By Joshua Holland
“Wall Street turned a few million home-loans into what Warren Buffet called “economic weapons of mass destruction,” cratered the global economy and then, when the bubble burst, turned around and insisted on a massive bailout courtesy of the American tax-payer.
That rightly infuriated most Americans, but it has nonetheless become something of an article of faith among conservatives that Wall Street bears little blame for the Great Recession. The dominant narrative on the right today is that “big government” is ultimately responsible for the crash. In the words of one of Andrew Breitbart’s bloggers, Democratic lawmakers like Barney Frank and Chris Dodd “brought down the banking industry by forcing banks to give loans to people who couldn’t afford them.”
That such a ludicrous claim could gain such wide traction is a testament to the intellectual debasement of modern conservative discourse. No bank was ever “forced” – or coerced or incentivized by the government in any way – to make a bad loan.
But the claim falls apart even before one digs into the particulars, for the simple reason that people’s mortgages didn’t bring down the banking system in the first place.
The entire subprime mortgage market was worth only $1.4 trillion in the fall of 2007, and that includes loans that were up-to-date. As former Goldman Sachs trader Nomi Prins noted in her book, It Takes a Pillage: Behind the Bailouts, Bonuses, and Backroom Deals from Washington to Wall Street, the federal government could have bought up every single residential mortgage in the country – good, bad and in between – and it would have cost a trillion less than the bailouts.
Short of that, notes Prins, if the crisis were really about people buying McMansions that they couldn’t afford, “we could have solved it much more cheaply in a couple of days in late 2008, by simply providing borrowers with additional capital to reduce their loan principals. It would have cost about 3 percent of what the entire bailout wound up costing, with comparatively similar risk.”
What brought down the global economy was as much as $140 trillion worth of financial gimmickery built on top of the mortgage industry. It was the alphabet soup of the credit meltdown – the CDOs, default swaps and other derivitaves that made less than a trillion dollars of foreclosed loans into an economic weapon of mass destruction that would cost the American economy alone $14 trillion in lost wealth.
A fair criticism of the government’s role is that it didn’t “meddle” in the free market sufficiently to protect borrowers, investors and the public – that $140 trillion house of cards was built in an environment created by decades of deregulation. But that situation is also the fault of Wall Street rather than an indication of the perfidy of “big government.” It was bought at great cost by the banking lobby (and as powerful chairs of congressional banking committees, the right’s bogeymen, Barney Frank and Chris Dodd, are two of the financial industry’s top recipients).
One could argue that the meltdown began with a chance meeting in 1997 in a line for coffee at Bank of America’s Chicago headquarters. According to the Financial Times’ Gillian Tett, a chance encounter brought together people working in BofA’s derivatives group with another team that was packaging mortgages into securities. From that meeting, as Tett wrote, “a new game was born: bankers began to use subprime loans to create these bundles of loan default risk, now called collateralized debt obligations (CDOs) on an explosively large scale.”
Present at that meeting was Robert Reoch, a trader who had come over from JPMorgan. In the mid-1990s, JPMorgan had found itself holding an abundance of loans on its books, which made it difficult to maintain the reserves required by banking regulators. They had come up with the idea of selling some of the risk of those loans off to investors, by bundling them into mortgage-backed securities. This had two consequencs that would eventually lead to the almost universally loathed Wall Street bailouts, a massive drop in employment, the forcelosure crisis and a skyrocketing deficit.
But the real origin of the crisis took place several years earlier. In 1994, some of the first derivatives – which allowed investors to gamble on interest rates – produced massive losses when currency markets began fluctuating wildly. Calls to regulate this shadowy field of financial speculation followed, but, as Tett noted, “the International Swaps and Derivatives Association fought back furiously, arguing that a regulatory clampdown would not only run counter to the spirit of capital markets, but also crush creativity.”
On the board of ISDA – whose lobbying expenditures more than doubled in 2010 to $2.4 million, as new rules on derivatives were being hammered out by federal regulators — sits managing directors of JPMorgan Chase, Morgan Stanley, Goldman Sachs, Citigroup and Bank of America Merrill Lynch, among other financial firms.
