Who is Really to Blame for the Financial Crisis?

Are we all to blame for this financial crisis?

That’s the current thinking coming out of Washington and being taken as accepted wisdom among economists and newspaper columnists. Consumers were greedy and didn’t read the mortgage documents they were signing. Banks were careless in their pursuit of profits and let credit standards lapse. Regulators sat by and did nothing while a housing boom and debt explosion raged for nearly a decade.

This doctrine of shared culpability, however, is starting to fray, as people are asking deeper questions about how so much debt could be piled on to so little equity. More interestingly, some columnists are beginning to wonder whether the banking system weighed the scales much more heavily against the consumer than anyone realized.

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The inestimable Gretchen Morgenson of the New York Times, probably America’s most astute business columnist, has a lengthy set of articles in today’s paper on the debt burden facing the average American. I will quote sections from it, but you can find the full article in the links provided below by Sean-Paul. Notice first the sub-headline, which is interesting in its own right: “A series about the surge in consumer debt and the lenders who made it possible.”

The lenders who made it possible. We’ll be hearing more and more about them, and it’s a sure thing that as this financial crisis deepens, the balance will shift almost entirely to articles and studies demanding a complete reform of the financial system.

Just why this is so becomes evident at the very beginning of the Morgenson article. Here are data she presents from the Federal Reserve regarding the debts of the average household in the U.S.:

Mortgage $84,911
Auto and tuition loans $14,414
Home equity loans $10,062
Credit cards $8,565
Savings each year $392

Alan Greenspan was fond of talking about these numbers, because he would point out that the value of the home for this average household was more than twice the amount of debt. In other words, there was a big cushion of wealth that made the debt sustainable. This argument was specious because unless you sold your home and lived on the street, or extracted equity from your house in order to make interest payments, the cushion of wealth didn’t mean much.

The classic way to assess debt is to calculate what’s called “debt service” – how much in interest payments it takes to pay down the debt, and how that relates to a consumer’s disposable income. This, rather than any wealth cushion, is what Morgenson concentrates on, and the picture is not pretty. It starts with the fact that many consumers are devoting over 40% of their disposable income to debt service, and what is left for savings is paltry. But she also identifies a fundamental change in the way banks lend money.

To be sure, the increased availability of credit has contributed mightily to the American economy and has allowed consumers to make big-ticket purchases like homes, cars and college educations.

But behind the big increase in consumer debt is a major shift in the way lenders approach their business. In earlier years, actually being repaid by borrowers was crucial to lenders. Now, because so much consumer debt is packaged into securities and sold to investors, repayment of the loans takes on less importance to those lenders than the fees and charges generated when loans are made.

Banks didn’t care if you paid back your loan, because investors purchased it in the securitization process. Banks cared only about the fees generated up-front, which could range from thousands of dollars in points for each refinancing, to $20 for talking to you on the phone, $100 for mailing documents, and $200 for negotiating with your lawyer.
These fees were not always clearly spelled out, and often were presented to the borrower at the last minute when documents were being signed. Banks could get away with this because the fees were bundled into the debt to be paid back over time, which in the consumer’s mind worked well during the housing boom because rising home values would take care of the problem.

What was really going on was quite subtle. Every time a mortgage was initiated or refinanced, the borrower was taking on debt, but the bank was receiving cash. How was this possible? The banks were taking their fees out of the equity that had built up in the home, in essence raiding the homeowner’s savings account. They often let the homeowner join in the game, encouraging them to “take some cash out of your home.”

In the past six years, when the housing boom took off, banks have lifted tens of billions of dollars from home equity values that took decades to build up. When you add in the trillions of dollars of equity extraction from homeowners themselves, it is easy to see how the economy could barrel along with fat profits for the banking industry and vacations, new cars, and home remodeling projects for the consumer.

Year by year as this bonanza played out, the equity cushion for the average homeowner fell lower and lower. Whereas thirty years ago the average homeowner had a mortgage that was worth about 38% of the home’s value, today that mortgage eats up more than 50% of the home’s value, a record low for the equity cushion.

