The Truth About the Financial Crisis, Part III

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 and Part II were published earlier this week.

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This post is the last installment in a three-part series harvesting the recent Financial Crisis Inquiry Report (FCIC Report) to debunk the top-ten urban myths about the Financial Crisis. To read about myths 1 – 5, click here.

Myth 6:  The Financial Crisis was caused by too much government regulation.

Reality 6: No.  Deregulation and regulatory forbearance contributed to the Crisis. Stronger, not weaker oversight is now needed.

• The Report states: “[D]eregulation 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.”

For example, housing advocates began “meeting with Greenspan at least once a year starting in 1999, each time highlighting to him the growth of predatory lending practices and discussing with him the social and economic problems they were creating.” Greenspan refused to use its authority under the Home Ownership and Equity Protection Act (HOEPA), which permitted the Fed to ban bad underwriting practices at both banks and “nonbank” institutions.

“This was a missed opportunity, says FDIC Chairman Sheila Bair, who described the ‘one bullet’ that might have prevented the financial crisis: ‘I absolutely would have been over at the Fed writing rules, prescribing mortgage lending standards across the board for everybody, bank and nonbank, that you cannot make a mortgage unless you have documented income that the borrower can repay the loan.’” (emphasis added).

Instead of a such a rule, in 2005, the Fed adopted non-binding “guidance” for the mortgage industry which “directed lenders to consider a borrower’s ability to make the loan payment when rates adjusted, rather than a lower starting rate. It warned lenders that low-documentation loans should be ‘used with caution.’”  In response, the American Bankers Association was “up in arms,” complaining that the guidance “overstated the risk of non-traditional mortgages” and, not surprisingly, the industry ignored it.

• The Thomas Dissent identifies as an important “causal factor,” “ineffective regulatory regimes, especially at the state level” for nonbank mortgage lenders like New Century and Ameriquest,” including “weak disclosure standards and underwriting rules” which “made it easy for irresponsible lenders to issue mortgages that would never be repaid.” It also faulted “lenient regulatory oversight on mortgage origination” at the federally regulated bank and thrift lenders, Wachovia, Washington Mutual and Countrywide.

• The Wallison Dissent rejects the assumptions that “the crisis was caused by ‘deregulation’ or lax regulation, greed and recklessness on Wall Street predatory lending in the mortgage market, unregulated derivatives and a financial system addicted to risk-taking.”  The Wallison Dissent is a one-hit wonder. Housing policy, that is all.

Although Greenspan chose not to protect homeowners, journalist Matt Taibbi in Griftopia, found particularly “revolting” that Greenspan in 2004 openly encouraged adjustable-rate mortgages. He endorsed ARMs in a speech insisting that “American consumers might benefit if lenders provide greater mortgage product alternatives to the traditional fixed-rate mortgage.” This was just a few months before the Fed began raising interest rates. According to a hedge fund manager Taibbi quoted, “If you had had people on thirty-year fixed mortgages, you wouldn’t have had half these houses blowing up. . it was the most disingenuous comment I’ve ever heard from a government official.”

Myth 7: Nobody saw it coming.

Reality 7: No. Plenty of people saw it coming and said something.The problem wasn’t seeing, it was listening.

Financial sector insiders, consumer advocates, regulators, economists and other experts saw the warning signs. They spoke out frequently concerning the housing bubble and the predatory and lax mortgage underwriting practices that fueled it. Yet most whistleblowers were ignored or ridiculed at best and fired and blacklisted at worst.

• The Report revealed that at least 10 years before the meltdown people on the front lines, the real estate appraisers, consumer advocates and housing lawyers raised flags. One housing lawyer, Ruhi Maker, met with the Fed’s Consumer Advisory Council in October of 2004 and warned them that she envisioned an “enormous economic impact” resulting from the fraudulent mortgage loans. After  seeing many “false appraisals and false income she suspected that some investment banks – she specified Bear Stearns and Lehman Brothers – were producing such bad loans that the very survival of the firms was put into question.” Real estate appraisers beginning in 2000, expressed concerned that they were being pushed into fraudulent appraisals and were blacklisted if they did not inflate property values. Eventually, a petition signed by 11,000 such appraisers, was taken to Washington.

Internal whistleblowers had their whistles taken away. In 2003, the head of the fraud department at Ameriquest was on the job for a month when he began to report fraud. He was scolded by senior management for looking too closely at the loans, then in 2005 downgraded from ‘manager’ to ‘supervisor,’ and finally laid off in May 2006.” Similarly over at Lehman Brothers, the former chief risk officer, was pushed aside in 2007 and the head of fixed income who “warned against taking onto much risk” departed due to “philosophical differences.” At Citigroup, in 2006, the newly promoted chief underwriter in the consumer devision, Richard Bowen, realized that about 60% of the mortgages Citi was buying up and selling to investors were defective – “if the borrowers were to default on their loans, the investors could force Citi to buy them back.” He brought this to the attention of certain members of the Board of Directors and thereafter was demoted from supervising 220 to only 2 people, his bonus was reduced and he received a poor performance review.

• The Thomas Dissent concurrs in places, indicating that for some this was no surprise. For example, it concludes that: “Managers of many large and midsize financial institutions in the United States and Europe 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.” (emphasis added).

