Making Recessions Great Again: Trump Aims To Unleash The Wolves Of Wall Street
The root cause of the 2008 crisis has been carefully hidden from the American people. It was consumer fraud by the banks. Dodd-Frank implemented a few (not nearly enough) protections for the working class to prevent it from happening again. Trump is hell bent on taking them off and unleashing the worst wolves of Wall Street on the most vulnerable of consumers.
Before we look at the protections that Dodd-Frank implemented, let’s have a look at the nature of the fraud on low-income earners and how it has been obfuscated by banker friendly analysts in the usual explanations of the crisis.
Banking business models have radically changed. They no longer make their profits by making loans. When they did that, bankers were pulling home only the same kind of salary as in any other industry. Bankers discovered new ways of making huge profits resulting in the obscenely high-level banker pay that started in about 1990 and that the public has accepted as normal for bankers today.
One of the new ways centers on mortgage lending. Mortgage lenders can be the commercial banks that we see in malls and on street corners, or they can be private label companies. Because they were unregulated, mortgage companies were called shadow banks. The most famous of the latter in the financial crisis was Countrywide Financial. These private-label companies are usually a borrower’s second choice after they had been turned down by a commercial bank.
Mortgage lenders of both types no longer keep the mortgages on their own books. They sell them off for an immediate profit. It’s called the ‘originate and sell’ model of banking.
With the coming of this new model, more lower income people got to buy homes, investors got rock solid secure investments.
This sounds like an idyllic arrangement — and it was for decades!
Here is the history of how it got started, how it got abused and how the abuse got hidden under a cover of superficial causes.
It’s another lesson in the law of unintended consequences. It started out with the best of intentions…
The Rise And Collapse Of The Housing Market
To fully understand this, we must go back to 1938 when Fannie Mae (Federal National Mortgage Association) was just being founded and when governments were more powerful than banks
The government wanted to help the salt of the earth working class buy homes. Banks have lending standards. We all know them: a job history, a salary four times the amount of the monthly mortgage installment, a 20% down payment and so on.
Fannie Mae would also have the same lending standards with only one lower: its mortgagors could have a 5% down payment, but otherwise, must meet the other lending requirements. The trick was getting low monthly installments that lower income people could meet.
The solution was 30 year amortized mortgages, which means that the installments were calculated so that the mortgage was completely paid off in 30 years. This allowed the mortgage installment payments to be lower. For example, if a 30 year amortized mortgage monthly payment was $1000. If the mortgage was changed so the borrower had to pay the mortgage off in 25 years, the installment payment might be $1500.
Fannie Mae mortgages became known as conforming mortgages because they conformed to its standards. While the requirements were lower because of the lesser down payment, they were still considered prime mortgages i.e., experience had proven there was extremely little risk of default.
(Keep this term in mind when reading any analysis of the 2008 financial crisis. If it doesn’t mention conforming mortgages, its writer, no matter how well intentioned, has likely been influenced by the bankers’ spin version.)
Then came a brilliant idea. (It came from Ginnie in 1970, but I’ll continue with Fannie for simplification.)
Why brilliant? Here’s why: Fannie would no longer lend to purchasers but buy mortgages that met her standards from lenders. These lenders were private mortgage companies (the shadow banks) and the regulated commercial banks. Fannie would buy them, package and sell them to wealthy investors with an implied guarantee that she would pay if the mortgagors didn’t.
Why so brilliant? Fannie got her money from buying the mortgages back immediately to buy more. With proper management, there could be no, or very little, gap so Fannie could be self-funded. Of course, this was a government run agency so you know that didn’t happen — but that issue, as the Russians say, is another opera.
Also, this got the risk off the banks’ books that allowed them to make more and more mortgage loans so more and more low-income people could buy homes — and the lenders got their profit up front.
Wealthy people are not after the big kill in investing. They have it. They want to protect it. So, investing in government-backed subprime mortgages was as safe as treasury bills, but with a few percentages higher interest. Great!
So, what about these ninja loans? you ask. Such people had No Income — No Job — No Assets. They clearly did not meet Fannie’s standards. That’s the bright question.
We need a bit more background and obfuscation busting.
Packaging these mortgage loans together is one type of a derivative called a collateral debt obligation (CDO). The collateral is the house. The agreement to repay the loan is the debt obligation. The package, or derivative, would be sold under one name, such as Abacus 2007 AC1.
Derivative is an intimidating word, but all it means is that the investment derives its value from another investment. The derivative Abacus 2007 AC1 would derive its value from the mortgages in its package.
Here’s an example of how bankers eventually crafted complexity into derivatives so that valuation became anyone’s guess.
