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How housing bill helps banks, not taxpayers

Sean Olender

Sunday, September 14, 2008
   

This is the complicated story of how Congress' recent $300 billion housing bill is a theft of taxpayer money.

To understand how it works, you must first put yourself in the shoes of Bank of America, Countrywide Financial, or any of the many U.S. banks facing big losses on delinquent mortgages. If you are a bank, you probably make loans to people to buy homes. You give the borrower money, and the borrower gives you a signed promise to repay - a mortgage - which is secured by the house.

Over the past five years, you got to sell a lot of your mortgages to Wall Street banks that then sold them to international investors. Wall Street paid you well for those mortgages. Because you didn't think you'd get stuck with them on your books, you started loaning anything to anyone.

But as the housing market's parabolic ascent stalled, you got stuck with a lot of mortgages you hadn't yet sold to Wall Street banks. And some Wall Street banks and investors may have forced you to buy back other mortgages, sticking you with hundreds of billions in bad debt. You also know that some of the mortgages that were sold to investors are packed with lies about the appraised value, the borrower's income and other information that may allow investors to force you to buy them back after foreclosure.

You've wisely been dragging your feet on sending out delinquency and foreclosure notices. Foreclosures are recorded on your books, and you're expecting a government bailout, so you are waiting sometimes more than a year to initiate foreclosure proceedings. You don't even know if some of these folks are living in their homes anymore.

You have a lot of friends in Congress. You paid them a lot of money to be your friends. But you know that if they start talking about passing a law that will give you a lot of taxpayer money to make up for your losses, voters might get angry and scare the representatives, who then may refuse to vote for your bill because they're worried about getting voted out of office.

What to do?

You can try to write a bill that is a bailout, but is disguised to appear to not be a bailout, something I call reverse legislating. You can make it look like you are taking a significant loss on the mortgage and that you are helping people keep their homes, but in reality job one is to unload toxic waste on the taxpayer.

After thinking a while, you get an idea: Write the bill so that you reduce the principal of the mortgage to 90 percent of the current appraised value (this gives the homeowner 10 percent equity, the taxpayer a 10 percent cushion against losses and relieves the homeowner from having to scrape together even $10 for a down payment on the new loan). This all makes it look like you are taking a big "haircut" by writing down the loan principal.

Better yet, include a provision that requires borrowers to share half the future appreciation with the government, creating the ridiculous image that there will be appreciation above the appraised value in the next 10 years. But you know that's impossible. You know that because you're the one who picks the appraiser.

You learned during the boom that appraisers are chosen by mortgage brokers, real estate agents, and sometimes banks. Appraisers who don't "hit the number" by appraising the house for the amount needed to close the deal don't get called back and have to get a job doing something else.
A red herring

Some idiot might suggest the creation of a radically different appraisal system. Some lawmakers may suggest that FHA or HUD select the appraiser, that the bill institute civil money penalties, or criminal penalties for improperly influencing appraisals. But you, the bank, know just how to deal with that - with a red herring, of course.

How about deleting these effective provisions from the bill and instead adding a meaningless requirement that appraisers have more education hours? Or maybe we could fingerprint them? It doesn't matter as long as it is irrelevant, but sounds relevant to a voter.

You write into the bill, of course, that only loans you choose can be refinanced in the federal assistance program. Desperate borrowers who can't afford their current mortgage payment and would benefit from this bill aren't entitled to the federal refinancing assistance without you choosing them. You coach your lawmakers to use the word "voluntary" a lot because people generally think that things that are voluntary are good. But the point is that nobody gets refinancing help unless you say it's OK.
Choosing the worst

Which homeowners are you going to allow into this refinancing program? The worst you can find. Not ones merely having trouble repaying. You're going to start with ones who stopped making payments six months ago who will walk away regardless, or better yet who have already walked away and you just haven't foreclosed on yet. You're going to track them down and you may even have to pay them to sign the documents.

If it gets too dirty, you can outsource it to any of thousands of mortgage brokers who've probably been living in their cars for the past year. You can pay big commissions and fees to create a powerful demand to close those deals without you having to get your hands dirty in the details. People who abandoned their homes or who still live there, but haven't made a payment in months, or a year, will sign anything you like if you give them $5,000, or pay the mortgage brokers enough so they can afford to buy the borrower's cooperation. The borrowers, after all, are on the hook for nothing whether they sign or not. The borrower would be wise to sign in exchange for some cash.