Its successful campaign against regulations on derivatives in the mid-1990s was only one battle in a long campaign to deregulate investment banking that dated back to the 1960s, when lobbyists reportedly bragged that the effort was putting their kids through college. Their primary target was the Glass-Steagall Act, a depression-era law that created a firewall between investment banking and the commercial banks that hold deposits and make loans. Their first victory came in 1986, when, under intense lobbying from Wall Street, the Federal Reserve reinterpreted a key section of the act, deciding that commercial banks could make up to 5 percent of their gross revenues from investment banking. After the board heard arguments from Citicorp, J.P. Morgan and Bankers Trust, it loosened the restrictions further – in 1989, the limit was raised to 10 percent of revenues; in 1996, they hiked it up to 25 percent.
According to a report by PBS Frontline, “in the 1997-98 election cycle, the finance, insurance, and real estate industries (known as the FIRE sector), spends more than $200 million on lobbying and makes more than $150 million in political donations. Campaign contributions are targeted to members of congressional banking committees and other committees with direct jurisdiction over financial services legislation.”
In 1999, after 12 unsuccessful attempts, Glass-Steagall, which would have made the crash of 2007-2009 impossible, was finally repealed. And it was only then that the explosion in shaky mortgage-backed securities began. “Subprime” loans made up 5 percent of the total the year before repeal, but skyrocketed to 30 percent of all mortgages at the time of the crash.
Fanny, Freddie and the Community Reinvestment Act
Jeb Hensarling, a notably obtuse Republican lawmaker from Texas, wrote that “the conservative case [against the government] is simple”:
The [Community Reinvestment Act] compelled banks to relax their traditional underwriting practices in favor of more “flexible” criteria. These subjective standards were then applied to all borrowers, not just low-income individuals, leading to a surge in lower-quality loans….Blame should [also be] directed at Fannie [Mae] and Freddie [Mac], and their thirst for weaker underwriting to help meet their federally mandated “affordable housing” goals…
This tale has everything a conservative could want: Big Government overreach and well-intentioned but out-of-touch liberals causing devastating unanticipated consequences with their social tinkering.
But, contrary to the conservative spin, University of Michigan law professor Michael Barr told a congressional committee that although there was in fact quite a bit of irresponsible lending in low-income communities in the late 1990s and the early 2000s, “More than half of subprime loans were made by independent mortgage companies not subject to comprehensive federal supervision; another 30 percent of such originations were made by affiliates of banks or thrifts, which are not subject to routine examination or supervision, and the remaining 20 percent were made by banks and thrifts [subject to CRA standards].” Barr concluded, “The worst and most widespread abuses occurred in the institutions with the least federal oversight.”
The reality is that no bank has ever been “forced to comply with government mandates about mortgage lending” – it’s a bald-faced lie.
There are no “government mandates,” and there never were. In order to qualify for government-backed deposit insurance—a benefit that banks aren’t forced to accept but enjoy having—the Community Reinvestment Act – and similar measures designed to prevent discrimination in lending (to qualified individuals) – only encourage banks to lend in all of the areas where they do business. And Section 802 (b) of the Act stresses that all loans must be “consistent with safe and sound operations”—it’s the opposite of requiring that lenders write risky mortgages.
There are no penalties for noncompliance with CRA guidelines. The only “stick” hanging over banks that fail to meet those standards is that their refusal might be taken into account by regulators when they want to open new branches or merge with other financial institutions. What’s more, there are no defined standards for CRA compliance, and within the banking community, the loose guidelines are considered to be somewhat of a joke.
As Sheila Blair, the chairwoman of the FDIC, asked in a December 2008 speech, “Where in the CRA does it say: make loans to people who can’t afford to repay? Nowhere! And the fact is, the lending practices that are causing problems today were driven by a desire for market share and revenue growth…pure and simple.”
