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.
It is simpler than this. It is not a pure matter of economics, but about history and the function of the law. Wall Street walked off with FNMA’s securitization process essentially unregulated because the government wasn’t paying attention. It just let the private sector do what the government had done. Down to the very techniques, the mechanics. The SEC didn’t bother to lift a finger to look with its anti-fraud lens at either Fannie’s activities, or Wall Street’s in replicating Fannie. Yet the securities law requires such scrutiny in anything inherently subject to price manipulation and fraud. I worked in a Wall Street law firm with government connections in the early 80s when the legal community was scoping all of this out. The legal profession was well aware that CDOs and MBS and innovative financial derivatives were securities. The government was also so advised, but, apparently, into a black hole. Lawyers then hastened to help Wall St. evade the the spirit of the securities law by deep sixing any implication that onerous full disclosure, transparency and due diligence was required of them. Regulators were stovepiped in departments set up in the 1930s, reflecting the divisional categories of a simpler day.
The public assumes the government protects it, by virtue of how complicated everything all is, but the flip side of comprehensive complexity is that no one understands it. Bureaucracy drones on by rote. Underpaid relative to Wall Street, regulators need to be at the cutting edge of a changing field, but rarely are. Nor does the private sector care to cue regulators in, lest they come under the spotlight next.
Fannie’s securitizations were originally workable only because (a) Fannie always had strict rules guarding the quality of the loans in the securitization pool and (b) because of the 100% taxpayer guarantee, a promise that only works for the taxpayer if limited to a narrow category. Not expanded to cover anything and everything—and government always tends to replicate itself in the effort to justify its existence. Fannie was conceived as a national insurance monopoly. A development plan to help the US out of the Depression of the 1930s. It was never conceived as a market-based financial institution or operational insurance company. It wasn’t a business, insurance or otherwise, but a government program.
This government process involving securitization couldn’t be just handed over to Wall St., not unless Wall St. got heavy securities law scrutiny. Unfortunately the law tends to be a playground these days for sophists who run about asserting that black is white and 2+2=5. Let’s just say that anything complicated isn’t hard for an unscrupulous and well paid lawyer to tie up in knots for years.
Washington politicians looked only at the promoted upside, not the down—e.g., the magical properties of portfolio diversification. On this rationale, all of banking was allowed to merge and cartelize, starting in the 80s, as banking crises started to happen. As Washington rationalized it, with the aid of soothsaying bank lobbyists, absurdly large banking entities somehow “ensured” against risk, as opposed to creating insanely overlarge and unmanageable conglomerates. They also no longer had any interest in scrutinizing for quality. Quality was random walked out of the room as a consideration. Pooling, like a magic elixir, would meliorate all. Ironically banks imitated Washington, literally, in the sense of that warehouse at the end of the movie Raiders of the Lost Ark, where any toxic waste could be buried, with no one the wiser. Banks to some extent themselves may have been dumbed down by FDR’s securitization gambit to begin with, to become companies looking for the next guaranteed, easy-money paper pushing racket to wangle out of the government. The existence of Fannie meant banks no longer had to be market-disciplined, sharp-eyed lenders scrutinizing debtors for quality. Just machines focused on an algorithmic ticking of boxes, assembly line style. Boring zone-out operations based on a “business model” handed to them by the government, who itself stopped thinking about anything but following the template, decades ago. No longer having skin in the game changed their character. Inevitably, their talents and abilities declined, as their prestige of size, and arrogance over what now seemed magical (US guaranteed) money making skills rose.
Antitrust law was under a cloud for a generation, due to a fad in legal circles. Disparaging antitrust was in vogue due to a few ill-considered judge-ordered breakups and bad dicta in antitrust. But that didn’t mean antitrust and the principle of free markets and competition was dead. To be anti-antitrust became a narrative trope. The fad for deregulation also was misused by lobbyists promoting special interest legislation. Deregulation obviously doesn’t mean total regulatory abdication. Basic government services need to be done competently and in the public interest. Criticism of the government or the private sector is not ad hominem or per se. Regulatory laxity and ditching the public interest is not what deregulation calls for. The revolving door is always a corrupting force in government but the point of government reform is to cut fat, not arteries.
Narrative proclamations of law in no way insures that the stated conclusions will be enforced. At any moment in time government is fully occupied with whatever previous legislators heaped on their plate, and don’t have time for more. Time is money and any new major duty heaped on government, has to be paid for.
Regulators wound up declaring certain assets safe by law. But no asset can be “presumed” safe by “type.” A law declaring certain types of things AAA is a circular tautology, assuming a fundamentally economic conclusion that has to be market tested and now won’t be. Only market actors, not lawmakers, can make market decisions about pricing. And there is a limit to all government guarantees against loss. If the government is the ultimate guarantor, then it is the principal in the transaction, not the putative “private market” firm. FDR understood business better than politicians do today. He strictly limited what the government would guarantee. Washington today copycats FDR’s techniques in its affection for 30s era national insurance schemes. But they don’t follow FDR’s lead in strictly limiting their scope, or the behind the scenes imposition of rigorous rules selecting on a global basis for quality.
