Wall Street Does Not Bear Sole Responsibility For Subprime Crisis

So I had a little cameo yesterday on NPR's On Point program titled The Mortgage Bailout Debate. On the air at the same time as me were Robert Shiller (Yale, author of Irrational Exuberance, you know the guy) and Robert Kuttner of The American Prospect. Two very smart guys. The tone of the discussion swayed from "How could those bankers have gotten paid millions of dollars only to get bailed out; how come the heads of the Wall Street firms haven't lost their jobs?" to "There are some fundamental flaws in our regulatory system that need to be addressed." Clearly a mix of populist rhetoric and economic substance, which I guess is necessary to both engage listeners and further the learning process. But I'd like to say what I would have liked to have said if I had more time to spar with the Bobs on-air.

First, let's take a step back. What were some of the forces that gave rise to the subprime mess in the first place? Here is my own short list (in no particular order):

1. Cheap debt a/k/a accomodative Fed policy
2. Abundant investor liquidity
3. Lack of sensible know-your-customer standards in mortgage origination
4. CDO investors who didn't do their homework and/or relied on rating agencies
5. Bank investors who didn't do their homework and understand the potential impact of off-balance sheet vehicles
6. Rating agencies lack of experience in dealing with CDO credits of such complexity
7. Poor accounting rule-making

Now if you look at this list and then say 'How many of these problems did Wall Street create?", my answer would be "precious few." What Wall Street is exceptionally good at is taking advantage of the rules. They make sure they know the rules very, very well, better than any other constituency on the planet. Then they innovate, develop, structure and sell based upon delivering customers (be they issuers or investors) value in a form that enables them to make money. Risk sharing and mitigation. New asset classes for investment. Greater liquidity. These are all good things.

Say what you want about Wall Street, but one thing I haven't heard in the sea of criticisms of late are the words "illegal" or "fraud." That's because they did nothing wrong. They did what the current screwed-up regulatory construct (hello, Congress?) and the markets (hello, what,-me-worry? investors?) allowed them to do. So take a look in the mirror before throwing stones, all ye critics. Because odds are that you play a part in this crisis as well.

Mr. Kuttner made the comment that "SIVs were new and invented by Citigroup, I think." Wrong. SIVs and their intended use has been around in a variety of forms for decades. Operating leases, sale/leasebacks, asset defeasance transactions - these are all geared around keeping assets off the balance sheet. The thing is, analysts (at least those who are sentient beings) know this, and good ones properly capitalize these off-balance sheet exposures effectively undo this accounting imagery in their models. Investors should be doing this as well, and if they don't, too bad. Problem is when investors who are stewards of mutual funds, pension funds and other fiduciary vehicles do dumb things it is everyone who suffers. Not just Wall Street. Main Street.

Mr. Shiller made a point I agree with very strongly, that our fractured, decentralized regulatory infrastructure is woefully inadequate given the rapidly increasing scale, complexity and globalization of our financial markets. We do need a single set of rules for areas where market inefficiencies necessitate regulation, and one which both Bobs mentioned and which I agree with relates to underwriting standards. I am personally less concerned with the standards themselves than I am the "Know your customer" concept that already exists at retail brokerages both outside and inside Wall Street firms. This same concept needs to be enforced on mortgage originators, in order that customers will only be shown products that are appropriate given their income, job stability, etc., because it is clear that there were widespread abuses of people originating paper that never should have been written in the first place. And coordination of regulation between states and the Federal government is critical for clarity, which will make regulation easier and facilitate innovation.

So if you were to draw a picture of the problem with arrows and a big SIV in the middle, you've got loans in on the left, some good, some bad, into the SIV, and then CDO paper out. Retail investors need better protection on the left, in my opinion via know-your-customer and product appropriateness standards. CDO investors, many of whom relied on ratings agencies to make their purchases, need the confidence to be able to trust the integrity of the agencies and the quality of their analytical work.

Right now, both issues are in question. That said, investors need to do their homework, over and above an implicit "seal of approval" from the rating agencies. And none of this addresses the accounting rules, which still enable off-balance sheet structures that defy both economics and logic. That is a post for another day.

I am glad these issues are being hashed out in public. I just wish that they were more dispassionate in their approach, leave the populist rhetoric to the side and to focus on the underlying problems that need to be fixed. Because there is a whole lot of fixing to do, and griping about Wall Street salaries is not going to get us there.

Comments

[JSF:]

What I find interesting is how the media ignores the process by which buyers got stuck with these now non-performing loans in the first place. Buyers were attracted to 100% financing (no money down) arrangements. Real Estate agents knew these borrowers had no skin in the game but had no problem getting them into the game with none of their money. They told their clients that Real Estate historically has gone up, it's a good investment, you get a tax writeoff, they aren't making any more land, etc. They told the buyers what they wanted to hear. They did not see it as their responsibility to discourage their clients from having what they wanted with discussion about the risks of 100% financing.

