Johns Hopkins Lecture on Black Box Casino: Pricing the Key Causes of the Financial Crisis of 2008

Class Lecture
Carey School of Business
Johns Hopkins University
Washington, D.C. Campus

April 17, 2012

By Robert Stowe England

For most Americans, a thick fog still shrouds the origins of the financial crisis.

This is true despite the fact three years have past since the crisis burst on the scene in September 08 with the bankruptcy of Lehman Brothers.

Finding the answer to what went wrong is what compelled me to write Black Box Casino. In the end, it was a detective story where even a list of important actors could run into the hundreds.

At the center of origins of the crisis is a single industry – the mortgage industry.

As senior writer for Mortgage Banking magazine since 1988, I have reported on the vast changes sweeping through the industry for more than two decades.

We’ve come a long way.

In the early 1990s, the mortgage industry was disciplined by the free market. It was flexible and innovative. New loan products would appear and market players would experiment with flexible underwriting standards. Risky products were priced to cover expected losses. When players miscalculated, they were soon out of business.

A new player with new products or a new business model could become an overnight success. A successful mortgage banker could be quickly wiped out by changing conditions in the housing market, upstart competitors, or missteps in business strategy.

Over time, however, the virtues of the mortgage market slowly failed and the market became an engine of vice and toxic mortgages. It was Paradise Lost.

By the summer of 07 the entire private sector side of securitization had collapsed under the weight of bad mortgages. No investors would buy the securities that funded these mortgages, so no new lending could occur.

One year later in 08 the government-sponsored enterprise or GSE side of the market – Fannie Mae and Freddie Mac – failed and had to be nationalized. So far, their failure has caused the taxpayers $187 billion and the tally is still rising.

Fannie and Freddie, once the benchmarks for prime credit, became fallen angels.

An insider at one of the downtrodden duo has told me: “Our reputation is somewhere just above or just below that of the Ebola virus.”

That was said before the Securities and Exchange Commission in December charged six former Fannie and Freddie executives with fraud for engaging in vast amounts of subprime and risky lending while lying to the public and investors to hide it.

Never has a market so large – at $11 trillion in ’08 one of the largest securities market in the world at the time – failed so thoroughly and spectacularly.

The failure of the mortgage industry is the underlying event that created trillions in toxic assets spread around the globe that set the stage for the larger financial crisis.

The extent of risky lending and shady accounting practices were hidden because so much activity had moved into black boxes – which are financial institutions or instruments that lack transparency.

Watching the mortgage market collapse was a shocking experience for me. It was even more alarming to watch the fallout from that crash mushroom into the financial crisis.

While many connections in the framework of causation will be debated for many years, I think we can safely make some conclusions and be confident about them.

In the debate over who and what caused the crisis, it is important to understand the difference between fundamental causes that created the conditions for the crisis and the proximate causes that lit the match to the gunpowder that blew up of the financial system.

I think there is fairly widespread agreement that the Lehman Brothers bankruptcy is the explosion that brought us the crisis.

Using war military history a metaphor, Lehman’s failure’s role in the financial crisis is equivalent to the role of the 1914 assassination of the Archduke Ferdinand in Sarajevo to World War I.

The failure of Lehman did not occur in a vacuum and would not have happened without the decline and fall of the mortgage industry and the fallout from the mortgage meltdown.

Root causes

We need to go back to root causes to understand why the mortgage market failed. When we do that, we find that Fannie and Freddie were the key contributors to the fundamental transformation of the mortgage market from a sound one to an unsound one.

They were part of a larger infrastructure of housing policies put together in Washington in the mid-1990s that set the mortgage market on the road to ruin.

Congress is the ultimate responsible party for the failure of Fannie and Freddie because Congress wrote a terribly flawed and dangerous law in 1992 to set up the system of regulation to govern the two GSEs. That law is called the Federal Housing Enterprises Financial Safety and Soundness Act. It is often shortened to the GSE Act. Its provisions did not assure safety and soundness – indeed, they worked to guarantee the institutions would fail.

Thus, I put the 102nd Congress at the top of any list of causes of the crisis, with special blame to House Banking Committee Chairman Henry Gonzalez.