Today Congress, from the top, just manufactures moral hazard, merrily, without even recognizing that it is doing so. The basic point is that of the agency problem of economics. The integrity of an investment decision cannot be wholly trusted if the entity making it has no skin in the game. With no skin in the game you have to have absolute trust in their competence, good faith, and integrity. Rarely do such conditions exist. Our politicians are experts in faking it. The government had no basis on which to guarantee super high leverage on specific asset types. Having taken on full responsibility to guard market integrity for the nation, our government is to blame for the failure, but so is their partner, the banks. Today it is Wall Street who is the senior partner in the crony relationship with Uncle Sam. It was the expert in securities law, it must have known all along at some level what it was setting up, and at all points it proved to have no compunction about robbing the US taxpayer, for its own account.
The best way to get a handle on the causes of the financial crisis is to read two books, one a little hard for the lay reader, the other not at all—Gretchen Morgenson and Joshua Rosner’s Reckless Endangerment is a fun read; the Financial Crisis Inquiry Commission Report more of a slog—but still a barrel of monkeys for lawyers, accountants, and crisis aficionados. For a government report it is a veritable tour d’ force (if not as page-turning as The Starr Report).
Some in Washington want to pin blame for the financial crisis on “Fannie and Freddie.” To be sure, these State Owned Enterprises are a part of the story but it is grossly misleading to blame them, or laws like the Community Reinvestment Act, as the “cause” of the crisis. The FCIC Report found that the bad loans generated by these initiatives comprised an insignificant portion of all faulty loans, and that Fannie and Freddie’s loan standards, while joining the general lowering, were higher than the rest of the market. Fannie and Freddie are at the root of the crisis only in the broad, historical sense that we inherited them and the reality they reconstructed from the New Deal—not because during the 80s (Reagan) or the 90s (Clinton), as the partisans say, these companies ruined lending standards. In fact, Fannie and Freddie were the last gasp of holding lending standards up. Unless you believe in a purely literalist, fundamentalist sense that no government is the best government, and that this has been and always will be true at all times and in any and all circumstances, Fannie and Freddie were not the cause of the financial crisis—certainly not its proximate cause.
There is much to dislike about how Fannie and Freddie were run. As Reckless Endangerment recounts, in 2006 America discovered that Fannie was flagrantly violating the rules for public companies—having cooked the books and massaged their financials through the (no) good auspices of Goldman Sachs. Fannie’s richly paid CEO, Franklin Raines, seems not to have understood basics about how public companies are supposed to operate, putting in question the rationale for his massive executive comp. How could this be? By 2006, Fannie and Freddie had long been public companies. Originated as government programs, they just continued on as such, with all the lawlessness (l’etat, c’est moi!) inherent in all government action, particularly when government processes become disconnected from a commitment to the public good.
By definition a government program is not a business. It is a subsidy. Government programs do not function by market logic or subject to market discipline. They are the “nation.” They are backstopped by the taxpayer by simple legal pronouncement. Their liabilities are potentially a dangerous blank check.
Reckless Endangerment shows how Wall Street, in theory a market disciplined machine, gradually took on the essentially lawless character of Washington, especially its hardball political tactics. Wall Street proceeded to reform the securities laws to wipe out that aspect of its public utility function for the country that was interfering with their profit maximization. They had good cover, because the glut of banking, securities, commodities, and insurance laws and regs in fact did need significant updating—had for decades in light of the vast changes in finance, particularly its gargantuan aggregation (having evaded antitrust scrutiny during a period in which antitrust was unpopular), and most consequentially, computerization.
Like any good empirical scientist, Wall Street observed Fannie’s operations closely—and quietly replicated it. Yet Wall Street knew it was subject to the securities laws in all enterprise packaging operations. Wall Street is the world’s expert on the securities laws. Fannie, by contrast, as a government operation (yet now, confusingly, a “public company” that nevertheless did not operate as one), had not been. Fannie securitized but had forgotten why. Having been coded to do what it did, it just did it. Originally, to FDR, mortgage securitization was national insurance, a post-Depression development program set in place for the nation—for, and structured to be strictly limited to, small savers and homeowners. Limitation of its potential costs to the taxpayer was one reason for the stovepiping of all the laws, which formed subject matter boundaries around, in effect, business operations. This stovepiping would later become obsolete and confused, with large but hidden economic consequences.
Apart from unregulated securitization, Fannie’s process also revolved around political fixers and tactics to get whatever it wanted when it wanted it—hiring the best schmooze operators to grease wheels by hook or crook. Pure politics is Standard Operating Procedure for government bureaucracies. They survive in this way by nature, and one can’t really blame them for that—it’s the nature of the beast. The good will of government is supposed to take care of ethics. No market discipline is present, or required, in government.