So that's how you do it: You, the bank, get rid of your most dubious mortgages by, in effect, transferring them to the federal program - and letting the taxpayers foot the bill.

On June 20, the National Review broke the story that Bank of America had essentially written the FHA bank bailout bill and posted Bank of America's "confidential" proposal on its Web site. The FHA bill is identical in almost all respects. That alone should tell taxpayers all they need to know.

I optimistically predict that within 12 months, half of these refinanced loans will result in default.

"If we had these higher-cost loan limits four years ago, buyers would not have had to go to the subprime market and would have been able to get an FHA loan," said William E. Brown, president of the California Association of Realtors.

But in reality, real estate agents and mortgage brokers steered lots of people into subprime loans with time-delayed, exploding interest rates, because they got paid kickbacks from the lender. The banks paid them extra money - sometimes $20,000 or $30,000 - to take a borrower with a good credit score and put the person into a bad loan with a teaser intro rate that exploded into a 12 percent monster later and included a prepayment penalty.

Why would the banks do this? Because it makes more money for them. Fully 60 percent of subprime borrowers qualified for a lower rate and better loan terms than they were given. Their mortgage brokers and real estate agents never told them they qualified for better. If they did, the borrowers would have gotten better.
Bloated inventory

Recent reports indicate that existing home sales have increased more than expected. Buried deeper was the fact that existing home inventory ballooned to 11.2 months. The record inventory of 11.5 months was reached in 1982. Optimistic economists suggest that an additional 10 percent drop in home prices is coming, while the doomsday crowd claims housing will suffer an additional 20 to 30 percent fall. Nobody knows, because a housing bust this big has never happened before. But inventory doesn't get this large unless sellers are way too high on price. Coming price declines will also sap taxpayer money on these bad loans.

And $300 billion isn't enough. In the same bill, Congress gave the Treasury Department authority to hand limitless taxpayer money to Fannie and Freddie, which can use it to buy mortgage bonds from irritable banks. After finding Fannie and Freddie in bad shape, Treasury Secretary Henry Paulson will allow them to expand their portfolios by $200 billion, like a credit card shopping spree six months before you plan to go bankrupt.

Once again, Congress has delivered the goods to its banker bosses. No lawmaker voted on specific terms for a Fannie and Freddie bailout, because precise terms are the things that get legislators voted out of office. Instead, Congress gave an arguably unconstitutional spending power to the Treasury Department, which is buying worthless mortgage bonds with our tax money. This is how to deliver $500 billion to the banks without leaving fingerprints. It is the art of postmodern democratic oligarchy.
A crazy rationale

Most surreal is the ceaselessly repeated rationale for all this bailing: If we don't give these banks your tax money, they won't be able to lend it to you. And without credit, you're all screwed. Let me get that straight. If we don't give banks our tax money, we will be in dire straits because they won't be able to lend us that money.

Before anyone writes about my wild conspiracy theories suggesting it's laughable and ridiculous that banks would try to offload worthless loans onto a third party by working with mortgage brokers and appraisers to get fraudulent appraisals and false borrower income information, isn't that rather clearly and exactly how we got into this situation?

Sen. Obama Speaks In Golden, Col. on the Economy

CQ Transcriptwire
Tuesday, September 16, 2008; 1:38 PM


OBAMA: Over the last few days, we have seen clearly what's at stake in this election. The news from Wall Street has shaken the American people's faith in our economy. The situation with Lehman Brothers and other financial institutions is the latest in a wave of crises that have generated tremendous uncertainty about the future of our financial markets. This is a major threat to our economy and its ability to create good-paying jobs and help working Americans pay their bills, save for their future, and make their mortgage payments.


Since this turmoil began over a year ago, the housing market has collapsed. Fannie Mae and Freddie Mac had to be effectively taken over by the government. Three of America's five largest investment banks failed or have been sold off in distress. Yesterday, Wall Street suffered its worst losses since just after 9/11. We are in the most serious financial crisis in generations. Yet Senator McCain stood up yesterday and said that the fundamentals of the economy are strong


A few hours later, his campaign sent him back out to clean up his remarks, and he tried to explain himself again this morning by saying that what he meant was that American workers are strong. But we know that Senator McCain meant what he said the first time, because he has said it over and over again throughout this campaign -- no fewer than 16 times, according to one independent count.