This maverick Texan, who boasted he refused campaign contributions from PACs, secretly handed over the writing of the law to an informal alliance of housing activists, such as ACORN, who were not at all interested in safety and soundness and Jim Johnson, chairman of Fannie Mae. The agreements hammered out between the activists and Johnson were introduced as Gonzalez’s own bill and became law.

I also blame all subsequent Congresses up to 110th Congress for failing to deal in a timely fashion with the problems created by the 102nd Congress.

Virtually every provision in the GSE Act was toxic and created moral hazard and, in retrospect, the law seemed to have been set up to benefit politicians and reward executives at Fannie and Freddie first and foremost, and generate funds for community and housing advocates secondarily. Taxpayers and everyone else be damned.

The law set up capital standards that were far too low – 0.45 percent of capital against the guarantees by Fannie and Freddie they would pay investors their regulator payments of principal and interest. That’s a leverage of 200 to 1. As billions in loans have failed, it is the taxpayer now paying the holders of those securities.

Fannie and Freddie had to hold only 2.5 percent capital for any securities and loans they decided to keep on their balance sheet – usually done to improve profits and reward top executives. This compares to 4 percent capital requirements for banks holding mortgages.

The regulator for Fannie and Freddie – the Office of Federal Housing Enterprise Oversight or OFHEO – was not an independent agency, but housed within the Department of Housing and Urban Affairs or HUD. You can give part of the blame for that to the first Bush Administration’s Treasury Secretary Jim Brady, who implausibly wanted to see OFHEO under HUD’s thumb.

Under the GSE Act, Fannie and Freddie did not have to have audit their financial statements or make periodic filings to the SEC. They were not subject to the kinds of accounting rules banks have to follow. This legally-sanctioned cover of darkness created an environment where executives could manipulate earnings and increase compensation – which Franklin Raines, Leland Brendsel and others did with gusto. And paid no penalty for their massive accounting control fraud.

The law also gave HUD the authority to set affordable housing goals – which were broad lending quotas to three designated population targets: a broad low and middle income target, a separate target for low income, as well as goal for rural and urban geographies with high levels of low income and minorities.

The affordable housing targets could be raised by HUD without regard for the safety and soundness of Fannie and Freddie and OFHEO had no say in the matter. OFHEO also had no authority to require Fannie and Freddie to raise their capital standards or reduce their assets to improve their safety and soundness.

Given the political appeal for members Congress to boast they were providing housing for targeted populations, it was inevitable that the goals would be raised ever higher and higher until Fannie and Freddie failed. And that is what happened.

The goal for low and moderate income rose from 30 percent to 57 percent. The separate low-income goal rose from 11 percent to 27 percent. So, nearly one-third of all loans had to go to a population that historically had the lowest homeownership rates. Fannie and Freddie could not achieve these goals without steady and significant declines in lending standards.

In addition to engaging in subprime and other risky lending and hiding it from the public, Fannie and Freddie also acquired hundreds of billions in private label MBS and held them in their portfolio. They were allowed to count those against their affordable housing goals.

Former Federal Housing Finance Agency director Jim Lockhart has said that Fannie and Freddie could not have met their affordable housing goals without buying the private label securities they loaded onto their balance sheet. In 2004, for example, the GSEs bought 45 percent of all subprime private label securities issued.

By mid-08, Fannie and Freddie held $2 trillion of $4.8 trillion in risky mortgages outstanding in the market. Another $900 billion from FHA, VA and other programs brings the government-related total for risky loans then outstanding to $2.9 trillion – greater than the $1.9 trillion represented by the private label MBS market.

Thus, the government share of risky mortgages was 60 percent versus 40 percent for the private MBS for the private sector securities.

It’s no surprise then that the largest toll to taxpayers so far is to cover losses at Fannie and Freddie – far, far more than losses incurred in any of the other bailouts.

Private Sector

While Fannie and Freddie drove the trend to riskier and riskier mortgages in the 1990s and early 2000s, beginning around 03 and 04, the private sector took the lead.

Private label had gained a dominant share of mortgage securitization by 05 – not by doing more jumbo prime lending but by greatly expanding subprime and greatly weakening lending standards in the Alt-A business.

