Bailout Nation (38 page)

The administration also ignored remarkably prescient warnings that foretold the financial meltdown, according to an AP review of regulatory documents.

Similarly, the Office of the Comptroller of the Currency (OCC) “played a key role in the mortgage meltdown, both by actively blocking state consumer protection laws through the expansion of federal preemption, and by simultaneously failing to adequately monitor the nationally-chartered lending institutions under its purview,” as Eric Stein, senior vice president of the Center for Responsible Lending, testified in October 2008 at a Senate hearing entitled “Turmoil in the U.S. Credit Markets: The Genesis of the Current Economic Crisis.”
¹⁰

The OCC bowed to pressure from National City and its subprime lending subsidiary First Franklin Financial in preempting “comprehensive mortgage reform legislation” passed by the state of Georgia, Stein testified.
¹¹
There are other examples of the OCC thwarting legislation that could have prevented some of the most irresponsible bank loans, including predatory lending.

Despite his professed belief in free markets over government intervention, George W. Bush ended up overseeing the greatest nationalization of private industry the United States has ever had. The irony of the Bush administration's bailout fever was captured by Allan Mendelowitz, who observed: “The Bush administration, which took office as social conservatives, is now leaving as conservative socialists.”
¹²

O
ver the course of two terms, Bush appointed three misfit SEC chairmen, each ill-suited for the position. They formed a veritable parade of poor regulators, none right for the agency's role of being the investors' advocate.

Bush's first SEC appointment, Harvey Pitt, was a securities industry defense attorney. To say he was wholly unsuited to the position is to understate the case. Instead of representing the interests of investors, Pitt was a well-known industry lapdog. Pitt pledged a “kinder and gentler” SEC in the midst of a huge run of corporate misfeasance. He was the precise opposite of what was needed.

Even worse, in an era of corporate accounting scandals, Pitt had close ties with the accounting industry. As a Wall Street lawyer, Pitt had “recommended that clients destroy sensitive documents before they could be used against them—advice that seemed to find echoes in the SEC's investigations into Enron and its shredder-happy auditor, Arthur Andersen.”
¹³
Pitt had to recuse himself from many of the SEC's votes, as they were frequently about the clients he had represented as a defense attorney. For inexplicable reasons, during
active
SEC investigations, Pitt would meet with the heads of companies under review.
¹⁴

It should come as no surprise that Pitt's chairmanship demoralized the agency. To investor advocacy groups, having Pitt as SEC chief was “like naming Osama bin Laden to run the Office of Homeland Security.”
¹⁵

By July 2002, Senator John McCain was calling for Pitt's resignation.
¹⁶
Pitt resigned following a series of scandals.

The next SEC chairman Bush appointed was William Donaldson, the former chairman of the New York Stock Exchange (NYSE). He was also the “D” in DLJ (Donaldson, Lufkin & Jenrette), which eventually was acquired by Credit Suisse.

Donaldson was called upon to lend some gravitas to the SEC after Pitt's resignation. Given the former NYSE chairman's close ties to big Wall Street firms, we shouldn't be surprised at what came next. During Donaldson's watch, the net capital rule for the five biggest investment banks was exempted in 2004. Instead of being limited to 12 to 1 leverage, banks were allowed to lever up 30, 35, and even 40 to 1 after the waiver. It isn't glib to say the financial meltdown was three times as bad as it might have been but for Donaldson's SEC granting this waiver.

Then there is Christopher Cox, the third Bush SEC chair. He shared Greenspan's and Gramm's hostility to regulations. “Cox's long-standing support of a deregulated market and friendliness to business made him the wrong SEC chairman at the wrong time.”
¹⁷

In July 2007, Cox eliminated the so-called uptick rule, removing a modest restraint on shorting just as the credit crunch was getting started. The market peaked a few months later. When it began heading south, there was no uptick rule in place to prevent indiscriminate short selling and piling on. Even if only for psychological reasons, removing the uptick rule, which was put in place in the aftermath of the 1929 crash, turned out to be not very smart.

Then in September 2008, with the crisis in full flower, Cox made shorting financial stocks illegal. Apparently, he was unaware that fierce market sell-offs often end with short sellers covering their positions, locking in profits on their bearish bets. With short sellers out of the market, the downturn became even fiercer. From the market highs of October 2007, the S&P 500 and the Dow Jones Industrial Average were cut in half in 12 months. Much of the damage came
after
the no-shorting rule went into effect.

