Reckless Endangerment
The Affordable Housing Scam
Raking over the politicians, regulators, brokers, and bankers who caused the financial crisis
Reckless Endangerment: How Outsized Ambition, Greed, and Corruption Led to Economic Armageddon, by Gretchen Morgenson and Joshua Rosner, Henry Holt & Co., 315 pages, $30
There will probably never be an Oxford Companion to the 2008 American Financial Disaster. Those interested in this baneful topic, however, would do well to read Reckless Endangerment. Veteran New York Times business reporter Gretchen Morgenson and financial analyst Joshua Rosner (who, Morgenson says, “has seen every trick there is”) acknowledge that their book about the events that led up to the financial crisis is not the last word on this sorry episode. But it is, they promise, a work that names names and smokes out 20 years of key incidents that produced the crash and its trillion-dollar aftermath. In this they deliver.
The thesis of Reckless Endangerment is simple: In a rush to orchestrate affordable home ownership—and generate enormous profits—politicians, government-sponsored enterprises, pusillanimous regulators, greedy mortgage brokers, and profit-chasing Wall Street investment bankers combined to drive the American economy into its worst crisis in 70 years, saddling taxpayers with trillions of dollars of debt and leaving the financial landscape littered with the wreckage of ruined lenders, borrowers, and taxpayers.
Morgenson and Rosner begin this ugly tale in 1991, following the savings and loan crisis and subsequent taxpayer bailout. “In just a few short years,” they write, “all of the venerable rules governing the relationship between borrower and lender went out the window, starting with the elimination of the requirements that a borrower put down a substantial amount of cash on a property, verify his income, and demonstrate an ability to service his debts.”
The poster boy for this narrative is Federal National Mortgage Association (“Fannie Mae”) CEO James A. Johnson, an ambitious Minnesota lad who worked his way up in Washington via connections with Walter Mondale, Bill Clinton (his roommate at a 1969 anti–Vietnam war conference), and other Democratic luminaries.
The Roosevelt administration created and capitalized Fannie Mae in 1938 when no private group came forward to charter a national mortgage association. Its purpose was to provide a secondary market for mortgages issued by bank lenders, thus replenishing their loan capital.
In the 1950s Congress pressed Fannie Mae into becoming the purchaser of otherwise unmarketable government-insured mortgages with below-market interest rates. In 1968 Congress created a federal corporation, the Government National Mortgage Association (Ginnie Mae), to purchase government-insured mortgages, and spun Fannie Mae off as a pseudo-private corporation to buy private mortgage paper from banks and other loan originators. Although it was now owned by private stockholders, Fannie Mae retained an exemption from securities laws, an exemption from D.C. real estate taxes, and the right to draw ultimately $2.5 billion from the U.S. Treasury. It was not explicitly backed by the full faith and credit of the government, but investors quickly leaped to the conclusion that it was. That perception allowed Fannie Mae (and its smaller savings-and-loan counterpart Freddie Mac) to borrow money at a significantly lower rate than most financial institutions.
In 1991 retiring Fannie Mae Chairman David Maxwell recruited James Johnson as his successor, mainly for his connections and political skills. Johnson, Morgenson and Rosner write, soon became “the financial industry’s leader in buying off Congress, manipulating regulators, and neutralizing critics.…Johnson’s manipulation of regulators provided a blueprint for the financial industry, showing them how to control their controllers and produce the outcome they desired: lax regulation and freedom from any restraints that might hamper their risk taking and curb their personal wealth creation.”
Throughout the 1990s, Fannie Mae recurrently faced the threat of congressionally spurred privatization. To protect the lender from the horrors of losing its competitive advantage, Johnson set out to make Fannie Mae so popular with Congress that its privileges would remain intact, keeping its money machine running at full throttle. His strategy was to produce millions of happy new homeowners, people whose credit history, income, or down payments were inadequate by traditional home loan standards. Community organizations, subsidized by the Fannie Mae Foundation, would generate applicants from groups believing themselves to be victims of a heartless capitalist system. Banks and other lenders would originate these loans with an agreement that Fannie Mae would buy the loan paper, leaving them with attractive servicing fees and political approval. Activist organizations such as the left-wing Association of Community Organizations for Reform Now (ACORN) and home buyers would become a political claque pressing their members of Congress to defeat any threat to their benefactor.
