, not possible solutions. Reagan famously quipped: “The nine most terrifying words in the English language are, ‘I’m from the government and I’m here to help.’ ” Reducing not only regulations, but the entire size of the government became a goal of this ideology.

  Of course, that was before the entire banking system fell apart, and Uncle Sam began writing checks for trillions of dollars. Today, the most terrifying words might be more along the lines of “I run a highly leveraged, unregulated financial institution that owns lots of derivatives.”

  But that was yet to occur. Adherents of a strict free market philosophy wanted to remove the decision-making oversight from the bureaucracy and replace it with the “relentless efficiency” of the markets. This was a hopelessly idealistic view of markets, naively premised on false assumptions of market efficiency and human rationality.

  Eventually, deregulation became an end unto itself, rather than a means to an end. Along with the costly, unnecessary regulations that were targeted for elimination, effective and necessary safeguards were also removed. Pragmatic decision making was replaced with rigid ideology.

  In the ensuing decades, the United States morphed from an overly regulated economy to an absurdly deregulated one. What started as a reasonable pushback against excessive government regulations was soon taken to all sorts of irrational extremes. Any supervision was soon viewed as suspect.

  This was especially true when it came to the regulation of commercial and investment banks. Under President Bill Clinton, several key legislative proposals were passed that reduced oversight and supervision. Key Depression-era legislation was overturned.

  While Clinton was a Southern Democrat who believed in both government and markets, President George W. Bush took this a huge step further. Like his predecessor, he believed in markets; but when it came to government, he was far less enthusiastic. His appointments to key administrative positions—SEC chairman, Treasury secretary, and most infamously the Federal Emergency Management Agency (FEMA)—were lackluster at best.

  Thus, the United States moved from a state of aggressive, post-Depression financial oversight to one of negligent supervision. The potential for disaster increased rapidly. It was this massive philosophical and regulatory shift that set the table for the current financial crisis.

  The first major regulatory changes came about in 1999. That’s when a significant Depression-era banking regulation, the Glass-Steagall Act, was repealed. The Gramm-Leach-Bliley Act reversed the rules that prohibited bank holding companies from owning other financial firms. This allowed insurers, banks, and brokerage firms to merge into giant financial centers. Had it not been for Gramm-Leach-Bliley, Citibank could not have evolved into the unruly beast it became.

  Freed from Glass-Steagall’s strictures, money center banks entered into all manner of underwriting: not just initial public offerings (IPOs) and bond issuance, but structured financial products, including collateralized debt obligations (CDOs) and credit default swaps (CDSs). These derivatives are one of the prime villains in the credit crisis, and grew out of the housing debacle.

  The key factor was size. In the new, deregulated environment, banks and brokers were allowed to scale up to become behemoths. What was big became huge; what was huge became enormous. With so many moving parts, too much leverage, and too much risk taking, banks became too big to be effectively managed. In bailout terms, they were too big to fail, but in actual operation they were too big to succeed. They had become so massive that managing all the moving parts—and controlling for risk—was all but impossible. Once conservative, risk-averse banks had become giant unregulated hedge funds, disaster was all but inevitable.

  More importantly, banks started adopting the “eat what you kill” compensation systems. The bonus structure, replete with short-term financial incentives, began to dominate banks. Throw in monthly performance fees and annual stock option incentives, and you end up with a skewed business model suddenly embracing quicker trading profits.

  This had an enormous impact upon the ways investment banks approached business generation and risk management. Like many public companies, they became increasingly short-term focused. “Making the quarter,” in Street parlance, meant pulling out all the stops to hit your quarterly profit figures, by any means necessary. Incentives became misaligned with shareholders’ interests, as risky short-term performance was rewarded with huge bonuses. Not surprisingly, this worked to the detriment of long-term sustainability.

  But short-termism was only part of the equation. Of greater concern was how these firms’ internal risk management changed. Unlike in public corporations, partners are personally liable for the acts of any of the members of the partnership. If any one of a firm’s partners or employees loses a trillion dollars, every last partner is on the hook for that money. As you would imagine, this creates enormous incentives to make sure that risk is managed very, very carefully. Nothing focuses the mind like the real possibility that any partner could bankrupt all the rest. It’s no coincidence that partnerships like Lazard Freres and Kohlberg Kravis Roberts did not suffer the same kind of risk management failures as Bear Stearns and Lehman Brothers, among others. (Lazard went public in 2005, but too late in the credit cycle for it to get into much trouble.)

  Depository banks are supposed to be managed in ways that limit risk. They hold the public’s deposit accounts (such as checking and savings accounts), which they then use to provide credit to businesses and individuals. The Federal Deposit Insurance Corporation (FDIC) insures all of these deposits against loss, and insists (quite reasonably, I might add) the monies not be handled recklessly. In contrast, investment banks by definition embrace risk; their business model focuses on more speculative activities that are inherently riskier. Activities such as trading and mergers, bringing companies public, and managing investments involve a greater possibility, even likelihood, of losses.

  The repeal of Glass-Steagall didn’t cause the crisis—it on
ly made the collapse worse, deeper, and more expensive. The skyrocketing costs of the bailouts are in part due to disasters in the riskier investment banking sector spilling over into the risk-averse commercial (depository) banking sector. Glass-Steagall was adopted in 1933 expressly to prevent this from occurring. Repealing the act allowed the commercial banks to operate investment bank units. Both ends of the risk spectrum ended up festooned with all manner of junk paper. If Glass-Steagall were still in effect, the banks would have had little incentive to buy the junk from the brokers.

  It also meant financial carnage at investment banks was no longer quarantined from commercial banks. Hence, the ugly financial impact at Citibank and others can be traced directly to the Gramm-Leach-Bliley act. The repeal of Glass-Stengall could very well end up being the single most costly legislative repeal in the nation’s history.

  Gramm-Leach-Bliley may not have been the proximate cause of the disaster, but it is precisely why the overall problem was not “contained.”

  The rapidly growing trade in derivatives poses a “mega-catastrophic risk.” . . . [F ] or the economy, derivatives are financial weapons of mass destruction that could harm not only their buyers and sellers, but the whole economic system.

  —Warren Buffett, Berkshire Hathaway 2002 Annual Report

  Allowing banks and brokers to merge was only one factor that led to the credit crisis. After repealing Glass-Steagall, the following year Congress passed the Commodity Futures Modernization Act of 2000 (CFMA). This legislation allowed derivatives such as credit default swaps (CDSs) to become an enormous, unregulated shadow insurance industry. Many of the horrific losses suffered by AIG, Lehman Brothers, and Bear Stearns trace their paternity to this act.