The End of Wall Street

Roger Lowenstein, “The End of Wall Street”, The Penguin Press, 2010, 301 Pages


In September of 2008 Lehman's failure was the largest in American history and yet another financial firm, the insurer American International Group, was but hours away from an even bigger collapse. Fannie Mae and Freddie Mac, the two bulwarks of the mortgage industry, had just been seized by the federal government. Dozens of banks big and small were bordering on insolvency. The market system itself had come undone. Banks couldn't borrow; investors wouldn't lend; companies could not refinance and the stock market crashed (its worst fall since the 1930s). Home foreclosures broke every record; two of America's three automobile manufacturers filed for bankruptcy, and banks themselves failed by the score. Confidence in America's market system was shattered. Lowenstein covers all this and more in this book.

The crisis prompted government to socialize lending and mortgage risk, and even the ownership of banks. The massive fiscal remedies evidenced the failure of an ideology and, the author mistakenly asserts, the eclipse of Wall Street's golden age. The book was released in 2010 but evidently before it was evident that ‘Too-Big-To-Fail’ would only get ‘Bigger’.

The origins of the mortgage fiasco took root in the aftermath of the 1970s, when banking and markets were liberalized. Prior to then, finance was a static business that played merely a supporting role in the U.S. economy. Finance became a growth industry, fixated on new and complex securities. Wall Street developed a heretofore unimagined prowess for securitizing assets: student loans, consumer debts, and, above all, mortgages. People discovered an unsuspected source of liquidity — the ability to borrow on their homes.

By the time Lehman filed for bankruptcy, the U.S. housing market, the singular driver of the U.S. economy, had collapsed. Home prices had been falling for nine consecutive quarters, and the rate of mortgage delinquencies over the preceding three years had tripled. In August, the month before Lehman failed, 303,000 homes were foreclosed on (up from 75,000 three years before). The failure of Lehman was not the cause of the collapse, it was only a visible wart.
My Notes:

Pg. 8: Fannie Mae was created in 1938 to provide citizens with mortgage financing and stem the tide of foreclosures that the depression had brought on. Nevertheless for many years no mortgages were approved if the monthly payment was more than 28 percent of the applicant’s income. Fannie thus exerted a constructive influence on Savings and Loans as they were very wary of writing loans that did not conform to Fannie’s guidelines and would thus be less marketable.

In 1968, President Johnson-doggedly trying to balance the budget—moved to get Fannie off the government’s books. Promptly, the company sold shares to the public, which allowed the government to take Fannie off budget. Fannie stayed, at this time, to its conservative agenda and, of course, it was assumed that, if needed, the government would come to its aid. In the 1980s, volatile swings in interest rates devastated the savings and loan industry, as thrifts were burdened with low-interest mortgages on which the yields were less than the cost of their funds. Fannie came close to failing; moreover, Freddie Mac, a sibling company that had been founded in 1970 to give Fannie competition, briefly would up as a ward of the Treasury Department. Thus, by the early 90s, the government had ample evidence that guaranteeing private housing markets was a risky business.

Pg. 20: The United States, the United Kingdom, Spain, and Australia absorbed more than half of the world’s surplus capital; at the manic peak of its borrowing, in the late 2000s, the United States alone sopped up 70 percent.

Pg. 25: From 1976 to 1999 home prices and incomes tracked each other and then surged apart. In Boston, for instance, the median home, which had sold for a reasonable 2.2 times median income in the mid-90s, soared to 4.6 times income a decade later. Similar leaps were tracked in other high-growth and coastal cities.

Pg. 39: The rating agencies began selling independent bond ratings in 1909. They worked for the subscribers, not for the issuers. This model did not last. In the 1970s, the SEC, in its effort to ensure that Wall Street brokers had sufficient capital, decided to penalize brokers for holding bonds that were less than investment grade. The agency decided to create a new category of officially designated rating agencies, and grandfathered the big three—S&P, Moody’s, and Fitch. In effect, the government outsourced its regulatory function. The agencies, realizing they had a hot product, now started to charge the very issuers whose bonds they were rating. Thus the agencies were in a conflicted position. Rather than selling opinions to investors, they were selling “licenses” that enabled very self-interested borrowers to operate in credit markets. Also, the issuers could seek the best rating—after all, they were paying the bill.