Indeed the $1.8 trillion in risky mortgages in the private label side were of poorer credit quality than many, if not most of the risky loans in the government sector.

What went wrong?

Part of this derives from a decision by key players to go for market share at exactly the wrong time. The leader of the pack was Angelo Mozilo, chairman and co-founder of Countrywide, who set out to dramatically increase market share in 2003. At the time, the mortgage company’s share was 11 percent. Mozilo wanted to raise it to what anyone would deem to be an impossible 30 percent by 2010.

Countrywide was able to reach a nearly 17 percent share of originations by 07 but the company was on the verge of failing. It was first rescued from collapse and then acquired by Bank of America.

Mozilo and many other mortgage bankers, surprised perhaps at the degree to which investors were willing to fund subprime and Alt-A mortgages in the midst of the growing housing bubble, were able to pursue market share schemes and competitive strategies that would embarrass a novice riverboat gambler.

Fannie and Freddie responded to private label’s growing market share by jumping deeply into the adjustable rate mortgage or ARM market in 2004, becoming one of the nation’s biggest predatory lenders with atrocious products such as 2/28 ARMs for wage earners with both low FICOs and stated or no incomes.

The private sector, nor surprisingly got the short end of the stick when Fannie and Freddie decided to move lower into subprime credit scores to take market share. That’s because having an implicit government guarantee gave them a pricing advantage and they could undercut the private sector in whatever market they chose to enter.

Why didn’t the private market correct? Why didn’t investors in private label pull back?

The answer is that Wall Street found a way to short-circuit a market correction and keep the securitization party going by rolling unwanted BBB tranches of subprime securities into AAA subprime collateralized debt obligations or CDOs.

In my book I recount how Kyle Bass, a hedge fund manager from Texas who invested in subprime, inadvertently learned about Wall Street’s role when he attended a friend’s wedding in a small Mediterranean resort town in Spain. There he was introduced to someone from a major investment bank who clued him in on what Bass later called “the greatest bait and switch of all time.”

The investment banker told Bass that American institutional investors had stopped buying the BBB or non-investment grade tranches of private label subprime MBS beginning in ’03 and the people who put these deals together were looking for a way to keep the party going.

The solution: Wall Street firms, such as Credit Suisse, began to create CDOs to acquire the unwanted BBB tranches and thereby turn 91 percent of them into AAA-rated CDOs. This was justified as sound financial engineering under the idea that geographic diversification of the loans would prevent sufficient losses to hit cash flow to the AAAs.

American investors were not particularly attracted to the CDO AAA’s, knowing full well they were BBB subprime securities disguised as AAAs.

The guy from the big investment bank told Kyle Bass that it was foreign investors with dollar surpluses who needed dollar-denominated investments that fell for AAA subprime CDOs, including banks and investors in Asia and Europe. For these investors, the higher coupon on these triple A’s seemed irresistible and they snapped them up.

Wall Street would never have been able to engage in this alchemy without a key decision made by Basel Committee on Banking Supervision, representing the major central banks of the world.

Thanks to agreement among central bankers in Basel, it was recommended that private label MBS be given the same low 1.6 percent capital requirement as Fannie and Freddie securities. That idea emerged in a Basel white paper in 1999, and was adopted by U.S. banking regulators and went into effect in ’02. Moody’s Investor’s Service strenuously objected to the idea in a letter to the Basel Committee in 2000, warning if it were adopted, it would create moral hazard.

What Moody’s realized then was that the new capital rules meant credit rating agencies would determine bank capital requirements as they handed out their credit ratings. Since the agencies had to rate each deal and not a broad class of investments, they would face intense pressure to give AAA ratings from the securities issuers who were paying to rate the deal, according to Moody’s.

We all now know Moody’s was right and the Basel Committee was foolish when it failed to heed Moody’s advice.

As the subprime CDO market took off in 05, Merrill Lynch and Citigroup expanded their business at the worst time and ended up holding more toxic CDO assets than any of the others by 07.  All the other major Wall Street firms, however, were also holding significant amounts toxic assets: Morgan Stanley, Goldman Sachs, JPMorgan Chase, Lehman and Bear Stearns.

