The Truth About the Financial Crisis, Part II

Jennifer S. Taub is a Lecturer and Coordinator of the Business Law Program at the Isenberg School of Management, University of Massachusetts, Amherst. Her research interests include corporate governance, financial regulation, investor protection, mutual fund governance, shareholders rights and sustainable business. Previously, Professor Taub was an Associate General Counsel for Fidelity Investments in Boston and Assistant Vice President for the Fidelity Fixed Income Funds. She graduated cum laude from Harvard Law School and earned her undergraduate degree, cum laude, with distinction in the English major from Yale College. Professor Taub is currently writing a book on the financial crisis for Yale University Press.

The Truth About the Financial Crisis,  Part I was published yesterday.

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Last week, I began musing here, about mining the Financial Crisis Inquiry Report to confront the top ten urban myths about the Financial Crisis.  Expecting to dash off a blog series in a day or so, I found that my eyes were bigger than my brain capacity. Though I had read a good portion of the Report, it took many days longer to digest all 530 or so pages.

I selected most of the urban myths  before I began reading. They emanated from wider study of this topic, experience watching the Dodd-Frank legislation and implementation unfold, and also questions that come my way while teaching a course that includes a segment on the Financial Crisis.

So, here goes.

Myth #1:  The Financial Crisis Inquiry Commission failed to come to any agreement, as the six Democratic appointees published a Report containing conclusions completely at odds with the views of the four Republican appointees.

Reality #1:  No. As Lawrence Baxter commented here, there is accord among nine of the 10 Commissioners on a variety of factors. Indeed, all 10 even agree on a precipitating cause of the crisis. As for the nine Commissioners, the centerpiece of the consensus is that poor risk management at US financial institutions was a chief contributor to the Crisis. As one such example, they all agree that insufficient capital and a reliance on short-term borrowing resulted from risk management failures at financial institutions.

• The Report states that: ”[I]t was the collapse of the housing bubble—fueled by low interest rates, easy and available credit, scant regulation, and toxic mortgages— that was the spark that ignited a string of events, which led to a full-blown crisis in the fall of 2008.” Additionally, the Report argues that a reliance on “massive, short-term borrowing” by large financial institutions created instability, leading to the Crisis.
• The Thomas Dissent (signed by three Republican appointees) found that: “high-risk, nontraditional mortgage lending by nonbank lenders flourished in the 2000s and did tremendous damage in an ineffectively regulated environment, contributing to the financial crisis.” In addition, it saw that regarding large financial firms “Just as each lacked sufficient capital cushions, in each case the failing firm’s liquidity cushion ran out within days.”
• The Wallison Dissent supports the precipitating cause: “Virtually everyone who testfied before the Commission agreed that the financial crisis was initiated by the mortgage meltdown that began when the housing bubble began to deflate in 2007.”

It is not clear why coverage of the Report tends to emphasize division and not cohesion. Harvard senior fellow and former GE Senior VP & General Counsel, Ben W. Heineman, Jr. has been critical of this tendancy:

“[T]hese assessments ignored a fundamental agreement among nine of the 10 members — a source of the report’s continuing importance. The bipartisan commissioners emphatically concluded that one of the primary causes of the meltdown was massive failure of private sector decision-making, especially in major financial institutions.”

In addition, director of investor protection for the Consumer Federation of America, Barbara Roper found much consensus among the majority and the Thomas Dissent. “I doubt the Democratic members of the Commission would find much if anything to disagree with in this account.” The difference, in her view, largely lies in the implications for regulatory reform.

It will be unfortunate if this lack-of-consensus-narrative flourishes.

Myth #2:  The Financial Crisis was an accident, without human causes.

Reality #2: No.  On this, the Report and two dissenting statements align. Without question the Crisis was caused by people. While the Thomas Dissent suggests the outcome could not have been prevented, the Report is clear in its contention that the disaster, at least in the magnitude we experienced was preventable.