Johnson’s playbook for blocking privatization and troublesome regulations became a blueprint for any large institution seeking freedom or favor. When one courageous Congressional Budget Office analyst, Marvin Phaup, produced a report in 1995 measuring the value of Fannie Mae’s implied government guarantee and the equally startling amounts that found their way into Fannie Mae’s executive pay packets, Johnson’s lobbyists spread the rumor that Phaup suffered from mental illness. Fannie Mae’s political contributions became enormous.
Fannie Mae not only played defense in Congress; it also seized on the practice of securitizing mortgage loans for sale to the country’s leading financial institutions. Wall Street—notably Goldman Sachs—in turn made huge profits selling these securities to investors.
This superstructure all came crashing down in 2007, and in late 2008 former Goldman Sachs CEO Henry Paulson, serving as George W. Bush’s treasury secretary, presided over the Troubled Asset Relief Program bailout and the disappearance of firms such as Bear Stearns and Lehman Brothers. A year later Fannie Mae and its smaller counterpart, Freddie Mac, went into government “conservatorship.” (Amusingly, the conservators are now suing the larger banks for selling Fannie Mae and Freddie Mac the toxic mortgages that the buyers eagerly solicited.) James Johnson made it out the door unscathed in 1999, going on to chair the compensation committee of Goldman Sachs, Fannie Mae’s go-to collaborator, then headed by Henry Paulson.
Morgenson and Rosner turn over a lot of rocks, doing a good job of explaining the incentives and motivations of various actors, including those few who sounded the alarm, usually in vain. The most infamous of the bad boys are, in addition to Johnson, Rep. Barney Frank (D-Mass.), Sen. Chris Dodd (D-Conn.), Clinton administration Treasury Secretary Robert Rubin and his deputy Larry Summers, and Fannie Mae officials Franklin Raines and Robert Zoellick.
President Bill Clinton was an enthusiastic enabler. In 1994 he launched the Johnson-conceived National Partners in Homeownership program, a public-private partnership booster club aimed at encouraging greater home ownership financing. President George W. Bush foolishly took a plunge into affordable home ownership in 2002 by announcing expanded support for home buyers from the Department of Housing and Urban Development, but made at least two efforts to get Congress to put the brakes on Fannie Mae’s runaway express. His most serious effort, in 2005, died when Bush capitulated to a united front of Democratic senators, including the Fannie Mae–financed Sen. Barack Obama (D-Ill.), who vowed to filibuster a Republican-authored regulatory reform bill. To the end of his presidency Bush seemed not to grasp the awful consequences of his passion for irresponsibly expanding home ownership.
Also notable among the villains were the three securities rating agencies: Standard & Poor’s, Fitch’s, and Moody’s. A 1975 Securities and Exchange Commission (SEC) ruling conferred a shared monopoly on the three, and each learned that asking for too much information about a pool of loans was bad for its business. Since the rating agencies only offered opinions, they were not subject to civil action by investors who discovered that they had paid too much for junk.
On the mortgage origination side, the most prominent villain was the flamboyant Angelo Mozilo of Countrywide Financial. But there were plenty of others, including many in the higher suites of Wall Street’s most prestigious investment banks.
There were also some white knights, men and women who saw where all this was headed and tried to get it under control. They include Bush’s first treasury secretary, John Snow; regulators Bill Taylor (Federal Reserve), Armando Falcon (Housing and Urban Development), and Don Nicolaisen (SEC); Congressional Budget Office Director June O’ Neill; and several less visible lawyers and analysts whose warnings were beaten down by Fannie Mae’s powerhouse lobbying.
Reckless Endangerment is not, at least directly, about the role of the Federal Reserve Board. The Fed, however, was an enormous enabler, with its shockingly promiscuous money creation and shockingly low interest rate policy from 2001 to 2003. Year-over-year growth of the money aggregate M2 ranged from 8 percent to 10 percent, while the Fed lowered its target for the federal funds rate, the rate at which banks borrow from the Fed to maintain their reserve requirements, from 6.25 percent in 2001 to 1 percent in 2003. This policy produced a negative real rate of interest and an enormous incentive for investors to seek out riskier, more lucrative debt—such as Fannie Mae’s mortgage-backed securities. Morgenson and Rosner do not fault Federal Reserve Chairman Alan Greenspan and Ben Bernanke, then a member of the Fed’s board, for their wrong-headed monetary performance and ambivalent pronouncements. But it is hard to see how anything like the housing bubble could have happened had there been a stable 2 percent monetary growth rate and a 6 percent federal funds rate.
