Review: Black Box Casino: How Wall Street’s Risky Shadow Banking Crashed Global Finance

Today I am pleased to announce a new series at TBP, book reviews by Chris Whalen. Longtime readers of TBP are quite familiar with Chris Whalen. From his perch at Institutional Risk Analyst to his appearances on Bloomberg and CNBC, the former NY Fed and Bear Stearns analyst is an astute observer of banking foibles.

Chris and I partly disagree about how to assign fault for the collapse. But unlike Mayor Bloomberg or Mitt Romney, he is not a mere politico rationalizing an unsupportable position. We can have an intelligent discussion as to the factors that contributed to the collapse — and collegially disagree.

Here is Chris’ first review:


In his new book Black Box Casino: How Wall Street’s Risky Shadow Banking Crashed Global Finance, Robert Stowe England provides some compelling data and analysis that adds to the collective understanding of the subprime crisis.  Leading analysts such as Barry Ritholtz, Josh Rosner, Gretchen Morgenson and Joe Nocera have been debating whether Washington or Wall Street owns the blame for “causation” in the subprime mess.  England approaches the crisis instead from a functional perspective that begins from the key central fact:  The housing GSEs and the Wall Street banks are one and the same.

One of the many reasons that I am grateful to my friend Alex Pollock at American Enterprise Institute is his reminders regarding the nature of reality when it comes to finance and analysis.  Accounting, he inveighs, is just one perspective on the elephant.  Where you stand determines your view of the pachyderm.

Instead of treating Washington & Wall Street as separate factors, England instead describes the interaction of Fannie Mae, Freddie Mac and the large Wall Street banks as part of a single market.  By focusing on the new bank capital standards put in place in 2001, the subsequent increase in subprime lending by Fannie Mae and Freddie Mac after 2004 and the amazing explosion of cash and derivative private label RMBS, Black Box Casino describes the affordable housing partnership as a true collaboration between the Wall Street banks, national realtors, home builders, politicians and community activists.

In Chapter 3, for example, appropriately entitled “Seeds of the Disaster,” England describes how the culture of affordable housing in Washington was enforced by federal bank regulators such as Boston Fed President Richard Syron.  Under his leadership, the Boston Fed published a series of scathing research reports detailing the “racist motives” behind bank lending patterns in New England – a message that was also being delivered by Fed examiners working in that region.

The point here is that a series of positive and negative incentives emanating from Washington and driven by politics did alter bank lending behavior during the past decade and more.  Badly underwritten loans were then sold to investors.  You know the rest of the story.  When it comes to credit availability, were we are today is closer to normal.

The role of the GSEs going back to Fannie Mae Chairman David Maxwell is likewise treated in detail, especially the symbiotic relationship between Maxwell and  the Lehman Brothers rain maker Jim Johnson, who eventually came to run Fannie Mae.  The author also reminds us how deep and far back in time go the roots of the subprime mess.

“What is forgotten today is that the purpose of the GSE legislation in 1992 was not to inaugurate an era of credit allocation and affordable lending,” England writes, “but to provide Fannie and Freddie from suffering the fate of the failed savings and loan industry.”  England rightly identifies the GSEs as the funding fall back to the S&Ls of the 1980s for the housing industrial complex in the 1990s and thereafter.

England goes on to explain that the capital standards set by Congress for the GSEs were so small that the effective leverage was over 200:1: “This Congress basically created the framework for what would become the world’s two largest hedge funds.”  And England describes very nicely how the politicians of that era, from Henry Cisneros to Bill Clinton and George W. Bush, all focused on access to affordable housing as a political cash cow.

When Barry said on Bloomberg Radio this past Thursday that Fannie and Freddie were just two more messed up banks, he really does them a great service.  In fact, the GSEs were the highly leverage guarantors of Wall Street’s total mortgage production, subprime and conforming.  The largest lenders of the time, from Countrywide to WaMu to Wells Fargo and Bank America, controlled the entire secondary mortgage market, as they do today. Bank America, Wells Fargo, Citigroup and JPM are today a cartel operating in the secondary market for home loans in concert with the GSEs and the private mortgage insurers, which are effectively appendages of the banks and GSEs.

The fact that most of the insurance exposure taken by the GSEs was conforming, as Barry and many others rightly argue, misses the point.  Wall Street banks were using the underpriced GSE insurance to move supposedly “prime” loan production that would otherwise have never been done.  The supposedly high quality conforming, 80% debt, 20% cash down loans now are starting to go bad in growing proportions due to the fact that one third of all mortgages are now under water.

The gaming of the GSE guarantees for collateral in RMBS trusts created by Countrywide, WaMu and other lenders is well documented.  This short-changing on RMBS investors in conforming deals was a direct factor in the decision to force a merger with Bank America, which was Angelo Mozilo’s conduit lender.

The GSEs and private MIs, whose pricing was forced down by the GSE’s artificially low risk pricing,  were equally enablers in the sense that the pricing of their guarantees was an order of magnitude too low to cover the true economic risk.  The fact of Washington’s subsidy of the prime mortgage market and the political protection offered to Fannie and Freddie by politicos like former CT Senator Christopher Dodd is described nicely in Black Box Casino, particularly the refusal of Dodd, Rep Barney Frank (D-MA) and other key Democrats to move on GSE reform.

England recalls Frank telling the Washington Post that the reason for the collapse of the GSEs was market psychology, not “fundamentals.”  But the fundamental fact is that the government sponsorship for the US housing market going back to WWII has run its course, tracking demographic and social trends perfectly.  We should recall that it was only after WWII that Wall Street began creating structured securities following the financial boom of the Roaring Twenties.  The landmark Supreme Court decision by Luis Brandeis in Benedict v. Ratner in 1925, which created the standard for collateralized borrowing, also shut down the Wall Street sausage machine and arguably caused the Great Crash of 1929.  With the subprime crisis we now have come full circle.

Barney Frank, Chris Dodd and many other politicians of both parties leveraged the housing market with the full faith and credit of the US Treasury.  The tab for Fannie, Freddie and FHA is north of $170 billion and climbing.  After the 2012 election, we’ll get the bad news on embedded losses inside the GSEs from defaults on those supposedly “prime” conforming loans that were guaranteed by the US taxpayer for scant consideration.  Black Box Casino tells this story in a well written and sourced perspective on our shared misery.

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