Senate Investigation Says Banks Caused Crisis, Not Borrowers

They finally got it!  And geeze, it took them long enough.

I wrote an article TWO YEARS AGO, titled “What Happened on Wall Street and Why,” and it explained the factors the contributed to the unfolding crisis… no, not all the factors, for example I didn’t go back to the origins of securitization, or regulatory changes that were made during the Clinton years, or look to lay the blame on Fannie and Freddie and the CRA (Community Reinvestment Act).  Why?  Because to do so would have been stupid and I don’t do stupid.

Why would it have been stupid to cite those things, I hear some of you cry?  After all, each of those factors did in fact contribute to the crisis in some way.  Perhaps some had supporting roles, others talking parts, a few had cameos, and some were merely extras… but they were all in the movie, right?

Of course they were.  But so were many other things, and I don’t find it terribly useful to debate and discuss factors that, while contributing, did not contribute in a proximate cause sort of way, or contributed only in hindsight.

For example, some like to blame Alan Greenspan for keeping interest rates too low for too long, but this argument is kind of nutty, in my view, because while it may or may be true that interest rates helped fuel the real estate bubble from a demand perspective, low rates certainly didn’t cause the crisis.  To think that they did, would be like buying in when hearing General Motors blame cheap steel prices for their downfall.  Remember, the banks could have used the low rates and favorable lending conditions to create quality, consumer friendly, sustainable mortgages, but they did not.

So, the Senate Investigation Committee, which began its investigation into the financial crisis over a year ago, has finally started holding hearings so the public can see and hear the outcome of their work, has finally figured out what did directly cause the crisis and when the crisis began… or I should say they’ve come closer than what’s been published to-date in the mainstream media anyway.

As I’ve said what feels like a million times in a million different ways… it wasn’t the borrowers, it was the banks, and what caused the crisis was that the banks broke the bond market… and it remains broken to this day.  This wasn’t a market correction.  What we’ve endured, and continue to endure, was the result of criminal acts committed by Wall Street’s finest.  Someone should go to jail… and after watching the Senate hearings last week, I’m sure someone ultimately will.

I’m not saying that borrowers played no role in the crisis, they certainly did… we all did, in the sense that essentially all Americans have a tendency to take on too much debt.  We use our credit cards too much, we load up on student loans more than we probably should, and in general… we probably just plain buy too much stuff.  But to blame the crisis on borrowers is a bit like blaming flooding for the damage in New Orleans after Katrina.  Yes, there was flooding to be sure, but I’m pretty sure that it was the hurricane that was the actual problem.

When?  Well, my guess will be later this year and into next, because as I’ve also written on numerous occasions, this is a mid-term election year, and our elected representatives never look weak or lazy before heading home to campaign in their respective districts.  The banks finest hour is over.  After watching Washington Mutual’s CEO get grilled by Senator Levin and the other members of the committee, the writing is on the wall and from here forward, while they may still have too much political power for my tastes, it’s going to be all downhill.

A river, not a lake…

We’ve had our “Ferdinand Pecora moment,” and things are going to be different going forward… always remember that in this situation, we’re in a river, not a lake.  The water we’re standing in today won’t be the same water we’re standing in tomorrow, which is another way saying to homeowners and those involved in helping homeowners not to give up or resign yourselves to what’s happened in the past.

Ferdinand Pecora was a lawyer during the 1930s, who became famous nationwide as a result of his cross-examination of one Mr. John Pierpont Morgan (JP to his friends) at the time unquestionably one the richest men in the world, if not the richest.  During Pecora’s cross-examination, among other things, it came out that Mr. Morgan had paid no income tax since 1929, while the rest of the country had fallen on, shall we say, very hard times.

As a result of this and other testimony the country became outraged at what the bankers had done to cause, and in response to the deep recession in which the nation found itself.  The following year, the Glass-Steagall Act was signed into law by FDR, and there would be more regulation to protect consumers from the excesses of the financial services sector that would soon follow.  It would be roughly seventy years before we’d need another Ferdinand Pecora moment to set things right once again.

So, what caused the meltdown that led to the foreclosure crisis, the credit crisis, and every other kind of crisis you want to add on that’s kicked our economy to the curb these last couple of years?  It was the bankers who fraudulently packaged mortgage-backed securities, also called bonds, with loans that were not high quality, and then stood by and watched them get rated AAA.  When investors realized that they were holding bonds that had been improperly rated, they dumped them instantly, and overnight the bond market, and therefore the secondary mortgage market, froze solid overnight.

It didn’t help that this happened at a particularly crummy time, as well.  By July of 2006, the Fed had been concerned about inflation resulting from rising housing prices that was making Americans feel wealthier, and from rising oil prices, and it had raised rates 17 times in a row.  And this caused the adjustable rate loans that were set to adjust… to adjust higher.  The worst of the sub-prime loans started to default.

Banks, now unable to sell their loans in the secondary mortgage market, immediately started hoarding cash, and whether you wanted to refinance or originate a new mortgage, it was a very different world the day after that happened, than it was the day before.  Houses stopped selling, and soon the owners of those houses started lowering their asking prices.  Real estate had begun its freefall, and largely because the first loans to default were sub-prime and poorly underwritten sub-prime at that, no one realized just how far down that freefall would take us.

