The cosmology of our current financial and economic crisis
Allow me to share with you the observations of a mortgage market analyst who has been plying his trade for nearly 32 years. I spent a decade working for a Fortune 500 company, four years working for medium-sized companies, and almost two decades at a small firm that I co-founded with another economist. Our firm focused on mortgage banking research, primarily the wholesale market. More specifically, we studied and measured the production revenue and expense structures of the large mortgage companies that originated loans through multiple channels. We began this in 1993, and continued through 2008. The other major component of our research was examining the mortgage origination business and industry: The primary mortgage market. Every other year from 1991 on through 2006, we completed a rigorous and statistically valid examination of the mortgage brokerage business and industry. We also studied non-broker originators (or “lenders”). In both cases, we examined firms’ demographics, use of technology, product menus, interface with wholesale investors and their operations (including profitability). No one else counted operating firms, measured their production, inspected their staffing structure, probed how they used the Internet and other technologies, calculated their market share of residential originations and on and on.
Our two-decade old business collapsed last year. Revenue began declining in early 2007, and by early 2008 was insufficient to maintain a payroll. I’ve set up a one-person consultancy and am looking at several job opportunities. It will be most interesting to see how the next chapter of life proceeds … time will tell.
With that backdrop, let me next point out that three decades as a reader, writer and researcher—always grounded as a money market economist—have allowed me to observe and chronicle industry issues and trends, the interactions between the economy and the mortgage market’s anatomy and dynamics. In 1996, I warned (at the Mortgage Bankers Association’s Annual Convention) that Fannie Mae and Freddie Mac were “out of control,” siphoning off mortgage banking revenue and likely to end in ruination, seriously harming taxpayers. I maintained my anti-Fannie/Freddie campaign up to their takeover by the federal government, under conservatorship last September. Several years earlier, I was privileged to tell a Congressional sub-committee about the positive and prominent role of the mortgage broker in the mortgage delivery system, and about the threat posed by the two government-sponsored enterprises (GSEs), a statutory duopsony.
In 2005, my partners and I were hearing about the rapid growth of non-prime lending—namely alt-A and sub-prime—and we launched a study to measure the size of this market as of early 2005. We were shocked by the results. Wild things were now going on in the primary and secondary markets. Forty percent of new originations in the first half of 2005 were non-prime! Years earlier, around 1996-1998, when we studied the earlier generation of non-prime lenders which was now shuttered for about six years, we found a sub-prime world accounting for five to eight percent of total originations, not four of 10 loans and still expanding! In horror, I wrote to U.S. Department of Housing and Urban Development Secretary Alphonso Jackson in August 2005, warning him to slow his incessant cheerleading for homeownership. I admonished that this advocacy could and would hurt many young households financially, harming marriages and families. Since 2005, I’ve been telling anyone who would listen that the mistakes of the mortgage market were in all likelihood going to spill over to the broader economy, sending it into eventual recession. All of these claims are supported by many articles, speeches and conversations laying out my fears and expectations. In 2006, I called the publisher of this magazine to tell him I thought the types of loans that Argent Mortgage (Ameriquest) and others like them were soliciting brokers to originate would later boomerang on them. Recall that before the second half of 2004, there were few sub-prime brokerages and many of them were producing Federal Housing Administration (FHA) loans to satisfy Community Reinvestment Act (CRA) goals.
It is with this vantage point that my local trade association asked me several months ago to address them. I was told to pick my topic, make it contemporary and make it relevant to both the residential and commercial sides of our association. It was obvious what I needed to address and discuss with my peers.
Adapted from that earlier speech and updated, this article shares my personal assessment of the cosmology, or origins, of the economic and financial crisis we find our country and world mired in today. The crisis has worsened quarter by quarter since June of 2007, the month the two Bear Stearns hedge funds, highly levered and collateralized almost exclusively by non-prime mortgages, defaulted. Since then, the credit markets have been in turmoil and real Gross Domestic Product (GDP) has been faltering. More than five million folks have lost jobs, me among them, and the jobless rate now hovers around 16 percent nationwide.
