Host, Yves Smith:
Reckless Endangerment describes the players that helped create the housing bubble and bust that were at the heart of the financial crisis. Gretchen Morgenson and Josh Rosner focus on how regulators and other officials were complicit by promoting liberalized housing finance as a way to increase homeownership. Their account chronicles how a naïve vision of the American Dream, that of homeownership as the foundation of upward mobility and stable communities, turned into a nightmare in the hands of a growth driven and increasingly predatory mortgage complex.
Jim Johnson, who was a Mondale operative, one-time Bill Clinton, political consultant, and CEO of Fannie Mae from 1991 to 1998, was a major architect of a powerful alliance that sought and obtained more and more government support for housing. His immediate focus was to deepen Fannie’s relationship with the government to protect its implied state backing. Johnson bought support of his aggressive growth plans by sponsoring large-scale programs to target low income borrowers. These initiatives, while they sounded benign, often amounted to radical experiments that over time gutted many of the traditional guidelines for sound lending. And the need for these changes was often exaggerated. Some of the seminal studies that found that blacks and minorities were incorrectly denied mortgage finance were nowhere near as clear cut as Fannie and its allies suggested.
Johnson also used Fannie’s huge profits to hire virtually every independent housing analyst so as to limit criticism, and went savagely after anyone who questioned the GSE’s efforts. Fannie also formed the Fannie Mae Foundation, which siphoned funds to associations linked to favored politicians, in effect using government supported profits to protect and extent its franchise. The only party able to stand up to its onslaught was the Congressional Budget Office, which had the temerity to produce an analysis that showed that a full 1/3 of the huge value of Fannie’s government subsidy was going to executive pay and shareholders, rather than its professed goal of making housing more affordable.
An unduly accommodative regulatory climate helped supercharge overly aggressive lending. [cont’d.] Critical and often overlooked developments included a 1995 rule change by HUD that eliminated the requirement that lenders obtain independent appraisals. It probably did not help that Barney Frank had hinted that it would be nice if his partner and recently minted MBA, Herb Moses, got a job at Fannie. Frank has maintained that his notably protective posture towards Fannie had nothing to do with the fact that Moses worked there for seven years in the 1990s.
Another important enabler was Federal Reserve vice chairman Roger Ferguson, who was receptive to the banks’ desire for lower capital requirements and promoted the heretofore unheard of idea of letting them devise the risk metrics to be used in setting minimum capital requirements. Another big shift was the 2001 revision to the 1988 Basel accord that significantly reduced the capital a bank would be required to hold against privately issued (non Fannie/Freddie) private label securities and increased the importance of rating agency grades in deciding the riskiness (and therefore capital weightings) of many bank assets.
This private label (non Fannie-Freddie) securitization market, also known as “subprime” had grown in the early 1990s, Johnson cultivated a relationship with Angelo Mozilo, the permatanned CEO of Countrywide, which had been primarily an originator of conventional mortgages (that is, the kind that met the underwriting standards of Fannie and Freddie). Countrywide expanded aggressively into this market after Mozilo’s conservative co-founder and risk manager David Loeb retired in 2000. Needless to say, Countrywide also became expert in cultivating friends in powerful places, particularly through its notorious “Friends of Angelo” program, which gave cut-rate mortgages to Congressmen.
Even though Fannie and Freddie did not guarantee subprime mortgages, they began supporting the market in 1997 as a result of HUD chairman Andrew Cuomo’s push to have them buy subprime mortgages in their investment portfolios
The first generation of subprime took off in the 1990s when Wall Street started to offer financing, called “warehouse lines”, meaning credit lines against “warehouses” of mortgages, which allowed thinly capitalized originators to punch above their weight.
The book chronicles how, as predatory lending increased, efforts to beat it back were blocked by the mortgage-industrial complex incumbents, notably Standard & Poor’s and Countrywide. Later efforts to clip the GSE’s wings were opposed successfully; it took accounting scandals to put a brake on their growth and subject them to more oversight.
But the subprime market developed a life of its own as subprime originators became the new darlings of Wall Street. No one seemed to remember that this market had blown up impressively in the late 1990s. Warnings from housing analysts, and the few tuned in regulators like the Ed Gramlich of the Federal Reserve were ignored by the authorities. The assumption was that since investors were buying the mortgage securities, they were doing their homework and so the nay-sayers were worrywarts.
But in reality, in the toxic phase of 2005-2006, subprime bonds were increasingly being sold to collateralized debt obligations, which for the most part weren’t sold to investors, but were retained by the banks themselves because they were treated favorably under new Basel II rules. And most of the rest of the investors were seduced by flawed rating agency models. So overlevered banks uncharacteristically ate their own bad cooking and got spectacularly sick as a result
Reckless Endangerment focus on the nexus of politics, regulations, and markets, also shows how deeply major mortgage players are embedded in DC. Perversely, one of the few upsides of the seemingly intractable housing mess is that it may so badly discredit them as to eventually reduced their outsized influence.