For students of financial regulatory policy, Reckless Endangerment is valuable in identifying key decisions that led to unhappy results. For instance, a little-noticed provision in the Federal Deposit Insurance Corporation Improvement Act of 1991 authorized the Fed to bail out not just commercial banks but also investment banks and insurance companies. In November 2001 all four federal bank regulators agreed that AAA- and AA-rated mortgage-backed securities needed to carry only a 20 percent risk weight, down from the conventional 50 percent—drastically reducing the amount of reserves banks were required to hold against loan defaults. This change fueled investor confidence in the securities, which all too often contained a large component of subprime and Alt-A mortgages (“liar loans”).
The authors do not give enough attention to the Community Reinvestment Act (CRA), first enacted in 1977 to require banks to report the distribution of their mortgage loans. By 1995 the CRA had become a powerful tool in the hands of ACORN and allied activist organizations. Unless a bank could silence their protests by making (and passing on to Fannie Mae) the demanded amount of subprime loans, it faced serious difficulties in obtaining regulatory approval for branching, merging, and other corporate decisions.
The book is also marred by superficial criticism of the “repeal” of the 1933 Glass-Steagall Act, which prohibited deposit-taking commercial banks from underwriting or dealing in securities. As former Treasury Department General Counsel Peter Wallison has shown, the reformist 1999 Gramm-Leach-Bliley Act actually left this prohibition intact. Gramm-Leach-Bliley merely allowed a bank holding company that owned a deposit-taking commercial bank to also own other affiliated financial firms, such as insurance companies or stock brokerages. This change, Wallison persuasively argues, enhanced competition, preserved the protection against banks draining their depositors’ accounts to speculate, and in fact buffered the financial crash in 2008.
One other shortcoming of the book—perhaps understandable—is its decision to begin the story in 1991, when Johnson took the reins at Fannie Mae. The Housing Act of 1968, the law that created the modern Fannie Mae, contained an ominous provision replacing the “economic soundness” underwriting standard of the Federal Housing Administration (FHA) with a weaker “acceptable risk” standard. This practice inevitably spread throughout the industry.
The Housing Act also spawned the Section 235 program, under which the FHA insured 40-year home mortgages at 1 percent interest with a $250 down payment, in order to finance President Lyndon Johnson’s projected 6 million new units of subsidized housing over 10 years. That program produced every feature of the subprime loan scandals of the last 20 years: enormous default rates, liar loans, exploited purchasers, quick-buck profits, foreclosures, vandalism, fraud, and taxpayer losses. Reviewing the wreckage, Housing and Urban Development Secretary George Romney later reported to Congress in harrowing detail the failure of an idealistic proposal gone very, very wrong. How the architects of the most recent 20 years of disaster could have so rapidly forgotten that searing experience remains a mystery.
Those interested in this shameful topic would do well to read additional accounts by Jeffrey Friedman, Peter Ferrara, Richard Rahn, and Peter Wallison, among others. But all in all, Reckless Endangerment is an informative, understandable, and balanced account of the great homeownership madness. It is especially good in illuminating the scheming of actors in and out of government who made it worse, and a useful epilogue tells us what became of the key figures.
The authors stop short of offering an explicit reform agenda, but it’s not hard to infer their preferred model: more and better regulation by dedicated and courageous public servants. A market-disciplined system—with full and honest disclosure, no government risk taking, and no hope of bailouts—might have been a far better path.
Contributing Editor John McClaughry recently retired as president of the Ethan Allen Institute in Vermont.
source: The Affordable Housing Scam – Reason Magazine
Editors Note: You can take it a step further with blame. The U.S. started its real decline when manufacturing began moving overseas. The cannibalization began in full force. When a middle class has nothing to make some real money at, people turned to making short-term profit on long-term investments. Real estate became the industry of last resort.
In addition to real estate came healthcare. The human being became the next commodity in a world of dwindling natural resources.
Ending in cannibalizing our children with deficit spending.
Kill the patient.
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