This originated as a twitter thread, which some have requested I make available. It is not a scholarly paper, but a factual relation of events I witnessed from my perch in the financial industry.
The credit crisis of 2008 is one of the most dreadful events in recent memory. It’s effects, nearly a decade later, are painfully obvious around the world. And yet, the wrong conclusions are touted daily in the face of unemployment and weeks markets from Spain to China.
After the government screwed things up, as usual, it was time to lay it heavy on some scapegoat. Since blaming the Jews is no longer fashionable, the usual opportunists focused on financiers, banks and investors.
Those were, in fact, the first victims of the crisis, not the cause. And the financial products usually targeted for blame were also casualties of the crisis, not its origin. There is nothing wrong with ABSs, MBSs or CMOs. In fact, they are a good thing.
Banks, by definition, cannot make long term loans. Deposits are on demand, and nobody wants to be told upon presenting a check for payment: “sorry, we lent that money out last week and won’t get it back for three years. Come back then.”
Mortgages are long term loans. So several enterprises were created in the US over the years to create a secondary market and make those long term loans viable and more widely available.
These enterprises were:
- Fannie Mae (Federal National Mortgage Association), created in 1938, as essencialy a Government corporation until 1968, when it became public;
- Freddie Mack (Federal Home Loan Mortgage Corporation), created as a “government sponsored enterprise” or GSE) in 1970; and
- Ginnie Mae (Government National Mortgage Association), also a GSE, created in 1968.
The purpose of all of these was to “promote home ownership” by providing a secondary market for mortgage securities. That is, the packaging of mortgages into marketable securities that would serve a double purpose:
- To provide reliable income for investors, mostly retirees, and
- To provide funds banks could loan long term for real estate purchases.
Sallie Mae (Student Loan Marketing Association), also a GSE, was later established in 1973, originally designed to do the same for higher education loans. It has now branched into consumer loans as well, and it is a public corporation. Go figure.
Because of its status as a government corporation, Fannie Mae bonds enjoyed a US government guarantee, making it a top quality investment. While the GSEs were not outright government entities but “government sponsored entities” that guarantee was not explicit, but assumed. Hence, their bonds enjoyed an implicit government guarantee, making the also relatively safe investments.
The purpose of the first three was to enable long term loans for home purchasing, so that more people would be able to afford a home as opposed to cash purchases or short term loans. This process is called “securitization” or the bundling of loans into sellable securities. And it worked.
Here’s a good explanation of how: http://www.finra.org/investors/mortgage-backed-securities
Banks that followed the underwriting rules were able to “endorse” mortgage loans to these entities and continue lending without compromising their capital positions. The availability of long term loans fueled an unprecedented expansion of the US housing market through the 50s and 60s without parallel anywhere else in the world.
Non-conforming loans, where not accepted. Thus, if the purchaser’s income was too low, no dice. Likewise, if the purchasers income was OK but the value of the property too high for the program, other solutions had to be devised. No government guarantees for mansions. Other, private investments wre used for that purpose.
Then the Democrats discovered that these institutions, which had grown to become some of the largest financial enterprises in the world, were both cash cows and political rams to assist them in their incessant pandering.
This is the kind of crooked thinking that went into it: http://www.bostonfairhousing.org/timeline/1934-1968-FHA-Redlining.html
In other words, not loaning to people who cannot afford repayment is racist and wrong! Vote for us and you will not be denied!
In 1968, the purveyors of this kind of nonsense came up with the “Fair Housing Act.” — whenever a social democrat uses the word “Fair” hit the deck; someone is about to be robbed.
This legislative nonsense was enacted as Title VIII of the Civil Rights Act of 1968, and codified at 42 U.S.C. 3601-3619.