Shadow Banking

Meanwhile another great secular trend – shadow banking – made the global markets more vulnerable to panics from the sudden disclosure large hidden accumulations of toxic assets.

Indeed the growth of Fannie Mae and Freddie Mac greatly expanded shadow banking and they were the largest institutions in this segment.

A vast increase in overnight lending at very low interest rates, used to acquire high-yielding assets, like subprime mortgages and CDOs, put the global financial system at risk. For example, by mid-08, there were $7 trillion Treasury repos turning over daily.

Two hedge funds at Bear Stearns, relying heavily on overnight funding, used those funds to invest heavily in subprime MBS and CDOs to maximize returns for investors. The collapse of the two funds in June 07 dramatically exposed the vulnerabilities of the shadow banking system.

Yet, the regulators failed to grasp what was happening.

Less than two months later, in August ’07, the entire world of private label mortgage-backed securities collapsed – and with it the entire market for all asset-backed securities and all asset-backed CDOs.

Synthetic CDOs magnified the extent of the impact of the crash of CDOs by greatly increasing the size of bets made on subprime MBS.

Synthetic CDOs were made possible by creating a super senior tranche made up entirely of credit default swap contracts. The Wall Street firms that arranged the CDOs guaranteed the timely payment of principal and interest on one side of the credit default swap contracts, with savvy hedge fund investors snapping up the other side of the contract, standing to benefit when subprime MBS cratered.

Wall Street firms were able to put together synthetic CDOs because they could buy insurance protection from AIG and others to cover their guarantees. The synthetic CDO was even more perverse than the cash CDO because it creating opposing interests betting for and against the deal.

Some investors did not understand the idea of opposing interests and assumed deals were put together to be good investments. Even at AIG, people were slow to begin to ask whether or not their insurance against subprime loans might encourage CDO managers to deliberately create a pool of bad assets that would fail.

Some underwriters for these deals worked with the parties betting against them to identify what assets should go into the deal. This is how Goldman Sachs got into trouble in the Abacus deal that became the focus of a day-long hearing. Hedge fund manager John Paulson made $15 billion in 07 betting against subprime securities. These were zero-sum bets where other parties had to lose $15 billion.

It was really hedge funds, not Wall Street firms, that drove the process of adverse selection. Many of them sponsored CDOs so they could bet against subprime MBS referenced in the credit default swaps in the deal. To keep the CDO mania going, Wall Street firms began to sell each other their BBB tranches because no one else wanted them. Wall Street banks also held on to the super senior tranches when they could no longer obtain back-up insurance because they were deemed to be super safe.

A single Chicago hedge fund, Magnetar, sponsored $50 billion in CDOs that failed spectacularly. They made big gains betting against the deals they sponsored while publicly claiming to be neutral on the housing market.

The demand for weaker subprime credits had a perverse effect. To generate the BBB’s that went into the CDO, about ten times as many AAA and AA subprime securities had to be created. This was not too difficult, as Fannie and Freddie continued to be the biggest buyers of AAAs.

To meet the overall demand by CDOs for subprime private MBS, mortgage lenders increased the overall level of subprime and risky mortgages.

In an outcome a James Bond villain would love, hedge funds and Wall Street were facilitating a flow of funds into the mortgage industry in search of bad credits.

While securitization was supposed to distribute risk widely and thus improve the safety and soundness of the global financial system, it instead did the opposite. It dramatically weakened the financial system.

Wall Street firms and some major banks ended up holding concentrations of toxic assets – something they typically avoided in the past.

While losses were spread across the globe, the losses were greatly magnified through the use of credit default swaps.

The overall level of bets in the credit default system hit $45 trillion in 2008 against actual financial assets of $25 trillion, meaning that there were $20 trillion in naked credit default swaps that were pure casino bets. We don’t really know how much of that $20 trillion was bet on subprime – since the banking regulators did not track all of these assets for any non-depository institutions.

What if the subprime CDO market had never existed?

