Mr. Bush did foresee the danger posed by Fannie Mae and Freddie Mac, the government-sponsored mortgage finance giants. The president spent years pushing a recalcitrant Congress to toughen regulation of the companies, but was unwilling to compromise when his former Treasury secretary wanted to cut a deal. And the regulator Mr. Bush chose to oversee them — an old prep school buddy — pronounced the companies sound even as they headed toward insolvency.
President Hosts Conference on Minority Homeownership George Washington University Washington, D.C.
1:55 P.M. EDT
THE PRESIDENT: Thank you, all. Thanks, for coming. Well, thanks for the warm welcome. Thank you for being here today. I appreciate your attendance to this very important conference. You see, we want everybody in America to own their own home. That's what we want. This is -- an ownership society is a compassionate society.
More and more people own their homes in America today. Two-thirds of all Americans own their homes, yet we have a problem here in America because few than half of the Hispanics and half the African Americans own the home. That's a homeownership gap. It's a -- it's a gap that we've got to work together to close for the good of our country, for the sake of a more hopeful future. We've got to work to knock down the barriers that have created a homeownership gap.
I set an ambitious goal. It's one that I believe we can achieve. It's a clear goal, that by the end of this decade we'll increase the number of minority homeowners by at least 5.5 million families. (Applause.)
Some may think that's a stretch. I don't think it is. I think it is realistic. I know we're going to have to work together to achieve it. But when we do our communities will be stronger and so will our economy. Achieving the goal is going to require some good policies out of Washington. And it's going to require a strong commitment from those of you involved in the housing industry.
Just by showing up at the conference, you show your commitment. And together, together we will work over the next decade to enable millions of our fellow Americans to own a piece of their own property, and that's their home.
I appreciate so very much the home owners who are with us today, the Arias family, newly arrived from Peru. They live in Baltimore. Thanks to the Association of Real Estate Brokers, the help of some good folks in Baltimore, they figured out how to purchase their own home. Imagine to be coming to our country without a home, with a simple dream. And now they're on stage here at this conference being one of the new home owners in the greatest land on the face of the Earth. I appreciate the Arias family coming. (Applause.)
We've got the Horton family from Little Rock, Arkansas, here today. Actually, it's not Little Rock; it's North Little Rock, Arkansas. I was corrected. (Laughter.) I appreciate so very much these good folks coming all the way up from the South. They were helped by HUD, they were helped by Freddie Mac. Obviously, they've got a young family. And when we start talking about owning a home, a smile spread right across the face of the dad that could have lit up the entire town of Washington, D.C. (Applause.) I appreciate you all coming. Thanks for coming. He had to make sure I knew that he was educated in Texas. (Laughter.)
Finally, Kim Berry from New York is here. She's a single mom. You're not going to believe this, but her son is 18 years old. (Laughter.) She barely looked like she was 18 to me. And being a single mom is the hardest job in America. And the idea of this fine American working hard to provide for her child, at the same time working hard to realize her dream, which is owning a home on Long Island, is really a special tribute to the character of this particular person and to the character of a lot of Americans. So we're honored to have you here, Kim, and thanks for being such a good mom and a fine American. (Applause.)
I told Mel Martinez I was serious about this initiative. We started talking about it and I said, well, you know, I'm the kind of fellow, I don't like to lay out a goal and don't mean it. I think it's not -- I don't think it's fair for the American people to be -- to have a President or anybody else, for that matter, lay out a goal and just kind of say it, but don't mean it. I mean it. And the good news is, Mel Martinez believes it and means it, as well. He's doing a fine job of running HUD, and I'm glad he has joined my Cabinet. (Applause.)
And I picked a pretty spunky deputy, as well, Alphonso Jackson -- my fellow Texan. (Applause.) I call him A.J.
I appreciate the Secretary of Agriculture being here. She's got a lot of money having to do with rural housing. I appreciate Ann's commitment to rural America. And I'm really proud of the job she's doing, as well, for the American people, serving in my Cabinet. Thanks for coming, Ann. (Applause.)
I've got some others in my administration, as I look around. I see Rosario Marin, who's the Treasurer of the United States. Rosario used to be a mayor. Thank you for coming, Madam Mayor. (Applause.) She understands how important housing is. I see other mayors around here, and I want to thank the mayors for coming. After all, it's in your interest that this project succeed.
I know we've got some folks from the faith-based community here. Luis Cortes, from Philadelphia is here; and my friend, Kirbyjon Caldwell, from Houston, Texas. Kirbyjon, I had breakfast with him this morning. He told me he was going to have to leave before my speech. He's a wise man, that Kirbyjon Caldwell. (Laughter.) But he has gone back home to Texas. I appreciate Margaret Spellings and her staff. Margaret is the Domestic Policy Advisor to the President, and I want to thank you for putting on this conference, Margaret.
All of us here in America should believe, and I think we do, that we should be, as I mentioned, a nation of owners. Owning something is freedom, as far as I'm concerned. It's part of a free society. And ownership of a home helps bring stability to neighborhoods. You own your home in a neighborhood, you have more interest in how your neighborhood feels, looks, whether it's safe or not. It brings pride to people, it's a part of an asset-based to society. It helps people build up their own individual portfolio, provides an opportunity, if need be, for a mom or a dad to leave something to their child. It's a part of -- it's of being a -- it's a part of -- an important part of America.
Homeownership is also an important part of our economic vitality. If -- when we meet this project, this goal, according to our Secretary of Housing and Urban Development, we will have added an additional $256 billion to the economy by encouraging 5.5 million new home owners in America; the activity -- the economic activity stimulated with the additional purchasers, the additional buyers, the additional demand will be upwards of $256 billion. And that's important because it will help people find work.
Low interest rates, low inflation are very important foundations for economic growth. The idea of encouraging new homeownership and the money that will be circulated as a result of people purchasing homes will mean people are more likely to find a job in America. This project not only is good for the soul of the country, it's good for the pocketbook of the country, as well.
To open up the doors of homeownership there are some barriers, and I want to talk about four that need to be overcome. First, down payments. A lot of folks can't make a down payment. They may be qualified. They may desire to buy a home, but they don't have the money to make a down payment. I think if you were to talk to a lot of families that are desirous to have a home, they would tell you that the down payment is the hurdle that they can't cross. And one way to address that is to have the federal government participate.
And so we've called upon Congress to set up what's called the American Dream Down Payment Fund, which will provide financial grants to local governments to help first-time home buyers who qualify to make the down payment on their home. If a down payment is a problem, there's a way we can address that. And when Congress funds the program, this should help 200,000 new families over the next five years become first-time home buyers.
Secondly, affordable housing is a problem in many neighborhoods, particularly inner-city neighborhoods. You may -- we may have qualified home buyers, but if there's no home to buy, this initiative isn't going anywhere. And so one of the things that we're going to -- that I'm doing is proposing a single-family affordable housing credit to encourage the construction of single-family homes in neighborhoods where affordable housing is scarce. (Applause.)
Over the next five years the initiative will provide home builders and therefore home buyers with -- home builders with $2 billion in tax credits to bring affordable homes and therefore provide an additional supply for home buyers. It's really important for us to understand that we can provide incentive for people to build homes where there's a lack of affordable housing.
And we've got to set priorities. And one of the key priorities is going to be inner-city America. Good schools and affordable housing will help revitalize our inner cities.
Another obstacle to minority homeownership is the lack of information. You know, getting into your own home can be complicated. It can be a difficult process. I had that very same problem. (Laughter and applause.)
Every home buyer has responsibilities and rights that need to be understood clearly. And yet, when you look at some of the contracts, there's a lot of small print. And you can imagine somebody newly arrived from Peru looking at all that print, and saying, I'm not sure I can possibly understand that. Why do I want to buy a home? There's an educational process that needs to go on, not only to explain the contract, explain obligation, but also to explain financing options, to help people understand the complexities of a homeownership market, and also at the same time to protect people from unscrupulous lenders, people who would take advantage of a good-hearted soul who is trying to realize their dream.
Homeownership education is critical. And so today, I'm pleased to announce that through Mel's office, we're going to distribute $35 million in 2003 to more than 100 national, state and local organizations that promote homeownership through buyer education. (Applause.)
