13 Bankers: The Wall Street Takeover and the Next Financial Meltdown (25 page)

Between 2003 and 2007, all five major investment banks increased their overall leverage, taking on larger and riskier positions that increased their expected profits while increasing their overall risk.
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Bear Stearns’s leverage reached a ratio of thirty-three to one, meaning that if its assets fell by 3 percent the bank would be insolvent; it was the first to fall in 2008 when
rumors
that it might be insolvent caused its short-term funding to dry up in a matter of days.

In exchange for being allowed to increase their leverage, the investment banks gave the SEC new powers to monitor their operations through the Consolidated Supervised Entity program. However, the SEC declined to take effective action under this program. A 2008 investigation by the SEC inspector general found that

[the SEC’s Division of Trading and Markets] became aware of numerous potential red flags prior to Bear Stearns’ collapse, regarding its concentration of mortgage securities, high leverage, shortcomings of risk management in mortgage-backed securities and lack of compliance with the spirit of certain Basel II standards, but did not take actions to limit these risk factors.
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By this point, many regulators had bought into the idea that the financial markets could police themselves, so there was no need to intervene.

Securitization, credit default swaps, and more flexible capital requirements all made it possible for banks to increase their leverage, increasing both profits and risks. Historically, regulators have set limits on leverage, because it increases the likelihood of failures that may require government intervention. In the past twenty years, Wall Street banks invented new ways of getting around those limits. More important, the regulators no longer felt the need to protect the financial system by defending those limits, instead acquiescing in the general belief that markets were best left to police themselves.

Another potential threat to Wall Street’s golden goose was regulation of mortgage lending, and subprime lending in particular. The mortgage lenders were not unaware of this danger. Between 2000 and 2007, the lenders that lobbied most intensively against potential legislation restricting predatory lending were precisely those lenders who originated the riskiest mortgages (measured by loan-to-income ratios), grew the fastest, and grew the proportion of mortgages that they securitized the fastest.
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(They were also hit the hardest by the eventual financial crisis.) But the industry was fortunate to be protected by powerful figures in Washington.

In 1994, back when subprime lending was off Wall Street’s radar, Congress had passed the Home Ownership and Equity Protection Act, which amended the Truth in Lending Act to read, “A creditor shall not engage in a pattern or practice of extending credit to consumers under [high-cost refinance mortgages] based on the consumers’ collateral without regard to the consumers’ repayment ability, including the consumers’ current and expected income, current obligations and employment.”
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In other words, it banned predatory lending—loans where the lender doesn’t care if the borrower can’t make his or her payments, because then the lender can pick up the house cheaply. However, under the arcane structure of financial regulation, consumer protection statutes including the Truth in Lending Act were enforced by the Federal Reserve—headed throughout this entire period by Alan Greenspan, who not only opposed government regulation in general, but thought that even fraud would be deterred by the operation of a free market.

The Federal Reserve sidestepped its consumer protection responsibilities by claiming it lacked jurisdiction. Many subprime loans—52 percent of those originated in 2005, for example
⁶⁰
—were made not by banks, but by nonbank consumer finance companies or mortgage lenders. By the late 1990s, however, many of these specialized lenders had been bought up by banks (through their holding companies) or had been started by banks as independent subsidiaries. Consumer groups amassed mounting evidence of abusive lending practices, particularly in low-income and minority communities, and pressed the Fed to investigate. In 1998, however, the Federal Reserve Board of Governors unanimously decided “to not conduct consumer compliance examinations of, nor to investigate consumer complaints regarding, nonbank subsidiaries of bank holding companies,”
⁶¹
claiming it could not regulate nonbank entities
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(even though the Truth in Lending Act makes no distinction between banks and nonbanks).
⁶³

In 2000, a joint report issued by Treasury (then under Larry Summers) and the Department of Housing and Urban Development recommended restrictions on harmful sales practices and on abusive terms and conditions in the mortgage market.
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The report also urged the Fed to investigate abusive lending practices, claiming it had authority to do so.
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That same year, Edward Gramlich, a member of the Board of Governors, argued that the Fed should crack down on predatory lending by consumer finance lenders that were subsidiaries of bank holding companies. His proposal, like all the others, was shot down by Greenspan, who believed that subprime lending was an example of healthy financial innovation.
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(Conforming to the usual practice of not airing disagreements among governors, Gramlich did not go public with his concerns while at the Fed. Shortly before he died in 2007, however, he wrote, “In the subprime market, where we badly need supervision, a majority of loans are made with very little supervision. It is like a city with a murder law, but no cops on the beat.”)
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As late as 2005, Greenspan was still celebrating the growth in subprime lending:

