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The Truth About the Financial Crisis, Part III
Posted By Barry Ritholtz On February 11, 2011 @ 8:30 am In Markets,Think Tank | Comments Disabled
Jennifer S. Taub  is a Lecturer and Coordinator of the Business Law Program at the Isenberg School of Management , University of Massachusetts, Amherst. Her research interests include corporate governance, financial regulation, investor protection, mutual fund governance, shareholders rights and sustainable business. Previously, Professor Taub was an Associate General Counsel for Fidelity Investments in Boston and Assistant Vice President for the Fidelity Fixed Income Funds. She graduated cum laude from Harvard Law School and earned her undergraduate degree, cum laude, with distinction in the English major from Yale College. Professor Taub is currently writing a book on the financial crisis for Yale University Press.
This post is the last installment in a three-part series harvesting the recent Financial Crisis Inquiry Report  (FCIC Report) to debunk the top-ten urban myths about the Financial Crisis. To read about myths 1 – 5, click here .
Myth 6: The Financial Crisis was caused by too much government regulation.
Reality 6: No. Deregulation and regulatory forbearance contributed to the Crisis. Stronger, not weaker oversight is now needed.
For example, housing advocates began “meeting with Greenspan at least once a year starting in 1999, each time highlighting to him the growth of predatory lending practices and discussing with him the social and economic problems they were creating.” Greenspan refused to use its authority under the Home Ownership and Equity Protection Act (HOEPA), which permitted the Fed to ban bad underwriting practices at both banks and “nonbank” institutions.
“This was a missed opportunity, says FDIC Chairman Sheila Bair, who described the ‘one bullet’ that might have prevented the financial crisis: ‘I absolutely would have been over at the Fed writing rules, prescribing mortgage lending standards across the board for everybody, bank and nonbank, that you cannot make a mortgage unless you have documented income that the borrower can repay the loan.’” (emphasis added).
Instead of a such a rule, in 2005, the Fed adopted non-binding “guidance” for the mortgage industry which “directed lenders to consider a borrower’s ability to make the loan payment when rates adjusted, rather than a lower starting rate. It warned lenders that low-documentation loans should be ‘used with caution.’” In response, the American Bankers Association was “up in arms,” complaining that the guidance “overstated the risk of non-traditional mortgages” and, not surprisingly, the industry ignored it.
Although Greenspan chose not to protect homeowners, journalist Matt Taibbi in Griftopia , found particularly “revolting” that Greenspan in 2004 openly encouraged adjustable-rate mortgages. He endorsed ARMs in a speech insisting that “American consumers might benefit if lenders provide greater mortgage product alternatives to the traditional fixed-rate mortgage.” This was just a few months before the Fed began raising interest rates. According to a hedge fund manager Taibbi quoted, “If you had had people on thirty-year fixed mortgages, you wouldn’t have had half these houses blowing up. . it was the most disingenuous comment I’ve ever heard from a government official.”
Myth 7: Nobody saw it coming.
Reality 7: No. Plenty of people saw it coming and said something.The problem wasn’t seeing, it was listening.
Financial sector insiders, consumer advocates, regulators, economists and other experts saw the warning signs. They spoke out frequently concerning the housing bubble and the predatory and lax mortgage underwriting practices that fueled it. Yet most whistleblowers were ignored or ridiculed at best and fired and blacklisted at worst.
Internal whistleblowers had their whistles taken away. In 2003, the head of the fraud department at Ameriquest was on the job for a month when he began to report fraud. He was scolded by senior management for looking too closely at the loans, then in 2005 downgraded from ‘manager’ to ‘supervisor,’ and finally laid off in May 2006.” Similarly over at Lehman Brothers, the former chief risk officer, was pushed aside in 2007 and the head of fixed income who “warned against taking onto much risk” departed due to “philosophical differences.” At Citigroup, in 2006, the newly promoted chief underwriter in the consumer devision, Richard Bowen, realized that about 60% of the mortgages Citi was buying up and selling to investors were defective – “if the borrowers were to default on their loans, the investors could force Citi to buy them back.” He brought this to the attention of certain members of the Board of Directors and thereafter was demoted from supervising 220 to only 2 people, his bonus was reduced and he received a poor performance review.
For further reading on economists who sounded the alarm but were ignored, Professor James Galbraith’s article, “Who Are These Economists, Anyway ,” is very instructive. Galbraith includes economist Dean Baker who in 2002 wrote:
“If housing prices fall back in line with the overall rate price level, as they have always done in the past, it will eliminate more than $2 trillion in paper wealth and considerably worsen the recession. The collapse of the housing bubble will also jeopardize the survival of Fannie Mae and Freddie Mac and numerous other financial institutions.”
