Toxic bankers, captive regulators: Everything you think about the housing market is wrong

At the hearing, Greenspan explained that the origination of subprime mortgages had posed no problems between 1990 and 2002. In that early era, he said, it was a contained market, but then things changed. It was the expansive sale of adjustable rate subprime mortgages, followed by the securitization of these mortgages, and the transformation of those securities into collateralized debt obligations (CDOs) that caused problems. There was a huge demand from Europe for CDOs backed by such mortgages, thus fueling increasingly higher-risk originations. Greenspan also made it clear that without “adequate capital and liquidity,” the “system will fail to function.” He called for additional equity capital (less borrowing relative to assets held). He said he now realized that our banking system had been undercapitalized for forty to fifty years. But in 2011, when it came time to require banks to have greater equity capital, he publicly denounced “an excess of buffers” in an op-ed in the Financial Times. Seeming to forget the savings and loan (S&L) crisis of just twenty years earlier, he asked: “How much of its ongoing output should a society wish to devote to fending off once-in-50 or 100-year crises?” This was Greenspan, light and dark.

While he admitted in the abstract to being wrong 30 percent of the time, the FCIC found it impossible to pin him down on particular acts or omissions. Instead, he pointed toward many others who contributed to the problem. His view was supported by the evidence but was nevertheless incomplete. He asserted that effective markets depended on enforcement against fraud and misrepresentation. When asked by FCIC chairman Phil Angelides what the Fed had done to combat fraud, Greenspan admitted that between 2000 and 2006, it had made only two criminal referrals to the Justice Department. In contrast, in 2005, the Federal Bureau of Investigation (FBI) had 22,000 cases of mortgage fraud under investigation. Greenspan dismissed this figure, contending that out of 55 million outstanding residential mortgages, 22,000 did not indicate a systemic problem. Angelides then asked him to explain why the Fed had made only two referrals. Greenspan explained that in all other cases of concern, they had been able to achieve compliance without the need for criminal enforcement. He said, “[a] goodly part of supervision and regulation is to get things solved so that if somebody is in violation of something and you can get them to adjust so that the regulators are satisfied, it never gets to the point where it’s a referral for enforcement in some form or another.” This non-enforcement policy created an incentive for misbehavior. Cracking down both through criminal and civil enforcement is not just about compliance, but also a vital part of deterrence.

Brooksley Born, Again

One of the appointees to the FCIC was Brooksley Born, who had resigned from her position as commissioner of the Commodity Futures Trading Commission (CFTC) in 1999. It was appropriate for her to at last face Alan Greenspan, who with others in the Clinton administration had deregulated derivatives and helped create the conditions for the meltdown.

While Angelides questioned Greenspan about his record on combating fraud, perhaps on Born’s mind was a lunchtime conversation she’d had with him in 1996. She had just become chairman of the CFTC but was not new to Washington. She had been a partner at the Arnold & Porter law firm for many years and, before her appointment to lead the agency, had briefly served as a commissioner. In her new leadership role, Born was already concerned about risks associated with derivatives, a key area of the CFTC’s jurisdiction.

Over lunch, Greenspan had shared with Born his view of market fraud. As she later recalled: “He explained there wasn’t a need for a law against fraud because if a floor broker was committing fraud, the customer would figure it out and stop doing business with him.” Born challenged him on this view, contending that as an attorney, she believed that prohibitions on fraud were essential. At Arnold & Porter, for instance, she had represented clients entangled in the Hunt brothers’ conspiracy to manipulate the price of silver and defraud investors. After hearing her out, Greenspan replied: “Well, Brooksley, I guess you and I will never agree about fraud.” The exchange was so unsettling that she shared the conversation with her top aides, Michael Greenberger and Daniel Waldman, who confirmed her account of the discussion. This encounter was particularly disturbing given Greenspan’s influence, not just over the economy but over President Clinton and the other banking regulators. This conversation would not be the last or the most contentious of their encounters.

