The subprime paper that eventually collapsed found its way onto the balance sheets of many banks, funds, and other firms. Had “the securities initially received the risky ratings” they deserved (and many now carry), the various pension funds, trusts, and mutual funds that now own them “would have been barred by their own rules from buying them.”26
Nobel laureate Joseph Stiglitz, economics professor at Columbia University, observed:
I view the ratings agencies as one of the key culprits. They were the party that performed that alchemy that converted the securities from F-rated to A-rated. The banks could not have done what they did without the complicity of the ratings agencies. 27
In 2008, the House Oversight Committee opened a probe into the role of the bond-rating agencies in the credit crisis, and Congress held a hearing on the subject, featuring a now-infamous instant message exchange: “We rate every deal,” one Standard & Poor’s analyst told another who dared to question the validity of the ratings process. “It could be structured by cows and we would rate it.”28
When they are not rating bovine structured products, the rating agencies can be found belatedly downgrading junk paper into bankruptcy. In March 2009, Moody’s Investors Service came out with a new ratings list: The Bottom Rung.
“Moody’s estimates about 45% of the Bottom Rung companies will default in the next year,” the Wall Street Journal reported.29 Perhaps the cliché about analysts is better applied to rating agencies: You don’t need them in a bull market, and you don’t want them in a bear market.
While it was the investment banks that sold the junk paper, it was the rating agencies that tarted up the bonds. It was the equivalent of putting lipstick on a pig: This paper could never have danced its way onto the laps of so many drooling buyers without the rating agencies’ imprimatur of triple-A respectability.
Yet considering the massive damage they are directly responsible for, the rating agencies have all escaped relatively unscathed. Given their key role in the crisis—were they corrupt or incompetent or both?—one might have thought an Arthur Andersen-like demise was a distinct possibility. Warren Buffett should consider himself lucky—he is the biggest shareholder of Moody’s, and is fortunate the scandal hasn’t tarnished his reputation.
O f course, none of this would really have mattered if a few hedge funds and a much larger number of institutional investors—including foreign central banks—didn’t suck up so much of this suspect paper (China evidently bought $10 billion in subprime mortgages). Through the indiscriminate use of leverage and by failing to know what they owned, the purchasers of the triple-A-rated junk paper must also shoulder some of the blame.
How did so much of the investment world manage to overlook these issues? Didn’t anyone do any due diligence? Or was it simply a case of the casinos keeping the securitization process rolling? I’ve had conversations with CDO originators and insiders, as well as money managers, who unabashedly claimed: “We knew we were buying time bombs.”
So we can rule out sheer ignorance. Rather, it appears that as long as deal fees could be generated, Wall Street kept the CDO factories running 24/7.
Talk about your misplaced compensation incentives. This is precisely the kind of self-destruction that Alan Greenspan believed was impossible in a free market system. The flaw he misunderstood was simply this: It wasn’t that the free market would prevent it from occurring; it was that relentless competitive forces would drive such firms out of business. That is what began to happen in 2008. The free market actually worked as it should—firms that managed risk poorly were demolished by market forces. The trouble was, none of the erstwhile free market advocates had the stomach to live through the creative destruction Mr. Market was serving.
That is the risk that excessive deregulation brings: We can eliminate regulations that might prevent systemic risk. However, the free market advocates whine when the market doesn’t do their bidding. Bad choices by management led to failure. That failure brought on a global recession, bankrupted over 300 U.S. mortgage companies, and turned many of the biggest banks and investment firms into tapioca.
The firms that allowed excessive risk taking and leverage found themselves on the wrong side of the corporate version of Darwin’s laws—which was precisely where they belonged.
S everal of the states with the biggest foreclosure problem today had an opportunity to confront the problem when it was much smaller. These are the states that now lead the nation in foreclosures. Their regulatory agencies had long lists of complaints brought to their attention. None acted upon them.
A 2008 exposé by the Miami Herald revealed that Florida allowed thousands of ex-cons, many with criminal records for fraud, to work unlicensed as loan originators. More than half the people who wrote mortgages in Florida during that period were not subject to any criminal background check. Despite repeated pleas from industry leaders to screen them, Florida regulators refused.30
And in California, attempts to regulate the many subprime mortgage lenders working in the state were beaten back, primarily by Democratic lawmakers who were protecting the then fast-growing industry.
Today, California and Florida are the nation’s leading foreclosure factories.
Then there is Arizona. When Internet real estate service Zillow began publishing online housing price estimates in the state, it received a cease and desist order from the Arizona Board of Appraisal. Zillow’s site makes it clear that its data are merely estimates and not actual appraisals. Regardless, misguided Arizona pols did not want some online firm horning in on their local business. It is no wonder Arizona is ranked fourth in the nation in terms of defaults and foreclosures listed by RealtyTrac.31
The misguided deification of markets is the primary factor that led us to being a Bailout Nation. Markets can and do get it wrong—not by just a little, either; occasionally they can be wildly wrong.