And, of course, one of the larger obstacles to minority homeownership is financing, is the ability to have their dream financed. Right now, we have a program that all of you are familiar with, maybe our fellow Americans are, and that's what they call a Section 8 housing program, that provides billions of dollars in vouchers to help low-income Americans with their rent. It encourages leasing. We think it's important that we use those vouchers, that federal money to help low-income Americans go from being somebody who leases to somebody who owns; that we use the Section 8 program to not only help with down payment, but to help with continuing monthly mortgage payments after they're into their new home. It is a -- it is a way to help us meet this dream of 5.5 million additional families owning their home.
I'm also going to encourage the lending industry to develop a mortgage market so that this script, these vouchers, can regularly be used as a source of payment to provide more capital to lenders, who can then help more families move from rental housing into houses of their own.
These are some of the barriers that home owners face, potential home owners face, and this is what we intend to do about it. But like in a lot of our life, government can't do everything. It's impossible to provide every aspect of a national strategy, particularly in this case. And that's why we need the help of private and nonprofit sectors in our country to help play a vital role in helping to meet the goal. Many of you here represent the nonprofit, as well as the private sectors of our economy and our country, and I want to thank you for your commitment.
Last June, I issued a challenge to everyone involved in the housing industry to help increase the number of minority families to be home owners. And what I'm talking about, I'm talking about your bankers and your brokers and developers, as well as members of faith-based community and community programs. And the response to the home owners challenge has been very strong and very gratifying. Twenty-two public and private partners have signed up to help meet our national goal. Partners in the mortgage finance industry are encouraging homeownership by purchasing more loans made by banks to African Americans, Hispanics and other minorities.
Representatives of the real estate and homebuilding industries, through their nationwide networks or affiliates, are committed to broadening homeownership. They made the commitment to help meet the national goal we set.
Freddie Mae -- Fannie Mae and Freddie Mac -- I see the heads who are here; I want to thank you all for coming -- (laughter) -- have committed to provide more money for lenders. They've committed to help meet the shortage of capital available for minority home buyers.
Fannie Mae recently announced a $50 million program to develop 600 homes for the Cherokee Nation in Oklahoma. Franklin, I appreciate that commitment. They also announced $12.7 million investment in a condominium project in Harlem. It's the beginnings of a series of initiatives to help meet the goal of 5.5 million families. Franklin told me at the meeting where we kicked this office, he said, I promise you we will help, and he has, like many others in this room have done.
Freddie Mac recently began 25 initiatives around the country to dismantle barriers and create greater opportunities for homeownership. One of the programs is designed to help deserving families who have bad credit histories to qualify for homeownership loans. Freddie Mac is also working with the Department of Defense to promote construction and financing for housing for men and women in the military.
There's all kinds of ways that we can work together to meet the goal. Corporate America has a responsibility to work to make America a compassionate place. Corporate America has responded. As an example -- only one of many examples -- the good folks at Sears and Roebuck have responded by making a five-year, $100 million commitment to making homeownership and home maintenance possible for millions of Americans.
There have been other steps that are being taken to close the homeownership gap. And you've heard some of the stories here today, people much more eloquent than me, to talk about what's taking place on the front line of meeting this national goal.
The non-profit groups are bringing homeownership to some of our most troubled communities. And as you know, I'm a strong advocate of what I call the faith-based initiative. And the reason I am is because I understand the universal call to love a neighbor like you'd like to be loved yourself, and that includes helping somebody find a home.
One such example is the Enterprise Foundation, a national non-profit organization that provides assistance to grassroots homeownership organizations. Because of their work, as one example, 185 affordable homes will be available in the Baltimore neighborhood that was once so crime-ridden that people had written it off. Revitalizing neighborhoods is a real possibility if people put their mind to it. And at the same time, you're helping people own a home in America.
And the faith-based community is doing some fantastic work when it comes to encouraging homeownership, whether it be financial counseling, or job training or other outreach services, to help people understand what it takes to buy a home.
And then there's my friend Kirbyjon Caldwell. He not only provides counseling and job training, he actually decided to encourage a development of homes in the Houston area. People -- low-income people are going to be able to more afford a home in Texas because of Kirbyjon's vision and work. He's answered the call of faith to help people help themselves and to help them realize dreams.
The other thing Kirbyjon told me, which I really appreciate, is you don't have to have a lousy home for first-time home buyers. If you put your mind to it, the first-time home buyer, the low-income home buyer can have just as nice a house as anybody else. And I know Kirbyjon. He is what I call a social entrepreneur who is using his platform as a Methodist preacher to improve the neighborhood and the community in which he lives.
And so is Luis Cortes, who represents Nueva Esperanza in Philadelphia. I went to see Luis in the inner-city Philadelphia. Luis is -- at least he was -- he's probably still there -- in what one would call a tough neighborhood. There's a lot of abandoned buildings. And I mean, beautiful old structures just empty. Luis had a dream to revitalize his neighborhood, starting with a good charter school, one that would work, one that would teach kids how to read and write and add and subtract.
But he also understood that a homeownership program is incredibly important to revitalize this neighborhood that a lot of folks had already quit on. I suspect one day we'll all go back to Luis' neighborhood and we'll find first-time home owners there, and a good education system. And this will be the beginning of a -- of a neighborhood revitalization in that part of Philadelphia, because there was vision and drive and hope for our fellow citizens.
So I want to thank you all for coming. I want to thank you for your determination to help close the minority homeownership gap. It's an incredibly important initiative for this country. See, America is a good and generous country. It's a great place. Part of it was to make sure that the dream, the American Dream, the ability to come from anywhere in our society and say, I own this home, is a reality -- can be achievable for anybody, regardless of their status, regardless of their -- of whether or not they -- whether or not they think the dream is meant for them.
I mean, we can put light where there's darkness, and hope where there's despondency in this country. And part of it is working together as a nation to encourage folks to own their own home.
Again, I want to tell you, this is an initiative -- as Mel will tell you, it's an initiative that we take very seriously. We're going to stay on it until we're -- until we achieve the goal. And as we all achieve the goal, we can look back and say, America is a better place for our hard work, our efforts and our desires for our fellow Americans to realize the greatness of our country.
Thank you for coming. May God bless your vision. May God bless America. (Applause.)
In Their Own Words: Anatomy Of A Meltdown (SLIDESHOW)
December 22, 2008 09:26 AM
Al Hubbard, economic adviser to President Bush: "There is no question we did not recognize the severity of the problem."
Former Treasury Secretary John W. Snow, on the housing push that went too far: "What we forgot in the process was that it has to be done in the context of people being able to afford their house. We now realize there was a high cost.”
Lawrence B. Lindsay, economic adviser to President Bush: "No one wanted to stop that bubble."
Treasury Secretary Henry Paulson: "There was no playbook for responding to a once or twice in a hundred year event."
Roy Cooper, Attorney General of North Carolina, on the administration’s push to block states’ efforts to use consumer protection laws to crack down on predatory lending: "They took 50 sheriffs off the beat at a time when lending was becoming the Wild West."
Andrew H. Card, Bush’s former chief of staff, on the decision to approve a predatory lender as ambassador to the Netherlands: "Maybe I was asleep at the switch."
President Bush: "It turns out this isn’t one of the presidencies where you ride off into the sunset , you know, kind of waving goodbye."
“We could well have seen someone file suit years ago over these derivatives, but nobody could [today] because the hurdles are so high and the risks so great.” - Jonathan Alpert Photo by Steven P. Widoff
“One of the early causes of today’s problems was the deregulatory ripple that started in the Reagan administration. That included the appointment of people who didn’t believe in regulation.” - Meyer "Mike" Eisenberg Photo by Max Taylor
“The fact that a lot of executives bet their companies, like at Lehman, on the proposition that real estate prices will always go up, seems to indicate a governance failure, and I’m not sure how we fix that.” - Larry Ribstein Photo by iStockPhoto.com
And how they might have prevented it
January 2009 Issue By Terry Carter
In the game of blame that followed the deepest financial implosion since the Great Depression, bankers and money managers have borne their share of attention. But how much blame should lawyers bear? Plenty.
As legislators, they helped remove restrictions on commercial banks that allowed them to get involved with subprime mortgage-backed securities.
As regulators, they allowed leverage at investment banks to increase largely unchecked. As judges, they made it harder for shareholders to bring suits to stop the financial shenanigans.
As counsel, their legal opinions gave sanction to deals that, in the words of the analysts behind them, “could have been structured by cows.”