Fannie and Freddie: Tempted by Easy Profits
Fannie Mae and Freddie Mac were created by an act of Congress, but they are (or were, until being taken over in the wake of the housing crash) private, for-profit entities whose dual mandate was to increase the availability of mortgages to moderate- and low-income families, and at the same time turn a profit for their shareholders. Fannie and Freddie did end up with a very large portfolio of subprime loans, with a high rate of default, but they didn’t get into the market early, or because the government mandated it. They dived in deep because there were profits to be made as the housing bubble expanded. As Mary Kane, a finance reporter for the Washington Independent, put it:
Neither the Community Reinvestment Act—the law most cited as the culprit—nor other affordable housing goals set by the government forced Fannie, Freddie or any other lender to make loans they didn’t want to. The lure of the subprime market was high yields and healthy profit margins—it’s as simple as that.
Creating a Market
None of this is to suggest that millions of Americans didn’t bite off more than they would eventually be able to chew in the housing market. A lot of people looking to turn a quick buck by capturing the booming value of real estate in the mid- to late-2000s bought property with “teaser” loans that offered very low rates for the first few years; the investors assumed they’d be able to turn a tidy profit before higher interest rates kicked in. Many of those individuals have since found themselves “under water”—owing more on their homes (and investment properties) than they’re worth.
Yet as Salon business reporter Andrew Leonard wrote, beginning in the 1990s, “The incentive for everyone to behave this way came from Wall Street…where the demand for (debt-backed securities) simply couldn’t be satisfied. Wall Street was begging the mortgage industry to reach out to the riskiest borrowers it could find, because it thought it had figured out a way to make any level of risk palatable.” He added, “Wall Street traders, hungry for more risk, fixed the real economy to deliver more risk, by essentially bribing the mortgage originators and ratings agencies to…make bad loans on purpose. That supplied (Wall Street) speculators the raw material they needed for their bets, but as a consequence threw the integrity of the whole housing sector into question.”
The bankers’ hard sell created so much demand that lenders wrote loans to just about anybody for just about anything; loans, after all, were the raw material for the alphabet soup of exotic investment vehicles: the “collateralized debt obligations (CDOs),” “credit default swaps,” and other innovative products that turned “toxic” toward the end of the decade. Wall Street had little to lose by giving investors more of these fancy new bets. Wall Street traders made their fees, and as long as the housing market—the hard assets underpinning all of the theoretical wealth that was created—held up, everyone was happy.
The most important point here is that the bankers knew they were playing with fire. The Los Angeles Times reported, “Before Washington Mutual collapsed in the largest bank failure in U.S. history, its executives knowingly created a ‘mortgage time bomb’ by making subprime loans they knew were likely to go bad and then packaging them into risky securities.”
According to the Wall Street Journal, U.S. prosecutors are, as of this writing, investigating whether Morgan Stanley misled investors about mortgage-derivatives deals it helped design and sometimes bet against.” And the Securities and Exchange Commission charged Goldman Sachs with “defrauding investors by misstating and omitting key facts about a financial product tied to subprime mortgages as the U.S. housing market was beginning to falter.”
They needed some help laundering the risk out of those shaky loans, and they got it. According to a Senate investigation concluded earlier this year S&P and Moody’s, the two dominant ratings agencies, “issued the AAA ratings that made … mortgage backed securities … seem like safe investments, helped build an active market for those securities, and then, beginning in July 2007, downgraded the vast majority of those AAA ratings to junk status.” And when they did so, it “precipitated the collapse of the [mortgage-backed securities] markets and, perhaps more than any other single event, triggered the financial crisis (PDF).”
According to the Senate investigation, in the years leading up to crash, “warnings about the massive problems in the mortgage industry” — including internal warnings from their own analysts — had been ignored because of “the inherent conflict of interest arising from the system used to pay for credit ratings.” The big “rating agencies were paid by the Wall Street firms” that were making a fortune selling that glossed-up garbage to credulous investors. This, again, was Wall Street’s doing rather than a result of some public policy passed by Congress.
This isn’t about ideology; it’s about pushing back on some notably dangerous historical revisionism. Because there is one thing that’s as sure as death and taxes: Big Finance’s lobbyists will continue to resist calls to re-regulate the financial sector. And absent effective regulation of the financial markets, we can expect to continue to suffer through an endless series of booms and busts, while the fat cats of Wall Street continue to get fatter.”