So what caused the 2008 financial crisis? We know that
the direct cause was the meltdown in the US housing market. I think we are
still trying to put together the pieces and point the finger of blame. It was a
big bubble and there was an explosive reaction when the bubble burst. It took
many different forces to get the bubble so big.
Endangerment, Gretchen Morgenson and Joshua
Rosner take their turn looking at the outsized ambition, greed, and corruption
that lead up to the crisis. They point the finger of blame directly at Fannie
Mae and its executives.
The authors portray a company that ruthlessly leveraged
the implicit government guarantee to create billions of dollars of shareholder
wealth and millions of dollars in executive compensation. They beat the
drumbeat of housing as the American Dream. Everyone should get a chance to own
their own home. Fannie Mae used their version of the American Dream to bully
Congress and their regulators to let them have a very thin capital reserve and
to keep their finances very opaque. The authors pin the blame squarely on James
Johnson, the CEO of Fannie Mae during the 1990s and his successor, Franklin
The rating agencies also get some blame by the authors. I
think the rating agencies have not received enough of the blame. Their shoddy
rating of debt instruments let them get AAA ratings that they did not deserve.
Only a handful of companies and a handful of countries get the top rating. But
when it came to real estate backed securities, the rating agencies were handing
them out like cotton candy at the state fair.
Institutional investors were looking for safe places for
their money that could still earn a coupon. US treasury bonds were paying a
very low interest rate. Pension funds and insurance companies determine their
funding levels based on a projected rate or return. Many were limited to only
invest in the highest quality asset either by regulation or internal policies.
That meant they would only buy the top rated bonds.
Banks have to maintain their capital levels based on the
quality of the loans/bonds/assets they held. With top-rated bonds, the banks
had to retain very little capital. By holding AAA ratted bonds, the banks could
retain less capital and put more to work.
The rating agencies were telling them that these
mortgage-backed securities were top rated. (They were wrong.)
The vast majority of the book is spent sticking pins in
Fannie Mae, their lobbying efforts, and their executives. I agree that Fannie
Mae abused its position. I agree that Fannie Mae helped create an attitude that
everyone should be a homeowner and everyone should be able to afford to buy a
home. But their story comes to crashing halt in 2004 when Fannie Mae gets
caught in large scale accounting fraud. Most of the manipulation can be tied
directly to triggers for executive compensation.
In 2005 the first signs of bad mortgages were popping up
and the buyers for the lower rated pieces of mortgage debt were not buying
them. Without those buyers, the mortgage securitization would fail. Fannie Mae
was leading the charge up until that point. But it didn't stop there. That's
why I have a problem pointing the finger at Fannie Mae. The mortgage/housing
boom kept going.
The authors pull some of the dubious lenders into the
book. Countrywide, Novastar, and Fremont all get ripped apart.
It's not until the last chapter that they hit upon the
issue that hyper-inflated the real estate bubble. The buyers for the lowest
rated pieces of mortgage-backed securities were not buying as much. In part,
this was because the increased quantity of junk they saw ending up in the
pools. In part, it may be because they saw the bubble. Then the magic happened.
Wall Street firms packaged the lower rated pieces into
new pools and sold those securities. These were the toxic assets. Somehow they
convinced the rating agencies that some tranches of this pile of junk could
still get the top ratings. Those high rated tranches were sold off to the
institutional investors and the real nasty stuff was sold off to more
speculative investors. This kept the mortgage securitization pipeline going for
two more years.
Why keep going when you could see the bubble? It was
their job. There were thousands of jobs tied to originating the mortgages, the
warehouse lines that funded them, the organization of the pools and the selling
of the final securities. It was not their job to assess the bubble and just
stop working. There was no brakeman in the system. The regulators do not have
the oversight, the power, or the willingness to stop an asset bubble. (Let's
see what happens with the price of gold.)
The brakes were slammed on when the Wall Street firms
realized they were holding on to the lowest rated tranches of the
securitizations and they couldn't get rid of them. They stopped the production.
They stopped it fast. In early 2007 warehouse lines were cut off and
underwriting standards were suddenly raised to higher (more sensible?) levels.
With the pipeline cutoff, the hyper-inflated housing
bubble reached the bursting point. Then mortgage-backed securities investors
stopped getting their checks. They realized that their coupon-paying beauty
queen was just a pig with lipstick.
I think All
the Devils Are Here did a better job of putting all the pieces together
Big Short did a better job explaining the mechanisms of the
mortgage-backed securities industry. If you don't like Fannie Mae or want to
read a story of how corporate greed exploited American politics then Reckless
Endangerment should be on your reading list.
additional commentary on developments in compliance and ethics, visit Compliance Building,
a blog hosted by Doug Cornelius.
For more information about LexisNexis
products and solutions connect with us through our corporate site.