Bull by the Horns: Fighting to Save Main Street from Wall Street and Wall Street from Itself by Sheila Bair. This book was "instantly" delivered to my kindle the moment I read Tyler Cowen stating that he learned something on virtually every page. They say that the devil is in the details - this book nothing but first hand details and more details.
The Fix:
Yes, it had come to that: the government of the United States, the bastion of free enterprise and private markets, was going to forcibly inject $125 billion of taxpayer money into those behemoths to make sure they all stayed afloat. Not only that, but my agency, the FDIC, had been asked to start temporarily guaranteeing their debt to make sure they had enough cash to operate, and the Fed was going to be opening up trillions of dollars’ worth of special lending programs. All that, yet we still didn’t have an effective plan to fix the unaffordable mortgages that were at the root of the crisis.
In retrospect, the mammoth assistance to those big institutions seemed like overkill. I never saw a good analysis to back it up. But that was a big part of the problem: lack of information. When you are in a crisis, you err on the side of doing more, because if you come up short, the consequences can be disastrous.
A lesser known fact:
The FDIC has never been funded by taxpayers. Even though the FDIC’s guarantee is backed by the full faith and credit of the U.S. government, it has always charged a premium from banks to cover its costs. However, in 1996, banking industry trade groups convinced the Congress to prohibit the FDIC from charging any premiums of banks that bank examiners viewed as healthy, so long as the FDIC’s reserves exceeded 1.25 percent of insured deposits. This essentially eliminated premiums for more than 90 percent of all banks, which in turn created three problems.
First, because of those limits, the FDIC was unable to build substantial reserves when the banking system was strong and profitable so that it would have a cushion to draw from when a downturn occurred without having to assess large premiums.
Second, it created a “free rider” problem.
Finally, it did not allow us to differentiate risk adequately among banks.
Another lesser known fact:
Once the crisis hit, the myth that large banks were less risky because they had diversified loan portfolios proved to be just that: a myth. All of their portfolios suffered losses. And as it turned out, the quality and performance of the commercial real estate loans made by the smallest community banks were better than those originated by larger institutions. That was a prime example of how regulatory policy can have a disproportionate competitive impact on the industry. As examiners began enforcing the guidance, smaller banks were required to either reduce their CRE concentrations or put in better risk management controls. Meanwhile, the larger banks with which they had to compete for CRE loans did not come under the same scrutiny because they did not have CRE concentrations.
Fixed Rate vs Hybrid ARMs:
While on the one hand bashing subprime borrowers, the lobbyists also complained that by tightening standards on hybrid ARMs, we would be constricting credit to lower-income borrowers. They argued that the lower interest rate subprime borrowers received during the two- to three-year introductory period qualified more low-income borrowers to buy homes. I had heard the same argument from the Fed and OCC, and it really sent me through the roof. We had closely analyzed the terms sheets of several of the mortgage bankers and found that the thirty-year fixed rate they offered subprime borrowers was typically lower than or about the same as the so-called teaser rate they offered on hybrid ARMs.
Many of the bloggers obviously viewed subprime borrowers as flippers and speculators, not families trying to hold on to their homes. That was an erroneous perception. Indeed, our data showed that more than 93 percent of subprime loans had been made to individuals or families occupying their homes. Professional investors and speculators generally opted for the NTM loans— option ARMs— that provided extremely low payments for five years. Real estate professionals were too smart to take out the abusive 2/ 28s or 3/ 27s. Those, for the most part, were marketed to lower- and moderate-income people who lacked financial sophistication.
Failure of FED:
The subprime lending abuses could have been avoided if the Federal Reserve Board had simply used the authority it had since 1994 under the Home Ownership Equity Protection Act (HOEPA) to promulgate mortgage-lending standards across the board. The Fed was the only government agency with the authority to prescribe mortgage-lending standards for banks and nonbanks. The Financial Crisis Inquiry Commission (FCIC) concluded in its 2011 report:
(Lack of) Skin in the game:
Economic incentives to assure good-quality underwriting were weak because the banks were selling the loans and passing on the risk of future default to investors through securitizations. Regulators and accountants also gave banks incentives to securitize loans. If they kept the loans in their own portfolios, they would have to hold capital and reserves against them to protect against potential losses. If, on the other hand, they sold them into securitizations, the regulators and accountants assumed that the risk had been transferred, so there were no capital and reserve requirements.
