The crisis was the result of human action and inaction, not of Mother Nature or computer models gone haywire. That is how the Financial Crisis Inquiry Commission, called upon to examine the financial and economic crisis and explain its causes to the American people, kicked off its final report released on January 2011. The Commission, whose work involved the review of millions of pages of documents, interviews with more than 700 witnesses, and 19 days of public hearings in New York, Washington, D.C., and struggling communities across the country, concluded that this crisis was avoidable, which is not surprising at all; they said, paraphrasing Shakespeare, the fault lied not in the stars, but in us. The Commission found instead widespread failures in financial regulation; dramatic breakdowns in corporate governance; excessive borrowing and risk-taking by households and Wall Street; policy makers who were ill prepared for the crisis; and systemic breaches in accountability and ethics at all levels. You would have to dig a little deeper to find the main culprit, the explosion of risky subprime lending which led later to the collapse of the housing bubble.
The United Stated had set aggressive homeownership goals with the desire to extend credit to families previously denied access to the financial markets. Yet the government failed to ensure that the philosophy of opportunity was being matched by the practical realities on the ground. Witness again the failure of the Federal Reserve and other regulators to rein in irresponsible lending, recommends the Commission. Homeownership peaked in the spring of 2004 and then began to decline. From that point on, the talk of opportunity was tragically at odds with the reality of a financial disaster in the making.
In fact, while the vulnerabilities that created the potential for crisis were years in the making, the report indicates, it was the collapse of the housing bubble, fueled by low interest rates, easy and available credit, scant regulation, and toxic mortgages, that was the spark that ignited a string of events, which led to a full-blown crisis in the fall of 2008. Many mortgage lenders had set the bar so low that lenders simply took eager borrowers’ qualifications on faith, often with a willful disregard for a borrower’s ability to pay. Nearly one-quarter of all mortgages made in the first half of 2005 were interest-only loans. During the same year, 68% of “option ARM” loans originated by Countrywide and Washington Mutual had low or no-documentation requirements. These trends were not secret. As irresponsible lending, including predatory and fraudulent practices, became more prevalent, the Federal Reserve and other regulators and authorities heard warnings from many quarters. Yet the Federal Reserve neglected its mission “to ensure the safety and soundness of the nation’s banking and financial system and to protect the credit rights of consumers.” It failed to build the retaining wall before it was too late.
While many of these mortgages were kept on banks’ books, a significant amount of money came from global investors who clamored to put their cash into newly created mortgage-related securities. It appeared to financial institutions, investors, and regulators alike that risk had been conquered: the investors held highly rated securities they thought were sure to perform; the banks thought they had taken the riskiest loans off their books; and regulators saw firms making profits and borrowing costs reduced. But each step in the mortgage securitization pipeline depended on the next step to keep demand going.
From the speculators who flipped houses to the mortgage brokers who scouted the loans, to the lenders who issued the mortgages, to the financial firms that created the mortgage-backed securities, collateralized debt obligations (CDOs), CDOs squared, and synthetic CDOs: no one in this pipeline of toxic mortgages had enough skin in the game, said the Commission, chaired by Phil Angelides. They all believed they could off-load their risks on a moment’s notice to the next person in line. They were wrong. When borrowers stopped making mortgage payments, the losses—amplified by derivatives—rushed through the pipeline. As it turned out, these losses were concentrated in a set of systemically important financial institutions.
In the end, the system that created millions of mortgages so efficiently had proven to be difficult to unwind. Its complexity had erected barriers to modifying mortgages so families can stay in their homes and had created further uncertainty about the health of the housing market and financial institutions. Trillions of dollars in risky mortgages had become embedded throughout the financial system, as mortgage-related securities were packaged, repackaged, and sold to investors around the world. When the bubble burst, hundreds of billions of dollars in losses in mortgages and mortgage-related securities shook markets as well as financial institutions that had significant exposures to those mortgages and had borrowed heavily against them. The losses were magnified by derivatives such as synthetic securities.
The crisis, the report continues, reached seismic proportions in September 2008 with the failure of Lehman Brothers and the impending collapse of the insurance giant American International Group (AIG). Panic fanned by a lack of transparency of the balance sheets of major financial institutions, coupled with a tangle of interconnections among institutions perceived to be “too big to fail,” caused the credit markets to seize up. Trading ground to a halt. The stock market plummeted. The economy plunged into a deep recession.
Despite the expressed view of many on Wall Street and in Washington that the crisis could not have been foreseen or avoided, there were warning signs, concludes the Commission. There was an explosion in risky subprime lending and consequently securitization, an unsustainable rise in housing prices, widespread reports of egregious and predatory lending practices, dramatic increases in household mortgage debt, and exponential growth in financial firms’ trading activities, unregulated derivatives, and short-term “repo” lending markets, among many other red flags. Yet there was pervasive permissiveness, the report concludes; little meaningful action was taken to quell the threats in a timely manner.
For the Commission, the prime example is the Federal Reserve’s pivotal failure to stem the flow of toxic mortgages, which it could have done by setting prudent mortgage-lending standards. The Federal Reserve was the one entity empowered to do so and it did not. The record of the Commission’s examination is replete with evidence of other failures too: financial institutions made, bought, and sold mortgage securities they never examined, did not care to examine, or knew to be defective; firms depended on tens of billions of dollars of borrowing that had to be renewed each and every night, secured by subprime mortgage securities; and major firms and investors blindly relied on credit rating agencies as their arbiters of risk. When the housing and mortgage markets cratered, the lack of transparency, the extraordinary debt loads, the short-term loans, and the risky assets all came home to roost. What resulted was panic. We had reaped what we had sown.