Who Stole the American Dream? (31 page)

At its peak, the New Mortgage Game worked for several years, but when the housing boom that Greenspan promoted went bust, the losses were titanic.
American homeowners lost trillions in plummeting home prices from mid-2006 to the start of 2012. But that’s only half of the story.

Less visible was the massive loss of equity in their homes that average Americans suffered before the housing bubble burst in 2006. Back in 1985, Americans actually owned 69.2 percent of the value of their homes (the banks owned the rest), according to Federal Reserve data. By 2011,
the homeowners’ share of housing wealth had plunged to just 38.4 percent of the total value.
Homeowners lost nearly a 30 percent stake in what had been the nation’s $20 trillion housing stock—a collective loss of about $6 trillion primarily through equity stripping.

In short, the fantasy promise that housing prices would go up forever and you could borrow on your home time after time, combined with deceptive sales pitches on junk mortgages, seduced millions of middle-class families into draining the precious equity that they had painstakingly built up in their homes.

That steep national drop in homeowner equity, from nearly 70 percent down to below 40 percent of total housing value, represented a monumental transfer of the absolute core of middle-class wealth from homeowners to banks. Trillions of dollars in accumulated
middle-class wealth were shifted from average Americans to the big banks, their CEOs, and their main stockholders. For the first time in decades, banks owned more of the cumulative value of American homes than the so-called owners.

That seismic shift of wealth represented the theft from millions of middle-class families of a vital component of the American Dream. A large portion of the baby boomer generation, heading for retirement, were left in dire straits. Instead of having paid off their thirty-year mortgages, they were stuck with homes “under water” and they may literally have to pay money to get out of them.

Before the New Mortgage Game took over, people would plan on cashing out of the homes where they had raised their families and on using the proceeds to move to smaller, hopefully cheaper quarters in sunny Florida or Arizona. The housing bust changed all that. Even for those who hung on to their homes, it meant in many cases that
sellers
had to
bring cash to settlement
to cover the costs at closing. By economist Dean Baker’s estimate,
nearly one-fifth of older boomers in their sixties face this new financial challenge right now, and unless the housing market changes dramatically, roughly one-third of the younger boomers, in their fifties, are on track for a similar shock when they retire.

In going back to see how things got so badly off track, what emerges is a fatally flawed concept at the heart of the New Mortgage Game. It is the dangerous disconnect—the separation of Profit from Risk. The primary place where that happened was in what bankers call “the secondary market,” where regional banks sold their home mortgages and where Wall Street banks could buy those mortgages by the millions.

The secondary market was the engine of the housing bubble of the 2000 decade. It financed the “originate and sell” strategy that became the hallmark of the New Mortgage Game. One predictable
consequence of regional banks’ quickly selling off mortgages to Wall Street was that the brokers and bankers who originated the loans no longer cared whether those loans were paid back or defaulted, because they no longer owned the risk. They could pass the risk downstream to distant investors on Wall Street and beyond. Reliability was sacrificed on the altar of volume and profits.

This was a watershed change for the banking industry. Traditionally, banks closely scrutinized the three Cs of borrowers—credit, collateral, and cash flow (income)—to make sure that 99 percent of their loans paid off. But as we saw with Bre Heller and the Florida brokers using the no doc, stated income, and NINJA loans, checking the borrowers carefully no longer mattered to the loan originators in the New Mortgage Game. They made fast, big profits from handsome closing fees.

Then, Wall Street firms sliced, diced, and repackaged these mortgage loans into what became known as “synthetic” derivatives, or security pools with various levels of risk, and sold multibillion-dollar bundles of mortgages—or mortgage parts—known as “collateralized debt obligations,” to hedge funds, college endowments, pension funds, insurance companies, or investors in Germany, Japan, Abu Dhabi, or wherever. The investors loved them because mortgages used to be very safe investments and Wall Street bond-rating agencies still gave them AAA ratings.

