The subtitle hits the high spots, but the book also illuminates other important factors in our recent financial blow out. I’ll try to illustrate a few of them.
First, it is important to recognize that there is enough blame to go around. No single factor led to the collapse. It was not a Republican or Democratic show, nor was it big business vs. the little guy; everyone had a share in it. I could not detect a political or philosophical bias, except being in favor of honesty. The lead author, Morgenson, is an editor at the New York Times, not exactly a Tea Party organ. So, let us look at some of the contributors.
The underpinnings of the story can be said to have their beginnings with the Homestead Act of 1862, which gave land to settlers willing to develop it. America has always thought that homeownership was a foundation of our culture. President Clinton stated it well when he said in an important 1995 policy speech that “When we boost the number of homeowners in our country, we strengthen our economy, create jobs, build up the middle class, and build better citizens”. These are probably universal beliefs, but President Clinton, and most of the Congress along with most of the public did not realize that it makes a difference how these “homeowners” come to own a home.
The Federal National Mortgage Association, now known as Fannie Mae, was created as a regular government agency in 1938 to buy mortgages from banks, allowing them to lend to more borrowers in the belief that this would help the country recover from the Great Depression. Strict underwriting standards were practiced by both the banks and Fannie Mae. The results were generally positive, and Fannie Mae lived its life without much note, run by civil servants. In 1968 President Lyndon Johnson needed to clear Fannie Mae’s formal liabilities from the government’s general fund ledger because of the need to limit the perceived cost of the Vietnam War. Fannie Mae was gradually transformed into a nominally private company, with stock sold to the general public in 1989. The government had formally divested itself of Fannie Mae; but it retained a measure of control that implied, but did not explicitly provide, financial backing.
In 1991 James A. Johnson was elevated to be the head of Fannie Mae. He understood a few basic truths. First, the implied government backing of Fannie Mae gave it an advantage in selling bonds, and later mortgage backed securities. Investors were willing to take a "slightly" lower interest rate from Fannie than from ordinary commercial issuers. This was only a fraction of a percent, but when applied to hundreds of billions of dollars, it added up to real money. This general fact was, of course, obvious, and was touted as the reason Fannie could offer home loans at "slightly" less interest than other sources. Johnson’s insight, however, was that because the total cost structures of both Fannie Mae and all other lenders was complex, and protected as trade secrets, no one outside Fannie’s inner sanctum could know exactly the size of these two “slightlies”. That is, how much of Fannie’s cost advantage was passed on to borrowers, and how much remained for distribution to the top officers. It turns out that the amount was in the hundreds of millions of dollars. Johnson alone took home $100 million in nine years.
It’s not as though no one outside Fannie Mae was aware of this situation. Various financial and Congressional watchdogs attempted to open up Fannie’s books to see just how big was the advantage gained by the implied government backing, and how much of this was passed on to borrowers. Johnson’s second basic truth was that money could buy protection. Not all of Fannie’s cost advantage went to executive bonuses. A comparable amount was spent in the form of grants to diverse political organizations that could potentially harm Fannie, and of course directly to congressional office holders. One way this was done was to set up “outreach” offices in most large cities, even though Fannie was a centralized operation dealing only wholesale with the largest banks, all in New York. These outreach offices would hire relatives of important congressmen, and could also make donations to politically connected “public interest” groups. For example, an obscure outfit called the Association of Community Organizations for Reform Now (ACORN) had been agitating for tighter government control of Fannie Mae, but after receiving a generous grant, reversed course. Similarly, bills introduced in Congress to check on Fannie’s lending practices died when appropriate campaign contributions were made.
The infamous Community Reinvestment Act of 1977 is often cited as a major cause of the sub-prime mortgage fiasco. While it set some of the background conditions, it was in place long before the problems became rampant. One could say that the real problem started in 1992 when the Boston Federal Reserve Bank published a report, later shown to be seriously flawed, that suggested that racial bias by lenders was preventing minorities from getting loans that they deserved. This report led to a program called National Partners in Homeownership, crafted by none other than James A. Johnson, and taken as his own by President William Clinton in 1994. The central thrust of the program was “underwriting flexibility” especially in minority census tracts. Fannie and others experimented with a variety of “flexible” underwriting methods from 1994 to 1997, until they felt they knew how to do it. Aside from simply lowering standards of creditworthiness, they learned how to use new software that automated the process of evaluating borrowers. This speeded the loan process by essentially eliminating the human judgment factor. The Fair Isaac Corporation (FICO) credit score is a remaining element of this process. While it seems like a small factor, it allowed loan brokers to ramp up their production from one or two loans a day to fifty or so. And production it was. The real money was made not by widows and orphans collecting interest on their portfolios, but by the “originators” who collected hefty fees on each loan at the outset.
