Wall Street’s Meltdown: Who’s to Blame?

The financial crisis panel makes it clear that while many were responsible for the mortgage meltdown, the Fed was the one entity that could have stopped it.

Let's face it: You will not read every page of the Financial Crisis Inquiry Commission report. But FrumForum will, over the next days. So let's proceed together, page by page, identifying the key points. At best, maybe we can arrive at some agreed wisdom. At worst: it's a bluffer's guide.

Old-fashioned lawyers used to have a concept of the "but for" cause, the one cause without which an event would not have happened. A man slips on a banana peel. In one sense, that's the culmination of events tracing back to the Big Bang. Still, but for the careless banana-eater tossing the banana on the sidewalk, the accident would never have occurred. On page xvii of the preface, the FCIC identifies its own "but for" cause: the negligence of the Federal Reserve.

The prime example is the Federal Reserve’s pivotal failure to stem the flow of toxic mortgages, which it could have done by setting prudent mortgage-lending standards. The Federal Reserve was the one entity empowered to do so and it did not.

Many made the disaster. The Fed was the one entity that could have stopped the disaster. That statement should not be forgotten over the pages to come.

You often hear it said that the crisis was a crisis of deregulation. The FCIC itself will make that point often. Yet on page xviii, they concede that the rules that remained on the books were sufficient, if only they had been enforced.

[W]e do not accept the view that regulators lacked the power to protect the financial system. They had ample power in many arenas and they chose not to use it. To give just three examples: the Securities and Exchange Commission could have required more capital and halted risky practices at the big investment banks. It did not. The Federal Reserve Bank of New York and other regulators could have clamped down on Citigroup’s excesses in the run-up to the crisis. They did not. Policy makers and regulators could have stopped the runaway mortgage securitization train. They did not. In case after case after case, regulators continued to rate the institutions they oversaw as safe and sound even in the face of mounting troubles, often downgrading them just before their collapse. And where regulators lacked authority, they could have sought it. Too often, they lacked the political will—in a political and ideological environment that constrained it—as well as the fortitude to critically challenge the institutions and the entire system they were entrusted to oversee.

What kind of scandal was the financial crisis? To a great extent, a scandal of corruption.

From page xviii:

From 1999 to 2008, the financial sector expended $2.7 billion in reported federal lobbying expenses; individuals and political action committees in the sector made more than $1 billion in campaign contributions.

The corruption was expressed in retail fraud. Thus on page xxii:

One study places the losses resulting from fraud on mortgage loans made between 2005 and 2007 at $112 billion.

Yet for my money, the ground zero of fraud occurred not at the retail mortgage level, but at the rating agencies. Moody's, Standard & Poor's and Fitch were assigned monopoly powers by federal regulations. Their ratings determined which bonds could be bought by fiduciary institutions. They engaged in behavior that it's very hard to distinguish from auctioning off their ratings to eager bidders. Of all the things about the crisis I do not understand, the thing I understand least is why nobody from those agencies has faced any kind of legal sanction.

From page xxv:

From 2000 to 2007, Moody’s rated nearly 45,000 mortgage-related securities as triple-A. This compares with six private-sector companies in the United States that carried this coveted rating in early 2010. In 2006 alone, Moody’s put its triple-A stamp of approval on 30 mortgage-related securities every working day. The results were disastrous: 83% of the mortgage securities rated triple-A that year ultimately were downgraded.

You will also read about the forces at work behind the breakdowns at Moody’s, including the flawed computer models, the pressure from financial firms that paid for the ratings, the relentless drive for market share, the lack of resources to do the job despite record profits, and the absence of meaningful public oversight. And you will see that without the active participation of the rating agencies, the market for mortgage-related securities could not have been what it became.

Listen to talk radio or watch Fox News, and you'll most often hear the financial crisis blamed either on the Community Reinvestment Act (encouraging mortgage lending to poor and minority borrowers) or on the two government-sponsored mortgage lenders, Fannie Mae and Freddie Mac.

It's important to note that 9 out of 10 commissioners, including 3 out of 4 of the Republicans, rejected both explanations.

Here's the majority statement on Fannie and Freddie, from page xxvi. It is harsh on the GSEs. Yet it cannot lay blame at their door.

[W]e examined the role of the GSEs, with Fannie Mae serving as the Commission’s case study in this area. These government-sponsored enterprises had a deeply flawed business model as publicly traded corporations with the implicit backing of and subsidies from the federal government and with a public mission. Their $5 trillion mortgage exposure and market position were significant. In 2005 and 2006, they decided to ramp up their purchase and guarantee of risky mortgages, just as the housing market was peaking. They used their political power for decades to ward off effective regulation and oversight—spending $164 million on lobbying from 1999 to 2008. They suffered from many of the same failures of corporate governance and risk management as the Commission discovered in other financial firms. Through the third quarter of 2010, the Treasury Department had provided $151 billion in financial support to keep them afloat.

We conclude that these two entities contributed to the crisis, but were not a primary cause. Importantly, GSE mortgage securities essentially maintained their value throughout the crisis and did not contribute to the significant financial firm losses that were central to the financial crisis.

The GSEs participated in the expansion of subprime and other risky mortgages, but they followed rather than led Wall Street and other lenders in the rush for fool’s gold. They purchased the highest rated non-GSE mortgage-backed securities and their participation in this market added helium to the housing balloon, but their purchases never represented a majority of the market.

And here is the key section of the dissenting report signed by 3 of 4 Republicans:

There is vigorous debate about how big a role these two firms played in securitization relative to “private label” securitizers. There is also vigorous debate about why these two firms got involved in this problem. We think both questions are less important than the multiple points of contact Fannie Mae and Freddie Mac had with the financial system.

These two firms were guarantors and securitizers, financial institutions holding enormous portfolios of housing-related assets, and the issuers of debt that was treated like government debt by the financial system. Fannie Mae and Freddie Mac did not by themselves cause the crisis, but they contributed significantly in a number of ways.

There seems more agreement here than disagreement. The GSEs were a bad idea, badly and (often) abusively run. But they did not make the crisis.

Click here to read part 2.

Click here for the entire series.

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