Greenspan's Folly

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.

© 2008