Recall those two Bear Stearns hedge funds that blew up in June 2007. The S&P 500 stumbled in August 2007 at that early sign of a brewing credit crisis. But in the market’s infinite wisdom, it determined that credit wasn’t such a significant problem after all. The S&P 500 and Dow Jones Industrial Average proceeded to set all-time highs a few months later, peaking in October 2007. That they got cut in half over the next year makes one wonder why anyone would call the stock market prescient.
This was not the only time Mr. Market has managed to get things precisely wrong. There are far too many examples to enumerate here.
In the final analysis, allowing markets to set policy is inherently anti-democratic. Free people are entitled to elect a representative government, which then enacts legislation on their behalf. Those elected representatives go to Washington, D.C., to do the people’s will. If it is the people’s will to prevent testosterone-addled traders from saddling the taxpayers with trillions in losses, that is their choice.
Americans have long recognized the advantages of economic freedom. We want the markets to be relatively free to operate. However, we do not want to allow the worst of human behaviors to have free rein. Complaints about regulating markets are actually objections to proscribing the worst behaviors of the people who operate in those markets. We want markets to operate intelligently, but not run roughshod over us. Blame the radical free-market extremists who insist on replacing representative government with the so-called wisdom of markets. This has proven to be misguided.
What the actual result of market-based decision making does is to eliminate those pesky human voters from exercising their will through a representative government. Ultimately, the free-market zealots are not only antiregulation, they are antidemocracy and antirepresentative government. Taken to illogical extremes, they would create a market-based dictatorship.
One part bad philosophy, one part mob rule. That pretty much sums up the financial markets, circa 2008-2009.
Chapter 20
Misplaced Fault
Ignorance more frequently begets confidence than does knowledge.
—Ch
arles Darwin
O ne of the oddest things to come out of the 2008 U.S. presidential campaign was a series of accusations seeking to throw off blame for the current economic crisis. It wasn’t radical deregulation, the Federal Reserve, or so-called ninja loans that were at fault, politicos claimed. Instead, they shifted blame to decades-old government policy.
Some of the arguments had merit—at least as policy criticisms. However, none of them made the leap to correctly identifying the proximate causes of the present crisis. Here we’ll look at the targets of five such arguments: the mortgage interest deduction, naked shorting, the Community Reinvestment Act (CRA), securitization, and last, Fannie Mae and Freddie Mac.
Mortgage Interest Deduction
The Sixteenth Amendment to the U.S. Constitution was made in 1913, effectively reinstating an overturned 1894 tax law and making income tax legal. Ever since, all forms of interest—including mortgage interest—have been deductible.
Indeed, the tax code provides a fairly generous benefit for being a mortgage-paying homeowner: The full interest deduction reduces your taxable income. Hence, if a renter and a homeowner are making similar monthly payments, the renter’s after-tax costs are as much as 35 percent higher.1
Several commentators have criticized this, and some, such as Harvard economics professor Edward L. Glaeser, claim it to be a major factor in the housing collapse.2 Glaeser recently wrote:
Subsidizing interest payments encourages people to leverage themselves to the hilt to bet on housing markets. The size of the tax benefit is proportional to your debt. The deduction essentially encourages us to make leveraged bets on the swings of the housing market. That leverage means that housing price swings can easily wipe people out. We are currently experiencing the consequences of subsidizing gambles on housing.3
While the professor’s basic premise is intriguing, his conclusions are suspect. Yes, we do encourage people to become homeowners by subsidizing interest payments. But is it worth it? Do we get the maximum benefit out of this subsidy? That is a worthy discussion for another time.
But the leverage side of the argument remains dubious. It was only recently that so many home buyers engaged in reckless, highly leveraged purchases. Since the interest deduction came into effect a century ago, most homeowners have used it responsibly.
It is a huge leap to get from that history to placing blame on the interest deduction as the root cause of the current maelstrom. When something has existed for almost 100 years without incident, we are better served looking for more recent, intervening factors that are probable causes. For housing, ultralow rates and the abdication of lending standards were those factors.
Naked Shorting
A recurrent theme in 2008 was the role of naked shorting in the fall of Bear Stearns, Lehman Brothers, and others. This is yet another case of misplaced blame.
To legitimately short a stock, one must first borrow the shares, then sell them. Upon covering the short (“buying in the shares”), the borrowed stock can be returned. Naked shorting is where this borrowing never takes place.
“Going naked” has been a dirty secret among Wall Street firms for years, and for good reason: It is very profitable. Not only does a commission get transacted that might otherwise not, but there is an even juicier vig on the trade. Whenever a short sale is made, the transaction takes place in a margin account. The broker-dealer gets to charge an annual margin fee of 9 percent or more.
There is a delicious irony to bank CEOs complaining about naked shorting destroying their firms when they had spent decades profiting from it.
While it may be an illegal and abusive practice, it had little to do with the fall of Bear or Lehman. These firms had by their own volition leapt off the roof of the Empire State Building; naked shorts were the people who threw stones at the bodies as they fell. More likely causes of death were the excess leverage, the undercapitalization, the lack of risk controls, the bad mortgage-related investments, oh, and a general insolvency—not naked short selling.
