The Cause of the Crisis
Jared M. Ladden
HMN 679HB Special Honors in the Department of Humanities The University of Texas at Austin
------[First Reader’s Signature] ------Professor Brian Roberts Department of Government Supervising Professor
------[Second Reader’s Signature] ------Professor Robert Prentice Department Chair: Business, Government, and Society Second Reader
“The perception of reality is often realer than reality itself”
- Unknown The Cause of the Crisis 2
Table of Contents
Table of Contents………………………………………………………...2
Introduction: September 15, 2008 …………………….…………………3
Chapter 1: 1929 vs. 2008 ……………………………………….……….5
Chapter 2: Pointed Fingers………………………………………………7
Chapter 3: The Product………………………………………………….8
Chapter 4: The Insurer………………………………………………….13
Chapter 5: The American Dream…………………….………………….16
Chapter 6: The FHA …………………………………………………….20
Chapter 7: Degrading the System………………………………………. 23
Chapter 8: The American Consumer…………………………………….31
Chapter 9: The Mortgage Broker……………………………………….38
Chapter 10: The Investment Banker…………….……………………….48
Conclusion: A Lack of Ethics …………………………………………... 63
Bibliography……………………………………………………………...67
Vita ………………………………………………………………………76
The Cause of the Crisis 3
Introduction: September 15, 2008
“Anyone who says we’re in a recession, or heading into one – especially the worst one since the Great Depression – is making up his own private definition of ‘recession’.”
–Donald Luskin, The Washington Post – Sept.14, 2008
September 15, 2008. A sea of 28,600 cardboard-boxes filled with plants, paperweights, and coffee mugs, floods New York City’s 7th Avenue. These 28,600 boxes are carried by previous Lehman Brothers’ employees, as they filter out of the bank’s
$700-million New York headquarters. Surprisingly, this quantity of jobless Lehman employees is one of the smallest figures in the following story. In fact, the boxes would each need to contain $21,643,356 to match Lehman’s $619 billion’ worth of debt when it declared bankruptcy on September 15, 2008. Lehman Brothers was only the 4th largest
U.S. investment bank at the time. Therefore, their mammoth debt-pile only accounted for
16.2% of the “$10 trillion-dollars’ worth of market capital erosion” caused by the 2008 crisis (“The Collapse of Lehman Brothers”, 2017). The astronomical losses incurred by the banks led to sizeable losses for Americans as well. The Federal Reserve Bank of San
Francisco estimates that the Subprime Mortgage Crisis cost every American a “lifetime present-value income loss” of roughly $70,000 (FRBSF, 2017). Based on these appalling metrics, it should come as no surprise that countless historians have sought to calculate the true cost of the crisis. Enormous corporations deemed too big to fail crumbled into dust. Global financial markets joined them, as the Dow Jones Index plunged 500 points in its worst nose-dive since the terrorist attacks of September 11, 2001. The Cause of the Crisis 4
The fiscal decay of the crisis has been calculated by countless economists, all of whom have revealed how they reached their respective values of damage. Yet, despite these calculations, there is one number far more intriguing than any other. This number represents the quantity of American executives sentenced to jail for their involvement.
While the actions of bankers, insurers, and mortgage brokers should have rewarded countless unethical players jail-time, the number of American executives sentenced to jail is one (Noonan et al., 2018). This number is represented solely by Kareem Serageldin, the former Head of Structured Credit at Credit Suisse. Serageldin openly stated that he was “ready to pay [his] debt to society,” and has since served time for his role in the
Subprime Mortgage Crisis. If the estimated values of ruin are so large, how is it possible that only one American executive was issued a mere thirty-month-sentence? Even the judge on trial said Serageldin’s actions were “a small piece of an overall, evil climate within [Credit Suisse] and many other banks” (Abrams and Lattman, 2014). It is clear that Serageldin could not have caused the entire crisis on his own—not without the help of American consumers, Congress, investment banks, insurers, and the numerous mortgage brokers who helped destroy the U.S. economy. Despite the actions of countless bad actors, much of the unethical behavior displayed was not deemed “illegal.”
Unearthing the true costs of the crisis was rather simple, for it was extracted from financial statements, bankruptcy filings, and balance sheets. However, the true cause of the crisis still remains one of the largest financial ambiguities in American history.
Eleven years later, no one is in prison, most corporations involved still exist, and a consensus on the true underlying cause has not been reached. If no one is still in custody The Cause of the Crisis 5
for their involvement, it is clear that neither one person, nor a group of people are solely responsible. Yet the unanswered question still lies eerily on the table. If not one product, individual, organization, corporation, or even a specific combination of them has been universally deemed responsible, what truly caused the 2008 Subprime Mortgage Crisis?
Chapter One: 1929 vs. 2008
“There is no cause to worry. The high tide of prosperity will continue.”
–Andrew W. Mellon, Secretary of the U.S. Treasury–September, 1929.
The Great Depression of the 1930s negatively influenced multiple aspects of the
American economy. Unemployment rose to twenty-five percent, homelessness spiked across the country, international trade declined by sixty percent, and the stock market needed twenty-five years to recover (The Balance, 2019). Despite the devastation caused by America’s first recession, “the Great Depression [most likely] does not even qualify as a financial crisis,” for there were few financial institutions at the time and they were not yet as influential as they are now (Wallison 4). In addition to the lack of financial institutions, the causes of the Great Depression have been agreed upon as combination of global economic issues. In particular, decreased international lending and tariffs, the gold standard, World War I, and the market crash of 1929 have all been deemed contributing factors (Brittanica, 2012). These isolated causes of the Great Depression strongly contradict the variety of fingers pointed every direction following the Subprime
Mortgage Crisis. The Cause of the Crisis 6
The Great Depression stemmed directly from a period of rapid consumerism, known as the “Roaring 20s.” Throughout this decade, “the nation’s wealth more than doubled,” setting the stage for a drastic economic downturn (“Great Depression History”,
2009). Enthusiastic consumer spending finally plateaued on October 25, 1929. On this date, later coined “Black Thursday,” 12.9-million, overpriced shares were sold in bulk, as anxious shareholders became fearful of their investments (Great Depression History,
2009). Five days later, “Black Tuesday” emerged along with a 16-million share selloff.
The second market collapse sparked a series of bank runs throughout the nation, ultimately creating a public confidence crisis. America’s economic self-esteem was not restored until Roosevelt and his “fireside chats” revived the nation’s spirit (“Great
Depression History”, 2009).
The ten-year chronology of the Great Depression is a simple narrative to follow. A rapid, nine-year period of economic growth, fueled by mass consumerism, eventually led to an inevitable stock market peak and crash in October of 1929. An additional market crash occurred five days later, causing widespread bank runs that demoralized the economy. Sentiments of fear and greed perfectly intersected within America’s financial markets and chaos ensued.
The Great Depression of 1930 and the Subprime Mortgage Crisis are different for many reasons. However, out of all the details intertwined within each story, the largest dissimilarity is the agreement on direct causes. President Herbert Hoover claimed in his
1952 memoirs that “without the war there would have been no depression of such dimensions” (Hoover 2). In addition to World War I, many have acknowledged that the The Cause of the Crisis 7
“Roaring 20s” created a consumerism monster, fluffing the nation for collapse at the end of a prosperous era. The 2000s were at times exciting, encompassing a new digital age and the internet, but the start of the century was far from “roaring.” In fact, its onset was highlighted by fear from September 11, 2001 and an expensive war in Iraq, again leaving many searching for 2008’s true catalyst.
Chapter Two: Pointed Fingers
“Mankind does not reflect upon questions of economic and social organization until compelled to do so by the sharp pressure of some practical emergency.”
–R.H. Tawney, Religion and the Rise of Capitalism
Fingers have been pointed in every possible direction at those, and by those, deemed responsible for the 2008 Subprime Mortgage Crisis. The extensive culprit list includes, but is not limited to, investment bankers, ratings agencies, mortgage brokers,
American consumers, U.S. Congress, and more. The assessment of these culprits will help determine who is most directly correlated to the biggest economic catastrophe since the Great Depression. Whom these fingers belong to and their direction of blame must be assessed with proper diligence and consideration. Prior to delving into this culprit list, the importance of isolating the causes of an eleven-year-old event must be addressed.
It is crucial to study preceding market crashes for a variety of reasons. History is known to repeat itself and reviewing the mistakes of the past should help their prevention in the future. Therefore, by isolating the true catalyst of the Subprime Mortgage Crisis, The Cause of the Crisis 8
similar mistakes can be prevented from reoccurring. However, a deeper dive into the details of the crisis reveals far more than a manual for preventing future economic mistakes. Isolating the true catalyst exposes a disturbing behavioral trend, positioned deep within financial markets and American society. This particular trend has been swept so far under the rug many are still unaware of its diminished, yet ongoing presence.
Although it has since been reduced by regulatory measures, the behavior of the early
2000s conceived an immoral, economic environment, unseen and unregulated for nearly an entire decade.
Chapter Three: The Product
“The CDO was, in effect, a credit laundering service for the residents of Lower Middle
Class America. For Wall Street it was a machine that turned lead into gold.”
–Michael Lewis, The Big Short: Inside the Doomsday Machine
A derivative is a “contract between two parties, which derives its value and or price from an underlying asset” (The Economic Times). Derivatives contracts on hundreds of financial products are still in circulation, and existed years before the crisis.
However, derivatives on bundled home mortgages were unregulated in the early 2000s and were vaguely priced. These specific contracts served as a direct conduit for the unethical behavior exhibited by many market participants. Some of these particular participants can be found within the previously referenced culprit list in Chapter Two. The Cause of the Crisis 9
Although the term derivative itself is not confusing, Wall Street has created several derivative-based terms that are. Over time, a notorious “Financial-Product-
Dictionary” was seemingly created for the sole purpose of confusing outsiders. This dictionary is filled with so much jargon that terms with basic meaning can appear as ancient language. Wall Street has further complicated their “Financial-Product-
Dictionary” by taking already-confusing vocabulary and creating acronyms for each term. This intentionally confusing process helps explain how the term “derivative” was somehow morphed into the term “CDS.” A Credit Default Swap, or CDS, is merely one amongst thousands of complex acronyms found within Wall Street’s Financial-Product-
Dictionary. These swaps refer to contracts held by an individual who is betting against the market opinion of another individual. For further clarification, The Corporate
Financial Institute defines a CDS as a credit derivative that provides buyers with protection against default and other risks. In the case of the 2008 crisis, market players were wagering on the fate of mortgage debt within securitized products. Although these products are called Collateralized Debt Obligations, they are found in the Financial-
Product-Dictionary, under the term “CDO.” Collateralized Debt Obligations are filled with all kinds of debt, from corporate debt to residential and commercial debt, and so on.
They are defined as debt products with “pools of mortgage loans created [and originated]” by investment banks and other financial institution (Chen, 2018).
Additionally, these products contain tranches with respective ratings, based on the riskiness of the debt within them. The super-senior, triple A (AAA) rated tranche allegedly contains the least risky debt, and is deemed highly unlikely to default. The The Cause of the Crisis 10
single C rated tranche contains riskier pools of debt, but offers a higher yield on investment, if it does not default.
In order to reduce the complexities of CDOs, the debt in this particular story is presumed to be residential mortgage debt. This specific debt was also given its very own acronym of “RMBS.” RMBS (Residential Mortgage Backed Securities), were primarily made up of subprime mortgage loans leading up to the crisis. These securities are defined as mortgage-backed debt obligations created from residential debt, such as prime mortgages, home-equity loans, and subprime mortgages (Kagan, 2017). In the early
2000s, this subprime debt represented loans that were issued to low-income borrowers in their pursuit of homeownership. These borrowers could not afford to purchase homes on their own and were extended credit from mortgage brokers and lenders.