If Wall Street had not developed the subprime CDO and the subprime originations had remained at the ’02 level, there would have been $1.12 trillion less in private label mortgage backed securities and, of course, none of the $700 billion in subprime CDOs. Without synthetic CDOs, the huge credit default swap casino bets would not have been made. The entire crisis would have been greatly contained.

The hand of Fannie and Freddie should also be recognized in the CDO market. As the largest buyers of subprime MBS, they helped generate the raw material for the CDOs. Without them, the CDO market would have been smaller.

If Fannie and Freddie had limited themselves to buying sound prime loans and securities, after the bubble burst, housing prices would likely have seen lower price declines that the plus 30 percent level that topped the declines in the Great Depression.

That would be the case because there would have been fewer bad mortgages likely to fail and, thus, less houses would have come on the market. With less supply of foreclosed homes, the hit to private label MBS would have been less pronounced. Ditto to the hit to the financial system and the economy.

So the two factors in the mortgage market fueled the housing bubble: Fannie and Freddie’s wild funding spree driven by lowering underwriting standards, combined with the toxic subprime CDO market. These excesses created so many bad loans that when the bubble burst, the landing was far worse than it would have been if the bubble had been fueled only by low interest rates, as it was in other countries.

Bear Stearns

Bear Stearns became the first major victim of the fears about the level of toxic assets on balance sheets. Alan Schwartz, former Bear Stearns CEO, has acknowledged this point. This is one of the rare and plausible public insights from a principal player in the crisis.

The consequences of the panic over what was feared to lurk on Bear Stearns balance sheet was magnified by a critical error made by the Securities and Exchange Commission in 07, when the agency did away with the uptick rule. This rule disallowed short selling of securities except on an uptick or small increase in the price of a security.

In particular, the end of the uptick rule made in possible for market manipulators to engage in naked short selling on a vast scale and conduct bear raids that could crash their target completely. A naked short sale is when someone sells a security they do not own or have not borrowed – it is illegal.

Like a cloud of locusts over a cash crop ready for harvest, naked short sellers struck Bear Stearns with a swift devastating strike. It all began on March 11, 08, when an unidentified party made a $1.7 million bet through put options that Bear Stearns would collapse within 10 days. It was a stunning bet that no one would make without “knowing something” the rest of us did not know.

False rumors were widely circulated on Wall Street that Bear Stearns was out of cash even though they had $18 billion on hand. Panicky investment funds began to pull out their brokerage accounts from Bear and overnight lenders refused to roll over cash from repos. In only few short days, Bear Stearns was down to $2 billion in cash and on the verge of collapse.

During the same period, unknown parties placed sell orders for more than millions shares of Bear Stearns they did not own or borrow and failed to deliver when the settlement date arrived. This is an illegal activity.

Bear Stearns had a share price of $62 before the bear run. But in a matter of days, out of options, the company agreed to be sold to JPMorgan Chase for $2 a share or $236 million, less than the value of its corporate headquarters. Meanwhile, the party who had placed the $1.7 million bet pocketed $271 million – more than the initial sale price of Bears Stearns to JPMorgan Chase.

While the collapse of Bears Stearns should have been a wake-up call to Chris Cox at the SEC and Hank Paulson at Treasury, no one took steps to prevent naked short selling from bringing down other investment banks – as the market now expected. The feds, as Paulson recounts in his book On The Brink, began to prepare for a potential rescue of Lehman or, failing that, a plan to limit the damage.

Only six months later in September 2008, naked short sellers struck again. They sold tens of millions of shares of Lehman Brothers they did not own or borrow. In a matter of days they forced the company into bankruptcy, precipitating the financial crisis of 2008.

The regulators could have forestalled Lehman by earlier temporarily banning short sales on key financial firms – something they did after Lehman to stop a run on Morgan Stanley and Goldman Sachs – or reinstating the uptick rule on an emergency basis.

Having failed, thus, to take the steps that could have prevented the crisis, could they have still forestalled Lehman’s bankruptcy at the 11th hour?

That is often view as the most important question surrounding the crisis.

I believe Lehman could have been saved and should have been saved.

First, let me briefly explain what authorities were trying to do before the collapse. Under Treasury’s lead, federal officials were working over the summer to break Lehman into a good bank and bad bank. The good bank would be sold to a willing buyer looking to pick up Lehman’s best assets for a deep discount.

