Summary

From its intellectuals to its political leaders, the American conservative movement has fully endorsed an interpretation of the Bush-era housing bubble and Wall Street collapse that cannot be reconciled with reality. The political right insists that government policy encouraging homeownership among low-to-moderate-income families is the primary – or even the only – cause of the crisis. But data on the home loan industry shows this argument is false. In fact, the subprime boom was driven by private firms who were exempt from the much-vilified Community Reinvestment Act of 1977, not by Fannie Mae and Freddie Mac. The government’s contribution to the crisis was its failure to regulate Wall Street, not its efforts to expand homeownership.

Right-Wing Rationale: It Was The Community Reinvestment Act (CRA) And Government Lenders

GOP Presidential Candidates Blamed Government Policy For Housing Crisis. From Bloomberg: “The Republicans say the federal government pressed banks to make risky housing loans under a 1977 law called the Community Reinvestment Act, helping inflate home prices and ultimately sparking the crash. ‘The reason we have the housing crises we have is that the federal government played too heavy a role in our markets,’ Romney said in a Nov. 9 Republican debate. ‘The federal government came in with Fannie Mae (FNMA) and Freddie Mac, and Barney Frank and Chris Dodd told banks they had to give loans to people who couldn’t afford to pay them back.’ Gingrich has suggested jailing Frank, the former chairman of the House Financial Services Committee, and Dodd, who headed the Senate Banking Committee until his retirement this year.” [Bloomberg, 12/21/11]

Sen. DeMint Thinks “Liberal Housing Goals” At Fannie Mae And Freddie Mac “Fueled” The Financial Crisis. In 2010, Sen. Jim DeMint (R-SC) wrote: “Senator McCain has offered an amendment that would repeal their [Fannie Mae and Freddie Mac’s] liberal housing goals that encouraged more risky lending and fueled the housing crisis, as well as end their dominance of the mortgage market and let the private sector back in. While more needs to be done to quickly end the permanent bailout of these mortgage giants, the McCain amendment is an important first step. True financial reform must include Freddie Mac and Fannie Mae.” [DeMint.Senate.gov, 5/11/10]

House Speaker John Boehner Claimed In Nationally Televised Speech That “Government Mortgage Companies” Had “Triggered The Whole Meltdown.” In a May 9, 2011, speech on Wall Street, Speaker Boehner said: “And the government mortgage companies that triggered the whole meltdown went untouched.” [Boehner Remarks, 5/9/11]

American Enterprise Institute’s Wallison: “The Crisis Has Its Roots In The U.S. Government’s Efforts To Increase Homeownership, Especially Among … Low-Income Groups.” In 2008, AEI’s Peter Wallison wrote: “The Community Reinvestment Act (CRA), Fannie Mae and Freddie Mac, penalty-free refinancing of home loans, tax preferences granted to home equity borrowing, and reduced capital requirements for banks that hold mortgages and mortgage-backed securities (MBS) have all weakened the standards for granting mortgages and the housing finance system itself. […] The current financial crisis is not–as some have said–a crisis of capitalism. It is in fact the opposite, a shattering demonstration that ill-considered government intervention in the private economy can have devastating consequences. The crisis has its roots in the U.S. government’s efforts to increase homeownership, especially among minority and other underserved or low-income groups, and to do so through hidden financial subsidies rather than direct government expenditures.” [AEI.org, 11/25/08]

Reality: That Would Be The Community Reinvestment Act Of 1977…

The Subprime Collapse Didn’t Begin Until Thirty Years After The Community Reinvestment Act. From Bloomberg: “Losses on subprime mortgage-backed securities didn’t start shaking financial institutions until 2007, three decades after the CRA was introduced and 15 years after affordable housing goals were established for Fannie Mae and Freddie Mac.” [Bloomberg, 12/21/11]

• U.S. Housing Policy Cannot Explain The World-Wide Housing Bubble. From Bloomberg: “The Community Reinvestment Act can’t explain why house prices in the U.K., Ireland, Spain and France doubled earlier this decade and almost doubled in Australia. All have suffered steep losses since then, with Ireland’s home prices dropping 38 percent by December 2010 from the 2006 peak. Nor did Fannie Mae and Freddie Mac, the mortgage companies seized by the government in 2008 after their stake in subprime loans pushed them to the brink of collapse, have anything to do with commercial real estate, where prices rose by 91 percent in the seven years to October 2007.” [Bloomberg, 12/21/11]

…Which Did Not Apply To Private Firms Who Inflated The Subprime Market

Fannie And Freddie Are Insurers, Not Issuers, Of Loans – They Buy Loans From Private Banks So The Banks Can Continue Lending. From McClatchy: “Fannie, the Federal National Mortgage Association, and Freddie, the Federal Home Loan Mortgage Corp., don’t lend money, to minorities or anyone else, however. They purchase loans from the private lenders who actually underwrite the loans. It’s a process called securitization, and by passing on the loans, banks have more capital on hand so they can lend even more.” [McClatchy, 10/12/08]