The growth of these pyramiding bank loans and derivatives followed the policy prescriptions of Fed chairman Alan
Greenspan, who credited this process with diversifying risk and having “contributed to the stability of the banking system….”

What Greenspan evidently discounted was the colossal danger in separating profit from risk—the problem that when risk resides everywhere, risk resides nowhere in particular. No one was minding the store the way the old-fashioned bank did when it lent money from its own depositors to their neighbors.

When the roof fell in, the banks blamed borrowers who defaulted for behaving irresponsibly. But the banks themselves—and the Fed—had created a system of irresponsibility, by lending to millions of people who could not reasonably be expected to repay and then not carefully regulating the process for safety.

“
Ordinarily, the instinct for financial self-preservation should prevent lenders from making too many risky loans,” observed Simon Johnson, former chief economist for the International Monetary Fund (IMF). “The magic of securitization [reselling mortgages in bundles] relieved lenders of this risk … leaving them free to originate as many new mortgages as they could. Because mortgages were divided up among a large array of investors, neither the mortgage lender nor the investment bank managing the securitization retained the risk of default. That risk was transferred to investors, many of whom lacked the information and the analytical skills necessary to understand what they were buying. And the investors assumed that they didn’t need to worry about what they were buying, because it was blessed by the credit rating agencies’ AAA ratings.”

The secondary market turned the New Mortgage Game into a game of musical chairs that was destined for disaster. Because of the financial disconnect, it worked like a multitrillion-dollar Ponzi scheme. The secondary market grew so enormous that it constantly needed new money to cover losses and to keep the game going. But when the music stopped, the game brought down Bear Stearns, Lehman Brothers, Washington Mutual, Countrywide, and hundreds of regional banks, and it left millions of average Americans foreclosed out of their homes and millions more
vastly poorer—$9 trillion poorer—from both equity stripping and plunging home values.

The New Mortgage Game and the enormous loss of wealth by middle-class Americans were the direct consequences of new policies
in Washington—New Economy policies that wiped out laws and regulations that had worked well for decades.

The first major step was taken under President Jimmy Carter—the Depository Institutions Deregulation and Monetary Control Act of 1980. That law effectively abolished limits on interest rates for first mortgages that had long been imposed by state usury laws. It thus removed a basic protection for financially vulnerable borrowers and opened the door to unscrupulous subprime lenders. “More than anything else,” asserted former Federal Reserve Board governor Edward Gramlich, “
this elimination of usury law ceilings [on interest rates] paved the way for the development of the subprime market.”

In 1982, Congress took an even bigger step. It adopted legislation proposed by President Reagan that authorized the exotic loans that became the pathological hallmarks of the housing craze of the 2000s. This law enabled state banks to sell adjustable-rate mortgages (national banks had gotten that authority in 1981).
It also permitted something never allowed before—equity stripping loans, known in banking lingo as “negative amortization.” This meant authorizing banks to sell loans where the principal balance would go up over time, digging homeowners into ever-deepening debt. Finally, the law empowered the Office of the Comptroller of the Currency to issue rules in 1983 that permitted up to 100 percent financing, by canceling restrictions that required down payments from buyers.

These three items—ARMs, negative amortization, and 100 percent financing—in a law that President Reagan hailed as “
the most important legislation for financial institutions in the last 50 years,” were the grist, as
New York Times
financial columnist Gretchen Morgenson observed, for home
mortgages loaded “with poisonous features that made them virtually impossible to repay.”

Two years later, in 1984, the Reagan administration delivered the coup de grâce for the New Mortgage Game—the separation of Profit from Risk. In partnership with Wall Street bankers, the Reagan White House wrote the Secondary Mortgage Market Enhancement Act of 1984.
This law sanctioned the “securitization” of mortgages on the secondary market, which powered the explosive growth of
America’s mortgage market to the point that it outstripped even the market for U.S. Treasury bonds and bills.

For banks that originated loans, such as Washington Mutual and Long Beach Mortgage, securitization provided the avenue for selling their mortgages and the source for raising more capital to finance another round of lending. For investment banks such as Goldman Sachs, it created a new venue and new vehicles to reap lucrative fees and a casino for betting against the subprime market that they were getting their clients to finance.

