Wall Street financial wizards have conducted their businesses as though the complex financial products that generated billion-dollar compensation packages also created a protective moat beyond public accountability.
In the interdependent world of global finance that is now collapsing, home mortgages were abstractions. During this decade the basic human connection between lender and borrower in consumer finance was cut and thrown away as a quaint vestige of a bygone era.
In 1981, at the beginning of the era of retail banking deregulation, I wrote the first state consumer protection law for California to stop the practice of "playing the float" — holding customer deposits to earn money by delaying credits to the customer's account. This abuse crept into retail banking because the full market effects of lifting the previous interest rate ceilings were poorly understood. Follow-up regulation was necessary to close a window of market failure.
Just as in the current crisis with subprime loans, competition could not and did not do the job after deregulation.
Getting out of this mess will require four things: public recognition of the scope and scale of the backlog of mortgage-related defaults, a return to basic human connections in mortgage lending, aggressive consumer protection, and insistence on generous capital cushions (rainy day funds to buffer unexpected losses).
Bring all the bad loans out of the dark recesses of investment and commercial bank balance sheets and into the light of public review. We cannot fix it until we see it.
Next, back to basics. Remember that houses are homes, not abstract transactions that can be made profitable with unreasonable levels of leverage/borrowing.There is still a role for more conservative securitization, in which packages of home mortgages are sold to the restructured Fannie Mae and Freddie Mac, and a well-regulated private market. However, preserving the connection between originator and borrower is more likely to reduce fraud and consumer abuse.
This will require political and economic leadership to encourage Americans to return to the tough, unpleasant discipline of saving. At the heart of the current meltdown is a stark reality: America is the world's biggest debtor in both the public sector (budget deficits) and the private sector (financial institutions and corporations). The U.S. financial system is now at the mercy of foreign sovereigns and institutions sitting on enormous piles of cash, much of it from the sale of oil and other products to us.
Shifting the bad loans, and the financial instruments based on these loans, on to the balance sheets of commercial banks will not solve the problems we face.
In the new pea and shell game, Bank of America has become the new private shell of choice. B of A, the nation's largest bank, holds 10% of all deposits. It first absorbed Countrywide Financial, the biggest and most problematic subprime mortgage lender, with a loan from the Fed; this week it absorbed Merrill Lynch, with benefit of a waiver of a Fed rule designed to prevent the bank holding companies with FDIC-insured banks from lending to investment bank subsidiaries.
Bank of America, its depositors, and the FDIC are not the long-term solution to the accumulated pile of loans in default.
In August the inventory of unsold foreclosed houses reached 750,000. With the takeover of Fannie and Freddie, the federal government will be the owner of some of these properties.
The relationship between the house as collateral for a loan and the many layers of complex new financial products grew ever more strained in the rapidly changing environment. Regulatory ground rules became a passive backdrop as three factors converged to turn routine home loans into an international financial crisis: unregulated brokers, complex financial instruments, international financial integration. I know that it is not fashionable to talk about human values in the same sentence as global money, but maybe that is the real problem.
Modern financial titans, like Sherman McCoy, the central character of "The Bonfire of the Vanities," have unwound with a single wrong turn, carrying them from the heights of money, power, and privilege on Wall Street to the anger and rage of the ordinary folks in the South Bronx.
The wrong turn took place more than 10 years ago, when the first experiments with bad loans were pushed on poor and unsophisticated borrowers who lived in communities that had previously been starved, through redlining, from receiving any loans at all. Target practice in poor communities proved the viability of the abusive terms: no exit fees, pay-what-you-want ARMs, liars loans, low teaser rates, and balloon payments. These same terms were then quickly adapted to middle- and upper-middle-class borrowers in search of a vacation home or home equity for college tuition.
Within five years Wall Street hedge funds perfected the lending techniques first used in poor communities. In the new structure for housing finance, unregulated, independent brokers sold loans by misrepresentations. Houses that people depend on for shelter became chips in a high-stakes game of liar's poker.
The late Gov. Edward Gramlich of the Federal Reserve warned that the introduction of "huge new sources of capital and financing of largely unsupervised subprime mortgage lenders" had caused problems with subprime loans.
He argued for re-establishing the connection between the lender and the borrower through banning the most objectionable provisions and through a mandatory "suitability rule" which would require lenders to make loans that are matched to borrowers' economic profile and "in the borrower's best interest." The link between the borrower and the ultimate holder of the loan could be further strengthened by expanding existing rules to impose on the holder liability for fraud or other problems with the process.
The current crisis has been driven by the lack of adequate levels of cash to absorb the losses from defaults. Sovereign wealth funds have filled this cash gap, becoming the lender of last resort for cash-strapped commercial and investment banking companies like Citigroup and Merrill Lynch only nine months ago. The sovereign funds of Abu Dhabi, Singapore, and China were among a collection of funds that came to the rescue of these companies. China's four biggest listed banks decided to scale back drastically their purchase of Fannie and Freddie securities, triggering the government takeover just five days later.
Describing the mortgage meltdown is easy, but proposing a solution is less so.
For all the talk of "moral hazard" and "market discipline," these after-the-fact buzzwords are a Rorschach test of whether you believe the government should play an active, aggressive role in controlling the risk-taking and profit-seeking party, just as the guests have started to arrive and loosen their ties.