Black Box Casino Reveals Mad Max Follies of Crisis
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What Went Wrong
By Robert Stowe England
Remarks Made at a Book Signing at the Federal Street Gallery in Milton, Delaware
November 5, 2011
My name is Robert Stowe England and I’m here today to shed a spotlight on the causes of the financial crisis of 2008.
If you are like me, when this crisis broke, you were shocked and outraged that things could get so out of hand and cause such an enormous calamity – the worst financial crisis of modern times.
Something had gone terribly wrong to deliver us into the world of Mad Max, where the norms we thought necessary for society have vanished. We saw financial institutions crashing all around us while authorities seemed powerless to do anything about it.
As a financial journalist, I covered the mortgage industry at the heart of the crisis. I was on the frontlines reporting a multitude of institutional and market failures that began to unfold early in 2007.
By August 2007, fully half the mortgage market had collapsed or had to be rescued. By September 2008, most of the rest of the mortgage market had to be salvaged by a government takeover of Fannie Mae and Freddie Mac.
As the bills for the crisis mount, the cost of bailing out Fannie and Freddie have been the biggest for taxpayers, nearly $175 billion so far. The final tally could rise to $380 billion, according to Washington estimates, or nearly $700 billion according to Standard & Poor’s.
At the time of the crisis, the mortgage market was probably the largest single largest financial market in the world at $11 trillion.
From the beginning, I found mortgage banking to be a fascinating, tough, and dynamic industry. Mortgage bankers sometimes had to be as vigilant and focused as fighter pilots in order to navigate the challenges they faced.
Those who took their eyes off the ball were dealt a swift and ruthless judgment by competitors and the markets.
Mortgage companies survived by being nimble and quick. They were able to double their capacity to originate loans in short order when necessary – or cut their capacity in half. The value of the assets mortgage bankers owned could be decimated falling interest rates. If you made bad loans, you had to buy them back from the investors and take the losses.
The markets ruled with a vengeance. It was not just Adam Smith’s famous invisible hand at work. It was more like an invisible fist.
It was my first year on the mortgage beat that I met and profiled Angelo Mozilo, co-founder of Countrywide Home Loans.
To interview Angelo, I went to the company’s headquarters in Pasadena, California. At 47, he was already known for his perpetual tan. The wide-ranging interviewed last 7 hours and included a tour of Countrywide’s growing collection of Hudson River Valley School landscape paintings.
Mozilo was the epitome of the dynamic mortgage market and Countrywide became the pacesetter and leader of the industry. He had passion for mortgage banking that suited the business.
By 2009, however, Angelo had become the chief villain of the financial crisis on the front page of the New York Times.
But something we terrible wrong. In the early 1990s virtually the entire mortgage market was made up of sound credits. By 2008, $4.7 trillion or nearly half of all mortgages outstanding were risky loans.
This huge volume of bad mortgage credits is at the root of the financial crisis.
The road to ruin for the mortgage market began in 1992 when Congress passed a law that established a regulatory framework for Fannie and Freddie. The short name for the law was the GSE Act. GSE is short for government-sponsored enterprise – a firm privately held by shareholders, but with a mission assigned by the government.
The GSE Act was supposed to assure that Fannie and Freddie would be operated in a safe and sound manner and not meet the same fate as the savings and loan industry, much of which failed in the 1980s.
Washington policy makers thought that turning mortgage loans into securities would avoid the problems of the savings and loans that held loans on their own books.
Fannie and Freddie would buy mortgages and pool them into a trust and issue mortgage-backed securities that Wall Street would sell to investors as AAA bonds – AAA because of the implicit guarantee of the federal government.
In theory, securitization was a good idea. But, the GSE Act created a set of rules riddled with flaws and Trojan horses that would bring about the downfall of the market.
For starters, under the GSE Act, the regulator for Fannie and Freddie was not an independent agency like the banking regulators but part of the Department of Housing and Urban Affairs or HUD.
Also under the GSE Act, Fannie and Freddie had a tiny capital base of 2.5 percent that could be quickly wiped out by losses. Well-capitalized banks by contrast have to have 10 percent capital.