• The Report states that: “The crisis was the result of human action and inaction, not of Mother Nature or computer models gone haywire.”
• The Thomas Dissent identifies a list of “ten essential causes,” which point to human decisions and actions.
• The Wallison Dissent also points to human causes, thus rejecting the notion of a natural event. While his narrow focus on housing policy is not credible, for reasons described below, the chief point here is that it is not a storm or accident in his view. He wrote: “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.”

Myth 3:  The financial crisis was brought about because government (under the Community Reinvestment Act, a law enacted in 1977 to prevent banks from refusing to extend loans to creditworthy borrowers in particular neighborhoods) forced banks loan to poor people.

Reality 3:  No. Both the Report and the Thomas Dissent reject this myth, with Wallison the lone proponent of this shaky story.

• The Report 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  concludes 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.” (emphasis added).
• The Thomas Dissent also explicitly states that the Community Reinvestment Act was not a significant cause.
• The Wallison dissent singles out  US government housing policy, including the CRA as the sin qua non of the financial crisis.  As a fellow at the conservative think tank, the American Enterprise Institute, and a long-time dedicated proponent of deregulation, he came into his position as a Commissioner predisposed to this viewpoint and came out still holding it, notwithstanding all the evidence presented to the contrary.

Myth 4: This big government-sponsored companies (GSEs), Fannie Mae and Freddie Mac caused the Financial Crisis because the government pushed them to guarantee mortgage loans to poor homeowners as part of their public housing mission. Variations on this are that public housing mission drove bad underwriting by lenders who had to create risky mortgages to fulfill the demand of the GSEs who needed to buy them, as they were desperate to meet housing goals.

Reality 4:  Not exactly. Both the Report and the primary dissenting statement agree that on their own Fannie and Freddie did not cause the financial crisis. They focus blame largely on the so-called “private label” mortgage market. These are bank and non-bank,  brokers, lenders, and securitizers.  Fannie and Freddie did not originate loans; the “exotic” and dangerous loans were designed by and extended to borrowers through the private label channel. While the Report and the Thomas Dissent support the notion that Fannie and Freddie’s business model was flawed, they also agree that affordable housing goals did not either drive Fannie and Freddie to ruin or cause them create the overwhelming demand for predatory, high-risk, mortgages.

• The Report states that, “Affordable housing goals imposed by the Department of Housing and Urban Development (HUD) did contribute marginally” to Fannie and Freddie’s collapse.  However, it was the voluntary, profit, not mission-motivated decision by the management teams of the GSEs to load up on Wall-Street and other private bank created securities, coupled with a 75-1 leverage ratio that brought them to the brink. It was clear that the “private-sector, publicly traded, profit-making companies with implicit government backing and a public mission was fundamentally flawed.” The Report shows a shift in behavior, noting that in 2003 and 2004, for example, Fannie “would have met its obligations without buying subprime or Alt-A mortgage-backed securities.”  In addition, the Report explains that “Overall, while the mortgages behind the subprime mortgage–backed securities were often issued to borrowers that could help Fannie and Freddie fulfill their goals, the mortgages behind the Alt-A securities were not. Alt-A mortgages were not generally extended to lower-income borrowers, and the regulations prohibited mortgages to borrowers with unstated income levels—a hallmark of Alt-A loans—from countng toward affordability goals.”
• The Thomas Dissent concludes: “Fannie Mae and Freddie Mac did not by themselves cause the crisis, but they contributed significantly in a number of ways.” In addition, it observes that US housing policy does not itself explain the housing bubble. The Dissent echoed the majority 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.”
• The Wallison Dissent blames housing policy and as a subset, the GSEs  for the Financial Crisis. His position is questionable, not in the least because it contradicts numerous written statements he made in the past. As University of Missouri-Kansas City professor of economics and law, Bill Black points out that in the past:

“Wallison praised subprime mortgage loan[s] and complained that Fannie and Freddie purchased too few subprime loans. Wallison (correctly) explained that Fannie and Freddie’s CEOs acted to maximize their wealth – not to fulfill any public purpose involving affordable housing. He also explained that they used accounting abuses to make themselves wealthy. He predicted that low capital costs would increase economic growth. Wallison’s prior views contradict his current claims.”

