Wednesday, July 6, 2011

Book Review: Reckless Endangerment by Gretchen Morgenson and Joshua Rosner

Another book, which has received favorable reviews, has been added to the growing list of books that seek to explain the financial crisis. This one is Reckless Endangerment by Gretchen Morgenson and Joshua Rosner. Morgenson is a business reporter and columnist for The New York Times and Rosner, according to the jacket cover, is a housing and mortgage-finance consultant for "global policy-makers and institutional investors." In the Introduction, the authors state: "Investigating the origins of the financial crisis means shedding light on exceedingly dark corners in Washington and on Wall Street. Hidden in these shadows are people, places, and incidents that can help us understand the nature of this disaster so that we can keep anything like it from happening again."

The book is disappointing. It was obviously written in a hurry, which shows in its organization, which is haphazard, some minor factual errors, and its writing style. Most of the book is about Fannie Mae, but the authors veer off from time to time to criticize the Federal Reserve, among other targets, for issues not directly related to Fannie Mae. This would have been a much better book if it had only been about Fannie Mae (and, perhaps, Freddie Mac) and if the authors had not exaggerated the role Fannie Mae played in causing the financial crisis.

Given that the book seeks to explain the origins of the financial crisis (the subtitle is "How Outsized Ambition, Greed, and Corruption Led to Economic Armageddon") and that most of it is about Fannie Mae, the impression is left that Fannie Mae was the biggest single cause of the financial crisis. Fannie Mae and Freddie Mac did not lead the private market into subprime mortgages; they followed it after they figured out how they could. They were latecomers to the party. Morgenson's colleague at the Times, Joe Nocera, who coauthored a much better book, All the Devils are Here: The Hidden History of the Financial Crisis, pointed this out in a column criticizing a "primer" put out by the Republican commissioners of the Financial Crisis Inquiry Commission. (My review of All the Devils are Here can be found here and my discussion of the Republican primer, here.)

While I disagree with the book's large assignment of blame to Fannie Mae, I agree with many of the criticisms the authors make of that institution. Usually, the Treasury Department, both in Democratic and Republican administrations, has had a somewhat tense relationship with Fannie Mae and Freddie Mac. As a career Treasury employee whom I worked for in the 1980s liked to say, the executives at Fannie and Freddie paid themselves private sector salaries without taking private sector risks. Also, there was the sense that Fannie and Freddie debt securities competed with Treasuries. The Treasury would always insist that Fannie and Freddie securities were not backed by the full faith and credit of the U.S. government, which was true, but everyone assumed that if Fannie and Freddie, or any of the other government-sponsored enterprises ("GSEs"), got into trouble, holders of their debt obligations would somehow be protected, though owners of their equity securities could lose. That assumption has been proven correct.

In fact, it was the "implicit" government guarantee that allowed Fannie Mae to grow its way out of serious financial trouble that it experienced in the 1980s. In the 1980s and before, Fannie Mae was similar to giant savings and loan in that it financed long-term mortgage loans with shorter term debt. The mismatch in the duration of its assets and liabilities caused financial distress as interest rates rose significantly as the Federal Reserve embarked on severe tightening in order to end inflation. This eventually put a large number of savings and loans out of existence. Fannie Mae survived without direct government assistance because the implicit government guarantee enabled it to have continued access to the financial markets. New management under David Maxwell decided both to start issuing mortgage-backed securities (MBS) and to match better the duration of its liabilities and the mortgages it held in its portfolio. With MBS, Fannie did not bear interest rate risk, though it still had credit risk, and better managing the duration of its assets and liabilities served to reduce interest rate risk. The strategy worked, and Fannie began growing rapidly and seemed to have a target for return on equity of 20 to 30 percent beginning in the late 1980s.

Morgenson and Rosner are certainly right that Fannie played a political game in Washington, including a powerful lobbying operation, strategic hires, enough support for low-income housing to buy off key members of Congress, and initiatives in key Congressional districts. This was not, though, something that was hidden in the "shadows," everyone who paid attention to GSEs knew this. From my point of view, it made it very frustrating to work on GSE issues; on the narrow set of issues they were interested in, it was difficult, if not impossible, to accomplish much.

The authors are wrong, though, to say that this behavior began with Jim Johnson, who was CEO of Fannie Mae from 1991 to 1998. Fannie Mae under David Maxwell was plenty aggressive, as I can attest to, since I worked from time to time on GSE issues during the George H.W. Bush Administration.

Mr. Johnson is made out to be the principal villain in the book, perhaps because he did not agree to talk to the authors. There is plenty for which one can criticize Johnson, but it is wrong to leave the impression that he was the individual most responsible for the financial crisis. The authors probably do not think that (though I am not sure), but the way their book is written, it leaves that impression.

As for Freddie Mac, the book mentions this GSE in passing, but it considers that its CEO during much of the period, Leland Brendsel, was more passive because he "was not a politician." My impression was that Freddie Mac was playing a clever political game.

By way of background, before the 1989 enactment of the law cleaning up the Savings and Loan crisis ("The Financial Institutions Reform, Recovery, and Enforcement Act" or "FIRREA"), Freddie Mac stock was owned by the Federal Home Loan Banks and its board of directors were the members of the Federal Home Loan Bank Board ("FHLBB"), which also regulated S&Ls and the Federal Home Loan Banks, and it managed the Federal Saving and Loan Insurance Corporation, which insured deposits at S&Ls. FIRREA abolished the FHLBB and distributed its various functions to other government agencies, some newly created. It also made Freddie Mac similar to Fannie Mae, with a federal government charter and stock publicly traded on the New York Stock Exchange.

