Plan of the Book

The rest of this book elaborates and explores the basic argument laid out in this chapter. There are a number of themes that will animate these chapters, some of which have been developed here but several of which will come to the fore in our analyses.

Chapter 2 explores the emergence of the market for mortgage securitization. The chapter begins by considering how the savings and loan banks came to dom­inate the mortgage industry in the wake of the Great Depression. One of the key features of the structuring and functioning of the savings and loan business model was its dependency on the government. After World War II, the savings and loan banks' business model proved to be an amazing success, raising the rate of homeownership from about 43 percent on the eve of World War II to 63 per­cent in 1965.

Chapter 3 takes up the vertical integration of the mortgage securitization market during the 1990s. I provide an overview of how and when different kinds of banks entered various markets and provide an account of the rise of the non- conventional mortgage market as well. The market for mortgage origination be­came more concentrated in all market segments over the decade. The percent­age of mortgages originated that were securitized also increased, reflecting the integration of origination and securitization. I provide evidence that the banks were large investors in the mortgages they originated and securitized. On the eve of the twenty-first century, the business model of all the largest banks had converged around the origination and securitization of mortgages and buying them as investments. Countrywide Financial pioneered the vertical integration model and the market for nonconventional mortgages. I show how other banks followed Countrywide's lead. To illustrate how this worked in different kinds of banks, I provide four case studies of banks who pioneered vertical integration within different banking markets: Countrywide Financial (mortgage bank), Bear Stearns (investment bank), Washington Mutual (savings and loan bank), and Citibank (commercial bank).

Chapter 4 introduces the topic of financial innovation. Most people think of innovation primarily as new products.

Chapter 5 presents how the nonconventional mortgage market evolved from a small niche market dominated by what is often thought of as predatory lenders to a large market that eventually eclipsed the conventional mortgage market in 2004-2007. The story of the nonconventional mortgage market (including home equity loans and subprime, jumbo, and adjustable-rate mortgages) begins in the 1990s. By 2001, these were already large markets. When the refinance boom end­ed in 2003, banks turned aggressively to the nonconventional mortgage market. Eventually, that market began to dry up, and banks found themselves having to chase mortgagors with worse and worse credit in order to keep their securitiza­tion machines going.

Chapter 6 considers how the crisis came about in the United States and how it spread around the world. I describe the general breakdown of the banks in 2007-2009. I return to my innovators of the vertical integration model in the 1990s and provide an account of the collapse of Bear Stearns, Countrywide Fi­nancial, Washington Mutual, and Citibank. One of the most striking aspects of the crisis was that within weeks, many of the world's largest banks were insolvent and in need of bailouts from their governments. This chapter presents evidence that the main cause of the direction and timing of this collapse was the participa­tion of banks in many countries in the MBS-CDO market. Many foreign banks, such as HSBC, RBS, and Deutsche Bank, had become originators and securi- tizers just like their American counterparts. Others, such as Credit Suisse and Rabobank, bought massive amounts of securities. I show that between 2002 and 2007, foreign banks increased their ownership of mortgage securities by over $1 trillion, mostly securities based on nonconventional mortgages.

Chapter 7 takes up this question and provides an account of why there was so much mortgage and securities fraud. We know that mortgage and securities fraud increased dramatically, particularly after 2005. But there are few explana­tions of why this is the case. While the nonconventional mortgage market kept the vertically integrated banks going from 2003 to 2005, after 2005, it became difficult to find even mortgages for people with impaired credit. As competition for mortgages increased, more and more mortgages were originated through mortgage fraud. Mortgagors were encouraged to lie on their loan applications, with the complicity of banks. These mortgages were then packaged into securi­ties, thereby causing banks to commit securities fraud. Chapter 7 shows that the banks most likely to commit mortgage and securities fraud were those who were vertically integrated.

Chapter 8 considers why the Federal Reserve missed the oncoming crisis. By analyzing the transcripts of the meeting of the Federal Reserve Open Market Committee, I show that this happened for two reasons. First, there was a kind of positive bias inherent in every meeting. That means that there was a tenden­cy to downplay or dismiss bad news. Second, and more importantly, the use of macroeconomic analysis made it difficult for the Federal Reserve to see the con­nections among the origination market, the house price bubble, and the growth of the securitization market. This inability to understand the systemic nature of mortgage securitization led the Federal Reserve to underestimate the risk to the wider economy of the overall downturn in housing prices that began in 2005. Chapter 8 documents how, as late as the collapse of Lehman Brothers in Sep­tember 2008, the Federal Reserve was as worried about inflation threats to the economy as it was to a possible banking crisis.

Chapter 9 explores three themes. First, it describes how the financial insti­tutions have been reorganized since the financial crisis. The large banks have become financial conglomerates, fulfilling the dreams of banking economists in the 1990s. The ten largest banks owned $12.2 trillion in assets in 2018, fully two-thirds of the assets of all US banks. These banks now participate in nearly every financial service market. Most of these banks were reorganized during the financial crisis, including buying or merging with scores of failed banks. Second, I consider what regulators can do to avoid the next crisis. The Federal Reserve re­sponded aggressively and successfully to the systemic crisis that unfolded before them in 2007-2009. But they clearly missed the depth of the crisis and the inter­connectedness of markets. I propose some ideas as what might be done. Finally, I consider how the financial crisis has opened up the politics of thinking about the relationship between government and business.

Conclusion

One of the great business stories of the 1980s and 1990s was financial innovation. At the core of this period of innovation was the idea of securitization. The inno­vation was seeing that any asset that generated a cash flow could be turned into a security that could be sold to an investor. This meant that the holders of the asset could immediately translate that asset into cash, while investors would take on the risk of the investment. This innovation led to another insight. Risk should be bought and sold to investors who were sophisticated enough to understand what chances they were taking. Those who wanted more risk got higher returns, and those who needed certainty accepted less. The 1990s then witnessed an explosion of financial instruments of all kinds. All of these instruments worked to allow investors to pick and choose their portfolio of investments in a way that was not possible earlier.

There were two important effects of all of this, from the perspectives of the economics profession and the regulators of these instruments. First, risks would end up with people who understood them and priced them in a way that re­flected their concerns. Second, the growth of such innovations would lead to more credit being available to more households, businesses, and governments. Financial innovation would allow sophisticated investors to price risk, manage their portfolios responsibly, and invest in new kinds of risk. The explosion of these products was taken as evidence that they were fulfilling both functions and doing so in a way that worked to the benefit of everyone.

While there is certainly some truth to this analysis, it makes the mistake of generically equating financial innovation with the control of risk at the level of entire markets or the economy. My story about the mortgage securitization in­dustry offers a cautionary tale about financial innovation. While the creation of new financial instruments proved useful to expanding homeownership and allowing homeowners access to some of their home equity, it also helped create a business model that connected risks in the provision of mortgages to risk in the financial system as a whole. The fact that banks combined these two markets meant that the risks to the financial system were multiplied given the huge size of the mortgage industry. It is to making sense of how and why this happened that I now turn.