There were also lawyers who did their jobs, only to find their voices lost in torrents of money, rationalization or plainspoken hostility toward the rule of regulation.
Lawyers will have their say in the recovery. There will be lawyers aplenty to prosecute the culpable, rescue the bankrupt and reconfigure legislation that will attempt—yet again—to stimulate profits while throttling pure greed.
And there is another class of lawyers—the plaintiffs attorneys—who believe that their practice specialty would have provided a safety net of sorts for regulators whose hands were tied by Congress, or for investors who tagged innocently behind what they believed was due diligence, only to find that a whole global marketplace had been built on unsupportable loans.
“We could well have seen someone file suit years ago over these derivatives, but nobody could [today] because the hurdles are so high and the risks so great,” says Jonathan Alpert, a semiretired securities lawyer from Tampa, Fla.
Deregulation meant looser laws and even looser enforcement, they argue, and the credible threat of lawsuits might have helped derail the popularity of the credit risk marketplace—or, at least, expose the frailty of the assets on which it was based.
In recent years, the legal and political tide has turned against the use of the courts as a backdoor regulator of questionable lending practices, faulty consumer products or even the safety of food and drugs.
Could lawsuits have helped us avoid the massive credit meltdown? Did tort reform go too far? Regulators and plaintiffs lawyers are certain the questions are worth debating. Even defenders of tort reform are split on the value of their own success: some questioning whether the pendulum swung too far to endure as public policy and others wondering why the question is even being asked.
OF BOOM AND BUST
At the core of any debate about what went wrong is the issue of deregulation—a matter of economic philosophy often in conflict with the law.
“One of the early causes of today’s problems was the deregulatory ripple that started in the Reagan administration,” says Meyer “Mike” Eisenberg, who held two high-level jobs in the Securities and Exchange Commission over a span of almost 40 years, and now lectures at Columbia Law School in New York City. “That included the appointment of people who didn’t believe in regulation.”
Introduced in the early 1980s, the role of deregulation was quickly tested in the financial markets by the plight of savings and loans. Because of high interest rates in the late 1970s and early 1980s, the so-called thrift banks were struggling to make profits from low-interest, long-term home loans based on money gathered from regulated passbook savings accounts, as well as money borrowed from the Federal Reserve.
All that changed in 1982 with the enactment of the Garn-St. Germain Depository Institutions Act. Thrifts were suddenly free to act more like banks: making commercial loans, issuing credit cards and getting involved in real estate investments far more risky and complex than traditional 30-year mortgages.
The problem proved twofold: By being allowed to take substantial upfront profits just by approving the loans, thrifts lost their incentive to vet the deals accordingly; and though their lending powers had been made similar to those of banks, they had no comparable level of oversight. Examiners accustomed to approving title insurance and fair housing practices were suddenly required to evaluate multimillion-dollar commercial loans for shopping centers, office buildings and casinos.
Short-term profits, however, became long-term headaches, as thrifts and their borrowers used federally insured deposits for troubled—even fraudulent—financial instruments and real estate projects. During the mid-1980s through the early 1990s, 747 thrifts failed. Funded mostly by federal taxpayers, the bailout cost more than $160 billion, a figure that seems almost quaint by current standards.
As the thrift scandal unfolded, names emerged as celebrity symbols of the untethered greed that had driven it. Perhaps best known were Ivan Boesky and Michael Milken, who made high art of insider trading: Boesky in corporate takeovers, Milken with junk-level bonds.
“Those were not systemic, however,” says Eisenberg. “It was far-reaching and very dramatic, but they just went too far too fast and screwed a lot of people. There wasn’t a need for new legislation or regulation.”
Banking institutions eventually absorbed the savings and loan system. But as they began to compete for business with investment banks and brokerages, chartered banks demanded a larger view of their fundamental services. And the answer was, once again: deregulation.
The Gramm-Leach-Bliley Act of 1999 repealed the Glass-Steagall Act, which had been passed in 1933 in reaction to bank failures triggered by the Great Depression. The new regulatory structure permitted commercial banks many of the same powers as brokerages and investment bankers. Banks and their holding companies—leaving home loan due diligence to largely unregulated brokers—concentrated on mergers and acquisitions, retail brokering, and the underwriting of securities based on subprime loans and collateralized debt obligations.
The sheer scale of these subprime deals led to larger and larger packages (and larger and larger fees and commissions), which in turn led to even less incentive to scrutinize the underlying loans and assets on which these packages were based.
In 1997, Brooksley Born, a former Arnold & Porter partner who chaired the Commodity Futures Trading Commission, asked for public comment on a proposal to force more transparency and nominal supervision over derivative markets. Testifying before Congress, she expressed concern that if left unregulated, derivatives could become a threat to “our regulated markets or, indeed, to our economy without any federal agency knowing about it.”
Treasury Secretary Robert Rubin and Federal Reserve Chairman Alan Greenspan were fiercely opposed. Disclosure of the increasingly complicated derivative trades, they feared, would lead to a demand for increases in capital reserves against potential losses. And stricter regulation would drive the highly profitable derivative markets overseas.
Born, unfazed by increasingly scathing criticism, pressed forward with the CFTC derivative proposal. By June 1998, Greenspan and Rubin had taken their complaint to Congress, urging it to intervene. Congress obliged in late 1998 with a six-month moratorium on any action on derivatives to be taken by the CFTC.
After Born resigned as CFTC chair in 1999, Greenspan and Rubin asked Congress to make permanent their ban on CFTC supervision of derivatives. Without Born’s persistence behind it, the proposal simply died.
Born retired from Arnold & Porter, and she has refused all comment about the recent credit crisis.
A TAILORED RULE
When the derivative markets did become regulated, it was in a rule finalized by the SEC in 2004 that many believe may have supersized subprime losses from problematic to catastrophic.
The rule has one of those names that is salve for insomniacs: Alternative Net Capital Requirements for Broker-Dealers That Are Part of Consolidated Supervised Entities. Significantly, the rule resulted from a request for regulation by five of the meltdown’s largest losers: Goldman Sachs, Morgan Stanley, Merrill Lynch, Lehman Brothers and Bear Stearns.
To repeat: They asked to be regulated.
Well, sort of.
The rule was tailored in such a way that it pertained only to those who had requested it. And it came in response to a 2002 decision by the European Union to regulate subsidiaries of foreign investment banks—particularly those from the U.S.—out of concern about financial scandals. There was, however, a loophole: Foreign entities would be exempt from the EU’s rules if they had equivalent oversight in their own countries. In order to avoid EU oversight, the five investment houses asked that the SEC begin to regulate them—if in name only.
Essentially, the SEC let the financial concerns regulate themselves, under the scrutiny of SEC staffers assigned to each company. That allowed investment bankers and bank holding companies to greatly expand their debt-to-capital ratio requirement. The resulting growth proved disastrous.
As a leading expert in securities regulation, John C. Coffee, a professor at Columbia Law School, is blunt: “The staffers were probably junior lawyers up against dozens of quantitative Ph.D.s from MIT working the computer models, and it was a mismatch from day one. It was not a level playing field.”
Sure enough, the investment companies didn’t just go beyond the usual limit of 15-to-1 debt ratio; they more than doubled it. The computer models, however, reflected less leverage, a practice greatly discredited in the scandal that followed the failure of Enron.
“Increasing leverage is the best way to increase profitability,” says Coffee. “Unless you fail.”
And fail they did. Spectacularly.
Last year the government forced Bear Stearns to merge with JPMorgan Chase; Lehman went into bankruptcy; Bank of America acquired Merrill Lynch; Morgan Stanley and Goldman Sachs morphed into what amounts to another species as a bank holding company, and now are regulated by the Federal Reserve.
THE RULE OF RISK
Why take such risks? coffee says it is because executive compensation is equity-based with stock options and similar incentives. Thus they are more likely to “make decisions based on short-term stock-price reactions. If you made them hold on to stock options until two years after leaving the company, they’d have a very different view.”
Whatever the reason, risk ruled.
Last September the SEC’s inspector general released a report saying the agency had failed to sufficiently monitor Bear Stearns, which had collapsed six months earlier. The agency’s chairman, Christopher Cox, issued a statement saying the consolidated supervised entity program was being shut down. It had become, he said, “abundantly clear that voluntary regulation does not work.”
