PERSON OF THE WEEK: It has been more than three years since the September 2008 financial crisis, and many people are still trying to piece together what went so horribly wrong. Veteran financial journalist Robert Stowe England has offered his insight on what happened with his new book, ‘Black Box Casino: How Wall Street's Risky Shadow Banking Crashed Global Finance‘ (published by Praeger). MortgageOrb spoke with England about the circumstances that triggered the economic catastrophe.
Q: Was it possible that the 2008 financial crash could have been avoided? Or was this the financial services equivalent of a runaway train?
England: Both statements are true to some degree. There were so many vulnerabilities building up in the global financial system, it had, indeed, become a runaway train, while most did not yet realize that. Combine that with an ever-rising level of hidden bad credits and hidden bets and exposures, and a bad outcome was assured. In that sense, by 2005 or 2006, it was inevitable that we were headed for a train wreck. It was only a question of just how bad it was going to be.
There is a case to be made that certain actions could have prevented the coming crash from becoming the epic crisis it became. Admittedly, however, suggesting what might have been done to mitigate the expected outcome carries with it all the caveats one must make from hindsight bias.
By September 2007, it was clear that the shadow banking system was enormously vulnerable to panics and runs on overnight funding through repurchase agreements or repos. The fast money had grown to be a very large part of the financial world, with trillions turning over daily in overnight lending.
Many large firms were also subject to painful and costly margin calls on credit default swaps that began to threaten the viability of the world's largest insurance company, American International Group (AIG). It was also clear that structured investment vehicles (SIVs) funded by asset-backed commercial paper (ACBP) were likely going to crash, and take out as much as half a trillion dollars of funds from the system.
Then-Treasury Secretary Henry Paulson did, apparently, foresee that outcome for SIVs by September 2007, and he was worried about what it would do the banking system, especially Citigroup, which had concealed as much as $55 billion of exposures to toxic assets, mostly in SIVs – but also hidden through accounting gimmickry on its balance sheet. Federal banking and Treasury officials did not fully appreciate the significance of the widespread global fallout they were seeing in the mortgage meltdown in 2007 and were not factoring in any lessons learned from the global fallout that happened in 1998 as a possible indicator of what could go wrong.
I make that conclusion based on how they reacted, and not on what any of them has said then or since. If officials in Washington had fully grasped the potential severity of the ongoing panic by September 2007, they would have made an intensive effort to determine to what extent various parties were exposed to one another and find out just how many bad credits were lurking in the system.
Q: Subprime lending and Alt-A lending (in various forms and under various names) had existed for years without creating any great economic chaos. How and why did these loan products go horribly awry during the housing bubble?
England: In the early- and mid-1990s, early subprime and Alt-A were done with large down payments, and loans were priced significantly above the rate for conventional, conforming mortgages acquired by Fannie Mae and Freddie Mac. Premiums could be 300 to 500 basis points. Thus, lenders were charging for the risk they were assuming to take on the loans. The higher rates limited the amount of lending that was done. So did the large down payments. The market worked beautifully.
Fannie and Freddie began to push the market toward the layering of risks in order to meet affordable-housing goals and also to take market share away from other players to increase profits and compensation for top executives.
In 1996, the 3% down-payment mortgage was offered to borrowers. By reducing the down payment to an almost inconsequential amount, Fannie and Freddie moved the market into unchartered waters. In 2000, the government-sponsored enterprises (GSEs) introduced no-down-payment loans, and originators began to roll in the cost of closing the loan, sometimes pressuring appraisers to raise appraisals to cover the closing costs. The bubble was well under way at this point.
The private-label mortgage-backed securities market got off to a good start in the mid-1990s and then crashed after the 1998 financial crisis, and then restarted. As Fannie and Freddie expanded their market share and flooded the markets with more and more mortgage funding, it helped fuel the bubble. Private label mortgage-backed securities, which had focused mostly on A-minus subprime credits (660 to 620 FICO) had to go for the B and C credits (below 620 FICO scores), while Fannie and Freddie took on the majority of A-minus subprime credits.
The competitive interplay between agency securities and private-label securities created a race to the bottom for credits in an attempt to gain market share. In turn, a rising gusher of funds for mortgage lending created new demand for housing and pushed up housing prices. As prices kept rising, new and exotic mortgages, introduced and sold into the private-label market, as well as to Fannie and Freddie, did not quickly register the kind of significant delinquencies that would have raised red flags.
Q: For many people, Angelo Mozilo wound up being a prime force in bringing about the 2008 collapse. Is this an accurate charge, or is Mozilo being used as a scapegoat?