The original prohibited “financing of dwellings based on race, color, religion, sex or national origin.” Opening a can of whoop in litigation: you better watch out who’s loan you don’t approve. And later, it was amended to made it illegal to: “refuse to make a residential real estate loan in a particular area based upon the neighborhood in which the property is physically located;” making “redlining” illegal. And what was redlining? “The illegal practice of a lending institution denying loans or restricting their number for certain areas of a community.” Say, Watts on the day of the riots…
But the real mess really started in the Carter administration, as the carping on the left against “redlining” produced this abomination: https://www.federalreserve.gov/consumerscommunities/cra_about.htm
In other words, if you, banks, do not lend to those who cannot afford to repay, we will roast you!
It was amended in 1989, 1991, 1992, 1994, 1995, 2005, 2007 and, yes, 2008, every time lowering the standards further and forcing banks to ignore common sense in exchange for transferring the risk to Fanny Mae and the GSEs. Indeed, all but the last amendment demanded more and more loans, and forced the GSEs to swallow them while offering investors an “implied government guarantee” to assuage their well founded fears.
Banks did not do this. Congress forced them to. Banks who refused to relax their standards were in violation of the law and could not only be sued, but harassed with an increasing number of administrative tools.
Chief among the proponents of this idiocies in the 1990s was… Barney Frank (D-MA)
And when the shit hit the fan…Barney blamed the banks, those greedy bastards, without batting an eyelash. Sadly, even people who claim to be conservatives dance to this idiot’s tune to this day.
The Boston Globe, that nest of alt-right nutcases, had this to say in 2008: http://archive.boston.com/bostonglobe/editorial_opinion/oped/articles/2008/09/28/franks_fingerprints_are_all_over_the_financial_fiasco/
Yet, even today, geniuses to the left and right of the political spectrum are still going at it. They learnt NOTHING.
Ironically, even after all of this, the number of actual non-performance of CMO’s remained low and most paid interest and capital as expected. For all the dismal news from SW Florida and Las Vegas, 95% of prime mortgages ware paid, and defaults peaked at less than 5%. Admittedly, double the 2.5% average at any time.
Even including “sub-prime” loans, that had nothing to do with the institutions mentioned above, and that represent an always riskier market where no guarantees apply, the total number of defaults barely topped 10%.
So, if the performance of mortgage securities did not justify the massive collapse that we all witnessed, what did?
Two words: Sabannes-Oxley.
In 2001, ENRON, a behemoth in the energy sector, collapsed. They were not producers of energy. They were mostly speculators, and their business was primarily in the energy futures market. They had California by the nuts. But they weren’t as good as people thought, so they lost money hand over fist by making the wrong bets… which they hid by playing three-card-monty with a network of off-the-books partnerships where they parked their losses, keeping their shares up with the help of Arthur Andersen, so that their value would not tank while they looked to get out.
This was illegal, of course, but laws never stopped crooks. When the brown stuff hit the fan, the press blame fest began.
It so happens ENRON’s Chairman, Ken Lay, was an acquaintance of George W. Bush, so the press immediately speculated that he would skit. He didn’t. On May 25, 2006, he was convicted of a number of felonies (10 counts of securities fraud).
Lay’s sentencing was scheduled for September 11, 2006. He didn’t make it. On July 5th he keeled over and died, broke, of a heart attack.
The CEO, Jeff Skilling, was also convicted on 25 May 2006. This is his mug shot:
So, contrary to public speculation, “W” did not help either of them, and they landed in the pokey or died on their way there.
Still, there was wild speculation that GWB would pardon them. He never did. He hanged them out to dry, as he should have. But the Democrat narrative still makes a point to remind everyone “the Bushes knew them”!
Yet, nobody talks about Jon Corzine. I guess Lay and Skilling should have been friends with Obama.
In any case, the bean counters that helped create the house of cards, Arthur Andersen, folded like a cheap suit. Or so it appeared. In fact, they just moved headquarters, changed their name to just Andersen… shed off their consulting branch, were found guilty of obstruction of justice, and are now back hoping that nobody remembers.
In response to this, Congress decided to change the accounting rules. The problem was not that criminals had disregarded the law. No! The problem was that we needed new laws! We all need to be protected from the people who ignore the law…by making more laws!