Further, the regulator was not allowed to raise capital requirements if capital levels were deemed inadequate.
Also, Fannie and Freddie did not have to file quarterly reports with the Securities and Exchange Commission or SEC. They didn’t have to audit their financial statements.
They were allowed to lobby Congress.
They could hold securities on their balance sheet to boost profits and compensation for executives even though the whole point of their existence was to transfer that risk to investors.
The law governing Fannie and Freddie was part a new era in Washington where it became official government policy to push down lending standards to expand home ownership to lower income and minority households.
Over the years, as lending standards fell lower, mortgage origination volumes rose higher. Subprime and other risky loans took a steadily larger share and this flood of money into mortgages helped launch the housing bubble.
I warned way back in 1993 that trying to achieve equal outcomes for people with good credit and a good down payment and people with bad credit and little or no down payment was destined to cause grief and serious financial harm.
The GSE Act also set affordable housing goals for Fannie and Freddie to be set not by the regulator buy by the Department of Housing and Urban Development or HUD.
With Congress constantly applying the pressure, a sucession of HUD Secretaries from Henry Cisneros, Andrew Cuomo to Alphonso Jackson steadily raised the affordable housing goals.
For members of Congress, it was a political bonanza. They could take credit for benefits for constituents without having to go through the budgeting process, no matter that loans were made to people who could not pay them back.
In 1992, 30 percent of all mortgages acquired by the GSEs were aimed at low and moderate-income households. By 2008, the affordable housing goals required that 56 percent of all loans target that same population.
To meet these goals, lending standards had to steadily fall. In 1996, Fannie and Freddie ventured into 3 percent down payments. In 2000 they launched no down payment loans. They also ventured into subprime lending but mostly hid that activity by refusing to identify most of it as subprime.
In 2003 and 2004 Freddie and Fannie were caught up in huge accounting scandals. Leland Brendsel at the helm at Freddie and Franklin Raines at Fannie were found to have manipulated earnings to increase their compensation.
While both had to resign, Brendsel went quietly but Raines went out kicking and screaming. Neither paid any real penalty for their fraud. Brendsel, who had made $30,000 in campaign contributions the prior year, walked off with $24 million, while Raines hauled off $92 million.
The failure to hold Brendsel and Raines to account sent a dangerous signal, I think, to others who contemplated fraudulent schemes. Rewards could be huge and the potential downside limited.
Fannie and Freddie grow so large that by 2004, Fed Chairman Alan Greenspan worried that if one of them failed, it would pose systemic risk.
Fannie and Freddie, however, are only part of the story.
Wall Street came up with private label mortgage-backed securities to compete with Fannie and Freddie, including jumbo mortgages, Alt-A or low or no documentation loans, and subprime loans.
In 1995 HUD decreed that the GSEs could buy those private label securities to meet their ever-rising affordable housing goals. Former GSE regulator Jim Lockhart has said Fannie and Freddie could never have met those goals without buying the private label securities.
Fannie and Freddie and the private label originators fought for market share in a race to the bottom of the mortgage credit pool. With a pricing advantage, the GSEs took the stronger credit in the subprime market.
New and increasingly predatory loans appeared. There were interest only mortgages did not pay down the principal and resulted in huge jumps in payments after few years.
Just about anyone could qualify for no income no asset or loans. Then there were no income no job no asset loans.
It got to the point the mortgage brokers were scouting out illegal immigrants with menial jobs to give them loans even when the borrowers were not even thinking about buying a home.
In South San Francisco, a cleaning lady bought a house for $700,000 with no money down and walked away from the closing with $8,000 in cash. Shocked to learn how much each month’s payment would be, she and her husband moved out of the house after three weeks and never made a single payment.
What happened to the famed market discipline that rule the mortgage industry?
Beginning in 2002, Wall Street was having trouble selling the lower credit quality pieces or tranches of private label mortgage-backed securities to investors. These were rated A, BBB and BBB minus.