In light of this background, I had asked myself why? Why had it happened and who was responsible for creating it? This article shares my assessment of culpability. Read it and see if you agree or disagree. The assessment is mine in the sense of summarizing how I saw it evolve and pass by from where I was sitting. The currency trader in Frankfort, the oligarch in Moscow, the sugar cane farmer in Cuba and the partner at Goldman Sachs might have differing accounts. Here’s how I saw the crisis appear on the radar.
My current favorite metaphor for today’s financial crisis is the “perfect storm.” A confluence of factors came together to create it. In addition to “animal spirits,” to employ Adam Smith’s term for greed, these factors included:
1. Monetary ease;
2. A lack of regulatory and Congressional oversight;
3. Rapid home price appreciation (in many markets after 2000);
4. Funky mortgage products with low start rates and layered risk;
5. Lax underwriting standards;
6. A political establishment enamored with homeownership and an endless need for campaign contributions;
7. An excess of sub-prime wholesalers, brokers and loan officers, all poorly supervised and state regulated;
8. An oftentimes greedy, undisciplined consumer seeking a free lunch;
9. A cheerleading media that, for years, dutifully boosted housing; and
10. A large network of interested parties who promoted housing unendingly—from builders to realtors to brokers.
Take all of these ingredients, mix them together and let it ferment for a few years. Presto … a black swan event landed in our laps. The financial markets went from equilibrium to mania to panic to crash, to cite the title, Manias, Panics and Crashes, is the title of an important economics text by Charles P. Kindelberger, an economic historian and emeritus professor at MIT. Kindelberger is, in the view of many, the authority on financial crises, having studied them for nearly 50 years.
There seems to me a great need for Americans to understand why this crisis occurred and to apportion culpability. Just as a commission was established to examine the causes of the Great Depression, I’d argue that we must do likewise. As the philosopher George Santayana cautioned, "Those who cannot remember the past are condemned to repeat it."
In apportioning blame, I start with the Federal Reserve because that’s where Kindelberger starts with all manias: Phase one, always easy money. To soften the pain from the popping of the tech bubble and the events of 9/11, the Fed eased monetary policy dramatically in 2002. The funds rate was cut to one percent in 2003, lower than at any time even during the Great Depression. It was held there for 13 months after a fast descent in 2002 and a slow, incremental tightening late in 2004. Fed policy essentially flooded the market with credit for five straight years and cheap credit got borrowed. Without this single ingredient, easy money, the financial crisis could not have occurred.
Unfortunately, monetary policy errors weren’t the whole of the Fed’s fatal errors. It and its fellow regulators at the Securities and Exchange Commission (SEC), Federal Deposit Insurance Corporation (FDIC), Office of Thrift Supervision (OTS), etc. also failed to police the financial markets—from the primary mortgage market through Fannie Mae and Freddie Mac, from Wall Street and its structured products to the credit raters. Congressional oversight and the regulators could have, and should have, warned of market excesses: uninsured 100 percent lending, loans paying less than accumulating interest, no income/no asset loans (NINAs), home equity loans. Similarly, a vigilant SEC should have connected the dots in the Madoff scandal a decade ago, not four months ago. But they didn’t kick the tires, not even any periodic jawboning from the Fed or other regulators. Thus, I conclude it was a government failure, not a market failure, that precipitated this crisis, and unfortunately, not the last of the government failures in this crisis.
After the central bank, next up in terms of culpability is the federal government—both the legislative and executive branches and both political parties. Presidents Clinton and Bush and senators and representatives—Republicans and Democrats alike—promulgated housing and homeownership. They cheered it along beyond reason. The Bush Administration advanced the “ownership society” and Congress led bi-partisan cheers for a 70 percent homeownership goal for the United States. They ignored huge problems at Fannie and Freddie. Sadly, the law of unintended consequences stepped in, and when home prices stopped rising and started falling, we got payback: Delinquencies and defaults. I had written to the HUD Secretary in August 2005 to warn him that his unqualified advocacy of homeownership would backfire. In part I wrote, “Government officials really need to be careful on their advocacy for housing at this point in time or they will lead young working-class families, already confronted by myriad challenges, to financial hardship.” Delinquencies and foreclosures are now running at record levels.
