Who Really Caused The Great Recession?
When the politicians were looking to shift guilt, the banks forgot to duck.
Janet L. Yellen did something odd for a Fed chair. At the Boston Federal Reserve conference in 2014, she gave a not-so-subtle plug for her boss, President Barack Obama, just days before the mid-term election.
The coincidence wasn’t lost on people like me, who served as officers or on boards of directors of major banks. Was there collusion, I wondered, between our independent Fed and the political wing? Or was the crisis nothing more than banker’s greed, as the administration claimed? Occupy Wall Street was born as a consequence, shouting about America’s addiction to a virulent form of Capitalism, and the crash was the consequence.
To get a handle on this I looked for someone who understood banking and regulation. It would help if they didn’t run a bank that cratered, too. This search led me to John Allison, a former banking chief, but one unscathed by the Great Recession who was both intellectually savvy and financially astute. He had just written a book on the subject, The Leadership Crisis and the Free Market Cure, which Forbes said, “gets both the diagnosis and prescription just right.”
There was another reason I needed an expert. The media had given up any pretense to objectivity. When Wall Street Journal reporters interviewed me for evidence board of directors acted out of greed, the journalists had no idea how to calculate options compensation. How do you charge greed when you can’t count?
The Democrats were the majority during the financial meltdown, and so they were in a better position to disguise their role in the crisis. The party in power usually earns the right to tell its side of the story. But the part they left out is that the real estate lobby and Democrats are connected as city dwellers and food delivery. The real estate lobby supports them and vice versa, as President Trump can attest during the time he was a real estate tycoon.
The problems within the credit and real estate bubbles began long before the crisis. Mortgage lending and syndication were highly profitable businesses for bankers and politicians both. People loved buying homes with cheap loans that were approved overnight. There was a second problem that everyone knew about but as the boom continued few dared change it: the shadow banking industry, the unregulated financial institutions that were responsible for the bulk of the loans that ultimately did not perform.
To understand why the government and the Federal Reserve Bank have to take the bulk of the blame, it is important to recognize that banking is the most regulated industry in America. Nothing can happen that isn’t sanctioned by politicians. Mortgages were driven by Fannie Mae and Freddie Mac, both federally guaranteed mortgage packagers, both run by Democratic heavyweights, Jim Johnson and Franklin Raines, during the period leading up to the crash, and both had lavish incentives to keep the music going, at over $100 million each in compensation.
Were politicians like Barney Frank and Chris Dodd aware? The answer is that whoever appoints the regulators controls the incentives. That is essentially how the financial system operates. When A appoints B, and B gets as much as A allows him to make, you can be sure A is in charge.
The Federal Reserve Bank’s role is to investigate bank balance sheets and perform risk audits. When I served on the board of a Fed regulated bank, we would have 50 analysts looking over the books every month, checking on every loan and IRA (providing capital against the loan activity), and doing a deeper dive quarterly. The point is the Fed knows what’s going on in a bank the way your dentist knows your mouth. To claim later that the loans weren’t good or were fraudulent is misleading and perhaps untrue. Those loans are examined in excruciating detail each quarter.
If banks made too many low income and poor performing loans over a period of years, and these were undocumented or poorly documented, the Fed would have known about it. The bad loans were on the books for everyone to see. Why were they ignored? The fact was plain: the loans performed during the good times, and no one thought anything more about them. The question we have to ask is why?
Because there were political incentives to look away.
Chris Dodd and Barney Frank oversaw financial services in Congress, and both were vulnerable to charges of corruption. This was in part personal gain on the part of Chris Dodd who received favorable treatment for a personal mortgage (I know as I served on the board) and Barney Frank, who was able to lobby banks to accommodate special interests so that in turn they supported him politically.
Loan activity reflects not just economics or bank practices — which is what politicians want us to believe. It reflects what politicians tell regulators to do who in turn tell banks what to do.
So why did banks make lousy loans?
Yes, greed is part of the story. But a more obvious cause was that banks understood they needed to please the people in power to continue to operate. There is a political payoff to making lower-income loans that needs to be explained. ACORN and other activists fed off the need to increase homeownership among lower-income minorities. When these poor performing loans were packaged under the Fannie Mae government guarantee, financial institutions around the world purchased them. The market was hungry for mortgage-backed anything because the United States guaranteed it.
Goldman Sachs was fined nearly a half-billion dollars for its role in securitizing a package of loans that performed poorly for a German bank — yet the German bank was adamant about buying mortgage securities at a time the investment bank was trying to sell. How was that Goldman’s fault? Why was the U.S. government penalizing an institution for selling legal securities to a European bank?
When the crash happened we needed to focus on getting our financial house in order. That required working with the very politicians who led the charge into the sinkhole. Those same politicians realized they were looking at armageddon and passed legislation to punish the bankers as a diversion. In a flash of PR brilliance, they named the law after themselves, The Dodd-Frank Wall Street Reform and Consumer Protection Act. It became their ‘get out of jail free’ card. It passed with a Democratic majority.
Now the media didn’t have to question how it missed the story because there was a better one: Bankers’ greed. And no one was in a position to object. The new narrative was a Hollywood scripted drama with a victim, the homeowners, and a villain in pinstripes. It looked like politicians came to the rescue and banks were fined for misdeeds. They had no choice.
The bothersome questions is whether banks have access to the same information I am writing about? Why didn’t they know the bad loans on their books were bad? As Ronald Reagan said (quoting the boxer Jack Dempsey), “Honey, I forgot to duck.”
During the boom, which lasted ten years or more since the late 90s, interest rates made credit freely available. Most of the loans made during the period were standard, plain vanilla types, and as the market grew frothy, competition and syndication provided incentives to reach, as they always do.
When the problems began to fester, banks were too busy seeking help to charge Congress and the Fed with participating in the scheme. If a bank went up against its regulator or tried to shift blame to Congress, you can be sure it would be greeted as shirking blame as they had little credibility to begin with. So bank boards and officers dutifully accepted responsibility for a fiasco they contributed to but did not cause. It is axiomatic. You do what you need to do to get through a crisis.