These numbers are averages, but they don’t tell the whole story because the data are heavily skewed. On one side are 31% of all homeowners who have paid off their mortgage. These are mostly the elderly, whose mortgage in the first place was well under $100,000.
Then there are the 20% who have no equity at all in their home, or even negative equity. These mortgages are typically well in excess of $100,000, and it is this pool of homeowners who are candidates for foreclosure. About 2.5% of all mortgages are in foreclosure, and this number is rising rapidly. What happens when a homeowner tries to forestall losing their home?

As Morgenson makes clear, it is often impossible for a homeowner to even reach someone to talk to. The mortgage was sold to investors immediately, and the responsibility for collecting mortgage payments was hived off to a “loan servicer”, almost always a completely different bank from the one initiating the mortgage. The loan servicer only really pays any attention when the homeowner falls behind on payments, and guess what happens? The loan servicer starts adding on fees as penalties.

These fees are often in the thousands of dollars on a typical loan. Penalty interest rates are set at usurious levels in excess of 25%, and the combination of fees and high interest costs is increasingly resulting in foreclosure and loss of the home to the bank.

What is odd about this process is the loan servicer has no more home equity to tap into to cover the fees they are charging the homeowner, so their behavior is completely counterproductive. They are deliberately pushing homeowners into foreclosure and bankruptcy, and obtaining nothing in return but a house deteriorating in value. It is as if the banking industry is still operating in a world where all problems will be solved by rising home values, and no amount of reality will change their behavior.

It has been evident for some time that the American financial system has been geared towards maximizing borrowing. The famous credit score, assigned consumers by the Fair Isaac company’s model, penalizes borrowers for not borrowing. Those who pay off their credit card balances in full every month receive a lower score than those who keep a running tally (within some bound). As long as consumers stayed within these bonds, they could avoid a debt trap.

How the system evolved into a debt trap for consumers is altogether different and relates entirely to the banking industry’s self-imposed pressures for profitability. The first ill-fated step in this development began over 25 years ago when Citibank under its chairman Walter Wriston set itself a target of an annual return on equity of 15%. This was a shock to its competitors, since most banks achieved ROE’s of 5% to 8%. But this was a Citibank that was the biggest and baddest bank anywhere, operating in over 100 countries, inventor of the ATM and the certificate of deposit, and altogether drunk on its superiority.

It actually began achieving 15% returns, but only by pressuring managers to reach for profit in any way possible. The result was predictable. Profits collapsed when loans to Latin American borrowers, which were high yielding but poor risk, turned bad. Something else was needed to achieved superior returns.

The answer was to be found among Citibank’s competitors on Wall Street. Goldman Sachs, Merrill Lynch, Morgan Stanley and other investment banks were able to achieve such returns because they didn’t take on credit risk. They traded assets and sold off any loans as quickly as they were booked. Somehow Citibank, JP Morgan, Barclays, Swiss Bank Corp. and other big commercial banks had to do the same.

Thus began the transformation in banking away from loans, with their steady income stream from interest payments, to tradable assets with their instantaneous fees. Here is where the second step took place. Accounting rules that allowed tradable assets to be marked to market were expanded to many different assets, until the holy grail of loans was included as well. To incorporate loans into the tradable asset category, they had to be treated as securities, packaged together into bonds, and sold to investors.

To understand the critical importance of mark to market accounting, consider this example. A five year loan that generates $100,000 in interest income produces roughly $20,000 in such income each year. The same five year loan that is part of a security sold up front produces $80,000 income at conception, depending on the discount rate used, but no more income thereafter. The marked to market security allows the bank to achieve a 15% ROE and then some, whereas the typical loan does not. It also generates a much higher bonus for the banker booking the loan, not a minor consideration.

Four times the profit in the first year is certainly fabulous, but what do you do for years two to five? Expenses still have to be met, and more importantly, the ROE target of 15% is bearing down on all managers. The answer, of course, is to find another set of loans to securitize in each year, and from this is borne a debt trap for the bank of its own making. Someone, somewhere had to be induced to take on debt – indeed, ever-increasing amounts of debt.

Consumers around the world were natural targets for this role. They were susceptible to marketing ploys and advertising campaigns, and in a world of compressed incomes due to globalization, they were under their own pressures to keep up living standards. A financial culture arose where debt was acceptable, easy to access, and always discussed in terms of the monthly payment, never in terms of the total debt being incurred.

