The twisted path that led to the 2008 financial crisis began in the late 1970s, with the creation of a new financial product called the “mortgage-backed security.” Here, much simplified, is how it works: You find a house to buy, so you borrow money from Hometown Bank and promise to pay it back with interest. That’s a mortgage. Hometown Bank sells your mortgage to Wall Street Firm, which puts it into a pool with other mortgages, calls it a security, and divides it into three pieces based on high, low, and moderate risk. That’s “securitization.” Investors buy the pieces based on how much risk they want to assume. More risk equals higher potential profits.
That produces some positive results. First, by selling your mortgage, Hometown Bank has more money to make more loans. That’s good for Hometown Bank and other home buyers. Second, Wall Street Firm uses some of the cash from investors to buy additional mortgages from Hometown Bank and other lenders, which make even more loans. Third, investors get a return on their investment as you and other homeowners make your monthly mortgage payments. That encourages them to buy additional mortgage-backed securities.
It’s a money-generating, homeownership-supporting system—a virtuous cycle. There’s only one potential catch: What if the original borrowers can’t pay back their loans? The 2008 financial crisis was the answer to that question.
All the Devils Are Here: The Hidden History of the Financial Crisis, by Bethany McLean and Joe Nocera (Portfolio/Penguin, 2010), explains how the virtuous cycle spun out of control and turned into a maelstrom of financial horror. The tale they tell has all the elements of a classical tragedy, in which events move, seemingly inexorably, toward a catastrophe in the final act. Yet the authors make clear that, at various points along the way, the fatal trajectory of doom could have been interrupted. But greed, megalomania, lack of foresight, and lack of oversight repeatedly trumped caution and common sense. The “invisible hand” of the free market, which is supposed to save us from such calamities, failed.
Subprime Insanity
The reason so many borrowers couldn’t repay their loans is simple: too many bad loans were made. As All the Devils points out, when Hometown Bank and other lenders sold off mortgages, they severed the link between themselves and their local customers. As a result, they had less incentive to make sure loans were good, because they could unload risky loans onto other entities.
The authors detail some of the unsavory lending practices that created the conditions for default: not explaining to borrowers that a “teaser rate” was temporary and their interest rate would rise; charging “the highest fees” they “could get away with”; and not revealing the amount of the principal, lest customers see the gigantic fees they were being charged. Some lenders steered borrowers who qualified for prime loans into more-expensive subprime mortgages.
Risky mortgage products included low-down-payment loans, no-down-payment loans, adjustable-rate mortgages, and interest-only mortgages. The 2/28 mortgage offered a low rate for two years, followed by an adjustable rate for the next 28. We learn that by 2006, non-traditional subprime mortgages accounted for nearly half of all mortgage originations.
We hear from a mortgage industry veteran who describes a case of fraudulent documentation of a borrower’s creditworthiness. The borrower’s income is stated as $15,000 a month; in reality, she earns $1,500 a month. “The loan officer decided to see if he could get away with it,” the industry veteran tells the authors. “You see loans like that, and it tells you two things: the loans are going to go bad, and any system that makes these loans is broken.”
Fueling the rise of such loans was the success of the mortgage-backed securities business. The Wall Street firms that sold them needed a steady and growing stream of loans to securitize and sell, especially after the creation of another exotic financial product—the collateralized debt obligation (CDO) made up of securitized mortgages. McLean and Nocera write, “CDOs were fraught with risks and conflicts. Debt was being used to buy debt. CDO managers were paid a percentage of the money in the CDO, meaning they had an incentive to find stuff to buy—good, bad, or indifferent.”
Rating Agencies Fail
The CDO business was complex. Investors in CDOs (and other bonds) counted on the three rating agencies (Fitch Ratings, Moody’s, and Standard & Poor’s) to analyze bonds and rate them according to the likelihood of their being paid back—triple-A, double-A, triple-B, etc. The rating agencies failed. In a chapter titled “Why Everyone Loved Moody’s,” McLean and Nocera list in general terms what went wrong with the agencies: “an erosion of standards, a willful suspension of skepticism, a hunger for big fees and market share, and an inability to stand up to Wall Street.” The agencies, say the authors, “turned their backs on their own integrity.”
CDOs were magic. Wall Street repackaged lower-rated mortgage-backed bonds, like triple-Bs, into CDOS that the agencies rated triple-A. It was like melting 100 pieces of silver into a single ingot, painting it yellow, and calling it gold. “It really was alchemy,” the authors write, “though of a deeply perverse sort.”
CDO sales rose to approximately $500 billion in 2006. “It was an endless cycle of madness,” write McLean and Nocera. “The rating agencies were at the very heart of the madness. The entire edifice would have collapsed without their participation.”
The book covers much more ground and identifies numerous other “devils” who contributed to the crisis. These include legislators who, in the name of increasing homeownership, wrote laws that had negative unintended consequences; regulators who failed to regulate; Federal Reserve Chairman Alan Greenspan, who ignored subprime lending problems that the Feds could have addressed; and Fannie Mae and Freddie Mac. That’s a partial list.
Meanwhile, liberals who want to blame the Bush Administration for the crisis will take no comfort from the book. Nor will conservatives who claim Fannie and Freddie are solely to blame. But anyone interested in actual facts have much to gain by reading McLean and Nocera’s fascinating account. The authors pull together the various elements that, over a period of 30 years, combined in unexpected ways to trigger the worst financial crisis since the Great Depression. The writing is clear and comprehensible, and you don’t have to be an accountant or an economist to understand it.
Richard Dalglish - Richard Dalglish
