Public Policy Press
TABLE OF CONTENTS
Chronology xi
The Sizes of Things xv
Preface by Robert E. Litan xvi
INTRODUCTION 1
PART I: HISTORY AND MECHANICS OF THE BUBBLE
CHAPTER ONE: HOW WE GOT HERE 5
The Originate-to-Sell Model 8
Fraud and Collusion as Anti-Competitive Practices 11
Why was the Impact so Widespread and Explosive? 12
Leverage in the Banks 13
Leverage in the Investment Banks 17
Leverage in the Bond and Mortgage Insurers 18
Leverage in the Hedge Funds 20
Little Leverage in the Corporate Sector 20
Macro imbalances 21
CHAPTER TWO: FREE MARKETS, FREE LUNCH 23
Turbulence behind a Façade of Calm 23
Free Market Theory 24
“Competitive” versus “Free” Markets 27
No Free Lunch 28
Civil Rights and Community Activism 30
Think Like and Economist 31
CHAPTER THREE: THE MORTGAGE MARKET BEFORE SUBPRIME 33
The Depression Experience 33
The Problem of Rising Interest Rates 34
The Mortgage-Backed Securities Revolution 37
The Prepayment Problem 39
Mortgage Servicing Rights 40
“Conforming Loans” 41
Traditional Underwriting Criteria 42
The Appraisals Problem 44
Credit Risk 45
CHAPTER FOUR: SUBPRIME MORTGAGE LENDING 47
The Impact of Credit Scoring 48
Growth of the Subprime Market 49
Subprime Products 51
The Discovery of Alt-A Mortgages 54
Subprime and Alt-A Losses 57
Reaction of the Community Activists 58
Predatory Lending 59
Subprime and Alt-A Masquerade as
CHAPTER FIVE: HOME OWNERSHIP—THE AMERICAN DREAM 63
Fannie Mae and Freddie Mac 64
Targeted Subsidies 72
Community Reinvestment Act 73
The American Dream Downpayment Act 75
CHAPTER SIX: THE S&L DEBACLE 77
Mark-to-Market Accounting 79
Prompt Corrective Action 81
Transformation of the Commercial Banks 82
CHAPTER SEVEN: THE FED—RIDING THE BRAHMA BULL 85
Monetary Policy 86
Bolts from the Blue versus Signaling 88
Economic Forecasting 89
Long Rates versus Short rates 91
Inherent Limitations of Monetary Policy 92
Monetary Policy Post-9-11 93
Lender of Last Resort 100
The Fed’s Regulatory Roles 102
The Most Serious Policy Failures were not the Fed’s 104
CHAPTER EIGHT: DEREGULATION—STRENGTHS AND EXCESSES 107
Closing the Gold Window 108
Market-by-Market Deregulation 109
Banking Deregulation 110
Spitzer Mocked 113
No Regulation in
CHAPTER NINE: INSIDE THE BUBBLE 119
The Drumbeat—Buy Real Estate 121
The Home Price Bubble 123
Mortgage Brokers 124
The Key States 125
The Rust Belt 131
Reflections on the Bubble that Was 133
CHAPTER TEN: SECURITIZATION 135
A Simple Securitization Example 136
More Modern Securitizations 139
Getting CDO’d (an Example) 140
Mortgage Servicers 144
The Spread over LIBOR 145
The Super Senior Tranche 146
Subprime Assets Made More Money for Structurers 148
Why Not Keep Some of It? 149
Structured Investment Vehicles 150
Competition—Some Majors Played Catch-Up 152
How Big Was the Securitized Asset Market? 153
Securitization in American Finance 155
CHAPTER ELEVEN: THE RATING AGENCIES 157
The Original Sin 157
History of the Rating Business 158
Rating Agency Methodology for Structured Products 160
The rating Agencies’ Defense 168
PART II: THE BUBBLE DEFLATES
CHAPTER TWELVE: 2007—THE PROBLEMS SURFACE 173
The Fed Offers Reassurances 174
Two Bear Stearns Funds Implode 175
Still Dancing 177
The Guns of August 177
The Strange Case of the Landesbanks 177
LIBOR Out of Whack 181
What, the Monolines Are in Trouble, Too? 181
Mark-to-Market Accounting—Again 182
Toxic Super Senior Securities 183
Yes, The Crisis Had Begun 190
CHAPTER THIRTEEN: EARLY INTERVENTIONS 191
Hope Now alliance 192
The Super-Conduit Proposal 193
Actions on Interest Rates 194
