The book is must reading for those who want to know which government and private institutions contributed to the financial mess. The authors, to this reader's eye at least, have thoroughly researched the story they report, even getting most small facts right, while weaving a page-turning thriller.
There are two main weaknesses, though. First, the reader has no easy way to verify the facts the authors present because they provide no references. Second, the authors tend to accept uncritically the views of various government officials. Along the same lines, they give Barney Frank (D, Mass.) — for many years the ranking Democratic member and then chairman of the House Financial Services Committee — exactly two short mentions and zero blame, even though he had resisted attempts to rein in Fannie and Freddie.
Other people's money | Some free-market economists, including me, have argued that Fannie Mae and Freddie Mac were major contributors to the financial crisis. And they were. But McLean and Nocera show that, while Fannie and Freddie definitely added fuel to the fire — in 2008, they guaranteed or owned a whopping $5.3 trillion in mortgages — they came to the subprime game late in the crisis, essentially imitating what the most irresponsible players in the private sector were doing. What comes across in episode after episode is a story of unjustifiably self-assured men (almost all the devils were men) making huge bets with other people's money.
These men often had little understanding of the underlying risks. One assumption many of them made, for instance, was that house prices nationwide could never fall — or, at least, not fall by much. Of course, as we now know, that was false.
Even though Fannie Mae came late to the meltdown party, it was one of the initiators of securitized mortgages, one of the culprits in the crisis. In 1999, Treasury Secretary Larry Summers expressed mild concern about the large potential risk to taxpayers if Fannie Mae got in trouble. Fannie's allies, on both the Democratic and Republican sides, came down hard on him. How did Fannie Mae get such political clout? This is one of the best-told stories in the book. McLean and Nocera tell how a well-connected Democrat named Jim Johnson made Fannie Mae almost invulnerable politically. Johnson, who had been Vice President Walter Mondale's executive assistant during Jimmy Carter's presidency and had run Mondale's failed presidential campaign in 1984, was the chairman and chief executive officer of Fannie Mae from 1991 to 1998. During that time, he turned Fannie Mae into one of the most powerful lobbies in Washington, using that lobbying power to defend its government-granted privileges. The most important privilege was government backing. While the U.S. government did not explicitly back Fannie Mae — a government-sponsored enterprise rather than a government enterprise — everyone assumed, it turns out correctly, that it did.
To get powerful congressmen on board, Johnson set up "partnership offices" in their congressional districts. The first such office was in San Antonio, in the district of Henry Gonzalez (D, Texas), then-chairman of the House Banking Committee. These offices were staffed, the authors write, "by someone close to power — the son of a senator, a governor's assistant, a former congressional staffer." Expenditures on such offices don't even count as lobbying. But Fannie Mae also lobbied, spending $170 million between 1997 and 2006.
Interestingly, the George W. Bush administration in the mid-2000s demanded that the GSEs expand their affordable housing goals — that is, increase lending to borrowers who otherwise were unable to secure the loans they wanted. Of course, this just added more air to the subprime bubble.
Evaluating the unknown | What of the private sector? There were a lot of devils there too, and, in fact, McLean and Nocera devote most of the book to them. One such devil is Stan O'Neal, who took over as CEO of Merrill Lynch in 2002 and shifted its emphasis from that of providing stockbroking services for middle Americans to dealing in collateralized debt obligations, which McLean and Nocera refer to as "asset-backed securities on steroids." A CDO, they explain, "is a collection of just about anything that generates yield — bank loans, junk bonds, emerging market debt, you name it." CDOs are not a problem per se if their risk is understood, but the ratings agencies generally gave a large percentage of them a AAA rating, the highest possible. Wall Street firms would buy risky mortgage-backed bonds and reassemble them into CDOs with a lower risk rating. Wall Street players called this "risk arbitrage." By 2007, Merrill Lynch "held an astonishing $55 billion in subprime exposure on its balance sheet," mainly in the form of AAA tranches of subprime CDOs. This was up from "only" $5–8 billion in July 2006, when O'Neal had fired Jeff Kronthal for his more-conservative approach to mortgage risk.
But why would ratings agencies rate CDOs as so low-risk? Aren't they paid to assess risk wisely? Wouldn't they lose business if they consistently understated the risk of various bonds? You would think so. But in 1975, the Securities and Exchange Commission "decreed that [only] Moody's, S&P, and Fitch were nationally recognized statistical rating organizations." With this legal monopoly, they had less incentive than otherwise to do a good job. You might think that competition among the three ratings agencies would still give them a strong incentive to be right. But, although the authors do not mention this, it was not just that competition was limited to three firms; it was also that the government legally required, from the 1930s on, pension funds and other financial institutions to get ratings. That blocked other ways of disciplining financial management firms, ways that we cannot know because they did not happen. Also, as financial economist Charles Calomiris has pointed out, in many cases, the buyers of the assets, not just the sellers, wanted the rating agencies to give artificially high ratings.