An individual who purchases a swap contract believes that mortgage loans within a CDO will not be paid off in time by the borrowers. If borrowers are unable to pay back their loans on time, they default on their mortgages. An individual selling a swap contract disagrees. This individual backs the wager, and holds the notion that the bundled home loans will be repaid by the borrowers, and they will not default on their mortgages. If theses borrowers are unable to pay off their mortgages, different pools of debt within the
CDO will fail as a result of the defaults. The individual who purchased the swap will profit, as they have placed a bet that mortgages within a specific tranche would in fact default. Likewise, the individual who bet that the home owners would not default inherits a loss and must pay out the holder of the Credit Default Swap. The Cause of the Crisis 11
The details regarding the described transaction can differ in various ways, along with their pay-out structures. These details have been simplified in order to adequately reveal the basic fundamentals of Collateralized Debt Obligations and their derivatives contracts. Mortgage based CDOs and their Credit Default Swaps’ mass circulation played a pivotal role in the Subprime Mortgage Crisis. Additionally, the products enabled the generation of quick cash flows for investors on both sides of the trade. The CDS was birthed in 1994 by a J.P. Morgan Executive named Blythe Masters (Casey, 2015).
Thirteen years later in 2007, the products’ market value reached $45 trillion, exceeding the $22 trillion invested in public equity markets (The Corporate Financial Institute).
Unsurprisingly, employees within Lehman Brothers’ sea of cardboard boxes were the biggest owners of Credit Default Swap-debt. Of the bank’s $619-billion debt, $400- billion had been generated from being on the losing end of Credit Default Swaps (The
Corporate Financial Institute). Along with Lehman came its insurer, American Insurance
Group, which joined them in backing these deals, by insuring the highest-rated, pooled mortgage-debt within them. They believed the super-senior tranches were “riskless,” but found this to be tremendously false when they were unable to clear Lehman’s debt after the AAAs soured.
CDOs powerfully connected several housing market players together, especially investment banks and insurers. Although investment banks securitized the debt, they needed insurers to back super-senior tranches in order to generate profits. This process paired the mispricing of CDO risks, to various insurers’ reckless protection of super- senior debt. The insurers were so blinded by potential profits, that they hardly conducted The Cause of the Crisis 12
proper due diligence on the risks they were taking. Likewise, CDOs also connected low- income borrowers and mortgage brokers to the insurers and the banks. Mortgage brokers extended credit to low-income consumers, who signed off on misleading mortgage contracts. These subprime mortgage loans were then bought by banks and pooled together into debt tranches for further securitization in the CDO market. In the final years preceding the crash, Credit Default Swaps heavily impacted poor decision making as well. Rather than bring light to a looming economic catastrophe, banks utilized the swaps to reduce their own losses as soon as they recognized imminent market erosion. Banks began handcrafting the worst CDOs possible, immorally marketing them to clients, and hedging out housing market risks to reduce future losses.
The sheer destruction caused by a tiny little acronym known as a “CDS” would not have been possible without the development of its use and skyrocketing popularity.
Likewise, without insurers like American Insurance Group, Lehman Brothers and other investment banks would not have even been able to issue such products, due to leverage regulations. A Credit Default Swap has no moral compass, but its creators and distributors most certainly do. The investment banks teamed up with insurance giants and began utilizing this product unethically for all the wrong reasons, primarily to generate massive profits.
The Cause of the Crisis 13
Chapter Four: The Insurer
“I will never, ever, ever, ever live out that scar that I carry for what happened with something I created, something that did so much damage to so many people.”
–Lewis Ranieri, The Wall Street Journal – September 8-9, 2018
A period of aggressive deregulation primed the housing market for failure years before its demise. At the time, many of the newly imposed rules appeared to have had no negative impact at all, only further promoting the free market. Although several deregulatory measures were brought to market, the Commodity and Futures
Modernization Act of 2000 was perhaps the most detrimental. This act specifically forbade the Commodity Futures Trading Commission to regulate derivatives, such as
Interest Rate Swaps, Currency Swaps, and Credit Default Swaps (Wallison 74). Many perceived this Act to protect a trader’s ability’ to freely exchange derivatives.
Conversely, by forbidding the regulation of a new financial product and its derivative, ambiguities in pricing created opportunities for misleading behavior. Shockingly, the
Commodity and Futures Modernization Act of 2000 was actually not newly imposed deregulation. As noted by Peter Wallison is his novel, Hidden in Plain Sight, the product had never been regulated in the first place (Wallison 74). The enactment simply highlighted the government’s choice to not regulate these specific market derivatives.
The CDS was by no means the sole cause of the crisis, and the product itself is still rapidly exchanged today by traders on Wall Street. However, the refusal to regulate this product allowed it to connect several unethical players from various industries together. The Cause of the Crisis 14
The American International Group, known by its Wall Street-esque acronym, AIG, was a market player that suffered immensely from excessive involvement in this unregulated territory.
The U.S. Government bailed out AIG twelve years ago with an $85 billion cash infusion in exchange for an eighty percent equity stake. The bailout was required in order to save one of the nation’s largest insurance giants from defaulting. The American
Insurance Group successfully operated its business since inception in December of 1919.
As subprime mortgages became increasingly popular, AIG shifted its focus to insuring
Credit Default Swaps, straying from its formerly risk-averse path. The financial sector of the insurance behemoth was known as AIG FP, or AIG Financial Products. Led by
Joseph Cassano, AIG FP offered commercial and industrial insurance protection, life insurance, retirement products, and mortgage insurance to American borrowers. Profits on Collateralized Debt Obligations were far larger than those of other insurance products, and AIG FP sought to increase exposure.
In order to issue massive CDO deals, investment banks needed insurers to back the super-senior debt tranches within them. Essentially, because regulators did not want banks taking too much risk, they required them to shift additional risk to other entities.
Insurance giants such as AIG and Countrywide agreed to back the highest rated tranches within the deals. These triple AAA tranches were located at the top of a CDO’s capital structure and would not default unless the entire product failed simultaneously. AIG quickly discovered that by offering super-senior debt insurance to investment banks, they could transform their business and drastically increase revenue. The tranches within The Cause of the Crisis 15
mortgage-based CDOs contained diverse pools of housing debt from across the nation.
This diversified debt had been bundled together into CDO products, and therefore its chance of defaulting was said to be highly unlikely. AIG strongly believed that the diversification of mortgage debt mitigated the risks of the triple AAA rated debt tranches.
Yes, it was possible for a few bad mortgages in one particular region of the country to default. But the notion that pools of mortgage debt from all over could collapse simultaneously was perceivably impossible. Thousands of low-income mortgages suddenly lost their “riskiness” through a process known as securitization. This was an enormous misconception, and spread like a virus throughout insurance companies and investment banks. America’s biggest financial institutions saw a growing opportunity to securitize subprime mortgages into CDOs, market them towards other investors, profit from transaction fees, and dump the product’s unlikely risks or hold it themselves. This process was repeated hundreds of times throughout the early 2000s, as securitization masked risk perception. Investment banks and insurance companies had become infatuated. Subprime CDO deals, containing mortgages scattered across the entire country, rapidly churned out large profits. The U.S. housing market could never fail, so neither could its diversified, subprime debt products.
Although the securitization of subprime RMBSs grew throughout the 21st century, the process was created years prior in 1977 by a Vice Chairman at Salomon Brothers named Lewis Ranieri (Podkul, 2018). Ranieri had developed a transactional process on the mortgage lending desk at Salomon Brothers, to purchase risky mortgages from
American Savings and Loans associations. Salomon would then sell the pooled The Cause of the Crisis 16
mortgages to other associations and package them with older loans. The Salomon
Brothers mortgage lending desk, quarterbacked by Ranieri, had created an RMBS bond market and was generating profits on the spreads. This was a niche and unchartered market at the time, but Raineri’s team was generating significant revenue at rapid pace and competitors noticed. In the following decades, Lewis Raineri’s concept of securitizing mortgage backed securities would eventually develop into a trillion-dollar subprime CDO market. The market was opaque in terms of pricing, but still generated massive profits for the banks and insurers. By the early 2000s, Raineri’s securitization cash-cow rose to prominence; however, its growth would not have been possible without the U.S. Government, a general lack of regulation, and the new “American Dream.”
Chapter Five: The American Dream
“We can put light where there’s darkness, and hope where there’s despondency in this country. And part of it is working together as a nation to encourage folks to own their own home.”
–George. W Bush, The New York Times – Oct. 15, 2002
In contrast to Wall Street’s opaquely priced debt products, the political agenda of the
Bush administration was rather translucent. The administration’s key initiative was to promote the “American Dream,” which equated to single-family homeownership amongst low-income consumers. Regulations pertaining to this niche of consumer had obstructed their paths to homeownership for years. Congress sought to increase The Cause of the Crisis 17
homeownership through affordable-housing provisions, advancements in the Department of Housing and Urban Development, and the easing of low-income lending regulations.
George W. Bush seemingly favored Keynesian economic policies. This particular economic ideology calls for “increased government expenditures [and] lower taxes to stimulate demand” and prevent economic downturns (Chappelow, 2019). Bush proved to be the ultimate Keynesian, after approving a $700 billion bailout to save the tanking economy and its vital corporations. However, prior to the notorious government bailout,
Bush promoted Keynesian economics on a much smaller scale. Throughout his presidency, Bush sought to fuel the struggling U.S. economy by “pairing his belief that
Americans do best when they own their own homes, with his conviction that markets do best when left alone” (Becker et al., 2018).
Bush’s combination of laissez-faire economics and the pursuit of low-income homeownership was simply unfeasible for several reasons. First and foremost, buying a home in America had been a historically difficult process for a reason. Lending regulations were intentionally rigid, in order to ensure that only those who could pay off their mortgage debts were issued mortgage loans. The Bush administration aggressively encouraged low-income consumers to seek homes, believing that stimulus would increase economic prosperity. Congress’ bias in this belief proved so strong that it outweighed any prospective doubts on the initiative’s practicality. The U.S government displayed no concern as to whether reduced lending standards could support a market filled with riskier loans. Prior to the collapse of the subprime mortgage market, the housing initiative was met with amazing success. In fact, the Bush administration “took a lot of pride [in] The Cause of the Crisis 18
home ownership reach[ing] historic heights” (Becker et al., 2018). Congress perceived their plan to have worked, but its success was extremely artificial. The stimulus created by subprime loans would soon be erased alongside thousands of looming foreclosures, bankruptcies, and unemployment. Unfortunately, this perceived success was a silver lining at a time when the country was knee-deep in a war on terror. Some members of
Congress questioned the initiative’s feasibility, but refrained from interfering with the goals of the administration. Chief Economic Advisor Lawrence Lindsay noted that “no one wanted to stop [the] bubble [because] it would have conflicted with the president’s own policies” (Becker et al., 2018). This lack of interference was instantly detrimental; however, the damage of Bush’s housing initiative remained unveiled for years, due to its superficial success.
Enabling low-income Americans to purchase single-family homes was evidently a large objective of the Bush administration. As mentioned previously, the reason this initiative had not been successful beforehand was primarily due to formerly established regulations. Un-creditworthy borrowers took advantage of a new, attractive climate, in which they could acquire fictitiously, manageable mortgage loans. These subprime mortgage loans are named after their less-than prime rate borrowers. When borrowers with a sound credit history decide to purchase a home, they are issued a prime rate mortgage. Likewise, these prime rate mortgages are issued at the current benchmark rate of the economic environment. In contrast, borrowers who lack reliability in terms of credit are issued subprime rates. These loans include higher monthly interest payments in The Cause of the Crisis 19
order to compensate the lender for the borrower’s riskier credit profile, and likelihood of default.