MEMORANDUM

To: Members of the Permanent Subcommittee on Investigations

From: Senator Carl Levin, Subcommittee Chairman and Senator Tom Coburn. Ranking Member

Date: April 13, 2010

Re: Wall Street and the Financial Crisis

The Financial Crisis.  In July 2007, two Bear Steams offshore hedge funds specializing in mortgage related securities collapsed; the credit rating agencies suddenly downgraded hundreds of sub-prime residential mortgage backed securities; and the formerly active market for buying and selling sub-prirne residential mortgage backed securities went cold. Banks, mortgage brokers, securities finns, hedge funds, and others were left holding suddenly unmarketable mortgage backed securities whose value began plummeting.

Banks and mortgage brokers began closing their doors. In January 2008, Countrywide Financial Corporation, a $100 billion thrift specializing in home loans, was sold to Bank of America. That same month, one of the credit rating agencies downgraded nearly 7,000 mortgage backed securities, an unprecedented mass downgrade. In March 2008, as the financial crisis worsened, the Federal Reserve facilitated the sale of Bear Steams to lPMorgan Chase. In September 2008, in rapid succession, Lehman Brothers declared bankruptcy; AlG required a $85 billion taxpayer bailout; and Goldman Sachs and Morgan Stanley converted to bank holding companies to gain access to Federal Reserve lending programs.

Finally.  I’ve waited two years to see the crisis understood by those in our government.

Was there a real estate bubble fueled by low rates and uber-easy credit?  You bet there was.  And did some segment of homeowners buy homes they should not have bought during that bubble?  Darn right.  Would we have had a market correction regardless of bonds and their ratings.  Yep.  And would badly underwritten loans have defaulted regardless?  Uh huh.

But our situation today is not just a market correction.  It’s the result of bankers behaving badly.  It’s the result of Wall Street believing that financial innovation had reduced risk to such a degree that it was now possible to be “perfectly hedged”.  And it’s about boundless greed operating in an essentially unregulated climate.  It’s not the fault of someone that refinanced their home in order to pull out some equity to pay for a child’s education, or to remodel, or even to buy pair of jet skis and a flat screen.

My wife and I refinanced our home of 19 years in May of 2007, and after the refinance our loan-to-value ratio was 50%.  We also took out an Option ARM loan, although we had never had any sort of adjustable loan before, and we did so because we were planning on selling the home within the next year or two.  Besides, if rates did start to unexpectedly rise, we could always refinance to a fixed rate, right?

In May of 2007, our decision to refinance using an Option ARM seemed to be as close to risk free as I could imagine.  What could possibly happen?  Less than 90 days later, I saw what could possibly happen… a whole bunch of giant investment banks could defraud investors all over the world using trillions in bonds known as mortgage backed securities.  And that, was not something I had seen coming.  The market correction… yes.  The wholesale destruction of the bond market… no sir.

What if our Option ARM were to recast, doubling our mortgage payment, and what if a member of the family were laid off for a few months… and we found ourselves losing our home… and when we told our friends they looked at us like we were irresponsible deadbeats who couldn’t make our mortgage payments because we refinanced.  How would that scenario be considered our fault?

The Final Piece of the Puzzle

I also didn’t fully understand credit default swaps back then, and with good reason: they weren’t “swaps” at all.  I did understand other types of swaps, but credit default swaps were really just insurance policies you could buy on bonds with semi-annual payments and a fixed term… and they’d pay off if a bond defaulted.  It was really a way of “shorting” the mortgage backed securities market.

For example, you might pay $100,000 a year for a 10-year credit default swap on $50 million in AAA rated bonds.  The most you could lose would be $1 million… $100,000 a year for 10 years.  The most you could make was $50 MILLION, if the bond defaulted anytime in the 10-year period.

Credit default swaps paid off just like roulette wheels in Las Vegas.  You could lose your chips, or pick up a fifty to one payday if the bonds went bad.  As an investor, your downside was limited to the amount you paid for the credit default swap, and the upside was a huge multiple.  You didn’t get free drinks like you would at the Golden Nugget on the Las Vegas strip, but with paydays of 50:1, you could buy your own.

Credit default swaps were the perfect tool to bet against the sub-prime lending that had become a huge component of our financial sector, and the worse the underwriting standards on loans, the lower the borrower’s qualifications, the more certain the default and therefore the safer the bet.

It was even something you could time fairly accurately.  You’d just figure out when the garbage loans were set to adjust, say two years out, and then make the assumption that when they did, a number of borrowers would default.  The bond containing the loans would default and you’d go Ca-Ching as you collected on your credit default swap bet.

With derivative investment vehicles like credit default swaps available in an unregulated market, is it any wonder that the bonds were packed with mortgages that were all but certain to fail?  It was bad enough that the banks were making loans that they wouldn’t have to keep on their books and therefore didn’t care about credit worthiness, but when you add the perverse incentive created by credit default swaps, you have at the very least, a gathering storm.

This past week, we finally learned that Washington Mutual was intentionally selecting the worst loans for bonds, and that Goldman Sachs and Merrill Lynch were playing the game as well.  Soon there will be more and more bankers hauled before the Senate Committee and what we’ll learn will shock and deeply offend our sensibilities.  And hopefully the homeowners in distress will be free of the shame that they have lived with far too long and we can get back to the business of creating a more prosperous tomorrow.

Stay tuned… it’s far from over yet.  In fact, it’s just getting started.  Now is not the time to give in to the banking lobby’s obvious clout, because there’s only one group more powerful than they are… and that’s us… the American people.

It’s a mid-term election, and Congress is likely to act.  Remember… our politicians do place a higher value on one thing than any amount of money the bankers could provide, and that’s getting reelected.