This week Bruce is joined by Robert England. Robert is a journalist and author who has written extensively on mortgage finance, banking, retirement policy, and the financial and economic impact of aging population. His most recent work is Black Box Casino: How Wall Street’s Risky Shadow Banking Crashed Global Finance. Previous works include Aging China: The Demographic Challenge to China’s Economic Prospects. Robert is also a senior writer for Mortgage Banker Magazine.
Bruce said he really appreciated his Black Box Casino book and was familiar with the overall story. There are a lot of insider terms where when you are in Wall Street and you watch Squawk Box, they use the terms as if the world knows what they mean when they don’t. One thing his book really did that was very helpful was every time he had one of these words to use, he took time to explain what it means. Robert said he did this after a copy editor was reviewing his work that had a general but no financial background, so she kept saying she did not know what something meant. Since she did not understand what words meant, then Robert decided that he needed to define the term. Bruce said it was really helpful because there are some things you hear and you just pretend you know, but then you realize when you have to explain it to somebody that you really don’t know what it means.
The book talks about events as they unfolded in 2007 and 2008, yet Robert had just written the book in 2011. The reason for the long gap of time was it took a while for him to find a publisher who was interested and also to obtain a book contract. This was part of the reason. Another reason was information came out later on that was more helpful than what was available immediately after the crisis. This included a lot of research that was dug up by the financial crisis. Bruce wondered if as time passed people were more apt to say what really went on because there was a safety of distance between the events. Robert said this was probably true for some sources in the book; but for other sources they clammed up because whatever they had been involved with was being embroiled in lawsuits, so they did not really want to talk.
The name Black Box Casino is a concept that describes the change that was occurring in the global financial system. First, there was the increasing prevalence of black boxes within the system, which are financial instruments and institutions that have no transparency; you can’t see what is going on inside and therefore they are black boxes. The casino part of the title comes from learning that much of the activity that went on in a number of the black boxes was in fact speculation, even wild speculation.
Bruce said when we used to think of Fannie and Freddie; we used to think of the safest possible loan pool with a mandate to keep safety as first priority. Bruce wondered how wrong this perception is, to which Robert said this is completely 180 degrees from the reality that was going on at Fannie and Freddie. The way the regulation was set up to govern Fannie and Freddie did not guarantee that they would be operated in a safe and sound manner, and it may in fact have encouraged them to do the opposite.
Bruce wondered if the title of GSE (Government Sponsored Enterprises) came with benefits. Robert said it does because the government is sponsoring what you do, yet you are a private corporation that has shares that are publicly traded and that benefit the executives of the company if they can use the public mission of the corporation to increase revenues and profits for themselves. It is a hybrid form of a business that comes with a lot of problems and can reap a lot of damage if things get out of hand.
Bruce also wondered if the political club had considerable political clout. Robert said they did because both Fannie Mae and Freddie Mac had a considerable amount of clout in the beginning before the regulations were set up to govern them. Once the regulations were put in place, there were a number of provisions in the regulations and the statutes that gave them a lot of power. For one thing, they were allowed to lobby and also got involved with making campaign contributions. Even though they were government-sponsored enterprises, logically they should not have been allowed to lobby the government. What happened was by giving them the authority to lobby, or more specifically not prohibiting it, it allowed them to make contributions, influence Congress, and give politicians a way to provide benefits to constituents without having to go through the budgeting process since everything going on at Fannie and Freddie was not involving the budget. Even their regulator was given minimal powers to regulate them, keep them in line; and this in turn gave them more clout. The regulator did not have a source of income from fees, which is usually what the banking regulators have. Instead, they had to go to Congress every year and get funding for their activities; so they were hamstrung by the ways that the law was set up.
This law was the 1992 Federal Housing Enterprise Financial Safety and Soundness Act, which was a very important law but that unfortunately did not live up to its billing. It was supposed to have been set up for safety and soundness, but once Congress got a hold of the original idea and began devising a bill, it was really put together in a way that would benefit politicians the most as it would give them a way to constantly provide a benefit to a constituency, and that benefit would constantly rise over time. There was no way to restrain the lowering of lending standards, which would be required to increase the level of lending to designated populations.
