The Origins of the Financial Crisis: Who's to Blame? Part II
November 15, 2008
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Continuing on my past thread, I'm opening up the discussion to all the players who might have had a role in the financial crisis. Let's find out who is to blame by removing each participant from the equation--if you take away the specific participant and the boom/bust still happens, then that specific participant wasn't to blame.
Let's line up the suspects: CRA (Community Redevelopment Act), Freddie/Fannie, MBS's, Mortgage Brokers, Wall Street, Individuals, Washington, or CDS's.
CRA: If there were no CRA, we'd be in exactly the same mess today. Why? Because lending standards went out the window in all classes of credit ratings. I was living in San Francisco during the height of the bubble. We knew people making $60,000 per year getting loans for $500,000. They had good credit, professional jobs, and there was no way they could ever pay off their mortgage.
At the end, it appears some folks used the CRA as justification for throwing out lending standards for people with poor credit ratings as well. It made the problem bigger, but I'd say that politicians and lendors went hand in hand on this one using the CRA to justify extending the bubble that was making everyone so much money.
Besides, the CRA has been around for 30 years. You have to be a pretty virulent ideologue to blame a 30 year old piece of legislation for our current problems.
Freddie/Fannie: I don't like them anymore than you do, but I believe the bubble and bust would have happened with or without them. Go back to the original post and note that the majority of sub-prime MBS's were being purchased by Wall Street, not Fannie and Freddie.
There was a moment in early 2006 when Mozilo from Countrywide met with Fannie and told them they had to buy more sub-prime paper becuase otherwise Countrywide would send all their business to Wall Street. (I can't currently find the link for this, sorry.)
So, I'd be more than happy if we had let these two fail and disappear, but MBS's had already found an open and willing market on Wall Street. Lehman, Goldman, and Bear were all willing to buy as much of this garbage as the mortgage brokers were willing to create.
So, Freddie and Fannie were corrupt, bloated, illiquid, and deserved to go bankrupt, but I suspect their role would have been played by someone else if they hadn't been around during the past 10 years.
MBS: Mortgage backed securities have existed for a long time. I can't blame the bubble on the MBS, but I will say one thing. When mortgage brokers can bundle all their loans into an MBS and sell it into a secondary market, the loan originator no longer shares in the risk of default. It does set up a situation where lax lending standards are likely.
Mortgage Brokers: Here we have the culprits who originated all the lousy loans (I include the mortgage departments of banks along with Countrywide and friends in this category). There is a lot of guilt here. In the past, these companies were supposed to actually verify how much money a person could repay. Anyone who lived in a bubble city in the past 7 years can tell you that these companies completely stopped caring whether or not the loans would ever be repaid.
When I lived in San Francisco, I heard a story about someone who worked for a major mortgage broker. (I don't know it is true, but have no reason to believe it is false because I heard it before the boom went bust.) They claimed there was a glass table with a backlight in an office they called the "forging room." This is where they would create false documents lying about incomes and such. Sometimes the clients played along, sometimes they got the money and had no idea how it happened.
There were crimes among some of the companies here.
Wall Street: Wall Steet enabled the bubble. First, they created a much larger market for MBS than just FNM/FRE would have provided. Second, they created all the innovations like the market for CDS's. Without all these "products" and "innovations" the cheap money and market for lousy loans would not have existed.
It really was the financial alchemy of putting it all together which we are paying for today. Take any individual element away and the bubble still happens as long as Wall Street is shaking the toxic cocktail. These are the companies which took on the leverage, they made the toxic cocktail, they drank it, and they puked all over the party.
Individuals: People taking on more credit than they could ever repay are guilty on a personal level, not a system-wide level. If someone gets wiped out because they bought more house than they could afford, well, that's too bad. No one forced them to buy. No one said they couldn't plug some numbers into Excel to calculate how much house they could really afford. No one told them to ignore warnings from TMFBent and the housing bubble blogs who were considered a bunch of anti-American, sky-is-falling alarmists back in 2005/2006.
But, individuals are only responsible for their own personal financial collapse, not system-wide financial collapse.
Washington: To the degree that Washington is responsible (and I truly mean Democrats and Republicans)it is their failure to see what was going on, or if they saw, their failure to do anything about it. Of course, in 2003/2004, there were all kinds of reasons why "housing prices always go up" and anyone raising a red warning flag was rapidly ignored.
Yet, Gramm-Leach-Bliley looks like a major enabling event which gave Wall Street the free reign to create the toxic cocktail. The Republicans wrote it; Clinton signed it. After that, it was a failure to stuff the jeanie back into the bottle. The complaints about Fannie/Freddie during the past 8 years never got to the core of the problem, which was there was way too much easy money flowing with lax lending standards.
CDS: Warren Buffett said it best in 2002 calling Credit Default Swaps "financial weapons of mass destruction." He wrote in the 2002 BRK annual report: "Unless derivatives contracts are collateralized or guaranteed, their ultimate value also depends on the creditworthiness of the counterparties to them. In the meantime, though, before a contract is settled, the counterparties record profits and losses—often huge in amount—in their current earnings statements without so much as a penny changing hands. The range of derivatives contracts is limited only by the imagination of man (or sometimes, so it seems, madmen)."
Without the CDS market to hedge against losses on the MBS purchases, the MBS market would have been much smaller and buyers would have been much more concerned about the creditworthiness of the buyers on the other end of the loans. Lax lending probably would have been much smaller. The CDS market was the tequila shot in the toxic cocktail.
More specifically, it was the misuse of the CDS which caused the problem. The failure to price domino-effect failure into the price of the CDS written agains MBS contracts meant that the price for a CDS was too low. The insurance was too cheap.
Look at the price of a CDS now. To insure against default on a sub-prime MBS today, you have to pay something like 9% of the value of the MBS. 2 years ago, it was only about 1.2%. If the MBS only pays 6%, you cannot insure it against default anymore. Which means you'd better look at the fine print and make sure it doesn't default. (I saw this on TV a few weeks ago, so my numbers here are "order of magnitude" from what I remember.)
Verdicts:
CRA: Not Guilty
Fannie/Freddie: Guilty of a lot of things, but not bringing the system down
MBS: Not Guilty, but the boom and bust could not happen without the MBS market
Mortgage Brokers: Guilty
Wall Street: Guilty on all counts
Individuals: Guilty for their own losses, but not systemwide problems
Washington: Guilty of inaction
CDS: Guilty on all counts
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