1989 and 2008: Same fraud, different response
Michael Milken reportedly had a realization that provided the intellectual underpinning for the Savings and Loan crisis during a trip by car from New York to Los Angeles, his wife behind the wheel as he perused 10-Ks. At some point it hit him: if these junk bonds are too risky to attract investors, why not “diversify away” that risk by pooling them?
With a bit further thought, Milken was certainly smart enough further to realize – staring out the car window at the flat expanse of the Great Plains – that in reality the only risk that such pooling would “diversify away” was company-specific risk. When it came to a more generalized downturn in the economy or the asset class as a whole, such diversification was worth nothing. Sound familiar? In our most recent version of the S&L crisis, the so-called mortgage crisis, diversification may have protected against regional downturns, but it did nothing to protect against a nationwide downturn in the economy or housing prices.
But upon Milken’s arrival in LA, the truth about the limits of the risk-reducing effects of diversification didn’t stop Milken, his firm, Drexel Burnham Lambert, and eventually most of the banking establishment from piling onto this cleverly incomplete version of modern portfolio theory. Bankers slowly devolved into a frenzy, falling over each other to issue “high-yield” loans to pretty much any company or takeover artist that would assume one. The bankers amassed vast quantities of those high-yield loans on their own books and sold portfolios of them to investors who were told that they were receiving outsized returns for minimal risk. The more high-yield loans that the bankers could issue, the higher their banks’ current (transient and illusory) GAAP profits, and the higher the bankers’ personal bonuses. Sound familiar?
Such was the frenzy that the bankers did not even bother to document many of these high-yield corporate loans, much less do actual underwriting. They fabricated due diligence documents (or ignored due diligence altogether), forged signatures left and right, and created loan files with so many “gaps” that there was no way realistic prospect that anyone – ever – would be able to collect on the loans if push came to shove. Again, sound familiar?
And as is likewise equally true this time around – in our most recent version of the S&L crisis that we call the mortgage crisis – these “gaps,” forgeries and systematic circumventions of normal underwriting and documentation were (and are) extremely compelling evidence of scienter, the bankers’ awareness that they were committing fraud. The lack of underwriting and poor documentation demonstrates that the bankers knew perfectly well that many of the loans were jokes. Why properly document a loan that has no chance of ever being repaid?
For convenience, parts 2-4 continue below as comments…
And so we find ourselves at the common core of the S&L and mortgage crises. Namely, bankers stole from the futures of their own banks – loading their balance sheets with poorly-documented, fraudulent, low-quality loans – because doing so would create massive transient short-term GAAP profits for their banks and massive immediate compensation for themselves. As for who would actually collect on the loans… well, that was somebody else’s problem.
The key point is that in both crises senior bankers did not really expect that anyone would ever collect on the loans. That’s what people sometimes lose sight of in all of this talk about CDOs, CDS, MBS and synthetic-CDOs. It would be an insult to the intelligence of seasoned bankers such as Keating, Blankfein, Fuld or Mozilo to suggest that they did not fully realize that many of the loans and mortgages were uncollectible. Take, for example, a teaser-rate-to-“exploding” adjustable-rate mortgage for an amount greater than the value of the house to a borrower with no income. Give me a break.
Instead, in a reversal of the normal concept of what it means to be a banker, in both crises bankers not only countenanced but aggressively sought out the lowest quality loans. Low-doc; no-doc; no income necessary; the more vulnerable the borrower, the better. This was because super-bad loans goosed the banks’ illusory and transient short-term profits even more than mildly-bad loans, meaning greater compensation for the bankers. Super-bad loans were the best way of stealing from the future. In their communications to each other, bankers openly referred to the loans as “crap.” They didn’t even bother to document many of the loans or transfer them into the securities they sold to investors.
As a result, mortgage-backed securities now probably hold the world record for the number of separate frauds contained in the same security. There was fraud and forgery in the underwriting (including targeting vulnerable communities, misrepresentations to borrowers, and forging income verification documents, which was overwhelmingly done without the knowledge of the borrowers), fraud and predation in the servicing (including layers of predatory fees and penalties, force-place insurance, a failure to credit payments, etc.), fraud and forgery in the title and assignments (including MERS, and “gaps” and forgeries in an astonishing 80% of loan files), fraud in the trusts (including a failure even to transfer a huge percentage of mortgages into the trusts, meaning that purchasers of MBS were in many cases literally purchasing nothing), fraud in the insurance (including deceiving insurance counter-parties in a manner similar to the deception of investors), fraud in the packaging and issuance (including misrepresenting the underwriting characteristics of even the mortgages that the trusts were supposed to contain, or misrepresenting egregious conflicts of interests on the part of the underwriters or portfolio consultants, who in many cases were shorting the very portfolios they were selling to investors, or constructing those portfolios for the purpose of shorting them), and fraud and forgery in the foreclosures (including a nationwide epidemic of forgery resulting from literally millions of fraudulent attempts to create the right to foreclose on homes by entities that never legally owned the mortgage).