Critics say that regulation and enforcement were curtailed during Cox’s tenure, which began in 2005, when corporations were fuming about the strictures of the Sarbanes-Oxley Act. Passed in 2002—after a spate of accounting scandals at Enron, Adelphia, Tyco International and WorldCom—the Public Company Accounting Reform and Investor Protection Act sought to renew transparency in publicly traded companies.
But publicly traded firms began to argue that renewed transparency made strict regulation by the SEC unnecessary. Given the proper information, they argued, the market could punish wrongdoers on its own.
The SEC under Cox reduced fines and penalties dramatically. Last January, the Morgan Lewis law firm issued an analysis saying the SEC had reduced penalties by “a staggering degree.” They dropped from $1.5 billion in 2005 to $507 million in 2007.
According to the law firm’s analysis, “the numbers suggest a philosophical shift by the Cox commission in what constitutes an appropriate penalty.” Whether part of a philosophical shift or not, the agency pursued fewer big fish during Cox’s tenure and went after smaller operations, such as Ponzi schemes.
Cox has responded to such criticism, saying it resulted from a change in the kinds of cases brought to the agency’s attention after the big accounting scandals were dealt with.
Whether transparency was inadequate or laws were ineffective or regulators were simply failing to regulate, plaintiffs lawyers say they were marginalized from every direction—to the point that a lot of them simply disappeared.
LAWSUIT TO PUBLIC POLICY
Tampa lawyer Alpert had grown his law firm to a dozen or so lawyers in the early 1990s, doing some employment law and insurance defense work. He sued the Tampa Bay Buccaneers on behalf of season ticketholders and the Rays baseball team to get use of Tropicana Field for an annual festival honoring Martin Luther King Jr.
In 1993, he brought a class action against what was then NationsBank, saying it sold uninsured securities to customers who were led to believe they were FDIC- insured.
“It was complex as the dickens,” Alpert says.
The class action was in some way related to the changes in the banking system that took place in 1987 when the Federal Reserve removed restrictions on federally chartered banks, allowing them to deal in some securities.
Fed Chairman Paul Volcker had voted against the measure that passed 3-2, arguing that the banks might drastically lower standards and cause problems. Volcker resigned a few months later and was replaced by Alan Greenspan, who had always favored innovation in financial markets.
Alpert’s lead clients included a tollbooth operator and a retired military policeman. They charged that NationsBank, like many other banks, had sold securities such as mutual funds in their lobbies—often to older and more vulnerable customers who were led to believe the investments were FDIC-insured when they actually were not.
Alpert filed a class action in Tampa federal court. Eventually, the bank settled for $60 million: 100 cents on the dollar for the plaintiffs, which was on top of Alpert’s fees.
There were a spate of similar cases around the country against other banks. And by 1998 the self-regulating National Association of Securities Dealers adopted a rule requiring prominent disclaimers on bank products not federally insured—a standard subsequently adopted by the Federal Reserve, the FDIC and the Office of the Comptroller of the Currency. The lawsuits, Alpert says, had actually influenced policy.
But in 1995, a Republican-controlled Congress passed the Private Securities Litigation Reform Act, which was designed to raise the bar on plaintiffs and lawsuits like Alpert’s.
The PSLRA required that the lead plaintiff in a class action have the largest loss, replaced joint and several liability with proportionate liability, and offered safe harbor for forward-looking statements. The act also restricted discovery until after a complaint survives a motion to dismiss.
In effect, the PSLRA restricted lead plaintiffs to institutional investors and their big-firm lawyers.
“Lawyers like me definitely got pushed out of securities litigation by the PSLRA,” says Alpert. “And the individual consumers did, too.”
Only a handful of firms now are handling the bulk of securities class actions, owing in no small way to the tightening brought on by the PSLRA and the subsequent Securities Litigation Uniform Standards Act of 1998 that limits securities class actions to the federal courts.
The PSLRA was intended to thwart what had become a rush to the courthouse by one and all to become lead counsel, which often enough led to suits that were not well thought out.
“The dynamic has changed somewhat,” says Elliott J. Weiss, a professor emeritus at the University of Arizona James E. Rogers College of Law. “I do think the litigation tends to be more merit-driven and client-driven than before.”
Weiss co-authored an article in 1995 that was adapted by Senate committee staffers from galley proofs as the basis for the PSLRA.
Three years ago, Weiss entered the trenches himself after years in academia. He is of counsel to Bernstein Litowitz Berger & Grossmann, one of the handful of firms now handling major securities class actions.
“Right now I’m looking at a response to a motion to dismiss, and my firm spent $150,000 on experts just for work incorporated into an amended complaint,” says Weiss. “That’s different from dashing off boilerplate complaints when a stock price drops. It now takes serious research, private investigators and a lot of energy up front to develop enough facts to survive a motion to dismiss.”
Weiss says he has no idea how many meritorious cases might have been shut out by the PSLRA. “I don’t think a lot of them get thrown out,” he says. “But I’m sure some get chucked.”
Adam C. Pritchard, who teaches securities law at the University of Michigan Law School, says it is wrong to assume that weak cases have been chased out of the system. Big cases brought by institutional plaintiffs with big settlements often follow SEC investigations or earnings restatements and tend to be meritorious, he says.
But the median settlement value is only about $7 million, he explains. “And you cannot defend a securities lawsuit for less than $7 million. If half the settlements are for what looks like less than settlement costs, it gives reason to think a lot of them don’t have substantial merit.”
COURT INTERVENTION
The courts have taken up where Congress left off. For instance, no specific law provided for private litigation over securities regulated by the Securities and Exchange Commis sion until 1964, when the U.S. Supreme Court found an implied right to sue in Case v. Borak. The opinion noted that “private enforcement of the proxy rules provides a necessary supplement to commission action.”
But for the past dozen years, the court has been tightening requirements for such litigation, requiring more and more knowledge of wrongdoing and causation—particularly regarding suits that seek deeper pockets when the primary defendants are asset poor or defunct.
In Central Bank v. First Interstate Bank in 1994, the Supreme Court ruled there was no liability for merely aiding and abetting, but that such liability still would obtain for anyone who “employs a manipulative device or makes a material misstatement (or omission) on which a purchaser or seller of securities relies.”
In 2005, the Supreme Court ruled in Dura Pharmaceuticals v. Broudo that plaintiffs must show a direct link between their economic loss—the value of their securities—and a defendant’s misrepresentations.
Then in 2007 the court continued raising the bar—even for filing a lawsuit. In Tellabs v. Makor, the court said it was not enough to allege facts that might cause a “reasonable person” to infer fraudulent intent. Inferences of wrongdoing must be “cogent, and at least as compelling as any opposing inference of nonfraudulent intent.”
And a year later, the Supreme Court issued what many have called one of the biggest securities-fraud victories for business interests in many years—in effect, shielding lawyers, accountants and bankers as secondary parties in securities litigation.
In Stoneridge Investment Partners v. Scientific-Atlanta, a cable TV provider enlisted two cable-box suppliers to help create sham transactions and backdated documents to inflate its apparent revenues by $17 million so the company would not fall short of Wall Street estimates.
The Supreme Court ruled 5-3 that investors did not show that they relied on that deceptive behavior behind the scenes in deciding to buy stock in the company. Justice Anthony M. Kennedy wrote in the majority opinion that such behavior was not “communicated to the investing public during the relevant times.”
Even within the Bush administration, the case was viewed as highly volatile. In a friend-of-the-court brief prepared by the Justice Department on behalf of the SEC, the agency had sided with Enron investors.
But the brief was never filed. Following a complaint to the White House by Secretary of Treasury Henry Paulson, the solicitor general reversed field and filed a brief for the other side.
“As far as any of us can recollect, and I’ve been around a long time, the White House has never before interfered in a securities case,” says former SEC staffer Eisenberg, who filed an amicus brief favoring the investors on behalf of several former SEC officials.
Stoneridge had immediate impact. Just days after its decision, the court threw out a similar claim of $40 billion by Enron investors against Merrill Lynch & Co. and other firms and banks that made loans to Enron—claiming they had helped the troubled company inflate revenues and hide debt.
KEEPING THE FAITH
There are many who don’t see the Stoneridge decision as an aria by a metabolically challenged diva.
“The door is still cracked open a bit,” says Larry Ribstein, a securities law expert who teaches at the University of Illinois College of Law. “There still are questions about what exactly needs to be proven in terms of lost causation and what allegations are sufficient to prove liability on the part of nondirect participants.”
