The American economy came close to flat-lining in the closing months of 2008. A few months later, as the economy limped along, Congress established the Financial Crisis Inquiry Commission to get to the bottom of what almost killed the American economy.
In a report released today, the commission implicated a rogues’ gallery of reckless insurance companies, lax regulators, foolish investment banks and yes, millions of Americans who took out ill-advised mortgages.
“This calamity was the result of human action, inaction and misjudgment, not of Mother Nature or computer models gone haywire,” FCIC chairman Phil Angelides said in a news conference on the report’s finding.
Here are the culprits highlighted by the commission.
Government regulators, including Treasury Secretary Henry Paulson, Federal Reserve Chairmen Alan Greenspan and Ben Bernanke. The FCIC found officials in the federal government encouraged the growth of the housing bubble and underestimated the danger its deflation would eventually cause. They singled out Greenspan, Fed chairman from 1987 until 2006, for pushing deregulation of the markets and keeping interest rates at historic lows at a time of solid economic growth, encouraging a massive flow of capital into the mortgage industry.
Paulson, Bernanke, the Clinton administration and the George W. Bush administration also came under fire, first for failing to perceive and address the danger posed by the housing bubble and then for an uneven response that injected uncertainty into financial markets by saving some financial institutions like Bear Sterns, but allowing others, like Lehman Brothers, to fail, the report says.
The FCIC also criticized the patchwork of financial regulators, including the Federal Reserve, the Securities and Exchange Commission, the Office of Thrift Supervision and others, that had the power to stem the flow of toxic subprime mortgages into the securities market and failed to act.
One reason for that was the political clout of the financial industry, which spent $2.7 billion on lobbying the federal government between 1999 and 2008. That influence allowed them to put pressure on regulators to back off aggressive actions. And since many large financial firms were eligible to be regulated by multiple agencies, they used that influence to steer themselves toward the most lax regulator.
“The government allowed financial firms to select their preferred regulators, setting off a race to the weakest supervisor,” said FCIC commissioner John Thompson.
Mortgage lenders. Mortgage lenders were the first step in the deeply flawed mortgage process that was central to the financial crisis, according to the FCIC report. To push profits higher, they began to offer alternatives to the traditional, prime, 30-year, fixed mortgages that had been the norm, the report says.
During the run up to the financial crisis, they approved trillions of dollars’ worth of variable rate loans, subprime loans to customers with poor credit, low- and no-documentation loans and other exotic lending instruments that would eventually be the volatile fuel for the housing conflagration. Lenders like Washington Mutual, Countrywide and IndyMac ended up paying the price becoming sold at fire-sale prices or failing altogether.
“Shadow banking” issuers of mortgage-backed securities. One of the principal perpetrators in the FCIC’s account are the huge investment firms such as Goldman Sachs and Lehman Brothers that chopped up mortgages and recombined them into mortgage-backed securities, which they then sold to investors. One of their favorite tricks was to package highly rated prime mortgages with riskier subprime loans to create collateralized debt obligations which would then get higher ratings from ratings agencies, the report says.
When the housing bubble burst, no one was quite sure how much these packaged instruments were worth because they contained so many different loans of varying qualities. Those investors and institutions that had bought the investments, assuming they were safe, were suddenly unable to sell them. Because many had invested with borrowed dollars, they took major — sometimes fatal — losses.
The toxicity of these investments eventually caught up with many bundlers of mortgage-backed securities. While they only held on to a tiny percentage of the securities they created, they were producing them at such high volume that when the market dropped, they were stuck with billions of dollars’ worth of bad mortgages in the pipeline, as well as “super senior” tranches of MBS with interest rates too unattractive to sell, the report says.
Many bundlers of these mortgage securities, so heavily leveraged they had no hope of covering their bets, simply imploded. Others were sold in government-sponsored fire sales. Unfortunately, because bundlers of mortgage-backed securities were often investing with borrowed money, sometimes holding only $1 for every $40 they invested, the bondholders and investors who had loaned them capital were also wiped out, pushing the global markets into panic.