American institutional investors had stopped buying these lower-rated tranches that served as a buffer for losses for investors in the AAA bonds. Without buyers for the lower-rated bonds, the subprime private label market should have corrected – or even crashed.
However, Wall Street came up with the idea of taking all the lower credit pieces of subprime and other risky mortgage bonds and rolling them into collateralized debt obligations or CDOs.
Texas hedge fund manager Kyle Bass said it best when he called the subprime CDOs “the biggest bait and switch of all time.”
Wall Street was able to sell these assets to European and Asian buyers, who took the AAA rating as a seal of approval, without seriously questioning the process by which the credit rating agencies gave them such a rating.
These buyers of AAA CDO bonds had mountains of dollars from trade surpluses and recycled petro dollars and needed dollar investments. At a time of low interest rates, they couldn’t resist the higher premium offered by CDO bonds with AAA ratings. It seemed too good to be true. It was.
How could a bunch of bad credits rolled together create good credits? It was the financial equivalent of weaving flax into gold. Few seemed to question this improbable fairy tale that was justified with sophisticated computer models.
Even with willing buyers, the subprime CDO business faced another problem. No one really wanted the lower credit rated CDO tranches.
But, Wall Street firms came up with a solution. They would sell each other those lower tranches in order to generate the deals and earn the fees. Their gentlemen’s agreement was
“You buy my BBB tranches and I’ll buy yours.”
Often senior management at these firms did not understand the risk this posed – or did not want to know. All that mattered was that the deals were generating huge bonuses for everybody.
The creation of so many unloved lower-rated tranches of CDOs caught the eye of hedge funds who loved them because they were so bad.
Hedge funds wanted them at first because of their high returns, but later they decided to bet against them.
In time, hedge funds came to sponsor almost half of all CDOs. They would buy the equity piece of the deal for its super high premium while at the same time making much larger bets against lower rated tranches. They expected to get rich off the failure of the U.S. housing market.
Hedge funds were not supposed to choose the assets placed in CDOs – but evidence suggests strongly that they were able to influence those decisions to include more are more of the worst credits.
The demand from CDOs for weaker subprime credits – usually only a fraction of each deal – had a perverse effect. It greatly increased demand for mortgage lenders to increase the volume overall level of subprime and risky mortgages to supply the bonds needed for the CDOs.
In short, the subprime CDO business was poisoning the private label mortgage-backed securities business.
In an outcome James Bond villain Goldfinger would love, Wall Street was creating a flow of funds into the mortgage industry in search of bad credits.
Subprime mortgage originator Bill Dallas of Ownit opened a window into this world when he said Wall Street was paying him more to do a loan with poor underwriting than one with good underwriting.
Merrill Lynch and Citigroup were the kings of CDOs and bear much of the blame for the crisis.
Merrill’s chairman Stanley O’Neil made $91 million in 2006 while turbocharging the CDO business. A year later, Merrill had to take an $8.3 billion write-down and O’Neal was fired, walking away with another $151 million.
At Citigroup, it was Robert Rubin who talked chairman Chuck Prince into diving headlong into the CDO business. Citigroup hid the toxic assets it was creating in structured investment vehicles or SIVs off its balance sheet and in black boxes on its balance sheet.
In the first and second quarter of 2007, the company concealed the existence of $50 billion in subprime assets in its audited SEC filings.
Even though top officials are required to personally sign accounting statements and be held personally liable, the SEC did not investigate Prince or Rubin. The case was settled with minor fines to lower-level officials.
A whistleblower inside Citi named Richard Bowen tried to warn Rubin about the growing volume of bad mortgages feeding the CDO monster.
Bowen gave his warning in a memo to Rubin titled “URGENT—READ IMMEDIATELY,” all in capital letters. He told Rubin Citi could face billions in losses if investors demanded Citi repurchase defective loans.
When called before the Financial Crisis Inquiry Commission, Rubin was asked about the memo. His answer? “[E]ither I or somebody else, and I truly do not remember who, but either I or somebody else sent it to the appropriate people, and I do know factually that that was acted on promptly and actions were taken in response to it.”
