Bailout Nation

by Barry Ritholtz

  At Treasury, Rubin strongly supported the Commodity Futures Modernization Act. He actively opposed the concerns of Brooksley Born, then head of the Commodity Futures Trading Commission. In 1997, Born was raising alarms to Congress about unregulated trading in derivatives, such as credit default swaps (CDSs) .7 Unregulated derivatives could “threaten our regulated markets or, indeed, our economy without any Federal agency knowing about it,” she testified. Born called for a variety of fixes—now being enacted after the horse is out of the barn—including greater transparency, disclosure of trades through a central clearing firm, and required reserves against losses. Born was shouted down by the likes of Greenspan, Rubin, and Summers.

  President Clinton oversaw the passage of utterly ruinous legislation. He signed both the damaging Gramm-Leach-Bliley Act repealing Glass-Steagall and the odious Commodity Futures Modernization Act exempting derivatives from regulation. They may each have been sponsored by Senator Gramm, but they were both signed into law by President Clinton. He does not deserve the free pass for his misguided actions.

  But it was George W. Bush’s appointments who chanted the “laissez-faire, free markets reign supreme” mantra the loudest. The SEC chairs he appointed were terrible, and many of his other appointments—Office of Thrift Supervision, Federal Reserve, Treasury secretary, and other key regulatory roles—were similarly ill-advised.

  Question: What do you get when a president who doesn’t believe in government appoints those who share this philosophy to key regulatory and supervisory roles?

  Answer: Neither regulation nor supervision.

  Missed opportunities seem to be a hallmark of the Bush presidency: As the various crises unfolded, there were key choke points where the damage could have been contained. None were acted upon until after the crisis had fully flowered.

  When appraisers petitioned the White House in 2001, complaining of inflated home appraisals filed by corrupt home inspectors, they were rebuffed. When state banking regulators recognized signs of lending fraud early on, their attempts to curtail it were prevented by Bush. The White House asserted that it was the federal agencies—and not the states—that had jurisdiction over federally chartered banks. That’s a fine argument to make, until those federal agencies recognized lending problems and began proposing rules to curtail them on their own. They, too, were rebuffed by the White House—not state agencies, but the federal agencies the White House claimed had exclusive jurisdiction.

  The Associated Press (AP) summed up why the very government regulators assigned to prevent abuse failed so miserably to do so: “The administration’s blind eye to the impending crisis is emblematic of its governing philosophy, which trusted market forces and discounted the value of government intervention in the economy. Its belief ironically has ushered in the most massive government intervention since the 1930s.”8

  Let’s get specific as to the sort of warnings the White House ignored: Bank regulators had proposed new guidelines for writing risky loans in 2005. These were basic administrative rules; had they been enacted, the worst of the housing and credit crisis might have been avoided. The Bush administration backed away from proposed crackdowns on the subprime, no-money down, interest-only mortgages that were critical contributors to the credit and housing crisis.

  According to the AP, pressure from banks (many of which have since failed) was the prime reason:

  Bowing to aggressive lobbying—along with assurances from banks that the troubled mortgages were OK—regulators delayed action for nearly one year. By the time new rules were released late in 2006, the toughest of the proposed provisions were gone and the meltdown was under way. “These mortgages have been considered more safe and sound for portfolio lenders than many fixed-rate mortgages,” David Schneider, home loan president of Washington Mutual, told federal regulators in early 2006. Two years later, WaMu became the largest bank failure in U.S. history.9

  The list of banks that lobbied most aggressively against the proposed rules reads like a who’s who of bankruptcy and FDIC conservatorship, including IndyMac, Countrywide Financial, Washington Mutual, Lehman Brothers, and Downey Savings.

  What was so damning was that these proposals were all stripped from the final administrative rules by the Bush White House. None required congressional approval; they did not even require the president’s signature. The proposals that were removed from the administrative rules were:• Banks would have to increase efforts to verify that home buyers actually held jobs.