Today, she asked him this question: “In your view, did credit default swaps, which are a type of over-the-counter derivatives contract, play any role in causing or exacerbating the financial crisis?” Greenspan did not answer directly, although he knew what she was getting at. He said that to his knowledge, they had not been discussed at the President’s Working Group; they were “not on the agenda” at the time. That may have been his recollection, but the report that he signed in 1999 did include “credit swaps.” Born reminded him that in 1996, the Fed had issued supervisory guidance on them.

Next, Born asked him about his libertarian views and whether he thought the Fed was to blame for the crisis. Specifically she asked whether the Fed had

fail[ed] to carry out its mandates, . . . [in that] . . . the Fed and the banking regulators failed to prevent the housing bubble; they failed to prevent the predatory lending scandal; they failed to prevent our biggest banks and bank holding companies from engaging in activities that would bring them to the verge of collapse without massive taxpayer bailouts; they failed to recognize the systemic risk posed by an unregulated over- the- counter derivatives market; and they permitted the financial system and the economy to reach the brink of disaster.

Greenspan never answered that question. But he did deny that his “views on regulation” interfered with his performance: “I took an oath of office to support the laws of the land,” he said, and he insisted that he had enforced the laws, including those he “would not have constructed in the way they were constructed,” as “that was my job.” Born had a limited amount of time to ask her questions and Greenspan to answer. It was the next commissioner’s turn. Greenspan concluded by informing her: “So I know my time has run out, but I really fundamentally disagree with your point of view.”

After the long day, as after many others at the FCIC, it was difficult to fully understand the truth about the crisis. When a single witness can equivocate over a period of hours and then over a period of years, it is easy to think there is no there, there.

Truth about the Financial Crisis

After the crisis, many expected that the blameworthy would be punished or at the least be required to return their ill-gotten gains—but they weren’t, and they didn’t. Many thought that those who were injured would be made whole, but most weren’t. And many hoped that there would be a restoration of the financial safety rules to ensure that industry leaders could no longer gamble the equity of their firms to the point of ruin. This didn’t happen, but it’s not too late. It is useful, then, to identify the persistent myths about the causes of the financial crisis and the resulting Dodd-Frank reform legislation and related implementation.

Myth 1

There has been no official bipartisan consensus on the causes of the financial crisis: An official government report was produced in April 2011 by the Senate Permanent Subcommittee on Investigations, led by Chairman Carl Levin (D-MI) and Ranking Member Tom Coburn (R-OK), titled Wall Street and the Financial Crisis: Anatomy of a Financial Collapse. The “Levin-Coburn Report,” a 639-page document, including 2,849 footnotes unanimously and unambiguously concluded that “the [2008] crisis was not a natural disaster, but the result of high risk, complex financial products; undisclosed conflicts of interest; and the failure of regulators, the credit rating agencies, and the market itself to rein in the excesses of Wall Street.”

This myth got traction in January 2011, when after conducting over five hundred interviews and holding twelve days of hearings, the Financial Crisis Inquiry Commission (FCIC) failed to produce a unified report. The 545-page book the panel did publish, titled The Financial Crisis Inquiry Report: Final Report of the National Commission on the Causes of the Financial and Economic Crisis in the United States, had three sections. The first part was a lengthy majority report endorsed by the six Democratic appointees. This was followed by two much shorter dissents. Reading the three parts together, it is clear that all ten commissioners agreed that the collapse of the U.S. housing bubble was the proximate cause of the crisis.

In addition, there was substantial consensus among nine of the commissioners. For these nine—including three of the four Republican appointees—the centerpiece of the consensus was that poor risk management at U.S. financial institutions was a chief contributor to the crisis. For example, all nine agreed that risk management failures at financial institutions led to insufficient capital and a reliance on short-term borrowing.

