Barry Ritholtz: What Caused the Financial Crisis?

Here's Barry Ritholtz' view on the cause of the financial crisis. We agree on a lot of points regarding the cause, though I call the lending standards issue an "agency problem," and we agree that a source of liquidity was needed to inflate the bubble, though we disagree a bit on the source. He has the Fed playing a larger role than I do (though I agree low interest rates contributed), I would cite the importance of international sources of liquidity as well:

Fannie Mae and the Financial Crisis, by Barry Ritholtz: The Sunday New York Times has a very interesting article on Fannie Mae and the current financial crisis. They do a decent job at delving into the complexities of the GSEs, and the many factors that went into the decision making at the senior level of the company. This includes pressure from clients such as Coutrywide CEO Angelo Mozilla, pressure from Congress, and the demands from investors for the company to be more aggressive. Most of all, it looks at the ongoing competitive demands of the market place that Fanny was in.

The key to understanding the GSE story is grasping their role within the bigger picture of the economy and housing sector. While there are some pundits who prefer talking points over reality (Charlies Gasparino, Lawrence Kudlow, James Pethoukoukis, and Jeff Saut all toed the GOP line) I prefer to keep all of my analyses based on the data and facts. Rather than creating historical revisions for partisan reasons, I prefer to keep it reality based. (I'm an independent, and that's how I roll).

The current housing and credit crises has many, many underlying sources. Its my opinion there were two primary causes leading to the boom and bust in Housing: A nonfeasant Fed, that ignored lending standards, and ultra-low rates.

This nonfeasance under Greenspan allowed banks, thrifts, and mortgage originators to engage in all manner of lending standard abrogations. We have detailed many times the I/O, 2/28, Piggy back, and Ninja type loans here. These never should have been permitted to proliferate the way they did.

The most significant element were the 2/28 APRs, and their put back provision. Just about all of these gave the securitizer/repackager the right to return the loans within 6 (or 12) months if they went into default. Hence, our proposition that the 2002-07 period was unique in the history of finance. If any of these mortgages went bad within 6 months, the undewriter was on the hook.

HOW DIFFERENT WERE LENDING STANDARDS IF YOU ONLY NEED TO ENSURE THE BORROWER WOULDN'T DEFAULT FOR 6 MONTHS VERSUS FINDING BORROWERS WHO WOULDN'T DEFAULT FOR 30 YEARS.

In a rising price environment, 99% of the mortgages were not returned by the securitizers to the originator. From 2001 to 2005, the mortgage firms thrived. However, once prices peaked and reversed, things changed. From 2006-08, Wal Street began putting back mortgages to originators in greater numbers. This led to nearly 300 mortgage firms imploding.

We can blame the lenders, the securitizers, the borrowers, amd Fannie/Freddie, but it doesn't matter much.By the time Fannie and Freddie began changing their mortgage buying rules, the Housing boom was already in full gear, and the crash was all but inevitable.

[Update: Some people (especially the political hacks) are focusing their energies in the wrong places. According to a recent investigation by Barron's, Fannie's biggest problem was not the subprime mortgages they bought -- it was the better quality Alt A mortgages that caused their demise:

"As Freddie Mac Chairman and CEO Richard Syron recently put it, the GSEs have been hit by a "100-year storm" in the housing market, accentuated by some higher-risk mortgages that they were forced to buy to meet government affordable-housing targets.

The latter contention is more than disingenuous. A substantial portion of Fannie's and Freddie's credit losses comes from $337 billion and $237 billion, respectively, of Alt-A mortgages that the agencies imprudently bought or guaranteed in recent years to boost their market share. These are mortgages for which little or no attempt was made to verify the borrowers' income or net worth. The principal balances were much higher than those of mortgages typically made to low-income borrowers.

In short, Alt-A mortgages were a hallmark of real-estate speculation in the ex-urbs of Las Vegas or Los Angeles, not predatory lending to low-income folks in the inner cities."

Only pure partisans take as gospel the statements of an embattled CEO whose own words are belied by the firm's balance sheet and P&L statements.]

What about the ultra low rates? Consider that the Greenspan Fed maintained a 1.75% Fed fund for 33 months (December 2001 to September 2004), a 1.25% for 21 months (November 2002 to August 2004), and lastly, a 1% Fed funds rate for 12+ months, (June 2003 to June 2004). That was fuel for the fire, and fed the boom even more, sending prices skyward.

Update: And not just here . . . As the central bank for the largest economy in the world, the Fed's rate action had repercussions in Housing markets everywhere. Rate cuts here richocheted around the world, sending home prices upwards globally.

Fed Fund Rates, 1974-2008

Note the circled area of detail is the chart above, in its historical context

Fed Fund Rates, 2000-2008

As to the credit crisis, it too, has many many proximate causes, but the two I focus upon as having the greatest impact was exempting CDOs from any sort of regulatory scrutiny (Commodities Futures Modernization Act of 2000) and the payola scandal of the rating agencies Moody's, Fitch, S&P slapping Triple AAA ratings on all manner of junk paper.

In order to fully understand the housing and credit crisis, one needs to understand a bit of history in the housing market. To that end consider this timeline:

1987 Federal Reserve cuts rates
1989 Housing Market peaks
1996  Prior purchases get to breakeven
1997  Housing Taxpayer Relief Act
1998 3 Rate Cuts
1995-2000 -- Big stock market gains
2001 Rate cuts from 6% down to 1.75%
2002 More rate cuts to 1.25%
2003 one final cut to 1% 

Follow the timeline: Home sales and prices cycled up post '87 market crash -- they peaked in 1989, and for the next 7 years, they slid down to sideways. A 1989 house buyer did not get back to break even until 1996/97. (See chart above)

A few other factors impacted housing: In 1997, the Taxpayer Relief Act that dropped capital gains to 20% from 28%, and also exempted the first $500,000 for married couples selling house (allowable once every two years). 

Around that time, the stock market boom and tech dot com bubble was in full throat.  That put A LOT of money in people's hands in 1997, 98, 99 and Q1 of 2000. In the late 1990s, I had many discussions with clients, real estate agents and traders about the equities into house rotation: Take some equity profits off the table and then trade up in real estate. Consider these S&P500 gains in the markets: 1995=34%, '96=20%, '97=31%, '98=27%, and from Oct '99 to March 2000, the Nasdaq was up 100%.