Pg. 57: Though invisible to the public, derivatives enabled speculators to circumvent virtually every rule designed for the safekeeping of markets. They effectively voided limits on leverage and rendered disclosure practices woefully inadequate. In the modern era, no financial crisis erupted that did not have derivatives at its heart, beginning with the stock market crash of 1987, in which derivative instruments led to chain-reaction selling. Yet academics and practitioners continued to sing their praises. Greenspan held that “regulation of derivatives transactions that are privately negotiated by professionals is unnecessary”—and indeed was harmful to market efficiency and the standard of living.

Pg. 74: In 2006, Merrill’s bonus pool amounted to more than $5 billion—two-thirds as much as the firm’s net income—and traders knew that regardless of what happened to its CDOs, those bonuses were for keeps. At Goldman, in 2006, more than one hundred employees made in excess of $1 million and more than 50 of them earned more than $20 million each. The bankers learned to fool the system: to game the rating agencies, to bundle deadbeat mortgages into paper that was triple A and foist it on trusting clients.

Pg. 79: In 2006, JPMorgan analysts noticed that people who were current on their credit card debts and auto loans nonetheless were defaulting on their mortgages. That was not supposed to happen. It looked as though people were voluntarily defaulting—perhaps because the equity in their homes was negative. If that was the case, there was no telling how high defaults could go. Jamie Dimon told his employees to sell or hedge whatever they could.

Pg. 276: While Bush-style conservatives had loudly championed deregulation, Democrats such as Robert Rubin had deregulated in practice. The Democrats had done the most to insulate the mortgage twins, Fannie and Freddie, from demands that they reform and trim their balance sheets. On the other hand, blame for the ineffective or tardy response to the crisis rested with the Bush administration and with the GP naysayers in the House. After the election, Obama’s financial policy was largely a continuation of the Paulson-Bernanke-Geithner regime.

Pg. 277: The government’s response to the financial crisis consisted of thee man policies. The first was baling out tottering banks and other companies. The second consisted of numerous Fed facilities to maintain a minimum level of liquidity in the banking system and in the economy. These two policies began, of course, well before the transition of power, and they continued seamlessly under Obama. The third was a massive government stimulus, which the Democratic Congress enacted during Obama’s first thirty days. Obama’s policy also has a fourth element—financial reform.

Pg. 281: In January 2008, as Obama took office, the economy shed 740,000 jobs, a record high. The following month, the value of the median home fell to $165,000, erasing a full six years’ worth of gains. The National Bureau of economic Research determined that the Great Recession had begun in December 2007 and lasted until approximately the middle of 2009.

Why did it happen:
• The Fed greatly abetted speculation in mortgages by keeping interest rates too low.
• Regulators failed to prohibit inordinately risky mortgages (liar loans, zero downpayments, etc).
• Rating agencies worked for the credit issuers, not the buyers of the bonds.
• The government backstopping of Fannie and Freddie along with the federal agenda of promoting home ownership.
• High leverage and risk taking in general was fueled by Wall Street’s indulgent compensation practices.
• Mortgage issuers, the parties most able to scrutinize borrowers, had no continuing stake in the outcome of the loan.

Reform legislation is focused on four areas:
• Protecting consumers of financial products such as mortgages and credit cards.
• Regulating complex instruments such as derivatives.
• Obviating the need for future government bailouts, either by (a) keeping banks from becoming too big t fail or (b) ensuring that big banks did not assume too much risk.
• Limiting Wall street bonuses

Pg. 289: Early in 2009, after revelations of continued outsized bonus payments at AIG and Merrill Lynch, an uproar ensued. Astonishingly, Merrill had paid million-dollar bonuses to approximately seven hundred employees in 2008, a year in which the firm lost $27 billion and in which both it and its acquirer were rescued with federal TARP monies. And Merrill was far from alone. Goldman’s bonus machine barely paused for breath. The banks are now like Fannie and Freddie before the crash: for-profit institutions with a presumptive lifeline to the Treasury.

Pg. 294: Spending policies have shredded government finances. Among the G20 nations, deficits soared from an average of 1 percent of total GDP to 8 percent. The United States was among the worst offenders, with a deficit equal to 10 percent of GDP. America’s debt rose by $1.9 trillion in the year after the Lehman failure to a staggering total of $11.91 trillion. By 2009, each American (if accorded their share of the federal debt) owed $24,000—twice as much as a decade earlier. It is arguable that the U.S. government resolved the crisis simply by appropriating Wall Street’s debts, transferring a private sector problem to the public.