So successful was this process that bank ROE’s crept up until they exceeded 20% annually for many big banks. Wall Street investment banks joined in this process, recognizing how lucrative securitization of loans was becoming, and top firms like Goldman Sachs achieved annual returns of 30%. Banker’s pay and bonuses soared.

I dwell on this history, with all its arcane elements of accounting and securitization, because when it began greed was not a principal motivation. The Citibank innovations and ROE targets were designed to reward shareholders, because around 1980 corporate America developed a fetish for the shareholder based on research from consulting firms like McKinsey and Bain & Co. that showed companies which rewarded shareholders had the highest performing stocks. The research was flawed and short-sighted, it turned out, but it took firm hold in the executive suites, and led to such abuses as executive stock options. It also reversed the traditional model wherein the customer and labor took precedence over the shareholder.

When banks invested their future in this system, they set in motion a demand for excessive returns on capital for their shareholders. To meet this demand, every year higher amounts of volume had to be processed, meaning ever-greater amounts of debt needed to be imposed on the backs of consumers. The system developed into what some economists call Ponzi Finance, named after the fraudster Charles Ponzi, who took in investor money and paid fantastic returns in the early years to the first group of investors, only to eventually steal the investments of the latter group of investors.

Ponzi schemes always collapse of their own accord. They promise extraordinary returns and do so at first, but only by bringing in more and more new investors and greater volume. Eventually they reach a tipping point and a terrible scandal ensues. You can be sure that the respectable men who run America’s financial system do not think of themselves as fraudsters. Yet in the way the financial system worked, with incessant demands for higher returns, a point came where the rewards to the banks in the form of bonuses and stock option payouts were impossible to reverse. No one within the system could put a halt to its dynamics, which became inexorable.

By the time the scheme collapsed, the averaged household had $115,000 in total debt, was using as much as 40% of disposable income each year to service this debt (and all the fees involved), and had only $392 each year to put away as savings. You can see now how ridiculous it is to call the consumer equally at fault in such a system.

When Ponzi schemes collapse – and there have been many examples in recent years in Eastern Europe and Asia – riots often occur. Investors storm the offices of the bank or company perpetrating the fraud, and they sometimes attack the government offices of the regulators that should have been policing the system. Will that happen in America? It is certainly possible, and it may occur in the U.K., Spain, Australia and other countries with housing booms that have gone bust.

First, though, there has to be recognition of the fraud involved. It is entirely possible to construct a financial system involving securitization of loans and mark to market processes that does not morph into a Ponzi scheme. That did not happen here, because the bankers were seduced by the illusory wealth from their bonuses, which convinced them that it was their genius that created such bounty. They saw no reason to put any constraints on their own activity. It did not happen here because the Federal Reserve was in thrall to Republican and conservative orthodoxy that said the markets were perfectly self-regulating, and government oversight was inevitably inefficient.

True enough, consumers have responsibility for the debts they incurred and their inevitable consequences. What we have seen so far, though, is that only the consumer is paying a price for Ponzi Finance, in the form of bankruptcy, loss of shelter, and in many cases loss of the means to feed one’s family. A Ponzi scheme succeeds at first, after all, because it promises something for nothing, and that’s pretty much how so many consumers were dragged into it. But the perpetrators - the bankers - have paid no price because the federal government has forced the taxpayers – the consumers – to bail them out. The very people responsible for regulating the system have ensured that the perpetrators got away.

Maybe that’s because the government and politicians in general do not recognize yet the Ponzi Finance nature of what has been going on. But they will. All it takes is connecting the dots over the past 25 years, though occasional pockets of social disorder may get their attention sooner. Either way, the ultimate problem is not instilling some sense of personal responsibility among consumers when it comes to handling debt. The ultimate problem is drastically reforming the financial system so that Ponzi Finance cannot happen again.

Numerian July 20, 2008 - 9:57pm

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( categories: Miscellany | Agonist Exclusives | Analysis | Economics: USA | The Markets )

Too long term

"The ultimate problem is drastically reforming the financial system so that Ponzi Finance cannot happen again."

