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Ritholtz and the Big Lie

Barry Ritholtz accuses Mayor Bloomberg of helping to spread the Big Lie about the financial crisis.

The Big Lie made a surprise appearance Tuesday when New York Mayor Michael Bloomberg, responding to a question aboutOccupy Wall Street, stunned observers by exonerating Wall Street: “It was not the banks that created the mortgage crisis. It was, plain and simple, Congress who forced everybody to go and give mortgages to people who were on the cusp.”

I agree with Ritholtz that this is not THE cause of the crisis. I think it contributed and helped determine where the banking sector ended up making its mistakes. But it is not THE cause. Then Ritholtz gives his own narrative. I’ll comment as he goes along:

●Fed Chair Alan Greenspan dropped rates to 1 percent — levels not seen for half a century — and kept them there for an unprecedentedly long period. This caused a spiral in anything priced in dollars (i.e., oil, gold) or credit (i.e., housing) or liquidity driven (i.e., stocks).

I agree. Bad thing. Though I’m not sure what it actually did. He might be right.

●Low rates meant asset managers could no longer get decent yields from municipal bonds or Treasurys. Instead, they turned to high-yield mortgage-backed securities. Nearly all of them failed to do adequate due diligence before buying them, did not understand these instruments or the risk involved. They violated one of the most important rules of investing: Know what you own.

I don’t fully understand this argument. People always want higher yield. But higher yield comes with higher risk. The central question is why so many people invested in what turned out to be very risky instruments without doing sufficient due diligence. Here is Ritholtz’s explanation.

●Fund managers made this error because they relied on the credit ratings agencies — Moody’s, S&P and Fitch. They had placed an AAA rating on these junk securities, claiming they were as safe as U.S. Treasuries.

This is not plausible. Virtually everyone knew that the ratings agencies were being paid by the people who produced the risky assets. The agencies had little incentive to be careful. But it was in the interest of virtually everyone to ignore the risk. The government regulations allowed investors to use very high leverage for AAA rated assets. Investors like using borrowed money rather than own. The question remains as to why so many lenders were willing to lend money to invest in stuff that was called AAA but probably wasn’t and turned out not to be. And that’s why I used the word “virtually” in the sentence about ignoring the risk. There was one group that had an incentive to keep an eye on the real risk and that was the taxpayer who ended up paying for it. But most of us didn’t realize we were making that investment.

And that brings me to my biggest problem with Ritholtz’s narrative. It ignores the role past bailouts played in providing comfort to lenders who funded the leverage that made the bubble in mortgage-backed securities so enormous. I find it puzzling that a man could write a book called Bailout Nation and ignore the incentives this created for imprudence on the part of lenders–the group that gets bailed out so often. Not equity holders, but lenders. And that’s why the banks like bailouts. It allows them to ease the minds of lenders who fund the leverage. See my paper on the crisis.

• Derivatives had become a uniquely unregulated financial instrument. They are exempt from all oversight, counter-party disclosure, exchange listing requirements, state insurance supervision and, most important, reserve requirements. This allowed AIG to write $3 trillion in derivatives while reserving precisely zero dollars against future claims.

• The Securities and Exchange Commission changed the leverage rules for just five Wall Street banks in 2004. The “Bear Stearns exemption” replaced the 1977 net capitalization rule’s 12-to-1 leverage limit. In its place, it allowed unlimited leverage for Goldman Sachs, Morgan Stanley, Merrill Lynch, Lehman Brothers and Bear Stearns. These banks ramped leverage to 20-, 30-, even 40-to-1. Extreme leverage leaves very little room for error.

I don’t think this is true though I’ve had trouble verifying it. Andrew Lo in this article argues that that is not true. But either way it leaves unanswered the question of how these investment banks were able to take advantage of the relaxed leverage rules. I understand why they like leverage of 40-1. But who would be stupid enough to fund such investing when it indeed “leaves very little room for error.” My answer is that past bailouts reduced vigilance on the part of lenders.

•Wall Street’s compensation system was skewed toward short-term performance. It gives traders lots of upside and none of the downside. This creates incentives to take excessive risks.

• The demand for higher-yielding paper led Wall Street to begin bundling mortgages. The highest yielding were subprime mortgages. This market was dominated by non-bank originators exempt from most regulations. The Fed could have supervised them, but Greenspan did not.

• These mortgage originators’ lend-to-sell-to-securitizers model had them holding mortgages for a very short period. This allowed them to get creative with underwriting standards, abdicating traditional lending metrics such as income, credit rating, debt-service history and loan-to-value.

• “Innovative” mortgage products were developed to reach more subprime borrowers. These include 2/28 adjustable-rate mortgages, interest-only loans, piggy-bank mortgages (simultaneous underlying mortgage and home-equity lines) and the notorious negative amortization loans (borrower’s indebtedness goes up each month). These mortgages defaulted in vastly disproportionate numbers to traditional 30-year fixed mortgages.

●To keep up with these newfangled originators, traditional banks developed automated underwriting systems. The software was gamed by employees paid on loan volume, not quality.

These underwriting systems were wildly popular with government regulators and politicians who encouraged banks to relax standards. See my paper on the crisis. That helped push up the price of housing. As did the other regulations government put in place to encourage home ownership. The appreciation in housing prices helped make housing the perfect vehicle for creating fake AAA assets that would allow banks to leverage more than they otherwise would. My point in my paper on the crisis is that when you privilege AAA assets, the financial sector has an incentive to create AAA whether those assets are safe or not. Housing was just the vehicle to allow the banks to exploit the moral hazard created by past bailouts. In a real capitalist system, no one would want to lend you the money to exploit that leverage opportunity. But if you keep bailout out creditors, it gets a lot easier to get them to take a chance. And they are going to be less vigilant.

●Glass-Steagall legislation, which kept Wall Street and Main Street banks walled off from each other, was repealed in 1998. This allowed FDIC-insured banks, whose deposits were guaranteed by the government, to engage in highly risky business. It also allowed the banks to bulk up, becoming bigger, more complex and unwieldy.

●Many states had anti-predatory lending laws on their books (along with lower defaults and foreclosure rates). In 2004, the Office of the Comptroller of the Currency federally preempted state laws regulating mortgage credit and national banks. Following this change, national lenders sold increasingly risky loan products in those states. Shortly after, their default and foreclosure rates skyrocketed.

Ritholtz argues that Bloomberg and others are propagating a Big Lie. But everyone is pushing their own narrative. (Me, too.) Ritholtz (and others) want to blame the crisis on deregulation. Where I agree with Ritholtz is that if you protect lenders from losses, you shouldn’t rely on the self-regulating aspect of capitalism to protect us from reckless investing. But to suggest that we’ve been living in some laissez-faire fantasy during a time when the government very consistently bails out large lenders is bizarre. We have a sick system–a system where we often claim to rely on the natural feedback system of capitalism while at the same time systematically destroying the feedback loops on the loss side. That is the system the banks would design if they were in charge. Maybe they are.

But we shouldn’t learn from this horrific system that natural feedback loops can’t be trusted. We either need to stop bailing out and rewarding recklessness and thereby incentivizing it, or we should admit that we have a protected sector that gets special treatment. I vote for the former.