Banks relied on AAA ratings and credit default swaps. The subprime mortgage pools were sliced and diced into mortgage securities that were sold to various investors. About 80% of the securities were rated AAA by S&P or Moody's, and a huge chunk of those securities were held by American and European banks. Why? Bankers thought if a bond is rated AAA, they could always sell it at something close to par. Also, residential home values had held up fairly well during the Great Depression. Finally, because of rules related to regulatory capital, the mortgage bonds received a lower weighting on mortgage securities than on ordinary corporate loans.
The real estate bubble burst and bond prices collapsed. Most subprime mortgages were extended for 80% of the appraised value, but many home buyers in California and elsewhere financed 100% of their home purchase.
Because so many people were buying homes they could not afford, market discipline was lost. California, Florida, Nevada and Arizona experienced a real estate bubble. When the bubble collapsed, almost everyone who bought a home in those markets from 2005 onward saw their home equity wiped out.
Three years after private label mortgage securities took off, they started collapsing. Because of the non-standard documentation, the suspicion of underlying fraud, and the difficulty in restructuring the loans with the borrowers, the securities became very difficult to value and market for them dried up.
How did this steady deterioration suddenly become a global financial meltdown? The two-word answer is Hank Paulson.
9/12 Changed Everything. On September 12, 2008, just as Lehman entered into final negotiations to find a buyer, Hank Paulson announced that the government would not backstop Lehman's solvency. What was the difference between Lehman and Bear Sterns, or between Lehman and the other banks? The prices of mortgage securities had declined since the Bear Stearns bailout, so the level of government support for Lehman would have been higher. Also, Lehman's fiscal quarter ended one month earlier than the other banks, so the magnitude of its problems was disclosed before those of other banks.
Paulson's refusal to support Lehman was extraordinarily reckless, because there was no transparency in the financial markets, given that vast amounts of money tied up in hedge funds and credit default swaps. Markets became destabilized right after Lehman declared bankruptcy on September 15, 2008.
Lehman suddenly defaulted on 900,000 derivatives, hedge fund assets were frozen, and countless hedged positions suddenly became unhedged. Nobody knew who was solvent and who was not. The different capital markets started freezing up in succession: the interbank lending market, money market funds, the commercial paper market. Banks cut back on extending trade letters of credit, thereby slowing down shipping and the trade of raw materials around the world, and further pushing down commodity prices. Global trade declined for the first time since World War II.
Paulson's TARP bait and switch. To stabilize the markets, Congress forked over $700 billion to Paulson, who then gave the banks another sucker punch on November 12, one week after Obama was elected. Paulson said he would not apply TARP funds to help abate the foreclosure crisis, and the prices of mortgage securities plunged further, effectively forcing the largest banks into insolvency.
Fact Checking Time's List of 25 People to Blame
1. Angelo Mozilo Bottom Line: Countrywide's CEO deserves to be on the list, but not in the top five.
Time's Conspicuous Omission: Roland Arnall This omission is egregious because, as reported in Chain of Blame, Arnall popularized "no income no asset" loans that opened the doors to the fraud that eventually overwhelmed the mortgage markets. His firm, Ameriquest, was more like a vast criminal enterprise, operating as a boiler room that preyed on the elderly and fixed property appraisals. Arnall had powerful Republican friends, including George Bush, who appointed him Ambassador to The Netherlands over the objections of many in Congress.
The media has deemed Angelo Mozilo to be Arnall's stand-in, the poster child of all corrupt mortgage lenders. But there's really no comparison between Arnall and Mozilo. Arnall was far more corrupt. Why do reporters keep coming back to Mozilo and forget Arnall? The real reasons, I suspect, are: (a) Mozilo looks like a character from The Sopranos, (b) Roland Arnall died last year, (c) Arnall's firm, Ameriquest, shut down in 2007, and (d) Arnall was chairman of the Simon Wiesenthal Center.
2. Phil Gramm Bottom Line: He deserves to be at the top of the list. It's hard to overestimate the damage he caused.
Unmentioned by Time: Gramm slashed the SEC's budget, stacked the CFTC with his cronies, helped emasculated investor protections under the SEC acts.
3. Alan Greenspan Bottom Line: Time sanitizes Greenspan's record.
Greenspan recklessly ignored parts of his job description, which included correcting the regulatory loopholes that allowed predatory lenders like Ameriquest to flourish. And he recklessly ignored evidence of the risks. After the S&L crisis of the early 1990s, everyone knew the hazards of unregulated mortgage lending. (Greenspan had championed S&L deregulation and was a big booster of Charles Keating.) Everyone knew that subprime mortgage lending was fraught with peril and could lead to financial disaster by June 2000, when First Union wrote down its entire $2.8 billion investment in The Money Store, a subprime lender acquired two years earlier. But Time gives it all a "mistakes-were-made" spin, merely noting that "his long-standing disdain for regulation underpinned the mortgage crisis."
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