Bailout Nation (24 page)

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Authors: Barry Ritholtz

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Greenspan's encouraging remarks about the benefits of ARMs in February 2004 are another tale of woe (and woeful misjudgment).
“American consumers might benefit if lenders provided greater mortgage product alternatives to the traditional fixed-rate mortgage,” Greenspan said in a speech before the Credit Union National Association. “To the degree that households are driven by fears of payment shocks but are willing to manage their own interest rate risks, the traditional fixed-rate mortgage may be an expensive method of financing a home.”
12
Meanwhile, at the Office of Thrift Supervision, former chief James Gilleran took a chainsaw to a stack of regulations to symbolize how his agency was going to “cut red tape” for thrifts (aka S&Ls), which are heavily involved in mortgage lending. “Our goal is to allow thrifts to operate with a wide breadth of freedom from regulatory intrusion,” Gilleran said in a 2004 speech.
13
This wasn't malfeasance by Greenspan and Gilleran; rather, it was nonfeasance, the intentional failure to perform a required legal duty or obligation. Even the FBI got into the deregulatory act: In 2004, the FBI warned that “fraud in the mortgage industry has increased so sharply that an ‘epidemic' of financial crimes could become ‘the next S&L crisis.'” Subsequently, the FBI(!) made a “strategic alliance” in 2007 with the Mortgage Bankers Association (MBA), the trade association for (then) major industry players like IndyMac and Countrywide Financial.
14
Truly
,
the foxes were guarding the henhouse.
When we look into the details of these lenders, we see they were especially enamored of risk. In a fatal twist on traditional banking, their employees got paid on the volume, not the quality, of their loans. Besides, they didn't need to find a buyer who was a good risk for 30 years—they only needed to find someone who wouldn't default before the securitization process was complete, as detailed in Chapter 10.
This was an unbelievably enormous change in lending standards. So what did federal bank regulators have to say about this paradigm shift? Various government agencies did nothing about this shift, even though the FBI warned of an “epidemic” of mortgage fraud in 2004.
15
Not surprisingly, the abdication of lending standards—and the trillions in subsequent resets—resulted in skyrocketing mortgage default rates. As of December 2008, a record 10 percent of all homeowners with mortgages were behind in their payments, up from 7.3 percent in 2007. According to the MBA, among subprime borrowers, the rate was 33 percent. (In the United States, 70 percent of homes carry a mortgage.)
Tragically, this was avoidable. Former Fed Governor Edward Gramlich was an expert on subprime lending and became increasingly concerned about predatory lending in the early part of this decade. His 2007 book,
Subprime Mortgages: America's Latest Boom and Bust
(Urban Institute Press), presciently warned of the dangers these loans presented to the credit and housing industry, and the economy as a whole.
In 2007, the
Wall Street Journal
reported that Gramlich “said he proposed to Mr. Greenspan in or around 2000, when [predatory lending] was a growing concern, that the Fed use its discretionary authority to send examiners into the offices of consumer-finance lenders that were units of Fed-regulated bank holding companies.”
16
“I would have liked the Fed to be a leader” in cracking down, Gramlich, who retired from the Fed in 2005, told the
Wall Street Journal
shortly before his death in 2007. The
Journal
noted, “Knowing it would be controversial with Mr. Greenspan, whose deregulatory philosophy is well known, Mr. Gramlich broached it to him personally rather than take it to the full board.”
17
If only Greenspan had heeded Gramlich's warnings. Instead, he chose to dismiss them. As we have since learned, this turned out to be an enormous error on Greenspan's part.
Credit Ben Bernanke for having the good sense to close the barn door after all the horses had escaped. In December 2007, Bernanke reversed his predecessor's antiregulatory fervor:
The Federal Reserve, acknowledging that home mortgage lenders aggressively sold deceptive loans to borrowers who had little chance of repaying them, proposed a broad set of restrictions Tuesday on exotic mortgages and high-cost loans for people with weak credit. The new rules would force mortgage companies to show that customers can realistically afford their mortgages. They would also require lenders to disclose the hidden sales fees often rolled into interest payments, and they would prohibit certain types of advertising. Borrowers would be able to sue their lenders if they violated the new rules, though home buyers would be allowed to seek only a limited amount in compensation.
18
Ahhh, a return to lending money only to people who could “realistically afford their mortgages.” What a quaint and charming notion.
Chapter 12
Strange Connections, Unintended Consequences
There is only one difference between a bad economist and a good one: the bad economist confines himself to the visible effect; the good economist takes into account both the effect that can be seen and those effects that must be foreseen.
—Frédéric Bastiat
1
 