McLean and Nocera name Brian Clarkson of Moody's as one of the devils. Clarkson joined Moody's as an executive in 1991, having never worked as a credit analyst. One of his first jobs was to rate mortgage-backed securities issued by Guardian, another of the authors' designated devils. How well did Clarkson do? They write: "The bonds, needless to say, eventually blew up, but if there was a lesson in that, it was lost on Clarkson and his bosses. By 1995, he had become the co-head of the asset-backed finance group."
After Clarkson took over, if Moody's missed out on a deal, which, presumably, would happen if its standards were too demanding, "the credit analyst involved would be asked to explain why." Market share became the mantra. Needless to say, that kind of pressure did not lead to accurate ratings of lousy bonds.
I am skeptical of "important-person" theories, which claim that a major event would not have happened if not for the work of some specific person. So, although I think that Clarkson was important, possibly more important was the fact that the bonds being rated were new kinds of financial instruments and, therefore, it was likely that some firms would do a bad job of rating them. A set of regulations designed in the 1930s is unlikely to work well for financial instruments produced five and six decades later.
Still, employees do matter. Clarkson's co-head of Moody's asset-backed group was Mark Adelson, who was much more skeptical of asset-backed securities. While Clarkson was rapidly promoted, Adelson was "moved out" of that line of business. In 2001, he quit and became head of structured-finance research at Nomura Securities. The authors sum up beautifully the problem with having people rate bonds when they know little about them: "At securitization conferences, [Adelson] would look around at the audience and think to himself, 'No one in that room had ever loaned or collected back one red cent. Any schmuck can lend it out. The trick is getting it back!'"
Not to be missed in the rogues gallery is the firm Ameriquest, whose "core product" was the "2/28" loan. The interest rate was artificially low and fixed for two years, and then reset to an adjustable rate for the next 28 years. Ameriquest made a huge amount of money by charging points up front. The lender may have even broken the law; one disaffected Ameriquest employee claimed that she had seen her coworkers copying borrowers' signatures onto blank documents. When ACORN picketed 20 Ameriquest offices for deceptive lending practices, Ameriquest bought peace by committing to fund $360 million in ACORN-originated loans.
That is not a complete listing of the authors' private-sector devils — they devote substantial space, for example, to Angelo Mozilo, the CEO of Countrywide — but you get the idea.
Greenspan | One government "devil" the authors point to is Alan Greenspan, chairman of the Federal Reserve Board from 1987 to 2006. I do not think they make their case. I do grant that, in retrospect, he was much too blasé about the brewing financial storm. But then, almost everyone was.
The authors make three specific charges: First, in 1998, Greenspan huddled with a bunch of Wall Street players to bail out Long Term Capital Management. The authors never come out and say it, but I will: he shouldn't have done that, especially since legendary investor Warren Buffett was waiting in the wings with a low-ball offer for LTCM — something that, shockingly, the authors do not mention. Second, they point out correctly that Greenspan opposed regulation of derivatives. Yet the authors do not even try to make the case that regulating derivatives would have improved matters; they simply quote government officials' assertions on the issue. Finally, they blame Greenspan, as do many people, for low interest rates, which supposedly created the housing bubble. They never consider the idea that low interest rates were due to a savings glut from China and the Middle East oil-exporting countries, something that Jeff Hummel and I have argued elsewhere. (See our "Greenspan's Monetary Policy in Perspective," Cato Institute Briefing Paper No. 109, November 3, 2008.)
Criticisms | One weakness of the book is the authors' failure to understand the difference between managements' and stockholders' interests. They approvingly quote Goldman Sachs executive Gus Levy's belief that hostile takeovers were bad for Goldman's corporate clients. Hostile takeovers were bad for the managers of Goldman's corporate clients, but they were great for the shareholders.
In discussing the role of Securities and Exchange Commission member Annette Nazareth, the authors point out that her husband, Roger Ferguson, then vice chairman of the Federal Reserve, advocated some of the same kinds of regulation his wife favored. Their unstated implication seems to be that there was a conflict of interest here. That could be. For Bethany McLean to point it out, though, shows a certain audacity. Throughout her reporting on the Enron trial for Fortune — reporting that made her reputation and her fortune — McLean never once pointed out an apparent conflict of interest of her own: her "chumminess" with Sean Berkowitz, the lead federal prosecutor. The two married in 2008. Pot, meet kettle.
To their credit, the authors do not go beyond their expertise and claim to have a policy solution. One gets the impression that they believe in more regulation, but it is just an impression. In case they do, though, they should note what Jeffrey Friedman wrote in his edited volume, What Caused the Financial Crisis?:
[W]here there are competing powers, as in a capitalist economy, there is more chance of heterogeneity than when there is a single regulator with power over all the competitors. At worst, in the limit case of a market that, through herd behavior, completely converged on an erroneous idea or practice, unregulated capitalism would likely be no worse than regulated capitalism, since an idea or practice that is homogeneously accepted by all market participants in a given time and place is likely to be accepted by the regulators of that time and place, too. But at best, competing businesses will embody different theories, with the bad ones tending to be weeded out.
