Who is mostly to blame for the biggest upheaval on Wall Street since the Great Crash? The disaster appears to have many fathers. "In a way, it's the perfect crime: Who do you go after?" asks Jim Rokakis, the treasurer of Cuyahoga County in Ohio, one of a slew of state-level officials who saw the mess coming years ago but were ignored by the Feds. "If you arrest the mortgage brokers, how can you in good conscience not arrest the officers of the mortgage banks and the rating agencies?" Rokakis wonders. Ultimately, a big share of the blame lies with Wall Street CEOs who encouraged all this bad lending by packaging it into ever more complex securities, and then invested in it themselves by the billions. Indeed, the myth surrounding the subprime fallout is that no single player along the pipeline could have prevented what happened, including the giant investment banks that loaded their balance sheets with this dreck only to have it drag them into oblivion. "Everyone's to blame, and no one's to blame," says financial expert Joseph Mason of Drexel University, summing up a common view of academia and in Washington.
I don't buy it. Especially the idea that somehow the blame lies mainly with Wall Street's greed, as John McCain reiterated the other day, saying we have to "fix" it. How do you fix greed? And let's face it, left to its own devices, Wall Street has always operated on pure adrenalized greed, which is why financial manias and bubbles come and go and always will.
This mess is mostly a titanic failure of regulation. And the largest share of blame goes back to one man: Alan Greenspan. People mainly fault the former Fed chief, who once enjoyed a near-saintly reputation because of his reputed "feel" for market conditions, for ushering in an era of easy credit that accelerated the mortgage mania. But the much bigger problem was Greenspan's Ayn Randian passion for regulatory minimalism. Under the Home Ownership and Equity Protection Act enacted by Congress in 1994, the Fed was given the authority to oversee mortgage loans. But Greenspan kept putting off writing any rules. As late as April 2005, when things were seriously beginning to go wrong, he was saying that subprime lending would work out for the common good—without government interference. "Lenders are now able to quite efficiently judge the risk posed by individual applicants," he declared at the time. So much for his feel. New regs didn't get put into place until this past July—long after the crash had come, under Greenspan's successor, Ben Bernanke. The new Fed chief's "Regulation Z" finally created some common-sense rules, such as forbidding loans without sufficient documentation to show if a person has the ability to repay.
Greenspan has tried to defend himself repeatedly, though as bank after bank has failed he's retreated to the shadows. But in a 2007 interview with CBS he admitted: "While I was aware a lot of these practices were going on, I had no notion of how significant they had become until very late." This, from a man who once told me, in an interview, that he most enjoyed scanning economic reports for hours in his bathtub. Now, with Tuesday's $85 billion bailout of AIG adding to the hundreds of billions the government has already put up to rescue Bear Stearns, Fannie Mae and Freddie Mac, this apostle of free-market absolutism has realized his worst nightmare. He has given us the largest government intervention into the markets since FDR. Heckuva job, Greenie.
To be sure, there were other regulators who failed. The federal Office of the Comptroller of the Currency and Office of Thrift Supervision in 2002 pre-empted all states from regulating banks and thrifts. The regulator of Fannie Mae and Freddie Mac had almost no power at all. In addition, Fannie and Freddie are both funded by Wall Street, just as the OCC and OTS get their funding from industry fees. That created conflicts of interest: the "government-sponsored entities," as Fannie and Freddie were known, and the regulators of banks and thrifts were vested in boosting the profits that kept them going. "At the national level, the view prevailed that diversifying risk is a good thing, and markets can solve most problems," says Kathleen Engel, a finance expert at Cleveland State. "Advocates in the states were saying the markets weren't, but the federal agencies just sat on it." These regulators also encouraged the industry they so loosely oversaw to send battalions of lobbyists into state capitals to gut regulation at that level, as well. Tom Miller, the Iowa attorney general who successfully sued Ameriquest over irresponsible lending practices nationwide, told me over the summer that the OCC's director spent so much of his energy on turf battles—fighting state efforts to regulate—that he barely paid attention to what the banks were doing in subprime securitization. "He kept saying the states are too strong in regulation, and telling the banks, 'We're not going to be as tough on you'." OCC spokesman Robert Garsson defends his boss, saying that "almost everybody agrees that predatory lending is not a problem in the national banking industry." Now, that may be true. Still, any banks bought plenty of the securities that predatory lenders were helping to create.