Myth 8: This Financial Crisis was unavoidable. And, financial crises of this magnitude, are inevitable.
Reality 8: No. The majority unequivocally states this Crisis was avoidable.
This myth that we cannot avoid large scale financial crises is particular corrosive, as those who are in its thrall reason that since crashes are inevitable, regulation is fruitless. However, is not the necessary conclusion. Consider the Congressional Oversight Panel report  that found relative safety in the financial system for more than 30 years after the Neal Deal legislation until the regulatory fabric was unraveled.
Indeed, this myth distorts the view of economist Hyman Minksy, the person who first advanced the theory in 1992 that markets are prone to instability. The appropriate response to this recognition is not to let the system keep running up risk and collapsing, but instead to create counter-cyclical regulatory policy. For a clear discussion of this as applied to the recent Crisis, a useful resource is the energetic and insightful 2009 speech  entitled, “The Shadow Banking System and Hyman Minsky’s Economic Journey,” by former PIMCO managing director, Paul McCulley.
Myth 9: The bankers are the victims of greedy homeowners who borrowed money and did not pay it back.
Reality 9: No. There were some homeowners who participated in fraud and others who were simply unrealistic or speculating on the prospect that housing prices would continue to rise. However, the vast majority were victims either of abusive lending practices, or simply of the housing bubble and burst that resulted in their home values and their retirement savings being diminished. Moreover, even the hopeful and the speculators were no different from bank executives, including JPMorgan CEO Jamie Dimon who told the FCIC, “In mortgage underwriting, somehow we just missed, you know, that home prices don’t go up forever and that it’s not sufficient to have stated income.”
Yes, we do know, many homeowners made the same error. Of course the difference is, banks got trillions of dollars in bailouts and backstops and kept their billions in bonuses. That does not sound like victimhood. In contrast, since the burst of the housing bubble, there have been 4 million home foreclosures. In the fall of 2010, one in 11 residential mortgage loans was at least one payment past due. Unemployment hovers around 10% and the underemployment rate approximately 17%. Household net worth had declined from $66 trillion to $54.9 trillion.
Unfortunately, some keep telling this story. For example, an attorney who negotiates pay packages for Wall Street bankers told the Wall Street Journal  this week: “To blame Wall Street for the financial meltdown is absurd.”
Myth 10: This report was a waste of time and money, in part because Dodd-Frank fixed everything and now the banking system is safe again.
Reality 10: No. While the Report does not speak to these misconceptions, they are worth addressing. In both an absolute and relative sense, this report was worthwhile.
As for the Dodd-Frank Act, it was a small step forward. However, much was delegated to the federal agencies and with the new leadership in the House, efforts are underfoot to weaken implementation. As anticipated, the new leadership is executing its “triple-A ” agenda of appointments, appropriations, and annoyances. What little ground was made, may soon be lost.
As for relative value, Dylan Ratigan of MSNBC, recently made the comparison between the FCIC budget of $8 million and the amount that Kenneth Starr spent on the investigation of Clinton and Lewinsky. While he was slightly off in his figure, according to the GAO, the amount was just shy of $30 million , the point is made. Given the trillions of taxpayer dollars spent to bailout and backstop financial sector, given the $11 trillion in household wealth lost, investigating the reasons why so as to avoid this in the future, is a prudent investment.
Article printed from The Big Picture: http://www.ritholtz.com/blog
URL to article: http://www.ritholtz.com/blog/2011/02/the-truth-about-the-financial-crisis-part-iii/
URLs in this post:
 Jennifer S. Taub: http://www.isenberg.umass.edu/management/Faculty/Profiles/Jennifer_Taub/
 Part I: http://www.ritholtz.com/blog/2011/02/truth-about-financial-crisis-part-i/
 Part II: http://www.ritholtz.com/blog/2011/02/truth-about-financial-crisis-part-ii/
 Report: http://www.fcic.gov/report
 here: http://www.theparetocommons.com/2011/02/mythbusters-telling-the-truth-about-the-financial-crisis-ii/
 Griftopia: http://www.randomhouse.com/catalog/display.pperl/9780385529952.html
 Who Are These Economists, Anyway: http://www.nea.org/assets/docs/HE/TA09EconomistGalbraith.pdf
 report: http://cop.senate.gov/reports/library/report-012909-cop.cfm
 speech: http://www.pimco.com/Documents/GCB%20Focus%20May%2009.pdf
 Wall Street Journal: http://online.wsj.com/article/SB10001424052748703399204576108380072356842.html
 triple-A: http://www.theparetocommons.com/2010/11/making-mischief-after-the-midterms/
 $30 million: http://articles.cnn.com/1998-04-01/politics/starr.costs_1_cost-estimates-investigation-starrs?_s=PM:ALLPOLITICS
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