By Abigail Caplovitz Field | November 17, 2011
Note: I’ve substantially revised the original version for clarity, style and depth. I didn’t change the analysis, however. I finished the revision on 11/25.
In the wake of the financial crisis caused by bankers’ and traders’ alchemical mortgage-related securities, Wall Street and the big banks pretty quickly sized up the situation. That’s what they get paid to do, after all. Read the markets now, think about what it means next, and get out in front.
The bankers and traders soon realized that an awful lot of mortgages were going to sour. They understood that housing prices would fall far, pushing many people underwater. And Wall Street and the big banks knew the government would ultimately have two basic policy options: protect creditors and executives, or borrowers and investors. The two sets of interests were opposed; only one side could win. And so the bankers and traders started a media campaign aimed at forcing the government to side with them.
An Act of Class Warfare by the 1%
And that was a classic act of “class warfare.” In the face of a massive financial and economic crisis of their own making, the 1% tried to shape the landscape of the politically possible to force the government to protect them instead of everybody else. Think calling a media campaign an act of war is too strong? Well, consider what the two options look like in practice.
If government chooses to protect creditors and executives, the financial services executives get to maximize their companies’ profits and their personal wealth, while causing their companies to commit document fraud, incompetently service mortgages, negotiate in bad faith, foreclose on millions of families and otherwise run things just as they see fit. Protecting creditors and executives at the expense of investors and borrowers was the choice President Bush and President Obama and many in Congress made, I’d argue, because of that media campaign.
Defending Creditors and Executives-The Consequences
And you can see where defending creditors and executives has gotten us: millions of foreclosed and vacant, community blighting and tax base-destroying homes. Millions of homes that cause ongoing financial and other damage to their neighbors. Foreclosures are weapons of mass wealth destruction.
Re destroying the tax base, that’s common sense and happens because of falling home prices. With less property value to tax, it takes a higher percentage tax to keep revenues constant. As a result, foreclosures make taxes go up or force governments to slash budgets, laying people off and reducing or ending services.
Many families are now without any savings. Counter to stereotype, they really tried to pay their mortgages. Homeowners blew through all their savings—401ks too—trying to save their homes. And then were kicked to the curb.
Housing prices are in freefall with no mechanism in place to stop them. As a result, millions of families are deeply underwater on their homes, making them vulnerable to foreclosure. And the ranks of the underwater will continue to grow.
Part of defending creditors (the big banks) has been allowing banks to use fictional accounting, with the consequence that banks appear to be massively profitable even though they’re not. How do I know they’re not? Well, lots of reasons in the public record, but here’s a simple one: their share prices. They’re all trading below book value:
“As of September 30,  Bank of America was changing hands at 29 percent of its book value, Citigroup at 42 percent, Morgan Stanley at 43 percent and Goldman Sachs at 72 percent.” Source.
The market doesn’t really believe their accounting. And the doubt is worse than it seems, because share prices surely value the implicit government guarantee made when bailing out the banks the first time, perhaps discounted by the Dodd-Frank liquidation authority. But basically the same kind of market effect Fannie and Freddie used to enjoy.
Because the banks are allowed to use fictional accounting, top executives are still raking in obscene salaries and bonuses, big banks are still paying dividends. And protecting creditors and executives means no bankers are being prosecuted for their crimes.
Defending Investors and Borrowers, What Could Have Been
The road not taken would have had two lanes of action. Swiftly modifying millions of mortgages would have kept millions in their homes, stabilizing communities, preserving home values, and maximizing investors’ returns. Cleaning up our markets with modern equivalents of the ’33 Securities Act and ’34 Exchange Act would have brought investors back to the secondary mortgage market, providing the capital for millions of new mortgage loans.
That’s what’s most missing from the housing market now: capital looking to invest in mortgage loans. Incidentally, that was also what was missing during the Great Depression; that was why Savings & Loans were invented.
Picture how it works. With a functioning secondary mortgage market, banks are given a market signal: make mortgages; we’ll buy them from you. So banks deploy capital by giving loans to people, loans of sufficient quality that investors are willing to buy them. As soon as wannabe homeowners can get loans, they buy houses. Make enough loans, do enough sales, and housing prices will start to stabilize. Bottom wouldn’t be hit immediately; prices have too much downward momentum at the moment. But adding a bunch of demand to the market by making lots of sustainable loans would be like hitting the breaks hard.
Sustain the demand and avoid enough foreclosures to limit foreclosures’ impact on housing prices, and the breaks turn out to be beautifully engineered. Housing prices stabilize swiftly, cutting our losses as much as possible.
Cutting our losses is crucial. We’ve already lost trillions of dollars. Trillions. A trillion dollars is so much money no executive has come remotely close to earning that much in a year. I can’t imagine any executive has manufactured that much income in a lifetime. I mean, she’d have to have averaged $20 billion/year for 50 years.
To recap: Defending investors and borrowers would have resulted in a functioning secondary mortgage market and stable housing prices. Massive wealth destruction would end. And once housing prices were stabilized, housing would help drive our economy forward. People would be willing to invest in their homes again.
