by David Dreman
The bonds were then rated by a credit-rating agency such as Moody’s, Standard & Poor’s, or Fitch. Normally they were given a credit rating that was, as we’ll see, far too high for the quality of the mortgage pool rated. The higher the ratings the banks could get from the rating agencies, the more salable the mortgages were. Nobody cared to look under the hood to see what the collateral really was. It was just merchandise that had to go quickly. And it did, by the hundreds of billions of dollars.
If you’ve got the stomach, we’ll quickly look under the hood. What we see is a variety of products, almost all guaranteed to be major losers for buyers. Let’s take a quick peek into a mortgage broker’s or originator’s office. He has all kinds of goodies to offer the mortgagees to get their business.
“Over here we have the Ninjas, and they’re going fast,” he might say. “What is a Ninja?” somebody asks. “Well, actually, it’s an acronym the sales folk use for this class of mortgage. It stands for mortgages where the buyer has no income, no job, and no assets. But don’t worry, the housing market is sizzling and prices will go higher, so you are well protected,” the mortgage broker might answer.
“Over there,” another salesman might continue, “we’re having a special on negative amortization mortgages. Ninja buyers really like this product.” What’s that in English? Again, simple! The buyer doesn’t have to pay any interest on the mortgages for two or three years and gets to move into the home of his choice immediately. At the end of three years he owes about 140 percent of the original price because of the high interest charged, but no banks or mortgage bankers care. They unload the mortgages like hot potatoes to their institutional buyers. It all goes down as profit to them and means big commissions today for some, multimillion-dollar bonuses at year-end for others.
Who’s going to lend $200,000 to a Ninja buyer who will have to repay about $280,000 in three years and doesn’t have a dime? In retrospect, the answer is once again simple—we did, as taxpayers paying off the bank bailout.
Next we come to the largest section of the subprime salesroom, featuring the adjustable-rate mortgage, or ARM. Normally customers were lured in with a low teaser rate as bait. Two very popular adjustable-rate mortgages were the 2-28 and the 3-27. The 2-28 gave the mortgagee a low fixed rate of 2 percent for two years and an 11 or 12 percent rate for the next twenty-eight. The 3-27 gave the buyer a 3 percent rate for three years and a 10 to 12 percent rate for the next twenty-seven. Adjustable-rate mortgages were very popular, accounting for 80 percent of all subprime originations in 2005, or more than 1.7 million mortgages, and 70 percent of originations through the entire 2000–2007 boom.18
Chairman Greenspan gave subprimes the Fed seal of approval, stating that they were often cheaper than fixed-rate mortgages. Because a conventional fixed-rate mortgage has much lower indirect and hidden charges than a subprime mortgage and the cost to maturity might be 6 percent rather than 10 percent or higher for a subprime mortgage, I don’t quite catch his math.
Again, we are just skimming the surface of the subprime and Alt-A universe, but I hope you now have an idea now of what was under the hood. Many of the buyers of subprime loans were decent people. They were taken in by glib salesmen who often specialized in minorities, elderly people, and those who simply could not understand the lengthy and complex mortgage documents they signed. The FBI and local authorities, as well as the courts, have processed thousands of cases from such victims. Angelo Mozilo, the well-coiffed, Brioni-suited, perpetually tanned former CEO of Countrywide Financial and the largest subprime lender, settled with the SEC for $67.5 million for fraud in October 2010.19
Sure, there were speculators and hucksters among those taking out these mortgagees, but if someone has a chance to make big returns with little down in a rising market, doing so isn’t much different from using cheap margin to buy stocks. And the sellers, if they so chose, had highly sophisticated methods to check buyers’ credit and ability to meet payments of both interest and the principal when due—but that was rarely done. From the beginning the subprime industry was fatally flawed. Many people could not even afford the initial “teaser” rates of 2 percent or 3 percent, let alone the quadruple or quintuple rates after twenty-four or thirty-six months. The concept was doomed to fail, and it did.
Where Were the Fed and the Regulators?
It is disturbing that one individual can exert the influence that Alan Greenspan did during his twenty years at the helm.