Why wouldn’t investors tell the servicers to modify loans? After all, if a foreclosure cost more money than a modification, it was the investors, not the servicers, who took the loss. But in point of fact, just the opposite happened, with some investors threatening to sue servicers over modifying loans. Why would investors want to sue servicers for trying to rehabilitate delinquent loans? After all, that would usually save them money over the cost of foreclosure. The answer to that question goes to the heart of what I believe was probably the single biggest impediment to getting the toxic loans restructured: the conflicting economic incentives of investors themselves.
The culture was for the servicers and the investors they worked for to squeeze every penny they could out of borrowers, and that meant that they would negotiate loan by loan. “These guys will step over a dollar to pick up a nickel,” said George Alexander, our most seasoned securitization expert. No truer words were ever spoken.
In making our financial institutions work better, I have long believed that the most successful regulations are those that create the right economic incentives and let market forces do the rest. That is why I like skin-in-the-game requirements— because they force market participants to put their own money at risk and suffer the consequences if their actions result in financial loss.
So much for self regulating market:
I finished my speech, and the lackluster applause spoke volumes. I looked over the crowd of predominantly thirty-something white male Wall Street deal makers, and those who weren’t glaring at me were casting sideways glances at each other or rolling their eyes. I thought they were going to throw rotten eggs and tomatoes at me. Then the question-and-answer session began.
A hand shot up in the back of the room. The gentleman started lecturing me about how it wasn’t possible to help “these people,” referring to subprime borrowers. “You give them a break,” he said, “and they will just go out and buy a flat-screen TV.” So why, I asked, if he felt that way about “these people,” did he extend mortgage loans to them to begin with? I will never forget his answer: “Bad regulation.” So there you had it, straight from the heart of U.S. capitalism. It had been okay for the masters of the universe who filled that conference room to shovel out millions of mortgages to people who clearly couldn’t afford them because no one in the regulatory community had told them to stop. And if there was a problem now, it was because regulators hadn’t protected these securitization whiz kids from their own greed and corruption. So much for the self-regulating market.
Citi a.k.a dissonance:
Citi had not had a profitable quarter since the second quarter of 2007. Its losses were not attributable to uncontrollable “market conditions”; they were attributable to weak management, high levels of leverage, and excessive risk taking. It had major losses driven by their exposures to a virtual hit list of high-risk lending: subprime mortgages, “Alt-A” mortgages, “designer” credit cards, leveraged loans, and poorly underwritten commercial real estate. It had loaded up on exotic CDOs and auction-rate securities. It was taking losses on credit default swaps entered into with weak counterparties, and it had relied on unstable, volatile funding— a lot of short-term loans and foreign deposits.
If you wanted to make a definitive list of all the bad practices that had led to the crisis, all you had to do was look at Citi’s financial strategies.
I would later read in Ron Suskind’s book Confidence Men: Wall Street, Washington, and the Education of a President that Tim Geithner had consulted with Vikram Pandit prior to our call and had talked with him again afterward about where things stood. Looking back, I have to wonder. Tim Geithner seemed to view his job as protecting Citigroup from me, when he should have been worried about protecting the taxpayers from Citi.By January, they were announcing bonuses that rivaled the amounts they had paid before the crisis. It made me wonder whether all of the bailout measures had been to protect the system or make sure those guys didn’t have to skip their bonuses.
As John Reed, the well-regarded former CEO of Citigroup, stated at the time, “There is nothing I’ve seen that gives me the slightest feeling that these people have learned anything from the crisis. They just don’t get it. They are off in a different world.”
The La-La Land:
But finally, and perhaps most important, Tim Geithner wanted leverage against us. That is because he and some of the Republicans, while calling the resolution fund a “bailout fund,” were proposing that the fund be replaced by a line of credit with the Treasury Department. That’s right: they were arguing that our proposed resolution fund, which would be built from assessments on big hedge funds, investment banks, nonbank mortgage lenders, and others, would be a “bailout fund,” but that giving the FDIC a line of credit from taxpayers to support resolution activities would be fine. Got that? It was an argument straight out of George Orwell’s 1984. Big Brother couldn’t have said it better.Already amnesia was setting in about how bad the crisis had been.