In the early 2000s, there was a drastic increase in the issuance of subprime mortgage loans. Low-income borrowers had previously been deemed so un-creditworthy that they were unable to receive any form of mortgage loan. These borrowers suddenly became eligible for newly created mortgage loans that authorized them to purchase luxurious homes. Lenders began issuing credit to risky borrowers, and insurers began backing the loans, both believing that a nation-wide default was highly unlikely. On the surface, low-income borrowers saw an opportunity to achieve Bush’s new American dream; however, the terms of these new loans were deceiving. Many low-income consumers had never been issued mortgage loans before. Brokers took advantage of borrowers by shrewdly hiding increased rates into later payments, ultimately making the loans more appealing. Low-income borrowers quickly pursued the opportunity to receive instantaneous credit, but the structure of the subprime loans set them up for inevitable failure. These risky subprime loans were packaged directly into the previously referenced
CDOs, which were then traded throughout Wall Street. Investment banks profited from origination fees and investors made supposedly risk-averse investments, all the while fueling the new American dream.
Again, diversification was the key rationale explaining why these were perceivably sound investments. A nationwide U.S. housing collapse was still widely believed to be unimaginable, even after Congress aggressively promoted low-income homeownership. A few investors acknowledged a possible collapse and shorted U.S. The Cause of the Crisis 20
housing through Credit Default Swaps. However, the vast majority of the Street still believed U.S housing was infallible. Whether this misconception was birthed from a lack of market diligence, or from turning a blind eye to generate massive profits is still up for debate. Investors continued to purchase packaged mortgage products from banks and lenders continued issuing subprime loans to low-income borrowers. In order to best interpret how this process became possible through newly distorted regulations, the previously established lending standards must be examined.
Chapter Six: The FHA
“We conclude widespread failures in financial regulation and supervision proved devastating to the stability of the nation’s financial markets”
- Financial Crisis Inquiry Commission Report – 2010
The Federal Housing Administration, FHA, was created in 1934 and “designed to attract support from real-estate and banking industries, [that] were historically opposed to federal intervention” within the U.S. housing market (Duignan and Fritz, 2016). The administration’s primary function “was to insure home mortgage loans made by banks and other private lenders, encouraging them to make more” loans to potential buyers
(Duignan and Fritz, 2016). Most importantly, the FHA’s formation created a direct conduit for Congress to play a significant role in U.S. housing. Prior to the FHA’s conception, the typical loan structure included “short-term mortgages, with bullet- payments” at the loans termination (Wallison 127). This structure implied that final The Cause of the Crisis 21
payments on mortgage loans were not due until the loan reached maturity. Throughout the loan’s existence, smaller, amortized payments were to be made monthly leading up to a final bullet payment. The FHA fostered government involvement in the housing market because Congress now provided guarantees of repayment on certain mortgage defaults.
Likewise, while the previous repayment period on home mortgages was five to ten years, the FHA extended the duration “to twenty to thirty years” (Duignan and Fritz, 2016).
These dramatic provisions altered the sentiment of various investment banks and lenders.
Credit issuers were now much more likely to extend loans over longer terms to low- income consumers with riskier credit backgrounds. The previously conservative nature of mortgage lending began to radically change as a result of the FHA’s creation.
Loan-to-value ratios are utilized to assess the lending risks of extending credit to all classes of borrowers. The higher the loan-to-value ratio, the higher the risk of borrower default. The ratio is calculated by dividing a mortgage amount by the appraised value of the property being purchased. If a borrower is seeking a mortgage loan on a property valued at $1,000,000, and has requested a mortgage loan of $500,000, the LTV ratio is fifty percent. While the property holds significant value at $1,000,000, the borrower has likely paid a considerable amount in the form of a down payment. Down payments prevent borrowers from taking out larger mortgages, which ultimately cost more to finance over time. Likewise, if this particular borrower has requested a loan of
$800,000 on the $1,000,000 property, the LTV ratio increases to eighty percent. The ratio itself directly correlates to how much of the property the consumer has sought to finance through a loan. Likewise, the size of a borrower’s down payment represents their equity The Cause of the Crisis 22
stake within the property. Borrowers who make large down payments are viewed by lenders as less risky. Because these borrowers have already made a substantial investment in the property, the term of their loan will likely be shorter with reduced monthly interest payments. In terms of government guarantees, the FHA held the
“authority to insure [certain] mortgages for up to 100 percent of the loan amount”
(Wallison 106). It is crucial to understand LTV ratios, for their risk thresholds were dramatically ramped through new legislation, in order to fuel low-income homeownership. The provisions referenced directly promoted a shift in lending to riskier borrowers, padding potential default paths with extended repayment periods and government-backing.
After the Great Depression, lenders took a cautious approach to LTV risk probabilities. The benchmark LTV ratio rarely exceeded a threshold of fifty to sixty percent, and as a result of these stringent standards, the U.S. homeownership rate remained less than forty-four percent (Wallison 106). Once the FHA provided government guarantees, the standard structure of mortgages became longer, with maximum terms of twenty to thirty years, and loan-to-value ratios of up to eighty percent
(Wallison 101). Although the FHA had dramatically altered mortgage lending standards, even with LTV ratios of up to eighty percent and extended repayment periods, the
“default rates on FHA mortgages remained well under one percent” (Wallison 101).
Mortgage lending standards in the United States remained unchanged for years under the
FHA, and the newly imposed system proved to be harmless. However, economist Peter J.
Wallison notes that in 1957, a line was crossed when “Congress reduced the FHA’s down The Cause of the Crisis 23
payment requirement percentage to 3 percent” for the next three years (Wallison 102).
Wallison marks this event as the first instance of substantial government intervention, promoting the obvious goal of housing market stimulus. This particular government intrusion increased the rate of foreclosures within FHA mortgages by nearly sixteen times the previous rate. The new standards evidently represented a negative impact on the success of the FHA’s previously issued mortgages. While this intervention occurred far before Bush took office, it highlights one of the first visible correlations of government intervention within the housing market, to the creation of futile mortgage loans.
Likewise, the FHA provisions foreshadowed the possibility, that with increased government interference comes increased housing market failure. Congress merely decreased the minimum down payment to a three percent threshold and foreclosures increased by sixteen times. One can only imagine the potential danger in completely reshaping lending standards for the promotion of low-income homeownership in
America.
Chapter Seven: Degrading the System
“The incorrect Fed study on racial discrimination in bank lending turned subprime lending to minorities into a moral crusade for justice.”
–John Allison, Hidden in Plain Sight - Peter J. Wallison
At the dawn of the 21st century, activists began pushing government entities with influential roles in the housing market to simplify lending standards. The activists’ goal The Cause of the Crisis 24
mirrored the Bush administration’s, and they strove to effectively plant it in the minds of low-income borrowers. This goal was none other than homeownership in America. For many low-income Americans, FICO scores and credit histories were the primary obstacles impeding this dream. Likewise, rather than making larger down payments, or enhancing financial planning skills, Americans searched for the fastest route to make homeownership dreams a reality. The U.S. Department of Housing and Urban
Development rallied behind American’s cries for reduced regulatory standards, and
“created an Advisory commission on Regulatory Barriers to Affordable Housing”
(Wallison 115). The Advisory Commission began its crusade against lending standards by starting the “Not in my Backyard” movement in 1991 (Wallison 113). The movement called out government-sponsored enterprises, GSE’s, and exposed their heavy influence on prime-mortgage lending standards. Congress believed that by increasingly pushing
GSEs down a path of eased underwriting standards, they could achieve their goal of low- income homeownership. Pressures surmounted in 1991 and 1992, as studies revealed a shocking discovery. Activists claimed that not only were lending standards too harsh on minorities, but that there was also evident discrimination against Hispanics and African
Americans seeking mortgage loans. The Federal Reserve Bank of Boston released a study that noted “African American and Hispanic minorities were two to three times as likely to be denied mortgage loans” than whites (Browne, 2007). The study additionally revealed that “high-income minorities in Boston were more likely to be denied” than low-income whites in other regions of the country (Browne, 2007). The Cause of the Crisis 25
Negative light had been cast upon inequality in bank lending, and the pressure to reduce standards became overwhelming. The study gained enough traction to cause the creation of a detrimental Federal housing provision Act in 1992. The GSE Act, also known as the Federal Housing Enterprises Financial Safety and Soundness Act, mandated that government-sponsored enterprises “work to ensure that everyone in the nation has reasonable opportunity to enjoy access to the mortgage financing benefits” of these enterprises (Wallison 116). While the goals of this Act supported a positive cause, the government displayed carelessness in assessing the risks of new standards. This carelessness was driven by the desire to stimulate the economy through homeownership at all costs. The alleged racial inequality across mortgage lending vehicles was later deemed inaccurate; however, the study’s relevance was the final straw. Under the GSE
Act, the affordable housing initiative developed a “quota system” requiring a portion of annually originated loans to be made to low-income borrowers (Wallison 117).
Government-sponsored enterprises like Fannie Mae and Freddie Mac served as an influential industry benchmark for years. Under the quota system dispensation, they were now urged to reduce their standards in order to help Congress achieve its affordable housing initiative, and other lenders would have to follow. As mentioned previously, a slight change in the three percent minimum down payment led to drastically increased foreclosures rates. The previous regulations within the mortgage lending industry may have not yielded success in homeownership; however, these standards were put in place to ensure that money lent would later be repaid. The Cause of the Crisis 26
Markets are driven by emotions of fear and greed. The intersection of these two emotions often leads to economic chaos, such as the previously referenced market-crash in 1929. The state of the economic environment within the early 1990s was driven primarily by the greed of Congress in its careless pursuit of low-income homeownership.
Likewise, this pursuit was paired with newly imposed mortgage lending to un- creditworthy borrowers. Congress’ greed spread to borrowers, who took advantage of the new lending standards in order to purchase their previously unattainable dream homes.
Mortgage brokers saw an opportunity to issue deceiving subprime loans and increase profits through their newly eligible clients. Low-income borrowers, previously ineligible for any mortgage loan, had now become qualified borrowers. They were willing to sign misleading mortgage loans because their lack of credit had previously prevented them from receiving any loan. Banks saw an opportunity to package these loans into securitized debt products and profit. As loans approached default, the banks simply refinanced shakier loans in order to prolong failures within the CDOs. As soon as the government successfully imposed its will on mortgage lending, ethical lapses spread throughout every corner of the American economy. American consumers, brokers, bankers, insurers, and government officials displayed self-interested behavior that was not necessarily illegal, but was most certainly dishonest.
In order to examine the GSE Act’s effect on Fannie Mae and Freddie Mac, the two enterprises and their roles within the housing market financial system must be revisited. Fannie Mae and Freddie Mac were created by Congress to “provide liquidity, stability, and affordability to the mortgage market (FHA.gov). Fannie Mae was created in The Cause of the Crisis 27
1938 and Freddie Mac was created in 1970, both with a primary goal of “ensuring a reliable and affordable supply of mortgage funds” within the U.S. housing market
(FHA.gov). Fannie Mae buys loans from commercial banks, whereas Freddie Mac buys loans from smaller banks. Fannie represents the Federal National Mortgage Association, and was created in 1938 under the Roosevelt administration to purchase loans from commercial bank warehouses (FHA.gov). This process allowed banks to continue issuing mortgage loans so that more American consumers could purchase homes. Freddie Mac represents the Federal Home Loan Mortgage corporation and acquires and securitizes mortgage loans (The Balance). While the two Government enterprises slightly differ in their roles, their main purpose is creating liquidity within the U.S. housing market. This goal of liquidity is achieved through purchasing loans from banks, enabling them to continue issuing more loans to American consumers.
The U.S. Department of Housing and Urban Development believed that because
Fannie and Freddie were government backed enterprises, “they [had] the ability to underprice their competitors,” for any lending adjustments they made would likely be adopted by other mortgage lenders (Wallison 119). If lenders within the competitive landscape did not adjust their standards to match Fannie and Freddie’s, their success would suffer. Fannie and Freddie adopted more lenient standards for low-income consumers with risky credit profiles. Likewise, the GSE Act imposed by Congress created a system that ensured the increased lending of credit to un-creditworthy borrowers. This system inappropriately lacked protective measures to reduce any of its risks. New standards called for a “down payment requirement of 5 percent or less, The Cause of the Crisis 28
approval of borrowers who have a credit history of delinquencies, if [they] can demonstrate a satisfactory credit history for the 12-month period” after submitting their application, and the allowance of cash on hand for down payments (Wallison 119). While these provisions strayed far from previously established regulations, they aided
Congresses in their goal of enabling the American dream.
