American Dream 2: Default, Then Rent

Good post. The demise of Glass-Stegall came about after Citigroup had been in violation of G-S for a year or two. Rather than enforce the law Clinton signed the Graham-Leach-Bliley Act that effectively repealed the last of Glass-Stegall. It was actually Robert Rubin rather than Henry Paulson who helped undo Glass Stegall, not that Paulson is any better. If you’re interested in the topic Charlie Gasparino’s “Sellout” is a good book to read.

“To any significant degree, how exactly did the banks know the loans wouldn’t or couldn’t be paid back or the properties would be destroyed? “

Mortgage lenders jettisoned their traditional lending practices before the year 2000. With the invention of CMOs, CDOs and various other credit derivatives loan originators didn’t intend to hold the paper they generated. They sold it off to Wall Street where it was bundled and tranched and sold to investors. And the originators of the loans very often were not employees of the lender, they were loan brokers whose sole interest was in completing the loan, not worrying about its suitability or the ability of the client to service the loan.

To make matters worse the banks and Wall Street seriously underestimated the risk inherent in what they were doing and the rating agencies were compromised as well. Not that anyone cared because everyone involved was making tremendous amounts of money until it all blew up.

Lenders like other fiduciaries have a lot more financial knowledge than the majority of their clients. At one time it was inherent in the lending structure that they be prudent, since lenders kept their own paper and if they were reckless then they went broke. They wouldn’t give out bad loans. That built in restraint is now missing, and during the bubble lenders gave out a huge amount of crappy loans and many people in the industry were fully aware of it. The only part that surprised them is that they became collateral damage when the bubble collapsed.

Banks have been loaning money for about 1500 years now. Before the CRA they had come up with a pretty sure fire way to vet applicants. 1500 years of practice will do that for you. The CRA forced them to loosen their standards, and they knew that eventually this was a time bomb that would explode in their faces. Rather than choose to get out of the loan business, and force Congress to repeal the CRA, they chose to bundle, securitize and sell the loans. That way when they blew up, it would be on someone else’s balance sheet. They chose greed over principle, just as the people who walk away from loans choose greed over principle.

We agree there. What they should have done is quit lending money to anyone until Congress relented and let them determine what loan standards should be.

Something along those lines has become a popular story among radio hosts but it’s a case of special pleading. Blaming CRA is a convenient club for beating Democrats, which is always good fun, but it doesn’t accurately reflect the root of the problem. CRA loans constituted far too little of the subprime universe, and besides that CRA loans were conforming loans. The real excitement was in the liar loans, the Option ARMS, the NINJA loans (no income, no job, no assets). These were creations of the lending industry and Wall Street. They were time bombs waiting to go off.

The driving force behind subprime lending was the voracious pursuit of high yield mortgage paper by the likes of Bear Stearns, Morgan Stanley, Citigroup, Countrywide. The whole investment banking and mortgage origination industry. A lot of these people weren’t even covered by CRA. They were making incredible amounts of money off of the stuff and had waiting lists of months for the CDOs that they created out of subprime paper. Securitizing these loans was part of their business model, it freed up their capital for a new round of lending. They really weren’t doing it to avoid risk and in fact a lot of them simply had stopped paying any attention to risk. They weren’t about to stop what they were doing because the money was too incredible, so why worry about it?

There have been several good books on the development of the bubble written by people who were close to the industry. “Chain of Blame” by Muolo and Padilla, “Sellout” by Charles Gasparino, “Fools Gold” by Gillian Tett. You can find articles and interviews with these authors on the internet to get an idea of what they have to say.

The CRA opened the door to non-conforming loans. Once banks knew they could sell them, they care not whether the loan ever got paid back. I don’t club Dems because it’s convenient, although it is, I club them because they are destroying they country. Sometimes with the help of RINO’s. So, if your lender doesn’t care if you pay the loan back, why should you? Personal responsibility? That is a good reason, and admirable, but Wall Street doesn’t exhibit those traits any more than borrowers do. If you want people to be responsible with the money you loan them, you must be a responsible lender. Don’t be frivolous with your money. That includes paying $200 million bonuses and whatnot. Companies should be allowed to do that, but they shouldn’t cry foul when borrowers get sick of it and walk away.

Everyone has responsibility in this mess.

“The CRA opened the door to non-conforming loans. “

If that were true you would have a good point. But Wall Street investment banks learned of the high yields to be made in subprime lending by studying early hard money practitioners like Aames Home Loans and Household Finance. Aames and HFC long predated the CRA and were wholly independent of it. Wall Street took over that market and vastly expanded it. It provided tremendous profits while it lasted. CRA loans were in fact conforming loans, which made them far lower yielding than the non-conforming loans that were the invention of Wall Street.

“I don’t club Dems because it’s convenient,”

I didn’t have you in mind. I was thinking of some celebrity commentators who try to reduce every issue to mere politics. The credit collapse was largely the result of innovations in the credit and derivatives markets, which had little to do with politics. The politics that were involved were bipartisan efforts that removed regulations such as Glass-Steagall and reserve requirements.

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