But let’s not get lost in the details. In essence, the mortgage crisis was no different from the S&L crisis. Both were bankruptcy for profit. Bankers traded the certain eventual implosion of their own banks’ balance sheets in order to goose transient short-term profits and their own compensation, and they accomplished same through various interconnected types of fraud and forgery.
The regulatory reaction to the two crises, however, was incredibly different.
Michael Milken kept a chart of his net worth on the ceiling above his bed. This is true.
And during some of the trials that resulted in over 1,100 criminal convictions following the S&L crisis, details of the riches and obscenely decadent lifestyles of many of the banker defendants emerged – details that turned the stomachs of juries.
Political corruption also came to light. For example, the Keating Five — Senators Cranston, DeConcini, Glenn, McCain and Riegle – intervened in 1987 on behalf of Charles Keating, Chairman of Lincoln Savings and Loan Association, the target of a regulatory investigation by the Federal Home Loan Bank Board (FHLBB). As a result, the FHLBB backed off of Lincoln.
Lincoln then collapsed in 1989 at a cost of $3 billion to the government. Some 23,000 Lincoln bondholders were defrauded and many lost their life savings. Keating had made political contributions to the senators totaling $1.3 million (dwarfed in the latest crisis by bankers’ contributions to Barack Obama). In 1991 the Senate Ethics Committee found, after a lengthy investigation, that Cranston, DeConcini and Riegle had substantially and improperly interfered with the FHLBB’s investigation of Lincoln, and Glenn and McCain were criticized for having exercised “poor judgment.”
As a second example, Rep. James Wright was implicated by special counsel in improperly intervening on behalf of Vernon Savings and Loan. More troubling, Wright attempted to have William K. Black fired as deputy director of the Federal Savings and Loan Insurance Corporation. Black was enforcing the law a bit too evenly for the tastes of Wright and his backers. Wright resigned from Congress in 1989 after an ethics inquiry.
Ironically, William Black is now perhaps the most insightful analyst of the mortgage crisis and speaks from direct experience when he points out facts suggesting a breathtaking degree of corruption implicit in the Obama administration’s response to it.
In the current crisis, the President has played the role of Jim Wright and Keating Five, with some differences. First, the powers of a President – if he wants to save bankers from prosecution or from giving up their ill-gotten gains – include the ability to prevent any investigations from getting started in the first place. After all, most any federal agency that would undertake such an investigation is controlled by the Executive.
Second, Barack Obama – a student of “Chicago-style” politics – was willing emphatically to promise voters a platform that included bringing bankers to justice while simultaneously making backroom agreements with those very bankers/contributors that he would do the polar opposite. Obama would never have been the Democratic nominee for President nor elected President had he been honest with voters about his steadfast commitment to both keeping bankers out of jail and letting them keep the money.
Third, there is no mechanism akin to an “ethics inquiry” to which the other branches may probe the questionable conduct of a sitting President (other than impeachment).
So to put it bluntly, this time around the bankers realized that it’s not enough to buy off Congressmen and Senators: to achieve real impunity you have to buy off the President himself.
And thus the metaphorical net-worth charts hanging above the beds of Mozilo, Cassano, Fuld, Dimon, Blankfein and a thousand others have not yet come to light. Nor have the estates, jets, yachts, servants, prostitutes, furs, paintings, islands, and so on. Nor have any of the countless acts of predation, fraud, forgery, conspiracy, money laundering, racketeering, obstruction, perjury, false statements, and so on.
Over 1,100 convictions versus zero convictions. Now that’s a difference.
A final difference – or at least the last to be considered here – has been the conduct of the Federal Reserve.
Between 1986 and 1995, the number of thrifts in the U.S. declined by 50% from 3,234 to 1,645, and 1,043 federally-insured thrifts with total assets of over $500 billion failed. The failures overwhelmed the resources of the FSLIC so taxpayers – through legislation/agencies including FIRREA, RTC, FICO, FRF, SAIF and REFCORP – backed up the federal commitment to depositors of the failed institutions. The crisis cost taxpayers $124 billion and the thrift industry $29 billion, a total of $153 billion.
The goal of the clean-up was clear: protect depositors. The means was transparent and openly debated. The Fed was not involved.
Let’s engage in a thought experiment. How would the S&L crisis of 1989 have been cleaned up had authorities used the policies employed in 2008-2011?
1) Using the policies of 2008-2011, the S&L crisis would have been cleaned up – not by spending $124 billion to protect depositors – but by spending something on the order of $750 billion to $1 trillion to buy up the fraudulent real estate loans and junk bonds issued by the thrifts.
2) Instead of half the thrifts failing, most would have continued in business, or in a few cases been merged at the direction of the Fed into other thrifts and banks.
3) None of the thrift executives would have been prosecuted. None would have had to disgorge their riches. Most would have continued in their positions with little change in compensation or behavior.
4) About two-thirds of the $750 billion to buy up the fraudulent loans and bonds of the thrifts would have been done by the Fed with freshly-printed dollars, in violation of the Federal Reserve Act.