Fannie And Freddie Were Followers, Not Leaders, In The Massive Demand For Privately-Issued Mortgage-Backed Securities. From the University of North Carolina’s Center for Community Capital:

Fannie and Freddie also started purchasing private-label mortgage-backed securities, inverting the process that had been in place for three decades whereby the agencies bought whole loans to securitize and sell to investors. According to FHFA’s Annual Report to Congress, Fannie and Freddie purchased $5.7 billion in private-label securities in 1997, or about 4.8% of new issuance. The volume continued to grow in the 2000s, peaking at $221.3 billion in 2005. However, Fannie and Freddie never accounted for more than a quarter of private-label security purchases in a given year and that share was falling as yield spreads on private-label securities declined and real estate prices approached their peak.

[CCC.UNC.edu, September 2010, emphasis added]

UNC Center For Community Capital: “Profit Not Policy Was What Motivated Fannie And Freddie And Loan Products Not Borrowers Were What Caused Their Collapse.” From the University of North Carolina’s Center for Community Capital:  “There is clear evidence that Fannie and Freddie started purchasing lower quality loans at the peak of the housing market. However, it is also evident that they did so to regain market share from less-regulated private-label security issuers and finance companies. Housing goals do not appear to have played a significant role because Fannie and Freddie remained less concentrated in low-income market segments compared to the private market. Still, the high LTV, low FICO score, and alternative documentation loans that Fannie and Freddie purchased are performing significantly better than private subprime loans, suggesting the enterprises retained stronger risk management procedures than private financial companies. Ultimately, profit not policy was what motivated Fannie and Freddie and loan products not borrowers were what caused their collapse.” [CCC.UNC.edu, September 2010]

McClatchy: “Subprime Lending Was At Its Height From 2004 To 2006,” But Fannie Mae And Freddie Mac Saw Their Subprime Market Share Cut In Half During Those Years. As reported by McClatchy: “Subprime lending offered high-cost loans to the weakest borrowers during the housing boom that lasted from 2001 to 2007. Subprime lending was at its height from 2004 to 2006. […] Between 2004 and 2006, when subprime lending was exploding, Fannie and Freddie went from holding a high of 48 percent of the subprime loans that were sold into the secondary market to holding about 24 percent, according to data from Inside Mortgage Finance, a specialty publication.” [McClatchy, 10/12/08]

• Fannie And Freddie Faced Tougher Regulatory Standards Than The Private Firms. As reported by McClatchy: “One reason is that Fannie and Freddie were subject to tougher standards than many of the unregulated players in the private sector who weakened lending standards, most of whom have gone bankrupt or are now in deep trouble.” [McClatchy, 10/12/08]

At Height Of Subprime Bubble, Entities Subject To CRA Held Just 6 Percent Of Subprime Loans. From Bloomberg: “The CRA was enacted to combat ‘red-lining’ by lenders that often refused to serve low-income borrowers. Under the law, government regulators evaluate banks’ provision of credit and use their performance in approving mergers. At the bubble’s peak in 2005-06, only 6 percent of all subprime loans involved lenders or borrowers governed by the law, according to Federal Reserve data. ‘The available evidence seems to run counter to the contention that the CRA contributed in any substantive way to the current mortgage crisis,’ Fed economists Neil Bhutta and Glenn Canner wrote in 2009.” [Bloomberg, 12/21/11]

• 60 Percent Of Subprime Mortgages Were Held By Middle- And Higher-Income Borrowers. From Bloomberg: “About 60 percent of all subprime loans were extended to middle- or higher-income borrowers or neighborhoods, then-Fed governor Randall Kroszner said in a December 2008 speech. Another 20 percent were given to low-income borrowers by nonbank lenders that weren’t subject to the anti-discrimination law. Kroszner, a University of Chicago economist appointed to the Fed by President George W. Bush, said it’s ‘hard to imagine how this law could have contributed in any meaningful way to the current subprime crisis.’” [Bloomberg, 12/21/11]
• From 2004-2006, At Height Of Subprime Bubble, Almost $3 Out Of Every $4 In Sub-Prime Lending Was Done By Non-CRA Entities. As reported by the Orange County Register: “A Register analysis of more than 12 million subprime mortgages worth nearly $2 trillion shows that most of the lenders who made risky subprime loans were exempt from the Community Reinvestment Act. And many of the lenders covered by the law that did make subprime loans came late to that market – after smaller, unregulated players showed there was money to be made. Among our conclusions: Nearly $3 of every $4 in subprime loans made from 2004 through 2007 came from lenders who were exempt from the law.” The Orange County Register created a graphic showing who made the subprime loans in question:

[Orange County Register, 11/16/08; Ritholtz.com, November 2008]

• Even After Shrinking Their Subprime Business By Large Increments Over The Previous Year, The Largest Subprime Servicers In 2008 Were All Private Firms. From a McClatchy analysis of Inside Mortgage Finance data:

[McClatchy, 10/12/08]

Alternative Statistics Offered By Conservatives Fall Apart Under Scrutiny

The figures conservative critics offer for subprime mortgages held by Fannie and Freddie are based on a misleading definition of “subprime,” which does not account for the superior performance of those loans as compared to privately securitized mortgages to similar types of borrowers.