Too bad we didn’t defend investors and borrowers; too bad the secondary mortgage market isn’t working. Since we didn’t enact new versions of the ’33 and ’34 Acts. only no-risk mortgage backed securities can sell these days. No risk meaning, securities made of loans with a bailout guaranty; loans backed by the US Government via Fannie or Freddie. In turn that means that only loans under the Fannie/Freddie caps can be made, which is only at the lower end of the market. The middle of the market has no way to express demand because it can’t get loans. That’s why the limits on Fannie and Freddie have been raised; only a bailout promise gets loans made these days.
To understand why securities fraud by the big banks and big Wall Street firms destroyed the secondary mortgage market, to understand why investors needed and need protecting, put yourself in the investors’ shoes.
The natural investors for honest AAA mortgage backed securities are pension funds and life insurers. Those investors need a very predictable amount of money every year (actuaries are that good) and so look for securities that reliably pay a predictable amount each year. Mortgage backed securities could fit the bill perfectly, if that AAA meant what it was supposed to: the security will pay out as promised.
But starting in 2005ish AAA became a meaningless collection of letters. Some say that’s because the banks deceived the ratings agencies. I think the ratings agencies were complicit, based on my read of the record. In any case, Lloyd Blankfein noted the “dilution” of the AAA by 2008 in a speech to the Council of Institutional Investors. Blankfein said that:
“The overdependence on credit ratings coincided with the dilution of the coveted AAA rating.” (start around 8:48)
“In January 2008 there were 12 AAA rated companies in the world. At the same time there were 64,000 structured finance products rated AAA”. (follows the last quote)
How do you get 64,000 AAA structured finance products if the ratings agencies are genuinely investigating and accurately evaluating the risks of the securities? Again, I don’t think the ratings agencies are innocent. Maybe a state court fraud claim will vindicate my view someday.
As a result of the “dilution” of the AAA and the investors’ reliance on it–remember, these securities are highly complex and difficult to value–investors were badly burned. No way are they going to take any risk on a mortgage backed security right now. Any risk is too much because investors can’t do good risk calculus. How could they since they don’t know what information they can rely on?
Discovery-backed lawsuits charge that loans weren’t the quality promised to investors much or even most of the time. And CDOs and CDOs squared? How is even a sophisticated investor supposed to value those? Wall Street firms have proprietary algorithms to value them. The AAA was crucial and it was meaningless.
Note, by modern versions of the ’33 and ’34 Acts, I don’t mean messing with those laws. I mean creating new ones that would take on derivatives; give real teeth, including easier enforcement, to rep and warranty claims; really reform ratings agencies; set high conduct standards for securitization trustees; prohibit certain conflicts of interest; and ensure the transparency and accuracy of bank balance sheets, including counterparty risk.
Why Defending Investors and Borrowers Costs Creditors and Executives
As I laid out earlier, defending creditors and executives has destroyed trillions of dollars of wealth. The people taking the hit are investors, borrowers, and taxpayers. Defending borrowers and investors would come at a price too, this one paid for creditors and executives.
Protecting investors would expose bank balance sheet fiction. Some banks would have to be nationalized and restructured, or liquidated. Some might go bankrupt, or might sell off lots of units. In any of these approaches, the banks’ executives would lose lots of money, the banks’ bondholders and shareholders would lose lots of money, and the banks’ other creditors (generally, other banks) would lose lots of money. Protecting investors would make some bank business lines less profitable too.
Protecting borrowers would also expose bank balance sheet fiction, because mass mortgage modifications would force changes to banks’ accounting and reduce mortgage servicing revenue streams.
So rather than run the risk that they’d pay to prevent the social devastation they caused, the bankers and traders launched their media campaign to shape the politically possible.
The Media Campaign
How do I know bankers and traders started running a media campaign, since I’ve not seen a campaign plan or anything like it? Well, the message conveyed in the media starting at least in 2008—just months after the crisis hit—was unified and directed at two things: 1) blaming “irresponsible borrowers” for the crash, and 2) shaming and cajoling underwater borrowers not yet in default to do everything they could to stay current.
Here’s just a smattering; clips are easy to find on YouTube.
CNN’s Lou Dobbs in 2008
CNBC’s Rick Santelli in 2009
Congressman Tom McClintock of CA in Mar 2009
North Carolina Public Television in October, 2010
Please keep in mind a few things as you digest these efforts to blame homeowners for everything.
Second, banks knowingly made loans that couldn’t be repaid because they didn’t much care about them being repaid, they made them to sell to investors. Again, this is well documented; I synthesize a lot of the banks’ role in the mess, including deliberate lousy lending, here.
Third, bankers appraisal shopped and manufactured until they could get one that supported the loan they wanted to make. This type of fraud is also well documented, and jacked home values much higher than natural market forces would have. (See, this 2005 Mortgage News Daily article by Glenn Setzer; this contemporaneous report by the think tank Demos; this 2009 piece by the Center for Public Integrity.) As a result, people are far more underwater than they otherwise would have been. In fact, many purchasers in 2005, 2006 and 2007 were unwittingly “underwater” as soon as they signed the papers, despite their down payments. Banks’ appraisal fraud destroyed tremendous amounts of wealth and equity.
The videos I linked to above are by no means the only places the banking lobby has been pushing its message. Republican Presidential candidates push the blame-the-borrower line and the Faster Foreclosures! policy that the logic leads to during debates. People all around continue to believe in the irresponsible borrower stereotype despite how desperately damaging it is to our nation right now.
As an antidote to the videos above, please read Martin Andelman here.