Reckless Endangerment

12/14/2011

In Reckless Endangerment, Gretchen Morgenson and Joshua Rosner expose how the watchdogs who were supposed to protect the country from financial harm were actually complicit in actions that finally blew up the economy of the United States. The book described what led to the economic crisis of 2008. Morgenson focuses on the managers of Fannie Mae, the government-supported mortgage giant. She writes that CEO James Johnson built Fannie Mae into the largest and most powerful financial institution in the world. But in the process, the company fudged accounting rules, generated big salaries and bonuses for its executives, used lobby and campaign contributions to bully regulators, and encouraged the risky financial practices that led to the crisis. Worst of all, it was the result of actions taken by people at the height of power in both the public and the private sectors, people who continue, even now, to hold sway in the corridors of Washington and Wall Street. Reckless Endangerment is a story of what happens when unfettered risk taking, with an eye to huge personal paydays, gains the upper hand in corporate executive suites and on Wall Street trading floors. It is a story of the consequences of regulators who are captured by the institutions they are charged with regulating. The authors compelled to write this book because American economy was almost wrecked by a crowd of self-interested, politically influential, and arrogant people who have not been held accountable for their actions. (NPR 2011) The U.S government created Fannie Mae in 1938 to buy mortgages from banks than loaned money to homebuyers, which helped to recover from the Depression era. In 1992 when Office of Federal Housing Enterprise Oversight (OFHEO) was created, Johnson, made sure that Congress was companys boss as opposed to OFHEO. By offering the millions of dollars to hand out to lawmakers, Johnson made sure that he would always receive the support of the Capitol Hill. Later year OFHEO warned about Fannie Mae but warnings were ignored by the lawmakers. In the US, racial bias by mortgage lenders was pervasive. Political issue related to that was seen by Johnson as an opportunity for Fannie Mae. It could not only help Fannies expansion but its image. Fannie involved in underwriting flexibilities, new products, expanding outreach efforts were loosening underwriting standards and lending people whose income, assets or even abilities to pay fell below from the traditional homeownership spectrum, which existed before. The whole approach to expand subprime mortgages was more radical than Fannie and other parties wanted to admit. In 1994, Johnson announced Fannie Maes trillion dollar commitment to be spent from 1994 and 2000. The company said money would finance 11 millions homes for low-income families, minorities, immigrants and it would transform the nations housing finance system by working other industry partners to eliminate the barriers to homeownership. In fact, just year after coming to US and while I was on job visa, I was able to buy a 300k townhome in early 2000 by just paying 5% down. I did not default or anything but to make a point that how easy it was to buy a house without having much cash in hand. Fannie Mae continued to roll with various partnerships and support in Congress. According to OFHEOs reports, percentage of loans the company purchased with LTV ratio greater than 90 percent rose from 6 percent to 19 percent in 4 years. During that time, CBO reported questionable compensations to executives of Fannie Mae and Freddie and CBO suggested to revisit the special relationship that existed between the government and Fannie and Freddie. During the crisis of 2008, one former Fannie executive said that there were so many lessons for how missions were turned away from the true directions and how the housing market and public private partnership morphed into an institution that is corrupt at more than the margins at various levels. Fannie was hugely success in carrying the model it created independent of the underlying merits of that they were doing. In addition, after credit crisis erupted, Fannie and Freddie were rescued and became a creation of the generation of government sponsored enterprises implied with federal guarantees. As the author says the cancer of Freddie and Fannie is not gone yet now that it has metastasized. Precisely a decade before 2008, dress rehearsal took place when a bunch of subprime mortgage lenders failed and caused billions in losses. Unfortunately, that subprime was a red flag that regulators, lawmakers and housing policy wonks determinedly and conveniently ignored. In fall of 1999, Glass-Steagall law that protected consumers and individual investors breathed its final breath. The new law Financial Services Modernization Act (Gramm-Leach-Billy) of 1999, lobbied by corporate empire builder was enacted. Glass-Steagall gone, financial 1