The 1984 law was written to Wall Street’s specification. By several accounts,
Lewis Ranieri, a legendary Salomon Brothers trader, whom some have called the father of the modern mortgage bond market, worked hand in glove with the Reagan White House to craft the legislation. From experience in the 1970s, Ranieri knew exactly what legal barriers the investment bankers needed to eliminate in order to create a grand new mortgage marketplace. Then in 1986, Ranieri and the investment banks won another round of lucrative concessions in the tax reform law that established the real estate mortgage investment conduit, or REMIC, which granted complex special tax advantages for the mortgage bond market.

If the White House and Congress provided the legal blueprint for the New Mortgage Game, Alan Greenspan became its point man—its prime policy architect and its most influential advocate. Three elements were central to the New Mortgage Game—cheap money, subprime loans, and a portfolio of flexible interest rate mortgages—and all of them were either created by Greenspan or vigorously championed by him.

Greenspan instituted the Federal Reserve’s cheap money policy after the dot.com bubble burst and the stock market collapsed in early 2000. Greenspan turned to real estate and home construction as the new driving force for the U.S. economy. He led the Fed to cut
interest rates eleven times from 2001 to mid-2003. The Federal Open Market Committee cut the federal funds rate from 6.5 percent in January 2001 to 1 percent by mid-2003, providing mountains of cheap money for banks to lend and for Wall Street to invest.

Greenspan’s strategy worked. It rescued the economy from a free fall.
It gave housing a kick start, and the housing sector soared, generating more than 40 percent of new private sector jobs starting in November 2001. Operating at full steam in 2005, housing, construction, and real estate were pumping an enormous stimulus into the nation’s economy—
more than $1 trillion a year, by one economist’s estimate.

But danger lay in what became the meteoric rise of housing prices. Cheap money and rising home prices made people feel richer than they really were, so everyone took big risks. People borrowed more than they should have.

Yale University’s Robert J. Shiller, one of America’s premier housing economists, compared the price binge to
a “rocket taking off,” a spurt without precedent, except after World War II.
In the 114 years from the 1890s to 2004, Shiller reported, housing prices had risen only 66 percent, adjusted for inflation, or less than ½ percent a year on average. But from 1997 to 2004, in just eight years, prices had shot up 52 percent. Such a white-hot housing market, Shiller said, should be a warning to the Fed. Other dire prophecies came from financial experts warning that Greenspan’s cheap money was fueling a dangerous speculative fever, but Greenspan brushed aside those warnings as overblown.

Greenspan did more than provide cheap money. He vigorously promoted the subprime market, flexible-rate mortgages, and other exotic loans. Both Presidents Clinton and Bush had called for extending the American Dream of home ownership to those who had been left
behind, especially to minorities. Greenspan became a cheerleader for that policy. “Where once more-marginal applicants would simply have been denied credit, lenders are now able to quite efficiently judge the risk posed by individual applicants and to price that risk appropriately,” Greenspan declared in April 2005.

Unfortunately, by then, lenders such as Countrywide, Washington Mutual, and the main New York banks were doing just the opposite. Instead of weeding out the bad risks, they were dropping their standards and giving loans to poor risks.
But Greenspan took heart from the rapid growth in subprime mortgage lending, boasting that it had risen from just 1 or 2 percent of the U.S. mortgage market in the 1990s to 10 percent in 2005.

Greenspan also told solid middle-class homeowners that they would have been better off if they had stayed away from safe, traditional thirty-year fixed-rate loans. The Fed’s research, Greenspan said in early 2004, “suggests that
many homeowners might have saved tens of thousands of dollars had they held adjustable-rate mortgages rather than fixed-rate mortgages during the past decade.” He urged bankers to be more daring: “American consumers might benefit if lenders provided greater mortgage product alternatives to the traditional fixed-rate mortgage.”