The Tea Party— born of outrage over the 2008 bailouts— was redirecting its ire toward government. Instead of providing political support for commonsense measures such as higher capital requirements, resolution authority, and mortgage-lending reform, it was bashing government and regulations for impeding the economic recovery, forgetting that the recession had been caused by the excesses of many large financial institutions. That, of course, was playing into the hands of industry, and it frustrated me no end.
As a market-oriented Republican, I was outraged at the way some of the big firms had come running to Washington to be bailed out of problems of their own making. They had been worse than the proverbial welfare queen. Yet the narrative in some (not all) conservative circles was becoming that the crisis had been the government’s fault; folks at those poor big financial firms had been forced to do all those stupid things and be paid all of those big, multimillion-dollar bonuses because the government had wanted poor people to have mortgages. Right.
The Remedy:
Below is my list of reforms that I think are the most important to ensuring the stability of our financial system. I’ve divided them into three categories:
With resolution authority, Dodd-Frank was designed to make clear to stakeholders— the shareholders and creditors— that they will absorb the attendant losses if the institution they have invested in fails. It also makes clear to boards and management that they will lose their jobs and that those executives materially responsible for the failure will lose their last two years’ worth of compensation. In that way, we created stronger economic incentives for investors as well as boards and executives to monitor and control excessive risk taking in their institutions.
Similarly, with higher capital requirements, the bank’s owners— for whom the bank’s board and executives work— are forced to put more of their own money at risk, which again will give them more incentives to monitor risk taking. In addition, risk retention requires securitizers to absorb some percentage of the loss each time a loan they have securitized goes bad. Knowing that they will be responsible for future losses, the securitizers will exercise more care in the quality of the loans they securitize.
The Fix:
Yes, it had come to that: the government of the United States, the bastion of free enterprise and private markets, was going to forcibly inject $125 billion of taxpayer money into those behemoths to make sure they all stayed afloat. Not only that, but my agency, the FDIC, had been asked to start temporarily guaranteeing their debt to make sure they had enough cash to operate, and the Fed was going to be opening up trillions of dollars’ worth of special lending programs. All that, yet we still didn’t have an effective plan to fix the unaffordable mortgages that were at the root of the crisis.
In retrospect, the mammoth assistance to those big institutions seemed like overkill. I never saw a good analysis to back it up. But that was a big part of the problem: lack of information. When you are in a crisis, you err on the side of doing more, because if you come up short, the consequences can be disastrous.
A lesser known fact:
The FDIC has never been funded by taxpayers. Even though the FDIC’s guarantee is backed by the full faith and credit of the U.S. government, it has always charged a premium from banks to cover its costs. However, in 1996, banking industry trade groups convinced the Congress to prohibit the FDIC from charging any premiums of banks that bank examiners viewed as healthy, so long as the FDIC’s reserves exceeded 1.25 percent of insured deposits. This essentially eliminated premiums for more than 90 percent of all banks, which in turn created three problems.
First, because of those limits, the FDIC was unable to build substantial reserves when the banking system was strong and profitable so that it would have a cushion to draw from when a downturn occurred without having to assess large premiums.
Second, it created a “free rider” problem.
Finally, it did not allow us to differentiate risk adequately among banks.
Another lesser known fact:
Once the crisis hit, the myth that large banks were less risky because they had diversified loan portfolios proved to be just that: a myth. All of their portfolios suffered losses. And as it turned out, the quality and performance of the commercial real estate loans made by the smallest community banks were better than those originated by larger institutions. That was a prime example of how regulatory policy can have a disproportionate competitive impact on the industry. As examiners began enforcing the guidance, smaller banks were required to either reduce their CRE concentrations or put in better risk management controls. Meanwhile, the larger banks with which they had to compete for CRE loans did not come under the same scrutiny because they did not have CRE concentrations.