Coffee suggests that the role of credit agencies in the meltdown might be a good place to start.
“The credit rating agency was the gatekeeper that failed most [in the recent derivatives scandal] and they’ve never been held liable for malpractice, negligence or securities fraud,” Coffee says. “That could change.”
Jonathan Macey, a professor at Yale Law School and noted libertarian scholar on corporate issues, thinks the importance of Stoneridge lies in the eye of the beholder.
“If you’re in the bubble fantasy world of the plaintiffs bar and think there’s social value in bringing suits, then Stoneridge was wrongly decided,” says Macey. “It permitted people who were pretty active participants in an accounting fraud to be let off as defendants.
“But if you say these suits are like kudzu or cancer on corporate America, with massive amounts of costs and no benefits, then Stoneridge cuts away massive amounts of civil suits against extraneous parties.”
Ribstein, however, says he doesn’t think the credit meltdown, at its core, can be solved by either litigation or regulation. “It was a failure of judgment, a failure to recognize the obvious risk,” he says. “The fact that a lot of executives bet their companies, like at Lehman, on the proposition that real estate prices will always go up, seems to indicate a governance failure, and I’m not sure how we fix that.”
Greenspan might well agree. He admitted to Congress that in his own analyses, he had failed to account for human nature. “Those of us who have looked to the self-interest of lending institutions to protect shareholders’ equity—myself especially—are in a state of shocked disbelief.”
Criminal fraud may be the most underreported aspect of our current financial crisis. In this "Road to Ruin" report, former subprime lenders from Ameriquest, once the country's largest lender, describe a system rife with fraud. They describe how a "by-any-means-necessary" policy pushed employees to cut corners and falsify documents on bad mortgages and then sell the toxic assets to Wall Street banks eager to make fast profits.
Banking on the Fed: As Subprime Lending Crisis Unfolded, Watchdog Fed Didn't Bother Barking
The Fed may lose its consumer protection duties to a proposed new agency. Photo Credit: By Brendan Smialowski -- Bloomberg News Photo
By Binyamin Appelbaum Washington Post Staff Writer Sunday, September 27, 2009
The visits had a ritual quality. Three times a year, a coalition of Chicago community groups met with the Federal Reserve and other banking regulators to warn about the growing prevalence of abusive mortgage lending.
They began to present research in 1999 showing that large banking companies including Wells Fargo and Citigroup had created subprime businesses wholly focused on making loans at high interest rates, largely in the black and Hispanic neighborhoods to the south and west of downtown Chicago.
The groups pleaded for regulators to act.
The evidence eventually led Illinois to file suit against Wells Fargo in July for discrimination and other abuses.
But during the years of the housing boom, the pleas failed to move the Fed, the sole federal regulator with authority over the businesses. Under a policy quietly formalized in 1998, the Fed refused to police lenders' compliance with federal laws protecting borrowers, despite repeated urging by consumer advocates across the country and even by other government agencies.
The hands-off policy, which the Fed reversed earlier this month, created a double standard. Banks and their subprime affiliates made loans under the same laws, but only the banks faced regular federal scrutiny. Under the policy, the Fed did not even investigate consumer complaints against the affiliates.
"In the prime market, where we need supervision less, we have lots of it. In the subprime market, where we badly need supervision, a majority of loans are made with very little supervision," former Fed Governor Edward M. Gramlich, a critic of the hands-off policy, wrote in 2007. "It is like a city with a murder law, but no cops on the beat."
Between 2004 and 2007, bank affiliates made more than 1.1 million subprime loans, around 13 percent of the national total, federal data show. Thousands ended in foreclosure, helping to spark the crisis and leaving borrowers and investors to deal with the consequences.
Congress now is weighing whether the Fed should be fired. The Obama administration has proposed shifting consumer protection duties away from the Fed and other banking regulators and into a new watchdog agency. That proposal, a central plank in the administration's plan to overhaul financial regulation, is opposed by the industry and faces a battle on Capitol Hill.
The Federal Reserve is best known as an economic shepherd, responsible for adjusting interest rates to keep prices steady and unemployment low. But since its creation, the Fed has held a second job as a banking regulator, one of four federal agencies responsible for keeping banks healthy and protecting their customers. Congress also authorized the Fed to write consumer protection rules enforced by all the agencies.
During the boom, however, the Fed left those powers largely unused. It imposed few new constraints on mortgage lending and pulled back from enforcing rules that did exist.
The Fed's performance was undercut by several factors, according to documents and more than two dozen interviews with current and former Fed governors and employees, government officials, industry executives and consumer advocates. It was crippled by the doubts of senior officials about the value of regulation, by a tendency to discount anecdotal evidence of problems and by its affinity for the financial industry.
Fed Chairman Ben S. Bernanke testified before Congress this summer that the Fed has protected consumers with renewed vigor in recent years, writing new rules and responding to problems more quickly. The Fed has avoided a public position on the new agency, but Bernanke has testified that Congress instead could choose to strengthen the Fed's responsibilities.
An Industry Rises
Subprime mortgage lending sneaked up on the Federal Reserve.
Most subprime affiliates began life as independent consumer finance companies, beyond the watch of banking regulators. These firms made loans to people whose credit was not good enough to borrow from banks, generally at high interest rates, often just a few thousand dollars for new furniture or medical bills. But by the 1990s, thanks to big changes in laws, markets and lending technology, the companies increasingly were focused on the much more lucrative business of mortgage lending.
As profits soared, hundreds of banking companies took notice, buying or creating finance businesses for themselves. Consumer advocates demanded that regulators take notice, too.
The advocates amassed evidence of abusive practices by lenders, such as Fleet Finance, an affiliate of a New England bank that eventually paid the state of Georgia $115 million to settle allegations that it charged thousands of lower-income black families usurious interest rates and punitive fees on home-equity loans. The National Community Reinvestment Coalition pressed the Fed to investigate allegations against other affiliates.
On Jan. 12, 1998, the Fed demurred. Acting on a recommendation from four Fed staffers including representatives of the Philadelphia, St. Louis and Kansas City regional reserve banks, the Fed's Board of Governors unanimously decided to formalize a long-standing practice, "to not conduct consumer compliance examinations of, nor to investigate consumer complaints regarding, nonbank subsidiaries of bank holding companies."
The Fed could balk because Congress had allowed the laws governing the financial industry to become outdated.
Banks and the companies that own them, known as holding companies, have long operated under federal oversight. But a growing share of loans were made by companies that competed with banks, such as consumer finance firms. The money they gave to borrowers came from Wall Street rather than depositors. As a result, those firms operated beyond the authority of banking regulators, and Congress did not task anyone else with oversight.
The Fed Board decided that even when a nonbank was purchased by a bank holding company, the Fed still lacked authority to police its operations.
Fed staff recommended that it continue to investigate complaints from Congress, which oversees the central bank's performance as an industry regulator. Everything else was passed to the Federal Trade Commission, which has law-enforcement powers but neither the authority nor the resources to oversee the fast-growing industry.
The Fed's hands-off policy was quickly criticized by other parts of the federal government.
A 1999 report by the General Accounting Office warned that the Fed's decision created "a lack of regulatory oversight," because the Fed alone was in a position to supervise the affiliates.
"If the Fed really wants to take action against predatory lending, here is a clear opportunity," John Taylor, president of the National Community Reinvestment Coalition, told Congress after the report was issued.
A 2000 joint report on predatory lending by the Treasury Department and the Department of Housing and Urban Development made a similar recommendation. The report said the Fed clearly had the authority to investigate evidence of abusive lending practices, and urged a policy of targeted examinations.
Even inside the Fed, there was dissent. Gramlich was starting to express concern about predatory lending in his public speeches. He had voted for the hands-off policy in 1998, but by 2000 concluded that the Fed could demonstrate leadership by subjecting the lending affiliates to examinations. "A good defense against predatory lending, perhaps the best defense society has devised, is a careful compliance examination for banks," Gramlich later told a 2004 meeting of bankers in Chicago.
Alan Greenspan, then chairman of the Fed, recalled that Gramlich broached the subject at a private meeting in 2000. Greenspan said that he disagreed with Gramlich, telling him that such inspections would require a vast effort with no certainty of results, and that the Fed's involvement might give borrowers a false sense of security.