  • Lenders would have to assess whether the borrower could afford the house.

  • Regulators would inform bankers that exotic mortgages were often inappropriate for buyers with bad credit.

  • Banks that purchased mortgages from brokers also would need to verify that buyers could afford their homes.

  • Regulators proposed a cap on risky mortgages so a string of defaults wouldn’t be crippling.

  • Banks that bundled and sold mortgages would be told to be sure investors knew exactly what they were buying.

  • Regulators urged banks to help buyers make responsible decisions and clearly advise them that interest rates might rise.

  • Big increases in payments would need to be clearly disclosed, including how much more a loan would cost once it reset.

  The administration also ignored remarkably prescient warnings that foretold the financial meltdown, according to an AP review of regulatory documents.

  Similarly, the Office of the Comptroller of the Currency (OCC) “played a key role in the mortgage meltdown, both by actively blocking state consumer protection laws through the expansion of federal preemption, and by simultaneously failing to adequately monitor the nationally-chartered lending institutions under its purview,” as Eric Stein, senior vice president of the Center for Responsible Lending, testified in October 2008 at a Senate hearing entitled “Turmoil in the U.S. Credit Markets: The Genesis of the Current Economic Crisis.”10

  The OCC bowed to pressure from National City and its subprime lending subsidiary First Franklin Financial in preempting “comprehensive mortgage reform legislation” passed by the state of Georgia, Stein testified.11 There are other examples of the OCC thwarting legislation that could have prevented some of the most irresponsible bank loans, including predatory lending.

  Despite his professed belief in free markets over government intervention, George W. Bush ended up overseeing the greatest nationalization of private industry the United States has ever had. The irony of the Bush administration’s bailout fever was captured by Allan Mendelowitz, who observed: “The Bush administration, which took office as social conservatives, is now leaving as conservative socialists.”12

  Over the course of two terms, Bush appointed three misfit SEC chairmen, each ill-suited for the position. They formed a veritable parade of poor regulators, none right for the agency’s role of being the investors’ advocate.

  Bush’s first SEC appointment, Harvey Pitt, was a securities industry defense attorney. To say he was wholly unsuited to the position is to understate the case. Instead of representing the interests of investors, Pitt was a well-known industry lapdog. Pitt pledged a “kinder and gentler” SEC in the midst of a huge run of corporate misfeasance. He was the precise opposite of what was needed.

  Even worse, in an era of corporate accounting scandals, Pitt had close ties with the accounting industry. As a Wall Street lawyer, Pitt had “recommended that clients destroy sensitive documents before they could be used against them—advice that seemed to find echoes in the SEC’s investigations into Enron and its shredder-happy auditor, Arthur Andersen.”13 Pitt had to recuse himself from many of the SEC’s votes, as they were frequently about the clients he had represented as a defense attorney. For inexplicable reasons, during active SEC investigations, Pitt would meet with the heads of companies under review.14

  It should come as no surprise that Pitt’s chairmanship demoralized the agency. To investor advocacy groups, having Pitt as SEC chief was “like naming Osama bin Laden
to run the Office of Homeland Security.”15

  By July 2002, Senator John McCain was calling for Pitt’s resignation. 16 Pitt resigned following a series of scandals.

  The next SEC chairman Bush appointed was William Donaldson, the former chairman of the New York Stock Exchange (NYSE). He was also the “D” in DLJ (Donaldson, Lufkin & Jenrette), which eventually was acquired by Credit Suisse.

  Donaldson was called upon to lend some gravitas to the SEC after Pitt’s resignation. Given the former NYSE chairman’s close ties to big Wall Street firms, we shouldn’t be surprised at what came next. During Donaldson’s watch, the net capital rule for the five biggest investment banks was exempted in 2004. Instead of being limited to 12 to 1 leverage, banks were allowed to lever up 30, 35, and even 40 to 1 after the waiver. It isn’t glib to say the financial meltdown was three times as bad as it might have been but for Donaldson’s SEC granting this waiver.