Myth 2

The financial crisis was an accident without human causes: The Levin-Coburn Report clearly concludes that the crisis was not a natural disaster. In the FCIC Report, the Majority, Primary Dissent, and Solo Dissent also agree on this point. Without question, the crisis was caused by people. The Primary Dissent identifies a list of “ten essential causes” that point to human decisions and actions, yet it suggests that the outcome could not have been prevented. The Majority is clear in its contention that the disaster, at least in the magnitude we experienced, was preventable: “The crisis was the result of human action and inaction, not of Mother Nature or computer models gone haywire.” The Solo Dissent also points to human causes: “To avoid the next financial crisis, we must understand what caused the one from which we are now slowly emerging, and take action to avoid the same mistakes in the future.” In addition to these official reports, experts have renounced this false narrative.

Myth 3

The financial crisis was brought about because the Community Reinvestment Act of 1977 forced banks to lend to people with low incomes who could not afford to pay back their mortgages: The FCIC Majority and Primary Dissent roundly reject this myth, leaving the Solo Dissent as the lone proponent of this shaky story. The Community Reinvestment Act (CRA) was enacted to prevent banks from refusing to extend loans to creditworthy borrowers in particular neighborhoods, a practice known as “redlining.” The FCIC Majority notes that “the CRA requires banks and savings and loans to lend, invest, and provide services to the communities from which they take deposits, consistent with bank safety and soundness.” Further,
it states that

the CRA was not a significant factor in subprime lending or the crisis. Many subprime lenders were not subject to the CRA. Research indicates only 6% of high-cost loans—a proxy for subprime loans—had any connection to the law. Loans made by CRA-regulated lenders in the neighborhoods in which they were required to lend were half as likely to default as similar loans made in the same neighborhoods by independent mortgage originators not subject to the law.

Similarly, the Primary Dissent explicitly states that the Community Reinvestment Act was not a “significant cause.” Many government officials and scholars have also rejected this myth. In contrast, the Solo Dissent singles out U.S. government housing policy, including the CRA, as the sine qua non of the financial crisis.

Myth 4

The giant government-sponsored enterprises (GSEs), Fannie Mae and Freddie Mac, caused the financial crisis because the government pushed them to guarantee mortgage loans to people with low incomes as part of their public housing mission: Not exactly—both the FCIC Majority Report and the Primary Dissent agree that Fannie and Freddie on their own did not cause the financial crisis. They focus blame largely on the private-label mortgage market. Fannie and Freddie did not originate any loans; the “exotic” and high-risk loans were designed by and extended to borrowers through the private-label pipeline. While the Majority and the Primary Dissent concur that Fannie and Freddie’s business model was flawed, they also agree that affordable housing goals neither drove Fannie and Freddie to ruin nor caused them to create the overwhelming demand for predatory, high-risk, mortgages.

The Majority Report stated that the affordable housing goals that the Department of Housing and Urban Development (HUD) gave to the GSEs “did contribute marginally” to their purchase of risky mortgages. But it was the desire to gain market share and increase executive compensation that drove the management teams at Fannie and Freddie to fill their portfolios with high-risk private-label mortgage-backed securities. It was the growth of their portfolio business for profit coupled with a 75– 1 leverage ratio—not their public housing mission—that caused them to fail. Fannie and Freddie “had a deeply flawed business model as publicly traded corporations with the implicit backing of and subsidies from the federal government and with a public mission.”

Similarly, the Primary Dissent concluded that “Fannie Mae and Freddie Mac did not by themselves cause the crisis, but they contributed significantly in a number of ways.” It noted that U.S. housing policy does not itself explain the housing bubble. The Primary Dissent echoed the Majority in contending that “Fannie Mae and Freddie Mac’s failures were the result of policymakers using the power of government to blend public purpose with private gains and then socializing the losses.” In his Solo Dissent, Peter Wallison blamed housing policy and the GSEs for the crisis.