Fannie Mae had been part of HUD until 1969 when its stock was sold to the public. In this transaction, which enabled the Johnson Administration to report a budget surplus even while the Vietnam War was raging, the government retained the Government National Mortgage Association, which is still part of HUD. In other words, Fannie Mae had become more independent of direct control of the federal government much earlier than Freddie Mac. Not surprisingly, Freddie Mac chose to follow a less confrontational strategy.

But Freddie Mac did not have to be confrontational as long as Fannie Mae was willing to play the heavy. When it came to government policy, the interests of the two corporations were aligned, and Freddie made similar policy arguments as Fannie. Being the nicer GSE could work to Freddie's advantage in having a less strained relationship with federal government policymakers, and it was probably an easier strategy to follow.

The authors do not discuss this. Another issue that they totally miss is the relationship of Fannie and Freddie with the Treasury Department. During the George H.W. Bush Administration, the Treasury argued that Fannie and Freddie should be required to have a triple AAA credit rating ignoring the implicit government guarantee. This proposal was vociferously opposed by the Fannie and Freddie and did not go anywhere, which is what Treasury career staff expected. There were also serious questions about how the rating agencies would come up with this hypothetical rating. In fact, Standard and Poor's got a contract from Treasury to perform this analysis, which was published, but Moody's did not think there was any way to perform this analysis. Given the recent performance of the credit agencies, more problems with this idea, which was well-intentioned because of worry that these two GSEs posed systemic risk and could require, with likely legislation, a government bailout if they got into trouble, are now obvious.

Another issue in the Treasury-GSE relationship that the authors do not discuss is the requirement that Fannie and Freddie debt securities needed to be approved by Treasury. In the 1980s, Treasury used this mainly to make sure that not too many GSE securities and Treasury securities were being sold on the same day. Treasury called this a "traffic-cop" function. Treasury did, though, use the authority to prevent Fannie Mae from issuing securities for tax purposes. For example, Fannie Mae was blocked from using a Netherlands Antilles subsidiary to issue securities in the Eurobond market free from the 30 percent foreign withholding tax that applied to interest payments at that time. (There was also at least one other deal that was tax motivated that Treasury blocked in the early 1980s, though I have forgotten the details.)

However, Treasury never used the authority on debt issuance to force Fannie and Freddie to reduce the size of their portfolios, even though this was considered. The authors might have reported on this timidity. Were there questions about Treasury's legal authority to do this or was there a fear of a ferocious lobbying campaign and an angry reaction from certain important members of Congress? (In the end, though, while this would have reduced Fannie and Freddie earnings, it would not have prevented their financial troubles, which were due to credit risk, not the interest rate risk that caused Fannie problems in the 80s.)

When the authors discuss the Federal Reserve, they are certainly right that the Fed published numerous research studies that argued that there was no national housing bubble. If the authors wanted to discuss this, they should have focused more on why Fed economists wrote these studies and why Chairman Greenspan chose to do nothing about abusive practices of mortgage lenders in making subprime loans, over which the Fed had regulatory authority, even when warned about this by another Fed governor, Ed Gramlich. The authors are critical of Tim Geithner, as president of the Federal Reserve Bank of New York, for not being a strong enough regulator, but this is hardly balanced. Geithner, for example, was the key official who forced the banks and other financial institutions to clean up sloppy back office practices with respect to OTC derivatives. The Fed was, in general, not tough enough on the banks, but other regulators, including the Office of the Comptroller of the Currency, the Office of Thrift Supervision, and the SEC also failed. If the authors wanted to discuss regulatory failure, they could have gone into the reasons. After all, Jim Johnson was not lobbying the OCC and the Fed to go easy on Citigroup.

Also, in discussing primary dealer surveillance, the authors make it seem like the New York Fed was shirking its responsibility. This is not the whole story. The New York Fed had set up a dealer surveillance unit because, prior to 1986, many of the primary dealers were not subject to any regulatory authority. In 1986, the Government Securities Act brought all government securities brokers dealers under regulation, with Treasury, the SEC, and the bank regulators all playing a role, depending on the type of institution. This made the dealer surveillance function of the New York Fed less necessary. The authors do not mention this, nor is it clear why they discuss this issue at all. It was not trouble in the government securities market that caused the financial crisis.

While the authors are critical of the Fed, when it comes to Fannie and Freddie, the Fed is a fount of wisdom. It is true that the Fed criticized the GSEs, as did the Treasury. While the Fed was right about some things and wrong about others, this book does not do nuance – there are white hats and black hats, no grey ones. It is somewhat jarring, then, when the Fed changes hats, with no explanation.

The authors' thesis that Fannie Mae and Jim Johnson and government policies encouraging home ownership have a very large responsibility for the financial crisis is far from a full explanation of the development of the housing bubble and its end, nor does it explain what happened in other countries. For example, one of the first financial failures was not a U.S. institution, but Northern Rock in the U.K., a bank which made mortgage loans. There was a classic run on this bank in 2007, reminiscent of the lines of depositors wanting to withdraw money at U.S. banks during the depression. As a result, the U.K. government decided that it would back all the deposits and nationalized the institution. U.S. housing policy and Fannie Mae could not have been responsible for this episode, nor, for that matter, the housing bubble in the U.K.

The authors would have written a better book if they had just concentrated on Fannie and Freddie and presented a balanced view of their role in the financial crisis. Morgenson certainly has journalistic skills and Rosner appears to know a great deal about U.S. housing policy and mortgage issues. One wishes they had devoted more time thinking through the issues, rather than dumping all the facts they had uncovered into the book, whether or not they really fit, and putting white hats and black hats on the characters they discuss.

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