Among Loans To Riskiest Borrowers, Mortgages Securitized By Fannie And Freddie Performed Dramatically Better Than Equivalent Private-Sector Loan Packages. From pages 216-18 of the Financial Crisis Inquiry Commission report: “The data contained mortgages in four groups—loans that were sold into private label securitizations labeled subprime by issuers (labeled SUB), loans sold into private label Alt-A securitizations (ALT), loans either purchased or guaranteed by the GSEs (GSE), and loans guaranteed by the Federal Housing Administration or Veterans Administration (FHA). […] That means that only 5% of GSE loans were in subgroups with average delinquency rates above 6.0%. In sharp contrast, the black bar for private-label subprime securitizations (SUB) spans average delinquency rates between 24.0% on the low end and 31.0% on the high end, and the full bar spans average delinquency rates between 10.0% and 32.0%. That means that only 5% of SUB loans were in subgroups with average delinquency rates below 10%. The worst-performing 5% of GSE loans are in subgroups with rates of serious delinquency similar to the best-performing 5% of SUB loans. […] The data illustrate that in 2008 and 2009, GSE loans performed significantly better than privately securitized, or non-GSE, subprime and Alt-A loans. That holds true even when comparing loans in GSE pools that share the same key characteristics with the loans in privately securitized mortgages, such as low FICO scores. For example, among loans to borrowers with FICO scores below 660, a privately securitized mortgage was more than four times as likely to be seriously delinquent as a GSE.” [Financial Crisis Inquiry Commission Report, p.219, January 2011, emphasis added, internal citations removed]

In Arguing That Fannie And Freddie Held Dramatically More Subprime Loans, Conservatives Ignore Differences In Loan Performance. From page 219 of the Financial Crisis Inquiry Commission report: “According to Ed Pinto, a mortgage finance industry consultant who was the chief credit officer at Fannie Mae in the 1980s, GSEs dominated the market for risky loans. In written analyses reviewed by the FCIC staff and sent to Commissioners as well as in a number of interviews, Pinto has argued that the GSE loans that had FICO scores below 660, a combined loan-to-value ratio greater than 90%, or other mortgage characteristics such as interest-only payments were essentially equivalent to those mortgages in securitizations labeled subprime and Alt-A by issuers. […] Importantly, as the FCIC review shows, the GSE loans classified as subprime or Alt-A in Pinto’s analysis did not perform nearly as poorly as loans in non-agency subprime or Alt-A securities. These differences suggest that grouping all of these loans together is misleading. In direct contrast to Pinto’s claim, GSE mortgages with some riskier characteristics such as high loan-to-value ratios are not at all equivalent to those mortgages in securitizations labeled subprime and Alt-A by issuers. The performance data assembled and analyzed by the FCIC show that non-GSE securitized loans experienced much higher rates of delinquency than did the GSE loans with similar characteristics.” [Financial Crisis Inquiry Commission Report, p.219, January 2011, emphasis added]

Default Rate Was Much Higher For Privately Securitized Mortgages Than For Those Connected To Fannie, Freddie, And The CRA. From the Center for American Progress: “Mortgages originated for private securitization defaulted at much higher rates than those originated for Fannie and Freddie securitization, even when controlling for all other factors (such as the fact that Fannie and Freddie securitized virtually no subprime loans). Overall, private securitization mortgages defaulted at more than six times the rate of those originated for Fannie and Freddie securitization. Similarly, mortgages originated for CRA purposes have performed at much higher rates than loans originated for private securitization, going into foreclosure 60 percent less often than loans originated by independent mortgage companies that were key to providing the mortgages needed to supply private securitization.” [Center for American Progress, 12/21/10]

Federal Reserve Empirical Study Of Conservative Claims About Housing Policy Found No Evidence That Loans Involving CRA, Fannie, Or Freddie Performed Worse – And They May Have Even Led To Better Outcomes Than Elsewhere. From a Federal Reserve report titled “The Subprime Crisis: Is Government Housing Policy To Blame?”:

Our analysis examining the type of lenders extending credit to [low-to-moderate income] census tracts found no evidence that tracts with proportionally more lending by CRA-covered lenders experienced worse outcomes, whether measured by delinquency rates, high-PTI loans, or higher-priced lending. In fact, the evidence suggests that loan outcomes may have been marginally better in tracts that were served by more CRA-covered lenders than in similar tracts where CRA-covered institutions had less of a footprint. Loan purchases by CRA-covered lenders also do not appear to have been associated with riskier lending. Additionally, this analysis found no evidence that either the CRA or the GSE goals contributed to house prices appreciation during the 2001-2006 subprime buildup.