The law contained federal affordable housing provisions, which was a kind of coup for the politicians. Bruce was shocked that they had a mandate they had to loan to low-to-moderate income people a certain percentage of their loans. When the GSE Act was being put together, at that point both Fannie Mae and Freddie Mac had informal goals in place where approximately 30% of their business would be acquiring loans that went to borrowers who were low or moderate income borrowers. That reflected on natural market share or an entity in their position that would not distort the market. The crafters of the legislation wanted to give HUD the right to raise the affordable housing goals that were put into law and to do them on a periodic basis along with constantly raising them without any consideration to whether or not it would impair the safety and soundness of Fannie and Freddie.
What is interesting about all of this is the legislation really came on just after the SNL crisis, so you would think that everyone would be in the mood to create something that was safe and sound. Robert believes everyone was in the mood, but no one was paying attention to what was being done. First of all, the concept that you would now securitize loans would be a predominant way to finance mortgages was thought to be the way they would reduce the potential fallout from a bad period of lending that occurred with the savings and loans, which held their mortgages on their book. When interest rates rose very high, there was a huge mismatch between their assets and liabilities, which did them in. Securitization was supposed to take that risk off the book, but starting with that people thought they had a magic solution. However, they did not put together a regulatory regime that would be capable of assuring the safety and soundness of Fannie and Freddie, from setting up capital standards to allowing them to have investments in portfolio, to not allowing the safety and soundness regulator to raise their capital standards if they deemed that they were inadequate at any point. In addition to having to go to Congress every year for money, the regulator was also not an independent regulator. They were a part of HUD, and they did not have any control over the Affordable Lending Goal and could do nothing about them. HUD did not have to consider safety and soundness when they were considering the goal. There were actually three goals at the time, and the main goal was raised to over 55% by the time of the crisis, so there was a subsequent goal to low income households, which is more narrowly targeted. This had not existed before and began at about 11% and rose to nearly 27% at the time of the crisis.
Bruce wondered how people qualified for the loans, whether they were really subprime or if they were good credit but low income. Robert said over time the lending standards at Fannie and Freddie declined in order to meet the affordable lending goals. As the goals were put in place gradually, they weakened their lending standards. They first lowered the down payment then gradually lowered the FICO score for borrowers to qualify to be part of the Fannie and Freddie program. They then increased the segment of the business that was funding subprime without identifying that publicly. They drastically increased the amount of business funding Alternative A or low to no documentation loans even more without publicly acknowledging it. The legislation that set up Fannie and Freddie did not require them to file quarterly audited statements to the Securities and Exchange Commission, so they could get away with not telling investors the truth about their portfolio. By the time of 2000, they were doing 100% loan-to-value mortgages and were greatly expanding their subprime lending, but it was never identified as that. This was how we ended up this past week with the SEC filing charges against former Fannie and Freddie executives for lying about the amount of subprime and Alt-A in their portfolios and in their investment holdings. They had a black box, and they were wildly at odds with the actual amount they had.
Bruce wondered if a lot of the fulfillment of the lower income goals happened because they were able to invest in mortgage-backed securities that had the loans in them. Robert said it was both through acquiring them and not calling them subprime, and also through buying private label mortgage-backed securities that had loans that met the qualifications and that would meet the goals. Jim Lockhart, the former head of the Federal Housing Finance Agency, told Robert in a recent interview that they could not have met their goals if they had not bought up a lot of the private label mortgage-backed securities. They bought large amounts of it and were the major purchaser of private MBS. Another reason may have been they were able to leverage it more. Their capital standards were very low, so they could leverage the acquisitions and increase their earnings as well as buy extensions, which was the compensation of the top executives. As a lot of people may know, the former heads of Fannie Mae and Freddie Mac were involved in accounting scandals in 2003 and 2004 where they were found to have manipulated the earnings targets to maximize their compensation. Both Franklin Raines and Leeland Brendsel had to leave the two GSEs at the time. You can jut up the amount of securities you purchase to increase your overall compensation and profitability that was at first profitable but later was not. By creating a compensation system that rewarded the executives by increasing volumes, it really drove the GSEs’ top executives to greatly expand their business in order to make more money.