Now I certainly don't fault Senator McCain for all of the problems we're facing, but I do fault the economic philosophy he subscribes to. Because the truth is, what Senator McCain said yesterday fits with the same economic philosophy that he's had for 26 years. It's the philosophy that says we should give more and more to those with the most and hope that prosperity trickles down. It's the philosophy that says even common-sense regulations are unnecessary and unwise. It's a philosophy that lets Washington lobbyists shred consumer protections and distort our economy so it works for the special interests instead of working people.


We've had this philosophy for eight years. We know the results. You feel it in your own lives. Jobs have disappeared, and peoples' life savings have been put at risk. Millions of families face foreclosure, and millions more have seen their home values plummet. The cost of everything from gas to groceries to health care has gone up, while the dream of a college education for our kids and a secure and dignified retirement for our seniors is slipping away. These are the struggles that Americans are facing. This is the pain that has now trickled up.


So let's be clear: what we've seen the last few days is nothing less than the final verdict on an economic philosophy that has completely failed. And I am running for President of the United States because the dreams of the American people must not be endangered any more. It's time to put an end to a broken system in Washington that is breaking the American economy. It's time for change that makes a real difference in your lives.


If you want to understand the difference between how Senator McCain and I would govern as President, you can start by taking a look at how we've responded to this crisis. Because Senator McCain's approach was the same as the Bush Administration's: support ideological policies that made the crisis more likely; do nothing as the crisis hits; and then scramble as the whole thing collapses. My approach has been to try to prevent this turmoil. In February of 2006, I introduced legislation to stop mortgage transactions that promoted fraud, risk or abuse. A year later, before the crisis hit, I warned Secretary Paulson and Chairman Bernanke about the risks of mounting foreclosures and urged them to bring together all the stakeholders to find solutions to the subprime mortgage meltdown. Senator McCain did nothing.


Last September, I stood up at NASDAQ and said it's time to realize that we are in this together -- that there is no dividing line between Wall Street and Main Street -- and warned of a growing loss of trust in our capital markets. Months later, Senator McCain told a newspaper that he'd love to give them a solution to the mortgage crisis, "but" -- he said -- "I don't know one."


In January, I outlined a plan to help revive our faltering economy, which formed the basis for a bipartisan stimulus package that passed the Congress. Senator McCain used the crisis as an excuse to push a so-called stimulus plan that offered another huge and permanent corporate tax cut, including $4 billion for the big oil companies, but no immediate help for workers.


This March, in the wake of the Bear Stearns bailout, I called for a new, 21st century regulatory framework to restore accountability, transparency, and trust in our financial markets. Just a few weeks earlier, Senator McCain made it clear where he stands: "I'm always for less regulation," he said, and referred to himself as "fundamentally a deregulator."


This is what happens when you confuse the free market with a free license to let special interests take whatever they can get, however they can get it. This is what happens when you see seven years of incomes falling for the average worker while Wall Street is booming, and declare -- as Senator McCain did earlier this year -- that we've made great progress economically under George Bush. That is how you can reach the conclusion -- as late as yesterday -- that the fundamentals of the economy are strong.


Well, we have a different way of measuring the fundamentals of our economy. We know that the fundamentals that we use to measure economic strength are whether we are living up to that fundamental promise that has made this country great --that America is a place where you can make it if you try.


Americans have always pursued our dreams within a free market that has been the engine of our progress. It's a market that has created a prosperity that is the envy of the world, and rewarded the innovators and risk-takers who have made America a beacon of science, and technology, and discovery. But the American economy has worked in large part because we have guided the market's invisible hand with a higher principle -- that America prospers when all Americans can prosper. That is why we have put in place rules of the road to make competition fair, and open, and honest.


Too often, over the last quarter century, we have lost this sense of shared prosperity. And this has not happened by accident. It's because of decisions made in boardrooms, on trading floors and in Washington. We failed to guard against practices that all too often rewarded financial manipulation instead of productivity and sound business practices. We let the special interests put their thumbs on the economic scales. The result has been a distorted market that creates bubbles instead of steady, sustainable growth; a market that favors Wall Street over Main Street, but ends up hurting both.


Let me be clear: the American economy does not stand still, and neither should the rules that govern it. The evolution of industries often warrants regulatory reform - to foster competition, lower prices, or replace outdated oversight structures. Old institutions cannot adequately oversee new practices. Old rules may not fit the roads where our economy is leading. But instead of sensible reform that rewarded success and freed the creative forces of the market, too often we've excused an ethic of greed, corner-cutting and inside dealing that threatens the long-term stability of our economic system.


