by William K. Black, New Economic Perspectives
This column discusses the most embarrassing title of an economic study of the U.S. financial crisis. It rivals the most embarrassing title of an economic study of the Icelandic crisis.
“The 2010 Academy Award-winning documentary Inside Job tells how [Frederic] Mishkin changed the name of the study from ‘Financial Stability in Iceland’ to ‘Financial Instability in Iceland’ on his curriculum vitae.”
Geetesh Bhardwaj of AIG Financial Products and Rajdeep Sengupta, a St. Louis Fed economist, entitled their September/October 2008 article:
“Where’s the Smoking Gun? A Study of Underwriting Standards for US Subprime Mortgages.”
Earth to AIG Financial Products: You are the “Smoking Gun”
Indeed, you’re the billowing trench mortar that was about to blow up the global economy by defaulting on hundreds of billions of dollars in Credit Default Swaps (CDS) at the time your economist finished the article.
As Bhardwaj and Sengupta were finishing their article claiming that subprime loan underwriting was improving rather than becoming more toxic, the global financial system crashed because their claims were being falsified hourly. Lehman was crushed in large part by the fraudulent subprime liar’s loans that it originated or purchased and often sold to the secondary market through fraudulent reps and warranties that created enormous liabilities to purchasers through contract and fraud claims. Even the bizarrely sympathetic Washington Post admitted that AIG Financial Products symbolized financial greed and failure.
“AIG Financial Products, the little-known unit that set off a panic on Wall Street and came to symbolize the recklessness and greed behind the financial crisis, died this week. It was 24.
The firm’s death sentence was sealed after it nearly brought insurance giant American International Group to its knees and forced a massive government bailout in 2008.
[I]t had become an albatross for AIG and a pariah within the financial circles where it once had been revered.”
The same article then describes a shameful event at AIG Financial Products after the bailout that enraged President Obama.
“The massive and risky bets the firm made insuring mortgage-backed securities for banks around the world turned sour when the housing market tanked, leading to billions of dollars in losses. That meltdown prompted the federal government to provide a rescue that grew to more than $182 billion.
In March 2009, news that employees at the Financial Products division had received more than $165 million in bonuses despite the bailout sparked national outrage. Protests and bitter hearings followed on Capitol Hill. Scornful e-mails and calls poured into the firm’s offices. Even President Obama weighed in angrily.
‘How do they justify this outrage to the taxpayers who are keeping the company afloat?’ he said at the time, vowing to ‘pursue every single legal’ action to block the bonuses, which never were fully recouped.”
The federal bailout was required because of the perverse incentives that the “idealistic” leaders of AIG and Financial Products crafted to incent the division’s personnel to create huge fictional income that would maximize the leaders’ compensation while actually producing massive losses that would take years to hit. The size of the bailout was essentially the same as the massive bonuses extracted by the parasitical Financial Products personnel. As I wrote recently, David Axelrod’s new book confirms another episode about AIG Financial Products that demonstrates Timothy Geithner and Larry Summer’s true character and loyalties and President Obama’s inability to manage even his direct appointments. Instead of his administration “block[ing] the bonuses” his top financial aides made sure the bonuses were paid.
“Axelrod was ‘livid’ when he found out that Geithner and [Larry] Summers ‘had quietly lobbied’ against an amendment to the stimulus that would have restricted the payment of bonuses at firms that received bailout funds. Those bonuses had become a huge political sore point for the administration, but the finance guys argued that retroactive steps to claw back the money would have violated existing contracts.
‘This would be the end of capitalism as we know it’ Geithner told Axelrod, to which Axelrod says he responded: ‘I hate to break the news, Mr. Secretary, but capitalism isn’t trading very high right now.'”
Geithner and Summers deliberately sabotaged their President’s policy because their ultimate loyalty lies with the financial elites. Those financial elites believe that they should receive massive compensation for looting “their” financial institutions and blowing up the global economy – which exemplifies the depravity of “capitalism as we know it.” Geithner and Summers knew that those financial elites would reward their loyalty by making them wealthy in the future.
As the authors were finishing their article the global economy was collapsing because the Fed had refused for over a decade to use HOEPA to end the raging epidemic of fraudulent liar’s loans that was leading to the imminent collapse of Lehman and AIG’s Financial Products unit was about to cause a global systemic risk because it had exploited the regulatory black hole for CDS that the Fed and its economists had championed. They created the black hole to block Brooksley Born’s effort to protect the integrity of the financial system.
