Jesus Creed
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, Reckless Endangerment: How Outsized Ambition, Greed, and Corruption Led to Economic Armageddon by Gretchen Morgenson and Joshua Rosner.
The first ten chapters of Reckless Endangerment: How Outsized Ambition, Greed, and Corruption Led to Economic Armageddon, by Gretchen Morgenson and Joshua Rosner, deal primarily with the regulatory environment in the 1990s and early 2000s that set the stage for the real estate boom and subsequent collapse that triggered the 2008 recession. Three of the final five chapters chronicle the rise and fall of three particularly representative companies: Countrywide Financial, NovaStar Financial, and Fremont Investment & Loan. The details of their stories are fascinating but are outside the scope of this review.
The real estate boom, which peaked in 2003, was brought on by several factors. As we’ve seen in previous chapters, the government wanted to expand homeownership and the financial industry was only too happy to oblige, as long as Fannie and Freddie were there to back them up. To further fuel the fire, the Federal Reserve had lowered the prime rate to about 1% in order to stimulate the economy. “Everyone had a story, or had heard one, about fistfights breaking out at open houses and bidding wars ramping up prices of singularly unremarkable homes.” (219-220) Further, “[t]hose who already owned homes were ecstatic that their properties were vaulting in value and many rushed to refinance their mortgages, extracting some of the bounty to buy a vacation home, go on a cruise, remodel the kitchen, or send the kids to college.” (219)
Do you have a story like this? Do you know folks who took advantage of low interest rates and high equity to overextend themselves?
[Personal Note: In 2003 we sold our house in preparation for moving overseas. Dozens of families expressed interest in our “unremarkable” home with the first week or two, and we sold it to the couple that answered our ad the first day it was posted. At the time, we were happy to sell our house, unaware and unconcerned of the real reason for the boom. In retrospect, it is clear that many of the prospective buyers were taking advantage of lax lending criteria as well as low interest rates.]
As with other regulatory issues, the Fed continued to cover their ears when others warned about the bubble and the potential dangers if it burst. In October 2004, Alan Greenspan expressed satisfaction that the equity extractions were stimulating the economy. As late as 2006, Ben Bernanke, Greenspan’s replacement as Fed chairman, insisted that the Fed was unable and unwilling to monitor and intervene the real estate bubble. At first Fed economists claimed there was no bubble, and later claimed that even if there was one it would not cause harm to the national economy. Their analyses typically overestimated the amount of equity people had in their homes, and underestimated the extent to which the real estate market had become much more homogenous. The latter, which was due mainly to automated underwriting and bank consolidation, made it much more likely that the country’s real estate market would rise and fall uniformly, as opposed to having regional variations that evened out over the whole country. Thus, as long as prices were rising, everyone was happy, but if prices fell, it would impact everyone.
Not everyone was failing to notice that the emperor wasn’t wearing clothes. The authors engage in a bit of self-congratulation by noting that Joshua Rosner warned of the mortgage crisis several different times between 2001 and 2007. In 2001 he wrote: “The virtuous circle of increasing homeownership due to greater leverage has the potential to become a vicious cycle of lower home prices due to an accelerating rate of foreclosures.” (220) The only response was an angry phone call from FNMA.
By 2004, there were already signs that the bubble was deflating. With interest rates as low as they could be, the market for new homes and refinancing had become saturated. Rising home prices were starting to make homeownership difficult and, to make matters worse, the prime rate had climbed up to 2%. The banks, in a desperate attempt to keep the profits coming, responded by digging deeper into the subprime market. In addition, in order to attract business, they unveiled new mortgage products such as interest-only loans and negative amortization loans (where the principal actually increased with time). These types of loans increased from 6% of all loans in 2003, to 29% in 2005.
In 2005, banks that sold mortgage-backed securities started to notice an increase in mortgage non-payment and foreclosure. However, instead of refusing to buy bad loans from the primary lenders, they simply purchased them at a discount, sold them to investors at the same price as before (without telling the investors about the quality of the loans) and kept the difference. When investors eventually started noticing that their returns were slipping, they stopped buying mortgage-backed securities. In response, the banks simply repackaged the bad loans from different mortgage pools into a single pool known as a collateralized debt obligation (CDO). These instruments were so complicated that neither regulators nor the ratings agencies could understand them well enough to warn investors about them. To add insult to injury, some firms, such as Goldman Sachs, were actually short-selling CDOs, presumably because they knew the underlying quality of the loans involved.
Another bank innovation, aimed almost solely at deceiving investors, was variable interest entities (VIEs). These off-book subsidiaries were made famous by Enron as a way to hide risky operations from investors. Post-Enron, the rules had changed concerning these practices, but companies eventually figured out how to use the rules to give themselves legal cover to continue the practice. VIEs, of course, were the perfect place to hide risky mortgage-based investments. In the end, Citigroup, as well as many others, were found to have hundreds of billions of dollars accounted for in this way.
As late as 2007, Congress was still in the dark regarding what was going on in the mortgage investment industry. Ben Bernanke was more concerned about inflation, and then-chairmen of the New York Fed, Tim Geithner, was more worried about unregulated hedge funds. Both Bernanke and Henry Paulson (Treasury Secretary and former Goldman Sachs CEO) were confident that any mortgage problems could be contained and would not hurt the economy.
The reality, of course, was much different. In March 2007, banks like Goldman Sachs were starting to realize that the situation was getting out of hand and stopped buying mortgage from primary lenders and even stopped extending credit for other purposes. By March of 2008, Bear Stearns had failed, requiring taxpayer bailout and a buyout by JPMorgan Chase. This bought a few months of peace, but within six months, Fannie, Freddie, Lehman Brothers, and AIG had all failed, and many smaller mortgage lenders had also failed or were on the ropes.
As I mentioned in Part 1, the authors seem relatively non-partisan in their criticisms. While it is clear that they intended to highlight Democrats who were complicit, perhaps to balance out the popular perception that Republicans were mostly to blame, they never blame one party or one ideology for the crisis. Instead, as the subtitle suggests, they blame greed, both on the part of corporate executives and on the part of politicians who were too easily influenced by lobbyists and corporate contributions. The authors close with this:
Will a debacle like the credit crisis of 2008 ever happen again? Most certainly, because Congress decided against fixing the problem of too-big-to-fail institutions when it had its chance… The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 [ironically sponsored by two of Congress’ most strident defenders of FNMA] … failed the most basic test—it did not insist that large and unmanageable institutions be cut down to size to alleviate their threats to taxpayers in the future. Nor did it increase the accountability of those running institutions that will need government assistance in the future.” (304)
Do you agree with the authors’ conclusions? What are some practical measures that could be taken to prevent something like this from happening again? As Christians, do we have any personal or corporate responsibility?
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