England: Angelo Mozilo was the most important mortgage banker in America throughout the period that the bubble formed and then burst. He built Countrywide for most of its life on a solid basis, on good credits and cautious underwriting, leading the way in technological innovation for the entire industry. Mozilo also created the fully integrated financial company that did everything from originations to securitizations. Countrywide was in the lead, too, as the mortgage market turned to exotic new products, although its level of subprime lending was not as great as some of their competitors'. Countrywide embraced these changes, too, and led the way to financial perdition.
In 2003, Mozilo decided he wanted to increase Countrywide's share of mortgage originations from 11% to 30%. Even though interest rates began rising in 2004, and the mortgage industry would logically retrench its origination capacity, Mozilo plowed ahead with his quest using exotic loans with low initial down payments.
Driven by a ‘fire in the belly,’ Mozilo was fiercely determined to keep Countrywide a viable independent company. Having weathered so many storms that knocked out his competitors, it would be helpful to know why he let his overarching desire to increase the firm's footprint in the market take precedence over his long-standing devotion to surviving as an independent. Mozilo increased market share to just under 17% by 2007, but at the cost of his reputation and the independence of Countrywide.
As the head of Countrywide, Mozilo is logically someone who should face intense scrutiny. Is Mozilo the prime force? I think it is hard to make that case because so many other people and institutions and trends were necessary to bring about the crisis. So, perhaps for some journalists and observers, Mozilo was a handy scapegoat because of the complexity of teasing out all the various factors that drove the crisis. Everyone wants a villain when there is a crisis that brings about widespread suffering. Mozilo was given that role on the front page of The New York Times for a while.
Q: Who would you peg as the chief villain in this mess?
England: I would say that Congress, as an institution, was the chief villain. It was Congress that designed the regulatory regime that pushed Fannie and Freddie into bad lending practices.
As for actual names, what about Barney Frank, who still refuses to admit any wrongdoing or even error of judgment in his long-playing act as the persistent and heated defender of Fannie and Freddie that made him their chief advocate in Congress until it became a political liability to do so? Frank famously said he wanted to ‘roll the dice a little bit more in this situation towards subsidized housing’ rather than require Fannie and Freddie to have stronger capital standards.
And what about Jim Johnson and Franklin Raines at Fannie Mae, or Leland Brendsel at Freddie Mac? They drove Fannie and Freddie off the cliff in the pursuit of higher earnings to boost their compensation, fighting every attempt at reform that would have required them to act in a safe and prudent manner.
What about Department of Housing and Urban Development Secretaries Henry Cisneros and Andrew Cuomo, who raised the affordable loan limits and allowed the GSEs to purchase private-label bonds to meet those goals without regard to their effect on the safety and soundness of Fannie and Freddie or the systemic risk that was being created?
Then there's Wall Street. Clearly, Stanley O'Neal at Merrill Lynch and Chuck Prince and Robert Rubin at Citigroup should be on any list, because they recklessly expanded the subprime collateralized debt obligation (CDO) business that drove Wall Street's role in spawning the crisis even after it was clear that trouble was brewing. Prince and Rubin were there when Citigroup failed to disclose its toxic assets for two quarters before being forced to do so when their SIVs failed and they had to take those assets back on their books.
And what about the boastful Joe Cassano, formerly of AIG's credit default swaps business, who maintains he is not deserving of any blame for the failure of his company, whose bonds were once rated AAA? What about CDO sponsoring hedge fund managers like Alec Litowitz at Magnetar, a fund that sponsored $50 billion in CDOs that failed spectacularly?
Also, what about Dick Fuld at Lehman Brothers, who oversaw massive manipulation of accounting that puts him high on the wrongdoing rating scale? Fuld could have played a more constructive role in mitigating the crisis and might have even saved Lehman. Instead, he appears to have tried to finesse his way through with minimal losses, like some think he did during the 1998 financial crisis.
Countrywide certainly played a starring role. The company engaged in reckless lending, sometimes with great gusto. They championed the growth of private-label bonds powered by risky new mortgage products. The company's aggressive pursuit of the option-ARM business was a huge mistake. Their securitizations left assets on their books that have led to huge losses that are now weighing down Bank of America, along with the disasters tied to the CDO business at Merrill Lynch.
Q: Throughout the entire crisis, President George W. Bush never truly seemed to be in charge of the economy's decline and collapse. Where was Bush, and why was he not more forceful in trying to calm the storm?
England: Paulson shed some light on that question in his book ‘On the Brink.’ He did regularly brief the president. The question is whether or not Bush was a leader or simply let Paulson make all the decisions, which he, in turn, backed. The White House was in the loop, according to Paulson's accounts, but we are left without a clear idea of whether or not the President was sufficiently engaged and even always informed of the potential of the crisis to spin out of control.