Liquidity and Insolvency 194
Foreclosure as a Transmission Mechanism 196
The Losses Continue 197
A Bank Called IndyMac 198
SIV Assets Come Back onto Balance Sheets 198
Could Money Market Funds Experience Problems? 199
The Great Unwind Continues 201
SWFs to the Rescue 201
Fannie and Freddie as Antidotes 202
The Economy Still Looks Okay, But . . . 203
CHAPTER FOURTEEN: THE DEMISE OF BEAR STEARNS 205
The New Investment Banking Paradigm 205
The Growth of Bear Stearns 207
The run on Bear Stearns 210
Dealing with Failing financial Institutions 213
Palm Sunday Weekend 214
The Glitch that Stole Easter Sunday 215
Bailout Reasoning 216
CHAPTER FIFTEEN: MISSIONS IMPOSSIBLE 217
The Summer of 2008 217
The Failure of IndyMac 218
Hope for Homeowners Act 219
Fannie and Freddie Get Conserved 219
Government Assistance 220
The July Legislation 221
What Caused the Failures? 222
CHAPTER SIXTEEN: LEHMAN, MERRILL, AIG AND RESERVE FUND 223
Lehman Brothers 224
The New Lehman Brothers Holdings 226
The Search for Capital 227
No Government Money 229
Do Bailouts Make Sense? 231
AIG Gets the Money 232
Merrill Lynch Seeks Cover at B of A 235
Paulson Forces the Deal to Close 237
Reserve Fund Breaks the Buck 239
CHAPTER SEVENTEEN:
Lou Pepper 242
Kerry Killinger 242
Ramping up Mortgage Banking 243
The Occasio Strategy 245
Management Changes 246
Riskier Lending 247
Maybe it was the Old S&L Problem 248
Why Did Wamu Fail? 250
CHAPTER EIGHTEEN: MORE INTERVENTIONS 253
The TARP Story—French Farce Made in
FDIC Insurance Raised to $250,000 255
The Stock Market Swoons 255
The Economy Falls off a Cliff 256
Wachovia in Play 257
Morgan Stanley and Goldman Sachs Seek Refuge 259
All Big Banks Must Accept Assistance 259
Credit Markets Dry up, But Nobody Wanted to Borrow Anyway 261
Still No Bailouts for Borrowers 261
Inconsistency and Apparent Confusion 262
PART III: TAMING THE DEBT SPIRAL
CHAPTER NINETEEN: BOARDS OF DIRECTORS-WHERE WERE THEY 265
Risk management Practices 267
What Bank directors Should Do 269
CHAPTER TWENTY: ALTERNATIVE CAUSES 271
Minsky cycles 273
Macro Imbalances 276
Moderation Leaves Too Much Debt 279
Financialization 282
Fiat Money 283
Animal Spirits 283
Credit Mispricing 285
Too Much or Too Little Regulation 285
The Lobbyists Did It 286
The Shadow Banking System Did It 287
Government Housing Policy 288
CHAPTER TWENTY-ONE: COMPETITIVE MARKETS 289
Information Asymmetries 290
Frauds and Faithless Agents 291
Rational Market Assumptions 292
An Irrational World 293
Fads and Crowd Behavior 293
Expanded Rationality 294
Treat Finance Differently? 295
Competition as the Foundation of Economic policy 296
CHAPTER TWENTY-TWO: CREDIT IN AMERICAN CAPITALISM 299
Value and Economy as You Value a Business 300
Changing the Mix between Debt and Equity 301
New Housing finance? 304
Taming the Debt Spiral 305
CHAPTER TWENTY-THREE: REDUCING BANK SUBSIDIES 307
Is Commercial Banking a Failed Business Model? 309
Government Subsidies for Banks 311
Deposit Insurance 313
Investment Alternatives 315
Government Savings Accounts 315
Money Market Mutual Funds 317
The Future of Bank regulation 319
Too-Big-to-Fail 320
Intermediation is not Always Necessary 321
Complexity 322
The Future of Securitization 324
CHAPTER TWENTY-FOUR: REFLECTIONS 327
Credit in
Countercyclical thinking 328
Consumer protection 329
Pro- or Anti-Business 330
Housing Policy 331
War and finance 332
Why the Stagnation? 334
Radical Thinking 337
String ‘em Up 337
APPENDIX: CAPITAL DEFINED—BY
SELECTED BIBLIOGRAPHY 344
INDEX 349
ABOUT THE AUTHOR 353