  Then there is Christopher Cox, the third Bush SEC chair. He shared Greenspan’s and Gramm’s hostility to regulations. “Cox’s long-standing support of a deregulated market and friendliness to business made him the wrong SEC chairman at the wrong time.”17

  In July 2007, Cox eliminated the so-called uptick rule, removing a modest restraint on shorting just as the credit crunch was getting started. The market peaked a few months later. When it began heading south, there was no uptick rule in place to prevent indiscriminate short selling and piling on. Even if only for psychological reasons, removing the uptick rule, which was put in place in the aftermath of the 1929 crash, turned out to be not very smart.

  Then in September 2008, with the crisis in full flower, Cox made shorting financial stocks illegal. Apparently, he was unaware that fierce market sell-offs often end with short sellers covering their positions, locking in profits on their bearish bets. With short sellers out of the market, the downturn became even fiercer. From the market highs of October 2007, the S&P 500 and the Dow Jones Industrial Average were cut in half in 12 months. Much of the damage came after the no-shorting rule went into effect.

  As the GOP presidential candidate in 2008, Senator John McCain called for Cox’s resignation.

  And as this book went to press, the latest SEC black eye was reaching a milestone: Bernie Madoff had finally been sent to prison after pleading guilty to stealing as much as $50 billion in investor assets in a giant Ponzi scheme. Madoff had “made off” with his clients’ monies for several years, despite many warnings to the SEC.

  Numerous people, including hedge fund manager Doug Kass and options strategist Harry Markopolos, had warned years before that the ability to provide such unusually smooth returns with so little volatility was more likely the result of fraud than investing acumen.18

  Markopolos, particularly, made unveiling Madoff ’s fraud his passion. He sent numerous anonymous letters to the SEC and met with officials of the SEC’s Boston office in 2001 to lay out his concerns, the Wall Street Journal reported. Around the same time, “Barron’s and hedge-fund trade publication MarHedge suggested Madoff was front running for favored clients.”19

  Despite frequent tips, which led to at least eight examinations of Madoff ’s firm in 16 years by the SEC and other regulators, the fraud was discovered only after Madoff, faced with redemptions, confessed that the firm was nearly bankrupt.

  Testifying before Congress on February 4, 2009, Markopolos blistered the SEC and other financial regulators for their “abject failure” to stop Madoff, “even when a multi-billion-dollar case [was] handed to them on a silver platter.”20

  Soon after Madoff ’s confession, the SEC was rocked by yet another major scandal surrounding Stanford Financial Group, whose namesake founder, Sir Allen Stanford, stands accused of overseeing an $8 billion fraud. As of March 2009, Stanford has refused to cooperate in the government’s investigation of what the SEC alleges is fraud “of a shocking magnitude.”21

  What isn’t shocking to anyone is that the SEC missed it for years.

  Next up in our cavalcade of criticism: the mortgage brokers and originators. What did federal bank regulators have to say about this paradigm shift? Very little, even though the FBI warned of an “epidemic” of mortgage fraud in 2004.22

  The lightly regulated industry was filled with aggressive salespeople who ruthlessly found ways to generate the highest commissions. The mortgage originations that were likely to have the highest vig were the 2/28 adjustable-rate mortgages (ARMs)—loans with cheap teaser rates that lasted for two years and then reset to a much higher, market-based rate for the rest of the 30-year term. These now-notorious loans allowed brokers to sell the highest dollar loan possible for the lowest monthly payment to the least qualified borrowers.

  Much of the mortgage industry embraced these irresponsible, high-default products. All the parties involved knew the high likelihood of foreclosures, as detailed in Chapter 10. They abdicated traditional lending standards because the defaults would take place after the mortgages were off their hands. Indeed, these companies happily played dumb, so long as the loan didn’t default within 90 days. By month four, it was someone else’s headache, as far as the originator was concerned. Now it has become everyone’s worry.