In addition to drastically altering previously, successful and conservative underwriting standards, the U.S. Department of Housing and Urban Development also enforced lending modifications. The HUD rapidly increased its threshold of required mortgage loans to low-income Americans throughout the end of the 1990s, bumping their initial ten percent goal to fifty percent by 2000 (Wallison 120). Impactful lending modifications imposed by the HUD and Congress rapidly implemented a faulty mortgage lending system in as little as eight years. Lending provisions not only created an influx of subprime mortgage debt within the U.S. economy, but also simultaneously uprooted a previously successful lending system. Congress effectively took a sixty-year history of strong underwriting standards and amended them to foster the issuance of credit to incredibly delinquent borrowers on a massive scale. As depicted by the graph below, provided by CNBC, the magnitude of subprime mortgage lending significantly increased in terms of billions originated prior to the market crash. The initial amount of subprime loans originated continuously increased from 1994 into the 21st century.
Additionally, the percentage of subprime loans as a total of mortgages originated consistently remained at ten percent until the housing market crash. Subprime rates continued to increase until reaching nearly twenty percent of all mortgage originations in The Cause of the Crisis 29
2004, 2005, and 2006 before tumbling in 2007. The discussion of these provisions and their subsequent influence on subprime mortgage lending clearly depicts increased lending to low-income American consumers. However, only a visual representation can reveal the shocking magnitude of subprime growth prior to its 2008 demise.
The previously established system embodied various risk measurements for the prevention toxic loan issuance. However, lending provisions enforced prior to the crisis reveal that Congress’ will to achieve a goal previously considered unachievable prevailed over financial rationality at the highest level. The deterioration of lending standards The Cause of the Crisis 30
birthed a ticking-time bomb embedded deep within the U.S. housing market, and its destruction radius increased with each additional ethical lapse made by market participants.
Members of Wall Street occasionally join Congress after prosperous careers in the investment banking industry. In fact, Henry Paulson, Secretary of the Treasury, at the peak of the crisis, was formerly the Chairman and Chief Executive Officer of Goldman
Sachs. Paulson is one of several high-ranking executives who passed through
Washington’s and Wall Street’s revolving door. Intriguingly, Paulson’s transition enabled him to further enhance his personal wealth. Paulson was required to sell his shares of
Goldman stock in order to begin his career as Secretary of the Treasury. Ironically, “U.S. government ethics rules exempt[ed] [Paulson] from paying taxes on any capital gains” generated by his $485 million, equity sale (Gelsi, 2006). Paulson followed previous
Goldman CEO Robert Rubin, who was Clinton’s Secretary of Treasury years prior, as well as John W. Snow, the former CSX CEO (Sorkin, 2006).
It is important to note these CEOs’ transitions to Washington, for they each highlight a prevailing relationship between high-profile Wall Street bankers and the U.S. government. Newly appointed government officials landing in Washington after years on the Street, most likely kept previous relationships in mind when imposing financial market regulations. Further, these relationships potentially explain the enactment of the
Commodity and Futures Modernization Act of 2000 and other deregulatory provisions.
By forbidding the Commodity Futures Trading Commission from regulating derivatives, The Cause of the Crisis 31
such as Interest Rate Swaps, Currency Swaps, and Credit Default Swaps, Congress enabled banks to trade unregulated derivatives at free will.
The powerful and historical relationship between Wall Street and Washington reveals how newly implemented lending standards could have been enforced in order to please big banks. On the contrary, presidential administrations that make historical strides in any economic aspect, while also stimulating growth, are likely to receive high praise.
The Clinton and Bush administrations both yearned to stimulate the economy, and evidently did so at the cost of rationality. A combination of Wall Street’s unique relationship with Congress and the desire for economic stimulus expose the probable forces behind a lengthy period of deregulation.
Chapter Eight: The American Consumer
“At the height of the housing boom, home ownership hit an all-time high of almost 70 percent…. I was pleased to see the ownership society grow. But the Exuberance of the moment masked the underlying Risk.”
–President George W. Bush, Decision Points
Widespread subprime lending resulted in a homeownership jump to nearly seventy percent, casting a vail of deception across the nation, in terms of its own economic success. As homeownership continuously increased, the rise of subprime lending seemed to have yielded positive results. In reality, this success was entirely artificial and unsustainable. Adjustable rate mortgages could only be refinanced so many The Cause of the Crisis 32
times, and thousands of subprime loans on luxurious homes would soon face inevitable defaults.
The fictitious jump in homeownership brought joy to housing market players, all of whom enjoyed the short-lived fruits of a newly implemented lending system. These fruits and the homeownership bump became part of a growing economic façade, further contributing to Americans’ faulty perception of their financial reality. The guise of success within the housing market blinded investors, lenders, and borrowers to underlying risks within a subprime market that would not stop growing. Congress’ modifications to the lending system finally began influencing the quantity of toxic loans within the market. Again, the poor judgement of Congress was joined by the greed of low-income borrowers. Minority consumers believed they were taking advantage of an attractive lending era, when in reality they themselves were being taken advantage of. All categories of borrowers were presented with an opportunity to achieve a previously unachievable dream. Americans rapidly began purchasing dream homes they knew they could not afford, in a system that enabled and promoted them to do so.
A transformation of mortgage lending standards shifted Congress from simply promoting the American dream, to actually enabling it on the largest scale possible. Low- income American consumers were now able take out exotic mortgage loans for the purchase of extravagant homes. Mortgage terms and rates appeared attractive, but many of the loans issued would ultimately prevent borrowers from ever being able to pay their mortgages. According to NPR, the majority of housing market analysis during the 2008 crisis reveals “African American and Latino borrowers were more likely to receive high- The Cause of the Crisis 33
risk loans than whites with similar incomes and credit scores.” (Sullivan and Shapiro,
2018). The “Not in my Backyard” movement’s fictitious lending discrimination report had impacted lending standards so drastically that low income African American and
Latinos now received the largest percentage of subprime loans.
Various lending horror-stories of low-income borrowers properly reveal their undesirable fate during the subprime lending era. Although much of the blame has rightfully been pointed towards corrupt mortgage brokers, it is crucial to also acknowledge the lack of financial responsibility displayed by all classes of borrowers.
Adriana Rodriguez previously held a job as a dental administrative assistant in
Phoenix; her husband worked as a forklift operator (Sullivan and Shapiro, 2018). The
Rodriguez’ occupations placed them in the Latin American, low-income borrower category. Adriana and her husband were prime targets for a subprime loan. The family’s socioeconomic background perfectly fit the mold of newly eligible borrowers chasing dreams of homeownership. As the U.S. housing market trended upwards during the early
2000s, the Rodriguez’ decided to refinance their mortgage and renovate their house. They perceived the current market conditions to be perfect for refinancing their mortgage at a discounted monthly rate. Adriana Gonzales noted that she “did [not] understand [her] loan completely” when the terms had been discussed. Unexpectedly, after a few years of reduced monthly rates, Adriana’s mortgage ballooned with significantly higher monthly payments (Sullivan and Shapiro, 2018). Adriana had become victim to an “Adjustable
Rate Mortgage”, also known as an “ARM.” Adjustable Rate Mortgages were commonly issued to low-income consumers during the subprime lending era. These loans appeared The Cause of the Crisis 34
to offer lower monthly mortgage rates in their first few years, but rates dramatically increased down the road.
The newly imposed lending system not only enabled, but also encouraged lenders to target low-income minority consumers, who sought to refinance their mortgages in a seemingly favorable environment. In some cases, risky borrowers were still unqualified for subprime loans, causing brokers to devise new loan structures in order to meet congressional goals. The brokers would still prosper from origination fees if they could isolate loopholes that permitted the issuance of subprime loans to riskier borrowers.
Mortgage brokers did not care if low-income borrowers defaulted years later because they had already prospered from origination fees. Previously established lending criteria for qualified borrowers had been based on initial down payment size, credit history, and a borrower’s monthly and annual income. As the pool of qualified, low-income borrowers shrunk, brokers concocted new ways to extend credit to non-creditworthy consumers.
Down payment percentages approached minuscule values and in some cases were even zero percent. Although their goal was to issue mortgage loans to low-income minorities, brokers were incentivized by the quantity of loans they originated. With the governments negligent lending system officially in place, mortgage brokers devised exotic loans like
ARMs and NINJAs (No Income, No Job, No Assets) to help all types of unqualified borrowers buy their dream homes.
The influence of degraded lending standards led to a toxic lending environment across the nation. Although the majority of borrowers targeted were low income, all types of consumers became victim to misleading products. Peter J. Wallison notes a particular The Cause of the Crisis 35
lending horror-story, referencing a Merrill Lynch Financial Advisor who took out a loan for one hundred percent of his dream home’s price (220). Although many borrowers were mistreated, American consumers, even those who had made a living in financial planning, still exhibited risky financial behavior.
The Merrill Lynch advisor and his wife had been house hunting in Las Vegas for a home in the $350,000 range (Wallison 220). The couple voraciously bumped up their budget after a broker led them to their dream home listed at $575,000 (Wallison 220).
Again, much of the blame has been cast upon brokers, as they most likely led borrowers to out-of-budget properties on purpose. This process enabled brokers to obtain more revenue in fees if they could successfully sell their clients on pricier homes. Meanwhile, brokers also offered seemingly attractive loan terms in order to help entice borrowers into buying unaffordable properties. Furthermore, the broker is not on the hook if a client defaults on their newly-purchased out-of-budget home. In fact, shortly after the borrower signs off, the mortgage loan’s risk embarks on an extensive journey throughout the entire housing market.
A subprime mortgage’s journey typically began after its purchase by a financial institution specializing in the securitization of mortgage debt. Some of the masters within this arena included Lehman Brothers, Bear Stearns, and Washington Mutual, all of whom went bankrupt shortly after the crisis. Once the mortgage is acquired by a financial institution, it is securitized into a CDO debt tranche based on its level of risk. The least risky debt tranches contain triple AAA rated mortgages, while the riskiest mortgages are placed into single C tranches. The financial planner’s mortgage was most likely stuffed The Cause of the Crisis 36
somewhere in the triple AAA to single A range, due the borrower’s income, assets, and employment. However, this rating does not account for the financial planner’s fiscal negligence, illustrated by his decision to purchase a pricey home with zero down payment. The mortgage loan is then securitized with thousands of other loans within the
CDO. Afterward, the CDO is marketed as a risk-averse investment due to the diversification of loans within it. CDOs were purchased by other banks and investment advisors, who believed they had made sound investments. The low rate environment at the time created a powerful sales pitch for Collateralized Debt Obligations. Investors could now purchase what was believed to be a minimal risk investment that could generate a higher return than a municipal or treasury bond. The products were purchased all across Wall Street, as investors poured pension funds and the life savings of their clients into supposedly risk-free debt products. The lengthy journey of mortgages will be revisited in the discussion on the role of investment banks.
The previously referenced mortgage lending accounts contain different types of consumers who took out different types of loans. Yet, both anecdotes represent a unity amongst borrowers, in terms of their lack of ethical reasoning. Although low-income borrowers had specifically been targeted for increased homeownership, the newly imposed lending system led to the distribution of misleading loans across all American consumers, including financial planners. The Merrill Lynch advisor earned a living by understanding financial markets and helping clients responsibly plan their retirements.
Although cautious on borrowing one hundred percent of his desired loan, the planner believed if “they [were] willing to lend it to [him] it must be O.K.”, immediately The Cause of the Crisis 37
revealing his own ethical lapse as a borrower (Wallison 220). Instead of acknowledging the echoing concerns pertaining to his loan, the planner cast aside gut instincts in order to attain a previously unaffordable home. Ironically, Merrill Lynch itself would declare bankruptcy in 2008, prior to being acquired by Bank of America. Although this borrower was not categorized as a low-income consumer, he was still offered a mortgage loan that raised several red flags. The planner’s decision to cast away reverberating doubts regarding the quality of his loan, illustrates the lack of financial integrity across all
American consumers, not just minorities.