Clearly nothing was done. Citi would have failed if Treasury, the FDIC and the Fed hadn’t put together $476 billion in TARP funds and guarantees against losses from bad mortgage assets.
Washington’s worst dereliction of duty was its failure to enforce the laws on the books that could have helped prevent or mitigate the crisis.
The SEC was the weakest link – mostly by Congressional design – but also because it was a lax enforcer of laws against fraud and market manipulation.
Take the case of the naked short sellers that brought down Bear Stearns. On March 11, 2008, an unidentified party made a $1.7 million bet through put options that Bear Stearns would collapse within 10 days.
At the same time, rumors were widely circulated that Bear Stearns was out of cash even though they had $18 billion on hand. Investment funds began to pull out their brokerage accounts. In only few short days, Bear Stearns was down to $2 billion in cash and on the verge of collapse.
More than ten million shares were sold into the market by “sellers” who did not own them or had not borrowed them, as required by law. This pushed Bear’s share price from $62 to $30.
Facing a sudden demise, Bear agreed to be sold to JPMorgan for $2 a share or $236 million, less than the value of its corporate headquarters. Meanwhile, the party who had place the $1.7 million bet made $271 million.
There was a SEC investigation of the naked short selling of Bear’s shares but not one was brought to justice.
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.
Only six months later in September 2008, naked short sellers struck again. They sold tens of millions of Lehman Brothers’ shares they did not own or borrow. In a matter of days they forced the company into bankruptcy, precipitating the financial crisis of 2008.
The SEC won’t even say if there was an investigation of the Lehman naked short sales. No one has been brought to justice.
There is another painful lesson learned from the crisis. The architecture of financial system had grown far more rickety and vulnerable.
During 2007 and 2008, there were massive mostly hidden runs on both the shadow banking system and on regulated banks and investment banks.
It all began in August 2007, when a panic began in overnight funding contracts known as repurchase agreements or repos. Firms can obtain cash by selling their assets overnight and buying them back the next day for a tiny increase in price of those assets
The panic got underway on trading desks when the parties that provided overnight cash wanted additional collateral above and beyond the value of the cash. They were asking for a haircut on the value of the assets.
By the end of 2008, a steadily increasing haircuts drained more than a trillion dollars out of the banking system. It all happened out of the public eye.
There were other calamities. For example, a run on SIVs that funded by asset-backed commercial paper drained another $451 billion out of the system in late 2007.
Credit default swaps, a form of insurance against debts, brought more financial pain. Margin calls on the swaps began to drain funds from the system, bringing down the world’s largest insurance company AIG.
How did the financial get to be so weak? That is the question that I sought to answer. It was a monumental mystery that needed to be investigated and explained.
Not surprisingly, people central to the story did not want to talk. I learned that the fastest way to a dial tone was to call a Wall Street firm and ask to talk about subprime CDOs.
Progress was slow, but I managed to piece together the story.
Black Box Casino is a story about the one half of the world of banking that is shadow banking. It is the story of how huge swaths of that shadow banking and financial activity moved into black boxes.
Black boxes are financial institutions and vehicles with no transparency. You can’t see inside and know what bad assets might be hidden there. I discovered through my work, that some of these black boxes housed financial casinos where fast money and high stakes were the norm.
Black boxes can also conceal fraud. We would learn only after its failure, for example, that Lehman Brothers filed public disclosures that hid massive manipulation of accounting.
Mortgage bonds became attractive to market players who wanted to bet for or against them using credit default swaps.
Leading up to the crisis, more than $20 trillion in bets were made on credit assets not owned by those making the bets.
In the end, I learned the painful reality of the new financial world order.
The financial system had become more sophisticated and opaque and vastly more vulnerable.
If we are to address the weaknesses in the system, we first need to understand what went wrong.
For the most part, Washington has failed to that. In some cases Washington pols and officials have covered their eyes and ears and eyes to avoid seeing and hearing the truth.
I hope my book will be a contribution toward understanding what went wrong and I look forward to the efforts of others in this vital quest.
The American people – indeed, the people of the world – deserve honest answers.