Arnold Kling  

Meet the Suits

Warren Nutter: A Reminiscence... Who Said It?...

You simply must make room on your financial crisis porn bookshelf for the forthcoming All the Devils are Here, by Bethany McLean and Joe Nocera.

The worst financial crisis books, such as David Wessel's undeservedly popular tripe, focus their narrative on 2008, when the crisis broke. In contrast, Devils goes back to the 1970's and 1980's, with only the brief last chapter dealing with the events of 2008. After that, the authors give a brief epilogue, which is the only weak chapter in the book. They are journalists who handle the financial narrative deftly, but they are not in a position to step back and really draw the deeper lessons of what they so competently describe.

Given my emphasis on what I call the Suits vs. Geeks divide, Devils had me at the prologue. It describes a meeting in September of 2007 in which John Breit, a low-level, marginalized geek at Merrill Lynch, gives CEO Stan O'Neal his first clue about the depth of Merrill's exposure to subprime mortgage credit risk.

The rest of my review is below the fold.

Devils starts with the origins of mortgage securitization. It quite aptly depicts the triangular relationship among Freddie/Fannie, Wall Street, and the government. The relationship was characterized by mutual suspicion and often by one party seeking to intimidate another into submission. But always in the end, they worked together because of mutual need.

For example, on p. 17 we see Fannie Mae's Chairman David Maxwell in 1988 anxious to get a favorable ruling from the Department of Housing and Urban Development to issue REMICs, a tax-advantaged form of mortgage security that initially neither Wall Street nor the government wanted Fannie to be able to issue.

How did Fannie Mae persuade Pierce to rule in its favor? Not be sweet-talking, that's for sure; Maxwell had an iron fist inside that velvet glove of his. "We essentially gutted some of HUD's control over us in a bill that passed the House housing subcommittee," Maloni says today. In that bill, HUD's ability to approve new programs was revoked. HUD went to Fannie, and essentially pleaded for mercy. "In return for asking the Congress to drop the provision, HUD approved Fannie as issuers," says Maloni.

Maloni also called Lou Nevins and told him that if Salomon didn't back off, Fannie wouldn't do business with the bank anymore...This was a major threat. "It's like the post office saying we won't deliver your mail!" Nevins says. He remembers thinking to himself, "If they get away with this, there won't be a private company in the world that will stand up to them."

There are many more examples of the arrogance and lobbying prowess of Fannie Mae. The techniques they employed to emasculate their regulator are laid out in detail. This alone makes the book worth reading. One of my themes, that mortgage securitization emerged from rent-seeking, gets a lot of support, the way I read it.

I also think that the Suits vs. Geeks divide gets a lot of play. The geeks invent risk management tools, such as Value at Risk, and often the suits misunderstand and misuse them. On p. 57:

many Wall Street CEO's would view their daily VaR number as an expression of their firm's worst-case scenario. But it was nothing of the sort....The fact that VaR told you how much your firm might lose 95 percent of the time didn't say a thing about what might happen the other 5 percent of the time.

Devils points out that there were many indications of fragility in the financial system that were ignored. For example, on the rating agencies, p. 114

The rating agencies had missed the near default of New York City, the bankruptcy of Orange County, and the Asian and Russian meltdowns. They failed to catch Penn Central in the 1970's and Long-Term Capital Management in the 1990's. They often downgraded companies just days before bankruptcy--too late to help investors...To critics like Partnoy, the fact that ratings carried the force of law explained a troubling paradox: even as proof piled up that the agencies made mistake after mistake, their power continued to grow.

So far, I have not told you anything that came from the book that I did not already know. But in fact I gained a fresh perspective, particularly from two of the executives profiled in Devils: Angelo Mozilo, the CEO of Countrywide Funding; and Roland Arnall, the owner of a number of large subprime mortgage lenders. Each of these men were capable of saying--and apparently believing--that they were the good guys, making safe, customer-friendly loans, in a world of greedy cutthroats. About Arnall, p. 133:

Headquarters, in fact, acted as if the company were a paragon of subprime virtue, rather than a place that oozed with sleaze and fraud. In July 2000, for instance, Ameriquest publicly committed to a set of best practices...The following year...Ameriquest had been invited to testify because many in Washington considered Ameriquest a model subprime lender...

The company was constantly being hit with accusations, investigations, and lawsuits charging fraud and deceptive practices...At best, Arnall seemed to practice a kind of willful ignorance.

We also see "consumer groups" being bought off by people like Arnall. Indeed, I always thought of ACORN as shakedown artists--they would accuse a big company of racist or anti-consumer lending practices, and the main result of any settlement would be that the company would make a big grant to ACORN, as opposed to really changing its practices.

On Countrywide, p. 219:

By 2006, there was a distinct Dr. Jekyll and Mr. Hyde-like quality to Angelo Mozilo. The good Angelo had been warning for a surprisingly long time that his industry was heading into dangerous territory. "I'm deeply concerned about credit quality in the overall industry," he said in the spring of 2005...

The bad Angelo insisted that none of this would be a problem for Countrywide...Countrywide's "proprietary technology" would help it "avoid any foreclosure," Mozilo told investors

Mozilo and Arnall come across to me as pathological. They can articulate the difference between right and wrong, but they have an ability to convince themselves that they are doing right even as they are doing the opposite of what they claim. How do such people rise to the top of large companies? Once again, I say that if somebody made me the chief risk regulator and said that I had to prevent financial crises, I would change the gender of the financial CEOs. I don't think female executive minds are as capable of the same pathology.

