The Financial Crisis of Our Time FINANCIAL MANAGEMENT ASSOCIATION Survey and Synthesis Series Beyond Greed and Fear: Understanding Behavioral Finance and the Psychology of Investing Hersh Shefrin Value Based Management: The Corporate Response to Shareholder Revolution John D. Martin and J. William Petty Debt Management: A Practitioner’s Guide John D. Finnerty and Douglas R. Emery Real Estate Investment Trusts: Structure, Performance, and Investment Opportunities Su Han Chan, John Erickson, and Ko Wang Trading and Exchanges: Market Microstructure for Practitioners Larry Harris Valuing the Closely Held Firm Michael S. Long and Thomas A. Bryant Last Rights: Liquidating a Company Dr. Ben S. Branch, Hugh M. Ray, Robin Russell Efficient Asset Management: A Practical Guide to Stock Portfolio Optimization and Asset Allocation, Second Edition Richard O. Michaud and Robert O. Michaud Real Options in Theory and Practice Graeme Guthrie Slapped by the Invisible Hand: The Panic of 2007 Gary B. Gorton Asset Pricing and Portfolio Choice Theory Kerry E. Back The Financial Crisis of Our Time Robert W. Kolb The Financial Crisis of Our Time 2011 ROBERT W. KOLB 1 Oxford University Press, Inc., publishes works that further Oxford University’s objective of excellence in research, scholarship, and education. Oxford New York Auckland Cape Town Dar es Salaam Hong Kong Karachi Kuala Lumpur Madrid Melbourne Mexico City Nairobi New Delhi Shanghai Taipei Toronto With offices in Argentina Austria Brazil Chile Czech Republic France Greece Guatemala Hungary Italy Japan Poland Portugal Singapore South Korea Switzerland Thailand Turkey Ukraine Vietnam Copyright © 2011 by Oxford University Press, Inc. Published by Oxford University Press, Inc. 198 Madison Avenue, New York, New York 10016 www.oup.com Oxford is a registered trademark of Oxford University Press All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording, or otherwise, without the prior permission of Oxford University Press. Library of Congress Cataloging-in-Publication Data Kolb, Robert W., 1949– The financial crisis of our time / Robert W. Kolb. p. cm. Includes bibliographical references and index. ISBN 978-0-19-973055-1 (cloth : alk. paper) 1. Financial crises—United States—History—20th century. 2. Financial crises—United States—History—21st century. I. Title. HB3743.K58 2011 330.973—dc22 2010015648 9 8 7 6 5 4 3 2 1 Printed in the United States of America on acid-free paper 3 CONTENTS Preface ix Abbreviations xxi 1 Introduction: The Financial Crisis of Our Time 1 Before the Great Depression 2 From the Great Depression to Financial Deregulation 4 From Financial Deregulation to the Savings and Loan Crisis 10 2 From Securitization to Subprime 16 The Development of Securitization 16 The Process of Securitization: An Overview 26 Credit Enhancement 33 The Subprime Difference 35 3 Before the Deluge 38 Subprime Lending: To the Peak 38 The Height of Subprime Lending 46 4 From the Subprime Crisis to Financial Disaster: An Overview 57 The Housing Peak to Hints of Something Wrong 57 vi CONTENTS The Slide Accelerates 59 Mortgage-Backed Securities and Foreclosures 61 No Relief in 2008 63 The Climax? 67 Back from the Brink 72 5 Extinctions 74 Among the Ruins 74 From Countrywide to IndyMac 75 IndyMac 77 Washington Mutual 80 Wachovia 82 Bank Extinctions, Banking Consolidation, and Too-Big-to-Fail 84 6 The End of Investment Banking 87 Big Brains, Big Egos, and Big Pay 87 Bear Stearns 88 The Bankruptcy of Lehman Brothers 96 Merrill Lynch: The Herd Goes to the Abattoir 98 Goldman Sachs, Morgan Stanley, and the Week That Remade Wall Street 102 7 When Zombies Walk the Earth 109 Fannie Mae and Freddie Mac 110 AIG 117 Citigroup: The Biggest Zombie of Them All 124 Zombies and the Future 126 8 Policy Responses and the Beginnings of Recovery 128 Unfurling the TARP 129 The Market Reacts 131 The TARP Evolves 133 Introduction of the TALF 136 Instituting More Programs 138 Support for the Auto Industry 138 Support for Home Owners 139 Green Shoots in the Financial Sector 139 Initial Cost Assessment 140 viiContents 9 Causes of the Financial Crisis: Macroeconomic Developments and Federal Policy 143 The Basic Story 144 Macroeconomic Developments 146 Federal Stimulative Policy and Legislation 148 Attempts to Combat Mortgage Lending Discrimination and to Expand Home Ownership to Minorities 149 National Homeownership Strategy 151 