The folks who want to place the entire crisis at FNM/FRE 's doorstep miss the point -- and let me hasten to add that I was never a fan of the company, and we were short FNM from over a year ago, at $42+ -- these people seem to miss all of the big picture issues, and are focusing on minor factor and outright irrelevancies. This was not a "social engineering" experiment, as the radical right has called it. This was extreme short sightedness.

Fannie Mae was not a government entity, they were an independent, publicly traded, private sector firm. They were allowed to borrow at better rates than banks as a GSE. They bought what they did in an attempt top grab share and profits. If they came under pressure from Congress -- or Angelo Mozilla, or hedge fund investors -- it was because they were trying to capture market share and profits and maintain an advantageous position in the marketplace.

Consider:

"The chief executive of the mortgage giant Freddie Mac rejected internal warnings that could have protected the company from some of the financial crises now engulfing it, according to more than two dozen current and former high-ranking executives and others.

That chief executive, Richard F. Syron, in 2004 received a memo from Freddie Mac’s chief risk officer warning him that the firm was financing questionable loans that threatened its financial health.

Now consider the key points from the NYT article today:

• Company was in disarray after an accounting scandal;

• New CEO came on board in 2004;

• Competitors were "snatching lucrative parts" and market share away;

• Between 2001-04, the subprime mortgage market grew from $160 to $540 billion

• Between 2005-08, Fannie purchased or guaranteed at least $270 billion in loans to risky borrowers. 

• By 2004, Fannie had lost 56% of its loan-reselling business to Wall Street;

• Angelo Mozilo, Countrywide Financial CEO, the nation’s largest mortgage lender, threatened to end their partnership unless Fannie started buying Countrywide’s riskier loans;

• Congress was pressuring for more loans to low-income borrowers;

• Hedge fund managers and other investors pressured Fannie executives that the company was not taking enough risk in pursuing profits;

• Like many other firms, Fannie’s computer systems did a poor job of analyzing risky loans;

• Between 2005-07 -- after the market's peak -- Fannie's acquisitions of mortgages with less than 10% down payments almost tripled;

• Fannie expanded in hot real estate areas like California and Florida;

• From 2004-06, Fannie operated without a permanent chief risk officer;

As I have said repeatedly, Fannie and Freddie were cogs in the great housing machinery, and they bear some responsibility for the current debacle.  But to argue they were the most significant factor misses the true tale of the Housing and credit debacle.

Fannie has been around since 1938, Freddie since 1968, the CRA has been around since 1977 -- suddenly, all of housing goes to hell in 2005, and then credit collapses 2 years after -- and the best explanation some people can come up with is Fannie, Freddie and CRA?  Gee, isn't that rather odd -- especially after 70 years?

Update: Then there is the international issue: If Fannie and Freddie and the 1977 CRA are to blame for the US boom and bust, how did the rest of the world end up with a housing boom too? Why did prices and sales go skyward in the UK, France, Spain, Ireland, Australia, etc.? They had no CRA, or a Fannie Mae, or a Freddie Mac, -- so then what caused their housing boom?

The short answer: Ultra low rates, securitization, and perhaps some of our homegrown, innovative lending standards.

While I understand that reducing the complexities of economic history into bumper sticker phrases is politically expedient, it does not help us understand the root cause of the problems. And, it gets in the way of helping us fashion a solution for the future. Hence, why I hold the weasels who are attempting to obscure reality and rewrite history in such disdain.

Update: For the non-partisan, non hacks amongst you, for the policy makers and academics and economists who are truly interested in how this came to pass, and what we can do to fix it, the bottom line remains: The CRA was irrelevant to the current crisis, and Fannie Mae and Freddie Mac are mere cogs in a complex machine.

But the primary cause of the mess? Not even close . . .

>

click for bigger graphic

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Previously:
How Washington Failed to Rein In Fannie, Freddie (September 14, 2008)   
http://bigpicture.typepad.com/comments/2008/09/how-washington.html

Freddie's Risk Officer: CEO Ignored Warning Signs (August 05, 2008)   
http://bigpicture.typepad.com/comments/2008/08/freddies-risk-o.html

His Name is Mudd (August 20, 2008)
http://bigpicture.typepad.com/comments/2008/08/perilous-pursui.html

Fannie Mae Looks Like Hell (November 16, 2007)
http://bigpicture.typepad.com/comments/2007/11/fannie-mae-look.html

Sources:
Pressured to Take More Risk, Fannie Hit a Tipping Point
CHARLES DUHIGG
NYT, October 5, 2008
http://www.nytimes.com/2008/10/05/business/05fannie.html

At Freddie Mac, Chief Discarded Warning Signs
CHARLES DUHIGG
NYT,  August 5, 2008
http://www.nytimes.com/2008/08/05/business/05freddie.html

Comments

[hari]

First, I definitely prefer the objectivity of this analysis taking into account the role of F&F (as discussed elsewhere).

Now what we require is a better understanding of the role of CRA, since 1977.

Was there business pressure on F&F to take on *stuff* which other's prefered to unload in exchange of something else - as subprime mess exploded in terms of turnover?

Administratively it seems F&F was politically not only protectected but implicitly guranteed its excesses to boot.

[Steve Roth]

THANK YOU BARRY RITHOLTZ!

"...credit crisis...many proximate causes, but the two I focus upon...excepting CDOs from any sort of regulatory scrutiny (Commodities Futures Modernization Act of 2000) and the payola scandal of the rating agencies Moody's, Fitch, S&P slapping Triple AAA ratings on all manner of junk paper."

Isn't it about time the econobloggers started saying *something* about these two crux points?

Searching all my blogs in Google Reader, the only discussion I find of the CFMA is (extensive coverage) in DailyKos and Huffington Post. ('zat where we're supposed to get our economics discussion? Jeez.) Exceptions: a passing but substantive few sentences by Justin Fox, and two promises by Tyler Cowen to get back to this topic Real Soon Now.

Mark?

