They Got Away With It

The new semester is underway and I’m teaching an honors course:  “Consumerism, Politics and Values.”  We start with the book  The Big Short by Michael Lewis, describing the housing bubble and derivative market mania that caused the collapse of the economy in 2008.

bigshort

The housing bubble and subsequent crisis was created by the big banks who were able to pull off the equivalent of a high stakes ponzi scheme and get away with it.  Alan Greenspan, onetime devotee of Ayn Rand, even admitted that events had proven his “markets get it right” philosophy wrong.

Markets don’t always get it right; unregulated, markets can create calamities.   We shouldn’t forget what happened.

Back in 2000 we entered a recession thanks to the puncturing of the dot.com bubble.  It had been a classic bubble and when the bubble burst the economy went into a needed recession to balance out the excesses of the late 90s.  Then on 9-11-01 al qaeda attacked the US with a devastating blow to the American economy.  The blow wasn’t a direct result of the terrorist attack, but an indirect one – the federal reserve decided to offer extremely cheap credit to help pull us out of the recession.  That turned out to be poison.  That is the one area where the government shares the blame – bad monetary policy.  But that alone could not have created this crisis.

The housing bubble was also not a sub-prime lending problem, nor one related to Fannie Mae and Freddie Mac.  They had their faults, some extreme, but nothing they did could have caused the economic collapse.   What happened can best be viewed by considering risk and incentives.

It doesn't take a genius - this is adjusted for inflation home prices since 1890 - look at the insane bubble after 2002!

It doesn’t take a genius – this is adjusted for inflation home prices since 1890 – look at the insane bubble after 2002!

Risk:  Between 2002 and 2005 virtually all risk was removed from the mortgage market – or so it seemed.  Banks and mortgage brokers knew they’d sell their mortgages to one of the big Wall Street banks.   That meant they had no risk – so every home loan was a win for them, regardless of whether the lender could pay it back.  The banks then took the mortgages and turned them into mortgage backed derivative bonds which they sold, pushing the risk to the investors.  These bonds received a AAA rating from the rating agencies, meaning they were viewed as the safest form of investments.  98% of mortgages get repaid.   Investors gobbled them up, thinking they were essentially risk free.   There was, it seemed, no risk!

Incentives:  Mortgage brokers thus had incentive to cheat – to make loans they knew couldn’t be repaid.   This started the housing market booming.   As prices went up, banks, brokers and buyers had incentive to create risky mortgage instruments.  Since value was going up so fast, it appeared that if you could buy a house at $100,000, it would be worth as much as $150,000 in two years.  So if you couldn’t afford a standard mortgage, you could buy one with artificially low payments for two years.   At that time the house would be worth more, you could refinance at a standard rate and take out a home equity loan for easy money.   Everyone wins!   Meanwhile, the banks gobble up more and more mortgages as they are making massive amounts of money – hundreds of trillions of dollars in mortgage backed derivatives!

Derivatives include futures markets and anything where the value is derived from something else.  But the huge spike in derivative trade from 2000 to 2007 was due to unregulated mortgage backed bonds

Derivatives include futures markets and anything where the value is derived from something else. But the huge spike in derivative trade from 2000 to 2007 was due to unregulated mortgage backed bonds

As with any bubble, everyone thinks all is great until it pops.   Housing prices started to drop in early 2007.  The first pain was in the worst loans, the subprime market.   No one panicked – that market wasn’t big enough to cause a crisis.   Little did people realize that the entire derivative bond market, even bonds with the best loans, were toxic.

Soon prices started to drop.  Thanks to the people at CNBC and the other business “reporting” networks, people had the belief that real estate prices might level off, but wouldn’t go down.   While some like Peter Schiff had been warning people, most of the media were predicting real estate price growth as late as 2007.  People simply didn’t believe the party was ending.

Many people were directly affected.  People who had adjustable mortgages planning to refi with a higher value ended up bankrupt.  People who bought the AAA ranked derivative bonds ended up losing their entire investments.  This included groups like fire departments and school systems which thought a AAA bond was no-risk.   People who had been doing real estate speculation thanks to the rising prices went from being nouveau riche to old fashioned poor.  Those who simply bought houses at record high prices ended up under water – they often owe tens or even hundreds of thousands of dollars more than their homes are worth.