Devils does a particularly good job explaining what happened with AIG. Here is a tidbit that was new to me (p. 203):

FP did not completely turn off the spigot at the end of 2005, even though that is what the company later told the world...under the terms of the swap contracts it wrote, CDO managers had the right to switch collateral to help maintain the yield--without having to inform AIG. As borrowers prepaid mortgages, for instance, the CDO managers would replace those earlier mortgages with mortgages that had been written in 2006 and 2007.

In various places in the book, you can see data that explain why "loan modifications" and "keeping borrowers in their homes" will not work. A large percentage of home buyers did not make even one payment and never occupied their homes. On p. 255:

Rosner's eureka moment [this is Josh Rosner, about whom Russ Roberts and I both blogged recently] comes when he sees data showing that about 35 percent of the mortgages used to purchase homes in 2004 and 2005 are not for primary residences, but for second homes and investment properties.

I should note the a Fed study found only 15 percent of mortgages for non-owner-occupied in that period. However, it would not surprise me if Rosner found a more accurate source--there is a lot of fraud in which a borrower says that the loan is for a primary residence when it's not.

Overall, I find the book to be filled with examples of what I call expert failure. Experts in the private sector as well as the public sector greatly over-estimated their knowledge and abilities. It is hardly comforting when in their epilogue, the authors of Devils write on p. 363:

These new regulations also will only be as good as the regulators themselves.

COMMENTS (9 to date)
subrosa writes:

I find the VAR point irrelevant. Everyone knew the 95% was not a 'worst case scenario'. It is what it is, a percentile. You need enough observations to calibrate a VAR, which is why it is better than a 99.99% number. But if one thinks VAR was necessary, sufficient, or even really mattered, I think that's just wrong. If you assume nation-wide, housing prices don't fall year over year, these assets are riskless, which is what everyone thought. Blaming VAR is really misleading, because it was one of tens if not hundreds of metrics that said the same thing.

As per rating agencies, anecdotes prove nothing. On average, the default rates increase exponentially by rating grade, so it's not like their ratings are arbitrary. Now, the rating agencies, like everyone else, made the same cognitive error on these assets, but that highlights this wasn't driven by the agencies, but rather the idea that was shared by investors, rating agencies, and academics. The borrowers just got cheap options on homes, so their mean return expectation on their collateral was irrelevant.

I'm on page 75ish. I hope it gets better. They seem to suggest that blocking regulation really fueled this market, but I'm not seeing why one would think that regulating Countrywide or the others with some new agency would have made a difference, given that regulators were actually requiring more lending to low-income borrowers, not discouraging it.

david writes:

Hypothetically speaking, how bad does private and public evaluation of risks have to be before we can legitimately say "okay, screw you both. Nobody's contracts trading such risk are enforceable from here on."

Mark writes:

The Monster, by Michael W Hudson, is a recently published book about Asnall and his companies, First Alliance & Ameriquest and is the best thing I have read on true predatory lending. It is consistent with much of this post. For example, the point about Rosner seeing so many mortgages being placed on existing homes - that is the goal of predatory lending, to get elderly and other homeowners, not homebuyers, to take out mortgages. How Asnall's companies did that was really ugly stuff. I strongly recommend the book.

Tom Ault writes:
Once again, I say that if somebody made me the chief risk regulator and said that I had to prevent financial crises, I would change the gender of the financial CEOs. I don't think female executive minds are as capable of the same pathology.

Then it is fortunate that you not chief risk regulator. Not only is this remark quite sexist, it's also quite wrong. I've had the misfortune to meet at least two such pathological women, who could be just so darn sweet as they clawed, lied and cheated their way into money (and would have killed too, had it been necessary or if either could have gotten away with it). Women can be just as evil - and rationalize it just as well - as men.

topcat writes:

Dr Kling
I would be interested in your review of David Wessel's book.
Or did I miss it?

Arnold Kling writes:

I found Wessel's book beneath reviewing. The closest I came was here

Jaap writes:

@ Tom Ault: spot on. in the Netherlands we have a famous example in Nina Brink (now Storms-Vleeschdrager) who launched Worldcom. the very much hyped company turned out to be a disaster. even after 9 years she is still around in the media with related issues.
gender is not relevant when it comes to the small sample of psychology of CEO's.

Tracy W writes:

I don't think female executive minds are as capable of the same pathology.

I take it from this that you, unlike me, did not attend a single-sex girls high school.

I went straight from there to electrical engineering, 90% male. I think I am qualified to say that no gender has a monopoly on any type of thinking, except that women have to be a bit more pragmatic about blood.

Robert Bell writes:

Arnold: With respect to expert failure, you write in the linked post:

"The power of government experts is concentrated and unchecked (or at best checked very poorly), whereas the power of experts in the private sector is constrained by competition and checked by choice"

As a pragmatic matter however, monopoly power, lack of choice, and information asymmetry can persist for substantial periods of time (e.g. a significant fraction of a human lifetime), so the damage that overconfident private sector experts can inflict can still be substantial.

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