Myth 5

Mistakes were made, but there was not widespread fraud and abuse throughout the financial system: There is evidence of widespread fraud and abuse throughout the private mortgage market. Examples exist across the mortgage supply chain, beginning with fraud in mortgage documentation and ending with the peddling of worthless synthetic mortgage-related bonds to guileless institutional investors. From borrowers, to brokers, to lenders, to bank securitizers, to credit-rating agencies, to investment bankers, the Majority Report found evidence of either fraud or corrupt and abusive behavior across each link. It describes FBI agents warning of mortgage fraud in 2004 and 2005 and housing advocates early and consistently trying to get the attention of regulators to crack down on predatory lending. As for abuse, the bipartisan Levin-Coburn Report and the FCIC Majority provided many instances of lenders making loans they clearly knew borrowers could not afford.

The Primary Dissent agreed that the industry’s conduct went well beyond mistakes and errors: “Securitizers lowered credit quality standards and Mortgage originators took advantage of this to create junk mortgages.” Although Wallison’s Solo Dissent rejected the notion that fraud was an “essential cause” of the crisis, he agreed that it was a “contributing factor and a deplorable effect of the bubble.” He acknowledged that “mortgage fraud increased substantially” beginning in the 1990s “during the housing bubble” and that “this fraud did tremendous harm.” But unlike the Majority and Primary Dissent, Wallison blamed “predatory borrowers” as the ones who “engaged in mortgage fraud.”

Myth 6

The financial crisis was caused by too much government regulation: Deregulation and regulatory forbearance—too little regulation, rather than too much—contributed to the crisis. The entire toxic- mortgage supply chain was enabled by decades of deregulation and desupervision. The Levin-Coburn Report included more than eighty pages focused exclusively on the regulatory failure at one agency, the Office of Thrift Supervision (OTS). It also made recommendations for further reform beyond Dodd-Frank’s changes. The FCIC Majority stated that more than three decades of:

deregulation and reliance on self- regulation by financial institutions, championed by former Federal Reserve chairman Alan Greenspan and others, supported by successive administrations and Congresses, and actively pushed by the powerful financial industry at every turn, had stripped away key safeguards, which could have helped avoid catastrophe. This approach had opened up gaps in oversight of critical areas with trillions of dollars at risk, such as the shadow banking system and over-the-counter derivatives markets. In addition, the government permitted financial firms to pick their preferred regulators in what became a race to the weakest supervisor.

Similarly, the Primary Dissent identified “in effective regulatory regimes” for nonbank mortgage lenders as an important “causal factor.” It faulted “lenient regulatory oversight on mortgage origination” at the federally regulated bank and thrift lenders Wachovia, Washington Mutual, and Countrywide.

In the Solo Dissent, Wallison claimed the Majority had “completely ignored” solid evidence that there were not thirty years of deregulation. He pointed to the FDIC Improvement Act of 1991 (FDICIA), a law that he said “was celebrated at the time of its enactment as finally giving the regulators the power to put an end to bank crises.”

Contrary to his assertion, the Majority did discuss FDICIA; it has nothing to do with the deregulation that enabled high-risk mortgage lending and securitizing. This law requires the FDIC to shut down or sell a failing bank or thrift. This part of the law did not apply to independent investment banks like Bear Stearns and Lehman Brothers; for them the choice was bailout or bankruptcy. And, there were loopholes in FDICIA. If the regulators determined that the firm posed a “systemic risk” to the financial system, the FDIC did not have to pursue a resolution of “least cost” to the deposit insurance fund. Also, the Fed was permitted to make emergency loans to failing banks. Given these loopholes, the Majority explained that FDICIA sent a “mixed message: you are not too big to fail—until and unless you are too big to fail. So the possibility of bailouts for the biggest, most centrally placed institutions—in the commercial and shadow banking industries—remained an open question until the next crisis, 16 years later.” Indeed, the “systemic risk” exception would be invoked several times during the bailouts.

Myth 7

Nobody saw it coming: Plenty of people saw it coming, and said so. The problem wasn’t seeing, it was listening. As both the Levin-Coburn Report and the FCIC Majority showed, financial sector insiders, consumer advocates, regulators, economists, and other experts saw the warning signs. They spoke out frequently about the housing bubble and the mortgage underwriting practices that fueled it. Yet most whistleblowers were ignored or ridiculed at best, and fired and blacklisted at worst.

