We’re done with the book reviews, but John S isn’t done breaking down the books of the financial crisis. We still have a few things left to cover, most importantly….
Obviously I wasn’t going to read 16 books and NOT rank them.
It was a little hard to determine the criteria. Some of the books were well-written, but not especially good at delving into the causes; others were thorough but boring; some were great but a little off-topic. If someone asked me to recommend one of these books, I wouldn’t answer until I got more information about what exactly she was looking for. If, however, she were somehow unable to clarify, I would recommend them in this order:
16) A Colossal Failure of Common Sense
15) Reckless Endangerment
14) The Quants
13) The Greatest Trade Ever
12) Crash of the Titans
11) On the Brink
10) Bailout Nation
9) Financial Crisis Inquiry Report
8) Confidence Men
7) House of Cards
5) More Money Than God
4) Too Big To Fail
3) The Big Short
1) All the Devils Are Here
Some Questions, Answered
So, um, whose fault was it?
Well, okay, that’s not really helpful or correct, but there is certainly plenty of blame to go around. Any attempt to pin it on one group or one institution is both doomed and counterproductive. It won’t be completely correct, and it will allow others who deserve some of the blame to get off scot-free.
Perhaps, though, it would be better to answer this question by focusing on who doesn’t deserve blame, and the answer to that would be: poor people and homeowners. Yet no group has received more criticism, abuse, and obloquy, and been the beneficiary of less leniency, reform, and debt-forgiveness than common borrowers.
If you’ve been paying any attention at all, you’ve probably heard about all those people who bought homes they couldn’t afford, who spent more than they earned, who built pools and bought second homes. Heck, entire political movements have been spawned by blaming the crisis on “losers’ mortgages.”
One of Suskind’s favorite sources is Carmine Visone, the former manager of Lehman’s real estate portfolio. Visone is the kind of guy who reporters love: He has a great personal story and he’s good at telling it. The son of a bricklayer, Visone joined Lehman in 1971, got a night-school degree from Pace University, and was one of the last partners without an Ivy League pedigree. He talks a lot about value and tangible assets, and Suskind makes a big deal of his trips to local soup kitchens* to serve food to New York’s homeless.
*Yet another recurring theme in these books is that if rich people give money or time to charity, then that redeems whatever they do for the rest of their day.
But Visone comes off as a despicable embodiment of Wall Street’s flaws. He deliberately shows up late for meetings to avoid waiting for people; he insists that nothing he did was wrong, and that he is entitled to everything he has. Towards the end of the book, Suskind quotes him giving a Pontius Pilate-like tirade for two pages, where he completely absolves himself of any culpability for the crisis:
“So don’t blame me because I manufacture capital, okay? …You wanna blame me for that? Where’s your responsibility? Your self-discipline? I have no sympathy. I have no sympathy because you never should have been there to begin with. You should have exercised restraint every step of the way. Just because the drug dealer is on the corner, you could have walked right past him. You bought the drugs. I didn’t sell you the drugs, you bought the drugs.”
Not even Walter White employs moral logic this perverted.
It is frankly sickening to hear and read this total inversion of the concept of “personal responsibility.” Not only is it morally repulsive to blame society’s failures on those who have the least power and influence in it-—it is also completely at odds with the facts to blame common borrowers for the crisis. For one, it is a borrower’s job to get the best deal or the lowest rate he can get. Nobody forced the banks and lenders to give out these loans—in fact, they were lining up to do it. And if this means a borrower can get a lower rate or a bigger house, he should by all means take advantage of that. Blaming a buyer for getting a good deal is like blaming a defense attorney for getting his client acquitted.
Did some borrowers stretch beyond their means? Did some lie about their income or assets to get a bigger home or a lower rate? Did some use home equity to take lavish vacations and buy new cars? Sure.* But this is a constant fact of the world of credit—there will always be people who borrow more than they can afford. Part of a bank’s job is to watch out for those people. The crisis was not caused by some new influx of greedy homeowners.**
*Though it’s worth remembering that it is not a CRIME to owe money. It’s easy to forget that, since society does effectively jail people for their debts nowadays, but it is not criminal, or even particularly immoral, to have debt. The primary cause of bankruptcy today is, by far, illness. In other words, most people who are borrowing more than they can afford are literally doing it to save their lives.