Our regression discontinuity tests, which focus on lending and loan performance around the income levels used to determine whether loans are favored by the CRA and GSE goals, finds little evidence of an effect for either regulation, except for an increase in loan purchases by CRA-covered depositories in their assessment areas. Both loan quality and performance are clearly related to census tract income with both improving as income rises. However, these relationships are evident for both favored and not-favored loans and there is no evidence of a discontinuity at the threshold points. Data on loan volumes also fail to find evidence of a regulatory threshold effect; indeed, the share of loans originated by CRA-covered lenders in their assessment areas and the share of loans sold to the GSEs are higher in the tracts not favored by the regulations than in favored tracts. Though loan purchases by CRA-covered lenders appear to have been sensitive to the definition of a CRA-favored loan, there is no evidence that this affected the overall quality of loans originated. [“The Subprime Crisis: Is Government Housing Policy To Blame?” via FederalReserve.gov, 8/3/11, emphasis added]

Many Things Contributed To The Meltdown, But Blaming CRA “Just Isn’t Credible”

Senior Banking Industry Lobbyist: Blaming CRA For Subprime Meltdown “Just Isn’t Credible.” As reported by the Orange County Register: “Bob Davis, executive vice president of the American Bankers Association, which lobbies Congress to streamline community reinvestment rules, said ‘it just isn’t credible’ to blame the law CRA for the crisis. ‘Institutions that are subject to CRA – that is, banks and savings asociations [sic] – were largely not involved in subprime lending,’ Davis said. ‘The bulk of the loans came through a channel that was not subject to CRA.’” [Orange County Register, 11/16/08]

“Bailout Nation” Author Ritholtz: “30 Year Sequence” Of Events That Precipitated Financial Crisis Has Nothing To Do With CRA. From subprime crisis expert Barry Ritholtz:

When writing Bailout Nation, I tried to steer clear of partisan finger pointing. I kept the focus on what actually occurred, what could be proven mathematically. I blamed Democrats and Republicans — not equally, but in proportion to their actions, and what they did. Unsupported theories, tenuous connection, loose affiliations were not part of the analysis.

To be blameworthy, every legislative change, each regulatory failure, any corporate action had to manifest themselves in actual mathematical proof. This led me to ascertain the following 30 year sequence:

-Free market absolutism becomes the dominant intellectual thought.

-Deregulation of markets, investment houses, and banks becomes a broad goal: This led to Glass Steagall repeal, unfettering of Derivatives, Investing house leverage exemptions, and a new breed of unregulated non bank lenders.

-Legislative actions reduce or eliminate much of the regulatory oversight; SEC funding is weakened.

-Rates come down to absurd levels.

-Bond managers madly scramble for yield.

-Derivatives, non-bank lending, leverage, bank size, compensation levels all run away from prior levels.

-Wall Street securitizes whatever it can to satisfy the demand for higher yields.

-”Lend to securitize” nonbank mortgage writers sell enormous amounts of subprime loans to Wall Street for this purpose.

-To meet this huge demand, non bank lenders collapse lending standards (banks eventually follow), leading to a credit bubble.

-The Fed approves of this “innovation,” ignores risks.

-Housing booms . . . then busts

-Credit freezes, the markets collapse, a new recession begins.

You will note that the CRA is not part of this sequence. I could find no evidence that they were a cause or even a minor factor. If they were, the housing bubbles would not have been in California or S. Florida or Las Vegas or Arizona — Harlem and South Philly and parts of Chicago and Washington DC would have been the focus of [real estate] bubbles. [Ritholtz.com, 5/13/10, emphasis added]

What Really Happened: Deregulation Turned Wall Street Into A High-Stakes Casino Capable Of Crashing The Economy While CEOs Cashed In

Three Decades Of Financial “Deregulation And Desupervision.” In an op-ed for Benzinga.com, financial fraud expert William Black wrote: “The last three decades reveal recurrent, intensifying financial crises brought on by dramatic deregulation and desupervison followed by efforts at reregulation which are soon undercut by subsequent deregulation and desupervision. The historical pattern is mixed, but it includes radical financial deregulation and desupervision in many Western nations.” [Black op-ed, Benzinga.com, 2/7/11]

Congressionally Appointed Financial Crisis Inquiry Commission: The Crisis Was Caused By “Reckless” Behavior On Wall Street And “Weak” Regulatory Oversight. From the Huffington Post: “In a report released today, the Financial Crisis Inquiry Commission found that ‘reckless’ Wall Street firms, an abundance of cheap credit and ‘weak’ federal regulators caused the crisis. ‘This financial crisis could have been avoided. Let us be clear,’ chairman Phil Angelides said at the Washington press conference marking the official release of the report. ‘The record is replete with evidence of failures. None of what happened was an act of God.’” [HuffingtonPost.com, 1/27/11]

FCIC Depicted “Pipeline” Of Bad Loans, Securitization, Default Swaps, And Negligent Ratings Agencies. From the Huffington Post story on the Financial Crisis Inquiry Commission’s final report:

“Collapsing mortgage-lending standards and the mortgage securitization pipeline lit and spread the flame of contagion and crisis.”