The Oracle left us with a remarkable record during his tenure as chairman of the Fed. Two of the most serious financial crashes in U.S. history, in 1987 and 2000–2002, took place while he headed the Federal Reserve.*88 He was also at the helm and played a major role in the real estate bubble from 2002 to 2006, stepping down not long before the largest crash since 1929 and the worst financial crisis in Western history. No other chairman in Fed history has had more than one market debacle during his tenure. The great majority have had none.
Why didn’t the Oracle or Ben Bernanke, his successor at the Fed, and other senior Fed officers see the mortgage problems that the national and local press wrote about repeatedly, starting in 2006? Why did they not realize there was a problem until months after the housing market had already turned down?
Nobel laureate Paul Krugman and Pulitzer Prize winner Gretchen Morgenson repeatedly detailed various aspects of the subprime problem dating back to 2006. Possibly Greenspan found The New York Times too liberal for him; after all, he is a professed libertarian. But the issues were also covered in The Wall Street Journal, and state governments around the country were taking steps to ban some of the worst practices of the mortgage originators. Greenspan admitted back in the fall of 2007 that he did not see the subprime crisis coming, more than ten months after it began.20 Skimpy regulation practices appear to have been encouraged by the Federal Reserve. And even when Greenspan finally saw the crisis was about to hit, the Fed took no measures to halt some of the most blatant lending practices. In fact, around that time, it took steps to block North Carolina and other states from taking action against federally chartered banks using poor mortgage practices.
As far back as 2000, Greenspan rejected a proposal by Fed Governor Edward Gramlich to have the Fed examine the lending practices not just of the banks but of subprime lenders. Gramlich frequently spoke out about the dangers of the latter’s sales practices. An expert in the subprime area who realized the major danger that the subprime market would blow up, he pushed hard for greater regulation and spoke to Greenspan about the necessity for it. But mortals don’t often defeat gods. Gramlich, one of the real heroes of the period, published a book entitled Subprime Mortgages: America’s Latest Boom and Bust that strongly warned about those dangers shortly before he died of leukemia in 2007. In 2008, when asked about his failure to perceive the dangers, Greenspan merely said, “I turned out to be wrong, much to my surprise and chagrin.”21 That is scant recompense for the many millions of Americans who suffered from both the crisis and its aftermath.
Greenspan had the authority to control these lending practices under a law passed by Congress in 1994, the Home Ownership and Equity Protection Act (HOEPA), but his antiregulation beliefs were so strong that he was adamant in refusing to do so.
The Fed chairman in 2005 and then his successor, Ben Bernanke, in 2006 completely missed the opportunity to have the Fed take the strong measures necessary to puncture the bubble.22 Worse, the Fed’s refusal to act encouraged practices that led to the victimization of hundreds of thousands of subprime borrowers and a large number of institutional lenders. The Fed was reactive, not proactive, through almost the entire collapse.
By the time the Fed realized the enormity of the problem, it was far too late. In 2007, even after the bubble was already imploding, both Greenspan and Bernanke continued to issue reassuring statements that all was well. Bernanke said in late March 2007, “At this juncture . . . the impact on the broader economy and financial markets of the problems in the subprime market seems likely to b
e contained.”23 Three months before the collapse of Lehman Brothers, he stated, “The danger that the economy has fallen into a ‘substantial downturn’ appears to have waned.”24
How did Greenspan and, to a somewhat lesser extent, Bernanke make blunders of this magnitude? According to Daniel Kahneman, one of the most revealing moments of the 2007–2008 economic meltdown came at a congressional hearing in 2009, when Greenspan admitted that his theory of the world was mistaken. He expected and believed that financial firms would protect their interests, because they are rational companies and the markets are rational, so they would not take risks that would threaten their very existence. Where he went wrong, according to Kahneman, was that there was a huge gulf in the goals between the firms and their managers’ (their agents’) interests. The firm takes the long view of profitability over time. The agents take a much shorter-term view, basing decisions on possible promotions, large salaries, and bonuses. As we saw, the executives did not commit suicide by taking such risks. They walked away unscathed. It was the corporations they managed that were crippled or committed suicide.