But even setting aside medical debts or student loans, why do we stigmatize consumer debt, while simultaneously lionizing consumption? When we talk about the “losers’ mortgages” and what they are doing with their borrowed money, it’s worth remembering that, for the most part, they are doing what we all do: They are taking vacations with their families and buying homes to raise children in and buying Christmas presents for friends and having weddings and funerals and birthday parties. Should we ask them to stop living their lives because they are incurring too much credit card debt?
**For more on the moral confusion around the issue of debt, and I strongly recommend David Graeber’s book, Debt: The First 5,000 Years.
More importantly, to say that the crisis was nothing more than the result of a bunch of greedy homeowners neglects the massive abuses that entered the mortgage industry during the crisis. There were countless cases of lenders talking borrowers into rates that would reset, assuring them that they could simply refinance when payments got too high.
In many cases, lenders would encourage borrowers to take worse deals than they could have possibly qualified for, sometimes by just not telling them that they were getting a worse deal. Such incentives were explicitly written into the deals lenders had with the banks that ultimately bought the mortgages—lenders would get paid a “yield spread premium,” which was essentially a bonus for getting borrowers to accept higher rates.
And of course there were cases of outright fraud—lenders encouraging borrowers to lie or misstate their income, in many cases writing it in for the customer; corrupt deals between lenders and appraisers, who would inflate the price of a home; lenders who flat out lied to borrowers about the rate they were getting; etc.
In other words, there were systemic abuses that went way beyond the abuses of even the greediest homeowners. The crisis really came down to an institutional failure on the part of lenders and banks. The people and institutions that are supposed to protect against bad loans not only missed them, but actively encouraged them.
And what happened to them? The banks have been bailed out, forgiven, made whole, and are currently recording record profits. Meanwhile, the wave of foreclosures (often improper) is only just now ending, and homeowners still have to face the permanent damage done to their credit.
OK, so, what did the banks actually do wrong?
Alright, that’s not really a fair answer. For one, I’ve been using phrases like “the banks” and “Wall Street” as imprecise shorthand that lumps every bank together. Obviously there are huge differences between commercial banks and investment banks, between regional banks and national banks, between banks that failed completely and those that weathered the crisis fairly well, etc. Some banks were culprits and perpetrators of fraud, and others were victims of the fraud of others. And it’s sometimes hard to tell where the line between those banks is drawn.
But if there’s one thing that all of the major American banks—commercial and investment banks, big and small—got wrong, it was that they collectively misjudged the housing market. There was a pervasive but mistaken notion that housing prices “always go up,” and that it was thus a safe investment, particularly if they were diversified by region. The reality was that, though housing is a generally safe investment, it has rarely been an especially good investment; historically, it has only modestly outpaced inflation. And yet, the idea that “housing always goes up” led to a bubble mentality.
Investment banks in particular also misjudged how this would lead to declining lending standards. On some level, investment banks didn’t even care about the quality of the loans—after all, if housing prices only go up, then borrowers who couldn’t afford their mortgage could simply refinance when the value of their home increased.
But several of the books make it clear that many financial institutions weren’t even aware of what they were buying. As Lewis tells it in The Big Short, several risk analysts at AIG, when asked to estimate how many loans in their average credit default swap were subprime mortgages, guessed around 10 or 20%. In reality, it was 95%.
This type of willful ignorance of the market also led them to miss the bubble they were creating. There is a common myth, propagated largely by Alan Greenspan, that you can’t identify bubbles while they are happening. This is nonsense. There were countless signs about the housing bubble. FBI reports of mortgage fraud rose fivefold between 2000 and 2005; the number of subprime and ARMs skyrocketed, even as interest rates started to rise*; there were frequent reports of accounting fraud and abuse among national lenders like IndyMac and NovaStar.
*Is it obvious why subprime loans should go DOWN when interest rates go up? Interest rates going up should make it especially hard for the least qualified borrowers to get loans.
