Reckless Endangerment 2 (Joe Canner)

This post is by Joe Canner, a regular commenter on this blog, and he is taking on a new book that examines why we had the economic meltdown of 2008.

Chapter 7 of Reckless Endangerment: How Outsized Ambition, Greed, and Corruption Led to Economic Armageddon by Gretchen Morgenson and Joshua Rosner begins with the repeal of Glass-Steagal, a Depression-era bill that prohibited banks, insurance companies, and investment firms from merging. The first beneficiary of the repeal was Long-term Capital Management, a large hedge fund that had gotten into trouble during the Russian debt crisis of 1998. They were bailed out by the Federal Reserve Bank of New York because they were deemed too large to fail. The bailout succeeded, but set a bad precedent for the future, no doubt encouraging other companies to take more risks, knowing that they, too, would be bailed out.

The repeal of Glass-Steagal was just one of a number of regulatory rollbacks during the 1990s. Capital requirements were reduced and capital calculation methods were changed to favor the banks. Rules were changed to allow pre-payment penalties, which made investing in mortgage-backed securities more attractive. Meanwhile, new HUD secretary Andrew Cuomo was feeding the subprime mortgage boom by insisting that Fannie and Freddie buy more loans for low- and moderate-income families. The Federal Reserve, for its part, seemed content to let banks regulate themselves:

But as the S&L disaster faded into a distant memory, the mood shifted among regulators, and especially among those at the Fed. Rather than argue that bankers needed to be policed and ridden hard, Fed officials started to believe these executives could be trusted to do the right thing for the system, for their shareholders, and for themselves. Regulators no longer needed to stand over these institutions with a whip, the Fed argued. After all, what banker in his or her right mind would do something crazy enough to blow up their company? This view was a key element of the free market philosophy that had taken hold during the Reagan years and became even more accepted during the Clinton administration. Greenspan was the chief proponent of the concept that self-interested individuals operate in ways that benefit an entire group. Therefore he and like-minded people reasoned, they can be counted on not to act destructively. (111)

Does this attitude surprise you? What does it say about the government’s view of human nature? What is the correct balance between trust and distrust when it comes to financial market regulation?

Although there was generally an anti-regulatory culture in Washington and at the Fed during the late 90’s and early 2000s, there were sporadic efforts to reign in FNMA. James Johnson left FNMA in 1998, and his last victory was to kill a Clinton administration proposal to require FNMA to register their securities. Johnson’s legacy lived on with his successor, Franklin Raines, as well as through his presence on a number of corporate boards. In 2000, Congressman Richard Baker (R, LA) tried to get Treasury to cut of Fannie’s $2.5 billion line of credit. This proposal was widely opposed, both by those who supported housing for low-income families and anyone who had been lobbied by FNMA. Gary Gensler, a Treasury undersecretary, testified in support of the proposal, but was later hung out to dry by the Clinton administration. The bill was also supported by big banks who were in competition with Fannie and Freddie. However, despite big bank opposition and despite being caught using shady lobbying tactics, Fannie prevailed and the bill was killed.

Regulatory efforts were slightly more successful in 2001, when OFHEO managed to force Fannie and Freddie to abide by the same conflict-of-interest laws as private companies. In early 2002, Christopher Shays (R, CT) and Edward Markey (D, MA) proposed bill to end Fannie and Freddie’s exemption from financial disclosure rules. Alan Greenspan, who was slowly shifting away from his anti-regulatory mood (at least with respect to Fannie and Freddie, if not for Wall Street), supported the idea. After negotiations, FNMA “capitulated,” agreeing to register its stock with the SEC. However their debt securities were not subject to registration, which was still a big victory for FNMA. Peter Fisher, a Treasury undersecretary, came out against the legislation, saying the Fannie and Freddie were “well-run” and that their voluntary registration initiative made Shays-Markey unnecessary.

In 2002, journalists and economists were also starting to raise the alarm. One article quoted a NYU business-school professor: “It’s as if the public had cosigned Fannie and Freddie’s debt. To pay for a very small cut in mortgage rates, the taxpayers bear the risk of a massive bailout.” (177) In September 2002, Congress called on Franklin Raines to testify regarding it’s strong-arm treatment of banks who were concerned about Fannie and Freddie’s drive to become direct lenders. In addition to the usual defense, Raines reported that Standard & Poor’s had given FNMA a corporate governance score of 9 out of 10. Congress was sufficiently impressed and took no further action.

In 2003 Armando Falcon, head of OFHEO, wrote a letter to Congress warning of potential problems if Fannie and Freddie were not properly regulated. Within 24 hours the Bush administration asked him to resign. The authors speculate that the White House was not anti-regulation, per se, but were backing big banks against Fannie and Freddie.

Also asleep at the switch during this time were the ratings agencies. Issuers of mortgage-backed securities were required to obtain the rating of two of the big three agencies: Moody’s, Standard & Poor’s, and Fitch Ratings. Unfortunately, the rating agencies had little incentive to exert themselves, as the companies they were rating were the ones paying the bill. Often the agencies would make their ratings without referring to the underlying supporting data (like borrower debt-to-income ratio), and without requiring that the information be provided it if it was not available. This laxity persisted even after the WorldCom and Enron collapses, which none of the ratings agencies had predicted. In the wake of WorldCom and Enron, Congress passed Sarbanes-Oxley to firm up accounting practices but were either unable or unwilling to take on the ratings agencies, who claimed no responsibility for their failures, despite being the only groups with inside information on financial institutions.

Ironically, it was the ratings agencies that were inadvertently responsible for killing state legislation in Georgia (and probably elsewhere) that was aimed at cracking down on predatory lending. After passage of the Georgia law, the ratings agencies prohibited Georgia based loans from being sold in mortgage-backed securities because of liability concerns. As this would have totally crippled all Georgia lenders, Georgia quickly repealed the law.

With this regulatory climate as backdrop, in the next installment we will look at the economic situation that led to the financial meltdown, along with the accompanying government action (or inaction).

Which government agencies, if any, should have been more aware of risky bank practices and done something to reign in the banks? Why do you think they failed to do so?