The report found irresponsible lending was prevalent, and there were warnings, but “the Federal Reserve neglected its mission,” and mortgage lenders passed the risk along.

“From the speculators who flipped houses to the mortgage brokers who scouted the loans, to the lenders who issued the mortgages, to the financial firms that created the mortgage-backed securities, collateralized debt obligations… no one in this pipeline of toxic mortgages had enough skin in the game.”

“Over-the-counter derivatives contributed significantly to this crisis…”

Speculating on devices like collateralized debt obligations fanned the flames, with everyone from farmers to corporations to investors betting on prices and loan defaults. When the housing bubble popped, these were at the center of the fallout.

“The failures of credit rating agencies were essential cogs in the wheel of financial destruction…”

But, the report found, those bets wouldn’t have been possible without the seal of approval from ratings agencies. [HuffingtonPost.com, 1/27/11, emphasis original]

GOP-Appointed FCIC Commissioners Voted To Ban Words Like “Deregulation” And “Wall Street” From Findings. From Accounting Today: “The four Republican members decided last week to release their own nine-page version of the report, entitled ‘Financial Crisis Primer,’ through a think tank called the American Action Forum. In the process, they also have effectively disowned the ‘final’ version of the report that the Democratic-led commission now plans to release in January. They are concerned that the final report will end up putting the blame on Wall Street for the financial crisis, whereas they believe the blame should be placed instead on government-sponsored housing agencies like Fannie Mae and Freddie Mac, and the affordable housing goals of the Clinton and second Bush administrations.  The Republican commission members even voted in private to ban phrases like ‘Wall Street,’ ‘shadow banking,’ ‘interconnection,’ ‘deregulation,’ ‘magic,’ and ‘alchemy’ from the final report.” [Accounting Today, 12/21/10, emphasis added]

Deregulation

1999: Congress Repeals Depression-Era Finance Law, Paving The Way For “Too Big To Fail” Banks. From the Huffington Post: “On the 10th anniversary of Congress voting to repeal the law that had long separated Main Street commercial banking from Wall Street investment banking, current members of the body are talking about ways to potentially bring it back. A return to the Depression-era law — known as Glass-Steagall — is now being seriously discussed. Some leading economists and financial thinkers point to its repeal as a precipitator of the current crisis, because it enabled banks to become ‘too big to fail.’ […] On November 5, 1999, when Congress passed the bill repealing Glass-Steagall, it was hailed as something that would provide the country with the ‘opportunity to dominate’ the new century. The bill was the Gramm-Leach-Bliley Act of 1999, and it enabled banks to engage in the kind of activities that had been largely prohibited since the Great Depression.” [HuffingtonPost.com, 11/5/09]

• Glass-Steagall “Shielded” Deposits From “Losses That Might Come Of More Risky Activities Involving Securities.” From WNYC: “The Glass-Steagall Act, officially known as the Banking Act of 1933, was a Depression-era reform that separated commercial banking from investment banking: an institution could either take deposits or trade securities, but it couldn’t do both. In essence, deposits were shielded from losses that might come of more risky activities involving securities. Glass-Steagall also created the Federal Deposit Insurance Corporation, which insured those deposits. Protecting them from risk attributed to securities made sense: if the government was on the hook to insure those deposits, it didn’t want depository institutions risking securities losses.” [WNYC.org, 11/30/11]

• Repeal of Glass-Steagall Expanded Banks’ Ability To Take Risks With Consumers’ Money. From WNYC:

Legislators under the influence of lobbyists would chip away at Glass-Steagall beginning the 1970s, as looser restrictions on banks were seen as a way to counteract the dangerous impacts of inflation. It wasn’t until 1999, when Congress passed the Gramm-Leach-Bliley Act, that the central provision of Glass-Steagall was abandoned; a holding company was finally allowed to control both commercial and investment banks. […]

In short, repeal of Glass-Steagall allowed commercial lenders to make loans (say, in the form of mortgages) and trade instruments derived from those loans (say, in the form of mortgage-backed securities). Commercial banks could even create new investment entities that would be responsible for buying those securities.