All these things were major warning signs that were effectively ignored, both by the Federal Reserve, which kept the Fund Rate at then-historic lows for nearly three years after 9/11 and only raised it slowly and modestly when it did begin to lift it, and by the banks in general, which kept buying loans even as their quality was decreasing.
The reason wasn’t that it was impossible to see the bubble, but that there was no incentive to see it. Many of the books, particularly All The Devils Are Here, talk about how all the major investment banks went public by the 1990s, and how this led to an emphasis on revenues at the expense of risk. As long as the banks were still partnerships, the partners could be liable for losses, and so they were vehement about protecting their balances. But as record revenues increased share prices, which led to massive bonuses for executives, the long-term interest in potential losses was vastly outweighed by the short-term interest in profits. You can certainly see something like this at work in Greg Farrell’s description of Merrill Lynch (though Merrill went public way back in 1971, so it’s hard to really blame that one thing).
This lust for revenues is partially why many refer to investment banks as just “giant hedge funds” now. Rather than serving merely as a vehicle and conduit for the investments of others, the vast majority of revenues at these banks come from their own proprietary investments, which can lead to cases where the interests of a bank’s clients and its own bottom line are at odds.
Yet another way in which these banks mirrored hedge funds is their reliance on leverage. In fact, banks leveraged to a far greater extent than any hedge fund can (as Mallaby’s book makes clear). Part of this is simply because banks have other assets to borrow against—its clients’ accounts or, in the case of commercial banks, deposits—but it was also the result of a cozy relationship with their regulators. The SEC and the Federal Reserve essentially allowed the banks to set their own limits on leverage so that they could pursue more investments.
This helped lead to the emergence of what the FCIC’s Report calls the “shadow banking” world. Shadow banking consists of the repo market—which I’ve already attempted to explain—and the market for “commercial paper,” or unsecured short-term corporate debt. The shadow banking world was essentially made up of short-term debt backed either by no collateral or collateral that hadn’t been fully evaluated—it relied largely on trust between the parties. Still, most major firms used it as a cheap way of borrowing money to meet day-to-day expenses. By 2005, in fact, there was more money in the shadow banking world than the traditional (and regulated) banking system.
Of course, one of the effects of the cheap, quick loans that made up the shadow banking sector was that they could disappear quickly, which is exactly what happened to many firms in 2008. It got so bad, in fact, that, according to Sorkin’s Too Big To Fail, even Jeffrey Immelt, CEO of General Electric, then the nation’s largest corporation, called Hank Paulson to complain that he couldn’t get funding.
And investment banks were even more susceptible to market uncertainty as the holders of all the housing debt. If banks hadn’t been so reliant on the repo and commercial paper markets, it’s possible they could have withstood the shock of the housing crisis. As the Bear Stearns example shows in House of Cards, it was a lack of liquidity that ultimately did in most banks.
In general, there was a pattern of disregard for risk at the banks, whether that meant risk in the housing market or the overnight lending market. Why were they so dismissive of risk? Partially, it was because institutions like credit rating agencies and government regulators had erroneously downplayed the risk. But ultimately they outsourced the risk because, as things would play out, they didn’t end up bearing it.
Speaking of those credit rating agencies, why did they screw up so badly?
Poor Moody’s. Poor Standard and Poor’s. Poor Fitch. The credit rating agencies really have no defenders out there. At least Wall Street CEOs get to have senators and congressmen grovel before them, but nobody really respects the credit rating agencies. As one banker told Michael Lewis, “Guys who can’t get a job on Wall Street get a job at Moody’s.”
And it certainly seems fair to criticize the credit agencies for the job they did rating housing bonds and CDOs. Data in the FCIC’s report makes it clear: Of the mortgage-backed securities given Moody’s highest rating (Aaa) in 2006, 83% would be downgraded the next year. All of those rated Baa were downgraded. Of the tranches given investment-grade ratings in 2007—meaning tranches that were supposed to have very low to moderate credit risk—a full 89% were downgraded to junk status.
This is terrible. This is not like predicting sunshine when it rains—this is like predicting sunshine after the sun has burned up and all humanity has perished. How on Earth could agencies designed to rate credit do it so poorly?