Issuers of credit default swaps. Bundlers and investors of mortgage-backed securities had some idea of the massive risks they were taking, so they turned to buying insurance products called credit-default swaps that would pay out in the event borrowers defaulted on the mortgages underlying the securities.
But the companies that sold collateralized debt securities underestimated the risk they posed, the report says. When the housing bubble burst and the investors in mortgage-backed securities came to collect, these insurers, such as AIG, did not have enough cash on hand to cover the losses.
Investors that had been counting on this insurance were no longer certain they could count on it, further destabilizing the market and forcing the federal government to bail out AIG, one of the largest sellers of collateralized debt securities, with $182 billion of taxpayer funds.
Ratings agencies. The job of ratings agencies in global markets is to assess the risk of investments and stamp them with a rating that reflects their risk. Historically, mortgage-backed securities were assumed to be an extremely safe investment. Only a small percentage of homeowners ever defaulted and when they did, their home usually fetched enough value in foreclosure sales to cover the shortfall.
This assumption, along with the hefty fees bundlers of mortgage-backed securities were paying for ratings agencies’ services, motivated ratings agencies to slap their highest ratings on many of these securities, despite the fact that they were made up of many mortgages of uncertain quality, the report says.
The AAA rating, the same rating bestowed on U.S. Treasuries, in turn led many investors to assume these securities were safe, broadening the market for them and setting the stage for the mortgage meltdown.
American consumers. Investment banks and insurers weren’t the only ones who bought into the mortgage boom and ended up too heavily leveraged to survive its bust. Millions of American consumers took full advantage of lax lending standards to bet trillions on the housing market.
These bets came in the form of “investment properties,” cash-out refinances and home equity loans that would leave many Americans unable to meet their financial obligations or paying a mortgage that was thousands of dollars underwater.
When you’re talking about a crisis of this magnitude, the major players aren’t everyone. Every Goldfinger needs his Oddjob, and there are still some bit players in FCIC’s account of the near-death of the economy that need to be recognized.
Fannie Mae and Freddie Mac. Fannie Mae and Freddie Mac, two government-sponsored enterprises, buy mortgages, insure them and sell them on the secondary market. Some economists, particularly some on the FCIC, suspected the GSEs were forced to offer mortgage loans to risky borrowers to help them meet affordable housing goals mandated by the Department of Housing and Urban Development.
The final FCIC report finds that Fannie and Freddie don’t deserve as much blame as the players involved. Thanks to the fallout from a 1990s accounting scandal, they did not become as heavily invested in subprime mortgages as many private mortgage insurers did. Affordable housing goals may have boosted their involvement on the margins, but it did not have a major effect on the U.S. economy.
Even so, Fannie and Freddie had other weaknesses that made them vulnerable to a housing crash. Because their exposure to the housing market was so huge and their leverage so extreme, reaching $75 in debt for every $1 they held, they took massive losses once housing values began to drop and prime borrowers began defaulting on their loans.
Fannie and Freddie’s role was hotly disputed by FCIC members during the formulation of the final report. Four GOP members — Bill Thomas, Douglas Holtz-Eakin, Keith Hennessey and Peter Wallison — released a “Financial Crisis Primer” in December, ascribing a much more central role to the GSEs than the official report would eventually reflect.
The Community Reinvestment Act. In 1977, Congress passed a law that encouraged banks to lend to homebuyers in certain economically distressed neighborhoods where they took deposits. While the FCIC noted this was an unsound policy, it concluded in its final report that the CRA did not contribute significantly to the crisis.
This turned into another hot-button issue for the committee, as Thomas, Holtz-Eakin, Hennessey and Wallison persisted in blaming the CRA in their report, and Wallison released a dissent that concluded the CRA was a big factor in the financial crisis.