Loan agents were told to deliver on 100% financing and nobody - neither buyer nor Real Estate agent - wanted to hear their opinions about risks either. Loan agents were told "there are 5 guys down the street who can get me into a home with no money down; if you cannot do it I will find someone who can". So, the Real Estate agents dutifully wrote up the purchase contracts with 100% financing, and the loan agents dutifully provided financing. And the buyers got the houses they wanted with no money down. Part of these marginal buyers were owner occupants, but part of them were investors looking for easy money flipping properties, and no emotional attachments to the homes they bought. Nearly every marginal buyer had bought a house, bidding up prices to astronomical heights, when the music stopped. Prices began to edge down, and all of a sudden everyone realized that - surprise, surprise - the Real Estate market is a market after all. Like all markets, that means that prices sometimes go down, and they don't always go up. And then the finger pointing began, with the lenders and especially the mortgage brokers being singled out for scapegoating. We all know the truth, that one profession cannot be singled out for greed. This was a group effort, with everyone involved in the game.

2007 Oct 24 02:51 PM

[JSF:]

What I find interesting is how the media ignores the process by which buyers got stuck with these now non-performing loans in the first place. Buyers were attracted to 100% financing (no money down) arrangements. Real Estate agents knew these borrowers had no skin in the game but had no problem getting them into the game with none of their money. They told their clients that Real Estate historically has gone up, it's a good investment, you get a tax writeoff, they aren't making any more land, etc. They told the buyers what they wanted to hear. They did not see it as their responsibility to discourage their clients from having what they wanted with discussion about the risks of 100% financing.

Loan agents were told to deliver on 100% financing and nobody - neither buyer nor Real Estate agent - wanted to hear their opinions about risks either. Loan agents were told "there are 5 guys down the street who can get me into a home with no money down; if you cannot do it I will find someone who can". So, the Real Estate agents dutifully wrote up the purchase contracts with 100% financing, and the loan agents dutifully provided financing. And the buyers got the houses they wanted with no money down. Part of these marginal buyers were owner occupants, but part of them were investors looking for easy money flipping properties, and no emotional attachments to the homes they bought. Nearly every marginal buyer had bought a house, bidding up prices to astronomical heights, when the music stopped. Prices began to edge down, and all of a sudden everyone realized that - surprise, surprise - the Real Estate market is a market after all. Like all markets, that means that prices sometimes go down, and they don't always go up. And then the finger pointing began, with the lenders and especially the mortgage brokers being singled out for scapegoating. We all know the truth, that one profession cannot be singled out for greed. This was a group effort, with everyone involved in the game.

2007 Oct 24 02:55 PM

[beallsy:]

I have read you comment and some is accurate.

I know quite a few realtors that have been in the business for over 20 years and warned their clients in 2004 and 2005 that the market would hit it's peak then tank big time. It is a cyclic market.
The only consistency of the market is that it is up and down.

Consumers started running scared when the market was increasing at such a rapid rate, and feared they would be priced out of the market if they didn't buy something fast.

Then came the predator lenders.
Do you know the 5 year history of the LIBOR?
I bet not.
Should a new homeowner be expected to know?
I have asked to friends that have made millions in the stock market and they didn't even know what the LIBOR was.

This cruel attitude that these lenders have and are passing on to the public no affected by these ARM resets is, "you should have read the paperwork - we got ya, and you are responsible for that, so pay up".

Doesn't this say it all?

What is the purpose of a mortgage broker if they don't bother to education the consumer about the loan programs they are getting paid to originate?

Did you know that the LIBOR was at an all time low in 2004 and averaged 1.4% for the year. Resulting in lenders telling the borrowers that their payment would most likely come down when it adjusted.
The norm is over 4.8%.
Are you aware that the lenders didn't provide to the borrower's the 5 year history of the index their rate was tied to as required under TILA?

Did you also know that the lenders pool loans, get mortgage insurance on all the loans in the pool and then sell them to investors. When a loan defaults they are reimbursed up to 35% of the original loan balance to include all losses, even back interest.
I am not referring to PMI that a homeowner gets when putting less than 20% down. I am talking about something entirely different which very few people are aware of.

This is why they have no incentive to modify loans or work with borrowers to prevent them from losing their homes. And when they claim they are losing money they are telling a big fib.
Then they try and sue the homeowner for the difference of what was owed and what the property was sold for at auction.
A loss they never incurred.

Here is a little industry secret: The good houses coming up for foreclosure are grabbed up by the banks buddies. They call their buddies when a loan is starting to defaut to head them off so they can check out the property. Then they tell them what they can get it for. This has been going on for over 30 years.

The old saying is so true, "the man with the gold makes the rules".

How sad that peoples homes have become hedge funds.

2007 Oct 24 03:47 PM

[Adriano:]

There is a very bad use of the word "innovation" when it is related to what Wall Street put into the market. "Innovation" is related to the creation of new products and services, in a way that create value. But when you are not creating value, we can not use the world innovation. In all the industries there is always a problem with wether or not an innovative product, give real value to the custumer. Thats part of the social responsability that a company must have, in other words, it is wrong to sell crab, and pretent it is an innovative product or service. Maybe it is clear comming from a third world country, that it always will be hard for the goverment to structurize strong controls for this kind of
"innovations". The only way is to fallow the ethics of the business, which is create REAL value to your custumers!!!

Bogotá
Colombia.

Feb 04 05:11 PM