Did the president ask White House counsel looking into options that the Treasury may have missed in terms of preventing Lehman's bankruptcy? Were there conversations about that in meetings at the White House? Did the president have White House economic advisers challenge the solutions being offered up by Treasury? We do not know. I have not seen any evidence any of this occurred.
Importantly, the Bush administration blundered badly in 2005, when the Republicans had their best shot ever at reforming the GSEs. Intrepid Fannie and Freddie opponent Rep. Richard Baker had managed to get a reform bill through Congress after years of trying. The accounting scandals at Fannie and Freddie had created a unique political opening to get reform. But, when it passed, Treasury Secretary John Snow came out against it, because it did not do enough to impose reductions in the portfolios at Fannie and Freddie. Alan Greenspan increasingly saw the GSE portfolios as posing systemic risk.
What were they thinking at the Treasury and the White House? Or were they thinking at all? If reform had passed in 2005, it would have mitigated the eventual severity of the crisis, because it would have likely prompted a decline in the volume of originations for the newest and riskiest mortgage products.
Q: Could this catastrophe happen again, or has Wall Street and Washington learned their lessons in this debacle?
England: Yes, it is possible – and no, the lessons have not been learned either on Wall Street or in Washington. Some who benefited from massive bailouts, for example, have not indicated in any way that they may have been chastened in the least by their firm's near-death experience.Â
The financial system remains vulnerable to runs and panics that could freeze up global finance. There are still black boxes in both regulated financial institutions and in the shadow banking system, and they hold unknown risks of unknown magnitudes. In Europe, banks have foolishly invested heavily in government bonds because of capital rules that allow them to hold such bonds with no capital backing them. The European crisis, if it grows large enough, could have fallout here.
The Dodd-Frank Act did address the fact that regulators knew very little about the risks in the system, and regulators will have more authority to collect information about those potential risks. Steps have been taken by private exchanges and the Commodity Futures Trading Commission to improve the transparency of credit derivatives, but much of that world remains in black boxes.
Financial institutions have moved away from the more volatile sources of short-term and overnight funding. Presumably, another buildup in naked credit default swaps could endanger the system, as it did in the last crisis, when as much as $20 trillion in bets were placed by people and institutions who did not own the underlying asset. This can again turn the financial system into a casino.
The disastrous subprime CDO market is gone, and regulators are working on a rule to prevent the kind of trading strategies by hedge funds that drove that market to generate bad credits. They have done nothing about the incentives imbedded in capital regulations that led banks to create CDOs to turn BBB and BBB- credits into AAA credits on their balance sheet.
The Dodd-Frank Act has created systemically important financial institutions that appear to be too big to fail. While legislation was aimed at finding a way to resolve and allow large failed institutions to actually fail, the institutions that are seen to have some kind of quasi-government guarantee of their survival are able to enjoy a lower cost of funding, giving them an advantage in the marketplace. The Dodd-Frank Act is doing the opposite of what was intended, which seems to be the benchmark by which all new legislation from Congress now works in the real world.
The biggest banks have taken a larger share of the markets than before the crisis, making the failure of one ever more disastrous. Citigroup, which brushed with insolvency during the Latin American debt crisis two decades ago, continues to function as an awkward amalgamation of businesses that would presumably be worth far more if the bank were broken up into its several parts, to say nothing of the fact that such a move would likely reduce potential systemic risk.
Washington did not seem to be genuinely interested in getting at the root causes of the crisis. The role of Fannie and Freddie was deemed insignificant without examination by the same people who created and defended the disastrous regulatory regime that governed the GSEs. Under chairman Phil Angelides, the Financial Crisis Inquiry Commission quietly sidelined the role of Fannie and Freddie as a factor in the crisis, in the process undermining their claim of objectivity and their credibility. Wall Street has not engaged in any significant public self-examination.
The failure of the Securities and Exchange Commission (SEC) or the criminal justice system to successfully investigate and prosecute wrongdoing that led to the crisis may embolden others in the future to engage in similar activity. When Fannie and Freddie executives Raines and Brendsel walked away with fortunes in 2003 and 2004, it was an unheralded green light to others who might be tempted to engage in such activities.
Similarly, the failure of federal investigators to adequately obtain the evidence needed to prove cases of fraud and market manipulation and successfully prosecute those cases sends a signal of enforcement impotence. To be sure, as the financial world grows more complex, activities can be hidden in more and more black boxes. It's harder and harder to get the evidence to make a good case that can prevail in the courts. Even when the SEC has what appears to be a winning hand, its failure to exact more stringent settlements may lead some to conclude the payoffs for high-stakes fast-money speculation and fraud are worth it.