That does not account for what's going to happen to the consumers in the short term, the ones with the excessive debt payments. That could trigger a real crash.

And I see no debt forgiveness in the system, none at all. I had a client come to me and we looked at his mortgage -- 9.5%. Take out in 2005. We called the bank "no, we don't adjust loans that have not reset". He'll default, he has no choice.

Synoia July 21, 2008 - 12:52am

By the time the scheme

By the time the scheme collapsed, the averaged household had $115,000 in total debt, was using as much as 40% of disposable income each year to service this debt (and all the fees involved), and had only $392 each year to put away as savings. You can see now how ridiculous it is to call the consumer equally at fault in such a system.

Numerian, thanks for this well informed analysis. As I don't have any expertise in finance or economics I always appreciate being able to come here to have it sorted out.

I am however familiar with the elites punting everything onto us little people. Dean Baker has an interesting piece at TPM along these line in regards to the Fannie/Freddie bailout.

I had noted here at the Agonist in a post from April how the Times was pushing the other side of this same meme based on false quasi-libertarian pretenses in, The War on Housing Crisis, DIY Commandos to the Rescue.

Btw, you mention other countries, and I was wondering what you knew about the Danish housing market and if it's at all connected? I haven't been here that long but it seems that what you have described has been taking place here as well, just within a more recent period.

stuart noble July 21, 2008 - 7:01am

The memes seem to be shifting

For awhile there was not much sympathy for people facing foreclosure. There are millions of homeowners who controlled their impulses, kept borrowing low, and preserved the equity in their homes. They watched while their neighbors loaded up on debt, new cars, fancy kitchens, overseas vacations, etc. There were also all those "investors" who bought second or third homes as speculations, riding the housing bubble for profit as they flipped their properties. These investors, toward the peak of the bubble, were pushing property values to absurd highs in many locations in California and Florida, and now a lot of them got caught with properties they cannot sell except at a fraction of the original investment.

So there is some natural disgust among the prudent homeowners for all the shopaholics and investors who ramped up the market and brought about the bubble.

What we are discovering, though, is that there are just as many first-time home buyers and otherwise prudent homeowners who are trapped in debt they cannot repay, partly because rates have reset, and fees have been added, and banks won't respond to their requests for accommodation. Many of these people have had personal setbacks, with more to come as unemployment edges up. These people didn't take expensive vacations, and they can't extricate themselves from a lending system that lured them in with cheap rates, doubled or tripled their payments all at once, and then turned a deaf ear to any calls for help.

It would be nice if we could somehow separate the profligate homeowners from the cautious homeowners, but that's not possible. Hardly any of these parties should have received a mortgage in the first place, and all taxpayers are going to pay a price to clean up the mess. But while they do, taxpayers are entitled to ask what went wrong with the lending system in the first place.

I suspect the focus is now going to shift to the lending system, and away from the victims, whether the victims were foolhardy and profligate or not.

As for Denmark, I think it ranks in the middle of the pack for housing values that are out of whack in comparison to rental costs, which is the usual yardstick to determine whether a bubble exists. It looks like Denmark is going to go through a tough period of adjustment, and will suffer as well from a general slowdown in Europe. But the real pain is in the U.K. and Spain, where housing values are still tremendously distorted compared to rental costs.

Numerian July 21, 2008 - 7:53am

Well, one could argue they were not sufficiently prudent...

"partly because rates have reset..."

Prudent people would not go for a variable rate mortgage unless they had done all the calculations, based on past rates and realistic predictions of their own future income levels, and concluded that the risk was under control. The rates we have today are still pretty low, historically. So, they were not unpredictable at all in a worst case scenario analysis.

creativelcro July 21, 2008 - 10:05am

Very true

On the other hand, the banks approved these loans on the basis of the initial, teaser rate. They also did not project out whether the borrower could meet the payments once rates reset.

That has now changed; arms are now approved on "worst case" assumptions.

Numerian July 21, 2008 - 10:42am

A Danish Friend

...commented to me around 2005 that "zero-down" mortgages were beginning to be offered. He couldn't understand such lunacy.

So, Denmark is going to get hurt, too.