At this juncture as everything they were about to write was being falsified by reality we had the spectacle of a Fed economist choosing to partner with an AIG Financial Products’ economist to put in print a claim that home loan quality had been improving for years. It is still impossible to compete with unintentional self-parody.
But why did AIG Financial Products’ CDS sales cause AIG such massive losses that, absent the Fed’s bailout, AIG and hundreds of counterparties would have failed when it defaulted on its CDS? The Washington Post’s attempted explanation provides this fabulous financial fable.
“In 1998, the firm ventured into new and fateful territory. It began writing a new kind of deal called credit-default swaps. In essence, the firm essentially would insure a company’s corporate debt in case of default. The models suggested a 99.85 percent chance of never having to pay out. It seemed like free money.
What started as a side business grew exponentially. In less than a decade, Financial Products became a leader in writing credit-default swaps that insured the massive pools of mortgages fueling the housing boom. The deals were immensely profitable but also deceptively risky.
When the housing crash came, Financial Products owed billions of dollars and nearly bled AIG dry, forcing the government to rescue the company.”
I’ll only take a few whacks at this low hanging and stationary piñata. The first thing you learn in finance is that there isn’t (honest) “free money.” If the Financial Products’ team’s models claimed there was a 99.85% probability of never losing money on selling a guarantee against loss to the owner of a collateralized debt obligation (CDO) then you know that the team that designed the model sought to maximize their income by massively understating risk and losses. CDOs were primarily “backed” by toxic mortgages. Obviously, “backed” is an oxymoron.
Contrary to Bhardwaj and Sengupta’s claims, it was easy to know that the probability of default and expected loss upon default were surging after 2003. The underlying mortgages were frequently fraudulently originated and resold on the basis of inflating the borrower’s income by more than 50% and inflating the appraisal so that the borrower not only bought the home near or at the peak of the bubble but was also underwater even at the bubble values. If you were a competent leader and a person of integrity you knew with a probability of 1.0 that you had to replace the AIG Financial Products’ model team and their “model” the first day you took charge.
Consumer representatives, regulators, bankruptcy examiners, and prosecutors who investigated lenders all understood and repeatedly warned about the surging toxic loss exposure of lenders and purchasers of loan paper, particularly to fraud. They repeatedly urged the Fed to use its unique regulatory authority under the Home Ownership and Equity Protection Act of 1994 (HOEPA) to ban liar’s loans. The finance industry, however, almost universally opposed any meaningful restraints on liar’s loans and Alan Greenspan and then Ben Bernanke refused to use that authority until mid-2008 – a year after the secondary market for subprime loans collapsed. Even when Bernanke finally adopted the rule he delayed the effective date for over a year lest he inconvenience a fraudulent lender
Among the most horrifying events described by FCIC, much of the Fed’s leadership became enraged at a Fed supervisor, and engaged in “personal” attacks against him, for daring to provide the Fed’s leadership with data he had been tasked to collect about the extent to which the largest banks were making liar’s loans.
“In late 2005, regulators decided to take a look at the changing mortgage market. Sabeth Siddique, the assistant director for credit risk in the Division of Banking Supervision and Regulation at the Federal Reserve Board, was charged with investigating how broadly loan patterns were changing. He took the questions directly to large banks in 2005 and asked them how many of which kinds of loans they were making. Siddique found the information he received ‘very alarming,’ he told the commission.
Federal Reserve Governor Bies recalled the response by the Fed governors and regional board directors as divided from the beginning. ‘Some people on the board and regional presidents . . . just wanted to come to a different answer. So they did ignore it, or the full thrust of it,’ she told the Commission.
Within the Fed, the debate grew heated and emotional, Siddique recalled. ‘It got very personal,’ he told the Commission. The ideological turf war lasted more than a year, while the number of nontraditional loans kept growing and growing” (FCIC 2011: 20, 21).
Much of the Fed’s leadership, particularly the regional presidents who were (and are today) closest to the banking industry believed it was entitled to its own facts (i.e., fictions). When you are attacked by your regulatory bosses for providing them with accurate data you know they’re crazy. I have considerable personal experience with this pathology when Danny Wall ran our regulatory agency.
The point Siddique was making, with data, refuted Bhardwaj and Sengupta’s claim that lenders were steadily reducing the risk of loss. The St. Louis Fed is known as the most anti-regulatory of the regional Fed banks. That’s a large statement because the regional Fed banks are overwhelmingly hostile to real regulation and supervision. The odds are high that Sengupta’s boss at the St. Louis Fed was one of the leaders in the opposition to Siddique – and relying on Sengupta’s claims that lenders were becoming ever more prudent in the years where Siddique’s data demonstrated the opposite was true. The FCIC report, however, does not name the regional
Fed presidents that attacked Siddique for daring to provide the agency with data provided to him by many of the largest banks.