[robertdfeinman]

I sound like a broken record. OK, we get it, housing prices went up too fast and the ability to pay off the mortgages declined so that defaults went from insignificant to noticeable.

But we have had bubbles before and they didn't bring down the entire (global) financial sector. What is different is the huge amount of side bets that have been placed that have nothing to do (directly) with housing. That's what all the CDO's, SIV's and the like are about. These wouldn't have been possible (at all) if there had been regulations in place about leverage.

This was the lesson of 1929 and it was forgotten or deliberately removed by the greed of the past decade or so. The story about the poor policies of the SEC appeared just last week in the NY Times (cited above), but I don't see anyone following up on it. The situation with hedge funds is even worse since they were never under any regulation.

There is no way that a 33:1 leverage can withstand even a 10% drop in a market. Why is this so hard to understand?

It is also the reason that the "bailout" won't solve the larger problem. All those bets will have to be settled and all the losers will lose. This will remove a lot of capital (real or leveraged) from the marketplace.

It is hard to control a loose money policy when non-banks can create funds using 3% down.

[Steve Roth]

There has been an equal paucity of ratings-agency discussion in the econoblogospher. (Especially "paucitous" given Mark's assertion of revealingly aptly titled "agency" problems.)

Is Ritholtz (and Roth) right or wrong on this? If right, what are the implications for future regulation and policy?

[anne]

"As to the credit crisis, it too, has many many proximate causes, but the two I focus upon as having the greatest impact was exempting CDOs from any sort of regulatory scrutiny (Commodities Futures Modernization Act of 2000) and the payola scandal of the rating agencies Moody's, Fitch, S&P slapping Triple AAA ratings on all manner of junk paper."

Please reference "Moody's, Fitch, S&P slapping Triple AAA ratings on all manner of junk paper," if possible, since I have no study showing this was so.

The rating agency I followed early on, Moody's, appeared to me to be continually warning investors away from mortgage packages in terms of historical default studies and projections. So much so, that I stopped paying attention to the mortgage sector since there was no reason to invest there.

What did I miss?

[Mark Thoma]

There's been a lot of talk about that here and elsewhere (if you search for "ratings agencies" on the sidebar on my site, the first post that comes up is called "Risk Mis-Assessment Agencies".

I should have been more specific, but this comes under the general heading of agency problems (because of how they were paid) and bad risk assessment models. So they fell under points I covered, I just wasn't specific (and probably should have been).

But I don't see the agencies themselves as the primary cause in and of themselves, they reflected more general problems so I grouped them all together under general headings, but they were one of the reasons the flow was so large.

[anne]

http://economistsview.typepad.com/economistsview/2008/07/risk-mis-assess.html

July 9, 2008

Risk Mis-Assessment Agencies
By Mark Thoma

http://www.nytimes.com/2008/07/09/business/09credit.html?hp&pagewanted=print

July 9, 2008

Study Finds Flawed Practices at Ratings Firms
By MICHAEL M. GRYNBAUM

The analyst at the credit ratings agency was blunt: "Let's hope we are all wealthy and retired by the time this house of cards falters."

That candid assessment, sent by e-mail to a colleague in December 2006, referred to the market for certain investments linked to subprime mortgages — investments that were assigned top AAA ratings from major agencies, only to later plummet in value.

That e-mail message and dozens like it were disclosed Tuesday in a blistering 37-page report issued by the Securities and Exchange Commission, which confirmed what many on Wall Street had long suspected: the major ratings firms, including Fitch, Moody's and Standard & Poor's, flouted conflict of interest guidelines and considered their own profits when rating securities, among other suspect practices.

The report represented a definitive dent in the aura of objectivity that has been cultivated for decades by ratings firms, considered the ivory towers of Wall Street. Investors, public and private alike, often gamble billions of dollars on securities the agencies deem reliable. The assumption was that the firms' analysts — ostensibly disinterested types who assess the financial health of everything from states and cities to complex mortgages — offered a bias-free view of potential investments.

Instead, the S.E.C. found that the agencies had become overwhelmed by an increase in the volume and sophistication of the securities they were asked to review.

Analysts, faced with less time to perform the due diligence expected of them, began to cut corners.

"It could be structured by cows and we would rate it," an analyst wrote in April 2007, noting that she had only been able to measure "half" of a deal's risk before providing a rating.

The agencies continued to issue ratings despite frequent complaints from managers that they had neither the time nor manpower to measure the safety of investments sufficiently.

"We do not have the resources to support what we are doing now," a managing analyst wrote in an e-mail message in February 2007.

The trust in the ratings firms plays a vital role in the modern financial system. To ensure their bonds are rated AAA, many states and cities buy specialized insurance policies that are themselves dependent on premium ratings.

The agencies appear to be taking steps to address the problems; Moody's has ousted two high-ranking executives in the last two months.

The report was the result of a 10-month investigation into practices at Fitch, Moody's and S.& P. None of the e-mail messages or findings were attributed to an individual firm, according to standard commission practice, a spokesman said....

[robertdfeinman]

Let's pretend that we eventually find the root causes of the current problems. Let's also assume that some good government types get various fixes passed so that these activities are reined in. Will this fix the problem in the future?

Much as I like to say that the best solution we have for social problems is a democratic system of governance we are seeing one of its weaknesses writ large.

Either you can consider it as the tyranny of the majority, or of a small group to subvert democracy by using money and propaganda to sway public opinion. Even the wisest of governments can vote itself into a future disaster if it wishes to.

The real culprits in this collapse are us, the US public. I've written about this before:

When our elected governments and institutions do the things we asked of them

For several decades the public has been pushed into investing in the stock market. The secure retirement funds have been eliminated and they had no choice. Even those with traditional plans have been encouraged to do further investment using IRA's and other vehicles. The nightly business news hypes new stocks every day and people tend to believe that 10-30% returns are to be expected.

In this atmosphere any firm which doesn't engage in risky behavior soon sees it stock in disfavor and it CEO bounced out by Wall Street types who want to "unlock the potential" of the firm.

As Pogo said: "We have met the enemy and he is us".