The Primary Dissent emphasized that some players in the market saw what was ahead: “Managers of many large and midsize financial institutions in the United States and Eu rope amassed enormous concentrations of highly correlated housing risk on their balance sheets. In doing so they turned a building housing crisis into a subsequent crisis of failing financial institutions. Some did this knowingly; others, unknowingly.”

The Solo Dissent stated that the housing bubble was clearly growing but also claimed that the “number of defaults and delinquencies among these mortgages far exceeded anything that even the most sophisticated market participants expected.”

Myth 8

The financial crisis was unavoidable. And financial crises of this magnitude are inevitable: The Majority Report unequivocally stated that “this financial crisis was avoidable. . . . The captains of finance and the public stewards of our financial system ignored warnings and failed to question, understand, and manage evolving risks within a system essential to the well-being of the American public.” The Solo Dissent contended that. “No financial system . . . could have survived the failure of large numbers of high risk mortgages once the bubble began to deflate.” However, it blamed housing policy, not bankers, for the creation of the high-risk mortgages.

This myth that we cannot avoid large-scale financial crises is particularly corrosive, as those who are in its thrall reason that since crashes are inevitable, regulation is fruitless. But this is not the necessary conclusion. There were no major financial crises between the New Deal and the S&L crisis, a span of fifty years when each type of firm was protected in its own niche and limited in their activities. Deregulation delivered the S&L debacle and the related 2008 financial crisis. This inevitability myth also distorts the view of Hyman Minsky, the economist who advanced the theory in 1986 that markets are prone to instability. The sensible reaction to this recognition is not to let the system keep running up risk and collapsing, but instead to create countercyclical buffers. This could involve doubling equity capital requirements in good times when it appears an asset bubble is inflating, so as to slow down its growth and create a better cushion on the downturn. It might also require higher capital to finance those assets the prices of which tend to rise and fall with the business cycle.

Myth 9

The Dodd-Frank Act has ended “too big to fail”: In 2009 Federal Reserve chairman Ben Bernanke defended the multi-trillion-dollar bailouts, explaining that “it wasn’t to help the big firms that we intervened. . . . [W]hen the elephant falls down, all the grass gets crushed as well.” Today, the elephants are larger than ever, and the grass is still crushed. The conditions that brought the financial system to the brink of failure in 2008 persist. The top banks are bigger, and they still borrow trillions of dollars in the short-term and overnight repo markets, leaving them vulnerable to runs.

Because they are perceived as “too big to fail,” the largest banks borrow money more cheaply, receiving an $83 billion annual subsidy according to a Bloomberg News study, which also suggests that the profits earned by these top banks are “almost entirely a gift from Dispelling Myths about the Crisis 281 U.S. taxpayers.” Regulatory proposals have been made to modestly raise equity capital for giant banks, but the permitted leverage ratio is still just 3 percent (equity to total assets). This means borrowing $97 for every $100 in assets, or a 33- 1 leverage ratio. This level of leverage was a key factor in the 2008 crisis.

The law pins most of its hopes on new powers granted to the FDIC to dismantle failing bank holding companies and “systemically important” nonbank financial institutions. This is an alternative to the terrible choice between the chaos of a Lehman- like bankruptcy and taxpayer- funded bailouts. Many question whether regulators will have the courage to pull the plug on a dying financial firm and others worry that this won’t work in cross- border insolvencies. However, the FDIC is confident that its experience resolving large banks and thrifts will translate well. During the contentious legislative process, the requirement that banks finance an orderly resolution fund to be used by the FDIC during the resolution process was taken out. Politicians, including House Minority Leader John Boehner, actually contended that bank pre-funding would be a taxpayer-funded bailout. This Orwellian argument carried the day, so under Dodd-Frank, upon the takeover of a failing firm, taxpayers will front the money the FDIC needs via a line of credit from the Treasury. If the proceeds from selling pieces of the failed institution are not sufficient to pay back the Treasury, the surviving banks will be assessed.