For this to work, of course, the investors who ultimately bought the loans had to have some assurance that they would be paid back in the form of a regular income stream coming from mortgage payments. Enter the Ratings Agencies, of which Standard and Poor’s, Moody’s , and Fitch are the biggest. As a matter of fact, they are not only just big. Federal financial regulations require that banks, among others, can hold their required capital only, or mostly, in issues that are rated highly by just these agencies. This is a big factor for banks because such capital earns less than the bank can make on regular loans. Other large investors use the ratings for evaluating their own purchases. This would be fine if the rating agencies took their fiduciary responsibility seriously. Unfortunately, the rating agencies are paid by the issuers for each separate security they rate. So, they have a strong interest not only in volume, that is, lots of securities, but also in being accommodating to the issuers. There are, after all, three agencies, and an issuer packaging a block of mortgages can go to any of them. He is unlikely to go back to one that gave his last issue a low rating based on a downbeat assessment of the likelihood that the borrowers would repay. Can you spell “Conflict of Interest”? (There are rating agencies that are paid by the buyers of bonds, but they have only a tiny fraction of the market.)
Representative Barney Frank of Massachusetts is often excoriated as the embodiment of Congressional corruption in the matter of Fannie Mae. He not only prevented several attempts at opening investigations of Fannie’s practices, he used his influence to cause the company to hire his “partner”, Herb Moses, for a top job shortly after receiving an MBA. Moses was taken on as assistant director for product initiatives, which meant finding ways to relax lending standards. While certainly corrupt; Frank probably was not much more corrupt than other congressmen have been in similar positions of arbitrary power.
Much of the investment banking business was just as corrupt as Frank, though not as visibly. They made big fees by underwriting mortgage backed securities. What this underwriting means is that the bank, say Citigroup, would create a security, kind of like a bond, using its own capital to buy mortgages for the security. When they had enough, like a hundred million dollars, they would get one of the rating agencies to rate the issue, and then sell it to large investors, like pension funds or mutual funds. To keep this business going, they had to continually find new mortgages, which came from “originators”, who could be banks but more likely retail mortgage brokers, who often were little more than bucket shops. Similarly, the originators needed the continual flow of new capital so they could make more loans and thus more fees. The fees were indeed high for everyone because as time went on, and restrictions were loosened, the borrowers were of a lower class and less sophisticated, so less able to understand the terms to which they were agreeing, leading to what has been called “predatory” lending.
Predatory lending can take many forms. For example, it could be a matter of steering someone with basically good credit to a more expensive loan more suited to a real deadbeat. Or, it could be selling someone a negative amortization loan on the basis of the attractively low payments, without explaining that the lender would be going progressively further in debt with each payment. Or, it could be a refinance at poor terms sold to someone who owns his modest home free and clear, with the likelihood that the payments will be impossible, and foreclosure soon to follow.
Regular retail banks are supposed to follow rules that preclude most of these practices, and most do, but independent mortgage brokers are not held to such high standards, and investment bank packagers of loans are not either. (This is an oversimplification, but seems generally to be the case.)
The story goes on and on. Franklin Raines took over Fannie Mae from James Johnson. He learned from Johnson, and was at least as good at it. Angelo Mozilo grew Countywide Mortgage Company from a two man shop on the West Coast to a multibillion dollar operation with thirty five thousand employees by 2003. One of these employees was Paul Pelosi Jr., the son of Nancy Pelosi. This was a small example of how Mozilo used cash and connections to influence regulatory rules to his advantage, mostly in the direction of weakening credit standards. In this, he worked closely with Fannie and Freddie.
But enough reporting; what can we learn from all this muck? First, and this has little to do with government, when ordinary people handle gargantuan amounts of other people’s money, in multilevel transactions both arcane and hidden by proprietary secrecy, they are eventually likely to want to keep some for themselves. When they see that this is possible with no consequences, they get greedy and accelerate their depredations.
Second, when government tries to achieve generally desirable social goals by manipulating private activity, there will be unanticipated consequences even beyond the greed factor mentioned above. The reason is that the real world is just too complex for disinterested monitors to manage it well. Some will see some of the problems, and will warn of them, but others will see only what they want to see, and ignore the Cassandras. We can always look back and say that the Congress should have seen the problems growing in the unregulated mortgage market and written “good” regulations, but this ignores the influence that the beneficiaries of lack of regulation can bring to bear as well as the probability that every new regulation will be followed by a new means of circumventing it.
As investors, we must remember that only we are responsible for our wealth. We can’t really lay this off to someone else, be it a large company or the government. As the economy becomes more complex, this is harder to do, but must be done.
Finally, few of the essential rules have been changed. Banks are required to hold more capital, but Fannie and Freddie’s underwriting rules are not much different. The Community Reinvestment Act is still in force. The rating agencies are still paid by the issuers. All of the nefarious actors are still either in power or in very comfortable retirement. The difference is that about a trillion dollars of taxpayer money has been injected into the system
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DOPPLEGANGER
"A SPONGY CONDUIT"....
Reviewed in the United Kingdom 🇬🇧 on December 14, 2012
Stuart Parkinson, Eliffile
Great book; pity that so many lessons remain unlearnt
Reviewed in the United Kingdom 🇬🇧 on March 2, 2017
Mrs. P. Czyzak-dannenbaum
Comprehensive analysis
Reviewed in the United Kingdom 🇬🇧 on December 14, 2019