If we had a stable society where people were assured that their old age would be funded and that illnesses would not bankrupt them and their families then appeals to such speculation would not be so inviting. German's put a quarter as much of their earnings into stocks as do Americans. They prefer banks. The fact that they have much better social services means they can go for low risk investments.

So, no, there is no way to prevent another bubble-crash cycle in the US as long as the social structure and financial incentives remain as they are.

[anne]

Agreed; I read the important article carefully when initially posted and again, but I am not still sure where the problem was and with what securities.

[anon/portly]

"We agree that a source of liquidity was needed to inflate the bubble, though we disagree a bit on the source. He has the Fed playing a larger role than I do (though I agree low interest rates contributed), I would cite the importance of international sources of liquidity as well[.]"

I'm a little confused. In paragraphs 3-5 of "What Caused the Financial Crisis," just below, I thought MT was citing, as the "most important factors" leading to "enough available liquidity to inflate a housing bubble," the following: "agency problems, the mis-pricing of risk, and the failure of securitization to distribute risks across the financial system."

I actually thought the Thoma explanation made more sense than the Ritholz one. If the central bank keeping interest rates low is so important, why did we have the 1995-2000 stock market bubble? ("1998 3 Rate Cuts," hmm).

ISTM that you can have a tougher Fed but still have liquidity for a bubble if you have the problems MT cited. One more direct quote:

"Fundamentally, then, it was the agency problems and the failure of risk prediction and distribution models that allowed the bubble to inflate and then cause big problems after it popped."

Oddly, for I am a pro-market type of silly person, I keep feeling that these analyses underplay possible cultural causes of the crisis. Could there be a connection between the "failure of risk prediction and distribution models" and the incentives provided by the prevailing norms of compensation that obtain in the (worldwide) financial industry?

[ken melvin]

Don't think that speculation in housing should be tolerated. Do not think that after the fact, including borrowers who could not make mortgage payments on houses worth much less than the mortgage, is the problem. The problem is/was the speculative bubble. From thence, how best preclude recurrence? This wanting to blame the borrower's by me. If the seller, the one who benefited most, hold the bag, the mortgage, had to take it back if it really wasn't worth umpteen thousand more than sold for ... OK, seller in partnership with a local bank, if you wish. Capital gainsing the dickens out of housing prices is another way. I’m not sure about the net positives of any and all forms of bubbles, tulips don’t bother me much, but some things, such as the price of housing and health care should be rendered immune from speculation.

says...

In 2003, during the height of the predatory lending crisis, the OCC invoked a clause from the 1863 National Bank Act to issue formal opinions preempting all state predatory lending laws, thereby rendering them inoperative. The OCC also promulgated new rules that prevented states from enforcing any of their own consumer protection laws against national banks. The federal government's actions were so egregious and so unprecedented that all 50 state attorneys general, and all 50 state banking superintendents, actively fought the new rules.

But the unanimous opposition of the 50 states did not deter, or even slow, the Bush administration in its goal of protecting the banks. In fact, when my office opened an investigation of possible discrimination in mortgage lending by a number of banks, the OCC filed a federal lawsuit to stop the investigation.

[Barry Ritholtz]

I've been discussing the role of the ratings agencies over the course of several years: But check out the recent Bloomberg.com series on them:

Bringing Down Wall Street as Ratings Let Loose Subprime Scourge
Bloomberg, Sept. 24 2008
http://www.bloomberg.com/apps/news?pid=20601109&sid=ah839IWTLP9s&

'Race to Bottom' at Moody's, S&P Secured Subprime's Boom, Bust
Bloomberg, Sept. 25 2008
http://www.bloomberg.com/apps/news?pid=20601109&sid=ax3vfya_Vtdo

Some older commentary:
Ratings Agencies 2007 = Equity Analysts 2000 ? (Aug 07)
http://bigpicture.typepad.com/comments/2007/08/ratings-agencie.html

The Abysmal Track Records of Moody's, Fitch and S&P
http://bigpicture.typepad.com/comments/2007/11/berating-the-ra.html

Moodys Warning Labels (sub-prime version)
http://bigpicture.typepad.com/comments/2008/02/moodys-warning.html

Sweetheart Deal for Rating Firms
http://bigpicture.typepad.com/comments/2008/06/sweetheart-deal.html

Mortgage Bond Ratings Change: "Too little, too late."
http://bigpicture.typepad.com/comments/2008/02/mortgage-bond-r.html

[James Kroeger]

Why are economists ignoring the important role that the Bush tax cuts played in this whole drama? Throwing billions of dollars at rich people directly leads to a huge injection of dollars into the financial services sector. The stock market was not a popular a choice of investment after the dot com bust, so other 'investment' options received the huge influx of dollars. The result---just as it always is after Republican politicians throw billions of disposable dollars at their 'base'---is asset inflation.

Banks flush with extra dollars felt free to pursure ever riskier bets. All of the other variables were important, of course, but I suspect the big influx of dollars into the pockets of rich people encouraged bankers, et al., to believe that whole highly leveraged game could keep going on forever and ever.

[bakho]

What brought down Bear and Lehman is the credit default swaps. They agreed to back up the CDOs if they failed to return on investment. They skirted the normal "insurance" rules and capitalization requirement. When the paper went bad because of mortgage defaults (historically, people never default on their mortgage), they had insufficient funds to pay off their bad bets. Absent, the credit swaps, the CDOs would have had far more risk associated with them. With better ratings agencies, the writers of the credit swaps might have realized that the default risks were higher than they thought.

The bottom line is that people invested in very risky investments (or secondarily backed very risky investments) that were falsely advertised as low risk. The risky investments allowed housing prices to bubble and housing to be overbuilt.

The problem starts with denying that a housing bubble existed and refusing to enact rules that would at least identify high risk loans. That provided the necessary cover for describing them as "low risk". Now that we know that people do indeed default on house loans, more attention can be given to ensure that borrowers have the means and incentive to pay off the loans. More transparency and proper borrower incentives would fix the housing side of the problem.

However, preventing financial bubbles requires transparency and correct assessment of risk. As long as risky assets can be classified as "low risk" (incorrect valuation) bubbles will occur. (That was more or less the Enron problem- incorrect valuation). This time, the incorrect valuation was housing. Next time it could be something else.

