“All the Devils Are Here,” by Bethany McLean and Joe Nocera is full of interesting information about the financial crisis of 2008. The book presents the information somewhat scientifically, although they clearly hold a position on the guilt or innocence of the participants. That, and the scarcity of hard data available on the subject, gives the book a bit of a gossip column tone. Even so, it makes a fascinating read.
I am writing this only to clarify my own thoughts on the subject. If you are interested, this might make a good synopsis, but there are better sources on this subject elsewhere – starting with the book itself.
In the fall of 2008 I was working out of the country on a business trip. My customer asked me what I thought about the US bailout of the financial markets. Ideologically, I was strongly against it. But I told him I didn’t know enough to have a strong opinion. It seemed necessary at the time. Having read this book, I still believe that, but I wish it had been done a little differently.
For years prior to 2008 (can’t remember how long — 3 or 4 years), I had been convinced the housing market would see a correction. The stories of bay area dual-income professional couples having to take balloon loans on houses got me started.
It was common to hear people say that real estate would always go up. But how could it – especially if nobody could buy their first house? I soon learned that 40 to 60% of Northern California mortgages were balloon loans or negative amortizations!
At the time, I could not believe that anyone would issue these loans. In shopping for my own house in 1998, my wife and I were encouraged to exaggerate and even be deceptive on one mortgage application that turned out to be a bit of a stretch (we found a different house and a different mortgage broker). So I knew the brokers were not all straight shooters. But I assumed the people doling out the cash were prudent and cautious.
At first, I believed this was a regional problem – in California and Nevada. But the willingness of lenders to play crazy games with loans gave me pause. I soon learned enough to become convinced this was nationwide.
Facts
A few facts can be stated about the cause:
- If the individuals who borrowed more money than they could ever have paid on mortgages had had more character, this could never have happened. The book is full of stories of 500K mortgages granted to people with no income at all. Surely most of them understood what they were doing.
- If the Glass-Steagal Act had not been repealed in 1980, this could not have happened. The repeal allowed banks, investment banks, traders, and insurance companies to mix their businesses in a way that became unregulatable (sic?). If the retail banks had not been at risk, a bailout could probably have been avoided.
- If the ratings agencies (Moody’s, Standard & Poor’s, and Fitch) had not lied with their ratings, this could never have happened. Packaged securities based on mortgages like the one above were treated as if they carried no risk of default. All of the major players were surprised when their AAA-rated debt packages began to show high rates of default.
- If the U.S. government had not taken action, we would now be in a severe situation on a par with the Great Depression.
- The financial markets became complex with new products so fast, that the big financial companies lost track of their risk.
- A large part of the massive bad debt that precipitated all of this is now on the books of the US government. We will pay for this for generations.
- The price of a house today – even after the big correction — is artificially high. If you are buying a new house, you are paying a higher price because your government is financing the buyers and discounting the interest (through tax deductions). This was completely overlooked in the book and continues to be overlooked in the press.
Without those influences, I wonder what a new house would cost today? Certainly a lot less. We would not have to live our lives in debt in order to own a house. It strikes me as a mild kind of indentured servitude.
Home Ownership & Free Markets
Why did all of this come about? The ideals involved were the belief that free market self-interest would protect against this and the goal of increasing home ownership in the US.
It was believed that the players in a free market would not buy loan packages that contained bad loans. They would not over-extend themselves without the proper hedges against risk. This failed primarily because the ratings agencies lost all scruples – gradually, but truly they did. Personally, I will never again regard a rating from such an agency as anything but nonsense. I am still a free market believer, but this story gives me pause.
A high rate of home ownership has long been advocated as a good thing for the US. I remember an advocate for the poor ranting on NPR in 2006 that lower income people were locked out of home ownership. Her arguments completely ignored the debt that those people would have to carry. No doubt many of the sub-prime sharks were licking their chops when she got on the air. In any case, she got her way.
That was the drum beat in Washington any time someone questioned the validity of Fannie Mae – a corporation tacitly guaranteed by the US government. Similar arguments were trotted out any time someone wanted to regulate sub-prime loans.
Note to self: When opposing idealists agree on something, look out!
Anyway, both types of idealists were wrong. Home ownership had grown only 1.5% from 2000 to 2008. Most of the financing went into refi’s for cash or real estate speculation. And we have all seen what happened with the free financial market.
The complexity of these markets grew from the idea that one could insure against the risk exposure in mortgage-backed securities. If you were a big bank and wanted to package a bunch of securities to sell to others, you would end up with some of the worst quality debt left unsold – and on your books. To hedge against that, they would buy insurance against the debt going bad. AIG was the big player in that arena.
When the shit hit the fan, they all realized that the value of derivatives depends on market confidence as much as the value of the loans on which they were based — even more, in fact.
Worse than that, some such insurance was not based on anything real – it just referenced real packages of mortgages like an index. So a single loan default could result in losses that were 15 times the value of the loan – very much like a house of cards.
Sleaze-Balls
The stories in this book about the sub-prime loan originators are disgusting. Ultimately, I believe it should be, “Buyer Beware.” Never-the-less, the behavior of companies like Ameriquest (and most other companies owned by Roland Arnall), New Century, and even Countrywide was despicable.
Applicants were routinely encouraged to lie. Appraisers were literally bribed into over-pricing houses by double (or more ?). And the loan originators did all of this in order to charge outrageous fees – as high as 20% of the loan value. The loans were usually short term balloon loans – some with negative amortization. A lot of hapless borrowers were taken to the cleaners.
How could they get away with it? Apparently, the subprime mortgage companies had the blind trust of the applicants – who, for their own part, were taking cash out of the house they owned. Was it blind trust or tacit conspiracy? It would be interesting to hear hard-ball interviews with some of those individuals.
At the same time, the sub-prime guys had the big financial companies begging them to bring in more loans. Big financial companies like Merrill Lynch, Salomon Bros., et. al. were making a fortune off of the mortgage backed securities – especially those based on sub-prime loans. Packaging mortgages into securities had made them rich. And they had to keep growing. So any loans could be sold to them.
My Conclusion
I used to trust bankers to act prudently, investment companies to have some scruples about what they sold, and – most of all – ratings companies to have standards.
I no longer do. In the end, my take is that a fool and his money are easily parted. Any one of those guys could easily be a con artist. I got lucky on this one – no huge losses thanks to a broker who put me in something safe. I will remember this history the next time I have investment decisions to make. Buyer beware!