It happened in the 1980s, when we loosened restrictions on Savings and Loans and appointed regulators who ignored even these weaker rules. Too many S&Ls took advantage of the lax rules set by Washington to gamble that they could make big money in speculative real estate. Confident of their clout in Washington, they made hundreds of billions in bad loans, knowing that if they lost money, the government would bail them out. And they were right. The gambles did not pay off, our economy went into recession, and the taxpayers ended up footing the bill. Sound familiar?


And it has happened again during this decade, in part because of how we deregulated the financial services sector. After we repealed outmoded rules instead of updating them, we were left overseeing 21st century innovation with 20th century regulations. When subprime mortgage lending took a reckless and unsustainable turn, a patchwork of regulators systematically and deliberately eliminated the regulations protecting the American people and failed to raise warning flags that could have protected investors and the pensions American workers count on.


This was not the invisible hand of the market at work. These cycles of bubble and bust were symptoms of the ideology that my opponent is running to continue. John McCain has spent decades in Washington supporting financial institutions instead of their customers. In fact, one of the biggest proponents of deregulation in the financial sector is Phil Gramm -- the same man who helped write John McCain's economic plan; the same man who said that we're going through a "mental recession"; and the same man who called the United States of America a "nation of whiners." So it's hard to understand how Senator McCain is going to get us out of this crisis by doing the same things with the same old players.


Make no mistake: my opponent is running for four more years of policies that will throw the economy further out of balance. His outrage at Wall Street would be more convincing if he wasn't offering them more tax cuts. His call for fiscal responsibility would be believable if he wasn't for more tax cuts for the wealthiest Americans, and more of a trillion dollar war in Iraq paid for with deficit spending and borrowing from foreign creditors like China. His newfound support for regulation bears no resemblance to his scornful attitude towards oversight and enforcement. John McCain cannot be trusted to reestablish proper oversight of our financial markets for one simple reason: he has shown time and again that he does not believe in it.


What has happened these last eight years is not some historical anomaly, so we know what to expect if we try these policies for another four. When lobbyists run your campaign, the special interests end up gaming the system. When the White House is hostile to any kind of oversight, corporations cut corners and consumers pay the price. When regulators are chosen for their disdain for regulation and we gut their ability to enforce the law, then the interests of the American people are not protected. It's an ideology that intentionally breeds incompetence in Washington and irresponsibility on Wall Street, and it's time to turn the page.

Just today, Senator McCain offered up the oldest Washington stunt in the book -- you pass the buck to a commission to study the problem. But here's the thing -- this isn't 9/11. We know how we got into this mess. What we need now is leadership that gets us out. I'll provide it, John McCain won't, and that's the choice for the American people in this election.


History shows us that there is no substitute for presidential leadership in a time of economic crisis. FDR and Harry Truman didn't put their heads in the sand, or hand accountability over to a Commission. Bill Clinton didn't put off hard choices. They led, and that's what I will do. My priority as President will be the stability of the American economy and the prosperity of the American people. And I will make sure that our response focuses on middle class Americans -- not the companies that created the problem.


To get out of this crisis -- and to ensure that we are not doomed to repeat a cycle of bubble and bust again and again -- we must take immediate measures to create jobs and continue to address the housing crisis; we must build a 21st century regulatory framework, and we must pursue a bold opportunity agenda that creates new jobs and grows the American economy.


To jumpstart job creation, I have proposed a $50 billion Emergency Economic Plan that would save 1 million jobs by rebuilding our infrastructure, repairing our schools, and helping our states and localities avoid damaging budget cuts.


I worked with leaders in Congress to create a new FHA Housing Security Program, which will help stabilize the housing market and allow Americans facing foreclosure to keep their homes at rates they can afford. Going forward, we need to replace Fannie Mae and Freddie Mac as we know them with a structure that is focused on helping people buy homes -- not engaging in market speculation. We can't have a situation like the old S&L scandal where its "heads" investors win, and "tails" taxpayers lose. That's going to take ending the lobbyist- driven dominance of these institutions that we've seen for far too long in Washington.