Of course, this all lead to massive loses on Wall Street and an economic downturn that is still with us today.   People totally outside the housing market lost their jobs or their investments when the economy tanked.  The ones who suffered the most were the poor.  The wealthy can take a hit on their portfolio and still enjoy nice homes and an easy life style, after all.

Yet the ones who did this – the ones who created the derivative bonds and then worked to disguise or avoid risk, taking massive short term profits even knowing that in the long run everything could collapse – they’re doing well.  No one had to repay their bonuses or their income from the bubble years.  Most simply found new work.   Sure, Bear Stearns, Lehmann Brothers, and a number of other banks went under.  Yet the people working there found other work.   Some  probably ended up with a dramatic downsize in lifestyle, but prison time or actual penalties?  Nah, they were just doing business.

Many people are still livid about the lack of accountability, but that’s the its always been.   The wealthy have power and clout, and can usually avoid accountability, especially if they’re in the financial sector.  In this case both Democrats and Republicans accepted the free market mantra and refused even modest regulation.  Yet tighter regulation might have avoided the collapse and we’d be at 5% unemployment now.

During the Clinton Administration Brooksley Born tried to regulate the derivative industry; Greenspan, Summers, and Rubin led the attack to stop her, documented in the PBS special "The Warning."

During the Clinton Administration Brooksley Born tried to regulate the derivative industry; Greenspan, Summers, and Rubin led the attack to stop her, documented in the PBS special “The Warning.

It’s also proof – absolute proof – that the ideology that the market is always best is dead wrong.   It is just as wrong as the Communist belief that a state run economy is more fair.  Ideologies delude more than enlighten. Reality is messy, ambiguous and paradoxical.   People enslaved by simplistic ideological beliefs tend to interpret reality in a way that suits their beliefs and avoid cognitive dissonance at all costs.  We need accountability, rule of law, and transparency — especially in the market.

So now six years from the collapse we’re still reeling, trying to correct imbalances that could have been avoided.  The people who created the mess and made huge profits off the bubble got away with it.

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  1. #1 by List of X on January 27, 2014 - 00:58

    And not only got away with it, but pretty much pinned the blame on the same teachers and firefighters who lost their pensions because of them.

  2. #2 by lbwoodgate on January 27, 2014 - 06:53

    Great post Scott. For supplemental reading you might suggest Matt Taibbi’s piece in Rolling Stone, Why Isn’t Wall Street in Jail?

    • #3 by Scott Erb on January 27, 2014 - 12:50

      Matt Taibbi’s good “Griftopia” is also a good read on this. I suspect the book was based on the reporting behind that article.

      • #4 by lbwoodgate on January 27, 2014 - 13:30

        Very possibly. Matt has a keen eye for financial shenanigans on Wall Street

  3. #5 by pino on January 27, 2014 - 17:03

    Markets don’t always get it right

    No one ever claimed that they do – this is a straw man. Rather, markets get it right more often than any other system yet conceived.

    The housing bubble was also not a sub-prime lending problem, nor one related to Fannie Mae and Freddie Mac.

    This is where your analysis is wrong.

    The bubble was created by a decades long push to increase home ownership among the poor and minority populations. Government regulators pushed the banking and lending systems to take on more and more loans from folks who couldn’t otherwise qualify. Even Barney Frank admitted the tragedy:

    “I hope by next year we’ll have abolished Fannie and Freddie,” he said. Remarkable. And he went on to say that “it was a great mistake to push lower-income people into housing they couldn’t afford and couldn’t really handle once they had it.” He then added, “I had been too sanguine about Fannie and Freddie.”

    And this isn’t all, just look at data surrounding the two siblings:

    For most of his career, Barney Frank was the principal advocate in Congress for using the government’s authority to force lower underwriting standards in the business of housing finance. Although he claims to have tried to reverse course as early as 2003, that was the year he made the oft-quoted remark, “I want to roll the dice a little bit more in this situation toward subsidized housing.” Rather than reversing course, he was pressing on when others were beginning to have doubts.

    His most successful effort was to impose what were called “affordable housing” requirements on Fannie Mae and Freddie Mac in 1992. Before that time, these two government sponsored enterprises (GSEs) had been required to buy only mortgages that institutional investors would buy–in other words, prime mortgages–but Frank and others thought these standards made it too difficult for low income borrowers to buy homes. The affordable housing law required Fannie and Freddie to meet government quotas when they bought loans from banks and other mortgage originators.