The expanded palette of products and operations that were available in the wake of Glass-Steagall’s repeal certainly contributed to the financial crisis, as banks took risks with their customers’ deposits and debts that were previously illegal. Banks had new ways to make money, and new license to get “too big to fail”; a holding company could hold and create whatever it wanted. [WNYC.org, 11/30/11]

• Financial Services Industry Resists Return To Glass-Steagall-Era Regulation. From the Huffington Post: “The financial services lobby is fighting proposals that would amount to a full or partial return of Glass-Steagall, warning that such action would kill jobs, send top financial companies oversees [sic] and generally damage the economy. [Democratic Rep. Brad] Miller doesn’t think much of that argument. He notes that for the biggest firms, ‘the highest-risk, highest-rewards parts of their business were using the entire balance sheet of the firm implicitly as collateral…. And that, to a large extent, is what led to the collapse last fall. ‘I’m interested in the idea of creating firewalls,’ Miller told the Huffington Post, ‘but if we are maintaining the separation, what’s the point of having them in the same holding company anyway? If there’s always going to be an implicit use of the assets of the entire holding company, the only way to solve that is for those activities to be off the firm.’” [HuffingtonPost.com, 3/18/10]

2000: GOP Senator “Inserted A Key Provision Into The 2000 Commodity Futures Modernization Act That Exempted … Derivatives Such As Credit Default Swaps From Regulation.” According to Time: “As chairman of the Senate Banking Committee from 1995 through 2000, Gramm was Washington’s most prominent and outspoken champion of financial deregulation. He played the leading role in writing and pushing through Congress the 1999 repeal of the Depression-era Glass-Steagall Act that separated commercial banks from Wall Street, and he inserted a key provision into the 2000 Commodity Futures Modernization Act that exempted over-the-counter derivatives such as credit-default swaps from regulation by the Commodity Futures Trading Commission (CFTC).” [Time, 1/24/09]

• Lenders Were Protected From Credit Risks Of Their Loans, And Investors Were Not Responsible For Fraud By Lenders. In a Businessweek op-ed, business consultant Michael Watkins wrote: “Securitization of mortgages into collateralized debt obligations (CDOs) decoupled mortgage originators (brokers and others) from the credit risks of the loans they were writing. At the same time, U.S. investment law shielded sellers of these securities from the legal consequences of fraud by originators. This introduced corrosive conflicts of interest into the system.” [Watkins Op-Ed via Businessweek, 12/17/07]

• The Credit Default Swap Market Totaled Over $45 TRILLION By 2007, With No Regulation Over The Selling And Re-Selling Of CDS Products. From Time: “The CDS market exploded over the past decade to more than $45 trillion in mid-2007, according to the International Swaps and Derivatives Association. […] Banks and insurance companies are regulated; the credit swaps market is not. As a result, contracts can be traded — or swapped — from investor to investor without anyone overseeing the trades to ensure the buyer has the resources to cover the losses if the security defaults. The instruments can be bought and sold from both ends — the insured and the insurer.” [Time, 3/17/08]

• The CDS Market Came To Function Like An Informal Betting Parlor For Finance Firms To Wager On Mortgage-Backed Securities They Did Not Own. From Time: “The CDS market then expanded into structured finance, such as CDOs, that contained pools of mortgages. It also exploded into the secondary market, where speculative investors, hedge funds and others would buy and sell CDS instruments from the sidelines without having any direct relationship with the underlying investment. ‘They’re betting on whether the investments will succeed or fail,’ said [Reed Smith LLP partner Andrea] Pincus. ‘It’s like betting on a sports event. The game is being played and you’re not playing in the game, but people all over the country are betting on the outcome.’” [Time, 3/17/08, emphasis added]

• Credit Default Swaps On Packaged Subprime Mortgages Allowed Them To Be Rated “AAA” By Credit Agencies, And Resold To Investors. From the University of North Carolina’s Center for Community Capital: “Without the implicit government guarantee, private-label mortgage-backed securities had always been seen as riskier investments than those issued by Fannie and Freddie. But innovative financiers discovered that by giving different levels of priority to the shares, or ‘tranches,’ of a security, along with corresponding rates of risk and return, they could shield a particular income stream from loss. A single security would be divided into higher risk tranches that would absorb earlier losses and lower risk tranches that would be hit only once the others were exhausted. Additional insurance against losses was obtained through derivatives like credit default swaps, where for a fee one company (e.g. AIG) would compensate another for defaults in an investment. Consequently, these investments were considered ‘safe’ enough to warrant AAA credit ratings— that is, there was virtually no predicted risk of loss, despite being built on high risk subprime mortgages. It appeared as if investors could have safety comparable to U.S. Treasury bonds, but with significantly higher returns.” [CCC.UNC.edu, September 2010, emphasis added]

2004: In Dramatic Change To 30-Year-Old Rule, SEC Allowed Megabanks To Hold As Much As 40 Times As Much Debt As Collateral. From the New York Sun:

The so-called net capital rule was created in 1975 to allow the SEC to oversee broker-dealers, or companies that trade securities for customers as well as their own accounts. […]

The net capital rule also requires that broker dealers limit their debt-to-net capital ratio to 12-to-1, although they must issue an early warning if they begin approaching this limit, and are forced to stop trading if they exceed it, so broker dealers often keep their debt-to-net capital ratios much lower.

In 2004, the European Union passed a rule allowing the SEC’s European counterpart to manage the risk both of broker dealers and their investment banking holding companies. In response, the SEC instituted a similar, voluntary program for broker dealers with capital of at least $5 billion, enabling the agency to oversee both the broker dealers and the holding companies.