To prevent fraud in the mortgage market, I've proposed tough penalties on fraudulent lenders, and a Home Score system that will ensure consumers fully understand mortgage offers and whether they'll be able to make payments. To help low- and middle-income families, I will ease the burden on struggling homeowners through a universal homeowner's tax credit. This will add up to a 10 percent break off the mortgage interest rate for 10 million households. That's another $500 each year for many middle class families.


Unlike Senator McCain, I will change our bankruptcy laws to make it easier for families to stay in their homes. Right now, if you're a family that owns one house, bankruptcy judges are actually barred from helping you keep a roof over your head by writing down the value of your mortgage. If you own seven homes, the judge is free to write down any or all of the debt on your second, third, fourth, fifth, sixth or seventh homes. Now that may be of comfort to Senator McCain, but that's the kind of out-of-touch Washington loophole that makes no sense. When I'm President, we'll make our laws work for working people.


But as we've seen the last few days, the crisis in our financial markets now reaches well beyond the housing market. That's why it's time to do what I called for last September and again this past March -- and it is only more overdue today.


Our capital markets cannot succeed without the public's trust. It's time to get serious about regulatory oversight, and that's what I will do as President. That starts with the core principles for reform that I discussed at Cooper Union.


First, if you're a financial institution that can borrow from the government, you should be subject to government oversight and supervision. When the Federal Reserve steps in as a lender of last resort, it is providing an insurance policy underwritten by the American taxpayer. In return, taxpayers have every right to expect that financial institutions with access to that credit are not taking excessive risks.


Second, we must reform requirements on all regulated financial institutions. We must strengthen capital requirements, particularly for complex financial instruments like some of the mortgage securities and other derivatives at the center of our current crisis. We must develop and rigorously manage liquidity risk. We must investigate rating agencies and potential conflicts of interest with the people they are rating. And we must establish transparency requirements that demand full disclosure by financial institutions to shareholders and counterparties. As we reform our regulatory system at home, we must address the same problems abroad so that financial institutions around the world are subject to similar rules of the road.


Third, we need to streamline our regulatory agencies. Our overlapping and competing regulatory agencies cannot oversee the large and complex institutions that dominate the financial landscape. Different institutions compete in multiple markets - Washington should not pretend otherwise. A streamlined system will provide better oversight and reduce costs.


Fourth, we need to regulate institutions for what they do, not what they are. Over the last few years, commercial banks and thrift institutions were subject to guidelines on subprime mortgages that did not apply to mortgage brokers and companies. This regulatory framework failed to protect homeowners, and made no sense for our financial system. When it comes to protecting the American people, it should make no difference what kind of institution they are dealing with.


Fifth, we must crack down on trading activity that crosses the line to market manipulation. The last six months have shown that this remains a serious problem in many markets and becomes especially problematic during moments of great financial turmoil. We cannot embrace the administration's vision of turning over the protection of investors to the industries themselves. We need regulators that actually enforce the rules instead of overlooking them. The SEC should investigate and punish market manipulation, and report its conclusions to Congress.


Sixth, we must establish a process that identifies systemic risks to the financial system like the crisis that has overtaken our economy. Too often, we end up where we are today: dealing with threats to the financial system that weren't anticipated by regulators. We need a standing financial market advisory group to meet regularly and provide advice to the President, Congress, and regulators on the state of our financial markets and the risks they face. It's time to anticipate risks before they erupt into a full-blown crisis.


These six principles should guide the legal reforms needed to establish a 21st century regulatory system. But the change we need goes beyond laws and regulation. Financial institutions must do a better job at managing risks. There is something wrong when boards of directors or senior managers don't understand the implications of the risks assumed by their own institutions. It's time to realign incentives and CEO compensation packages, so that both high level executives and employees better serve the interests of shareholders.


Finally, the American people must be able to trust that their government is looking out for all of us - not the special interests that have set the agenda in Washington for eight years, and the lobbyists who run John McCain's campaign.


I've spent my career taking on lobbyists and their money, and I've won. If you wanted a special favor in Illinois, there was actually a law that let you give campaign cash to politicians for their own personal use. In the State House, they called it business- as-usual. I called it legalized bribery, and while it didn't make me the most popular guy in Springfield, I put an end to it.