    At first, this quota was 30%; that is, of all the loans they bought, 30% had to be made to people at or below the median income in their communities. HUD, however, was given authority to administer these quotas, and between 1992 and 2007, the quotas were raised from 30% to 50% under Clinton in 2000 and to 55% under Bush in 2007. Despite Frank’s effort to make this seem like a partisan issue, it isn’t. The Bush administration was just as guilty of this error as the Clinton administration. And Frank is right to say that he eventually saw his error and corrected it when he got the power to do so in 2007, but by then it was too late.

    It is certainly possible to find prime mortgages among borrowers below the median income, but when half or more of the mortgages the GSEs bought had to be made to people below that income level, it was inevitable that underwriting standards had to decline. And they did. By 2000, Fannie was offering no-downpayment loans. By 2002, Fannie and Freddie had bought well over $1 trillion of subprime and other low quality loans. Fannie and Freddie were by far the largest part of this effort, but the FHA, Federal Home Loan Banks, Veterans Administration and other agencies–all under congressional and HUD pressure–followed suit. This continued through the 1990s and 2000s until the housing bubble–created by all this government-backed spending–collapsed in 2007. As a result, in 2008, before the mortgage meltdown that triggered the crisis, there were 27 million subprime and other low quality mortgages in the US financial system. That was half of all mortgages. Of these, over 70% (19.2 million) were on the books of government agencies like Fannie and Freddie, so there is no doubt that the government created the demand for these weak loans; less than 30% (7.8 million) were held or distributed by the banks, which profited from the opportunity created by the government. When these mortgages failed in unprecedented numbers in 2008, driving down housing prices throughout the U.S., they weakened all financial institutions and caused the financial crisis.

    70% of the subprime loans were on the book of Uncle Sam.

    There can be no debate about it – the government wanted to increase home ownership statistics. And to do that, they forced the hand.

    By the way – one of the biggest reasons why folks on the margin can’t find a new job? They own a home and can’t afford to move to where the work is. For some people, renting is the best option.

    People totally outside the housing market lost their jobs or their investments when the economy tanked. The ones who suffered the most were the poor. The wealthy can take a hit on their portfolio and still enjoy nice homes and an easy life style, after all.

    Seems to be a very convincing argument in favor of moving SS funds to private accounts exposed to the market. According to this analysis, only the people NOT in the market were impacted. Those IN the market escaped harm at all.

    It’s also proof – absolute proof – that the ideology that the market is always best is dead wrong.

    No one is making that argument. We’re making the argument that the market is better at creating wealth and fairness than you and other regulators are.

    • #6 by Scott Erb on January 27, 2014 - 17:16

      Nothing in that counters my analysis. The person you cite (which I suspect is partisan) asserts it was a government created housing bubble, but that’s absurd. The subprime didn’t cause the problem, and the demand for mortgages to the tune of hundreds of trillions of dollars of mortgage backed derivatives were the cause – they drove up mortgage demand and housing prices. Nothing in that quote does ANYTHING to show that Freddie and Fannie were the cause of the bubble. It can’t show that because they weren’t. I suspect the person you are quoting has an ideologically motivated bias to try to push the blame on to government. But it can’t be done. This was absolutely a private sector big bank created crisis, with Freddie and Fannie on the sidelines through much of it (their standards were too strict up until 2007 when they loosened to try to regain their status – the big banks were buying everything). Seriously, there is NOTHING in your quote to suggest otherwise except one assertion.

      $1 trillion of bad subprime loans could not have caused this collapse, even if every loan was bad!

      • #7 by pino on January 27, 2014 - 17:51

        ,i>Nothing in that counters my analysis.

        Of course it does – you just can’t see it because you are wearing rose colored glasses. Just one, that Fannie was offering zero down loans in 2000 proves it.

        You claim that it wasn’t a subprime problem – but it was and the government drove it – to use your words – regulated it.

        This was absolutely a private sector big bank created crisis, with Freddie and Fannie on the sidelines through much of it (their standards were too strict up until 2007 when they loosened to try to regain their status – the big banks were buying everything).

        The banks were following the regulations forced on the by government. And yes, Fan and Fred were main drivers and the government the absolute cause.

        $1 trillion of bad subprime loans could not have caused this collapse, even if every loan was bad!

        That number is as of 2002 and only accounts for Fan and Fred. The government was much deeper by the crisis.

        You are the partisan in this. And it’s reflective that you can’t see it.