Fixed Rate vs Hybrid ARMs:
While on the one hand bashing subprime borrowers, the lobbyists also complained that by tightening standards on hybrid ARMs, we would be constricting credit to lower-income borrowers. They argued that the lower interest rate subprime borrowers received during the two- to three-year introductory period qualified more low-income borrowers to buy homes. I had heard the same argument from the Fed and OCC, and it really sent me through the roof. We had closely analyzed the terms sheets of several of the mortgage bankers and found that the thirty-year fixed rate they offered subprime borrowers was typically lower than or about the same as the so-called teaser rate they offered on hybrid ARMs.
Many of the bloggers obviously viewed subprime borrowers as flippers and speculators, not families trying to hold on to their homes. That was an erroneous perception. Indeed, our data showed that more than 93 percent of subprime loans had been made to individuals or families occupying their homes. Professional investors and speculators generally opted for the NTM loans— option ARMs— that provided extremely low payments for five years. Real estate professionals were too smart to take out the abusive 2/ 28s or 3/ 27s. Those, for the most part, were marketed to lower- and moderate-income people who lacked financial sophistication.
Failure of FED:
The subprime lending abuses could have been avoided if the Federal Reserve Board had simply used the authority it had since 1994 under the Home Ownership Equity Protection Act (HOEPA) to promulgate mortgage-lending standards across the board. The Fed was the only government agency with the authority to prescribe mortgage-lending standards for banks and nonbanks. The Financial Crisis Inquiry Commission (FCIC) concluded in its 2011 report:
"There was an explosion in risky subprime lending and securitization, an unsustainable rise in housing prices, widespread reports of egregious and predatory lending practices, dramatic increases in household mortgage debt... Yet there was pervasive permissiveness; little meaningful action was taken to quell the threats in a timely manner. The prime example is the Federal Reserve’s pivotal failure to stem the flow of toxic mortgages, which it could have done by setting prudent mortgage-lending standards. The Federal Reserve was the one entity empowered to do so and it did not."
(Lack of) Skin in the game:
Economic incentives to assure good-quality underwriting were weak because the banks were selling the loans and passing on the risk of future default to investors through securitizations. Regulators and accountants also gave banks incentives to securitize loans. If they kept the loans in their own portfolios, they would have to hold capital and reserves against them to protect against potential losses. If, on the other hand, they sold them into securitizations, the regulators and accountants assumed that the risk had been transferred, so there were no capital and reserve requirements.
Why wouldn’t investors tell the servicers to modify loans? After all, if a foreclosure cost more money than a modification, it was the investors, not the servicers, who took the loss. But in point of fact, just the opposite happened, with some investors threatening to sue servicers over modifying loans. Why would investors want to sue servicers for trying to rehabilitate delinquent loans? After all, that would usually save them money over the cost of foreclosure. The answer to that question goes to the heart of what I believe was probably the single biggest impediment to getting the toxic loans restructured: the conflicting economic incentives of investors themselves.
The culture was for the servicers and the investors they worked for to squeeze every penny they could out of borrowers, and that meant that they would negotiate loan by loan. “These guys will step over a dollar to pick up a nickel,” said George Alexander, our most seasoned securitization expert. No truer words were ever spoken.
In making our financial institutions work better, I have long believed that the most successful regulations are those that create the right economic incentives and let market forces do the rest. That is why I like skin-in-the-game requirements— because they force market participants to put their own money at risk and suffer the consequences if their actions result in financial loss.
I finished my speech, and the lackluster applause spoke volumes. I looked over the crowd of predominantly thirty-something white male Wall Street deal makers, and those who weren’t glaring at me were casting sideways glances at each other or rolling their eyes. I thought they were going to throw rotten eggs and tomatoes at me. Then the question-and-answer session began.
A hand shot up in the back of the room. The gentleman started lecturing me about how it wasn’t possible to help “these people,” referring to subprime borrowers. “You give them a break,” he said, “and they will just go out and buy a flat-screen TV.” So why, I asked, if he felt that way about “these people,” did he extend mortgage loans to them to begin with? I will never forget his answer: “Bad regulation.” So there you had it, straight from the heart of U.S. capitalism. It had been okay for the masters of the universe who filled that conference room to shovel out millions of mortgages to people who clearly couldn’t afford them because no one in the regulatory community had told them to stop. And if there was a problem now, it was because regulators hadn’t protected these securitization whiz kids from their own greed and corruption. So much for the self-regulating market.