When I got to Washington, we saw some of the worst corruption since Watergate. I led the fight for reform in my party, and let me tell you -- not everyone in my party was too happy about it. When I proposed forcing lobbyists to disclose who they're raising money from and who in Congress they're funneling it to, I had a few choice words directed my way on the floor of the Senate. But we got it done, and we banned gifts from lobbyists, and free rides on their fancy jets. And I am the only candidate who can say that Washington lobbyists do not fund my campaign, they will not run my White House, and they will not drown out the voices of the American people when I am President of the United States. That's how we're going to end the outrage of special interests tipping the scales.


The most important thing we must do is restore opportunity for all Americans. To get our economy growing, we need to recapture that fundamental American promise. That if you work hard, you can pay the bills. That if you get sick, you won't go bankrupt. That your kids can get a good education, and that we can leave a legacy of greater opportunity to future generations.


That's the change the American people need. While Senator McCain likes to talk about change these days, his economic program offers nothing but more of the same. The American people need more than change as a slogan-- we need change that makes a real difference in your life.


Change means a tax code that doesn't reward the lobbyists who wrote it, but the American workers and small businesses who deserve it. I will stop giving tax breaks to corporations that ship jobs overseas, and I will start giving them to companies that create good jobs right here in America. I will eliminate capital gains taxes for small businesses and start-ups -- that's how we'll grow our economy and create the high-wage, high-tech jobs of tomorrow.


I will cut taxes -- cut taxes -- for 95% of all working families. My opponent doesn't want you to know this, but under my plan, tax rates will actually be less than they were under Ronald Reagan. If you make less than $250,000 a year, you will not see your taxes increase one single dime. In fact, I offer three times the tax relief for middle-class families as Senator McCain does -- because in an economy like this, the last thing we should do is raise taxes on the middle-class.


I will finally keep the promise of affordable, accessible health care for every single American. If you have health care, my plan will lower your premiums. If you don't, you'll be able to get the same kind of coverage that members of Congress give themselves. And I will stop insurance companies from discriminating against those who are sick and need care the most


I will create the jobs of the future by transforming our energy economy. We'll tap our natural gas reserves, invest in clean coal technology, and find ways to safely harness nuclear power. I'll help our auto companies re-tool, so that the fuel-efficient cars of the future are built right here in America. I'll make it easier for the American people to afford these new cars. And I'll invest 150 billion dollars over the next decade in affordable, renewable sources of energy -- wind power and solar power and the next generation of biofuels; an investment that will lead to new industries and five million new jobs that pay well and can't ever be outsourced


And now is the time to finally meet our moral obligation to provide every child a world-class education, because it will take nothing less to compete in the global economy. I'll recruit an army of new teachers, and pay them higher salaries and give them more support. But in exchange, I will ask for higher standards and more accountability. And we will keep our promise to every young American -- if you commit to serving your community or your country, we will make sure you can afford a college education.


This is the change we need -- the kind of bottom up growth and innovation that will advance the American economy by advancing the dreams of all Americans.


Times are hard. I will not pretend that the changes we need will come without cost -- though I have presented ways we can achieve these changes in a fiscally responsible way. I know that we'll have to overcome our doubts and divisions and the determined opposition of powerful special interests before we can truly reform a broken economy and advance opportunity.


But I am running for President because we simply cannot afford four more years of an economic philosophy that works for Wall Street instead of Main Street, and ends up devastating both.


I don't want to wake up in four years to find that more Americans fell out of the middle-class, and more families lost their savings. I don't want to see that our country failed to invest in our ability to compete, our children's future was mortgaged on another mountain of debt, and our financial markets failed to find a firmer footing.


This time -- this election -- is our chance to stand up and say: enough is enough!


We can do this because Americans have done this before. Time and again, we've battled back from adversity by recognizing that common stake that we have in each other's success. That's why our economy hasn't just been the world's greatest wealth generator -- it's bound America together, it's created jobs, and it's made the dream of opportunity a reality for generation after generation of Americans.


Now it falls to us. And I need you to make it happen. If you want the next four years looking just like the last eight, then I am not your candidate. But if you want real change -- if you want an economy that rewards work, and that works for Main Street and Wall Street; if you want tax relief for the middle class and millions of new jobs; if you want health care you can afford and education so that our kids can compete; then I ask you to knock on some doors, and make some calls, and talk to your neighbors, and give me your vote on November 4th. And if you do, I promise you -- we will win Colorado, we will win this election, and we will change America together.