Adriana Rodriguez claims to have been “taken advantage of”, yet she did note that she had not completely understood the loan when it had been offered (Sullivan and
Shapiro, 2018). Like many low-income consumers, Adriana was blinded by the idea of remodeling her home in an economic environment that she perceived as advantageous for refinancing. The upgrades on the Rodriguez’ home became irrelevant when the family was unable to pay its skyrocketing monthly mortgage. Had Adriana looked further into her adjustable rate mortgage, she would have discovered that cheap monthly mortgage payments were followed by steeper rates down the road. Unfortunately, like many other borrowers, the Rodriguez’ took an opportunity to enhance their American dream through home improvements, and their lack of financial responsibility led to foreclosure.
Many consumers claim to have been taken advantage of, and some certainly were.
On the contrary, other consumers were so blinded by the American dream, that they did not conduct proper due diligence on their own loans. Numerous consumers, from low- income minorities to middle-class planners abandoned financial accountability in pursuit The Cause of the Crisis 38
of their dream homes. If Americans who lost homes as a result of the crisis had simply read through the terms of their subprime mortgage loans, they might have avoided default. The American consumer’s willingness to sign off on misleading loans resulted in large profits for the biggest subprime mortgage salesforce in the country—mortgage brokers.
Chapter Nine: The Mortgage Broker
“Although the high rate of delinquency has a number of causes, it seems clear that unfair or deceptive acts and practices by lenders resulted in the extension of many loans, particularly high-cost loans, that were inappropriate for or misled the borrower.”
–Written statement by Chairman Bernanke, July 14, 2008
Although numerous instances of borrower negligence have been emphasized in
Chapter Eight, it would be unwarranted to place the entirety of the mortgage crisis blame on American consumers. Low to moderate-income borrowers, previously ineligible for the issuance of any mortgage loans, were offered seemingly attractive mortgages.
Mortgage brokers had uniquely crafted exotic subprime loans to be purposely confusing.
ARMs and NINJAs were utilized by brokers to mislead their clients’ perceptions of loan structures. The most successful subprime brokers excelled in the realm of deceiving their clients. Loans offered were perceived to be beneficial for a borrower on first glance, but ultimately concealed expensive payments by driving them far into the future. This process enabled borrowers to purchase luxurious homes at seemingly cheaper rates, but The Cause of the Crisis 39
ultimately prolonged thousands of inevitable defaults, creating a lethally immoral lending climate. Mortgage brokers eventually originated such a large pile of subprime junk that
America’s most systemic financial institutions became polluted with toxic assets.
Although these assets were traded in high volume, they would not become detrimental to financial institutions until 2008. As these institutions began to file for bankruptcy, it became clear only an expensive government bailout could save the tanking economy. The excavation of these misleading loans from the pile of subprime mortgage lending waste, reveals the unethical tactics utilized by brokers. While deceitful brokerage schemes heavily contributed to the ensuing damage, they would not have existed without government intervention, a lack of regulation, and most importantly the brokers’ lack of ethics.
Before exposing the immoral tactics of mortgage brokers, new legislation pertaining to the U.S. housing market must be revisited. For years, Congress pushed the housing market to ease lending standards and called for the issuance of credit to unqualified, low-income borrowers. These efforts set the backdrop for brokers to place low-income borrowers in out-of-budget, luxurious homes. The Community Reinvestment
Act of 1977 was created to “encourage depository institutions to help meet the credit needs of the communities in which they operate[d],” nudging banks to issue credit to minority borrowers (FFIEC.gov). In its earliest stages the CRA did not have detrimental effects on the housing market, as it allowed the banks to preserve lending standards, so long as they made efforts to serve all classes of consumers within their communities.
However, over time the CRA deviated from its initial goal to simply, “reduce credit- The Cause of the Crisis 40
related discrimination, expand access to credit, and shed light on lending patterns” in the
1970s (Federalreserve.gov). Despite additional government intervention, the established standards for mortgage lending remained intact up until the Clinton administration drastically altered them in 1995.
President Clinton called for “banks and saving and loan organizations to acquire or make “innovative” and “flexible mortgages”, that would further enable all kinds of borrowers to take out home mortgage loans in 1995 (Wallison 137). Later in the same year, Clinton’s administration also bumped the “low and moderate income base goal from a thirty percent level specified in the GSE Act, to forty percent in 1996 and forty- two percent” for the following four years (Wallison 139). The provisions under the
Community Reinvestment Act, along with the GSE Act, and Clinton’s new low-to- moderate-income base goals, further strengthened Congress’ initiative to ease previously stringent lending standards. Congress’ goal clearly encouraged banks to issue credit to low-income borrowers across the country, in order to stimulate the U.S. housing market.
The government’s agenda to place low income minorities into homes, again outweighed the cautions of lending credit to risky borrowers.
Banks were faced with a choice of either pausing growth by not cooperating with
Congress, or massively enhancing it by purchasing risky loans they previously stayed away from. The CRA served as the governments conduit for forcing subprime lending exposure upon the banks. America’s banking environment was highly competitive at the time, and smaller banks like Morgan Stanley began evolving into financial giants. The The Cause of the Crisis 41
government would have been able to reduce the growth of these banks through legislation, had the banks refrained from involvement in subprime lending.
Shortly after the banks decided to cooperate, the Glass-Steagall Act of 1933 was repealed in 1999. The repeal of the Act enabled Citicorp and Travelers Group to merge into Citigroup. A brief history on the Glass-Steagall Act of 1933 reveals that it was created after the 1929 financial crisis, due to the collapse of the nation’s commercial banks (Hekal, 2019). The purpose of the Glass-Steagall Act was to separate the activities of commercial and investment banks in order to reduce the risk of commercial banks investing with depositor money (Hekal, 2019). The Act was repealed on November 12,
1999 after President Clinton signed the Financial Service Modernization Act, which allowed commercial and investment banks to operate underneath financial holding companies (The Balance). It is speculative to claim the Financial Service Modernization
Act would not have been sanctioned, had the banks not cooperated with Congress.
However, shortly after Congress repealed the Glass-Steagall Act, many commercial and investment banks saw a rare opportunity to legally merge. America’s financial institutions became so integral to the health of the U.S. economy, that their failure would result in disastrous measures.
The relationship between Congress and financial institutions appeared cordial, as several banking executives continued to land powerful jobs in Washington after careers on the Street. The cooperation on both sides allowed Congress to finally achieve their goal of low-income homeownership growth. Banks created different products from The Cause of the Crisis 42
subprime loans and masked risk in order to create a liquid market for the trading of risky mortgage debt. These products and trading strategies enabled banks to minimize the risks they had been urged to take, while still generating positive returns, and abiding by provisions within the CRA and GSE Act. Most importantly, the escalation of subprime lending and the reduction of standards led to a massive increase in the pool of eligible borrowers available to mortgage brokers. Previously the lending standards had prevented brokers from lending credit to risky borrowers. Congress’ new lending goals and their encouragement of them, led to increased bank involvement in the securitization subprime mortgage debt. America’s largest financial institutions and insurers began purchasing the loans of previously ineligible borrowers. Once the massive profits in subprime lending became evident, mortgage brokers began targeting their large new customer pool of previously unqualified low-income borrowers.
The typical payment structure of a mortgage broker incentivizes the size and quantity of loans originated. For borrowers, the process of receiving a loan becomes lengthy for those partaking in extensive searches for the cheapest market offerings. The role of the mortgage broker is to create an efficient process for clients. The process enables a borrower to tell their broker exactly what they are looking for to reduce their search process. Mortgage brokers will offer the borrower a variety of options that they can select from. Ideally, a broker is supposed to find the most attractive mortgage loans possible and decrease a client’s search process, by knowing their needs and payment capabilities. Although mortgage brokers must be licensed, they do not report to banks, and earn an income on fees for their services. A mortgage broker’s commission fees The Cause of the Crisis 43
range from 0.75 percent to 2.00 percent of mortgage loan value. Fees can also be higher than 0.75 percent, and are referred to as “Yield Spread Premiums,” or “YSPs”. While
YSP percentages may appear small in comparison to the size of a loan, many brokers receive additional compensation form lenders. During the subprime lending era, lenders rewarded brokers for hiding fees and issuing high yield loans. Mortgage brokers that closed deals with higher monthly rates took home larger YSPs and collected the arbitrage between the loans par rate and the marked-up rate they offered their clients.
Hiked rates created larger profits for brokers, but led to missed payments and delinquencies for home owners. First American Loan Performance reported that by
January of 2007, “more than 14% of subprime mortgages were at least 60 days’ delinquent, almost double the rate [of] a year earlier.” Steve Heideman, a mortgage broker from United Mortgage Financial Group, Inc., noted that brokers “have some culpability” for the mortgage debt crisis (Barr, 2007). Heideman further recalled that in
2007, “problems and abuses [occurred] because brokers [viewed] it as their right to make as much money” possible on each of their originated loans (Barr, 2007). The compensation structure of mortgage brokers immediately destroyed trust between borrower and broker. The borrower never truly knew what incentives lenders had offered brokers for getting them to sign a loan. Mortgage brokers quickly refuted any correlation to this lack of trust by shifting the focus on the borrowers’ lack of due diligence. In 2007 at a congressional hearing on subprime lending, Harry Dinham, President of the National
Association of Mortgage Brokers, noted that brokers “do not represent every loan product available in the market place” (Barr, 2007). Dinham further shifted blame on borrowers The Cause of the Crisis 44
rather than accept any responsibility, asserting that “the role of the consumer is to acquire the financial acumen necessary to take advantage of the competitive marketplace, shop compare, [and] ask questions,” so they are able to find the best terms for their specific situation (Barr, 2007). Dinham powerfully exposes the lack of ownership displayed by mortgage brokers, who transferred blame to borrowers, when in reality they hid fees and mislead their clients.
The brokerage business itself is deal driven, and mortgage brokers who are able to close more deals generate more fees, and therefore more revenue. In terms of closing deals with low-income home buyers, brokers devised strategies that repositioned and hid rates. Pricey, upfront closing fees were relocated and accounted for in the overall mortgage yield. Likewise, brokers helped low-income borrowers purchase homes, by taking fees that were typically paid in closing on properties and restructuring them somewhere else within the mortgage. This process enabled the costs of upfront fees to be
“spread [out] over the many years the loan [was] in force” (Barr, 2007). Brokers utilized devious lending strategies in order to prosper on the lofty ambitions of prospective, low- income home buyers. Because these borrowers had never been qualified, they wanted to purchase homes instantly, and would remedy increasing monthly rates later, or simply not acknowledge them at all. Minority consumers were excited by the lack of expensive upfront closing fees on properties. Unfortunately, they did not comprehend that while closing fees did not have to be paid at the time, the lack of payment beforehand, would lead to skyrocketing monthly rates down the road. The Cause of the Crisis 45
The repositioning of closing fees into boosted mortgage rates created higher YSPs for brokers. This process was one of many brokers deployed in order to rake in unethical revenue during the subprime lending era. The manipulation of YSPs was incredibly immoral, as these rates were supposed to be clearly disclosed in “Good Faith Estimates” issued to borrowers after they completed loan applications. Zillow, is a leading real estate and rental marketplace “dedicated to empowering consumers with data, inspiration, and knowledge” in the home searching process. Zillow defines “Good Faith Estimates” as documents that “include the breakdown of approximate payments due upon the closing of a mortgage loan” (Zillow.com). Carolyn Warren, a mortgage broker with ten years of experience, conducted an investigation on corrupt brokerage practices at the end of the crisis. Posing as a prospective home buyer, she applied for ten mortgages at ten different brokerage firms. After completing applications, Carolyn shockingly discovered that within all of the “Good Faith Estimates” she received, half did not disclose YSPs at all and the other half did not disclose them properly (Barr, 2007).