They were a hit with investors. There were almost no defaults. Fannie was successful in providing the working class with homes they could not otherwise have afforded — and it was highly profitable.
Coming up to the year 2000, investors liked ’em; the working class liked ’em and the government liked ’em — and the economy smiled. There were no serious Great Depression level meltdowns from Fannie’s founding — until…
But first a little more background.
In 1982, During Reagan’s presidency, Congress passed a bill permitting adjustable-rate mortgages (ARMs). Prior to this mortgage lenders could only provide fixed rate mortgages. But now they could offer customers a choice between the same rate for the term of the mortgage (remember that the term of the mortgage is usually three or five years — It is not the amortization period) or a rate that varies by some other measure.
While the politicians who passed the provision may have thought that adjustable rate would mean variation with the prime lending rate set by the Federal Reserve Bank, crafty lenders saw a very different opportunity.
Coincidentally, in the 1980s, investment banker, Lewie Ranieri, at Salomon Brothers decided that he would package prime mortgages as Fannie did, certify that they were indeed prime mortgages and sell these derivatives to wealthy investors. This financial innovation caught on.
Soon we had both Fannie Mae and all the big investment banks in the business of creating CDOs and selling them as AAA, can’t get any safer, type investments to the large institutions, pension funds, and individual wealthy investors.
And they were indeed AAA. They lived up to their rock of Gibraltar solid reputation. Both the Fannie Mae and the investment bank derivatives proved wonderful investments over time, thus building confidence in the mortgage CDO. The market for them exploded!
The wealthy investors hungered for these derivatives and so Fannie Mae and the investment banks looked to the mortgage lenders to supply.
But as the demand increased, both commercial and investment banks ran out of supply. There weren’t enough people who could meet Fannie’s standards.
That’s when the mortgage lenders sent out mobile mortgage brokers to recruit any warm body that was capable of signing its own name. When they ran out of people with enough breath to fog a mirror, no problem; they roused people from the grave. In Ohio, 23 dead people were approved for loans. (Mark Zandi, The Financial Crisis in Perspective, p.184)
To further lure unsuspecting applicants into signing for mortgage loans, the mortgage lenders invented a special adjustable rate mortgage for them. The original rate would be, say a low 3% that would double after two years. Not to worry, the applicant would be told, the housing market always goes up. So, in two years your house will be worth so much more you’ll be able to refinance.
These were the ninja loan applicants who became so famously mocked in Internet memes which played into the banker propaganda. The creative ‘memers,’ who believed they were raging against the machine, were protecting it. They entirely missed that this was widespread predatory lending by the banks — not banker foolishness.
The mortgage lenders didn’t care about the defaults because they were selling these mortgages on to Fannie Mae or the investment banks. The defaults would be downloaded to the investors. The bankers would get their big profit and pay, somebody else would take the hit, maybe the taxpayers.
And so it came to pass. Although a few of the private-label banks got fined for predatory lending, the bankers got to keep their bonuses. No banker salary or bonuses were clawed back.
Important fact: the lenders were charged with checking into the applicant’s background and certifying that they met Fannie Mae’s lending requirements. Investment banks also claimed they had independently vetted the applicant’s income info and it all checked out
Both at the commercial bank and investment bank level, bank employees forged, or knowingly approved fraudulent, applications so they would appear as if they met the lending standards. The ninja loans were passed off as if they were Fannie Mae conforming mortgages.
We owe it to Michael Lewis and his The Big Short for making the role of predatory lending in the financial crisis understandable. The reason that the four money managers knew not only that the housing market would tank but when it would do so was that they had read the terms of the mortgages and knew when the higher rates were going to kick in. That’s when the default started and that’s when the housing market collapsed.
The Path Forward
That’s why as part of Dodd-Frank, the Obama administration established a new consumer protection agency to oversee mortgage lending to stop predatory lending.
There are two simple reforms, not in Dodd-Frank, that could make predatory lending a lot more difficult.
First, eliminate variable-rate mortgages. How can an ordinary custom be expected to knowledgeably bet against the bank about future changes in interest rates? Even ex-Fed Chair, Alan Greenspan, said he would not take out an adjustable rate mortgage. There can be no benefit to ordinary customers, especially low-income borrowers, to these ARMs.
Secondly, have every applicant for a mortgage loan at a systematically important mortgage lender sign a consent so that the relevant regulator can get that applicant’s income tax information directly from the tax department. That would eliminate the opportunity for the bank employees to fudge applications. The regulator could do spot surprise audits and check random samples of applications directly against tax department information.
Simple, uncomplicated regs that anyone one can understand and implement. But that ain’t gonna happen. Instead, with his financial CHOICE act, Trump is refilling the swamp with greedy financial predators.