Back when my firm initiated a short in Lehman Brothers in June 2008, the stock was over $30. It was an easy borrow. There was no need to short naked; we simply called the stock loan desk and got an authorization number. My biggest regret about Lehman Brothers—aside from all the unfortunate souls who lost their jobs when the company imploded—was that I didn’t think of buying put options, an even bigger, more leveraged bet against the company.
And no, option trading didn’t kill the company, either.
Community Reinvestment Act (CRA)
Let me ask you, where in the CRA does it say to make loans to people who can’t afford to repay? Nowhere.
—FDIC Chairman Sheila Bair4
As housing and credit collapsed into the heart of the 2008 presidential campaign, a mad dash began. Politicos sought to duck responsibility for what occurred, with each side trying to lay the blame at the feet of the opposing party. Of all the flailing criticism and finger-pointing after the collapse, blaming the Community Reinvestment Act (CRA) was probably the oddest:
On the Republican side of Congress, in the right-wing financial media (which is to say the financial media), and in certain parts of the op-ed-o-sphere, there’s a consensus emerging that the whole mess should be laid at the feet of Fannie Mae and Freddie Mac, the failed mortgage giants, and the Community Reinvestment Act, a law passed during the Carter administration. The CRA, which was amended in the 1990s and this decade, requires banks—which had a long, distinguished history of not making loans to minorities—to make more efforts to do so.5
The purpose of the CRA was to encourage banks to lend money back to their own business customers and depositors. The CRA followed other legislation such as the Fair Housing Act of 1968, the Equal Credit Opportunity Act of 1974, and the Home Mortgage Disclosure Act of 1975. CRA compliance is part of the standard bank review by regulators—Federal Reserve, Federal Deposit Insurance Corporation (FDIC), and Office of the Comptroller of the Currency (OCC)—and includes a very soft rating system, not a hard quota. This modest legislation was designed to help overcome redlining. That was an illegal bank practice of literally encircling a neighborhood on a map with a red marker and not making any loans to residents within that red line, regardless of income or creditworthiness.
The CRA told banks that if they opened branches in Harlem, they could not suck up all the local businesses’ and residents’ cash deposits, then turn around and lend the funds only to Tribeca condo buyers. Banks were under no obligation to open Harlem branches, but if they did, they were required to at least try to lend the locals back some of their own money. There were no quotas, minimums, or mandates—just a good-faith attempt to make loans.
Those who insist the CRA was to blame for the current crisis have a hard time explaining some obvious logical flaws.
Why was there no credit or housing meltdown from 1977 to 2005? Why did dozens of other countries, from the United Kingdom to much of Europe to New Zealand and Australia—none of which are covered by American laws such as the CRA—have a remarkably similar housing boom and bust to the U.S. one? The pundits fail to address these questions. It’s as if this legislation somehow manages to transcend both time and space.
It’s even more dramatic when you see where the foreclosure crisis is concentrated in the United States. California leads the nation in defaults, delinquencies, and foreclosures, followed by southern Florida, Arizona, and the Las Vegas area. As of December 2008, year over year, California’s foreclosure activity was up 51 percent. The foreclosures are concentrated primarily in bedroom communities in the suburbs of cities like San Diego and Los Angeles. These are not, as you would imagine, CRA regions.
Florida is in some ways worse: At the end of 2008, its foreclosure activity was up 68 percent from the year before. Blame the enormous overbuilding of condos for the real estate debacle. As Dan Gross pointed out in Newsweek, these weren’t inner-city loans to minorities; they were the products of, for example, “WCI Communities, builder of highly a
menitized condos in Florida (no subprime purchasers welcome there).... Very few of the tens of thousands of now-surplus condominiums in Miami were conceived to be marketed to subprime borrowers, or minorities—unless you count rich Venezuelans and Colombians as minorities.”6
Oh, and WCI Communities filed for bankruptcy in August 2008.
There are additional errors with the “blame CRA” argument. The CRA applies to depository banks. But the financial institutions that made a headlong dive into the subprime market weren’t regulated banks; they were the innovative new mortgage originators. Companies like Argent and American Home Mortgage and their ilk were not required to comply with the CRA. And these firms worked closely with Bear Stearns and Lehman Brothers to securitize their subprime mortgages. Neither Bear nor Lehman was covered by the auspices of the CRA.7
Of course the CRA did not force mortgage companies to offer loans to people with bad credit or whose incomes would not support the payments. And the no-money-down, no-income-check features were also innovations independent of the CRA. Throwing underwriting standards out the window was the creation of the mortgage originators alone. And as far as I can tell, nothing in the CRA forced the credit rating agencies to slap AAA high-grade ratings on subprime debt that went into default in record numbers.8
Numerous studies have found the CRA blameless in the current mess. Fed Governor Randall S. Kroszner9 and Federal Deposit Insurance Corporation Chair Sheila Bair10 each, in unrelated speeches, drew the same conclusion.
Since the Bear Stearns collapse in March 2008, there has been a veritable parade of bankers, mortgage originators, lenders, fund managers, and investment bank CEOs all testifying before Congress. Curiously, not one blamed the CRA:
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