The following is an excerpt from Chapter 8 of my book, Predicting the Markets: A Professional Autobiography.

HOUSING CERTAINLY CONTRIBUTED to making the Great Recession the worst US economic downturn since the Great Depression. It lasted 18 months, from December 2007 through June 2009, which was longer than all the prior postwar recessions. Real GDP fell 4% from the end of 2007 through mid-2009. That was bad, but so were the recessions of the early 1970s and early 1980s. What made the Great Recession so great was that it was followed by a very weak recovery. The Great Recession was associated with a financial crisis deeply rooted in extraordinary excesses in the mortgage industry. The consequences lingered well past the official end of the recession and weighed heavily on the recovery.

Ever since the magnitude of the crisis became apparent in 2007, people have been writing articles, books, and official reports on who caused it. As in Agatha Christie’s Murder on the Orient Express, all the suspects were guilty. There were 12 perpetrators in Christie’s tale. Time put together a list titled “25 People to Blame for the Financial Crisis.” The weekly news magazine accused the following:

Angelo Mozilo / Phil Gramm / Alan Greenspan / Chris Cox / American Consumers / Hank Paulson / Joe Cassano / Ian McCarthy / Frank Raines / Kathleen Corbet / Dick Fuld / Marion and Herb Sandler / Bill Clinton / George W. Bush / Stan O’Neal / Wen Jiabao / David Lereah / John Devaney / Bernie Madoff / Lew Ranieri / Burton Jablin / Fred Goodwin / Sandy Weill / David Oddsson / Jimmy Cayne

On the magazine’s website are links to dossiers on each of the alleged perpetrators.[1] Plenty more blameworthy names and groups could be added to the list, including Henry Cisneros, Andrew Cuomo, Barney Frank (D, MA), Chris Dodd (D, CT), the Association of Community Organizations for Reform Now (ACORN), the credit rating agencies, and every person who made or took out a “liar’s” mortgage loan based on false income information. Their common defense was that no one expected home prices nationwide could ever plummet en masse, which is exactly what happened.

The stage was set for both the S&L crisis and the latest financial crisis way back in the early 1900s, when the housing industry teamed up with the financial industry to lobby the government for lots of support. Along the way, owning a home became part and parcel of the American Dream, and the government became increasingly committed to making the dream come true for as many Americans as possible. For its politician proponents, this promise represented lots of votes—and lots of campaign contributions.

The housing bust that started in 2007 was preceded by a housing boom that arguably started on April 6, 1998. That day, John Reed of Citicorp and Sandy Weill of Travelers Group announced their intention to merge the bank with the insurance company, forming Citigroup. One small roadblock: the law. The merger violated the Glass–Steagall Act of 1933 prohibiting any one financial institution from acting as any combination of an investment bank, commercial bank, and insurance company. Nevertheless, the Fed under Chairman Alan Greenspan gave Citigroup a temporary waiver in September 1998. (Weill and Greenspan were both on Time’s list of perps.)

Lo and behold, 14 months later, on November 12, 1999, Congress enacted the Gramm–Leach–Bliley Act, also known as the “Financial Services Modernization Act of 1999,” which was strongly promoted by Senator Phil Gramm (R, TX) and signed into law by President Bill Clinton. It swept away the Glass–Steagall barriers among financial institutions. They now could merge and acquire one another with abandon, becoming instant financial supermarkets. At the time, the popular rationale was that such modernization was necessary so that American banks could compete with Europe’s “universal banks.”[2] (Gramm is on the perps list.)

But the Clinton administration had threatened to veto the Act unless it included a provision—proposed by Senators Chris Dodd and Chuck Schumer (D, NY)—prohibiting mergers by any financial holding company that owned a subsidiary that had received an unsatisfactory rating on its most recent Community Reinvestment Act (CRA) exam. CRA exams assessed banks’ compliance with a 1977 law prohibiting banks from “redlining,” or denying credit to qualified minority, low-income borrowers. The inclusion of this provision in Gramm–Leach–Bliley is important because it gave the regulatory bodies that enforced the CRA say-so over which banks could and could not consider mergers, depending on their CRA performance.

Was the CRA—and particularly was hyper-empowering its enforcing agencies through the Gramm–Leach–Bliley Act—a major contributor to the subprime mortgage disaster? That question remains ensconced in controversy. The heightened importance to banks of earning satisfactory CRA ratings after passage of the Act no doubt encouraged subprime lending. And banks’ necessity to score well on the CRA exam seemed to embolden community activist groups such as ACORN to virtually extort subprime lending—and contributions to their nonprofit organizations—from banks with low CRA scores. The activists’ threat: lend below prime or deal with public shaming and be barred from any merger activity.

However, subsequent analyses of the subprime mortgage lending showed that mortgage brokers, who were not covered by the CRA, accounted for a significant portion of lending to people who should never have qualified for a loan. So the CRA was only partly to blame for the reckless proliferation of subprime lending.[3]

Fannie Mae and Freddie Mac also deserve some of the blame for accepting so many of the subprime loans made by the mortgage brokers as well as by the bankers. They were under political pressure to make the American Dream come true for more Americans during President Bill Clinton’s administration. The push to expand homeownership continued under President George W. Bush, who, for example, introduced a “Zero Down Payment” initiative at the start of 2004 that under certain circumstances could remove the 3% down payment rule for first-time homebuyers with FHA-insured mortgages.[4] However, the Bush administration was troubled by the rapidly growing role of Fannie Mae and Freddie Mac in the mortgage market, especially since there was widespread belief that the GSEs were backed by the government, which they were not at that point.

