Comment on a ProPublica blogPosted: November 11, 2011
Everyone has missed the point.
When invented, Fannie Mae seemed to legitimize the process of mortgage securitization. Later, Wall Street walked off with that process, and in doing so it also walked off with Fannie’s exemption from the securities laws—colorably in order to “compete” with Fannie on a level playing field.
Fannie was a national mortgage insurance program, a government-run monopoly intended by FDR to prop up small banks and homeowners after the Depression by massively loosening the credit available to homeowners at that time. Fannie had been “privatized” in 1968 by LBJ in a cynical effort to get it off the government’s books. It became apparent in 2006 when Fannie was found to have manipulated its earnings, that Fannie had never really bothered to comply with the US securities laws, even after privatization. The implications of Wall St’s walking off with Fannie’s process went unnoticed.
But it is the duty of government under the securities laws to ensure the markets’ integrity by “regulating” them. It is not Wall St’s duty to advise government what government is failing to see. Mortgage packaging was enterprise formation and to sell them, after packaging them, was a classic securities process—one that lacked the arms’ length transaction between firm (packager) and investment banker that is presumed to exist in the ordinary stock and bond situation. If Fannie, a fully insured government program, was packaging MBSs and CDOs, who needed securities law regulatory scrutiny? Fannie WAS the government, and taxpayers were 100% on the hook. But if Wall St. packaged, there certainly was a need for such scrutiny.
What’s more, when Wall St started copycatting Fannie’s business model, it also copycatted Fannie’s pricing. The market mispriced the risk as just a little bit less than Fannie’s MBSs, because no one realized that to copycat Fannie’s business model was only legitimate if all the steps the market robotically assumes are in place with respect to Wall St, actually are in place. Ironically, the government’s successful regulation of Wall St. led everyone to assume that government’s same level of competent scrutiny was present here, too, and thus to bid these prices too high. Out of the gate, MBSs and CDOs seemed to have the same government Good Housekeeping Seal of approval that the rest of the market had.
The securities laws are an imperfect mechanistic substitute for the elements of common law antifraud. Drafted in the 30s, they can be read as applying only to stocks and bonds as understood and traded in the 30s, given the precisionism of its legal language. Laws generally must have some precisionism, for overly broad language can also have untoward consequences. This left the door open to the implication, or the appearance, that whatever Congress had not prohibited in the Securities Acts, was permitted. The intent of the securities laws of course is broader than just stocks and bonds circa 1933. The securities regulators ought to have understood this, given that their legal mandate is to “regulate” the markets, which implies taking full responsibility for their integrity. Particularly as they expanded and changed through time. But regulators and bureaucrats, by and large, are not big thinkers, and often their power is limited. They focus on doing office procedures set up for them to work on, long ago. The mindset is about little legalisms and small details. They might not see the forest for the trees. If they do spot something, they might often be unable to express it clearly, or to marshall the power, being mere cogs in a cumbersomely large governmental machine, to do anything about it. Look at Brooksley Born.
I have knowledge in this area because I once wrote a long memo for the CFTC as a very young law associate, on Wall St, that took me all of a summer in the very early 80s, on the subject of whether the new derivatives Wall St was in the process of dreaming up (futures on options and vice versa), were securities. I said they were, given the broad antifraud intent of the post-Depression securities laws. I was told later by a junior partner of the firm that my interpretation had caused a heated discussion between the older WWII generation and the more go-go young turks, who were eager to run off to the races and the big bucks on Wall St. Naturally, the memo had plenty of lawyerly wiggle room, given the obvious go-go period then erupting on Wall St and the political trend toward deregulation.
So, the reason the SEC can’t prosecute is, first of all, because it’s too hard to put history and policy on trial in a courtroom. Secondly, because the government approved all that went on. Government urged Wall St. to compete with Fannie by imprinting its process—one that in recent years had devolved into nothing but a corrupt government monopoly, a Chinese-style State Owned Enterprise. Granted, the government, blind and dumb, didn’t know what it was doing and had forgotten what the securities laws stood for. Perhaps Wall St. should have behaved more honorably (knowing securities law like the back of its hand), so as to lead government by the hand to terminate one of the biggest money bonanzas in its history. But from its point of view, why should it? Wall Street is a government creation through and through, and it lives on and expects all its subsidies. An even bigger one the government doesn’t even see it’s handing out, is just more of the same—even, its due.