Where once more-marginal applicants would simply have been denied credit, lenders are now able to quite efficiently judge the risk posed by individual applicants and to price that risk appropriately. These improvements have led to rapid growth in subprime mortgage lending; indeed, today subprime mortgages account for roughly 10 percent of the number of all mortgages outstanding, up from just 1 or 2 percent in the early 1990s.
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While the Federal Reserve was neglecting to protect consumers, other regulatory agencies were neglecting to ensure the soundness of the banks they supervised. At the peak of the subprime lending boom, the Office of Thrift Supervision (OTS) was allowing thrifts to
reduce
their capital levels, which fell to their lowest level in decades by 2006. Only in 2005 did the Office of the Comptroller of the Currency (OCC) initiate a proposal saying that lenders should have to make sure that borrowers could afford their monthly payments; even then, it was not actually issued until September 2006, by which point housing prices were already falling.
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Material loss reviews conducted after many smaller banks had failed in 2009 showed that banking regulators were often aware of the risks that the banks were running, but failed to take any significant corrective action.
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While federal regulators were content to turn a blind eye to subprime lending—when they were not cheering it on—there remained the risk that state regulators might attempt to put an end to the party. In 1999, the North Carolina Predatory Lending Law subjected high-cost (subprime) loans to a number of constraints, such as limits on loan flipping (refinancing a borrower into a new loan after only a few years) and prepayment penalties; in 2002, the Georgia Fair Lending Act introduced similar restrictions.
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Standard & Poor’s responded by announcing that it would not allow any loans governed by the Georgia Fair Lending Act into securitizations that it rated; if similar laws had been enacted throughout the country, this would have brought the subprime mortgage securitization assembly line to a screeching halt.
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However, the primary federal bank regulators came to the industry’s aid, ruling that state regulations are “preempted” by federal regulations.
*
In August 2003, the OCC ruled that state regulation of lending practices did not apply to national banks, preempting the Georgia Fair Lending Act and holding that federal regulators alone had the power to regulate lending activities by federally chartered institutions.
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This decision followed letters by the chief counsel of the OTS concluding that federal law preempted both the Georgia Fair Lending Act and the New Jersey Home Ownership Security Act of 2002.
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(Later in 2003, the OCC also preempted the New Jersey law; in January 2004, it exempted national banks from state mortgage regulations in general.)
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The federal courts have usually sided with federal regulatory agencies on the issue of preemption, giving the OCC and the OTS the ultimate say on whether states may regulate banking operations.
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During the subprime boom, the effect was to disarm state governments and give the mortgage lenders (and the investment banks securitizing their loans) free rein throughout the fifty states.

In addition to protecting the flow of subprime loans into the securitization market, the federal government also increased demand for subprime loans through its regulation of Fannie Mae and Freddie Mac. The financial crisis was not primarily due to Fannie and Freddie.
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However, their purchases of securities that were backed by subprime loans did, at the margin, provide additional sales for the Wall Street banks manufacturing those securities.

Before 2008, Fannie Mae and Freddie Mac were governmentsponsored enterprises (GSEs)—private corporations with a government mandate to provide liquidity to the housing market. They did this by buying mortgages and mortgage-backed securities on the secondary market and by creating and guaranteeing mortgage-backed securities of their own. To protect themselves, they only bought loans or guaranteed mortgage-backed securities made out of loans that conformed to their relatively strict (by industry standards) underwriting standards and size limits—so-called conforming loans. (The upper limit on conforming loans for single-family houses grew from about $253,000 in 2000 to $417,000 in 2006, but still left many houses beyond its reach.)
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Because Fannie and Freddie could borrow money cheaply, there was a ready supply of cash that could flow into mortgage lending.

The common indictment of Fannie and Freddie charges that Democrats in Congress, trying to expand homeownership among the poor and minorities, pushed the GSEs to buy more and more subprime loans, pumping up subprime lending and housing prices in the process. (The implication, of course, is that the financial crisis was caused by government intervention in the markets.) There is a grain of truth to this story. The targets set by HUD in both the Clinton and George W. Bush administrations (under a law passed in 1992) mandated that 42 percent, 50 percent, and finally 56 percent of the loans bought by Fannie and Freddie had to go to people with low or moderate incomes. In 2002, as part of the Bush administration’s Blueprint for the American Dream, they committed to finance $1.1 trillion in loans to minority borrowers.
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The riskiest mortgages, however—the ones that pushed the housing bubble to dizzying heights—were simply off-limits to Fannie and Freddie. The GSEs could not buy many subprime mortgages (or securitize them) because they did not meet the conforming mortgage standards. As profit-maximizing private corporations, Fannie and Freddie tried to relax their underwriting standards in order to get into the party, reducing documentation requirements and lowering credit standards. But ultimately, regulatory constraints prevented them from plunging too far into subprime lending. As housing expert Doris Dungey wrote, “[T]he immovable objects of the conforming loan limits and the charter limitation of taking only loans with a maximum [loan-to-value ratio] of 80% … plus all their other regulatory strictures, managed fairly well against the irresistible force of ‘innovation.’ ”
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As a result, in 2004–2006, as subprime lending reached its peak in both volume and innovation, Fannie and Freddie were pushed out of large parts of the market, because the loans being made violated their underwriting standards and because the Wall Street banks were so eager to get their hands on those loans. After 2003, the GSEs’ share of secondary market subprime loans was cut in half, while the volume of private mortgage-backed securities (those not issued by the GSEs) soared.
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Fannie and Freddie could not have pushed mortgage lenders into the most extreme forms of subprime lending, because those were precisely the loans they could not buy. They created demand for conforming mortgages, which were precisely what the aggressive subprime lenders were
not
selling.

Instead, however, Fannie and Freddie were able to buy the senior (AAA-rated) tranches of private mortgage-backed securities backed by subprime debt. These securities could count as money loaned to people with below-average income, and they were supposed to be safe.
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These purchases of MBS were a mechanism by which government pressure to increase lending to low-income Americans translated into greater demand for mortgage-backed securities and therefore greater profits for Wall Street. At the end of the day, government pressure on Fannie and Freddie contributed to the housing bubble by increasing the amount of money flowing into the securitization pipeline. The two GSEs were not the primary factor stoking the subprime fire, and were consistently behind the curve as both subprime lending and securitization heated up, out-hustled by the mortgage lenders and the Wall Street banks who built, expanded, and profited from the mortgage securitization money machine. But they were yet another way that Washington provided fuel for that machine.