The other component of this witches’ brew is that Congress today does not seem to take its job seriously as an intellectual matter. Its staffs are quite adroit at p.r., and word spinning, and general b.s., but complicated business and legal legislation requires a more sophisticated level of competence. Big banking is about as complicated as it gets, requiring expertise in many difficult areas of law. Complexity serves the banks’ (and lawyers’) purpose—that of obscurantism, and hours churned.
Yet legislators today are famous for not even reading the laws they advocate. They will not parse the creative sophistry a sentence may engender in the future, or a law’s potential for unintended consequences, or the interactive effects with other laws outside the categories of the one presently under discussion. Congress rarely if ever revisits a law after it is passed to assess its failures, its negative impacts, with an eye to revision. Their egos prevent them from ever admitting error of any kind. Congress focuses on “results” in the form of numbers of photo ops, the inspirational spin of the words in the press release describing each latest national legal panacea. It is a sort of “volume sales” approach to the law, ironically echoing the attitudes today of banks toward lending, or that of the police in 1960’s toward convictions (leading famously to ignoring drug kingpins while padding prosecution numbers with hordes of inconsequential street dealers). The media then lap up such press releases with little analysis or skepticism apart from tacking on what they today consider to be “selling” left-right narratives. More fodder for the daily copy grind.
Marketing was the true rocket-science fueling the “masters of the universe” over the last 20 years—that and computerization. What slogan pleases the ears of Republicans? Easy: “deregulation.” What pleases Democrats? “Housing for all.” Slam dunk. Wall Street rolled Washington with its favorite taglines and a fantastical promise of ever-expanding national wealth through securitization without end. A growth industry in financial innovation, with no limits! Wall Street profits seemed to validate the new, claimed reality. For politicians it was easy to believe the claim of the “rocket scientists” to have discovered the goose with golden eggs. Breathless paeans in the press to financial innovation and the magic of code glittered up Wall Street’s dog and pony show, probably adroitly manipulated by Wall Street’s p.r. efforts, since they have the cash to afford the best. Some individuals knew the truth, but they weren’t talking. The longer it all went on, the more money they’d make, in one form or another (legal fees, big shorts).
Wall St. is in fact a public utility. You can tell it’s a public utility just from the mass of regulations around it—a mind-blowing panoply of banking, securities, antitrust, housing, commodities, insurance and (even) gambling laws overseen by dozens of regulatory bureaus. The “regulators” almost never do anything cross-disciplinary or “systemic.” By definition what they do is bureaucratic and routine. If the regulatory alphabet soup were even asked to coordinate among themselves, they might have no time left over for their regular chores. Creative systemic oversight isn’t something it is even reasonable to expect of most bureaucrats.
As a public utility, what Wall Street does never strays far from what government says it’s supposed to do.
What this means is, if Wall Street is being evil, then government is necessarily complicit.
Deregulation had been botched early on. It was grossly irresponsible of Congress to pitch Fannie and Freddie into the private sector and let Wall Street just ape their processes without scrutinizing the precise economics. It was absurd for the government and the Fed to just blithely assume that Fannie and Freddie’s operations were honed by sound economics. (A mental error that too much study of pure theory such as the efficient market hypothesis can sometimes trick the literal-minded into.) Fannie and Freddie had never been in the market, and their operations had never been subjected to any market rationality or sustainability screens. Fannie and Freddie were never conceived as an investment bank to package and resell mortgage backed securities to begin with at all, but a national insurance pool to be run as a government monopoly. Fannie/Freddie’s actuarial risks had never been evaluated because the US simply stood behind them, come what may. The taxpayer paid for this as a straight subsidy to the banks and to homeowners through the banks. And for the 1930’s, it worked beautifully: ordinary terms for mortgages improved tremendously for people as a result of this government subsidy: from 50% down and 5 years to pay in the 1930’s, to the 20% down and 15-30 years to pay of today. (See Raghuram Rajan, Fault Lines.) But no racket works forever.
With FDR’s subsidy, banks could grow very large. Banks also shifted their focus from evaluating loan quality in competition with other banks to generating maximum loan volume. For generations, the banks reaped huge financial benefits from the US government’s willingness to stand as ready buyer of all mortgage debt the banks could generate. But the system also bred a laxity that later would have grave consequences.
“Deregulation” as a slogan invited Wall Street to cheat Congress. Instead of wise, fully thought through regulatory reform, ideally involving massive simplification—blinded by the law’s very clutter—Congress and the regulators let Wall Street persuade them to “deregulate” the securities laws’ core—antifraud. This was accomplished less by any one legal smoking gun, but by indirection, a strategic progress by which key facts were at the right moment hidden, or masked, and dropped between stools. The arrangement of the stools itself had become obsolete, permitting a game of hide and seek by all manner of mischief-makers.