All The Devils Are Here

Bethany McClean & Joe Nocera, “All The Devils Are Here: The Hidden History of the financial crisis”, Kindle Edition, 2010, 380 Pages

I am really getting to like my Kindle.

The authors of this book are two very notable business journalists and have here written a thorough account of the origins of the 2008 financial crisis. Of course, as expected, the book thoroughly recounts what led us to the crisis. Additionally they introduce us to problems certain to come. For starters, there is the unfolding foreclosure-paperwork fiasco. Next up will be a clash over whether big banks should be forced to take back billions of dollars in contaminated mortgages they sold. Down the road, we will confront the danger of the next asset bubble inflating as a result of the Federal Reserve’s use of extreme monetary policy to stimulate the economy.

I am somewhat disappointed with these authors as well as all others I have read in the past year that deal with the financial crisis. All summarize the cause of the crisis as the result of Wall Street substituting elaborate, statistically based insurance schemes that, with the belief in efficient financial markets, were assumed to make old-fashioned credit analysis and human judgment irrelevant. Although they all mention how business incentives control behavior, they do not sufficiently dwell on it as a cause of this disaster. That is, the people making the loans cannot be allowed to not have an interest in whether the loan is repaid, securitization had severed this link; the credit rating agencies cannot be employees of those they are rating; bonuses must be subject to be clawed-back, or should be subject to long term evaluation. Of course: Too Big to Fail must be dealt with. I conclude that none of this is sufficiently dealt with in the books I have read in the past year.

My Notes:
Location 306: The thirty-year fixed mortgage is standard in only one other country than the U.S.: Denmark.

Location 321: It was not Wall Street that first securitized modern mortgages; it was the government. Ginnie Mae began selling securities in 1970 that consisted of FHA and VA loans, and guaranteeing the payment of principal and interest. A year later, Freddie Mac issued the first mortgage-backed securities using conventional mortgages, also with principal and interest guaranteed. Volume grew slowly; it was not a huge success.

Location 338: Tranching the risk streams and getting the credit rating agencies to shovel out Triple A ratings made all the difference. From a standing start in the late 1970s, bonds created from mortgages on single-family homes grew to more than $350 billion by 1981 and to $3.3 trillion by the end of 2001. Congress and the regulators placed such trust in the rating agencies that they had designated them as Nationally Recognized Statistical Ratings Organizations, or NRSROs. This allowed pension funds to invest in these securities.

Location 651: For the fiscal year ending in February 1992, refinancing accounted for 58 percent of Countrywide’s business; two years later, they accounted for 75 percent of its business. Countrywide was not putting people into homes so much as it was making it possible for homeowners to use their homes as piggy banks.

Location 730: A series of laws passed in the early 1980s, intended to help the S&Ls get back on their feet, wound up having profound unintended consequences. The first law, passed in 1980, was the Depository Institutions Deregulation and Monetary Control Act; among other things, it abolished state usury caps, which had long limited how much financial firms could charge on first-lien mortgages. It also erased the distinction between loans made to buy a house and loans, like home equity loans, that were secured by a house, which would prove critical to the subprime industry. Two years later came the Alternative Mortgage Transaction Parity Act, which made it legal for lenders to offer more creative mortgages, such as adjustable-rate mortgages or those with balloon payments, rather than plain vanilla thirty-year fixed-rate instruments. It also preempted state laws designed to prevent these new kinds of mortgages and prepayment penalties. Of course, as always, the rationale was promoting homeownership. Thus was the subprime mortgage industry born. Yet, a staggering 82 percent of subprime mortgages were refinancing, and in nearly 60 percent of those cases the borrower pulled out cash, adding to his debt burden.

Location 927: In 1992 Congress passed a bill imposing on Fannie and Freddie two things they had never had to deal with before. The first was a regulator, called OFHEO. The second was a clear definition of what had previously been the GSEs’ vague mission to help lower-income Americans buy homes. The first Bush administration was worried that Fannie and Freddie were taking on risk that the taxpayers would likely have to absorb if the housing market ever tanked. It was proposed that better rules and a regulatory oversight should fix it. The GSE’s reacted by convincing Congress that the new regulator should be placed in HUD, an agency with very little institutional understanding of banking regulation and risk. Then Fannie maneuvered to have OFHEO—virtually alone among ‘safety and soundness’ regulators—subject to the appropriations process. This meant that its annual budget was at the mercy of politicians. It became so bad that for a two year stretch in the late 1990s, OFHEO did not even have a director. When the regulator requested information, the GSEs would often respond that the information was confidential.

Location 1056: Republicans studied what it was that made people vote Republican. ‘The number one predictor of voting Republican was a job in the private sector, and number two, is that you own your own home.’

Location 1093:The great irony of the mortgage market in the 1990s was that to the extent that lower and moderate income Americans were being swept along in the rising tide of homeownership the 1990s, it was happening not because of Fannie and Freddie, but despite them.