But these smaller federal regulators do have some excuses. The new subprime securitization phenomenon cut across so many once-segregated sectors of finance—mortgage lending and securitization were once entirely separate practices—that no one could keep up with it or muster the regulatory oversight of all its parts. The Securities and Exchange Commission oversaw publicly issued securities, but the SEC rightly contends that since most of these collateralized debt obligations or CDOs based on subprime mortgages were "privately" placed with investors, it couldn't regulate them. The Comptroller of the Currency oversaw banks, but not nonbank lenders—which were often the biggest culprits—while the OTS was just in charge of thrifts, and so on. Only the Fed had the authority and the ability, granted to it 14 years ago, to supervise the entire emerging landscape. "They're the only ones who can regulate everybody," says Iowa's Miller. And until the activist Bernanke came along, the Fed did virtually nothing.
In the wake of the failures of Bear Stearns, Lehman Brothers, Freddie and Fannie—and the near-escape of Merrill Lynch and AIG from oblivion, the everybody's-to-blame argument remains popular. It runs like this: at one end of the long mortgage-securities pipeline—which ran from small towns in America to sovereign-wealth funds in Europe and Asia—unscrupulous brokers peddled mortgage deals to reckless nonbank lenders like Argent, which looked the other way at how insolvent or fraudulent the borrowers were. Greed drove the train: to fill Wall Street's demand for more mortgage-backed securities, lenders kept reaching lower and lower down the scale in both property and borrowers until the street hustlers jumped in to offer up their "product." By the time the mortgages were packaged en masse by Ivy-educated math whizzes at giant Wall Street firms such as Bear and Lehman, there were so many layers of middlemen that blame was spread as widely as the risk. On the 70th floor of a Wall Street tower, down-in-the-weeds mortgage details in small towns don't matter much. As long as real estate kept going up, everybody would win.
It's not as if Wall Street didn't understand that it was playing with fire. But by splitting the securities into many tranches, or pieces for different investors, the Street whizzes also thought they were distributing the risk so widely no one would notice. The statistical analysts at Moody's and Standard and Poor's—the top agencies that "rate" securities so investors will know how risky they are—figured things the same way. They stamped "triple-A" ratings on the top tranch as if it were a lone security and didn't carry a long "tail" of junk with it. But the risk was merely being distilled to the bottom tranch. And when real-estate prices started to drop in 2006, the junky tranch of the security dragged the value of all the other tranches down with it. So brokers, raters and the players in between made mistakes along the way that added up to disaster.
Yet the idea of widespread blame is as ill-founded as the Street's premise that risk was well distributed. For one thing, many of the borrowers could barely understand the thick stacks of paper they were signing. And many brokers blatantly falsified their incomes to qualify them, often without telling them, says Bill Brennan, a lawyer with Atlanta Legal Aid who has helped many defaulted borrowers with workouts. "This idea that borrowers were giving false information to lenders is just nonsense," he says. As investigations continue, the emerging truth is that no matter what kind of fancy new paper Wall Street was inventing, its corporate officers knew, or should have known, that the "collateral" backing up that paper was often bogus, provided by shysters and criminals.
The one who should have known most of all was Greenspan. Rokakis, the Cuyahoga treasurer, recalls when he first sensed the beginnings of the storm: way back in 2000. The foreclosure rate in the Cuyahoga County had doubled in one year, the treasurer noticed. That suggested, very early on, that lending practices were becoming irresponsible and very often fraudulent. In October of that year, Rokakis led a local delegation to the Federal Reserve Bank of Cleveland asking for help. After much pleading the Fed scheduled a daylong conference in March 2001, titled, "Predatory Lending in Housing." "We asked them to step up and take action," Rokakis recalled recently in his office in downtown Cleveland. Nothing was done. At the national level, Greenspan even stymied marginal efforts to put innocuous restrictions in place, like protections for Habitat for Humanity borrowers. "He was just philosophically opposed," says Mike Calhoun of the Center for Responsible Lending in Washington. "Here's what I learned about the Fed: They do wonderful lunches. Their cafeteria is really good," says Rokakis. "But the Federal Reserve Bank is not there to protect us. It's there to protect the banks." And now the banks are helping themselves to vast amounts of taxpayer money. Enjoy your retirement, Alan.