Petronius July 21, 2008 - 3:52pm

Debt Peonage, the Social Contract, and the Safety Net

Yeah, it makes sense to examine the conditions under which lenders granted these loans, to whom, and the social climate--both on Wall Street and on Main Street (and Washington)--as they played out.

But I wonder if this isn't the culmination, the crowning achievement, of the ideologically hidebound conservative movement? Not only do we have deregulation of the financial industries, but also instantly re-negotiable credit agreements (credit cards), usurious interest rates, and significantly prohibitive federal bankruptcy terms.

The powers that be got everything they wanted--as employers they broke the social contract (circa 1980s, a now-quaint relic of pre-Reagan days); they broke the Unions; they gutted the financial safety net for most Americans by taxing Social Security, "reforming" welfare programs (i.e. defunding food stamp and WIC programs), letting the minimum wage stagnate, and running off bogus inflation numbers to avoid cost of living increases for Social Security. They offshored jobs, collectively refused to pay wages that kept up with inflation, paid themselves through stock options, and thoroughly corrupted state and federal legislators with lobbyist money and anti-consumer legislation. They resisted any sort of health care reform, so as to maintain corporate tax deductions for private insurance (really, a form of federally subsidization for private interests), big Pharma, and the insurance companies.

The effect on working people has been to enter a sort of debt peonage, where merely maintaining the standard of living requires one, then two incomes; one, then two, then maybe three part-time jobs. Avoiding medical and financial catastrophe meant keeping a job with health insurance at all costs, whether they were working longer hours, groveling before management, raising productivity with no hope for a raise. Finally, whether by emergency or impulse, debt, and lots of it.

I think the powers that be didn't count on the collapse of the US consumer/laborer. And since they didn't care about one's ability to repay, they should take a wash.

Jonathryn July 21, 2008 - 8:25am

Enough blame to go around

Fairy tale belief that we can get something for nothing fueled this mess. That applies to borrowers, lenders and investors.

Management of the collapse once the scheme implodes is where the big shots assume more culpability, but even there, more than a handful of borrowers will be happy to let someone else bear their burden.

Privatized profits, socialized risk.

I did inhale.

Don July 21, 2008 - 9:04am

above you say

I suspect the focus is now going to shift to the lending system,

why do you think this? who's focus? The NYT's?
have you seen Tanta's take on the same article?

http://calculatedrisk.blogspot.com/2008/07/duelling-discourses-of-debt.html

btw, yours is a really good piece. why it's the closest I've ever seen you come to a rant ;) but I've got to wonder if there's really much hope when so much power is dependent on this Ponzi system. ie, FRN & FRE reportedly have paid campaign donations and lobbyists in excess of 200 million over the past decade. And this year almost 100million has been donated by the I Banks
http://www.opensecrets.org/industries/contrib.php?cycle=2008&ind=F07

must be where all those executive bonuses go?

dk July 21, 2008 - 9:09am

The focus will shift in the MSM

Even the Wall Street Journal is starting to do articles on what went wrong in the financial system, rather than laying most of the blame on the consumer.

I did respond to the Tanta article on S-P's threat.

The interview with Diane in the video on the NYT website features a women who admits to using spending as therapy for divorce, loss of job, etc., and who got in too deep. Morgensen tries to tie Diane's problems to predatory practices by the lending industry, but doesn't make a convincing case. Moreover, Diane is presented as a lower middle class woman who can't control her spending (and admits as much). But what about middle class people who spend not on jewelry or clothes, but for college and necessary home maintenance? Do they deserve to be cut off by the lending industry when their debt load becomes too much?

Ultimately Tanta thinks everyone should be treated the same, just like all home mortgages should now be considered sub-prime rather than making artificial distinctions among prime and alt-A mortgages. Tanta is probably correct here, but it will be difficult to achieve.

There used to be simple guidelines for lending, some of them imposed by regulators, 25 years ago. Your debt service couldn't exceed a maximum percentage of disposable income. Down payments were 20% minimum. No one could finance a down payment - it had to be cash. Home equity withdrawals were permitted only with proof of use, which was limited to home improvements or college tuition. Everyone had the same rules, but exceptions could be made occasionally because the bank knew the customer and their circumstances personally. Banking was local and loans were kept until maturity.