With little regulation and seemingly zero enforcement of ethical brokerage standards, malpractice in the field of brokering rapidly occurred. Mortgage brokers acting as correspondent lenders closed deals with borrowers and “immediately [sold] the loan[s] to another lender at a pre-negotiated price” (Barr, 2007). This dishonorable practice enabled brokers to receive compensation for closing a deal, before quickly transferring loan risk to another entity. These entities likely packaged the mortgage loan and sold it to another investor, alleviating themselves of the loans’ risks as well. During the subprime lending boom, correspondent lenders did not have to disclose YSPs at all. The lack of The Cause of the Crisis 46
transparency within the field of correspondent lending created a sales driven business.
Correspondent lenders did everything in their power to hike up YSPs, with zero concern for their client potentially defaulting. There was no need for brokers to care, for even if they initially backed the loan themselves, they instantaneously sold the mortgages at pre- negotiated prices, where they likely entered an endless cycle of risk transferal.
Mortgage brokers were previously unable to serve low-income borrowers, as their backgrounds made them ineligible for the issuance of credit. However, government encouragement and a shift in bank exposure to subprime lending created opportunities for mortgage brokers to close more deals. The previous mortgage loan structure was unfeasible for low-income borrowers, so exotic structures were devised to help cut corners. Categories of such mortgage loans are referred to as “Liar Loans,” and facilitated the issuance of “low documentation or no documentation mortgages” during the crisis.
(Kagan, 2018).
“Liar Loans” hold similar acronyms to Wall Street products and downplay the riskiness of the loans themselves. NINA and NINJA loans reference mortgage loans that are issued to borrowers with either “No Income and No Assets” (NINA), or “No Income,
No Job, and No Assets (NINJA). While the term NINJA loan still sounds relatively strange, it presents less of a red flag than a “No Income, No Job, No Assets Loan.” The issuance of these “Liar Loans,” enabled brokers to tap into the most un-creditworthy borrowers in the country and offer them mortgages on expensive homes, despite their lack of assets, jobs, and income. The Cause of the Crisis 47
President Clinton’s recently requested brokerage tactics were now in full force.
“Liar Loan” structures allowed low-income borrowers to purchase homes and mortgage brokers to reap profits. Prospective home buyers with zero credit received sizeable loans without proving their incomes, jobs, or assets, a phase of the lending process that previously prevented them from homeownership. The likelihood of borrowers issued “Liar
Loans” to default was much higher than that of other structures. Such borrowers had no job, no income, no assets, and basically no credit whatsoever, yet they still could purchase expensive homes in America. Mortgage brokers were incentivized by fees from closing on deals in addition to compensation from lenders. Some brokers became so blinded by potential profits that they “overstate[d] income and/or assets” of their clients “in order to qualify [them] for larger mortgages” on bigger homes to increase profits (Kagan, 2018).
The larger the mortgage issued, the larger the mortgage broker’s return. The standard compensation structure and lack of regulation prompted deceitful behavior by numerous mortgage brokers, who sought to place low-income ineligible borrowers into massive single-family properties.
On the surface, low-income borrowers achieved homeownership and the
American dream. Furthermore, as a result of their new client pool, mortgage brokers raked in fees, and closed more deals. The risk of the subprime mortgage itself was securitized into subprime CDOs and transferred across Wall Street by banks. Each housing market player generated revenue as a result of increased subprime lending, fueled by aggressive and misleading broker tactics. Refinancing these toxic mortgages would prolong thousands of inevitable defaults, but the inevitable was still inevitable. As new forms of The Cause of the Crisis 48
unethical behavior expanded throughout the economic environment, so did the nation’s housing bubble.
Chapter Ten: The Investment Banker
“The mortgage market meltdown occurred for a number of reasons, but new and poorly
underwritten mortgage products were a significant contributor...”
–Jamie Dimon, Chairman JPMorgan Chase & Co. January 13, 2010
The vast majority of crisis blame has been cast upon the nation’s most prestigious
investment banks. According to the Financial Crisis Inquiry Commission Report,
“widespread failures in financial regulation and supervision proved devastating to the
stability of the nation’s financial markets” and global economy (2010). The FCIC’s
conclusion is derived from a full-bodied report on the crisis, and asserts that a lack of
corporate governance within banks was one of the largest contributing factors of the
crisis. It should come as no surprise that banks are one of the easiest crisis participants to
scapegoat. Executives at the helm of the world’s largest financial institutions made
several bad decisions. Poor judgement spread within corporations, creating a decadent,
overall climate that heavily contributed to the crisis. However, while there is adequate
blame to be placed upon the banks, they are not solely responsible. Individuals with
fingers pointed their direction often forget that the banks’ unethical actions occurred
alongside those of American consumers, mortgage brokers, insurers, and Congress.
Ironically many of the fingers pointed towards the banks can be found on the hands of the
previously listed housing market participants. The Cause of the Crisis 49
While bad decisions driven by profits occurred at a rapid pace throughout the entire country, the actions of investment banks appeared to generate the most revenue. Each immoral act was rewarded by large profits, in a banking environment incentivized by performance in numbers. The culture of banks blinded employees of their moral compasses and encouraged the use of misleading products and strategies equated to large returns. Employees who excelled in this field were showered with performance-based bonuses and promotions. The fastest way to generate large profits was through subprime mortgage products like CDOs and their derivatives contracts. Bankers were able to mask the risk of subprime CDO debt through diversification and inflated ratings. Swaps on
CDOs were exchanged in unregulated markets, further creating dishonest trading opportunities. Subprime lending as a total of mortgage origination drastically increased from five-percent to twenty-percent in the eleven-year period from 1994 to 2005
(Fratianni and Marchionne, 2009). While it is evident that Congress played a key role in the promotion of subprime lending, its agenda also cannot be deemed as the sole cause of the crisis. The Community Reinvestment Act was strengthened in 1989, with the
Financial Institutions Reform Recovery and Enforcement Act, which required banks to publicize their lending records (The Balance). Although the amendment called for transparency, the tactics of banks remained opaque until their demise years later.
The previously discussed legislation reveals that investment banks had been sufficiently nudged by Congress. Yet, only the banks themselves are responsible for casting aside fiduciary duties in exchange for large profits. As soon as Congress successfully influenced lending standards, profitable yet immoral opportunities appeared The Cause of the Crisis 50
for each market player. Low-to-moderate borrowers were immediately on board, as they were finally eligible to receive mortgage loans. While these new home buyers perceived their loans to be beneficial, in reality they were incredibly harmful. Insurance lenders and mortgage brokers saw the opportunity to prosper off their newly-approved, client pool.
AIG sold $62 billion dollars’ worth of home insurance over several years, with the notion that senior, diversified subprime products could not possibly default simultaneously
(Beales, 2018). Mortgage brokers continued placing low-income borrowers into luxurious homes, through the use of deceitful loans with hidden fees. Although brokers had misled their clients, they increased their own profits and moved on to the next prospective buyer.
This toxic lending system was joined by widespread unethical judgement and the investment banks served as its lynchpin. Banks utilized their massive influences and infrastructure to profit off each component of the system. While they generated cash flows in various ways, subprime products enabled banks to earn massive profits. Again, these profits were garnered through the trading of unregulated derivatives and the masking of risk within collateralized subprime debt instruments. Although most of these actions were incredibly immoral, most were not necessarily classified as illegal. These decisions contributed to the systems growth until it ultimately crippled the economy in
2008. This destructive subprime lending scheme had several accomplices, but the banks truly connected each market participant to each other via unregulated derivatives and debt products. Although the demise of this horrid lending system did not occur until 2008, The Cause of the Crisis 51
investment banks embarked on their journey to global economic destruction by subprime
CDOs years prior in 1998.
AIG Financial Products, quarterbacked by its’ Chief Financial Officer, Joseph
Cassano, was first offered a chance to insure securitized debt on a massive scale by J.P.
Morgan in 1997. In its first ever synthetic deal, J.P. Morgan coined their new product the
“Broad Index Secured Trust Offering,” also referred to as BISTRO (McLean and Nocera
79). Most members of AIG FP were hesitant to engage, but Cassano saw a prosperous opportunity. Cassano lacked a quantitative background, and had risen within AIG FP after working his way up from the bottom (McLean and Nocera 80). Unlike the mortgage based CDOs that contributed to the 2008 crisis, J.P Morgan’s BISTRO deal contained commercial loans paired with corporate and municipal bonds (Chen, 2019). Although
BISTRO’s debt was not subprime, the deal reveals a securitization process utilized by banks to fuel subprime lending while shrewdly disguising its risks. Credit Default Swaps offered on BISTRO served as its insurance and “covered [the] $9.7 billion worth of corporate credits, spread out among 307 companies” within the deal (McLean and Nocera
79). J.P Morgan cleverly diversified this pool of credits to infer that the product’s risk had been successfully mitigated. This diversification of debt led J.P to infer “only $700 million worth of notes would be required to ensure the entire $9.7 billion” debt product
(McLean and Nocera 79). The next phase of the deal was the creation of a “Special
Purpose Entity,” that J.P. would utilize to make insurance payments on the $700 million deal to investors (McLean and Nocera 79). The Cause of the Crisis 52
The BISTRO deal appeared lucrative for all parties involved. J.P. Morgan would generate management fees on the deal, and investors could purchase a product that was incredibly diversified and supposedly held little risk. The investors could assess various tranches within the synthetic product and invest based on risk appetite. The triple AAA tranche posed little risk as it sat at the top of the capital structure. Conversely, the single
C rated tranche was the first to take losses if defaults began to eat through the equity located at the bottom of the deal. Yields on investments within the synthetic product were based off tranches and their distinct risks. Investors who purchased debt within the single
C rated tranche, instead of the “riskless” triple AAAs, were rewarded with higher yields on their investment. On the contrary, the investors who bought debt within the triple
AAA rated tranches received smaller yields. Senior tranches were less risky because they were so high within the capital structure that the entire product would have to default prior to the AAAs incurring losses.
Regulators were tolerable of this new synthetic product, but expressed a conflict of interest to J.P. Morgan before they could launch BISTRO. This conflict pertained to J.P.
Morgan’s dangerous rate of leverage within the BISTRO deal. Capital requirements are enforced by regulators to ensure that banks do not take on excessive leverage within their operations. The rationality behind a capital requirement is to prevent integral banks from operating with disproportionate leverage, in case a deal catastrophically fails. If BISTRO did not pan out accordingly, J.P. Morgan’s rate of leverage was so large that the bank could potentially become insolvent. If this chain of events occurred, J.P. Morgan would be unable to pay off its debt and the bank would likely collapse. Regulators concerned The Cause of the Crisis 53
with the size of BISTRO asked J.P. Morgan about their plan of action if the diversified debt pools concurrently defaulted. A simultaneous default of the credit would wipe out the entire product from single C’s, all the way through the “riskless” triple AAAs.
Investors holding default swaps on the deal would profit, but J.P. Morgan would suffer a tremendous loss. Again, BISTRO was filled with commercial loans and corporate and municipal bonds. A simultaneous default would require the failure of several diversified debt obligations all at once. However, imagine if BISTRO was filled with residential mortgage loans instead of corporate, municipal, and commercial debt. A simultaneous default on America’s residential mortgage debt was considered inconceivable. Such a catastrophe would require endless immoral decision making across the entire housing market. These poor decisions would need to occur within a system that lacked correlated legal penalties. Refocusing the shift back to BISTRO’s capital requirements, J.P. Morgan itself would be liable if a $700-million default occurred. Regulators reached the conclusion that “banks [with] super-seniors got no capital relief”, unless they were able to find an insurer (McLean and Nocera 80). These “super-seniors” refer to the triple AAA tranches within synthetic CDOs. Regulators wanted J.P. Morgan to insure these debt tranches in order to deleverage BISTRO’s inconceivable, yet massive default risk.