This alternative approach, which all five broker-dealers that qualified — Bear Stearns, Lehman Brothers, Merrill Lynch, Goldman Sachs, and Morgan Stanley — voluntarily joined, altered the way the SEC measured their capital. Using computerized models, the SEC, under its new Consolidated Supervised Entities program, allowed the broker dealers to increase their debt-to-net-capital ratios, sometimes, as in the case of Merrill Lynch, to as high as 40-to-1. [New York Sun, 9/18/08, emphasis added]

• At 40:1 Leverage, A 2.5 Percent Drop In Asset Values Will Bankrupt A Firm. From Ezra Klein of the Washington Post: “If you’re a bank, the upside of leverage is that it gives you a lot of money that you can use, well, to make more money. It’s the difference between investing $1 in the stock market and $40. The downside is that it makes your firm fragile. If your leverage is at 2:1 — that is to say, you’ve borrowed one dollar to add to the dollar you already had — you could lose a full dollar and still be able to pay your creditor back. If you’re at 10:1, anything beyond a 10 percent decline in your assets means that if your creditors want repayment, you can’t pay them back (as you’ve lost more than your original dollar). At 20:1, a 5 percent decline will put you underwater. At 40:1, a mere 2.5 percent decline can finish you off.” [WashingtonPost.com, 4/19/10]

• Former SEC Official Who Helped Write Original Net Capital Rules: 2004 Change “Is The Primary Reason For All The Losses That Have Occurred.” From the New York Sun: “The Securities and Exchange Commission can blame itself for the current crisis. That is the allegation being made by a former SEC official, Lee Pickard, who says a rule change in 2004 led to the failure of Lehman Brothers, Bear Stearns, and Merrill Lynch. […] Making matters worse, according to Mr. Pickard, who helped write the original rule in 1975 as director of the SEC’s trading and markets division, is a move by the SEC this month to further erode the restraints on surviving broker-dealers by withdrawing requirements that they maintain a certain level of rating from the ratings agencies. […] ‘The SEC modification in 2004 is the primary reason for all of the losses that have occurred,’ Mr. Pickard, who is now a senior partner at the Washington, D.C.-based law firm Pickard & Djinis, said.” [New York Sun, 9/18/08]

Bush’s Anti-Regulators

President Bush’s First SEC Chief Was “Leading Opponent Of Vigorous Securities Regulation And Effective Accounting.” In an op-ed for Benzinga.com, financial fraud expert William Black wrote: “George W. Bush was an ardent anti-regulator. He appointed the nation’s leading anti-regulators to run the regulatory agencies. Bush appointed Harvey Pitt, for example, to run the SEC because he was the leading opponent of vigorous securities regulation and effective accounting. On October 16, 2001, Enron announce[d] massive losses and accounting restatements. On October 22, 2001, SEC Chairman Pitt addressed the AICPA Governing Council (his former client) and bemoaned the fact that the SEC had not always been a ‘kinder and gentler’ place for accountants. He called accountants the SEC’s ‘partners.’ […] Pitt blamed the SEC staff for purportedly intimidating accountants and refusing to listen to them. He explained his guiding rule: ‘I am committed to the principle that government is and must be a service industry.’” [Black Op-Ed, Benzinga.com, 2/7/11, emphasis added]

Another Bush SEC Chief Opposed Derivatives Regulation In 1990s, Was Not Asked About The Subject At 2005 Confirmation Hearing. From ProPublica: “[Chris] Cox has long known about the pitfalls of poorly understood hedging instruments; as a Congressman, he represented Orange County, California, when it declared bankruptcy in 1994 after its investments in derivatives went badly awry. But at the time, he did not join calls to regulate them: ‘I’m concerned that now anything called a derivative will be considered inherent evil in Congress,’ Cox said, according to the Orange County Register. ‘It is sort of like a fire hose: In the wrong hands, it is dangerous.‘ Did his opinion evolve by the time he was confirmed as SEC Chairman? You won’t find any clues by looking at his Senate confirmation hearing of July 2005. That is because no senator asked him a question about the topic.” [ProPublica, 10/6/08]

• SEC Historian: Agency Regulated With A “Trust The Market” Philosophy. From the Los Angeles Times: “Word came late Wednesday that President-elect Barack Obama is expected today to name Mary L. Schapiro to succeed Christopher Cox as SEC chief. Schapiro is chief executive of the Financial Industry Regulatory Authority, an industry group that regulates brokerages. […] The change in leadership at the SEC is an opportunity to reverse years of a failed ‘trust the market’ philosophy permeating the agency, said Joel Seligman, an SEC historian.” [Los Angeles Times, 12/18/08]

Federal Reserve Chairman Ben Bernanke In 2005: “Very Sophisticated” Traders Make Regulation Of Derivatives Unnecessary. From ProPublica:

When former Sen. Paul Sarbanes asked [Federal Reserve Chairman Ben] Bernanke about derivatives at his November 2005 Senate confirmation hearing, Bernanke said he felt “sanguine” about these instruments, noting the sophistication of those who dealt with them. Sarbanes responded that this attitude toward derivatives and the hedge funds dealing in them could “come back to haunt you.”

