Recent findings for the causes of the GFC
02/05/2011
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The US Senate Permanent Subcommittee on Investigations (PSI) has released its final report on its investigation into the causes of the global financial crisis (see HERE).  You might think this would be dull and boring, but it provides a fascinating insight into the real causes of the global melt-down, based on previously unavailable internal documents. 

The report demonstrates that you cannot legislate for good governance – dishonesty and greed will happen.  It indicates, if anything, that black letter law, like recent Australian government initiatives to improve governance in executive remuneration, are not the answer. 

And, as we reported 2 years ago (see HERE),executive remuneration was not a fundamental cause of the GFC.

Nevertheless, compensation that facilitated a focus on revenues and short-term profits and excluded any assessment of risk featured in all of the case studies cited in the report.  How compensation did this makes interesting reading, and demonstrates the influence compensation has on behaviour. But what was lacking was a counterbalance in terms of risk management, compliance and enforcement.

The factors identified by the PSI as the primary causes of the GFC are

   High risk lending

   Regulatory failure

   Inflated credit ratings and

   Abuses by investment banks.

The PSI conducted detailed case studies in relation to each of these factors, and summarised its findings as follows.

Inflated credit ratings

The Report concludes that the most immediate cause of the financial crisis was the July 2007 mass ratings downgrades by Moody’s and Standard & Poor’s that exposed the risky nature of mortgage-related investments that, just months before, the same firms had deemed to be almost as safe as Treasury bills. 

The result was a collapse in the value of mortgage related securities that devastated investors.  Internal emails show that credit rating agency personnel knew their ratings would not “hold” and delayed imposing tougher ratings criteria to “massage the … numbers to preserve market share.”  Even after they finally adjusted their risk models to reflect the higher risk mortgages being issued, the firms often failed to apply the revised models to existing securities, and helped investment banks rush risky investments to market before tougher rating criteria took effect. 

The ratings agencies also continued to pull in lucrative fees of up to $135,000 to rate a mortgage backed security and up to $750,000 to rate a collateralized debt obligation (CDO) – fees that might have been lost if they angered issuers by providing lower ratings. 

The mass rating downgrades the agencies finally initiated were not an effort to come clean, but were necessitated by skyrocketing mortgage delinquencies and securities plummeting in value.  In the end, over 90% of the AAA ratings given to mortgage-backed securities in 2006 and 2007 were downgraded to junk status, including 75 out of 75 AAA-rated securities issued in 2006 by Long Beach Mortgage Corporation, which was Washington Mutual’s subprime lender.  When sound credit ratings conflicted with collecting profitable fees, credit rating agencies chose the fees.

High risk lending

Washington Mutual Bank (WaMu) was a $300 billion thrift that became the biggest US bank to fail in the GFC. 

The PSI case study reveals that, with an eye on short term profits, Washington Mutual launched a strategy of high-risk mortgage lending in early 2005, even as the bank’s own top executives stated that the condition of the housing market “signifies a bubble” with risks that “will come back to haunt us.”  Executives forged ahead despite repeated warnings from inside and outside the bank that the risks were excessive, its lending standards and risk management systems were deficient, and many of its loans were tainted by fraud or prone to early default. 

WaMu’s chief credit officer complained at one point that “[a]ny attempts to enforce [a] more disciplined underwriting approach were continuously thwarted by an aggressive, and often times abusive group of Sales employees within the organization.” 

From 2003 to 2006, WaMu shifted its loan originations from low risk,

fixed rate mortgages, which fell from 64% to 25% of its loan originations, to high risk loans, which jumped from 19% to 55% of its originations.  WaMu and Long Beach Mortgage securitized hundreds of billions of dollars in high risk, poor quality, and sometimes fraudulent mortgages, at times without full disclosure to investors, weakening U.S. financial markets. 

WaMu also sold some of its high-risk loans to Fannie Mae and Freddie Mac, and played one off the other to make more money. 

Regulatory failures

The PSI’s case study of the Office of Thrift Supervision (OTS), which was Washington Mutual’s primary regulator, beggars belief. 

The OTS repeatedly failed to correct WaMu’s unsafe and unsound lending practices, despite logging nearly 500 serious deficiencies at the bank over five years, from 2003 to 2008.  New information available to the PSI details the regulator’s deference to bank management and how it used the bank’s short-term profits to excuse high-risk activities. 

Although WaMu recorded increasing problems from its high-risk loans, including delinquencies that doubled year after year in its risky Option Adjustable Rate Mortgage (ARM) portfolio, OTS examiners failed to clamp down on WaMu’s high risk lending. 

OTS did not even consider bringing an enforcement action against the bank until it began losing substantial sums in 2008.  OTS also failed until 2008, to lower the bank’s overall high rating or the rating awarded to WaMu’s management, despite the bank’s ongoing failure to correct serious deficiencies. 

When the Federal Deposit Insurance Corporation (FDIC) advocated taking tougher action, OTS officials not only refused, but impeded FDIC oversight of the bank.  When the New York State Attorney General sued two

appraisal firms for colluding with WaMu to inflate property values, OTS took nearly a year to conduct its own investigation and finally recommended taking action — a week after the bank had failed. 

The OTS Director treated WaMu, which was its largest thrift and supplied 15% of the agency’s budget, as a “constituent” and struck an apologetic tone when informing WaMu’s CEO of its decision to take an enforcement action. 

When diligent oversight conflicted with the desire of OTS officials to protect their “constituent” and the agency’s own turf, they ignored their oversight responsibilities.

Investment banks and structured finance

Investment banks reviewed by the Subcommittee assembled and sold billions of dollars in mortgage-related investments that flooded financial markets with high-risk assets.  They charged $1 million to $8 million in fees to construct, underwrite, and market a mortgage-backed security, and $5 to $10 million per CDO. 

Deutsche Bank helped assemble a $1.1 billion CDO known as Gemstone 7, stood by as it was filled it with low-quality assets that its top CDO trader referred to as “crap” and “pigs,” and rushed to sell it “before the market falls off a cliff.” 

Deutsche Bank lost $4.5 billion when the mortgage market collapsed, but would have lost even more if it had not cut its losses by selling CDOs like Gemstone. 

When Goldman Sachs realized the mortgage market was in decline, it took actions to profit from that decline at the expense of its clients.  New documents detail how, in 2007, Goldman’s Structured Products Group twice amassed and profited from large net short positions in mortgage related securities. 

At the same time the firm was betting against the mortgage market as a whole, Goldman assembled and aggressively marketed to its clients poor quality CDOs that it actively bet against by taking large short positions in those transactions.  Goldman recommended four CDOs, Hudson, Anderson, Timberwolf, and Abacus, to its clients without fully disclosing key information about those products, Goldman’s own market views, or its adverse economic interests.  For example, in Hudson, Goldman told investors that its interests were “aligned” with theirs when, in fact, Goldman held 100% of the short side of the CDO and had adverse interests to the investors, and described Hudson’s assets as being “sourced from the Street,” when in fact, Goldman had selected and priced the assets without any third party involvement. 

At one point in May 2007, Goldman Sachs unsuccessfully tried to execute a “short squeeze” in the mortgage market so that Goldman could scoop up short positions at artificially depressed prices and profit as the mortgage market declined.  

What chance did we have?  And what has really changed in the US to prevent the same things happening again?

© Guerdon Associates 2021
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