J.P. Morgan began searching for an entity to insure their product’s $700-million default possibility. The perfect insurer was none other than AIG Financial Products. AIG
FP was a division of AIG that utilized insurance derivatives to generate revenue. It is crucial to note that “because [AIG FP] was a derivatives dealer operating inside an insurance company” it had zero capital requirements and could take on massive risk The Cause of the Crisis 54
(McLean and Nocera 80). The BISTRO deal illustrated the emergence of a profitable friendship between investment bank titans and an insurance behemoth. AIG FP generated revenue by insuring J. P. Morgan’s super-senior triple AAA debt tranches. These particular tranches had been marketed by the banks as virtually “un-default-able.” In terms of BISTRO, the deal was well diversified and did not contain mortgage loans from risky, low-income consumers. Although the debt within BISTRO was less risky than subprime mortgage loans, AIG FP was still on the hook if BISTRO somehow defaulted through its triple AAA debt. J.P. Morgan had successfully mitigated risk to please regulators, and could continue creating more synthetic deals. Due to the size of these synthetic deals, J.P. Morgan’s revenue from management fees was massive. This appeared as a win-win for all involved parties, especially AIG, who believed they had partaken in a riskless yet profitable transaction. Joseph Cassano was a large proponent of these deals, and even boasted that it was a “watershed event in 1998 when J.P. Morgan came to [him]” with BISTRO. The success of this deal led to other banks’ participation with AIG FP, and other insurers who began backing synthetic CDOs. Executives at AIG and Countrywide were raking in fees from banks by insuring their newly issued securitized debt. However, as subprime lending grew astronomically, the components of debt within BISTRO-like deals shifted from corporate and municipal debt to subprime residential mortgage debt. America’s most systemic banks were packaging subprime loans into synthetic products, buying insurance, and marketing the deals to investors as riskless investments. AIG FP’s failure to conduct due diligence on synthetic mortgage- based deals led to its catastrophic failure years later. The Cause of the Crisis 55
The focus of this particular section is to determine how the banks themselves contributed to the crisis. Deceitful actions were driven by the pursuit of money, in an era when the rich could get richer, and could do so quickly by casting aside moral obligations. The actions of executives at AIG have already been addressed; however, it is important to revisit their involvement in the CDO market, and their lack of responsibility in truly understanding the risks of products they insured. Had insurers not focused primarily on generating quick returns, they would realize that backing subprime debt products could be detrimentally costly in the long run.
Although J.P. Morgan was the first to develop a synthetic CDO and solve the capital requirement dilemma, once their deal was brought to market, many banks replicated it. Again, as subprime mortgage lending grew, Morgan Stanley, Lehman
Brothers, Goldman Sachs and others saw an opportunity to create synthetic products filled with America’s abundant subprime mortgage debt. J. P Morgan’s BISTRO deal was merely the blueprint for a series of highly-profitable, subprime debt products later created by banks. Profits from subprime CDOs were so large, that the rapid, short-term gains blinded banks to the deals’ hazardous, long-term effects. As soon as the banks created these subprime-mortgage based CDOs, the housing-bubble received its first breath of air. During the ten-year period following BISTRO’s creation in 1997, banks concocted synthetic subprime CDOs, purchased super-senior insurance, earned substantial management fees, and repeated. Throughout the decade following the creation of BISTRO, only one object expanded faster than the subprime CDO market—The largest housing bubble in history. The Cause of the Crisis 56
The returns from subprime CDOs were so large that banks were further inclined to continue masking the products’ risks for the generation of profits. Further, many
American consumers began speculating on the housing market and purchased multiple homes as long term investments in a fictitiously booming industry. The speculation of these consumers contributed to the supply of mortgage loans that could be bundled up into new issue subprime CDOs. Banks continued this process for several years without much concern until a small percentage of investors began questioning the sustainability of America’s growing housing market. For several years, investment banks and institutional investors operated with a notion that the entire housing market could not combust simultaneously. However, because the majority of investors were long U.S. housing despite its unsustainable growth, skeptical investors began shorting the housing market through Credit Default Swaps. In the event of a universal housing default, these investors would reap large profits from their swaps on CDOs filled with subprime debt.
After further analyzing the products they had been creating for years, banks began to consider hedging the risks of their own CDOs. By engaging in this process, the banks started placing bets against the very same products they had created and sold to clients.
As housing prices started to decline in 2007, investment banks realized that their first few rounds of “riskless” CDOs offerings were built up entirely of high-risk mortgage loans. Likewise, the banks’ subsequent rounds of CDOs most likely were built up of more subprime garbage, paired with the first round of borrowers’ speculative home loans on their second and third houses. Low-income borrowers heavily gambled the market, purchasing several homes as investments. Consumers believed home prices would The Cause of the Crisis 57
continue rising and viewed additional homes as future cash flow generators. Mortgage brokers had issued misleading loans, and low-income consumers did not diligently review loan terms. It was only a matter of time before the effects of this toxic lending system began affecting the economy. Banks devised strategies to reduce their inevitable future losses and reposition them upon their own clients.
In February of 2007, Goldman Sachs originated a mortgage product titled ABACUS
2007-AC1 (Baer, 2013). Goldman claimed the product was an ordinary subprime CDO, but this was incredibly false. Abacus had been specifically designed to enable Goldman and one of its clients to increase short positions on the housing market before it collapsed.
The product itself was created by Goldman Sachs trader, Fabrice Tourre, who was referred to by his colleagues and himself as the “Fabulous Fab” (Baer, 2013). On the brink of a housing collapse, the “Fabulous Fab” created a “complex deal made up [of] credit default swaps that [would] [pay] out if mortgage bonds” defaulted (Baer, 2013).
Abacus contained twenty-five different mortgage-based deals that Tourre and his team marketed to clients as attractive investments that had been verified by ACA Management.
According to the SEC complaint, Goldman’s “marketing materials for ABACUS 2007-
AC1, all represented that the reference portfolio of RMBS underlying the CDO was selected by ACA Management, a third-party with experience in analyzing credit risk in
RMBS” (2010). The complaint refers to Goldman’s marketing of ABACUS as a product that contained RMBSs handpicked by ACA. In reality, the mortgages within ABACUS had been handpicked by a wealthy investor named John Paulson. Paulson had chosen the worst mortgages possible and placed them within the portfolio, with anticipation of The Cause of the Crisis 58
default. After Goldman obtained ACA’s stamp of approval, Paulson purchased Credit
Default Swaps on pooled mortgages within his handcrafted, junk CDO. Assuming
Paulson had selected the worst residential mortgage loans in the country, his fund and
Goldman Sachs would earn large profits when these mortgages inevitably defaulted.
An incentive driving Fabrice Tourre to advise a client to invest in a product that another client had carefully created to implode had to be incredibly compelling. Paulson determined Tourre’s encouragement would need to be about $1.7 million dollars. He sent over this motivation in the form of a $15-million-dollar origination fee to Goldman Sachs on behalf of the bank and Tourre structuring his predictably fallible deal. Tourre would receive a sizeable portion of the fee for his services. According to the New York Times,
Tourre sold $10.9 billion worth of ABACUS deals to investors in Europe and stated via email that he even “manage[ed] to sell a few ABACUS bonds to widows and orphans” he came across at an airport. Paulson and Goldman would not generate meaningful profits from Swaps until “99 percent of the portfolio of mortgages [were] downgraded” in 2008
(Morgenson and Story, 2009). Investors deceived by the “Fabulous Fab” inherited combined losses of more than a billion dollars, most of which landed in Paulson’s pockets (Morgenson and Story, 2009). Seven years after misleading his clients, Fabrice
Tourre was fined $825,000 and found liable for six of the seven fraudulent claims brought upon him by the SEC (BBC, 2014). While the fate of the “Fabulous Fab” was not decided until 2014, Goldman Sachs quickly severed ties with Tourre and ABACUS. New
York Times reports that on July 15, 2010, Goldman Sachs agreed to a $550-million- dollar settlement, while adamantly stating they did no wrong. The Cause of the Crisis 59
Unfortunately, this was not a rare event from one bad apple at Goldman known as the
“Fabulous Fab.” The same short-selling tactics were used by Deutsche Bank, Morgan
Stanley, and UBS (Morgenson and Story, 2009). As the housing market plateaued, investment banks realized they had little time to hedge out years of risks they had taken by longing subprime CDOs. They quickly pooled the worst mortgage backed securities possible into CDOs, and knowingly marketed them as risk free to any investors they could find. Banks then purchased insurance on CDOs through Credit Default Swaps, placing bets that their very own products would fail.
The New York Times reports that some of the residential mortgage loans securitized by Goldman Sachs were so toxic, that they defaulted within a matter of months (2009).
One might claim with a devil’s advocate argument that the buyers of these products should have looked further into their contents and risks. This is true. Many CDO holders claimed to have been taken advantage of, but these were supposedly “sophisticated” investors, and wise investors would never purchase such toxic assets. However, there is still little defense to be offered up for banks who knowingly mislead their clients so they could bet on their own products’ failure. Structured finance expert and consultant,
Sylvain Raynes called this “simultaneous selling of securities to customers and shorting
[of] them … [to] [be] the most cynical use of credit information” ever (Morgenson and
Story, 2009). Raynes further linked the process to buying fire insurance on someone’s home and proceeding to cash out on that insurance by committing arson (Morgenson and
Story, 2009). Many of these CDOs were devised specifically for buy-side clients like
Paulson, who wanted more skin in the game. This process ultimately worsened the fiscal The Cause of the Crisis 60
decay of the crisis, offering more investors a chance to cash out through bets against subprime loans. Hefty origination fees written off to banks by investors were trivial as long as these investors increased their exposure on a bet they knew was a winner. This bet, was the simultaneous collapse of the entire American housing market.
In the last two years of the subprime lending boom, Dealogic reports that $108 billion of garbage CDO deals were issued, and the actual volume was likely higher because swaps were unregulated (2010). Goldman Sachs claims they changed their outlook on subprime mortgage lending from positive to negative in 2006, yet they did not voice any of these opinions publicly (Chan and Story, 2010). ABACUS was also not Goldman’s only default-destined product. Despite the bank’s shifting belief on the housing market, they sold another $800 million CDOs in October of 2006 called Hudson Mezzanine
(Morgenson and Story, 2009). The success of ABACUS perhaps led to the creation of one final product that Goldman could squeeze profits out of before housing market failure. In his novel, How I Caused the Credit Crunch, Goldman’s very own ABACUS and Hudson CDO salesman Tetsuya Shikawa says that Goldman “had moved on to hurting others in [their] [own] quest[s] for self-preservation.” Quests for self-preservation spread across Wall Street as investment banks devised more ways to secure profits on the brink of a nationwide economic failure.
Rather than collaborate to acknowledge the looming market erosion and reduce it, banks sought to quickly prosper from forthcoming destruction before it was too late.
Traders from various banks met at Deutsche Bank in 2005 to create a “Pay as You Go” system, in order to speed up the timeline for the short-seller’s recoupments of default The Cause of the Crisis 61
profits (Morgenson and Story, 2009). This new system was adopted by the International
Swaps and Derivatives Association, and incorporated many changes, including
“payments to short sellers under less onerous outcomes, or “triggers”, like a ratings downgrade on” a particular mortgage bond (Morgenson and Story, 2009). If a mortgage outlook was lowered by a ratings agency, the holder of the credit default swap now earned a profit. These triggers were not utilized in previous deals, and were created by the banks for the sole purpose of increasing short sellers’ payouts as defaults occurred.
Morgan Stanley joined the corruption party, devising complex deals with new features to benefit short sellers as well. Morgan Stanley created Buchanan and Jackson
CDOs, named after American presidents, and offered short-sellers the opportunity to
“lock in cheap bets against mortgages beyond the life of the mortgage bond” itself. The rationality behind this debauched strategy was that bets against the housing market would continue to become more expensive as investors caught on. By locking in cheap bets that would last throughout the bond’s existence, Morgan Stanley could increase their own profits and lure in other investors. A lack of regulation led to a corruption frenzy, filled with strategies that were all designed to take advantage of the toxic system and its looming failure.