 
O
ne of the great risks of human endeavors is that all actions, however well intended, have unintended consequences. This is especially true when governments are involved.
History shows that government actions—as well as inaction—have repercussions that are rarely anticipated. This is the case of legislation, tax policy, and most especially of bailouts. Legislative policy pursued at the request of a given company or industry often ends up harming that industry immeasurably. That it was pursued
by friend rather than foe
makes it only ironic, not untrue.
For the Bailout Nation, this critical issue is well worth pondering, especially now that we have written some rather enormous checks. Our collective actions and omissions will leave an onerous legacy to future generations, often manifesting themselves in unanticipated ways.
As examples of how unintended consequences can be felt far in the future, consider two legislative acts wholly unrelated to the current financial crisis.
The 1996 Telecommunications Reform Act amended the Communications Act of 1934 and eliminated media ownership regulations. This led to an enormous degree of media consolidation, especially in radio. Prior to the 1996 Act, broadcasters could own just 40 stations nationally. After the Act became law, 10,000 radio stations were bought up or merged.
The biggest of the buyers was Clear Channel Communications, acquiring over 1,200 channels. They fired local talent—DJs, program managers, music directors—and on many of these stations, ran a homogenized playlist feed from a central bunker in Texas. Call it Hamburger Helper for radio. Replace tasty, expensive meat with cheap filler and hope no one notices.
For a while, it worked. Clear Channel became enormously profitable. It had the costs of a small radio network, but an audience 100 times the size.
And then, that audience
. . .
left. They didn't even change the channel; they simply abandoned radio in droves. Ask a radio executive what broadcasters sell, and most will tell you “Advertising.” That is actually wrong; what radio sells is
an audience to advertisers
. Once the listeners figured out they were getting filler instead of steak, they went elsewhere. Between satellite radio, iPods, and streaming Internet audio, the terrestrial music business model of radio was thoroughly damaged—mostly, at the request of the industry.
Clear Channel once had a stock price over $70 and a market cap near $40 billion; now it trades for pennies. What's left is an outdoor billboard company, with an under $1 billion market cap.
Next, consider the Securities Litigation Reform Act of 1995. This legislation was supposed to be a way to eliminate class action lawsuits that were the bane of public companies' existence. Buried in the legislation was a little-noticed clause that eliminated “joint and several liability” for those who contribute to securities fraud. The consequences of the change were significant. It removed liability for fraud from the accountants who audited quarterly statements for public companies.
What do you think happened once accountants were no longer liable?
An explosion of accounting fraud!
The accounting scandals of the late 1990s and early 2000s were directly attributable to this small legal change. So too was the collapse of Enron, which led to the corporate death penalty for Arthur Andersen. We can probably pin the subsequent enactment of Sarbanes-Oxley, which is undoubtedly having all sorts of its own unintended consequences, on that same clause. These all trace back to what the industry itself had requested.
As the saying goes:
Be careful what you wish for; you may get it.
T
he repercussions of current Treasury Department bailouts and Federal Reserve rescue plans may not be realized for years or even decades. The unintended consequences of these bailouts fester beneath the surface, slowly working their mischief.
It turns out that many different prior actions contributed to the great unraveling of the U.S. financial system. The old cliche é is “success has many fathers, but failure is an orphan.” Let's do some DNA testing to see if we can identify the ancestry of the modern financial system collapse.
One of the oddest connections is the direct line one can draw from the Boskin Commission, a Senate-appointed board charged with reviewing the consumer price index (CPI) in 1995, to the collapse of Bear Stearns in 2008.
When Alan Greenspan brought interest rates down to such ultralow levels, he did not in all likelihood think he was being reckless. We will deal with the inherent contradiction of a free market economist's constant intervention in the economy in a later chapter (and perhaps on the couch of Alan's shrink). The Fed might have been panicked over the state of the economy, but a fair reading of Greenspan's public testimony shows the Fed chairman was convinced inflation was “contained.” He did what he felt was necessary to revive the economy.
Yet home prices doubled in a short period of time, crude oil increased ninefold from its 2001 lows of $16 to $147, and food prices skyrocketed. There was also enormous inflation in medical costs, education, insurance, and other services.
During most of this 2003-2007 run-up in prices, the consumer price index (CPI), the official measure of inflation, hardly budged. Credit the Boskin Commission for contributing to this illusion of low inflation. The Boskin reforms changed not only the basket of goods measured for inflation, but how we measure them. It allowed “hedonic adjustments” for the improvement of quality. Forget what the window sticker says; your new car isn't really more expensive—
it's better
.
Then there was “substitution”—for example, when the price of steak rises, consumers can replace it with chicken at the previous low prices. In the topsy-turvy world of Boskin, substituted prices remained the same. In the real world, inflation just drove steak out of your price range.
Convened by President George Bush Sr. and signed into law by President Bill Clinton, the 1996 report of this Advisory Commission to Study the Consumer Price Index concluded that CPI overstated inflation by 1.1 percent. It was through tricks like substitution, hedonic adjustments, and other intellectually dishonest methods that the Boskin Commission made their disingenuous claims.
It was as dishonest a study of inflation as has ever been published. The government's keeper of all things statistical is the Bureau of Labor Statistics (BLS). Some of the absurdities foisted upon the BLS by the Boskin Commission made it clear that accurately measuring inflation was not remotely their concern.
In reality, the Boskin Commission was formed to lower the reported inflation rate as a backdoor method of reducing the cost of living adjustment (COLA) paid by Social Security and many other government programs, including benefits for veterans and their dependents. These payments are linked to CPI inflation.
Rather than accurately measuring inflation, the commission's apparent goal was to avoid bankrupting the U.S. Treasury. Unfunded entitlement programs (Medicaid, Social Security, and now Medicare Prescription Drug Plans) have been the so-called third rail of American politics—and lacking the will or courage to deal with them directly, politicians of both parities simply kicked the can down the road for future policymakers to deal with (or not).
The Boskin study was an exercise in tortured logic that is itself worthy of another book—try Kevin Phillips'
Bad Money
(Viking, 2008). If the CPI was overstated by 1.1 percent annually for 10 years starting in 1996, the Congressional Budget Office estimated the error would add about $148 billion to the federal deficit in 2006 and $691 billion to the national debt.
2

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