The Causal Role of the GSEs 155 10 Causes of the Financial Crisis: The Failure of Prudential Regulation 160 Regulation of Depository Institutions 162 Regulation of Lines of Business 162 Capital Requirements 163 Interaction Between Capital Regulation and Credit Derivatives 166 Regulation of Size and Scope—“Too Big to Fail” 167 Restrictions on Concentration of Risk 169 Regulation of Securities Markets and Supporting Institutions 170 Capital Regulations 170 Off-Balance Sheet Corporate Entities 173 Credit-Rating Agencies 174 Mark-to-Market Accounting Rules 178 Complex Financial Derivatives 181 The Regulation of AIG 181 Poor Regulation of Mortgage Industry 183 Emergency Responses to the Crisis and “Really Too Big to Fail” 184 Defects in Regulatory Architecture 186 11 Causes of the Financial Crisis: From Aspiring Home Owner to Mortgage Lender 187 The Borrower 190 The Lender 191 The Appraiser 195 The Mortgage Broker 197 The Mortgage Frenzy, the Originator, and Underwriting Standards 203 12 Causes of the Financial Crisis: From Securitizer to Ultimate Investor 208 Purchasing Mortgages 209 Creating Securities and Obtaining Ratings 211 viii CONTENTS To the Ultimate Investor 221 Incentives from Securitizers to Ultimate Investors 224 13 Causes of the Financial Crisis: Financial Innovation, Poor Risk Manage- ment, and Excessive Leverage 226 Financial Innovation and the Creation of Complex Instruments 227 Poor Risk Management 232 Excessive Leverage 236 14 Causes of the Financial Crisis: Executive Compensation and Poor Corporate Governance 239 Pay at Financial Firms 241 Risk-Taking and Executive Compensation in the Financial Crisis 249 Incentives, Risk-Taking, and Compensation at Fannie Mae 250 Executive Compensation at Lehman Brothers 253 Incentive Confl icts 256 Corporate Governance in the Financial Crisis 257 15 Consequences of the Financial Crisis and the Future It Leaves Us 260 Measuring the Damage: A Warning 260 The Bailout and Its Costs 261 From 2006 to 2009: Our Economic World and How It Has Changed 266 Reduced Circumstances: Our Economic Future 268 Beyond the Merely Economic—American Recessional or American Renewal? 272 Perfecting the Fatally Flawed Regulatory Regimes of the Past 275 The Financial Crisis, the Great Recession, and Institutional Failures 277 Fundamental Reform? 281 “Too Big to Fail” 282 Corporate Governance, Executive Compensation, and Firms’ Risk-Taking 284 Conclusion: Dopes, Genius, Saints, Scoundrels, and Ordinary People 286 Glossary 289 Appendix A: Timeline of the Subprime Financial Crisis 301 Appendix B: The Original TARP Proposal: Legislative Proposal for Treasury Authority To Purchase Mortgage-Related Assets 317 Notes 321 References 357 Index 379 ix PREFACE The economic crisis that began in 2007 has changed the economic lives of Americans and many people around the world. By any measure, this financial crisis of our time is one of the most important economic events of the last century, and compared to all other economic and financial upsets since the Great Depression, it is surely the most significant. Like the Great Depression itself, these current financial problems, already dubbed the Great Recession, are proving to have profound social signif- icance as well. There are already many signs that the economic and social derange- ments caused by the crisis have affected the way that people think about their economic lives, their living habits, and their fundamental values. For example, we Americans have been notorious for our high consump- tion and low savings rate. Yet that behavior seems to have changed in just a few months. Contrary to our former love of conspicuous con- sumption, newspapers feature the joy of frugality that many of our fellow citizens claim to have discovered. Whether such new habits will persist will be revealed in time, and for the present these accounts may certainly occasion skepticism. However, such uncertainty about the meaning of the interesting times in which we live is characteristic of all evolving social phenomena of any significance. On any understanding, [...]