In addition, in a separate piece, entitled,  ”Wallison is Far Too Kind to Fannie and Freddie,” Bill Black questions the data provided by Edward Pinto, a former risk officer at Fannie Mae, upon which Wallison relies. Black writes:

“Pinto estimated that Fannie and Freddie held ’34% of all the subprime loans and 60% of all Alt-A loans outstanding’ [p. 7].  Pinto seems to have treated subprime loans as non-liar’s loans, but that is clearly incorrect.  I cited Credit Suisse’s finding that by 2005 and 2006, half of all subprime loans were also stated income (liar’s loans).  The presence of such large amounts of Alt-A loans is one of the demonstrations that Pinto, Wallison, and the Republican Commissioners’ ‘Primer’ are flat out wrong to claim that it was affordable housing goals that drove Fannie and Freddie’s CEOs’ decisions to purchase loans they knew would cause the firms to fail.  That claim doesn’t pass any logic test.  One of its unobvious flaws is that no one was making Fannie and Freddie buy liar’s loans.  For the reasons I’ve explained, and Pinto admits, Fannie and Freddie actions with respect to liar’s loans were the opposite of what they would have been if they were trying to demonstrate that the loans were made for affordable housing purposes.”

Myth 5:  Mistakes were made, but there was not widespread fraud and abuse throughout the system.

Reality 5: No. This went beyond mistakes and oversights. There is evidence of widespread fraud and abuse throughout Wall Street and the rest of the private mortgage market. From borrowers, to brokers, to lenders, to bank securitizers, to credit rating agencies, to institutional investors, the Report finds evidence of either fraud, corrupt or abusive behavior.

• The Report highlights a “a systemic breakdown in accountability and ethics.” It mentions that “One study places the losses resulting from fraud on mortgage loans made between 2005 and 2007 at $112 billion.” It notes that:

“Across the mortgage industry, with the bubble at its peak, standards had declined, documentation was no longer verified, and warnings from internal audit departments and concerned employees were ignored. These conditions created an environment ripe for fraud. William Black, a former banking regulator who analyzed criminal patterns during the savings and loan crisis, told the Commission that by one estimate, in the mid-2000′s, at least 1.5 million loans annually contained ‘some sort of fraud,’  in part because of the large percentage of no-doc loans originated then.”

It reveals that: “[B]etween 2000 and 2007, at least 10,500 people with criminal records entered the field in Florida, for example, including 4,065 who had previously been convicted of such crimes as fraud, bank robbery, racketeering, and extortion.”

In addition, the Report recounts FBI agents warning in 2004 and 2005 of mortgage fraud  as well as housing advocates early on and consistently trying to get the attention of regulators to crack down on predatory lending. As for abuse, the Report provided many examples, including that: “Lenders made loans that they knew borrowers could not afford and that could cause massive losses to investors in mortgage securities. As early as September 2004, Countrywide executives recognized that many of the loans they were originating could result in ‘catastrophic consequences.’ Less than a year later, they noted that certain high-risk loans they were making could result not only in foreclosures but also in ‘financial and reputational catastrophe’ for the firm. But they did not stop.”

• The Thomas Dissent finds that “Securitizers lowered credit quality standards and Mortgage originators took advantage of this to create junk mortgages.” Also, although the Dissent rejected the notion that fraud was an “essential cause” of the crisis, it agreed that it was a “contributing factor and a deplorable effect of the bubble.” It acknowledged that “mortgage fraud increased substantially,” beginning in the 1990s “during the housing bubble” and that “this fraud did tremendous harm.”
• The Wallison Report identifies “predatory borrowers” as the folks who “engaged in mortgage fraud.”

Part iii will conclude with myths 6 through 10.