Greenspan's Folly

The former Fed chief's culpability in Wall Street's woes.
Michael Hirsh
Newsweek Web Exclusive
Sep 17, 2008 | Updated: 12:10  p.m. ET Sep 17, 2008

Who is mostly to blame for the biggest upheaval on Wall Street since the Great Crash? The disaster appears to have many fathers. "In a way, it's the perfect crime: Who do you go after?" asks Jim Rokakis, the treasurer of Cuyahoga County in Ohio, one of a slew of state-level officials who saw the mess coming years ago but were ignored by the Feds. "If you arrest the mortgage brokers, how can you in good conscience not arrest the officers of the mortgage banks and the rating agencies?" Rokakis wonders. Ultimately, a big share of the blame lies with Wall Street CEOs who encouraged all this bad lending by packaging it into ever more complex securities, and then invested in it themselves by the billions. Indeed, the myth surrounding the subprime fallout is that no single player along the pipeline could have prevented what happened, including the giant investment banks that loaded their balance sheets with this dreck only to have it drag them into oblivion. "Everyone's to blame, and no one's to blame," says financial expert Joseph Mason of Drexel University, summing up a common view of academia and in Washington.

I don't buy it. Especially the idea that somehow the blame lies mainly with Wall Street's greed, as John McCain reiterated the other day, saying we have to "fix" it. How do you fix greed? And let's face it, left to its own devices, Wall Street has always operated on pure adrenalized greed, which is why financial manias and bubbles come and go and always will.

This mess is mostly a titanic failure of regulation. And the largest share of blame goes back to one man: Alan Greenspan. People mainly fault the former Fed chief, who once enjoyed a near-saintly reputation because of his reputed "feel" for market conditions, for ushering in an era of easy credit that accelerated the mortgage mania. But the much bigger problem was Greenspan's Ayn Randian passion for regulatory minimalism. Under the Home Ownership and Equity Protection Act enacted by Congress in 1994, the Fed was given the authority to oversee mortgage loans. But Greenspan kept putting off writing any rules. As late as April 2005, when things were seriously beginning to go wrong, he was saying that subprime lending would work out for the common good—without government interference. "Lenders are now able to quite efficiently judge the risk posed by individual applicants," he declared at the time. So much for his feel. New regs didn't get put into place until this past July—long after the crash had come, under Greenspan's successor, Ben Bernanke. The new Fed chief's "Regulation Z" finally created some common-sense rules, such as forbidding loans without sufficient documentation to show if a person has the ability to repay.

Greenspan has tried to defend himself repeatedly, though as bank after bank has failed he's retreated to the shadows. But in a 2007 interview with CBS he admitted: "While I was aware a lot of these practices were going on, I had no notion of how significant they had become until very late." This, from a man who once told me, in an interview, that he most enjoyed scanning economic reports for hours in his bathtub. Now, with Tuesday's $85 billion bailout of AIG adding to the hundreds of billions the government has already put up to rescue Bear Stearns, Fannie Mae and Freddie Mac, this apostle of free-market absolutism has realized his worst nightmare. He has given us the largest government intervention into the markets since FDR. Heckuva job, Greenie.

To be sure, there were other regulators who failed. The federal Office of the Comptroller of the Currency and Office of Thrift Supervision in 2002 pre-empted all states from regulating banks and thrifts. The regulator of Fannie Mae and Freddie Mac had almost no power at all. In addition, Fannie and Freddie are both funded by Wall Street, just as the OCC and OTS get their funding from industry fees. That created conflicts of interest: the "government-sponsored entities," as Fannie and Freddie were known, and the regulators of banks and thrifts were vested in boosting the profits that kept them going. "At the national level, the view prevailed that diversifying risk is a good thing, and markets can solve most problems," says Kathleen Engel, a finance expert at Cleveland State. "Advocates in the states were saying the markets weren't, but the federal agencies just sat on it." These regulators also encouraged the industry they so loosely oversaw to send battalions of lobbyists into state capitals to gut regulation at that level, as well. Tom Miller, the Iowa attorney general who successfully sued Ameriquest over irresponsible lending practices nationwide, told me over the summer that the OCC's director spent so much of his energy on turf battles—fighting state efforts to regulate—that he barely paid attention to what the banks were doing in subprime securitization. "He kept saying the states are too strong in regulation, and telling the banks, 'We're not going to be as tough on you'." OCC spokesman Robert Garsson defends his boss, saying that "almost everybody agrees that predatory lending is not a problem in the national banking industry." Now, that may be true. Still, any banks bought plenty of the securities that predatory lenders were helping to create.