• The Wallison Dissent has it both ways. On the one hand, it’s clear that the housing bubble was growing. On the other hand, it claims that “number of defaults and delinquencies among these mortgages far exceeded anything that even the most sophisticated market participants expected.”

For further reading on economists who sounded the alarm but were ignored, Professor James Galbraith’s article, “Who Are These Economists, Anyway,” is very instructive.  Galbraith includes economist Dean Baker who in 2002 wrote:

“If housing prices fall back in line with the overall rate price level, as they have always done in the past, it will eliminate more than $2 trillion in paper wealth and considerably worsen the recession. The collapse of the housing bubble will also jeopardize the survival of Fannie Mae and Freddie Mac and numerous other financial institutions.”

Myth 8:  This Financial Crisis was unavoidable. And, financial crises of this magnitude, are inevitable.

Reality 8: No. The majority unequivocally states this Crisis was avoidable.

• The Report majority concluded 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 Thomas Dissent disagrees. In a WSJ op-ed published when the Report was released, the dissenters seem to say that the Crisis was unavoidable. “[I]t is dangerous to conclude that the crisis would have been avoided if only we had regulated everything a lot more, had fewer housing subsidies, and had more responsible bankers.”

• The Wallison Dissent contends that without US government housing policy, “the great financial crises of 2008 would never have occurred.”  However, perhaps given that the housing policy was obvious to everyone, as was the bubble, he deflect blame off industry by writing that:  “No financial system . . could have survived the failure of large numbers of high risk mortgages once the bubble began to deflate.”

This myth that we cannot avoid large scale financial crises is particular corrosive, as those who are in its thrall reason that since crashes are inevitable, regulation is fruitless. However, is not the necessary conclusion. Consider the Congressional Oversight Panel report that found relative safety in the financial system for more than 30 years after the Neal Deal legislation until the regulatory fabric was unraveled.

Indeed, this myth distorts the view of economist Hyman Minksy, the person who first advanced the theory in 1992 that markets are prone to instability. The appropriate response to this recognition is not to let the system keep running up risk and collapsing, but instead to create counter-cyclical regulatory policy. For a clear discussion of this as applied to the recent Crisis, a useful resource is the energetic and insightful 2009 speech entitled, “The Shadow Banking System and Hyman Minsky’s Economic Journey,” by former PIMCO managing director, Paul McCulley.

Myth 9:   The bankers are the victims of greedy homeowners who borrowed money and did not pay it back.

Reality 9: No. There were some homeowners who participated in fraud and others who were simply unrealistic or speculating on the prospect that housing prices would continue to rise. However, the vast majority were victims either of abusive lending practices, or simply of the housing bubble and burst that resulted in their home values and their retirement savings being diminished. Moreover, even the hopeful and the speculators were no different from bank executives, including 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.”

Yes, we do know, many homeowners made the same error. Of course the difference is, banks got trillions of dollars in bailouts and backstops and kept their billions in bonuses. That does not sound like victimhood. In contrast, since the burst of the housing bubble, there have been 4 million home foreclosures. In the fall of 2010, one in 11 residential mortgage loans was at least one payment past due. Unemployment hovers around 10% and the underemployment rate approximately 17%. Household net worth had declined from $66 trillion to $54.9 trillion.

• The Report includes statements by bank executives acknowledging the role of banks  in the crisis. Jamie Dimon said “I blame the management teams 100% . . no one else.” He does not blame homeowners. 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.”

• The Thomas Dissent has a nuanced view concluding that “firms like Countrywide, Washington Mutual, Ameriquest, and HSBC Finance originated vast numbers of high-risk, nontraditional mortgages that were in some cases deceptive, in many cases confusing, and often beyond borrowers’ ability to repay. At the same time, many homebuyers and homeowners did not live up to their responsibilities to understand the terms of their mort- gages and to make prudent financial decisions.”

• The Wallison Dissent endorses this view even if the bankers themselves reject it. In its most jaw-dropping declaration describes investment banks. “They are better classified not as contributors to the financial crisis but as victims of the panic that ensued after the housing bubble and the PMBS market collapsed.” (emphasis added) (This quote can be found in the full dissent provided in the electronic version of the Report.)

Unfortunately, some keep telling this story. For example, an attorney who negotiates pay packages for Wall Street bankers told the Wall Street Journal this week: “To blame Wall Street for the financial meltdown is absurd.”

Myth 10: This report was a waste of time and money, in part because Dodd-Frank fixed everything and now the banking system is safe again.

Reality 10: No.  While the Report does not speak to these misconceptions, they are worth addressing. In both an absolute and relative sense, this report was worthwhile.

As for the Dodd-Frank Act, it was a small step forward. However, much was delegated to the federal agencies and with the new leadership in the House, efforts are underfoot to weaken implementation.  As anticipated, the new leadership is executing its “triple-A” agenda of appointments, appropriations, and annoyances. What little ground was made, may soon be lost.

As for relative value, Dylan Ratigan of MSNBC, recently made the comparison between the FCIC budget of $8 million and the amount that Kenneth Starr spent on the investigation of Clinton and Lewinsky. While he was slightly off in his figure, according to the GAO, the amount was just shy of $30 million, the point is made. Given the trillions of taxpayer dollars spent to bailout and backstop financial sector, given the $11 trillion in household wealth lost, investigating the reasons why so as to avoid this in the future, is a prudent investment.