[Ryan]

I believe, if all the various proposed reasons for the current mess Mark has posted is any indicator, there is no "reason" for the financial mess but a multiplicity of reasons. For some individual firms it was simply MBS that led to their downfall, while others had too much stake in the firms previously mentioned, and so on and so forth.

When it comes right down to it, the interconnectedness of all the financial markets is a complexity that most models simply couldn’t possibly deal with.

[bakho]

"When it comes right down to it, the interconnectedness of all the financial markets is a complexity that most models simply couldn’t possibly deal with."

This is only true if assets are not sufficiently transparent and risk is not accurately evaluated. Complexity is not necessarily a problem unless the complexity is used to obscure the true value of the assets.

There were people at many levels that mis-priced assets. Why were assets not correctly valued? and what could change to ensure proper value and risk determination in the future?

[anne]

Barry Ritholtz:

I've been discussing the role of the ratings agencies over the course of several years: But check out the recent Bloomberg.com series on them:

Bringing Down Wall Street as Ratings Let Loose Subprime Scourge
Bloomberg, Sept. 24 2008
http://www.bloomberg.com/apps/news?pid=20601109&sid=ah839IWTLP9s&

'Race to Bottom' at Moody's, S&P Secured Subprime's Boom, Bust
Bloomberg, Sept. 25 2008
http://www.bloomberg.com/apps/news?pid=20601109&sid=ax3vfya_Vtdo

[Excellent.]

[meter]

Isn't this just a case of people following their incentives?

1) CEOs pursuing win-win risky strategies: hitting a 'home-run' pays out handsomely and failure results in golden parachutes
2) Banks granting questionable loans as the repackaging and the servicing provide streams of income regardless of the loan performance
3) Mortgage brokers pushing applications of risky borrowers to the banks in pursuit of maximum commissions
4) Borrowers taking on insane mortgages in terms of loan amounts and terms under the false assumption that "real estate prices always go up" (at the prodding of Greenspan, banks, mortgage brokers, the NAR, and talking heads)
5) Ratings agencies issuing unwarranted favorable ratings as unfavorable ratings result in less patronage

Eliminate these, especially 1 with clawbacks and prison terms and I think at least some of this problem is averted. The effects trickle downward to reduce reckless investment vehicles and strategies.

[me]

Posted by: robertdfeinman

> All those bets will have to be settled

Why? Unlicensed gambling is illegal. How is this exempt?

> and all the losers will lose.

Why? Ten people bought credit insurance on a bond they didn't own, gambling it'd fail. Why should ten times the value of the bond be paid to people who had nothing at risk but their small bet?

> This will remove a lot of capital
> (real or leveraged) from the marketplace.

Okay, I'm just a dumb voter with a science degree. HOW does making bets on something you don't have any ownership in add "capital" to the "marketplace" --- does someone then resell the right to collect the winnings if the bet pays off to some fourth party equally not at risk?

I'm sorry. I don't understand how the leverage thing is not illegal as a game of chance.

Please explain.

[anne]

Barry Ritholtz, has a fine series of posts on credit rating problems, along with the recommended Bloomberg articles.

What I still do not understand however is whether the problem in credit rating extended to bonds that were packages of mortgages, with riskier mortgages rated artificially highly, or the problem was with the rating for derivatives based on mortgage packages.

The problem may be only in my reading, but the reference by Mark Thoma also never clarified the matter.

[anne]

The question I will try to find an answer to was whether packages of mortgages were methodically mis-rated by the agencies, thereby masking basic risks by investors concerned above all with safety. I do know from reports that derivatives based on mortgage packages were mis-rated.

[hari]

EU Commission investigated it last year and found out rating agencies were in the pocket of investment banks. The consequences to EU-27 policy on rating agencies is now being fully investigated and I suppose a regulatory/licensing regime will be mandated to control all rating agencies.

[Patricia Shannon]

Ninja Zombie says...

Where will the extra doctor-hours and other resources necessary to perform these procedures come from?

We could execute the CEOs & other members of the plutocracy responsible for defrauding our financial system into bankruptcy. Then the medical resources that they were using would be available for others.

[Patricia Shannon]

Oops, wrong thread

[Steve Roth]

Mark: "I don't see the agencies themselves as the primary cause in and of themselves"

No, and neither Ritholtz nor I have said that they were. There was no single primary cause.

But they remain a central crux/leverage point for smart regulation whose effects could multiply beneficially through the financial system.

The larger issue, though, is the failure to regulate overall, in fact the banning of regulation.

According to the NYT the other day, for instance, the Commodities Futures Modernization Act had exactly the effect Mr. Gramm certainly hoped for: allowing investment banks to overleverage. (The article only refers to "A 1999 law, however, [that] had left a gap that did not give the commission explicit oversight of the parent companies." But we know which law they're talking about.)

http://www.nytimes.com/2008/10/03/business/03sec.htm

I'm surprised to see little or no mention of this article in the econoblogs.

[anne]

http://www.nytimes.com/2008/10/03/business/03sec.htm?pagewanted=print

October 3, 2008

Agency’s ’04 Rule Let Banks Pile Up New Debt
By STEPHEN LABATON

“We have a good deal of comfort about the capital cushions at these firms at the moment.” — Christopher Cox, chairman of the Securities and Exchange Commission, March 11, 2008.

As rumors swirled that Bear Stearns faced imminent collapse in early March, Christopher Cox was told by his staff that Bear Stearns had $17 billion in cash and other assets — more than enough to weather the storm.

Drained of most of its cash three days later, Bear Stearns was forced into a hastily arranged marriage with JPMorgan Chase — backed by a $29 billion taxpayer dowry.

Within six months, other lions of Wall Street would also either disappear or transform themselves to survive the financial maelstrom — Merrill Lynch sold itself to Bank of America, Lehman Brothers filed for bankruptcy protection, and Goldman Sachs and Morgan Stanley converted to commercial banks.

How could Mr. Cox have been so wrong?