There are strong tools in Dodd- Frank, and time may tell if they are used effectively. The law called for nearly four hundred rulemakings by regulators already struggling with insufficient funding. Fewer than half of the rules have been issued, and more than a hundred deadlines have been missed. Among the delays is the implementation of Section 619 of Dodd-Frank, often referred to as the “Volcker Rule.” This provision bans banking entities (that have access to FDIC insurance and loans from the Fed) from engaging in proprietary trading—buying and selling securities for profit. The Volcker Rule also limits how much such banking entities can invest in hedge funds and private equity funds. It was meant to be a modern day Glass-Steagall, creating a separation between firms that have access to the public safety net from those that make high-risk bets. The provision was drafted and shepherded through the legislative process by Senator Jeff Merkley and Senator Carl Levin. However, it was named for former Fed chairman Paul Volcker, who initially recommended these restrictions to President Obama.

Myth 10

The bankers are the victims of greedy homeowners who borrowed money and did not pay it back: Some homeowners participated in fraud, and others were simply unrealistic or were speculating that housing prices would continue to rise. But a much larger number were victims either of abusive lending practices or of the housing bubble and burst that diminished their home values and retirement savings.

Even the hopeful and the speculators were no different from some apparently naive bank executives like JPMorgan CEO Jamie Dimon, who told the FCIC: “In mortgage underwriting, somehow we just missed, you know, that home prices don’t go up forever and that it’s not sufficient to have stated income.” Even if we accept this at face value, it does not follow that bankers are victims of homeowners. Many homeowners made the same error. The difference is that the banks got trillions of dollars in bailouts and backstops, and their employees kept their billions in bonuses. Meanwhile, since the burst of the housing bubble, there have been about five million home foreclosures, with millions more underway. Ten million homes are underwater—approximately one- fifth of all mortgaged properties. Unemployment remains high and home prices low. The gains of the post-crisis recovery have been uneven. The net worth for the top 7 percent of Americans increased by 28 percent while the net worth for the bottom 93 percent declined by approximately 4 percent.

In addition, blaming subprime borrowers doesn’t hold up mathematically. According to former Goldman Sachs executive Nomi Prins, even if every single subprime mortgage defaulted, the total money lost would have been $1.4 trillion. Yet much more was committed by the Fed, Treasury, and FDIC in the financial crisis. It is not credible to blame subprime mortgage borrowers alone for the crisis.

It was additionally the desire of banks to make profitable trades and the desire of hedge funds to speculate on mortgage- backed securities that brought down the system. It was the billions upon billions of side bets that put far more at risk than the total value of all the subprime mortgages.

As for banks being the victims, this myth is typically not propagated by bankers but by service providers, those who stand to gain from maintaining friendly relationships with banks. For example, Steve Eckhaus, an attorney who negotiates executive compensation packages, is one such denier. Over his career, Eckhaus claims to have helped bankers secure more than $5 billion in pay. Among his clients were executives from Lehman Brothers, Merrill Lynch, and Morgan Stanley. Defending his clients and the financial sector in general, Eckhaus has said: “To blame Wall Street for the financial meltdown is absurd.”

Notwithstanding this pay negotiator’s assertion that Wall Street was not to blame, when put under oath, bankers do not concur. Bank of America CEO Brian Moynihan told the FCIC: “Over the course of the crisis, we, as an industry, caused a lot of damage. Never has it been clearer how poor business judgments we have made have affected Main Street.” At an FCIC hearing in January 2010, JPMorgan Chase CEO Jamie Dimon told the Commission, “I blame the management teams 100% . . . and no one else.”

Excerpted from “Other People’s Houses: How Decades of Bailouts, Captive Regulators, and Toxic Bankers Made Home Mortgages a Thrilling Business” by Jennifer Taub, published May 2014 by Yale University Press. Copyright ©2014 by Jennifer Taub. Reprinted by permission of Yale University Press. All rights reserved.