After the Federal Reserve—which is neither federal nor holds reserves—the Congress and the federal regulators, I place Fannie Mae and Freddie Mac next up for culpability. Both GSEs were always a flawed business model, as I first suggested 12 years ago. Public choice theory, the capture theory and the law of unintended consequences told me so. Public choice theory is the branch of economics dealing with public decision-making. Captive theory involves relationships between regulated and regulator—for example, between the Office of Federal Housing Oversight (OFHEO … pre-2002) and Fannie and Freddie; or between Enron and the Federal Election Commission (FEC); or Madoff and the SEC, and so forth. Problems were ignored until accounting scandals hit all three exampled firms. Both Fannie and Freddie’s CEOs resigned under dark clouds. Three years later and both housing GSEs are under government-imposed conservatorship and are hemorrhaging red ink. Combined, Fannie Mae and Freddie Mac lost $110 billion in 2008. A loss of that magnitude negates decades of past earnings. They are currently on life support. Now their debt costs more, their ability to act counter cyclically is impaired, their credibility is worn globally and they cannot effectively support worthy affordability programs save for the taxpayers’ munificence. The Fed and the Treasury are buying hundreds of billions of their mortgage-backed securities (MBSs) to support them, after having provided tens of billions of capital and buying their debt. Without Fannie, Freddie (and Ginnie), there is no market; they are 95 percent of it.
The next guilty group resided in Manhattan along Wall Street. This group included investment banks, commercial banks, ratings agencies, hedge funds, law firms and accounting firms. The former participants practiced what ultimately proved to be financial alchemy, while the latter firms cited sanctioned the deception. First, the incentives were wrong. Standard & Poor’s, Moodys and Fitch Ratings were like prostitutes who sold their favors. And why not? They got very rich passing out booty. The more alluring the transaction, the bigger the kisses. Wall Street took home billions in bonuses before 2008. We haven’t yet had a full accounting, but it appears that in 2007, 2008 and 2009, bankers will give back every dime their firms earned over the past two generations! Poof. Total write-offs to date exceed $1.1 trillion. A generation of financiers aided and abetted by the political establishment, especially the Bush Administration, blew up the financial system. They messed up royally, permitting risky bets levered with big multiples. And all predicated on little more than ideology, free markets. Franklin Raines earned $90 million during his reign at the helm of Fannie Mae. Angelo Mozillo earned almost $500 billion running Countrywide. Meanwhile, Wall Street sold investors their fool’s gold, and now having realized the deception, investors are angry and on strike. One result is that none of the five venerable old investment banks exist in their historical form. Even giants die.
After the federal government, the regulators, Fannie Mae, Freddie Mac and Wall Street, the next most culpable in my view were the lenders—not all but many—predominately state-chartered lenders, non-banks mostly serving non-prime borrowers. Approximately 40 percent of what was originated in 2004 through the second half of 2007 was non-prime, essentially alt-A and sub-prime. Forty percent amounts to $2.8 trillion. Names like Argent, Ameriquest, New Century, First Franklin and Countrywide come to mind. There were dozens, mostly wholesalers, and they compensated loan officers handsomely for any consumer demand they could dredge up. A pulse, a breath and it seemed a loan was granted. No equity, high ratios, poor credit, bad employment history—no problem, there was a mortgage for everyone.
A 1999 New York Times article quoted Franklin Raines, Fannie Mae’s chairman and CEO, saying:
“Fannie Mae has expanded homeownership for millions of families in the 1990s by reducing downpayment requirements.”
The article concluded:
“In moving, even tentatively into this new area of lending, Fannie Mae is taking on significantly more risk, which may not pose any difficulties during flush economic times. But the government-subsidized corporation may run into trouble in an economic downturn, prompting a government rescue similar to that of the savings and loan industry in the 1980s.”