5) In addition to buying up their toxic assets, the Fed would have secretly extended unlimited loans to the thrifts.
6) The stated purpose of 1) to 5) above would have been opaquely described as “financial stability,” “protection of the financial system” and “credit easing.” The tremendous benefits provided to the thrifts and their executives would have been downplayed.
There are a few points to emphasize. First, the cost of directly protecting depositors in the S&L crisis was about a fifth of what it would have cost to take the course of protecting thrifts and their executives by buying up their fraudulent loans and bonds. By the same token, the cost of directly protecting victims/customers/consumers in 2008-2011 would have been a fraction of the cost of bailing out banks and their executives.
Second, the 2008-2011 approach required both a compliant President to stop regulatory and criminal investigations AND a Fed willing to engage in outrageous conduct. Unlike the Volcker/Greenspan Feds, the Bernanke Fed has been willing to violate the Federal Reserve Act.* It has blatantly engaged in fiscal policy. But worst of all the Bernanke Fed has engaged in a policy that, if we consider it from 10,000 feet, is perhaps best described as co-conspiracy in fraud.
By 2008, bank executives had filled their balance sheets with fraudulent loans and securities in order to steal from the future. In 2008-2011, the Fed “disappeared” the executives’ looting by printing dollars to transfer onto the Fed balance sheet almost $1 trillion in securities based on half-empty trusts half-filled with half-empty loan files based on predatory lending and forgery. It was akin to the Fed responding to the Enron collapse by buying up vast amounts of Enron securities (and giving Enron unlimited free loans) thereby “disappearing” Enron’s fraud.
No other central bank has ventured anywhere near such conduct. Brazil’s tremendously successful efforts at restoring stability took the form of direct payments to the poor and cheap direct consumer/business loans. Even in its LTROs, the ECB lent banks a discounted percentage of deposited collateral for at most three years.
Between Bernanke, Obama and Geithner, Milken and Keating must wish they had been born 20 years later.
* Section 14.1 of the Federal Reserve Act (Purchase and Sale of Obligations of United States, Counties etc., and of Foreign Governments) allows the Federal Reserve:
1. To buy and sell, at home or abroad, bonds and notes of the United States, bonds issued under the provisions of subsection (c) of section 4 of the Home Owners’ Loan Act of 1933, as amended, and having maturities from date of purchase of not exceeding six months, and bills, notes, revenue bonds, and warrants with a maturity from date of purchase of not exceeding six months, issued in anticipation of the collection of taxes or in anticipation of the receipt of assured revenues by any State, county, district, political subdivision, or municipality in the continental United States, including irrigation, drainage and reclamation districts, and obligations of, or fully guaranteed as to principal and interest by, a foreign government or agency thereof, such purchases to be made in accordance with rules and regulations prescribed by the Board of Governors of the Federal Reserve System. Notwithstanding any other provision of this chapter, any bonds, notes, or other obligations which are direct obligations of the United States or which are fully guaranteed by the United States as to the principal and interest may be bought and sold without regard to maturities but only in the open market.
2. To buy and sell in the open market, under the direction and regulations of the Federal Open Market Committee, any obligation which is a direct obligation of, or fully guaranteed as to principal and interest by, any agency of the United States .
The FHA, and its financing arm, Ginnie Mae, are agencies of the U.S. Government. But Fannie Mae and Freddie Mac are private corporations that lack agency status (“government sponsored enterprises”) and whose securities are not guaranteed as to principal and interest by the U.S. government (at least those maturing beyond 2012).
In other words, under the conservative language and plain intent of the Fed’s enabling statute, purchases of Fannie and Freddie securities are not within the mandate of the Federal Reserve.
Second, mortgage-backed securities probably hold the world record for the number of separate frauds contained in the same security. There was fraud and forgery in the underwriting (including targeting vulnerable communities, misrepresentations to borrowers, and forging income verification documents, which was overwhelmingly done without the knowledge of the borrowers), fraud and predation in the servicing (including layers of predatory fees and penalties, force-place insurance, a failure to credit payments, etc.), fraud and forgery in the title and assignments (including MERS, and “gaps” and forgeries in an astonishing 80% of loan files), fraud in the trusts (including a failure even to transfer a huge percentage of mortgages into the trusts, meaning that purchasers of MBS were in many cases literally purchasing nothing), fraud in the insurance (including deceiving insurance counter-parties in a manner similar to the deception of investors), fraud in the packaging and issuance (including misrepresenting the underwriting characteristics of even the mortgages that the trusts were supposed to contain, or misrepresenting egregious conflicts of interests on the part of the underwriters or portfolio consultants, who in many cases were shorting the very portfolios they were selling to investors, or constructing those portfolios for the purpose of shorting them), and fraud and forgery in the foreclosures (including a nationwide epidemic of forgery resulting from literally millions of fraudulent attempts to create the right to foreclose on homes by entities that never legally owned the mortgage). For the Fed to buy such securities is outside both the letter and spirit of the Federal Reserve Act.