Securitization has removed the connection between the bank and the borrower. Consequently, we are going to see stricter rules; 20% down payments are now mandatory in many states. Exceptions simply won't be permitted. Diane won't get to spend for jewelry, and responsible middle class borrowers will be limited to how much can be taken down even for tuition or emergencies.

As to whether we should hope for any change to Ponzi Finance, I believe circumstances will require fundamental change. For example, we are now 12 months past the initial crisis with the Bear Stearns funds, and to this date there has been no revival of many of the securitization markets. That includes global sales of mortgage-backed securities, collateralized debt obligations, variable-rate auctioned securities, and a number of other markets. We are at the point where Wall Street leadership is accepting the fact that the securitization process, and the parallel banking system on Wall Street, is broken and isn't coming back. All four of the major Wall Street firms are limping along, dependent on the Fed for their lifeline to liquidity. GS is still making some money, but who knows what their net asset position really is, since so many of their assets are now Level 3.

What's missing, though, is the acceptance of the flaws in the way consumer loans are created by banks. That's the subject of my rant, such as it is, and I think we are getting closer to the public and the press asking some significant and embarrassing questions of the banks.

Numerian July 21, 2008 - 9:24am

that's what I get

for not scrolling past the top post! and not reading Morgensen's article, just the video that Tanta referenced.
sorry about that.

but you know what? it's too late, it's closing the door after the horse has left the barn. the banksters are done making money in housing, and we're picking up the tab. And if we bail out the homeowners, (which we will)that is only going to help the banks. I'm guessing that has something to do with BAC saying today that they aren't guaranteeing CFC's debts.

Besides, the fraudsters haved moved on to energy and commodities. remember that quote from a white house staffer, something about 'we create the reality, and while your figuring it out, we'll be creating another". welcome to the new reality.

if you'll recall, in a previous I asked how long it would take the banks to recapitalize at 130/bbl oil. Brad Setser recently worked out that at an average of $125, there's an extra 1 Trillion being made for the year.
http://blogs.cfr.org/setser/2008/07/19/the-2008-oil-shock/

The I Banks are gonna be just fine taking their skim from that. Plus the fact that they're major players in the spot price to boot.

dk July 21, 2008 - 12:35pm

more evidence

Mabro: Some other people would say that oil, along with wheat and some metals, remains more attractive than other investments in the financial markets. And we know that the people who lead these markets are financial institutions, the banks and the hedge funds. They are the leaders. So the paradox is that, consciously or unconsciously, the determination of the oil price has gone away from the producers to the financial sector. It went away from the oil people to the non-oil people.

http://www.redorbit.com/news/business/1486589/the_oil_price_how_long_can_it_go_on_rising/

he makes the argument that it's not peak oil setting price, but of course everyone will jump on him for that

talk about coincidences:
http://bigpicture.typepad.com/photos/uncategorized/2008/07/21/abreas_20080720205615.gif

dk July 21, 2008 - 1:13pm

This is huge

"As to whether we should hope for any change to Ponzi Finance, I believe circumstances will require fundamental change. For example, we are now 12 months past the initial crisis with the Bear Stearns funds, and to this date there has been no revival of many of the securitization markets. That includes global sales of mortgage-backed securities, collateralized debt obligations, variable-rate auctioned securities, and a number of other markets. We are at the point where Wall Street leadership is accepting the fact that the securitization process, and the parallel banking system on Wall Street, is broken and isn't coming back."

Many experts are now saying the same thing: Securitization is dead because of abuse and lack of transparency. Moreover, it was dependent on a flawed if not complicit rating system. Basically, the so-called profits stemmed from mispricing risk through flawed models leading to misuse of leverage. The effects are years from settling, and no one in the business thinks that we are ever going back to that business model. The party is over, and the world will be fortunate if there isn't a meltdown.

tjfxh July 21, 2008 - 4:27pm

Curly has no one to slap

In nearly every episode of the stooges Moe slaps Larry, Larry turns and slaps Curly, and Curly turns and there is no one there. Of course there's always the scene where a fourth party slaps all three faces, slap, slap, slap in one motion.