But these smaller federal regulators do have some excuses. The new subprime securitization phenomenon cut across so many once-segregated sectors of finance—mortgage lending and securitization were once entirely separate practices—that no one could keep up with it or muster the regulatory oversight of all its parts. The Securities and Exchange Commission oversaw publicly issued securities, but the SEC rightly contends that since most of these collateralized debt obligations or CDOs based on subprime mortgages were "privately" placed with investors, it couldn't regulate them. The Comptroller of the Currency oversaw banks, but not nonbank lenders—which were often the biggest culprits—while the OTS was just in charge of thrifts, and so on. Only the Fed had the authority and the ability, granted to it 14 years ago, to supervise the entire emerging landscape. "They're the only ones who can regulate everybody," says Iowa's Miller. And until the activist Bernanke came along, the Fed did virtually nothing.

In the wake of the failures of Bear Stearns, Lehman Brothers, Freddie and Fannie—and the near-escape of Merrill Lynch and AIG from oblivion, the everybody's-to-blame argument remains popular. It runs like this: at one end of the long mortgage-securities pipeline—which ran from small towns in America to sovereign-wealth funds in Europe and Asia—unscrupulous brokers peddled mortgage deals to reckless nonbank lenders like Argent, which looked the other way at how insolvent or fraudulent the borrowers were. Greed drove the train: to fill Wall Street's demand for more mortgage-backed securities, lenders kept reaching lower and lower down the scale in both property and borrowers until the street hustlers jumped in to offer up their "product." By the time the mortgages were packaged en masse by Ivy-educated math whizzes at giant Wall Street firms such as Bear and Lehman, there were so many layers of middlemen that blame was spread as widely as the risk. On the 70th floor of a Wall Street tower, down-in-the-weeds mortgage details in small towns don't matter much. As long as real estate kept going up, everybody would win.

It's not as if Wall Street didn't understand that it was playing with fire. But by splitting the securities into many tranches, or pieces for different investors, the Street whizzes also thought they were distributing the risk so widely no one would notice. The statistical analysts at Moody's and Standard and Poor's—the top agencies that "rate" securities so investors will know how risky they are—figured things the same way. They stamped "triple-A" ratings on the top tranch as if it were a lone security and didn't carry a long "tail" of junk with it. But the risk was merely being distilled to the bottom tranch. And when real-estate prices started to drop in 2006, the junky tranch of the security dragged the value of all the other tranches down with it. So brokers, raters and the players in between made mistakes along the way that added up to disaster.

Yet the idea of widespread blame is as ill-founded as the Street's premise that risk was well distributed. For one thing, many of the borrowers could barely understand the thick stacks of paper they were signing. And many brokers blatantly falsified their incomes to qualify them, often without telling them, says Bill Brennan, a lawyer with Atlanta Legal Aid who has helped many defaulted borrowers with workouts. "This idea that borrowers were giving false information to lenders is just nonsense," he says. As investigations continue, the emerging truth is that no matter what kind of fancy new paper Wall Street was inventing, its corporate officers knew, or should have known, that the "collateral" backing up that paper was often bogus, provided by shysters and criminals.

The one who should have known most of all was Greenspan. Rokakis, the Cuyahoga treasurer, recalls when he first sensed the beginnings of the storm: way back in 2000. The foreclosure rate in the Cuyahoga County had doubled in one year, the treasurer noticed. That suggested, very early on, that lending practices were becoming irresponsible and very often fraudulent. In October of that year, Rokakis led a local delegation to the Federal Reserve Bank of Cleveland asking for help. After much pleading the Fed scheduled a daylong conference in March 2001, titled, "Predatory Lending in Housing." "We asked them to step up and take action," Rokakis recalled recently in his office in downtown Cleveland. Nothing was done. At the national level, Greenspan even stymied marginal efforts to put innocuous restrictions in place, like protections for Habitat for Humanity borrowers. "He was just philosophically opposed," says Mike Calhoun of the Center for Responsible Lending in Washington. "Here's what I learned about the Fed: They do wonderful lunches. Their cafeteria is really good," says Rokakis. "But the Federal Reserve Bank is not there to protect us. It's there to protect the banks." And now the banks are helping themselves to vast amounts of taxpayer money. Enjoy your retirement, Alan.