As the GOP presidential candidate in 2008, Senator John McCain called for Cox's resignation.

And as this book went to press, the latest SEC black eye was reaching a milestone: Bernie Madoff had finally been sent to prison after pleading guilty to stealing as much as $50 billion in investor assets in a giant Ponzi scheme. Madoff had “made off” with his clients' monies for several years, despite many warnings to the SEC.

Numerous people, including hedge fund manager Doug Kass and options strategist Harry Markopolos, had warned years before that the ability to provide such unusually smooth returns with so little volatility was more likely the result of fraud than investing acumen.
¹⁸

Markopolos, particularly, made unveiling Madoff 's fraud his passion. He sent numerous anonymous letters to the SEC and met with officials of the SEC's Boston office in 2001 to lay out his concerns, the
Wall Street Journal
reported. Around the same time, “
Barron's
and hedge-fund trade publication
MarHedge
suggested Madoff was front running for favored clients.”
¹⁹

Despite frequent tips, which led to at least eight examinations of Madoff 's firm in 16 years by the SEC and other regulators, the fraud was discovered only after Madoff, faced with redemptions, confessed that the firm was nearly bankrupt.

Testifying before Congress on February 4, 2009, Markopolos blistered the SEC and other financial regulators for their “abject failure” to stop Madoff, “even when a multi-billion-dollar case [was] handed to them on a silver platter.”
²⁰

Soon after Madoff 's confession, the SEC was rocked by yet another major scandal surrounding Stanford Financial Group, whose namesake founder, Sir Allen Stanford, stands accused of overseeing an $8 billion fraud. As of March 2009, Stanford has refused to cooperate in the government's investigation of what the SEC alleges is fraud “of a shocking magnitude.”
²¹

What isn't shocking to anyone is that the SEC missed it for years.

N
ext up in our cavalcade of criticism: the mortgage brokers and originators. What did federal bank regulators have to say about this paradigm shift? Very little, even though the FBI warned of an “epidemic” of mortgage fraud in 2004.
²²

The lightly regulated industry was filled with aggressive salespeople who ruthlessly found ways to generate the highest commissions. The mortgage originations that were likely to have the highest vig were the 2/28 adjustable-rate mortgages (ARMs)—loans with cheap teaser rates that lasted for two years and then reset to a much higher, market-based rate for the rest of the 30-year term. These now-notorious loans allowed brokers to sell the highest dollar loan possible for the lowest monthly payment to the least qualified borrowers.

Much of the mortgage industry embraced these irresponsible, high-default products. All the parties involved knew the high likelihood of foreclosures, as detailed in Chapter 10. They abdicated traditional lending standards because the defaults would take place after the mortgages were off their hands. Indeed, these companies happily played dumb, so long as the loan didn't default within 90 days. By month four, it was someone else's headache, as far as the originator was concerned. Now it has become everyone's worry.

That hundreds of these firms have gone bankrupt is cold comfort to the rest of us.

R
egardless of how low rates got, the fact remains that many borrowers took out mortgages regardless of their own ability to repay the monthly principle and interest. This was simply reckless behavior, and should be recognized as such. Innumeracy is no excuse.

Ultimately, banks have a fiduciary responsibility to their shareholders and depositors to lend money only to qualified borrowers. Hence, they have a greater liability in the lending crisis. This is especially true of the “lend to securitize” originators who
knew they would be causing future foreclosures.

However, the lenders' irresponsible behavior does not exonerate those people who failed to do basic math. It is incumbent upon borrowers to know what they can afford each month—and to not get themselves into financial trouble. Perhaps it's time to teach basic financial literacy in public schools.

Then there are the flippers, the speculators, the Donald Trump wannabes who got caught when the market turned. Those of you who are defaulting on your mortgages: congratulations—you have achieved your dreams! You are now just like the Donald: In late 2008, Trump reneged on a $40 million debt to Deutsche Bank for a commercial property development.
²³

The many real estate speculators who got caught without a chair when the music stopped must accept their fair share of the blame. (Surprisingly, Mr. Trump remains blameless for the current mess.)