And it certainly has, hasn’t it? Fannie and Freddie hold 10 million non-prime mortgages, two million of which have defaulted thus far. Congress has allocated $200 billion of capital to each to keep them from exploding. Too big to fail?
Next in line for criticism for participating in stupid, harmful lending was the mortgage insurance (MI) industry. Traditionally, they were the defensive line, holding back the offense—production for production’s sake. MIs best understood risk and pretty well priced for it in the 70s, 80s and 90s. Until late 2004 that is. That’s when they were big and bloated coming off a record five-year run. Like Fannie and Freddie, the MIs didn’t want to sacrifice market share, they didn’t want to downsize and they didn’t want to leave behind record profits. And like nearly everyone else, they (temporarily) forgot that home prices can fall, borrowers can become delinquent … and lenders can file insurance claims. A “senior moment” they should not have allowed themselves.
After the MIs in the chain of culpability come mortgagors. Many were motivated by an opportunity for a free lunch. They were swept away by the investment aspect, the lure of easy money, to borrow a phrase from an old Eagles tune. How could homebuyers go wrong? Little or no downpayment required and asset price appreciation of 10, 12, 15 even 20 percent per year for five straight years in markets like Florida, California, Arizona, Nevada and elsewhere looked irresistible. Sign ‘em up! And since 10 percent of $500,000 is larger than 10 percent of $300,000 (which may be affordable) let’s take the $500,000 house and finance it with interest only, at a 2.5 percent start rate (for six months) and a second mortgage. No guts, no glory, no skin in the game. An ATM in every home … if only for a while.
In reviewing this presentation, my friend Richard Garrigan, a retired professor of real estate finance at DePaul University in Chicago, noted that much of the housing speculation could be traced to the Federal tax law change that occurred in the late 1990s. This change permitted a married couple to avoid up to $500,000 in capital gains on a primary residence after owning it for a minimum two-year period. Furthermore, a second home could be acquired and become a primary residence after the first home was sold. Think of all the housing demand this tax law change stimulated. Free capital gains and tax write-offs to boot. Again, the law of unintended consequences surfaces.
Near the bottom of my hierarchy of blame rest the originators—the brokers, the real estate agents … the street level participants. Sure, they originated many loans now delinquent and foreclosed, and sure, they pocketed lots of commission dollars—though impishly small compared to Wall Street’s take. However, none of these brokers, which The New York Times recently called “predatory,” ever underwrote a loan or approved a commission. None. First and last, they were salespeople. They didn’t create payment option ARMs (POAs) and other risky products. And like all salespeople, they sold the products they were given, thinking little about the consequences or risk potential of a black swan. Not surprisingly, most felt they were doing borrowers a great favor, and for years, they literally were. In 2006 brokers, loan officers, real estate agents, lenders, etc. could look back and pat themselves on the back for a job well done. Virtually all of their customers had houses that were worth tens even hundreds of thousands of dollars more than when they were initially financed. Brokers were largely blind to any understanding of the magnitude of what they were doing. If Alan Greenspan didn’t see the crisis coming, nor Henry Paulson or Ben Bernanke, how could mortgage brokers?
In the Inferno, Dante reserves separate places in Hell for various transgressors. From where I’m sitting, a largely dispassionate perch, the worse places go to the Fed, the Congress and the regulators. That’s where the buck should stop. Less bad places go to Wall Street. The least of the worst seats are reserved for the mortgagors and mortgagees.
Or, to put it in the words of Vijay Mathur, professor emeritus of economics, in a recent op-ed piece:
“Hence the ultimate fault lies with Congress, the Bush Administration and the Fed, because they were the only ones who were capable of taking a macro view and seeing the inter-relationships between the various segments of the global financial market. But they all ignored the warning signs of the housing bubble and financial collapse.”
And so it goes … we now live with the aftermath and consequences of a two-term Administration and an ideology that put us at the bottom of a deep hole. The challenge ahead is to crawl out as quickly as possible, then fill in the hole so we can never again stumble into the perfect storm.
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