      • #8 by lbwoodgate on January 27, 2014 - 21:19

        “Fan and Fred were main drivers and the government the absolute cause.”

        If you can back this up Pino there’s a guy named Barry Ritholtz who’ll pay you $100,000. All you need to do is disprove the following facts:

        -The origination of subprime loans came primarily from non bank lenders not covered by the CRA;

        -The majority of the underwriting, at least for the first few years of the boom, were by these same non-bank lenders

        -When the big banks began chasing subprime, it was due to the profit motive, not any mandate from the President (a Republican) or the the Congress (Republican controlled) or the GSEs they oversaw.

        -Prior to 2005, nearly all of these sub-prime loans were bought by Wall Street — NOT Fannie & Freddie

        -In fact, prior to 2005, the GSEs were not permitted to purchase non-conforming mortgages.

        -After 2005, Fannie & Freddie changed their own rules to start buying these non-conforming mortgages — in order to maintain market share and compete with Wall Street for profits.

        -The change in FNM/FRE conforming mortgage purchases in 2005 was not due to any legislation or marching orders from the President (a Republican) or the the Congress (Republican controlled). It was the profit motive that led them to this action.

        Here’s his website and if you can make your claim stick, let us know how you did it.

        Get Me Rewrite

      • #9 by lbwoodgate on January 27, 2014 - 21:24

        You might want to review this report also Pino from the McClatchy group that challenges your allegations against the government, including fannie and freddie

        Private sector loans, not Fannie or Freddie, triggered crisis

    • #10 by lbwoodgate on January 27, 2014 - 21:29

      Who or what was your source on all of this Pino?

    • #11 by lbwoodgate on January 27, 2014 - 21:32

      “We’re making the argument that the market is better at creating wealth and fairness than you and other regulators are.”

      Wealth yes. Fairness? Not so much. Are you familiar with some of the terms being pushed by Big Pharma and the Telecom industry in the secret negitiations for the TransPacific Partnership?

  4. #12 by Scott Erb on January 27, 2014 - 22:12

    Blaming Freddie and Fannie or the government is absurd. The evidence is overwhelming. The banks were NOT loaning because of government regulation. Rather the lack of regulation allowed them to make bad loans and securitize them. They weren’t doing something they had to do. Click the link to “The Warning” (by the Brooksley Born photo) and you see how the banks and free marketeers fought the effort of minor regulation of derivative trade (just reporting how much) because they didn’t want limits. Nothing forced them to make loans, they were not following any regulation. Seriously, Pino, I can’t comprehend how you can make these claims!

    • #13 by pino on January 27, 2014 - 22:38

      Blaming Freddie and Fannie or the government is absurd.

      I have to admit that your inability to see government malfeasance is distressing. Be it the siblings, HUD or any other government agency the facts are very clear – government drove a policy of home ownership and THAT created the bubble.

      • #14 by Scott Erb on January 27, 2014 - 23:10

        Oh, I can see a lot of government malfeasance. But your claim above is something that is absurd, it is contrary to the evidence and the studies and Congressional investigations on what happened. You’re simply wrong, you can’t offer any support — yes, there were serious problems with Fannie Mae, but that does not mean they caused the bubble. I’ve given you a causal link in this post. You can’t provide one. Admit it Pino, in this case it was a private sector fiasco (government does get blamed for too cheap credit and lack of regulation) and the big banks and the derivative bonds drove the boom. Explain EXACTLY how government caused this. Be specific, lay out the argument with clear causal links.

      • #15 by Scott Erb on January 27, 2014 - 23:13

        And if you can make a case that they caused it, do so quickly. I’m teaching a course and giving the standard analysis that looks at Wall Street as the cause (including the Lewis book). A new unorthodox view blaming government seems very unlikely – but make your case.

  5. #16 by Scott Erb on January 27, 2014 - 22:45

    Oh, and what does 0 down loans in 2000 prove about anything? By 2004 zero down loans with interest only for two years, and home equity loans at 125% of value were common – and none of those were required by government regulation! I got a 0 down loan when I got my first house in 2000. It was at 8.3%, before the bubble started. 0 down loans were common, and not required by government regulation.

  6. #17 by runikus on February 9, 2014 - 18:36

    I may not be in classes but I can still read along! I’ve heard of this book (and anything recommended by you or Malcolm Gladwell HAS to be good)!

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