Reckless Endangerment

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institutions were now free to grow. Gramm-Leach-Billy allowed banks to cobble together all kinds of different and rosily operations. Its enactment therefore was a crucial step to financial perdition known as Too Big to Fail. It enabled far more banks to become far too powerful and intertwined. However, clearest signal that big financial players would no longer be allowed to fail came when New Your Fed brokered a rescue of a huge and troubled hedge fund called Long-Term Capital Management (LTCM), co-founded by Scholes, academic, noble prize winner and his academic partners. As Glass-Stegall was falling and the Fed and other regulators were easing up on financial institutions, Johnson began to prepare his exit from Fannie Mae. Though to outsiders, Fannie Mae was doing fabulously and it hit $1 trillion mark, top executives knew that year had been difficult and expecting years ahead. Accounting scandals and irregularities at Fannie Mae started to appear but the full-fledged account fraud at Fannie went undiscovered until 2005. Federal investigation determined that account tricks began under Johnsons watch. The belief that the free market could police better than any government regulator had already taken hold. Fed officials paid lip services to the important lessons of the 1998 crisis and ignored them. Instead of heightening the scrutiny of risky practices among the big banks they oversaw, the Fed backed these institutions to reduce capital requirements and increase their leverage and profits. Fed stopped itself becoming a policeman. In 2004, OFHEO sent report in a paper entitled Systemic Risk: Fannie Mae, Freddie Mac and the role of OFHEO to senior lawmakers. OFHEO had not simply attacked Fannie and Freddie, but it had also directly threatened the fastestgrowing businesses on Wall Street: the sale and trading of derivatives, including credit default swaps. Homeownership grew 68 percent and a record of $3.84 trillion in mortgages were written in 2003, triple amount originated just three years earlier. Countryside argued for relaxed lending rules and a regulatory retreat. With NovaStart, Countrywide and scores of other lenders working hard to make homeownership easy and it was inevitable that property price would soon start becoming upward. From 2000 through 2004, median home price rocketed 31 percent. Fannie and Freddie were bigger than ever. However, the competitive landscape was changing as mortgage rates hit their lowest levels. Also, the flags raised by Freddies auditors had to do with how the company accounted for the derivates it used to hedge the interest rate risks its vast home-loan portfolio. Prices of mortgage securities moved around a lot in response to changes in the interest rates. In case of Fannie Mae, OFHEO found that Fannie had orchestrated a concerted effort to develop and adopt accounting principles allow it to spread income or expenses over multiple recording periods. Much of the manipulation was designed to trigger executive bonuses. OFHEO maintained that Fannies weaknesses were significant, affecting nearly all areas of the company, existed and started under Johnsons leadership. The book summarized that economic crisis started with the collapse of Bear Stearns in March 2008. A few months later, rapid failures of Fannie Mae and Freddie Mac, Lehman Brothers and the American International Group (AIG). As of today, it is still not known how much this crazy debacles will cost to the American taxpayers. Morgenson describes that rescues of Fannie Mae and Freddie made liars out many people and as book started with Johnson who had claimed that Fannie would never cost taxpayer a dime. Books ends with question will this ever happen again? In addition, the author concludes that most certainly it will, as Congress did not grab the opportunity to fix the problem of too-big-to-fail institution when it had chance. We studied Dodd-Frank bill and reached the similar conclusion that law simply failed the most basis test it did not insist or provide specific guidelines that how large and unmanageable institution be cut down to size to alleviate their threat to tax payers. Nor did it increase the accountability of those running institution that will be need government assistance in future. The bill does not address adequately the issue of moral hazard. After reading a book, it is still puzzling whom to blame for the crisis. Fannie Mae and Freddie not the only ones to blame but they acted as the catalysts and they definitely helped it going.
Works Cited NPR 2011. How 'Reckless' Greed Contributed To Financial Crisis. May 2011. <http://www.npr.org/2011/05/24/136496032/how-reckless-greed-contributed-to-financial-crisis>. December 2011