Contents

LIST OF ILLUSTRATIONS ²Õ

PREFACE Õ²

1 A Long, SSaange Trip 1

2 FrsmMortgages IoMortgage Securitization 31

3 Tgie Rise of the Veoticolly IntcgratcdPiOvatc Banks_jIyyg-Aooi 63

4 Fmogclfirononafion and lhc AlgUaber Soup of

Fiognaial Products 103

5 Tlue Cubprimo M0ment,0001-2008 142

6 She tnresl s asddt s Sgsend Worldwide 170

7 IOnud and ItoeFinancial Crisis 195

0 Wdy DidSteeFcderci MeservdMioe Ocu Fiaanciag Crisioof 2008? 224

9 TheBanks Slid ft IWithrgeHclp gC IhoGovernmenS!) 256

notes 277

REFERENCES 281

ACKNOWLEDGMENTS 305

INDEX

ÇÎ7

Illustrations

Figures

2.1 Homsownerehip ratesfor the Uniesd States,i900-2008

2.2 Sii oroof nonfaem reeidentia1debt,ιl95-2005

2.3 An announCemontrhthefireSMBSissueOby Ginnio Mai in 1970

3.1 Residentigl msrtgaoe Oriosnstisn byts9e,1990-2003

3.2 Percrntagnrf SecuriOizerioni stone bv G9E,198o-2ooi

3.3 Concentration in Inoetgegolendiagitodtwenty-Iive market share

3.4 Percrnlage oo aSi Inagsthat sure securitized

3.5 The s^reoiit^ι^r-a intneoatedbnnk,drca 2001

4.1 Asaet-hewUrd escuritieo neoetcnnmg nner time

4.2 Key mttitutþnntnrrgundinhGSAMPTlust 2006-NC2

4.3 CepitalieructuseofGTAM PTiust 2006-NC2

5.1 Residenriel msrtgaoe Oriosnstdjn byts9e,1990-2008

5.2 Mrrtgeoe srigsnsSisns Oy euo^hreeoe^o eefinence

5.3 Moeenage-relntedsocurityhninmgs nf 101114111^^( Snvdetsr types, 2002-200O

5.4 г³^ñã^(^^ï1º-ã³^0^-ã er eshdre si ell profits

5.5 AmshntssSMBSesidendenr ^oP^e Ioroonagency firms

5.6 'ISral 2009; Gorton, 2010).

One other explanation was to shift the blame to countries around the world who were running high positive current account balances, often because of the US chronic trade deficit. Foreign banks had cash to invest, and they chose to invest it either wittingly or unwittingly in American mortgages (the explanation proposed by no less a figure than Ben Bernanke, chair of the Federal Reserve Bank). This explanation implies that the housing bubble was caused by foreign banks that had to park their cash somewhere. In essence, this explanation neatly shifts the blame from Americans who took out those mortgages and American bankers who sold the mortgages and created and sold mortgage-backed securities to foreign banks. Those banks with so much cash to spend made cheap mortgages too attractive for unworthy home buyers to pass up and thereby pushed the housing bubble forward.

Finally, some have argued that the entire crisis was simply the result of the greed of bankers trying to make as much money as possible (Akerlof and Schil­ler, 2009). The sophisticated version of this argument focuses on executive and trader compensation. Here, the argument implies that bankers were rewarded most for making the risky deals by originating subprime mortgages and creating risky securities made up of these mortgages. Such deals paid off handsomely for the bankers, who generated high profits, but ended up putting the banks at long­term risk (Bhagat and Bolton, 2014; Crotty, 2009).

All of these explanations seem plausible. But they can't all be true. Part of the problem is that each explanation sets itself up as the one real cause of the crisis. It proceeds from the view that if the favored variable had somehow been recog­nized and changed, the entire crisis could have been averted.

There have been two major problems with the literature as it has evolved so far. First, the banks have oddly not been a significant part of the story. In­stead, the causal story has tended to focus on regulators, the individuals who bought mortgages, financial instruments, CEOs and traders, and capital flows. The firms that created modern finance and the many markets that made up the industry at its demise have rarely received sustained analysis. My purpose is to put the banks front and center in the analysis and show how they evolved, morphed into new markets, and took advantage of opportunities that barely existed even thirty years ago. The title of this book is The Banks Did It because I want to show that the banks played the critical part in the construction of what happened. They created new products and industries and pioneered the mod­els underlying the new financial services. Banks watched one another, copied one another, and built entirely new kinds of organizations and markets. They also interacted with regulators and, for the most part, convinced regulators that what they were doing was both innovative and efficient. In the end, the world that the banks constructed and their role in making money from it are at the core of what happened.

Second, the most important idea missing in extant accounts of the crisis is that the banks formed a system. At the core of that system has been the relation­ship between the government and the banks in the making and remaking of the market for mortgages in the United States. In fact, the history of this relation­ship, which shows that the government and the market have been joined at the hip since at least the 1930s, opens up a view for an alternative political economy. The story of Americans getting mortgages for their homes is really a story of how politicians gladly put into place a system that produces the stable opportunity for homeowners to acquire mortgages and the opportunity for banks to thrive by producing a myriad of financial products to serve them.

That system has gone through four crises in the past ninety years. Every time, the system gets reconstructed, mostly by the government picking up the pieces and trying to ensure that Americans can get mortgages. The crisis of 2007-2009 was followed by just such a reorganization. It is impossible to understand what happened without connecting the dots between what citizens have wanted (more mortgages) and what politicians delivered. The complexity of the market over time shows the back-and-forth of the government's role in creating, stimulating, and regulating the provision of mortgages by banks. Banks have responded to these opportunities by taking advantage of what the system has given them to earn high rates of growth and enormous profits.

