Who Really Caused The Great Recession?
When the politicians were looking to shift guilt, the banks forgot to duck.
Janet L. Yellen did something odd for a Fed chair. At the Boston Federal Reserve conference in 2014, she gave a not-so-subtle plug for her boss, President Barack Obama, just days before the mid-term election.
The coincidence wasn’t lost on people like me, who served as officers or on boards of directors of major banks. Was there collusion, I wondered, between our independent Fed and the political wing? Or was the crisis nothing more than banker’s greed, as the administration claimed? Occupy Wall Street was born as a consequence, shouting about America’s addiction to a virulent form of Capitalism, and the crash was the consequence.
To get a handle on this I looked for someone who understood banking and regulation but wasn’t directly involved. I found John Allison, a former banking chief and Cato president, who was both intellectually savvy and financially astute and had just written a landmark book on the subject, The Leadership Crisis and the Free Market Cure, which Forbes said, “gets both the diagnosis and prescription just right”.
There was another reason I needed an expert. The media had given up any pretense to objectivity. Reporters from the Wall Street Journal interviewed me for evidence board of directors acted out of greed yet they didn’t know how to calculate options compensation. How do you charge greed when you don’t know how to count?
The majority party — Democrats — was able to disguise its role in the crisis, and this isn’t meant as partisan. The party in power has earned the right to be one sided. But the first part of the backstory is the real estate lobby and Democrats are connected as city dwellers tend to vote Democratic. President Trump was a Democratic supporter, for instance, long before he ran as a Republican.
The other contributing factors are, primarily, the problem began long before the crisis because mortgage lending at a high volume was highly profitable for everyone involved, bankers and politicians both. The second reason is there was an astounding lack of oversight over what had become accepted — if unhealthy — practice. But there was was an abundance of regulation that should have prevented the kind of behaviors but didn’t.
To understand it better, start with a premise: banking is the most regulated industry in America. Nothing can happen in banking that isn’t connected to politics. Mortgages were driven by whatever Fannie Mae and Freddie Mac wished, both federally guaranteed mortgage packagers. Both of them run by Democratic heavyweights, Jim Johnson and Franklin Raines, during the period leading up to the crash, who were compensated in the $100 million category for their troubles.
The question is whether all of this was known to the politicians? The answer to that is actually simple. Whoever appoints the regulators and oversees them controls the incentives and penalties for the banks. That is essentially how the financial system operates. When A equals B, and B equals C, you can be sure A is in charge.
The average person does not realize the Federal Reserve Bank is the regulator of the nation’s largest financial institutions and while it is technically independent, is heavily influenced by whoever is President.
The Fed’s role is to investigate bank balance sheets and perform risk audits. At my bank, we would have 50 Federal Reserve analysts looking over the books every month, checking on every loan and IRA (providing capital against the loan activity), and doing a deeper dive quarterly. The point is the Fed knows what’s going on in a bank the way your dentist sees what is happening in your mouth.
If banks made too many low income and poor performing loans over a period of years, and these were undocumented or poorly documented, the Fed would have known long before the crisis. The bad loans were on the books for everyone to see. Why were they ignored?
Because there were political incentives to look away.
Chris Dodd and Barney Frank oversaw financial services in Congress, and both were vulnerable to charges of corruption. This was in part personal gain on the part of Chris Dodd who received favorable treatment for a personal mortgage from a financial institution (I served on the board) and Barney Frank, who was able to lobby banks to accommodate special interests, so that in turn they supported him politically.
Loan activity reflects not just economics or bank practices — which is what politicians want us to believe. It reflects what politicians tell regulators to do who in turn tell banks what to do.
So why did banks make lousy loans?
Yes, greed is part of the story. But a more obvious cause was banks understood they first had to please the people in power to continue to operate. There is a political payoff to making lower income loans that needs to be explained. ACORN and other activists fed off this desire to increase homeownership, which of course, led to loan activity that over time contributed to a bubble that had to burst. When these poor performing loans were packaged under the Fannie Mae government guarantee, financial institutions around the world purchased them. The market was hungry for mortgage backed anything. Why? Because the United States guaranteed them.
Goldman Sachs was fined nearly a half billion dollars for its role in securitizing a package of loans that performed poorly for a German bank — yet the German bank was adamant about buying mortgage securities at a time the investment bank was trying to get out. How was that Goldman’s fault? This was a case of trying to blame a wealthy bank (who could afford to pay the penalty) to deter attention from the real culprit.
When the crash finally happened, there was so much blame to go around, and the crisis meant we needed to focus on getting our financial house in order. That required working with the very politicians who led the charge into the sink hole. Those same powerful politicians realized they were looking at armageddon and passed legislation to punish the bankers as a diversion. In a flash of PR brilliance, they named the law after themselves, The Dodd–Frank Wall Street Reform and Consumer Protection Act. It became their ‘get out of jail free’ card.
It passed with a Democratic majority.
Now the media didn’t have to question how it missed the story because there was a better one. Bankers’ greed. And no one was was in any position to object.
The new narrative was as if Hollywood scripted it for a villain. It made it seem politicians were coming to the rescue of the people through what became known as the ‘bank bailout’, and banks sang a chorus of mea culpas because they had no other choice.
But didn’t banks have access to the same information I am writing about? How did they end up looking like crooks and politicians like saviors? Why did people cheer when the automotive companies were bailed out around the same time?
As Ronald Reagan said (quoting the boxer Jack Dempsey), “Honey, I forgot to duck.”
The banks were were too busy seeking help from the Fed to charge Congress with participating in the scheme. Regulators can put a bank out of business. If a bank went up against its regulator or tried to shift blame to Congress, you can be sure it would cease to exist as an entity, and the bank board and officers would be charged, at least in civil court, with the bankruptcy if not criminally.
It is axiomatic. You do what you need to do to get through a crisis.