Debt ceiling: 10 lessons beyond that crisis
By Barry Ritholtz,
The debt ceiling is hanging heavy over our heads. But that’s not the only reason it looks dark down here. We’ve got some major and prolonged challenges: ongoing debt issues, structural unemployment, a housing overhang and continued economic frailty.
How did we get here? Well, by way of a financial crisis, stock market collapse, bank bailouts and, of course, the Great Recession — and a good many moments of poor judgment.
Given the drama of the debt-ceiling debate, this is a good moment for investors and policymakers alike to look back over the past decade at the mistakes made by our institutions, private sector and government.
If this were a college final exam, it would be in essay form. But because it’s summer, and most of you are out of school, consider this the answer key to that exam.
1 Rates: After the dot-com implosion and 2000 market crash, the Federal Reserve lowered rates to 2 percent for three years, including a 1 percent rate for more than a year. That monetary policy was unprecedented. It had an enormous impact on various asset classes, including dollars, real estate, bonds, oil and gold. A more “traditional” interest rate between 4 and 6 percent would likely not have started the inflationary spiral we saw in commodities during the 2000s. Had rates been “normal,” it is doubtful we would have seen a 41 percent drop in the dollar from 2001 to 2008.
2 The rating agencies: Moody’s Investors Service, Standard & Poor’s and Fitch Ratings — all originally served bond investors, who paid for their research. But that model changed in the 1990s to one that was funded by the syndicators and underwriter of structured financial products such as mortgage-backed securities. Essentially, bankers “purchased” the rating they desired. As a result, the performance of the rating agencies decayed, as they were no longer judged on the quality of their analytical reviews. Second, the underwriting quality of syndicators fell, as they —not a neutral third party — were, in effect, picking their own credit ratings. The real question for the financial markets is why we even require rating agencies to evaluate complex financial products any more.
3 The radical deregulation of derivatives: The Commodity Futures Modernization Act of 2000 was a highly unusual piece of deregulatory legislation. It created a new world of uniquely self-regulated financial instruments — the credit derivative. Unlike traditional financial instruments — bonds, stocks, futures, options, mutual funds — it did not require anything from underwriters or traders. No reserve requirements against future obligations, no counter-party disclosure, no exchange trading needed, no capital minimums. This had an enormous impact on risk management, leverage and mortgage underwriting. AIG, for example, wrote $3 trillion of credit derivatives with a grand total loss reserves against any payout of zero dollars. Bear Stearns and Lehman Brothers were able to expand dramatically into the mortgage-backed security space using very little capital and lots and lots of leverage. You remember how that worked out.
4 Subprime loans: More than 50 percent of subprime loans were made by nonbank mortgage underwriters not subject to comprehensive federal supervision; another 30 percent were made by thrifts also not subject to routine supervision. With this, traditional lending standards disappeared. Millions of unqualified borrowers poured into the residential housing market as overleveraged buyers.
The irony is that dropping credit standards is a key factor in just about every bubble and financial crisis in history. Call it a lesson never learned.
5 Leverage rules: In 2004, the Securities and Exchange Commission issued the “Bear Stearns exemption,” replacing the existing Net Capitalization Rule — that is a 12 to 1 leverage limit — with essentially unlimited leverage for the five largest investment houses. Goldman Sachs, Morgan Stanley, Merrill Lynch, Lehman Brothers and Bear Stearns were given carte blanche to pile as much obligation onto their capital base as they saw fit. Following the rule exemption, they leveraged up 25, 35 even 45 to 1.
Less than five years after the exemption was granted, none of these companies existed in the same structure as before the rule change.
6 Mortgage underwriting standards: Beyond the subprime mortgages, lending standards dropped for home purchases in the 2000s. Many lenders stopped verifying income, payment history and credit scores. The 20 percent down standard disappeared. No money down loans rose up. “Piggyback mortgages” piled on a second mortgage. Not to mention “innovations” such as adjustable-rate mortgages. What followed? Rising home prices, housing overstock and booming defaults and foreclosures.
7 Automated underwriting: Loan demand became so great that bankers developed an automated underwriting system that emphasized speed and volume over accuracy and risk management. And the players all learned how to game the system. Real estate agents and mortgage brokers used corrupt appraisers to facilitate loan approval. Mortgage brokers learned how to tweak even the worst loan application to get it approved. Even bank loan officers circulated “unofficial” cheat memos on how to get lousy applications through the automated system.
8 Collateralized debt obligation (CDO): Here is an issue for those of you who believe markets are so efficient: CDO managers created trillions of dollars in mortgage-backed securities without really understanding what was going into these giant mortgage pools. The institutional investors — pensions, insurance firms, banks — who bought these appear to have failed to engage in effective due diligence. This teaches us just about everything we need to know about self-regulation of the financial industry. Indeed, given the outsize bonuses of bankers and the profit motive of banks themselves, financial self-regulation does not appear to be remotely possible.
9a. Glass Steagall: The Depression-era Glass Steagall legislation was effective in keeping Wall Street crises separate from Main Street. Think back to the 1987 crash — it had little impact on the broader banking industry. But the repeal of Glass Steagall in 1998 allowed FDIC-backed depository banks and Wall Street investment firms to become intertwined. It took less than 10 years for the entanglements to become extremely dangerous. By the time the 2008 credit crisis hit, the troubles on Wall Street were inseparable from Main Street. So banks and investment firms collapsed together.
9b State banking regulations: Many states had anti-predatory lending laws on their books. These prevented the making of loans or mortgages to borrowers who could not afford them. In 2005, these state laws were “federally preempted” by order of John Dugan, head of the Office of the Comptroller of the Currency. States with anti-predatory lending laws saw lower default and foreclosure levels than states that did not have them. Not surprisingly, after the preemption, default and foreclosure levels in those states rose.
10 Fannie and Freddie: In 2006, more than 84 percent of subprime mortgages were issued by private lending institutions not covered by government regulations, according to data from McClatchy. Indeed, before 2005, the government-backed private firms Fannie Mae and Freddie Mac were not allowed to buy nonconforming loans. But they were losing massive market share to Wall Street and, in response, petitioned their regulator for permission to buy alt A and subprime loans. Fannie and Freddie plunged headlong into the junk bond market just as the housing market peaked. But it was the profit motive and competition — not government policies — that led to this.
Where does this leave us? We have created an intensely concentrated financial industry, where a handful of banks control the majority of assets. Competition is less than it was before the crisis, and bank fees are creeping upwards.
While risk-taking remains rather subdued, history informs us it is likely to return as the crisis fades in the collective memory. The bailouts left us with a legacy of poor balance sheets and moral hazard. None of 10 factors discussed above have been, in any meaningful way, resolved.
The debt ceiling is the least of our worries.
Ritholtz is chief executive of FusionIQ, a quantitative research firm. He runs a finance blog, the Big Picture.