The GSEs enjoyed great support from Senator Chris Dodd, chair of the Senate Banking Committee from 2007 to 2010. He was also the number one recipient of campaign funds from the GSEs from 1989 to 2008.[5] In the House, Representative Barney Frank—the powerful chairman of the House Financial Services Committee—defended Fannie Mae from the Republicans. He also had an alleged conflict of interest.[6]

The Fed deserves some of the blame too. Its easy monetary policy at the start of the decade and gradual rate hikes stimulated tremendous demand for yield. The Fed lowered the federal funds rate from 6.50% on January 3, 2001 to 1.00% on June 25, 2003, first in response to the recession and bear market in stocks that followed the bursting of the tech bubble. The residential and commercial construction markets were also under duress at the time. The 9/11 terrorist attacks only worsened the economic outlook. The Fed kept the federal funds rate at 1.00% until June 30, 2004. Then it proceeded to raise it at a “measured pace” of 25 basis points at each of the next 16 meetings of the Federal Open Market Committee (FOMC). That was a first: such a cautious and predictable normalization of monetary policy had never happened before.

The predictability of the Fed’s measured rate hikes also increased the gains from carry trades in which bonds could be financed with short-term borrowing as long as the trader was reasonably confident that those borrowing costs would remain below the yield on the bonds. Of course, that trade wouldn’t work if bond yields rose, causing bond prices to fall. However, yields didn’t rise. Instead, the US Treasury 10-year bond yield fluctuated around 4.50% from 2001 to 2007. Mortgage rates also diverged from the upward march of the federal funds rate. That was a big surprise given that short-term rates were almost certainly going to be rising incrementally at every FOMC meeting once the Fed commenced its measured rate hikes.

That phenomenon became known as “Greenspan’s conundrum.” In his February 16, 2005 semiannual testimony to Congress on monetary policy, then Fed Chairman Alan Greenspan said globalization might be expanding productive capacity around the world and moderating inflation. It might also be increasing the size of the global savings pool. “But none of this is new and hence it is difficult to attribute the long-term interest rate declines of the last nine months to glacially increasing globalization. For the moment, the broadly unanticipated behavior of world bond markets remains a conundrum. Bond price movements may be a short-term aberration, but it will be some time before we are able to better judge the forces underlying recent experience,” he concluded.[7]

Greenspan and other members of the FOMC were concerned about the fragility of the US economic recovery. They also feared deflation. In fact, Fed Governor Ben Bernanke addressed the issue in his November 21, 2002 speech “Deflation: Making Sure ‘It’ Doesn’t Happen Here.”[8] The inflation rate on a year-over-year basis fell to a low of 0.7% at the start of 2002, based on the personal consumption expenditures deflator.

The demand for alternative investments such as those created by the GSEs was tremendous because other options to generate returns at a perceived low risk were scarce. The GSEs were the trailblazers in the MBS industry. Mortgages were originated and packaged together into these securities, which could be kept or sold to other financial institutions. Ginnie Mae securities were a big hit because they were, and still are, the only MBSs guaranteed by the US government, comparable to US Treasury securities in that respect. In effect, Ginnie Mae nationalized the mortgage market and untethered it from the banks and thrifts. Housing finance no longer was constrained by the resources of local depository institutions. The national, and increasingly the international, capital markets became a huge source of mortgage financing, supplementing and substituting for bank funding.

Wall Street recognized a great opportunity to monetize the growing demand for mortgages, no matter their credit rating, and to fund even more growth with credit derivatives. The Street mimicked the GSEs on a massive scale and ultimately deserves much of the blame for the financial crisis. Indeed, several of the names on Time’s list were among the titans of Wall Street back then—for example, Paulson, Fuld, O’Neal, and Cayne. The list even included the chairman of the Securities and Exchange Commission (SEC) at the time, Chris Cox.

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[1] “25 People to Blame for the Financial Crisis,” Time magazine’s website.

[2] “Citi’s Creator: Alone With His Regrets,” The New York Times, January 2, 2010. The article reported that Citigroup CEO Sandy Weill hung in his office “a hunk of wood—at least 4 feet wide—etched with his portrait and the words ‘The Shatterer of Glass-Steagall.’”

[3] On this subject, The Financial Crisis Inquiry Report (2011) stated, “The Commission concludes the CRA was not a significant factor in subprime lending or the crisis. Many subprime lenders were not subject to the CRA. Research indicates only 6% of high-cost loans—a proxy for subprime loans—had any connection to the law. Loans made by CRA-regulated lenders in the neighborhoods in which they were required to lend were half as likely to default as similar loans made in the same neighborhoods by independent mortgage originators not subject to the law.” See p. xxvii.

[4] “Zero Down Payment,” HUD’s January 19, 2004 press release.

[5] See “Fannie Mae and Freddie Mac Invest in Democrats” on opensecrets.org.

[6]“Lawmaker Accused of Fannie Mae Conflict of Interest,” Fox News, October 3, 2008.

[7] “Federal Reserve Board’s Semiannual Monetary Policy Report to the Congress,” Greenspan’s February 16, 2005 congressional testimony.

[8] “Deflation: Making Sure ‘It’ Doesn’t Happen Here,” Bernanke’s November 21, 2002 speech.