Paulson wanted a consortium of big banks to buy Lehman bad assets and place them into a special purpose vehicle like the Maiden Lane entity set up for Bear Stearns’s bad assets in March.

Indeed, Paulson called together the heads of the major banks at the New York Fed in September – that scene was recreated in the HBO special Too Big To Fail. People like Jamie Dimon, Lloyd Blankfein, and John Mack engaged in marathon round-the-clock negotiations. They reached agreement to fund the purchase of the bad assets and place them in a new Maiden Lane. In principle, they agreed to share an estimated $10 billion in losses to remove the bad assets from Lehman’s books.

A private sector solution without a government bailout was about to be consummated. The only thing unsettled at the point was whether or not there was a buyer for the good assets.

After Bank of America backed out at the last minute, Barclays Bank, headquartered in the United Kingdom, agreed to buy the good assets at Lehman.

There was one hitch from Chancellor of the Exchequer Alistair Darling. He said that Barclays could not guarantee Lehman’s assets from the time the deal was struck until the time Barclays board could meet and agree on the deal, which could be 30 to 60 days. Another entity would have to take on that exposure.

The most likely candidate was the Federal Reserve. Bernanke, in testimony, claimed the Fed could not engage in loans or guarantees at Lehman because the value of the assets at Lehman were insufficient to cover the Fed’s exposure.

Neither Bernanke nor Paulson have ever revealed what options they were considering when they let Lehman go bankrupt. They did not say if they considered the option of having the Fed guarantee the trades.

Fed historian Allan Meltzer claimed the Fed had the authority to guarantee the trades and its failure to do so constitutes the biggest mistake the Fed has made in its entire history. I would agree.

One should also lay blame at the feet of Lehman’s chairman Dick Fuld, for failing to move in a timely manner to find a company to buy Lehman when it was still possible in the spring or early summer of 08.

As one observer put it, “They kept sending an ambulance and Dick Fuld refused to get in it.”

So what is the bottom line here? No major actor in the crisis who broke the law or engaged in reckless market manipulation and made fortunes in the process has been brought to justice. It is a colossal failure on the part of our political and judicial systems.

Further, those who made colossal policy blunders in Washington or foolish business decisions on Wall Street have issued no mea culpas and have shown no contrition.

With no honest assessment of what caused the crisis, the right remedies will not be put into place and we will soon find ourselves sailing into another crisis on an even bigger scale.

I have given nearly a dozen book talks since my book was published last fall and, to my chagrin, I have left many audiences depressed. Not wishing to repeat that here, I have tried to come up with some a few positives to report.

We face the difficult task of reviving the mortgage market – that is the most important we need to do right now. On that front, surprisingly, there are some noteworthy developments, albeit tentative ones.

Timothy Geithner’s Treasury Department has demonstrated a good understanding of how housing, mortgage and financial markets work. Their white paper in early 2011 declared that a future vibrant mortgage and housing market should rely primarily on the private sector. They also called for gradually shutting down Fannie and Freddie.

Yet, thanks to Dodd-Frank, bank regulators are in the process of imposing severe restrictions that will significantly limit the availability of mortgage finance and further delay a full housing recovery. It will also increase, not decrease the need for Fannie, Freddie and the FHA.

In Congress, important work has been done under the guidance of Representative Scott Garrett, Chairman of the House Subcommittee on Capital Markets and Government-Sponsored Enterprises. Legislation has come out of that committee that gives the Federal Housing Finance Agency the power to set underwriting and securitization standards that could help spark a revival of private label securitization.

Ed DeMarco at FHFA has done a stand-up job keeping Fannie and Freddie on the straight and narrow in terms of limiting the cost of the taxpayer bailout and forced them to cooperate with the SEC’s investigation – which led to the charges being filed late last year. Bravo to Ed.

The recent federal and state attorneys national mortgage settlement, however, is seen by mortgage investors as a setback to their property rights and might both reduce the available of mortgage funding and the cost of that funding in the future.

Thus, we’re still a long way from a revival in the mortgage market. That, in turn, is a serious impediment to a recovery in the housing sector.


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