The leverage for a mortgage-backed security that was stated in the books was 222 to 1, and this was for the guarantee. There were two capital rules. The first was the 222 to 1 guarantee, and the second was Fannie and Freddie had to only hold 0.45% of that capital against the guarantee of paying the principle interest to the investors in their securities. If they held any of the securities that they purchased, they only had to hold 2.5% capital against it. By early 2008, the GSEs were leveraged about 100 to 1 overall when you blend the two on standard accounting rules. The accounting rules were another way that Fannie and Freddie were able to get away with what they did. They did not have to meet what were normally considered bank accounting rules but could use generally accepted accounting principles, which allowed them to use some types of securities and assets to count as their capital when other people did not. This included losses that could be claimed against future taxes. When you are losing money constantly, there is no gain to apply the losses against.
The intended consequences of lowering lending standards was to increase homeownership rates among lower-income and moderate-income households. The homeownership rate was around 64-65% at the time that the GSE Act was passed, and they were hoping to raise it dramatically so that particularly minorities would have homeownership rates similar to those of whites. There was a disparity between both African-Americans and whites and Hispanics and whites in terms of the percentage of the population that owned a home. Although the homeownership rates were about 45%-50% range, they were better than a lot of people might have thought. However, they were not in the mid to high 60s. There was legislation in the 70s that tried to correct those things. This included the Home Mortgage Disclosure Act of 1975 that required the banks to collect data on which the person was that was the borrower as far as race. There was also the Community Reinvestment Act of 1977 against Red Lining.
When you are a lender, there are areas where you are not trying to be prejudice but you realize that an appraiser could literally get shot. Bruce is in the hard money business, and they get asked to go to certain areas to do loans; and all those things come into play that you are actually in danger. With Red Lining, the intent was not to have a prejudice outcome, which is just and fair; but you have to ask if it also takes away the ability to say no because you know it is not going to have a good outcome. The effect of all the various laws, provisions, and actions by regulators led banks and lenders to increasingly divorce the decision on whether or not to get the mortgage from hard realities of what lending is all about. At some point, in order to meet their Community Reinvestment Act targets, banks made loans they knew were going to be bad because they thought they had to do it to stay in business. The CRE Act originally required banks to make efforts to reach targeted populations but did not require that specific results be achieved. The Clinton Administration reinterpreted that law and rewrote the regulation regarding it in the mid-1990s and said that they actually had to show results. The Federal Reserve began to reject applications for mergers and opening branches to banks that did not have the Homeowner Disclosure Act data that was collected on lending by race, gender, and income. These steps taken by regulators had the effect of forcing banks to make bad loans. A common criticism against people who make claims that the CRE Act has an impact on lending is that it was passed in 1997 and the crisis was in the 2000s. The whole process was very gradual, and the idea of forcing banks to do lending against solid lending principles came into play in the mid 1990s. As each merger was made and came about in the years following 1995, the banks had to make a commitment to do a certain amount of CRE lending. By 2007, they had made commitments of over $4 trillion. If you go back to the mid 1990s, the CRE lending might be $50 billion inconsequential. In the end, it was trillions of dollars that the commitment had to be made.
There is a quote that states, “The GSE Act became the vehicle for putting forth the philosophical view that housing is the civil right,” which basically states that people are entitled to own a house. Major provisions of the act was written by a group of housing advocates and activists under an informal deputization by Henry Gonzales, who was the Chairman of the House Financial Services Committee in the early 1990s. These housing activists’ attorneys got together and crafted this language to achieve the goals and make housing more of a right and to impose that idea on lending. These are the same groups that are pointing out the loan programs and saying they were unfairly skewed to people of color and lesser income. They are now rewriting history and saying that lenders deliberately went out of the way to make bad loans, and therefore they are to blame instead of the rules, regulations, and laws. Because they were seemingly able to hide in the black box, not many people really understood the mandate underneath the covers that it was something Fannie and Freddie had to do. There was not much exposure to what was being proposed and put into law in the early 1990s. A lot of people thought it was just guaranteeing everyone equal access to credit and not steering it.
Tune in next week as Bruce and Robert England continue their discussion on the black box and real estate market
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