And they came up with this obscenity. That’ll teach the crooks!: http://www.investopedia.com/terms/s/sarbanesoxleyact.asp
The most destructive aspect of this abomination was a provision that came to be known as “mark to market,” a small change that yielded catastrophic results. Find it here, if you can: https://www.sec.gov/about/laws/soa2002.pdf
Essentially, the accounting change required public companies, including financial ones, to use the market value of assets in balance sheets, rather than their nominal value as has been customary, taking gains or losses if and when they occurred.
Why is this absurd? Because huge numbers of bond issues never quote in markets. They’re bought as packages at discount, and are never offered for sale at any exchange.
How must you then mark in your balance sheet a bond that does not quote in the markets?
Thus, good performing assets were restated to zero value causing enormous paper losses that had nothing to do with the value of those assets or the financial situation of their owners.
Some saw the stuff coming our way. It was big, nasty and brown. I sold everything I owned.
The adjustment caused companies to lose BILLIONS in assets…on paper. Lehman was the first casualty, but ALL financial institutions were reporting huge losses; and so were pension funds, industries, endowments… An equal opportunity mess.
Accounting profits inflated by reserve releases; FDIC insured banks: Pre-tax profits, loss provisions and economic profit (in $millions)
So interbank lending instantly ground to a halt. Nobody wanted to loan anybody any amount for two reasons:
- I don’t know if you are going to be here tomorrow to repay.
- I don’t know how much I need to keep my own requirements above water.
And as all lending halted, California could not get a 7 day loan to pay salaries. Neither could Caterpillar.
People started selling those bonds to get them out of their books. It killed the carry trade business. By some estimates, 30 TRILLION were wiped off of the M3. So the hedge funds tanked. And all hell broke loose.
By March of 2009, it was clear that Sarbannes-Oxley was to blame. So Congress finally moved to repeal the requirement, and banks had the largest profit in a quarter in history…in spite of losing money. All on paper. But the damage was done.
To add insult to injury, Congress then came up with a brand new knee-jerk reaction to the crisis it created with Sarbannes-Oxley:
Obamination No 2: Dodd-Frank (No 1 was Obamacare, of course) The product of the efforts of two of the most corrupt politicians ever: “Friend of Angelo” (Countrywide) Chris Dodd, and intellectual eunuch “Freddy Mac is God” Barney Frank.
This obscenity: https://www.sec.gov/about/laws/soa2002.pdf
Long, cumbersome, arbitrary and vague as it is, it gets worse. It spawned dozens of thousands of new regulations, causing the largest number of bank failures in the history of this country. It pulverized community banks, and if the number of failures did not set a record, it is because a majority were absorbed into larger banks and kept out of the stats.
As a consequence, “too big to fail” are now bigger and meaner than ever before. Thank Pocahontas, too. Her consumer chapter of the law made it much worse, creating obligations smaller banks could not meet.
Just to spice things up, at this time the FED offered banks unlimited amounts of money at 0% interest, which the Treasury then took paying 3%. A 3% spread, risk free, lending to the government the government’s own money. Kafkian! Billions upon billions of risk free profit!
And that is why most people reading this could not get a mortgage if they sold their souls. Or a business loan.
Community banks were leaving the marketplace and big banks were making a mint with no risk. Why would anyone lend a dime to you?
As the repeal of mark to market heralded the end of the credit crisis…a repeal of Dodd-Frank will make this country’s economy boom like at no other time before. Fasten seatbelts. Trump’s 3% growth & more
The House is already acted. Now it’s the Senate’s turn. Let’s hope they get to it. Soon.
In the end, those who held on to their mortgage bonds in ’08, got paid their interest and eventually got their money back. Those who either panicked and sold or were forced to sell at the wrong time, got fleeced. As it always happens. That’s why one should not invest without understanding the risks, out of greed, or following the advice of a used car salesman turned into an advisor after a two week “training” course at a brokerage house (or bank).
As for the rest of us, we can still see problems out there. The sluggish pace of the recovery, made all the worst by absurd regulations and the destruction of the secondary markets guarantee that most people cannot get a long term loan regardless of their ability to pay.