But the system that existed was not just about government regulation and oversight of the mortgage market. The underlying structure of how people get mortgages, who provides them, how capital is raised to fund them, and who ultimately the investors are requires deep analysis. The fact that the market for mortgages, the making of securities, the expansion of shadow banking, and the market for trading those securities were connected is critical to understanding what happened. Indeed, one of the problems that the regulators faced in the summer of 2008, as the system came unhinged, is that they lacked a thorough understanding of exactly how the markets were connected. While I admire the fact that Federal Reserve Chair Ben Bernanke and Secretary of the Treasury Hank Paulsen helped saved the world banking system from collapse, I believe that their theory of how the system worked was ad hoc at best. To this day, the people in charge of regulating our financial system do not really grasp its system­ic character. Now, of course, a great deal of that system is gone, blown away by the crisis. But the system that has emerged in its wake (which I describe in the conclusion) is still a system and one fraught with many problems.

Why has this kind of understanding been so difficult to grasp? Regulators tend to be bankers or economists, many of whom were trained as relatively narrow spe­cialists. One group of these specialists, who dominated the Federal Reserve, were trained as macroeconomists. They viewed the economy as a set of sectors with varying rates of economic growth that in the aggregate produce GDP. In analyzing the impact of changes in a particular sector's growth, the critical facts for their analyses were the relative size of the market and its potential for directly impact­ing some other sector. For example, if housing construction went down, then one could expect that certain related durable goods markets, say the market for toilets, would experience a downturn as well. This meant that they tended not to see the deeper connection between the housing market and the financial markets. So, in the spring of 2008, they saw the foreclosure crisis that was brewing in the subprime mortgage market as relatively contained because it was “only” a $200 billion mar­ket, missing that the entire banking system in the economy was wrapped up in the production of mortgage-backed securities.

The other group of experts were trained in financial economics. Their orien­tation was to understand the role of the financial markets in the economy. They were focused on arguing that financial innovation would make the financial sys­tem more efficient by creating financial instruments that would bring together people who had money to loan with people who had a need to borrow. The 1980s witnessed a flowering of financial innovation that garnered praise for its pro­motion of new financial instruments to control risk and put money to the best possible use. In the 1990s, financial economists also promoted the idea of banks becoming financial conglomerates. They wanted to break down the barriers be­tween retail, commercial, insurance, and investment banking and allow banks to participate in whatever markets they deemed profitable.

These perspectives made it difficult for regulators to analyze what was occur­ring in the mortgage market from the early 1990s. They never paid much atten­tion to or cared to understand how the system worked and the nature of the risks that were being taken. For much of 2008, macroeconomists were reassured that the difficulties were not substantial and would be contained without damage to the larger economy. Financial economists were convinced that what was going on was good for the economy. Neither group was oriented toward unpacking how Main Street (consumers buying mortgages to purchase homes) and Wall Street (the largest and most systemically important financial institutions) became fused. This book attempts to lay out the steps that the government and the banks took to produce this market. It did not have to happen this way—but it did.

Tracking out the critical moments when new banks and new markets emerged is crucial to laying out the basic facts of what happened. My main tactic in this project is to approach what happened historically. I want to show how the various pieces of the puzzle came together over time. The aim is less to understand the ultimate cause of the crisis and more to make sure that we have all of the pieces in place and can set them in motion. There is evidence that many of the factors that scholars and journalists have so far discussed played some role in the crisis. But how those factors fit together is poorly understood, if understood at all.

This does not mean that I am giving up on causal analysis altogether. I believe that it is possible to evaluate whether the causal stories that have been told make sense of what happened. My intention is not to just reconstruct what happened but to set what we know against many of these hypotheses about how people think things were working. So, for example, there is little evidence that the gov­ernment-sponsored enterprises were the cause of the subprime crisis. Those or­ganizations were not allowed to sell subprime mortgages until 2005, and by then the market was well developed and dominated by private banks. Indeed, they were quite late to the party and had little effect on what was going to happen. Moreover, private banks were the issuers of most of the securities based on sub­prime mortgages. There is similarly little evidence that everyone was passing the risk on to the next guy. The evidence shows quite clearly that the biggest banks involved in subprime mortgage lending were issuers of bonds and purchasers of those same securities. The important stylized fact is that when the end came, all of the largest banks in the country were holding such bonds, and most of went out of business, were forced to merge, or were substantially reorganized under pressure of the Federal Reserve.

For me, the craziest thing to explain is the most obvious: how did the savings and loan industry, with its emphasis on loaning locally and holding those loans, end up becoming the mortgage securitization industry centered on Wall Street and exotic financial instruments? How did mortgage securitization become the core way to make money not just in the American financial system but in the world's financial system? Putting it another way, how did Main Street end up being taken over by Wall Street? And how did the global market for securities get taken over by the market for American mortgage securities?

The story as it really happened is quite complex. But it is explicable, and the truth, to the degree that I have grasped it, is stranger than any of the stories that have been told. As the outcome of both crises and opportunities, the system was created with little intention. The government actively organized the market. But how they did so changed as the situation changed. The regulators and policymak­ers were pragmatic in their orientation to ensuring that Americans could buy mortgages. They gave little thought to the kind of system that had been construct­ed, and they used organizations and institutions at hand to try to make sure that mortgages were always available. As such, many of the endpoints had little to do with the beginning. Banks were only interested in finding markets to replace those that no longer had growth or proved profitable. That they all eventually became the same bank is the result of their collective realization that mortgage origination and securitization were so profitable that becoming organized around them was what the most successful banks were doing. It is therefore not surprising that bankers, regulators, and scholars never saw the true nature of the system (and still don't!). They did not appreciate all of its moving parts and how those parts came together.

This book is directed to making sense of that question.