A close friend of Kahneman, Nassim Taleb, author of the financial bestseller The Black Swan, put it in these words: “People are simply unwilling to accept the fact that they are actually taking huge risks . . . Alan Greenspan, the former chairman of the Federal Reserve . . . was driving a bus full of children with his eyes closed while he was in office.”25
Not only were the Fed’s actions totally inappropriate to meet the crisis, but with the Fed’s hand on the pulse of the economy and with the severe liquidity crisis having already cut deeply into the nation’s financial arteries for almost eighteen months, it seemed totally unaware of the forthcoming collapse in September 2008.
Whether the Fed has too much power is a controversial topic. But it certainly appears that the power it has was not used in an appropriate manner during the liquidity crisis and the Great Recession. According to statements by knowledgeable central bankers, including Chairman Bernanke, the Fed also did not use it well during the Great Depression, but at a Fed meeting in Jackson Hole several years before the 2007–2008 meltdown, Bernanke implied that the Fed’s methods were now too sophisticated ever to allow a devastating financial crisis to happen again.
Ironically, Congress and the Obama administration gave the Fed even greater supervisory authority in the Financial Reform Act of 2010.
Could such episodes happen again? It’s possible. Bernanke did continue Greenspan’s policies until it was far too late. Although he said in late 2010 that we needed more regulation, his statements were quite different in early 2007. I don’t think Bernanke is another Greenspan, or that he will continue to pursue Greenspan’s policies. But what will the next chameleon who becomes chairman do? There is little or nothing to restrain an ideologue who favors libertarianism at one extreme, or socialism at the other, from influencing monetary policy.
Next let’s briefly look at another outcome of the Fed and the previous two administrations’ support of the destructive non-exchange-traded derivatives, as well as the excess leniency in regulation of the banks in the post-Glass-Steagall environment, which allowed banks and investment bankers to take enormous advantage of the system before bringing themselves and the financial system to the brink of collapse.
Gaming the System
Earlier in the chapter, we glanced briefly at the credit-rating agencies (CRAs), Standard & Poor’s, Moody’s, and Fitch, and noted that their credit ratings on mortgage-backed securities were far too high. The CRAs had come through the 1929 crash and the Great Depression unscathed, and their ratings through those difficult times had been rock solid. They gained increasing respect over time. Investors relied on them to accurately assess the credit of the company securities they rated, and their decisions were almost universally accepted.
Why, then, did they blemish reputations built up over more than a hundred years? The answer is the same as the one the notorious bank robber Willy Sutton gave in the 1930s when a reporter asked him why he robbed banks: “That’s where the money is, stupid.”26
The three top credit-rating agencies became enormously prosperous, not unlike the mortgage lenders earlier in this chapter. From 2002 to 2007, their revenues more than doubled, from less than $3 billion to over $6 billion. Most of the rapidly increasing revenues came from rating complex financial instruments.
All of the securities sold by banks and investment bankers needed high ratings to sell. Moody’s and S&P each issued thousands of AAA credit ratings on subprime mortgage products near the height of the subprime bubble. As Senator Phil Angelides, the chairman of the Financial Crisis Inquiry Commission investigating the credit-rating agencies, said, “Moody’s did very well. The investors who relied on Moody’s ratings did not fare so well. From 2000 through 2007, Moody’s slapped its coveted Triple-A rating on 42,625 residential mortgage backed securities. Moody’s was a Triple-A factory. In 2006 alone, Moody’s gave 9,029 mortgage-backed securities a Triple-A rating.”27
Standard & Poor’s ran neck and neck. By comparison, only a handful of AAA ratings were given to the strongest U.S. corporations or foreign governments, whose creditworthiness was light-years above that of subprime.