Citi a.k.a dissonance:
Citi had not had a profitable quarter since the second quarter of 2007. Its losses were not attributable to uncontrollable “market conditions”; they were attributable to weak management, high levels of leverage, and excessive risk taking. It had major losses driven by their exposures to a virtual hit list of high-risk lending: subprime mortgages, “Alt-A” mortgages, “designer” credit cards, leveraged loans, and poorly underwritten commercial real estate. It had loaded up on exotic CDOs and auction-rate securities. It was taking losses on credit default swaps entered into with weak counterparties, and it had relied on unstable, volatile funding— a lot of short-term loans and foreign deposits.
If you wanted to make a definitive list of all the bad practices that had led to the crisis, all you had to do was look at Citi’s financial strategies.
I would later read in Ron Suskind’s book Confidence Men: Wall Street, Washington, and the Education of a President that Tim Geithner had consulted with Vikram Pandit prior to our call and had talked with him again afterward about where things stood. Looking back, I have to wonder. Tim Geithner seemed to view his job as protecting Citigroup from me, when he should have been worried about protecting the taxpayers from Citi.By January, they were announcing bonuses that rivaled the amounts they had paid before the crisis. It made me wonder whether all of the bailout measures had been to protect the system or make sure those guys didn’t have to skip their bonuses.
As John Reed, the well-regarded former CEO of Citigroup, stated at the time, “There is nothing I’ve seen that gives me the slightest feeling that these people have learned anything from the crisis. They just don’t get it. They are off in a different world.”
The La-La Land:
But finally, and perhaps most important, Tim Geithner wanted leverage against us. That is because he and some of the Republicans, while calling the resolution fund a “bailout fund,” were proposing that the fund be replaced by a line of credit with the Treasury Department. That’s right: they were arguing that our proposed resolution fund, which would be built from assessments on big hedge funds, investment banks, nonbank mortgage lenders, and others, would be a “bailout fund,” but that giving the FDIC a line of credit from taxpayers to support resolution activities would be fine. Got that? It was an argument straight out of George Orwell’s 1984. Big Brother couldn’t have said it better.Already amnesia was setting in about how bad the crisis had been.
The Tea Party— born of outrage over the 2008 bailouts— was redirecting its ire toward government. Instead of providing political support for commonsense measures such as higher capital requirements, resolution authority, and mortgage-lending reform, it was bashing government and regulations for impeding the economic recovery, forgetting that the recession had been caused by the excesses of many large financial institutions. That, of course, was playing into the hands of industry, and it frustrated me no end.
As a market-oriented Republican, I was outraged at the way some of the big firms had come running to Washington to be bailed out of problems of their own making. They had been worse than the proverbial welfare queen. Yet the narrative in some (not all) conservative circles was becoming that the crisis had been the government’s fault; folks at those poor big financial firms had been forced to do all those stupid things and be paid all of those big, multimillion-dollar bonuses because the government had wanted poor people to have mortgages. Right.
The Remedy:
Below is my list of reforms that I think are the most important to ensuring the stability of our financial system. I’ve divided them into three categories:
- Things that will make our financial institutions work better.
- Things that will make our regulators work better.
- Things that will make our entire financial system work better.
With resolution authority, Dodd-Frank was designed to make clear to stakeholders— the shareholders and creditors— that they will absorb the attendant losses if the institution they have invested in fails. It also makes clear to boards and management that they will lose their jobs and that those executives materially responsible for the failure will lose their last two years’ worth of compensation. In that way, we created stronger economic incentives for investors as well as boards and executives to monitor and control excessive risk taking in their institutions.
Similarly, with higher capital requirements, the bank’s owners— for whom the bank’s board and executives work— are forced to put more of their own money at risk, which again will give them more incentives to monitor risk taking. In addition, risk retention requires securitizers to absorb some percentage of the loss each time a loan they have securitized goes bad. Knowing that they will be responsible for future losses, the securitizers will exercise more care in the quality of the loans they securitize.
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