Many events in Washington, on Wall Street and elsewhere around the country have led to what has been called the most serious financial crisis since the 1930s. But decisions made at a brief meeting on April 28, 2004, explain why the problems could spin out of control. The agency’s failure to follow through on those decisions also explains why Washington regulators did not see what was coming.

On that bright spring afternoon, the five members of the Securities and Exchange Commission met in a basement hearing room to consider an urgent plea by the big investment banks.

They wanted an exemption for their brokerage units from an old regulation that limited the amount of debt they could take on. The exemption would unshackle billions of dollars held in reserve as a cushion against losses on their investments. Those funds could then flow up to the parent company, enabling it to invest in the fast-growing but opaque world of mortgage-backed securities; credit derivatives, a form of insurance for bond holders; and other exotic instruments.

The five investment banks led the charge, including Goldman Sachs, which was headed by Henry M. Paulson Jr. Two years later, he left to become Treasury secretary.

A lone dissenter — a software consultant and expert on risk management — weighed in from Indiana with a two-page letter to warn the commission that the move was a grave mistake. He never heard back from Washington.

One commissioner, Harvey J. Goldschmid, questioned the staff about the consequences of the proposed exemption. It would only be available for the largest firms, he was reassuringly told — those with assets greater than $5 billion.

“We’ve said these are the big guys,” Mr. Goldschmid said, provoking nervous laughter, “but that means if anything goes wrong, it’s going to be an awfully big mess.”

Mr. Goldschmid, an authority on securities law from Columbia, was a behind-the-scenes adviser in 2002 to Senator Paul S. Sarbanes when he rewrote the nation’s corporate laws after a wave of accounting scandals. “Do we feel secure if there are these drops in capital we really will have investor protection?” Mr. Goldschmid asked. A senior staff member said the commission would hire the best minds, including people with strong quantitative skills to parse the banks’ balance sheets.

Annette L. Nazareth, the head of market regulation, reassured the commission that under the new rules, the companies for the first time could be restricted by the commission from excessively risky activity. She was later appointed a commissioner and served until January 2008.

“I’m very happy to support it,” said Commissioner Roel C. Campos, a former federal prosecutor and owner of a small radio broadcasting company from Houston, who then deadpanned: “And I keep my fingers crossed for the future.”

The proceeding was sparsely attended. None of the major media outlets, including The New York Times, covered it.

After 55 minutes of discussion, which can now be heard on the Web sites of the agency and The Times, the chairman, William H. Donaldson, a veteran Wall Street executive, called for a vote. It was unanimous. The decision, changing what was known as the net capital rule, was completed and published in The Federal Register a few months later.

With that, the five big independent investment firms were unleashed.

In loosening the capital rules, which are supposed to provide a buffer in turbulent times, the agency also decided to rely on the firms’ own computer models for determining the riskiness of investments, essentially outsourcing the job of monitoring risk to the banks themselves.

Over the following months and years, each of the firms would take advantage of the looser rules. At Bear Stearns, the leverage ratio — a measurement of how much the firm was borrowing compared to its total assets — rose sharply, to 33 to 1. In other words, for every dollar in equity, it had $33 of debt. The ratios at the other firms also rose significantly.

The 2004 decision for the first time gave the S.E.C. a window on the banks’ increasingly risky investments in mortgage-related securities.

But the agency never took true advantage of that part of the bargain. The supervisory program under Mr. Cox, who arrived at the agency a year later, was a low priority.

The commission assigned seven people to examine the parent companies — which last year controlled financial empires with combined assets of more than $4 trillion. Since March 2007, the office has not had a director. And as of last month, the office had not completed a single inspection since it was reshuffled by Mr. Cox more than a year and a half ago.

The few problems the examiners preliminarily uncovered about the riskiness of the firms’ investments and their increased reliance on debt — clear signs of trouble — were all but ignored.

The commission’s division of trading and markets “became aware of numerous potential red flags prior to Bear Stearns’s collapse, regarding its concentration of mortgage securities, high leverage, shortcomings of risk management in mortgage-backed securities and lack of compliance with the spirit of certain” capital standards, said an inspector general’s report issued last Friday. But the division “did not take actions to limit these risk factors.”

Drive to Deregulate

The commission’s decision effectively to outsource its oversight to the firms themselves fit squarely in the broader Washington culture of the last eight years under President Bush.

A similar closeness to industry and laissez-faire philosophy has driven a push for deregulation throughout the government, from the Consumer Product Safety Commission and the Environmental Protection Agency to worker safety and transportation agencies.

“It’s a fair criticism of the Bush administration that regulators have relied on many voluntary regulatory programs,” said Roderick M. Hills, a Republican who was chairman of the S.E.C. under President Gerald R. Ford. “The problem with such voluntary programs is that, as we’ve seen throughout history, they often don’t work.”

As was the case with other agencies, the commission’s decision was motivated by industry complaints of excessive regulation at a time of growing competition from overseas. The 2004 decision was aimed at easing regulatory burdens that the European Union was about to impose on the foreign operations of United States investment banks.

The Europeans said they would agree not to regulate the foreign subsidiaries of the investment banks on one condition — that the commission regulate the parent companies, along with the brokerage units that the S.E.C. already oversaw.

A 1999 law, however, had left a gap that did not give the commission explicit oversight of the parent companies. To get around that problem, and in exchange for the relaxed capital rules, the banks volunteered to let the commission examine the books of their parent companies and subsidiaries.

The 2004 decision also reflected a faith that Wall Street’s financial interests coincided with Washington’s regulatory interests.

“We foolishly believed that the firms had a strong culture of self-preservation and responsibility and would have the discipline not to be excessively borrowing,” said Professor James D. Cox, an expert on securities law and accounting at Duke School of Law (and no relationship to Christopher Cox).

“Letting the firms police themselves made sense to me because I didn’t think the S.E.C. had the staff and wherewithal to impose its own standards and I foolishly thought the market would impose its own self-discipline. We’ve all learned a terrible lesson,” he added.

In letters to the commissioners, senior executives at the five investment banks complained about what they called unnecessary regulation and oversight by both American and European authorities. A lone voice of dissent in the 2004 proceeding came from a software consultant from Valparaiso, Ind., who said the computer models run by the firms — which the regulators would be relying on — could not anticipate moments of severe market turbulence.