The ratings were a very lucrative business for the credit-rating agencies, costing upward of $50,000 for plain-vanilla slices to $1 million or more for supercomplex, multilayered collateralized debt obligations (CDOs).*89
The dollar signs were spinning. Moody’s gross revenues from residential mortgage-backed securities (RMBS) and CDOs increased from $61 million in 2002 to more than $208 million in 2006. From 1998 to 2007, its revenues from rating complex financial instruments grew by a stunning 523 percent.28 S&P’s annual revenues from ratings more than doubled from $517 million in 2002 to $1.16 billion in 2007. During the 2002–2007 period, its structured finance revenues, a good part of which came from CDOs, more than tripled, increasing from $184 million in 2002 to $561 million in 2007.
Interestingly, after the collapse of thousands of AAA subprime rated issues that led to the worst financial crisis since the Great Depression, Standard & Poor’s on August 30, 2011, gave a AAA rating to another subprime borrower. This after it downgraded U.S. Treasuries in the previous month.
Rating agency stock prices tripled or quadrupled, on average, in the 2000–2007 period, while Moody’s stock was up more than sixfold. But there would be a terrible price to pay. Like Dr. Faustus, the rating agencies had sold their souls to the Devil.
The banks and investment bankers had a large and growing market for residential mortgage-backed securities, which if sliced and diced properly would give them major underwriting profits from a clientele that could not get enough of the right stuff, which consisted of high ratings from the credit-rating agencies as well as higher yields than they could obtain from non-mortgage-backed bonds or other paper. The bankers found the solution early in the decade: cut the quality of the AAA, AA, and A product, yet retain the same high investment-grade ratings. That was essential for buyers, many of whom could, by law, buy only investment-grade securities.
This solution was not unlike that used by more questionable bars, which water down their Glenfiddich single malts or other good brands, serving them from the original bottles, or by drug dealers who cut their product. The pivotal point was the cooperation of the CRAs. Dozens of underwriters with some of the Street’s largest investment bankers, including Merrill Lynch, Citigroup, UBS, Bank of America, Wachovia, Goldman Sachs, Credit Suisse, RBS, Lehman Brothers, and Bear Stearns, had years of experience working with the credit-rating agencies on RMBSs, more specifically subprime. They persuaded the CRAs to go along, using finesse and threats to take their business elsewhere. From that point on, it was a turkey shoot—or, more accurately, a client shoot.
Armed with the best credit ratings money could buy, the bankers sold the toxic mortgages to unsuspecting clients. The product gave the bankers the best of all possible worlds: both significantly higher yields, since a good part o
f the merchandise was junk, with very high credit ratings. Sales soared into the hundreds of billions of dollars, and the bankers’ margins on the business were in the stratosphere.
But the antics only started there. Once the bankers had the high credit ratings in hand, they were able to sell all sorts of complex paper, such as CDOs and structured investment vehicles (SIVs) to their clients. From 2003 to 2006, the demand was almost insatiable; where else could an insurance company, bank or hedge fund, or CDO get a yield like this with a top credit rating? By selling notes and other credit instruments, CDOs, SIVs, and hedge funds leveraged themselves up thirty to thirty-five times the amount of their capital invested, as we saw in chapter 5. Their clients saw consistent returns of up to 15 percent annually or even higher.
The bankers, however, were not happy with the billions of dollars they were making. With a little ingenuity and a lot of inside knowledge of the toxic assets they were selling, they could do even better. More complex derivatives were devised, which the traders dubbed “exotics” and “synthetics,” thanks to the work that Robert Rubin, Larry Summers, and Chairman Greenspan had done in pushing through the Commodity Futures Modernization Act of 2000.
Exotics were extremely complex derivatives normally written by a banker who wanted to short certain toxic assets, knowing that the odds were heavily on his side that they would go down in flames. Synthetics allowed a banker to short the worst toxic assets he could find, not once but many times the size of the poor-quality issue itself, by simply replicating these horrific mortgage portfolios. Replication was simple, since there were no rules to follow. All that was needed was the financial details and the composition of the pool of mortgages and the monthly return it provided. The odds for the short sellers of toxic junk were now almost as great as those for the house in our mythical casino. What’s more, the payoffs were in the billions rather than in thousands of greenbacks from the players in the casino.