Deutsche Bank trader Gregg Lippmann pitched the idea to short the housing market while handing out “T-Shirts that read I’m Short Your House” at meetings with various investors (Morgenson and Story, 2009). In 2013, UBS agreed to pay a $50 million settlement, after federally being accused of “misleading investors about complex mortgage securities” prior to housing market collapse (Protess, 2013). The details of the The Cause of the Crisis 62
case revealed that ACA Management “provided [UBS] with $23 million in upfront cash” on a deal that was then pocketed by UBS before sweeping the money into the bank’s mortgage based CDO (Protess, 2013). SEC director of enforcement George S. Canellos argued that “UBS kept the $23.6 million, that under the terms of the deal, should have gone to the CDO for the benefit of its investors” (SEC Complaint No. 21489, 2010).
Despite the incredibly immoral actions of Goldman Sachs, Morgan Stanley and Deutsche
Bank, UBS emerged as winner of the “most unethical bank award.” UBS has still refrained from admitting wrong doing, and in 2013 agreed to an $885-million settlement, after federal regulators accused the bank of selling toxic mortgages to Fannie Mae and
Freddie Mac throughout the crisis (Benson and Logutenkova, 2013).
Banks most certainly realized prior to September of 2008 that the American housing market would collapse. Additionally, they knew the market would simultaneously combust because they had sold excessive amounts of subprime CDOs throughout the previous decade. Investment banks were faced with two options after noticing the imminent crisis the rest of the country could not yet see.
The first option was to unify as one industry, and attempt to devise strategies that could possibly prevent the economic destruction on the horizon. The second option was to continue contributing to this destruction by pushing a few more toxic subprime CDOs to market, changing payout structures for short-sellers, and making the most money possible off the failing housing market before it collapsed. It is reasonable to infer it might have been far too late to save the U.S. housing market. Even if the banks joined together in a unified attempt to resolve the conflict, the nation’s economic fate could have The Cause of the Crisis 63
already been sealed. Conversely, it is clear that by pumping out more subprime CDOs, changing short-seller payment structure, and shorting the CDOs themselves, investment banks significantly worsened the magnitude of the forthcoming, economic destruction.
Conclusion: A Lack of Ethics
“During the lending boom, the industry developed products that were extremely risky, that were pushed by everybody, up and down the food chain…. We forgot about our customers, and making money and our commission checks were more important."
–John Robbins, “Wachovia Alum Tips Industry Rebound,” American Banker
Conference September 15, 2008
Dishonest behavior and poor judgment are undervalued contributing forces, strongly correlated to the fraudulent environment that caused The Subprime Mortgage Crisis. The absence of regulatory standards, along with Congressional myopia and the American dream, created the perfect storm for an ethical disaster. As this omnipresent poor judgment plateaued in 2008, it was far too late to save the housing market, and it was time to reevaluate the American financial system. In assessing why numerous unethical decisions were made, it is challenging to fathom how sophisticated individuals could display such fraudulent behavior. Behavioral economic theories shed light on the drivers of bad decisions and reveal why it is not only possible, but likely for poor judgment to resurface. The Cause of the Crisis 64
The “Self-Serving Bias” references a “tendency for people to seek out information and use it in ways that advance their own self-interests” (Ethics Unwrapped). This behavioral economic theory reveals why individuals “unconsciously make decisions that serve themselves in ways that other people might view as unethical” (Ethics Unwrapped).
Throughout the entirety of the subprime lending era, housing market participants were affected by this self-serving bias. Mortgage brokers, bankers, insurers, and low-income borrowers all sought to better serve themselves through unethical decisions that generated personal wealth.
A lack of fiduciary duty across insurers, mortgage brokers, and investment banks exposes an additional driver of bad decision making during the crisis. The term fiduciary represents trust, and a fiduciary duty is the “legal responsibility to act solely in the best interest of another party” (Ethics Unwrapped). It is evident that various players within the housing market arena abandoned fiduciary duties in order to increase personal gains and corporate profits. Countless mortgage brokers deserted their legal responsibilities by offering minority borrowers misleading mortgage loans on unaffordable homes.
Insurance companies that invested in super-senior CDOs without truly understanding the risks also did not act in the best interest of their clients. The actions of Goldman’s
ABACUS trader, “The Fabulous Fab,” serve as the best representation of client trust abandonment. Fabrice Tourre and several other bankers gained the trust of clients, only to later advise them on purchasing products they knew were destined for failure.
Congress displayed actions that were not necessarily as dishonest or unethical as other housing market players. However, the aggressive promotion of low-income The Cause of the Crisis 65
homeownership in America embodied the U.S. government’s “Moral Myopia.” Minette
Drumright and Patrick Murphy describe moral myopia as the “inability to see ethical issues clearly” (Ethics Unwrapped). An increase in low-to-moderate income homeownership is a sound idea on its face, but carelessly authorizing thousands of unqualified borrowers to borrow on a massive scale, reveals the government’s distorted vision. As the U.S homeownership rate increased dramatically, Congress believed it had achieved success in its housing initiative. This success was entirely artificial, and was propped up by adjustable-rate-mortgages and a massive housing bubble.
Leon Festinger’s theory of cognitive dissonance “suggests that individuals have an inner drive to hold attitudes and behavior in harmony” in order to avoid disharmony
(Simply Psychology). This behavioral economic theory directly applies to Bush’s Chief
Economic Advisor, Lawrence Lindsay, who noted that “no one wanted to stop [the] bubble [because] it would have conflicted with the president’s own policies” (Becker et al. 2018). Congress was overly optimistic about policy outcomes, believing minority borrowers would be able to pay off costly mortgage loans. The U.S. Government became infatuated with achieving this goal, and exhibited poor judgment by attempting to accomplish it without proper risk controls. Although Lawrence Lindsay and many others refrained from disrupting harmony, had they voiced opinions of concern, moral myopia could have been potentially reduced.
Ethical fading is perhaps the best behavioral economic theory for highlighting
America’s ethical lapse prior to The Subprime Mortgage Crisis of 2008. Ethical fading occurs when individuals “tend to see what they are looking for, and if they are not The Cause of the Crisis 66
looking for an ethical issue, they may miss it all together” (Ethics Unwrapped).
Psychologist Anne Tenbrunsel explains that “innate psychological tendencies often cause
[individuals] to engage in self-deception” which ultimately blocks out the ethical factors of a particular action or decision (Ethics Unwrapped). Additionally, the concept of moral disengagement also exposes the overall nature of decision making in America prior to the housing market crash. Moral disengagement occurs when “people restructure reality in order to make their own actions seem less harmful than they actually are,” reducing feelings of guilt that arise from poor choices (Ethics Unwrapped). Ethical fading and moral disengagement reveal American’s detrimentally false perception of their own economic reality in the early 2000s.
Individuals who have blamed singular components or players within the crisis as solely responsible have missed the bigger picture. Likewise, those still trying to isolate whom they should blame have also not pieced together the entire puzzle. Carelessly imposed legislation, recklessly crafted debt products, and misleading mortgage loans all presented opportunities for individuals to prosper from bad decisions. Self-deception blinded housing market participants and Congress for years and ultimately birthed a fraudulent financial climate replete with regulatory failures. Each participant’s unique involvement within the system, and respective relationships with others, further promoted a growing unethical economic climate. The amalgamation of these poor decisions and their influence within the housing market only further encouraged the ethical transgressions that resulted in the 2008 Subprime Mortgage Crisis.
The Cause of the Crisis 67
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The Cause of the Crisis 76
Vita
JARED M. LADDEN [email protected] 2414 San Gabriel Street Unit #310 • Austin TX, 78705 • (770)-500-9739 EDUCATION The University of Texas at Austin Liberal Arts Honors Program, Humanities May 2019 Business Ethics & The Law: Curriculum and Thesis Created within Humanities Minor: Business Administration, McCombs School of Business Overall GPA: 3.5/4.00; ACT 33 IES Abroad Liberal Arts and Business - Barcelona, Spain Spring 2018
EXPERIENCE Millennium Management – Summer Analyst; New York, NY June 2018 - Aug 2018 SEC Registered Multi-Strategy, Global Investment Management firm with $35.2 Billion in assets across Global Capital Structures; Offices in New York, London, Singapore, Hong Kong, Tokyo, Greenwich and Geneva. • Worked with Business Development team to conduct portfolio analysis and allocate capital to managers across various industry sectors • Supported Business Development team in analyzing investment strategies and performance across multiple asset classes • Assisted traders to interpret market conditions and understand idiosyncratic execution strategies and algorithms utilized by the firm • Participated in Credit Suisse strategy workshop to discuss foreign exchange derivatives, exotic option structures, and Global risk appetite • Produced evaluations on competing funds within Hedge Fund landscape across commodities, Credit, Macro, and Quantitative strategy sectors Whitebox Advisors – Analyst; Austin, TX May 2016 - Present SEC Registered Investment Advisor to hedge funds and institutional accounts that seeks attractively priced assets across Global Capital Structures; Offices in New York, Austin, Minneapolis, London and Sydney. • Assisted Senior Portfolio Managers in analysis of firms’ investment opportunities across all industry sectors and capital structures • Produced monthly return profiles of institutional clients for investor relations team • Created trade ideas and analysis within Structured Credit, Non-Agency Mortgage, CMBS Series 1-9 • Participated in special 3-month research project within Cash and Synthetic CMBS regarding U.S. retail exposures • Developed top 10 monthly profit and loss trade descriptions for investors relations team and founding partners Hull.io - Sales Development; Atlanta, GA Summer 2015 • Crafted large lists of target clients across multiple industries to pursue and sell data analytics software • Secured contracts with clients including AriZona Tea, Jackson Family Wines, Shopify, Airbnb NYC and Universal Pictures • Attended regular Sessions with the other start Up CEOs at Atlanta Tech Village Incubator to discuss the value of entrepreneurship Camp Sea Gull – Junior Counselor; Arapahoe, NC Summer 2014 • Responsible for the care, safety and character development of boys, ages 10-11 • Worked alongside Senior Counselor to lead, model, and educate campers in aquatics, athletics and a boating program • Instructed campers on both motor boating and sailing technique, boating nomenclature, and water skiing activities ACADEMIC PROJECTS Honors Humanities Program - Selected Candidate Spring 2017 - Present • Admission by special application only to design individualized, interdisciplinary course of study built around intellectual curiosities • Contract entitled “Ethics and Leadership of Business and Law” – Thesis embodying contract ideas to be completed Spring 2019
LEADERSHIP EXPERIENCE AND ACTIVITIES Texas Equity Group – Portfolio Manager Fall 2016 - Present • Formulated Portfolio weekly profits and losses and distributed results to other members of the Investment Club • Selected to join club after completing rigorous interview process involving an in depth stock pitch to incumbent club members • Actively managing over $10,000 invested across multiple industry sectors, successfully generated returns of 33%+ in 2017 YTD
Zeta Beta Tau – Social Chair / Rush Captain Spring 2016 - Fall 2017 • One of four elected fraternity members in charge of managing a social budget of over $100,000 and planning chapter wide events • Recruited and met with new member actives to ensure the future and strength of the Fraternity (largest ZBT chapter in the Country)
PANCAN Purple Stride – Fundraiser and Volunteer Fall 2013 - Present • Participated in annual walk to support Pancreatic Cancer Action Network, an organization benefiting Pancreatic Cancer research • Founding member of Team Poppy, in honor of my grandfather, which has raised $50K since 2013 in support of Pancreatic Cancer fighters
HONORS • Cum Laude Spring 2015 & Fall 2018 • Liberal Arts Honors Scholar – University selected Honors Program comprised of top 120 Liberal Arts students per grade Fall 2015 - Present
ADDITIONAL INFORMATION Computer Skills: MS Word, Excel, PowerPoint, Bloomberg Analytics Certifications: Bloomberg Market Concepts Languages: Proficient in Spanish Interests: Fitness, Cycling, Travel, Atlanta and Chicago Sports, Lacrosse (U.S. Southeast Champion)