“With the stroke of a pen, capital requirements are removed!” the consultant, Leonard D. Bole, wrote to the commission on Jan. 22, 2004. “Has the trading environment changed sufficiently since 1997, when the current requirements were enacted, that the commission is confident that current requirements in examples such as these can be disregarded?” ...

[anne]

http://www.nytimes.com/2007/12/21/opinion/21krugman.html?ref=opinion

December 21, 2007

Blindly Into the Bubble
By PAUL KRUGMAN

"Fed shrugged as subprime crisis spread," was the headline on a New York Times report on the failure of regulators to regulate. This may have been a discreet dig at Mr. Greenspan's history as a disciple of Ayn Rand, the high priestess of unfettered capitalism known for her novel "Atlas Shrugged."

In a 1963 essay for Ms. Rand's newsletter, Mr. Greenspan dismissed as a "collectivist" myth the idea that businessmen, left to their own devices, "would attempt to sell unsafe food and drugs, fraudulent securities, and shoddy buildings." On the contrary, he declared, "it is in the self-interest of every businessman to have a reputation for honest dealings and a quality product."

It's no wonder, then, that he brushed off warnings about deceptive lending practices, including those of Edward M. Gramlich, a member of the Federal Reserve board. In Mr. Greenspan's world, predatory lending — like attempts to sell consumers poison toys and tainted seafood — just doesn't happen.

But Mr. Greenspan wasn't the only top official who put ideology above public protection. Consider the press conference held on June 3, 2003 — just about the time subprime lending was starting to go wild — to announce a new initiative aimed at reducing the regulatory burden on banks. Representatives of four of the five government agencies responsible for financial supervision used tree shears to attack a stack of paper representing bank regulations. The fifth representative, James Gilleran of the Office of Thrift Supervision, wielded a chainsaw.

Also in attendance were representatives of financial industry trade associations, which had been lobbying for deregulation. As far as I can tell from press reports, there were no representatives of consumer interests on the scene.

Two months after that event the Office of the Comptroller of the Currency, one of the tree-shears-wielding agencies, moved to exempt national banks from state regulations that protect consumers against predatory lending. If, say, New York State wanted to protect its own residents — well, sorry, that wasn't allowed....

[anne]

Notice the dates:

http://www.nytimes.com/2008/10/03/business/03sec.htm?pagewanted=print

October 3, 2008

Agency’s ’04 Rule Let Banks Pile Up New Debt
By STEPHEN LABATON

Many events in Washington, on Wall Street and elsewhere around the country have led to what has been called the most serious financial crisis since the 1930s. But decisions made at a brief meeting on April 28, 2004, explain why the problems could spin out of control. The agency’s failure to follow through on those decisions also explains why Washington regulators did not see what was coming.

On that bright spring afternoon, the five members of the Securities and Exchange Commission met in a basement hearing room to consider an urgent plea by the big investment banks.

They wanted an exemption for their brokerage units from an old regulation that limited the amount of debt they could take on. The exemption would unshackle billions of dollars held in reserve as a cushion against losses on their investments. Those funds could then flow up to the parent company, enabling it to invest in the fast-growing but opaque world of mortgage-backed securities; credit derivatives, a form of insurance for bond holders; and other exotic instruments....

http://www.nytimes.com/2007/12/21/opinion/21krugman.html?ref=opinion

December 21, 2007

Blindly Into the Bubble
By PAUL KRUGMAN

Consider the press conference held on June 3, 2003 — just about the time subprime lending was starting to go wild — to announce a new initiative aimed at reducing the regulatory burden on banks. Representatives of four of the five government agencies responsible for financial supervision used tree shears to attack a stack of paper representing bank regulations. The fifth representative, James Gilleran of the Office of Thrift Supervision, wielded a chainsaw....

[anne]

http://krugman.blogs.nytimes.com/2008/07/13/look-whos-talking/

July 13, 2008

Look Who's Talking
By Paul Krugman

So John Reich, the director of the Office of Thrift Supervision, has found a villain * in the fall of IndyMac. Not management, which kept making Alt-A and builder's loans even as the housing bubble popped, but … Chuck Schumer, for expressing doubt about IndyMac's finances.

Hmmm … Office of Thrift Supervision … what do I remember about Mr. Reich's predecessor? Oh yeah — he's the one who cut up regulations with a chainsaw, just as predatory lending was going wild. And look who's posing with him …

A bunch of real cutups [Picture]

* http://www.nytimes.com/2008/07/12/business/12indymac.html

[kthomas]

anne, great post. Make me want to get a rope and hang some people from a very public place.

[anne]

Steve Roth:

The larger issue, though, is the failure to regulate overall, in fact the banning of regulation....

[Not the lack of legislated ability to regulate, but administrative directives not to regulate or administrative unwillingness to regulate regardless of limiting directives.]

[anne]

Thank you, K Thomas.

I had no sense of how vehement and broadly scaled and methodical the effort to make financial regulation effectively impossible actually was.

[anne]

http://krugman.blogs.nytimes.com/2008/07/13/look-whos-talking/

So that we understand, posing with the chainsaw at the cutting of regulations by the Office of Thrift Supervision was John Reich, then Vice Chair of the FDIC and now Director of OTS, among others.

[anne]

http://krugman.blogs.nytimes.com/2008/07/13/look-whos-talking/

So that we understand, posing with the chainsaw at the cutting of regulations by the Office of Thrift Supervision was John Reich, then Vice Chair of the FDIC and now Director of OTS, among others.

[Julio]

Anne,

"The question I will try to find an answer to was whether packages of mortgages were methodically mis-rated by the agencies, thereby masking basic risks by investors concerned above all with safety. I do know from reports that derivatives based on mortgage packages were mis-rated."

I'd be curious to know if anyone has any insight on a related issue:
Did agencies (and actors in general) "correctly" rate the packages individually, but fail to account for the risk of larger events causing a global downgrade?
For example, "correctly" assessing the risk that each individual hoemowner in a package of 1000 mortgages would default; then combining the risk "correctly" for the 1000; but failing to account for the risk that a bank owning similar mortgages would fail, and bring all valuations crashing down?