Location 1333: In 1994, J.P. Morgan put together its first credit default swap. It came about as a result of the Exxon Valdez oil spill. The oil giant, facing the possibility of a $5 billion fine, drew down a $4.8 billion line of credit from J.P. Morgan. After Exxon drew down its $4.8 billion line of credit, J.P. Morgan convinced the European Bank for Reconstruction and Development in London to participate in a swap deal where it assumed the default risk for the loan, with J.P. Morgan paying it steady fees for doing so.

Location 1898: By 1999 more than 50 percent of mortgages had down payments of less than 10 percent.

Location 2170: In 1998 the LTCM failure had clearly exhibited the potentially destructive power of derivatives. In fact, all the tools of modern finance—excessive leverage, probabilistic risk models, unseen counterparty exposure—had been shown to be flawed. So how did the government react? In 2000 senator Phil Gramm pushed through the Commodities Futures Modernization Act which Clinton signed into law. The new law explicitly stated that derivatives were not futures and could not be regulated by the CFTC—or any other government regulator. A year earlier the president had signed a law that repealed Glass-Steagall which had split commercial from investment banking ever since the depression era.


Location 2247: The rating agencies had always been stingy about bestowing triple-A status on corporate debt. In 2007, for instance, only six companies had a triple-A rating. Yet when it came to the tranches of mortgage-backed securities, the rating agencies handed out triple-As like candy. Literally tens of thousands of mortgage-backed tranches were rated triple-A. The rating agencies had missed the near default of New York City, the bankruptcy of Orange County, and the Asian and Russian meltdowns. They failed to catch Penn Central in the 1970s and Long-Term Capital Management in the 1990s. They often downgraded companies just days before bankruptcy—too late to help investors. In retrospect, the surprise is not that the rating agencies would eventually be corrupted by their business model, but that it took so long to happen.

Location 2367: The great advantage issuers had in seeking triple-A ratings is that they rarely needed all three agencies to be involved in any one deal. Investors liked having two agencies rate a deal, but nobody cared about having all three involved. So issuers could play the agencies off each other. Greenspan did not notice how this ratings shopping was a classic reason his theory of market discipline could not and did not work. The market competition between rating agencies, which Greenspan assumed would make companies better, actually made them worse. The only way to get market share was to be easier with the ratings.

Location 2415: Not a single analyst at either Moody’s or S&P lost his job as a result of missing the Enron fraud. Management stayed the same. Moody’s stock price, after a brief tumble, began rising again. Nobody really wanted to reform the rating agencies.

Location 2552: According to the Wall Street Journal, total household debt in America doubled, from $7 trillion to $14 trillion, between 2000 and 2007. Debt related to housing was responsible for 80 percent of that increase. And of curse housing prices themselves were going through the roof. Since 1940, according to data compiled by the S&P/Case-Shiller home price index, the average home increased in value by 0.7 percent a year. But between 2001 and 2006, fourteen of the twenty largest metropolitan areas in the country saw home values rise by more than 10 percent a year. The ration of home prices to income which had hovered between 2 and 4 since the Great Depression, shot up in some place to as high as 12.

Location 3341: By the end of the 1990s, Fannie and Freddie’s combined assets exceeded the GDP of any nation except the U.S., Japan, and Germany. Fannie’s capital requirements were minimal. Its leverage was sky high—over 60 to 1.

Location 4898: About 35 percent of the mortgages used to purchase homes in 2004 and 205 were not for primary residences, but for second homes and investment properties. Also, the number of people borrowing to buy an actual home at that time was dwarfed by the number of people borrowing to refinance and take equity out of their homes.

Location 5028: By 2006 the combination of the ABX index and the new credit default swap market made it possible to short subprime securitizations.

Location 5684: It wasn’t until July 2007-the same month the Bear hedge funds collapsed—that the rating agencies made their first major move toward downgrading. Yet even in July, the rating agencies still weren’t ready to go all in and actually downgrade triple-A tranches. Apparently the rating agencies feared the consequences of a widespread downgrade of mortgage-backed securities. With ratings so embedded in regulations, downgrades would force many buyers to sell. That forced selling, in turn, would put more pressure on prices, which would create a downward spiral that would be nearly impossible to reverse.

Location 6789: On July 21, 2010 President Obama signed the Wall Street Reform and Consumer Protection Act, a 2,300 page piece of legislation that marked the biggest change in the regulation of the financial industry since the aftermath of the Great Depression. The Federal Reserve would get new powers to look broadly across the financial system. A council of federal regulators led by the Treasury secretary would help ferret out systemic risk. A new consumer agency was created to help end the lending abuses and keep people from getting loans they could never hope to pay back. Under this new law, most derivatives will supposedly be traded on an exchange where prices and profits are transparent. The bill creates a process to liquidate failing companies, s that there is a reasonable alternative to bailouts. It outlaws proprietary trading at financial institutions that accept insured deposits. Perhaps the most glaring omission in the new law was any mention of Fannie and Freddie. By 2010, Fannie and Freddie (along with the FHA) were backing more than 95 percent of mortgages. Right now, you simply cannot finance a house in America without a government stamp of approval.