Gramlich did not press the issue. Years later, in 2007, after an account of the meeting appeared in newspapers, he sent Greenspan a note that read in part, "What happened was a small incident, and as I think you know, if I had felt that strongly at the time, I would have made a bigger stink."
Unchecked Growth
After the Fed's decision, several of the largest bank holding companies added finance arms, expanding into the regulatory vacuum.
In March 1998, First Union bought the Money Store, a California lender with a ziggurat for a headquarters, ads featuring baseball Hall of Famers Jim Palmer and Phil Rizutto, and a catchy phone number: 1-800-LOAN-YES.
"Thank goodness you can buy all of the things you need with a fixed-rate second mortgage loan," Rizutto told audiences.
In April 1998, Citibank announced a merger with Travelers and its finance arm, which was renamed CitiFinancial. Two years later, Citigroup added the nation's largest consumer finance company, paying $31 billion for Associates First Capital. Both the Justice Department and the FTC were investigating Associates for abusive lending practices, but Citi executives promised reforms. In 2002, the company agreed to pay the FTC a record fine of $215 million to settle allegations that Associates had "engaged in systematic and widespread deceptive and abusive lending practices."
The last of the large finance companies was also snapped up in 2002, as HSBC agreed to pay $14 billion for Household International. The Chicago firm described itself as the nation's oldest finance company and boasted in its corporate history that it pioneered direct-mail loan solicitations in 1896. More recently, it had become the subject of a massive investigation by state attorneys general who charged that it routinely misled borrowers about the true cost of refinance loans. Immediately before announcing its deal with HSBC, Household agreed to pay $484 million to settle those charges.
By 2004, the consumer finance industry had largely been folded into the banking industry, and the finance arms of bank holding companies were making at least 12 percent of all mortgage loans with high interest rates, according to data reported by lenders under the Home Mortgage Disclosure Act.
The rapid growth of subprime lending by affiliates renewed the interest of the GAO, which repeated its call for the Fed to examine affiliates in a 2004 report on shortcomings in federal efforts to combat predatory lending. The report noted the FTC investigations of Fleet Finance and Associates as reasons for concern.
"The significant amount of subprime lending among holding company subsidiaries, combined with recent large settlements in cases involving allegations against such subsidiaries, suggests a need for additional scrutiny and monitoring of these entities," the GAO said.
This time, the GAO suggested that Congress clarify the question of legal authority to address the Fed's concerns.
A response letter signed by Gramlich, who died in 2007, said the Fed had all the authority it needed if it wanted to act. "The existing structure has not been a barrier to Federal Reserve oversight," he wrote.
Five months later, the Fed took its first public enforcement action against an affiliate, fining Citigroup $70 million. In settling the FTC's earlier charges, Citigroup had agreed to a number of reforms. The Fed found that some practices had continued in violation of that commitment, and that employees had misled regulators.
Fed officials cite the fine as evidence that the agency was able to protect consumers without conducting regular examinations. Consumer advocates took the opposite lesson: Despite finding that a major affiliate was violating consumer protection laws, the Fed still was refusing to create a reliable system for identifying other abuses.
The Citigroup case remains the Fed's only public enforcement action against a lending affiliate.
Retreat From Oversight
The Fed's reluctance was part of a broad governmental retreat from oversight of the financial industry. Greenspan and many politicians in both parties saw regulation as a blunt instrument that often deprived more people than it protected.
"There was a long period when things were going very well and regulation was viewed as something that got in the way," said Alice Rivlin, the Fed's vice chairman from 1996 to 1999 and now a fellow at the Brookings Institution.
The Fed also minimized repeated warnings about mortgage lending abuses in part because it was an institution dominated by big-picture economists focused on the health of the broader economy rather than the problems faced by individual borrowers.
Greenspan said in an interview that he did not think the Fed was suited to policing lending abuses because of its focus on broader issues, but he added, "I'm not sure anyone could have done it better." He said the administration's plan to create a consumer protection agency was "probably the right decision."
Throughout the lending boom, consumer advocates trooped regularly to the Fed's monumental marble headquarters on Constitution Avenue to offer specific accounts of abuses in financial transactions. But what seemed powerful to advocates often was dismissed as anecdotal by regulators.
"The response we were getting from most of the governors and the staff was, 'All you're able to do is point to the stories of individual consumers, you're not able to show the macroeconomic effect,' " said Patricia McCoy, a law professor at the University of Connecticut who served on the Fed's consumer advisory council from 2002 to 2004. "That is a classic Fed mindset. If you cannot prove that it is a broad-based problem that threatens systemic consequences, then you will be dismissed."
As the anecdotes piled up, so did the frustration of advocates. By refusing to conduct examinations of lending affiliates -- by refusing to look systematically -- the Fed was basically preventing itself from finding systemic problems.
"I stood up at a Fed meeting in 2005 and said, 'How may anecdotes makes it real?' " said Margot Saunders of the National Consumer Law Center's Washington office. "How many tens or thousands of anecdotes will it take to convince you that this is a trend?' "
The Boom, the Burden
As the great housing boom soared toward its cataclysm, lending abuses became increasingly hard to ignore.
The Fed's Board of Governors had voted in 2002 to require more detailed annual reports from mortgage lenders. When the first data were released in the fall of 2005, they confirmed that the largest banking companies had developed split personalities. The banks, subject to regular scrutiny, mostly made loans at market rates and concentrated their lending in white, suburban neighborhoods. The unwatched subprime affiliates mostly made loans at high rates and concentrated their lending in minority neighborhoods.
Wells Fargo Bank, for example, charged high interest rates on only 9 percent of its loans between 2004 and 2007. Wells Fargo Financial, which used the same stagecoach logo and the same red-and-yellow color scheme, charged high rates on 80 percent of its loans during the same period. The disparities were similar at Citigroup and HSBC.
Nationwide, the data showed that black borrowers making more than $100,000 were charged high rates more often than white borrowers making less than $40,000.
The three companies have all said they complied with lending laws and that race was not a factor in their decisions.
Wells Fargo said that it complied with all relevant laws, and it is contesting the Illinois lawsuit. The company merged its subprime affiliate into its bank last year.
"We served customers across the United States regardless of their race. Our pricing and underwriting simply doesn't factor race into the equation at all," David Kvamme, president of Wells Fargo Financial, said in an interview. "We were regulated on a consistent basis by the states, and the states looked deeply into our compliance with all laws including consumer protection laws."
Consumer advocates used the data to press their case for increased regulation.
At the end of the March 2007 meeting of the Fed's consumer advisory council, during a slot reserved for presentations, two longtime advocates confronted the Fed's governors and staff with a study showing lending disparities in six cities including New York and Chicago.
"We thought it was pretty convincing evidence of discrimination," recalled one of the presenters, Sarah Ludwig of the Neighborhood Economic Development Advocacy Project, based in New York. "And afterward I remember nobody asking a question. I remember nobody making eye contact. Nobody called me from the Fed afterward saying, 'Let's talk about it.'"
"We thought it was incredibly important and we weren't seeing much of a response," she said.
Finally, as the housing market, then the financial system, then economy came crashing down, the reluctance to regulate started to fade away.
Bernanke asked the Fed's lawyers to revisit their concerns and, in July 2007, the Fed announced a pilot program to examine a few subprime affiliates.
This summer, pronouncing itself satisfied with the results, the Fed announced it would launch regular consumer compliance examinations.
"In looking at our responsibility to enforce these consumer laws we believe a somewhat more proactive stance is justified," Bernanke told Congress.
The Fed also said it will begin to investigate consumer complaints.
This is the first in an occasional series of articles about the record of the Federal Reserve.
Banks took advantage of the Federal ReserveÕs decision not to police abusive lending by bank affiliates, making more than 1.1 million subprime loans through affiliates between 2004 and 2007:
SOURCE: Staff reports | The Washington Post - September 27, 2009
By Patricia Sullivan | September 27, 2009; 12:14 PM ET
As I read the investigation into the Federal Reserve on the front page of this morning's Washington Post [main story first above], I remembered an obit from about two years ago of a Fed governor, Ed Gramlich [ http://www.washingtonpost.com/wp-dyn/content/article/2007/09/05/AR2007090502503.html ]. Sure enough, not far into the story about how the Fed failed in its duty to enforce the law, Gramlich's name popped up:
"In the prime market, where we need supervision less, we have lots of it. In the subprime market, where we badly need supervision, a majority of loans are made with very little supervision," former Fed Governor Edward M. Gramlich, a critic of the hands-off policy, wrote in 2007. "It is like a city with a murder law, but no cops on the beat."