  That hundreds of these firms have gone bankrupt is cold comfort to the rest of us.

  Regardless of how low rates got, the fact remains that many borrowers took out mortgages regardless of their own ability to repay the monthly principle and interest. This was simply reckless behavior, and should be recognized as such. Innumeracy is no excuse.

  Ultimately, banks have a fiduciary responsibility to their shareholders and depositors to lend money only to qualified borrowers. Hence, they have a greater liability in the lending crisis. This is especially true of the “lend to securitize” originators who knew they would be causing future foreclosures.

  However, the lenders’ irresponsible behavior does not exonerate those people who failed to do basic math. It is incumbent upon borrowers to know what they can afford each month—and to not get themselves into financial trouble. Perhaps it’s time to teach basic financial literacy in public schools.

  Then there are the flippers, the speculators, the Donald Trump wannabes who got caught when the market turned. Those of you who are defaulting on your mortgages: congratulations—you have achieved your dreams! You are now just like the Donald: In late 2008, Trump reneged on a $40 million debt to Deutsche Bank for a commercial property development.23

  The many real estate speculators who got caught without a chair when the music stopped must accept their fair share of the blame. (Surprisingly, Mr. Trump remains blameless for the current mess.)

  Other than CFMA and repeal of Glass-Steagall, I will not point to any single vote of the legislative body; those are political choices, which it is not my purview to second-guess. Instead, I want to specify two relatively new ways Congress carries out the people’s business that are utterly reprehensible.

  The first is the abhorrent practice of passing legislation sight unseen. This is simply beyond the comprehension of any rational person. It makes a mockery of the idea of a representative government elected by the people. Is there any meaningful difference between a dictatorship and an elected body that votes on legislation it has not so much as read?

  It wasn’t just the Commodity Futures Modernization Act that passed unread. The Patriot Act, the Digital Millennium Copyright Act, the TARP, and other legislation have been voted on essentially unread. If proposed laws are going to be passed without so much as a single reading, then we might as well elect a Congress of illiterates; perhaps we already have. How could we tell the difference?

  The second form of Congressional idiocy that has come into vogue is the “nonvote” vote. Rather than actually vote for a specific act, Congress grants authority to a third person to exercise judgment on behalf of Congress. The president and Treasury secretary have each received authority they claimed they wouldn’t need or use. “If you’ve got a bazooka, and people know you’ve got it, you may not have to take
it out,” Paulson famously said in July 2008, explaining the rationale for giving him the power to nationalize Fannie and Freddie.24

  One cannot tell whether it is sheer foolishness or cowardice that leads to this absurdity, but consider these nonvote votes that have occurred so far this decade:• The Iraq war authorization

  • The Fannie Mae recapitalization

  • The Troubled Assets Relief Program

  Such cowardice. Rather than actually confront the issue head-on, we get this foolish subterfuge. Anytime an administration obtains congressional authority to do something (go to war, spend money on bailouts), it is identical to actually authorizing the act—meaning yes, this is now guaranteed to eventually occur. Claiming you are merely granting authority only reveals your cowardice in not voting yea or nay on the act in the first place. The enabling vote may make the act more politically palatable, but it is obviously an attempt to hide it from the public. Don’t ever kid yourself—it is no different than the actual act itself.

  One understands how Mark Twain came to remark, “Suppose you were an idiot. And suppose you were a member of Congress. But I repeat myself.”

  Structured financial products, from residential mortgage-backed securities (RMBSs) to collateralized debt obligations (CDOs), lay at the heart of the global credit and financial meltdown. The process of creating, rating, and selling this paper is complex. As we have learned after the fact, the rating agencies were not (as they claim) passive participants who just happened to underestimate the likelihood of future defaults. Rather, when they placed precious triple-A ratings on all sorts of mortgage-backed and related securities, they were active participants—collaborators, according to the Wall Street Journal.25