Selling CDS protection against loss to owners of CDO interests in deals with toxic mortgages was never “immensely profitable” for AIG. It was always immensely unprofitable. If everyone is rushing to buy CDS guarantees from you on their toxic derivatives then (1) you should exit the business immediately and (2) you’re charging far too low a price for your CDS to cover the losses the buyers are expecting on the toxic CDOs. AIG’s Financial Products’ “profits” were simply an accounting scam. The seller of CDS guarantees receives the fee upfront and immediately books it as income – while establishing zero loss reserves even when it is guaranteeing toxic mortgage products stuffed with fraudulent loans certain to suffer huge losses as soon as the bubble slows.
The Washington Post then topped the elaborate financial fable it had just invented with this classic creation myth. Enjoy!
“What ended in disaster began with idealism.
In the mid-1980s, two enterprising traders at the junk-bond firm of Drexel Burnham Lambert, Howard Sosin and Randy Rackson, conceived of a nimble, creative enterprise that could seek out profitable opportunities in the seams and gaps of financial markets and federal regulation.”
Where to begin? Explaining any investment banking group as beginning “with idealism” is an act of comic genius. But claiming that the source of this idealism was being nurtured in the bosom of the “enterprising” culture of Drexel Burnham Lambert is an inspired act of parody. The parody was unintended and unrecognized by the reporter, whose beat (I am not making this up) was described as “food and drugs”). They must have been really powerful drugs.
For those too young to recall, Drexel Burnham Lambert was a massive fraud that failed due to frauds that its (real) leader, Michael Milken, pleaded guilty to. It too had models and pet economists who claimed it was brilliant and prudently managed. They too failed.
Oh, and the plan to “seek out profitable opportunities in the … gaps of … federal regulation” means that they deliberately sought to act in the Shadow financial sector because their accounting scam would have been forbidden in the regulated insurance sector. CDS is not “insurance.” It did not require an “insurable interest.” It did not limit the guarantee that could be purchased to the value of the underlying asset. An unlimited number of entities could buy a guarantee from AIG against loss on the same asset. I explained above that CDS does not require the entity selling the guarantee against loss to actually have the ability to pay the guarantee by ensuring that it has established appropriate reserves to pay those claims. Instead, AIG Financial Products paid scores of billions of dollars in bonuses to its managers on the basis of faux profits that were actually losses.
The gaps in federal regulation of CDS was the product of raw political and economic power by the finance industry (including AIG) and the intellectual dishonesty of the purported finance experts of both parties. They crushed Brooksley Born’s efforts to protect the nation against the dangers of more exotic financial derivatives through the passage of the Commodities Futures Modernization Act of 2000.
When AIG sold guarantees against loss on mortgage product that was endemically fraudulent and badly underwritten it lost money (in economic reality). If AIG Financial Products had been regulated as an insurance company by effective insurance regulators it would have had to establish and maintain sufficient loss reserves to reveal the truth that it was losing money when it sold CDS guarantees against loss to back toxic CDOs. This would have meant no bonuses to Drexel’s émigrés and the early closure of Financial Products by AIG. Of course, since they were motivated by “idealism” they would doubtless have embraced receiving no bonuses and being fired.
Bhardwaj and Sengupta’s Hunt for the Smoking Gun That They Helped Aim
The AIG Financial Products and St. Louis Fed partnership brought together two institutions heavily involved in creating the criminogenic environments that produced the fraud epidemics that drove the crisis – and which both institutions did nothing meaningful to halt. Bhardwaj and Sengupta were data-free fraud deniers – using the magic word “anecdotal” and a faux contrast to statistics to remove any need to analyze fraud.
“Third, some observers could raise the doubts about the veracity of the data. There is some anecdotal evidence that points to poor reporting and false documentation.43
43Federal investigators are probing into allegations of fraud and misrepresentations by mortgage companies like Countrywide Financial Corp….”
Recall that there were writing this as the global economy was collapsing under the assault of the three epidemics of accounting control fraud. There were powerful data available to the authors on the scope of fraud plus the FBI’s “anecdotal” warning in 2004 that an epidemic of mortgage fraud was developing that would cause a financial “crisis” if it were not halted. The appraisers’ warning about the epidemic of appraisal fraud and the deliberate generation of a “Gresham’s” dynamic by the lenders through the extortion of honest appraisers had been public for eight years. MARI and Steven Krystofiak’s warnings about the 90% fraud incidence in liar’s loans had been public for 14 months. The data on the massive growth in liar’s loans by the lenders the authors claimed were becoming ever more prudent had been public for five years.