... world of illusion was merely the prelude to disaster Chapter 4, From the Subprime Crisis to Financial Disaster: An Overview, quickly surveys the development of the crisis, starting from the housing peak The chapter provides a synoptic view of the buildup to the crisis, considers the architecture of the governmental response to the crisis, and takes the narrative up to the point at which the threat to the. .. the present difficulties x P R E FAC E The current financial crisis is a social phenomenon of a kind similar to the Great Depression, the Enclosure Movement in England of the nineteenth century, or the economic awakening of China in our own day While our financial crisis is unlikely to be of the same magnitude, it is nonetheless a development that alters the lives of millions Like these and many other... patterns of cash flows can be sold as new financial instruments with characteristics that differ radically from the original mortgages Chapter 3 surveys the illusory happy time before the crisis in the subprime market The remainder of the book focuses exclusively on the subprime crisis, which subsequently became a much broader crisis the financial crisis of our time Before the Great Depression Early in the. .. oversight of the mortgage market Chapters 11 and 12 offer a more detailed analysis of the problems inherent in the originate-to-distribute model of mortgage production Chapter 11, Causes of the Financial Crisis: From Aspiring Home Owner to Mortgage Lender, focuses on the initial part of the production chain, while chapter 12, Causes of the Financial Crisis: From Securitizer to Ultimate Investor, explores the. .. that pervaded the largest and supposedly most sophisticated financial firms in the world Chapter 15, Consequences of the Financial Crisis and the Future It Leaves Us, concludes the book This chapter assesses the likely lasting economic consequences of the financial crisis At present, there is an inchoate movement to change the regulatory system of the financial industry, as if fine-tuning the present... factors operated together to generate the financial crisis In contrast to those who seek to emphasize a single cause of the current crisis, this book moves from a broad study of the economic history of our times to focus on several decisive changes In addition to exploring the causes of the current crisis, the book provides the reader with a comprehensive review of the context within which these events unfolded... financial crisis is playing in the standing of the United States in the world, both in terms of its economic position and geopolitical power Acknowledgments For many of us who work in finance, the development of the financial crisis has consumed our attention for the last many months I would like to thank three of my colleagues at Loyola for the many discussions we have had of the events as they unfolded:... percent.1 These terms were advantageous for the lender, particularly the requirement that the value of the property had to be large compared to the loan amount But these features often required borrowers to renegotiate the loan frequently, particularly as few borrowers would be able to save the entire principal balance during the short life of the loan so that they could pay off the entire value of the home... defaults in a time of stress, which the Great Crash in October 1929 and the onset of the Great Depression provided in an extreme form, with the bank runs the sudden widespread customer withdrawals of deposits of that era Property values plunged by almost 50 percent from their peak, so lenders were unable or disinclined to refinance the loans at all, and they Introduction: The Financial Crisis of Our Time 3... TALF TARP VaR xxii Office of Federal Housing Enterprise Oversight Originate-to-distribute Originate-to-hold Savings and Loan Association Securities and Exchange Commission Structured-investment vehicle Special-purpose entity Special-purpose vehicle Term Asset-Backed Securities Loan Facility Troubled Asset Relief Program Value-at-Risk A B B R E V I AT I O N S The Financial Crisis of Our Time This page intentionally . namely the boards of directors of financial institutions. These boards, whose members typically include the titans of the financial industry, are charged with the high-level man- agement of their. movements that change the lives and perceptions of millions of people, the financial crisis of our age will be the subject of study and debate for decades. The public at large, profes- sional economists,. also explains the reasons for the transition from the originate-to-hold to the originate-to-distribute model and briefly explains the elements of the more complicated originate-to-distribute