He wasn't the only one warning of a disaster to come, of course, but he was one of the few in an official position who warned of what was to come. He expressed his concern in public speeches. "A good defense against predatory lending, perhaps the best defense society has devised, is a careful compliance examination for banks," Gramlich told a 2004 meeting of bankers in Chicago. He raised the issue in a private meeting with then-Fed governor Alan Greenspan. He had self-doubts, telling Greenspan later that if he had felt more strongly, he would pursued the issue further. But unlike many others, he raised it.
One former Goldman salesman wrote a novel about the crisis. A Deutsche Bank trader passed out T-shirts for investors hoping to profit on a housing bust. Right, William P. O'Donnell/The New York Times
Lewis Sachs, left, who oversaw C.D.O.’s before becoming a Treasury adviser, and John Paulson, whose company profited as the housing market collapsed. Left, Treasury Department; Kevin Wolf/Associated Press
By GRETCHEN MORGENSON and LOUISE STORY Published: December 23, 2009
In late October 2007, as the financial markets were starting to come unglued, a Goldman Sachs trader, Jonathan M. Egol, received very good news. At 37, he was named a managing director at the firm.
Mr. Egol, a Princeton graduate, had risen to prominence inside the bank by creating mortgage-related securities, named Abacus, that were at first intended to protect Goldman from investment losses if the housing market collapsed. As the market soured, Goldman created even more of these securities, enabling it to pocket huge profits.
Goldman’s own clients who bought them, however, were less fortunate.
Pension funds and insurance companies lost billions of dollars on securities that they believed were solid investments, according to former Goldman employees with direct knowledge of the deals who asked not to be identified because they have confidentiality agreements with the firm.
Goldman was not the only firm that peddled these complex securities — known as synthetic collateralized debt obligations, or C.D.O.’s — and then made financial bets against them, called selling short in Wall Street parlance. Others that created similar securities and then bet they would fail, according to Wall Street traders, include Deutsche Bank and Morgan Stanley, as well as smaller firms like Tricadia Inc., an investment company whose parent firm was overseen by Lewis A. Sachs, who this year became a special counselor to Treasury Secretary Timothy F. Geithner.
How these disastrously performing securities were devised is now the subject of scrutiny by investigators in Congress, at the Securities and Exchange Commission and at the Financial Industry Regulatory Authority, Wall Street’s self-regulatory organization, according to people briefed on the investigations. Those involved with the inquiries declined to comment.
While the investigations are in the early phases, authorities appear to be looking at whether securities laws or rules of fair dealing were violated by firms that created and sold these mortgage-linked debt instruments and then bet against the clients who purchased them, people briefed on the matter say.
One focus of the inquiry is whether the firms creating the securities purposely helped to select especially risky mortgage-linked assets that would be most likely to crater, setting their clients up to lose billions of dollars if the housing market imploded.
Some securities packaged by Goldman and Tricadia ended up being so vulnerable that they soured within months of being created.
Goldman and other Wall Street firms maintain there is nothing improper about synthetic C.D.O.’s, saying that they typically employ many trading techniques to hedge investments and protect against losses. They add that many prudent investors often do the same. Goldman used these securities initially to offset any potential losses stemming from its positive bets on mortgage securities.
But Goldman and other firms eventually used the C.D.O.’s to place unusually large negative bets that were not mainly for hedging purposes, and investors and industry experts say that put the firms at odds with their own clients’ interests.
“The simultaneous selling of securities to customers and shorting them because they believed they were going to default is the most cynical use of credit information that I have ever seen,” said Sylvain R. Raynes, an expert in structured finance at R & R Consulting in New York. “When you buy protection against an event that you have a hand in causing, you are buying fire insurance on someone else’s house and then committing arson.”
Investment banks were not alone in reaping rich rewards by placing trades against synthetic C.D.O.’s. Some hedge funds also benefited, including Paulson & Company, according to former Goldman workers and people at other banks familiar with that firm’s trading.
Michael DuVally, a Goldman Sachs spokesman [ http://www.gs.com/viewpoints ], declined to make Mr. Egol available for comment. But Mr. DuVally said many of the C.D.O.’s created by Wall Street were made to satisfy client demand for such products, which the clients thought would produce profits because they had an optimistic view of the housing market. In addition, he said that clients knew Goldman might be betting against mortgages linked to the securities, and that the buyers of synthetic mortgage C.D.O.’s were large, sophisticated investors, he said.
The creation and sale of synthetic C.D.O.’s helped make the financial crisis worse than it might otherwise have been, effectively multiplying losses by providing more securities to bet against. Some $8 billion in these securities remain on the books at American International Group, the giant insurer rescued by the government in September 2008.
From 2005 through 2007, at least $108 billion in these securities was issued, according to Dealogic, a financial data firm. And the actual volume was much higher because synthetic C.D.O.’s and other customized trades are unregulated and often not reported to any financial exchange or market.
Goldman Saw It Coming
Before the financial crisis, many investors — large American and European banks, pension funds, insurance companies and even some hedge funds — failed to recognize that overextended borrowers would default on their mortgages, and they kept increasing their investments in mortgage-related securities. As the mortgage market collapsed, they suffered steep losses.
A handful of investors and Wall Street traders, however, anticipated the crisis. In 2006, Wall Street had introduced a new index, called the ABX, that became a way to invest in the direction of mortgage securities. The index allowed traders to bet on or against pools of mortgages with different risk characteristics, just as stock indexes enable traders to bet on whether the overall stock market, or technology stocks or bank stocks, will go up or down.
Goldman, among others on Wall Street, has said since the collapse that it made big money by using the ABX to bet against the housing market. Worried about a housing bubble, top Goldman executives decided in December 2006 to change the firm’s overall stance on the mortgage market, from positive to negative, though it did not disclose that publicly.
Even before then, however, pockets of the investment bank had also started using C.D.O.’s to place bets against mortgage securities, in some cases to hedge the firm’s mortgage investments, as protection against a fall in housing prices and an increase in defaults.
Mr. Egol was a prime mover behind these securities. Beginning in 2004, with housing prices soaring and the mortgage mania in full swing, Mr. Egol began creating the deals known as Abacus. From 2004 to 2008, Goldman issued 25 Abacus deals, according to Bloomberg, with a total value of $10.9 billion.
Abacus allowed investors to bet for or against the mortgage securities that were linked to the deal. The C.D.O.’s didn’t contain actual mortgages. Instead, they consisted of credit-default swaps, a type of insurance that pays out when a borrower defaults. These swaps made it much easier to place large bets on mortgage failures.
Rather than persuading his customers to make negative bets on Abacus, Mr. Egol kept most of these wagers for his firm, said five former Goldman employees who spoke on the condition of anonymity. On occasion, he allowed some hedge funds to take some of the short trades.
Mr. Egol and Fabrice Tourre, a French trader at Goldman, were aggressive from the start in trying to make the assets in Abacus deals look better than they were, according to notes taken by a Wall Street investor during a phone call with Mr. Tourre and another Goldman employee in May 2005.
On the call, the two traders noted that they were trying to persuade analysts at Moody’s Investors Service, a credit rating agency, to assign a higher rating to one part of an Abacus C.D.O. but were having trouble, according to the investor’s notes, which were provided by a colleague who asked for anonymity because he was not authorized to release them. Goldman declined to discuss the selection of the assets in the C.D.O.’s, but a spokesman said investors could have rejected the C.D.O. if they did not like the assets.
Goldman’s bets against the performances of the Abacus C.D.O.’s were not worth much in 2005 and 2006, but they soared in value in 2007 and 2008 when the mortgage market collapsed. The trades gave Mr. Egol a higher profile at the bank, and he was among a group promoted to managing director on Oct. 24, 2007.
“Egol and Fabrice were way ahead of their time,” said one of the former Goldman workers. “They saw the writing on the wall in this market as early as 2005.” By creating the Abacus C.D.O.’s, they helped protect Goldman against losses that others would suffer.