Notice that after the classic economics dismissal of real facts as merely “anecdotal” the economists did not make any analytical or factual effort to refute that which had long been recognized throughout the industry at the time they were writing – the fraudulent lenders’ data were systematically unreliable because they had been falsified to dramatically understate the risk of home loans they were making and selling. Indeed, the secondary market in non-prime loans had collapsed months before they published their article (because the underwriting data had proven to be endemically biased by fraud), hundreds of non-prime lenders had failed, Bear had failed, Fannie, Freddie, and Lehman were at death’s door (or dead – the article, confusingly, bears both September and October dates). They were dying or dead largely due to fraudulent nonprime loans. Early payment defaults (highly associated with fraud), loan delinquencies, and loan defaults were surging.
Moody’s made very large rating downgrades on CDOs beginning in mid-2007 and attributed them to the combination of “aggressive underwriting” and falling home prices (FCIC 2011: 221-222). S&P did the same a few days later “All told, in the first10 months of 2007, 92% of the mortgage backed security deals issued in 2006 had at least one tranche downgraded or put on watch” (FCIC 2011: 221, 222). The fact that the 2006 vintage performed so much worse than earlier vintages while their reported underwriting was supposedly improving is powerful evidence that as a whole non-prime lenders were (1) taking on a far greater risk of loss and (2) falsely representing that they were not doing so. A wide range of data supported what the industry experts were saying.
“By the end of 2008, more than 90% of all tranches of CDOs had been downgraded. Moody’s downgraded nearly all of the 2006 Aaa and all of the Baa CDO tranches. And, again, the downgrades were large-more than 80% of Aaa CDO bonds and more than 90% of Baa CDO bonds were eventually downgraded to junk.”
Mortgage loan risk exploded during the crisis. Loan standards collapsed. Cutter (2009), a former managing partner of Warburg Pincus, explains:
“In fact, by 2006 and early 2007 everyone thought we were headed to a cliff, but no one knew when or what the triggering mechanism would be. The capital market experts I was listening to all thought the banks were going crazy, and that the terms of major loans being offered by the banks were nuttiness of epic proportions.”
Many nonprime mortgage lenders grew at rates matching the S&L “control frauds.“
“In summary, the bank in our analysis pursued an aggressive expansion strategy relying heavily on broker originations and low-documentation loans in particular. The strategy allowed the bank to grow at an annualized rate of over 50% from 2004 to 2006. Such a business model is typical among the major players that enjoyed the fastest growth during the housing market boom and incurred the heaviest losses during the downturn” (Jiang, Aiko & Vylacil 2009: 9).
Instead of facts or logic, the authors responded to the criticisms of the unreliability of their data with an irrelevant statistic that constitutes a “revealed bias.“
“However, it is difficult to make this case over a repository of nine million loan observations” (p. 28).
That sentence is embarrassingly bad. What does it mean? The authors did not study whether their underwriting data were unreliable because it would have been “difficult” to do so? That obviously is not a reason for assuming that one’s data are reliable, particularly when the overwhelming industry consensus was that the underwriting claims of nonprime lenders were endemically unreliable.
I think that the authors meant to be making a fake statistical argument. The non-logic underlying the sentence I quoted is that it is somehow obvious that because there are many home loans fraud and misrepresented underwriting practices, exceptions, and reports cannot be material. The quoted sentence has no logical content, but it is a sure sign of a revealed bias. The authors “know” that fraud and misrepresentation must be so rare that they could not be material to a data set “of nine million loan[s].” The authors don’t know of the Gresham’s dynamic, the criminology literature, George Akerlof and Paul Romer’s 1993 article on “looting,” or the history of the fraud epidemics that drove the second phase of the S&L debacle. They “know” something only because they lack vital information and suffer from a crippling bias towards believing bankers’ claims that their underwriting claims are reliable. They believe those claims without investigation or analysis.
The authors phrased their sentence in such a convoluted way because a simple, declarative sentence would expose their biases and the purely circular basis for their implicit claim about fraud. They would have had to say expressly:
“We know that mortgage fraud was immaterial because we know that mortgage fraud is immaterial.”
The authors are the bitter enders who continued to praise elite bank frauds even as the financial world was collapsing around them from the three most destructive financial fraud epidemics in history plus numerous other frauds by our largest banks (Libor, FX, municipal bond rates, tax fraud, fraudulent evasion of sanctions, money laundering for the most vicious drug cartels in the world, and endemic foreclosure fraud).