For one, the incentives were again perverse. Since credit ratings agencies get paid by the companies that issue the securities being rated, there is an incentive to give them the ratings they want. It’s true that credit rating agencies have leverage, since there are only three sanctioned by the government, but most securities only need to be rated by two of them. In All The Devils Are Here, MacLean and Nocera show how Moody’s obtained a dominant market share, at one point reaching 98%. This meant rating thousands of mortgage-backed securities. Since Moody’s got paid based on volume, and since high ratings assured more volume, Moody’s profited enormously even while its predictions were so wrong.
But the portrait the books paint of the ratings agencies is not really one of corruption, but of stupidity. It’s true that they didn’t really have an incentive to be honest, but it’s hard to see if they could have identified the real risk had they wanted to. For many bonds, Moody’s didn’t seem to differentiate based how many of the underlying loans were subprime. When the agencies looked at the loans that made up the bonds at all—which seems to have been rare—they focused on only the FICO scores of the borrowers, and even then on the average FICO scores of all the borrowers. Most famously, the agencies would rate some CDO tranches AAA even if the entire CDO was made up of BBB* tranches from other CDOs.**
*S&P and Moody’s use slightly different grading systems (which is annoying). The highest rating at S&P is AAA, while at Moody’s it’s Aaa. Below that at S&P is AA+, and Aa1 at Moody’s. BBB is the lowest investment grade rating at S&P.
**As Josh points out, there is a plausible explanation for this: Tranches made up of loans from BBB tranches in one CDO might be rated higher in another because the diversification of the loans is better, but since Moody’s and S&P rarely paid attention to the individual loans in the tranches, they had no way of knowing this. The better rating was only the result of weird financial alchemy that turned junk bonds into great ones.
Why were these models so bad? Well, for one, the agencies were generally understaffed and underpaid, so they were unable to attract the best talent. But it’s also worth pointing out that rating tranches of CDOs was not what the credit ratings agencies had historically done. For most of their existence, their main focus has been on rating corporate debt.
Quick: Do you know how many American corporations have AAA credit ratings? Four. Apple does not. Google does not. GE does not. Even the American government no longer has a perfect rating. It’s just Microsoft, ExxonMobil, Johnson & Johnson, and Automatic Data Processing. And yet credit rating agencies issued thousands of top ratings to mortgage-backed securities and CDOs that turned out to be worthless.
Evaluating the risk of a corporate bond and the risk of a bond backed by consumer loans are very different things. Corporations have lots of things you can look at: assets, revenues, long-term debt, expenses, payment history, etc. But the agencies obviously couldn’t evaluate every home loan individually, nor were they equipped to. According to the FCIC report, “Moody’s did not even develop a model specifically to take into account the layered risks of subprime securities until late 2006, after it had already rated nearly 19,000 subprime securities.”
Instead it appears that the ratings agencies relied mainly on information provided by the banks issuing the securities and the structure of the bonds themselves. That is, tranches were rated AAA if they were the safest bonds within that security and not based on the safety of the underlying loans.
These fundamental problems should really have doomed the credit rating agencies. Under normal circumstances, customers would have lost faith in their ability, likely in such great numbers that they would no longer be viable. Yet even though the crisis doomed so many companies, the credit rating agencies still stand.
This is because they are essentially enshrined by the federal government. Ever since 1975, the SEC has recognized only a few Nationally Recognized Statistical Rating Organizations, or NRSROs. As of now, there are only nine, though only the Big Three (Moody’s, S&P, Fitch) have any real relevance on Wall Street. There are laws and regulations that rely on the ratings of these NRSROs—many pension funds, for example, can only buy AAA-rated assets. This means that any security issued must be rated by at least one of these three firms, ensuring them ongoing revenues.
Though the logic behind the NRSROs is obvious—to ensure some external review of securities issued by banks—the harm is equally obvious. The government is stifling competition, and so when the NRSROs screw up, they suffer no consequences. They effectively serve as gatekeepers to the financial industry, but when they let start letting anyone through the gate, there is no way to stop them. This is yet another example of the strange relationship between government and the financial industry.
Stay tuned for tomorrow’s grand finale of The Great Read-cession, when John S wraps this whole thing up….