[Julio]

Patricia Shannon:

"We could execute the CEOs & other members of the plutocracy responsible for defrauding our financial system into bankruptcy."

...

"Oops, wrong thread"

[No, any thread on the economy will do.]

[anne]

Julio:

I'd be curious to know if anyone has any insight on a related issue:

Did agencies (and actors in general) "correctly" rate the packages individually, but fail to account for the risk of larger events causing a global downgrade?

For example, "correctly" assessing the risk that each individual homeowner in a package of 1000 mortgages would default; then combining the risk "correctly" for the 1000; but failing to account for the risk that a bank owning similar mortgages would fail, and bring all valuations crashing down?

[Nice question; which is why I have periodically looked to Moody's historical risk analyses, but I need to think more carefully here.]

[ErinSiobhan]

As I understand it, the CRA may have resulted in riskier mortgages being made. But financial institutions made their own decisions to repackage these loans as securities and then leverage these securities to ridiculous levels.

The whole mess is a result of incorrectly understanding and then mispricing risk. Everyone thought they were passing the risk on to someone else. They were wrong. They packaged up their mortgage securities and sold them on. They used credit default swaps as "insurance" although there was never any guarantee that companies issuing swaps had the financial depth to pay in the event of failure.

The only reason for looking at how this happened is to use that understanding to figure out how to safely deleverage the system without crashing the whole structure. The lack of transparency in generating financial contracts makes it difficult to determine how to prop up the structure - it's not like the Fed has a good building plan to work from here. My guess is that they will use the bailout cash to try to shore up the central structure. A lot of the peripheral structures are going to crash and burn - hopefully they won't take down the core when they go.

[anne]

Referring to the regulatory climate in September 2005:

http://www.nytimes.com/2008/10/07/business/07pequot.html?ref=business&pagewanted=print

October 7, 2008

Impartiality of S.E.C. Is Questioned
By WALT BOGDANICH

A federal inquiry has concluded that the Securities and Exchange Commission should consider disciplining its director of enforcement and two supervisors for their role in handling an insider trading investigation that led to the firing of an S.E.C. lawyer for trying to interview an influential Wall Street executive.

The commission’s inspector general, H. David Kotz, said in a 191-page report obtained by The New York Times that he had found evidence that “raised serious questions about the impartiality and fairness” of the S.E.C.’s investigation of possible insider trading at Pequot Capital Management, a giant hedge fund.

Mr. Kotz also condemned what he called the “common practice” of giving outside lawyers’ clients access to high-level S.E.C. officials when they had complaints about front-line investigators.

By accusing S.E.C. supervisors of treating the Pequot investigation differently from other similar investigations Mr. Kotz’s report puts added pressure on an agency that has recently been accused of failing to aggressively regulate financial institutions at the heart of the subprime mortgage crisis.

The inspector general’s report is the latest in a string of Congressional hearings and reports on the Pequot case. Those inquiries were begun after The Times, in June 2006, reported accusations by an S.E.C. lawyer, Gary J. Aguirre, that for political reasons his superiors at the agency had impeded his inquiry into possible insider trading at Pequot.

Mr. Aguirre complained that he was fired in September 2005, shortly after receiving a merit raise, because he wanted to take testimony from John J. Mack, currently the chief executive of Morgan Stanley and a close friend of Pequot’s founder, Arthur J. Samburg. Mr. Kotz’s investigation did not focus on whether insider trading occurred, but rather on Mr. Aguirre’s claims of preferential treatment and improper termination....

[anne]

Almost immediately then we can find a pervasive anti-regulatory bias from the SEC to the FDIC to the OTS (chose the initials) and on and on, running through these last years, fostered initially and steadily by Republican ideology but increasingly accepted and even fostered by Democrats.

[Patricia Shannon]

http://www.nytimes.com/2007/12/21/opinion/21krugman.html?ref=opinion

December 21, 2007

Blindly Into the Bubble
By PAUL KRUGMAN

"Fed shrugged as subprime crisis spread," was the headline on a New York Times report on the failure of regulators to regulate. This may have been a discreet dig at Mr. Greenspan's history as a disciple of Ayn Rand, the high priestess of unfettered capitalism known for her novel "Atlas Shrugged."

In a 1963 essay for Ms. Rand's newsletter, Mr. Greenspan dismissed as a "collectivist" myth the idea that businessmen, left to their own devices, "would attempt to sell unsafe food and drugs, fraudulent securities, and shoddy buildings." On the contrary, he declared, "it is in the self-interest of every businessman to have a reputation for honest dealings and a quality product."

So the financial future of our country was entrusted to someone who should have been in an institution for the mentally impaired.

[Patricia Shannon]

Thanks for the info, Anne.

[Patricia Shannon]

ErinSiobhan says...

As I understand it, the CRA may have resulted in riskier mortgages being made. But financial institutions made their own decisions to repackage these loans as securities and then leverage these securities to ridiculous levels.

If the CRA had forced the mortgage lenders to make too many risky mortgages, all the mortgage lenders would be in trouble, and there would be none left buying the ones in trouble.

[Steve Roth]

Anne, great posts!

[hari]

Bernake isolated himself from Paulson for the reason what Anne is linking with SEC and hedge fund manager. This kind of bed fellows are common in capitalism a la American. And this includes both political parties and their underlings who are, as our friend Bruce Wilder often argues, receipients of SEC posts.

We need to expose them with more factual info and analyses.

[kthomas]

"....but increasingly accepted and even fostered by Democrats."

anne.....be very careful. That's a very unsubstantiated claim, amiga mia. Be fair with the facts.

[matthew]

Thank you, K Thomas.
thank u r information

it very useful

u r blog Is very nice

[Dave C]

What caused the Financial Crisis ?
We did.

Our greed, self interest and egoistic attitudes are the cause of the crisis and the only cure is to change these internal attitudes.

This crisis is a lesson showing us how interconnected all the worlds finances and “we” are. Each of us like a cell in a body - dependant on each other for survival.

Financial regulation and political intervention will only treat the symptoms, not the cause.

Michael Laitman expands on the financial crisis and offers some fascinating insight in this blog item