Inside the Story of What Went Wrong

Remarks Made at a Book Party and Signing for Black Box Casino
Event Hosted at 3101 Chain Bridge Road, Washington, D.C. 20016

November 10, 2011

By Robert Stowe England

I’m here tonight to shine 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.

Something had gone terribly wrong to deliver us into the world of Mad Max, where the norms vanished that we thought necessary to sustain our way of life.

Financial institutions were crashing all around us while authorities seemed powerless to do anything about it. It was the worst financial crisis of modern times.

As a journalist writing for Mortgage Banking magazine for more than 20 years, I covered the mortgage industry at the heart of the crisis.

In January 2007, I found myself on the frontlines of the crisis reporting on a multitude of institutional and market failures than were just beginning to get underway.

By August 2007, fully half the $11 trillion mortgage market had collapsed or had to be rescued. By September 2008, the government had to take over Fannie Mae and Freddie Mac to keep most of the rest of the market from collapsing.

As the bills for the crisis mount, the cost to taxpayers of bailing out Fannie and Freddie has been the biggest of any financial institution, nearly $184 billion so far. More losses lie ahead.

Few financial institutions have suffered so great a fall in reputation as have Fannie and Freddie. One insider put is this way: “The public’s view of us couldn’t get any worse. We’re somewhere just above or just below the Ebola virus.”

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. Success could be fleeting as barriers to entry were low and, thus, new competitors could come out of nowhere and challenge your success. Companies had to be able to double in size or cut back half of capacity almost over night.

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 writing about the industry in 1988 that I traveled to Pasadena, California and I met and profiled Angelo Mozilo, co-founder of Countrywide Home Loans.

Mozilo personified the dynamic mortgage market and Countrywide became the pacesetter and leader of the industry. His “fire in the belly” 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.

The industry went from being an exemplar of market discipline and good credits two decades ago to a generator of toxic assets. 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 the mortgage meltdown began in 1992 when Congress crafted a law to govern the regulation of Fannie and Freddie. The short name for the law is the GSE Act. A GSE is a government-sponsored enterprise – a firm owned by shareholders, but with a government mandated mission.

The provisions in the GSE Act was supposed to assure Fannie and Freddie would be operated in a safe and sound manner and not end up like the failed savings and loan industry.

Washington policy makers believed that turning mortgage loans into securities would avoid the problems of the savings and loans that held mortgages 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. Congress, however, did not capitalize on the potential market strengths of securitization when writing the GSE Act. Instead, they inserted Trojan horse provisions, as Ed Pinto calls them that would inevitably cause Fannie and Freddie to fail.

For starters, under the law, the GSE regulator for Fannie and Freddie was not an independent agency but located within the Department of Housing and Urban Affairs or HUD. Banking regulators, by contrast, are independent agencies.

Also under the GSE Act, Fannie and Freddie were required to have only a tiny capital base of 2.5 percent for loans and securities and 0.45 percent of guarantees. This capital could quickly be wiped out by losses. Well-capitalized banks by contrast have to have 10 percent capital.

Further, the regulator was not allowed to require the GSEs to raise their capital levels if they felt it was necessary to assure their safety and soundness.

Under the GSE Act, Fannie and Freddie did not have to file audited quarterly reports with the Securities and Exchange Commission or SEC.

They were allowed to lobby Congress, while they also had to go to Congress every year for funding.

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 GSE Act was part of 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.

Congress gave HUD, not the GSE regulator, the power to set affordable housing goals for Fannie and Freddie.

A succession of HUD Secretaries from Henry Cisneros, to Andrew Cuomo to Alphonso Jackson steadily raised the affordable housing goals, often under pressure from Congress.

For Congress, steadily higher affordable housing goals proved to be a political bonanza. They could take credit for benefits for constituents without having to go through the budgeting process. It did not seem to matter to Congress 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, the broadest of the affordable housing goals. By 2008, this goal had been raised to 56 percent. The goal for low income households, which started at 11 percent, had reached an impossible 27 percent by 2008.

To meet these goals, lending standards and down payments had to steadily fall. As underwriting was loosened, mortgage funding volume expanded. The two GSEs grew so large, Fed Chairman Alan Greenspan began to worry they posed a risk to the financial system should one of them fail

In 2003 and 2004, accounting scandals were uncovered at Freddie and Fannie by the intrepid Armando Falcon, the GSEs chief regulator. Investigators found that Leland Brendsel at Freddie and Franklin Raines at Fannie had manipulated earnings to increase senior executive compensation.

Both had to resign but no one went to jail or paid a significant fine. 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 in the financial markets who contemplated fraudulent schemes.

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 subprime and Alternative-A or Alt-A, which are prime credit mortgages with low or no documentation of income and assets.

In 1995 HUD decreed that the GSEs could buy 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 industry fought for market share in a race to the bottom of the mortgage credit pool.

New and increasingly predatory loans appeared. There were interest only mortgages where borrowers did not pay down the principal for three to seven years. Afterwards payments jumped so high, many borrowers could no longer afford the payment.

Just about anyone could qualify for a no income no job no asset mortgage or NINJA.

It got to the point that an illegal immigrant from Brazil who cleaned houses for a living and earned only $24,000 a year bought a house for $700,000 in South San Francisco with no money down and walked away from the closing with $8,000 in cash. She and her husband moved out of the house after three weeks and never made a single payment.

The famed market discipline that ruled the mortgage industry was gone. What happened?

The short answer – market discipline was subverted.