SARBANES: Warren Buffett has warned us that derivatives are time bombs, both for the parties that deal in them and the economic system. The Financial Times has said so far, there has been no explosion, but the risks of this fast growing market remain real. How do you respond to these concerns?

BERNANKE. I am more sanguine about derivatives than the position you have just suggested. I think, generally speaking, they are very valuable. They provide methods by which risks can be shared, sliced, and diced, and given to those most willing to bear them. They add, I believe, to the flexibility of the financial system in many different ways. With respect to their safety, derivatives, for the most part, are traded among very sophisticated financial institutions and individuals who have considerable incentive to understand them and to use them properly. [ProPublica, 10/6/08, emphasis added]

President Bush’s Secretary Of The Treasury Was “Very Wary” Of Derivatives Regulations. As reported by ProPublica:

In June, Treasury Secretary [Henry] Paulson told the Washington Post that in one of his first meetings with President Bush, he warned that the growing use of derivatives posed a fundamental risk to the market. If that is the case, he didn’t say so publicly. In response to a written question by Sen. Mike Crapo (R-ID) submitted at the Treasury Secretary’s Senate confirmation hearing in June 2006, Paulson said he was ‘wary’ of proposals to strengthen regulation of derivatives because of their importance in managing risk. […]

PAULSON: I believe these proposals could have significant unintended consequences for the risk-management functions that the markets – whether over-the -counter or exchange-based – perform in our economy. It is my view that absent a clearly demonstrated need, we should be wary of major changes to the manner in which we regulate our derivatives markets. [ProPublica, 10/6/08, emphasis added]

Former Fed Chairman Alan Greenspan: We Were Wrong To Trust “The Self-Interest Of Lending Institutions” And Leave Derivatives Unregulated. As reported by the New York Times:

[O]n Thursday, almost three years after stepping down as chairman of the Federal Reserve, a humbled Mr. Greenspan admitted that he had put too much faith in the self-correcting power of free markets and had failed to anticipate the self-destructive power of wanton mortgage lending.

“Those of us who have looked to the self-interest of lending institutions to protect shareholders’ equity, myself included, are in a state of shocked disbelief,” he told the House Committee on Oversight and Government Reform. […]

On a day that brought more bad news about rising home foreclosures and slumping employment, Mr. Greenspan refused to accept blame for the crisis but acknowledged that his belief in deregulation had been shaken.

He noted that the immense and largely unregulated business of spreading financial risk widely, through the use of exotic financial instruments called derivatives, had gotten out of control and had added to the havoc of today’s crisis. As far back as 1994, Mr. Greenspan staunchly and successfully opposed tougher regulation on derivatives.

But on Thursday, he agreed that the multitrillion-dollar market for credit default swaps, instruments originally created to insure bond investors against the risk of default, needed to be restrained.

“This modern risk-management paradigm held sway for decades,” he said. “The whole intellectual edifice, however, collapsed in the summer of last year.” [New York Times, 10/23/08]

Regulators At The Office Of Thrift Supervision “Led A Race To The Bottom” To Accommodate The Industry They Were Supposed To Regulate. From the New York Times’ DealBook: “The Office of Thrift Supervision similarly comes in for heavy criticism. The regulator led a race to the bottom as the Senate report details how it promulgated ‘weak standards’, had ‘low expectations’ and unduly deferred to management. And in the case of Washington Mutual adopted a soft regulation approach because Washington Mutual paid fees accounting for 15 percent of the O.T.S.’s operating budget. In other words the agency watered down its standard to attract higher revenue, something the Senate report accuses the credit ratings agencies of.” [NYTimes.com, 4/15/11]

Wall Street’s Payday

Wall Street Journal Study: From 2003-2008, Executives In Industries Involved In The Crisis Made Over $21 Billion. On November 20, 2008, the Wall Street Journal reported: “The credit bubble has burst. The economy is tanking. Investors in the U.S. stock market have lost more than $9 trillion since its peak a year ago. But in industries at the center of the crisis, plenty of top officials managed to emerge with substantial fortunes. Fifteen corporate chieftains of large home-building and financial-services firms each reaped more than $100 million in cash compensation and proceeds from stock sales during the past five years, according to a Wall Street Journal analysis. Four of those executives, including the heads of Lehman Brothers Holdings Inc. and Bear Stearns Cos., ran companies that have filed for bankruptcy protection or seen their share prices fall more than 90% from their peak. The study, which examined filings at 120 public companies in such sectors as banking, mortgage finance, student lending, stock brokerage and home building, showed that top executives and directors of the firms cashed out a total of more than $21 billion during the period.” [Wall Street Journal, 11/20/08]