As early as the summer of 2006, Goldman’s sales desk began marketing short bets using the ABX index to hedge funds like Paulson & Company, Magnetar and Soros Fund Management, which invests for the billionaire George Soros. John Paulson, the founder of Paulson & Company, also would later take some of the shorts from the Abacus deals, helping him profit when mortgage bonds collapsed. He declined to comment.
A Deal Gone Bad, for Some
The woeful performance of some C.D.O.’s issued by Goldman made them ideal for betting against. As of September 2007, for example, just five months after Goldman had sold a new Abacus C.D.O., the ratings on 84 percent of the mortgages underlying it had been downgraded, indicating growing concerns about borrowers’ ability to repay the loans, according to research from UBS, the big Swiss bank. Of more than 500 C.D.O.’s analyzed by UBS, only two were worse than the Abacus deal.
Goldman created other mortgage-linked C.D.O.’s that performed poorly, too. One, in October 2006, was a $800 million C.D.O. known as Hudson Mezzanine. It included credit insurance on mortgage and subprime mortgage bonds that were in the ABX index; Hudson buyers would make money if the housing market stayed healthy — but lose money if it collapsed. Goldman kept a significant amount of the financial bets against securities in Hudson, so it would profit if they failed, according to three of the former Goldman employees.
A Goldman salesman involved in Hudson said the deal was one of the earliest in which outside investors raised questions about Goldman’s incentives. “Here we are selling this, but we think the market is going the other way,” he said.
A hedge fund investor in Hudson, who spoke on the condition of anonymity, said that because Goldman was betting against the deal, he wondered whether the bank built Hudson with “bonds they really think are going to get into trouble.”
Indeed, Hudson investors suffered large losses. In March 2008, just 18 months after Goldman created that C.D.O., so many borrowers had defaulted that holders of the security paid out about $310 million to Goldman and others who had bet against it, according to correspondence sent to Hudson investors.
The Goldman salesman said that C.D.O. buyers were not misled because they were advised that Goldman was placing large bets against the securities. “We were very open with all the risks that we thought we sold. When you’re facing a tidal wave of people who want to invest, it’s hard to stop them,” he said. The salesman added that investors could have placed bets against Abacus and similar C.D.O.’s if they had wanted to.
A Goldman spokesman said the firm’s negative bets didn’t keep it from suffering losses on its mortgage assets, taking $1.7 billion in write-downs on them in 2008; but he would not say how much the bank had since earned on its short positions, which former Goldman workers say will be far more lucrative over time. For instance, Goldman profited to the tune of $1.5 billion from one series of mortgage-related trades by Mr. Egol with Wall Street rival Morgan Stanley, which had to book a steep loss, according to people at both firms.
Tetsuya Ishikawa, a salesman on several Abacus and Hudson deals, left Goldman and later published a novel, “How I Caused the Credit Crunch [ http://www.iconbooks.co.uk/book.cfm?isbn=978-184831067-4 ].” In it, he wrote that bankers deserted their clients who had bought mortgage bonds when that market collapsed: “We had moved on to hurting others in our quest for self-preservation.” Mr. Ishikawa, who now works for another financial firm in London, declined to comment on his work at Goldman.
Profits From a Collapse
Just as synthetic C.D.O.’s began growing rapidly, some Wall Street banks pushed for technical modifications governing how they worked in ways that made it possible for C.D.O.’s to expand even faster, and also tilted the playing field in favor of banks and hedge funds that bet against C.D.O.’s, according to investors.
In early 2005, a group of prominent traders met at Deutsche Bank’s office in New York and drew up a new system, called Pay as You Go. This meant the insurance for those betting against mortgages would pay out more quickly. The traders then went to the International Swaps and Derivatives Association, the group that governs trading in derivatives like C.D.O.’s. The new system was presented as a fait accompli, and adopted.
Other changes also increased the likelihood that investors would suffer losses if the mortgage market tanked. Previously, investors took losses only in certain dire “credit events,” as when the mortgages associated with the C.D.O. defaulted or their issuers went bankrupt.
But the new rules meant that C.D.O. holders would have to make payments to short sellers under less onerous outcomes, or “triggers,” like a ratings downgrade on a bond. This meant that anyone who bet against a C.D.O. could collect on the bet more easily.
“In the early deals you see none of these triggers,” said one investor who asked for anonymity to preserve relationships. “These things were built in to provide the dealers with a big payoff when something bad happened.”
Banks also set up ever more complex deals that favored those betting against C.D.O.’s. Morgan Stanley established a series of C.D.O.’s named after United States presidents (Buchanan and Jackson) with an unusual feature: short-sellers could lock in very cheap bets against mortgages, even beyond the life of the mortgage bonds. It was akin to allowing someone paying a low insurance premium for coverage on one automobile to pay the same on another one even if premiums over all had increased because of high accident rates.
At Goldman, Mr. Egol structured some Abacus deals in a way that enabled those betting on a mortgage-market collapse to multiply the value of their bets, to as much as six or seven times the face value of those C.D.O.’s. When the mortgage market tumbled, this meant bigger profits for Goldman and other short sellers — and bigger losses for other investors.
Selling Bad Debt
Other Wall Street firms also created risky mortgage-related securities that they bet against.
At Deutsche Bank, the point man on betting against the mortgage market was Greg Lippmann, a trader. Mr. Lippmann made his pitch to select hedge fund clients, arguing they should short the mortgage market. He sometimes distributed a T-shirt that read “I’m Short Your House!!!” in black and red letters.
Deutsche, which declined to comment, at the same time was selling synthetic C.D.O.’s to its clients, and those deals created more short-selling opportunities for traders like Mr. Lippmann.
Among the most aggressive C.D.O. creators was Tricadia, a management company that was a unit of Mariner Investment Group. Until he became a senior adviser to the Treasury secretary early this year, Lewis Sachs was Mariner’s vice chairman. Mr. Sachs oversaw about 20 portfolios there, including Tricadia, and its documents also show that Mr. Sachs sat atop the firm’s C.D.O. management committee.
From 2003 to 2007, Tricadia issued 14 mortgage-linked C.D.O.’s, which it called TABS. Even when the market was starting to implode, Tricadia continued to create TABS deals in early 2007 to sell to investors. The deal documents referring to conflicts of interest stated that affiliates and clients of Tricadia might place bets against the types of securities in the TABS deal.
Even so, the sales material also boasted that the mortgages linked to C.D.O.’s had historically low default rates, citing a “recently completed” study by Standard & Poor’s ratings agency — though fine print indicated that the date of the study was September 2002, almost five years earlier.
At a financial symposium in New York in September 2006, Michael Barnes, the co-head of Tricadia, described how a hedge fund could put on a negative mortgage bet by shorting assets to C.D.O. investors, according to his presentation, which was reviewed by The New York Times.
Mr. Barnes declined to comment. James E. McKee, general counsel at Tricadia, said, “Tricadia has never shorted assets into the TABS deals, and Tricadia has always acted in the best interests of its clients and investors.”
Mr. Sachs, through a spokesman at the Treasury Department, declined to comment.
Like investors in some of Goldman’s Abacus deals, buyers of some TABS experienced heavy losses. By the end of 2007, UBS research showed that two TABS deals were the eighth- and ninth-worst performing C.D.O.’s. Both had been downgraded on at least 75 percent of their associated assets within a year of being issued.
Tricadia’s hedge fund did far better, earning roughly a 50 percent return in 2007 and similar profits in 2008, in part from the short bets.
House flippers triggered the US housing market crash, not poor subprime borrowers August 29, 2017 The grim tale of America’s “subprime mortgage crisis” delivers one of those stinging moral slaps that Americans seem to favor in their histories. Poor people were reckless and stupid, banks got greedy. Layer in some Wall Street dark arts, and there you have it: a global financial crisis. Dark arts notwithstanding, that’s not what really happened, though. Mounting evidence suggests that the notion that the 2007 crash happened because people with shoddy credit borrowed to buy houses they couldn’t afford is just plain wrong. The latest comes in a new NBER working paper [ http://papers.nber.org/tmp/80614-w23740.pdf ] arguing that it was wealthy or middle-class house-flipping speculators who blew up the bubble to cataclysmic proportions, and then wrecked local housing markets when they defaulted en masse. [...] https://qz.com/1064061/house-flippers-triggered-the-us-housing-market-crash-not-poor-subprime-borrowers-a-new-study-shows/
yet more invisible hand of the free market doing God's work -- . . .
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