Beginning in 2002, Wall Street was having trouble selling investors the lower credit quality pieces or tranches of subprime private label mortgage-backed securities. These were the certificates rated A, BBB and BBB minus.

American institutional investors had wised up and 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.

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.

Having no investor for the weakest subprime bonds, “We created the investor,” said Joseph Donovan at Credit Suisse in 2002. By that he meant they had created the CDO to be the investor and buy the lower-rated tranches of subprime mortgage bonds.

Texas hedge fund manager Kyle Bass called the subprime CDOs “the biggest bait and switch of all time.”

Wall Street was able to sell a lot of these assets to European and Asian buyers, who relied too much on the integrity of the AAA rating by the credit rating agencies.

Little did they understand the moral hazard of having credit rating agencies play a role in regulatory bank capital – an idea that came out of the Basel Committee for Banking Supervision in Switzerland, representing the world’s top central bankers.

Moody’s wrote to the Basel Committee in 2000 to told them not to urge nations to give credit agencies a regulatory role, warning it would lead those putting together deals to “shop” for ratings, undermining the process. Their warning was ignored. Their prophecy came true.

The 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.

How could a bunch of bad credits rolled together create good a credit? It was the financial equivalent of weaving flax into gold. Yet, few questioned the sophisticated computer models that justified the ratings for these deals.

Even with willing buyers, the subprime CDO business faced another problem. No one really wanted the lowest rated tranches of the CDOs.

Wall Street came up with a solution to this, too. They would sell each other those lower tranches in order to generate the deals and earn the fees. There was a tacit agreement: “You buy my BBB tranches and I’ll buy yours.”

Often senior management at these firms did not seem understand the risk this posed. All that seemed to matter was that the deals were generating huge bonuses.

In time, hedge funds came to sponsor most of the CDOs because they liked the weaker subprime credits. They would buy the equity piece of the CDO deal for its super high premium while making much larger bets against lower rated tranches. By 2004, hedge funds were buying 80 percent of all equity tranches in subprime CDOs. After that, there was never enough supply to meet the hedge fund demand until the subprime CDO mania collapsed in mid-2007.

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 and more of the worst subprime credits.

The demand for weaker subprime credits had a perverse effect. To generate the small piece of a subprime bond deal that goes into the CDO, a whole lot of subprime bonds had to be generated that were AAA. This was not too difficult as Fannie and Freddie steadily increased their demand for AAAs. To meet the demand generated by CDOs, mortgage lenders increased the overall level of subprime and risky mortgages.

In short, the subprime CDO business was poisoning the private label business and preventing it from responding to market signals.

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.

Merrill Lynch and Citigroup were the kings of CDOs and bear a great deal 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 $151 million.

At Citigroup, it was apparently 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 its audited filings with SEC for the first and second quarter of 2007, the company concealed the existence of more than $50 billion in subprime assets. When the bank owned up to it losses because failing SIVs forced them back onto the balance sheet, Prince resigned and walked away with $147 million. Rubin, who stayed on, had $50 million in compensation by the end of 2008.

Under the Sarbanes-Oxley Act, chief executives are required to sign accounting statements and be held personally liable. And yet, the SEC did not investigate Prince or Rubin or any other top official. The case was settled with minor fines to mid-level officials.

Citi stumbled toward collapse and would have failed except for a massive government intervention of $476 billion in guarantees from the FDIC, purchase and lending facilities from the Fed, and TARP funds from Treasury. More was done to save Citi than any other private financial institution.

Another cause of the crisis was Washington’s failure to enforce the laws on the books.

The SEC gained a reputation as an unsuccessful investigator and weak enforcer 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.

Out of options, Bear, whose share price a week earlier had been $62, 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 place the $1.7 million bet pocketed even more money, $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 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.

None of the naked short sellers of Lehman shares have been brought to justice.

The build up of toxic assets and increase in market manipulation exposed the financial system’s rickety architecture. This, in turn, led to massive, often unseen runs on the financial system.

A panic began August 2007 in overnight funding contracts known as repurchase agreements or repos.

Counter 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, ever-larger haircuts had drained as much as a trillion dollars out of the banking system.

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, precipitating a crisis at Citigroup and causing the largest bankruptcy in Canada’s history.

Margin calls on credit default swaps added to market woes. Swaps, a form of shadow bond insurance, brought down the world’s largest insurance company AIG while the guy who ramped up the business, Joe Cassano, walked away with $300 million.

How did the financial system get to be so weak? That’s the question that perplexed me and so I started out to find the answers and tell the world what I found in a book.

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. I did found many other sources, however, and pieced together the framework of the causes of the crisis.

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 financial activity moved into black boxes.

Black boxes are financial institutions and vehicles with no transparency. You can’t know what bad assets might be hidden there. Some of these black boxes housed financial casinos where activity was driven by fast money and high stakes and created huge risks for the financial system.

Black boxes can also conceal fraud. For example, Lehman Brothers filed public disclosures that hid massive manipulation of accounting.

In the biggest casino of all, the credit default swaps were the chips and the names of mortgage bonds were the numbered squares on the roulette table. More than $20 trillion in bets were made on credit assets not owned by those making the bets.

If we are to address the weaknesses in the system, we first need to understand what went wrong.

By and large, despite a great fanfare of good intentions, Washington has failed to do that.

I hope my book can make a contribution to a better understanding of what went wrong, the first step to setting things right. I also look forward to the findings of others studying the crisis.

The American people – indeed, the people of the world – deserve honest answers.



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