The greatest fraud that has ever happened, happened in America between 2000 and 2008.
To understand it we must go back to 1938 and the founding of Fannie Mae (Federal National Mortgage Association) and her siblings a bit later.
It was a brilliant idea.
The government wanted to help the salt of the earth working class buy homes. Banks have lending standards. We all know them: a job history, a salary four times the amount of the monthly mortgage installment, a 20% down payment and so on.
Fannie Mae would also have the same lending standards with only one lower: her mortgagors could have a 5% down payment, but otherwise must meet the other lending requirements.
These strict criteria were never, never lessened!
There were a couple small pilot projects with slightly lower standards. These were very small.
Here’s the brilliance in the idea: Fannie would buy mortgages that met her standards from lenders. These lenders were private mortgage companies (called shadow banks) and the regulated commercial banks. Fannie would buy them , package and sell them to wealthy investors with an implied guarantee that she would pay if the mortgagors didn’t.
These became known as conforming mortgages because they conformed to Fannie’s standards.
Why a brilliant idea? This got the risk off the banks’ books that allowed them to make more and more mortgage loans so more and more low income people could buy homes — and the lenders got their profit up front.
Wealthy people are not after the big kill in investing. They have it. They want to protect it. So, investing in government-backed subprime mortgages was as safe as treasury bills but with a few percentages higher. Great!
So what about these ninja loans? you ask. Such people had No Income — No Job — No Assets. They clearly did not meet Fannie’s standards. That’s the bright question.
We need a bit more background.
Packaging these mortgage loans together is one type of a derivative. Derivative is an intimidating word, but all it means is that the investment derives its value from another investment — in this case the underlying mortgages. The package, or derivative, would be sold under one name, such as Abacus 2007 AC1.
They were a hit with investors. There were almost no defaults. Fannie was successful in providing the working class with homes they could not otherwise have afforded — and it was highly profitable for the government.
So coming up to the year 2000, investors liked ’em; the working class liked ’em and the government liked ’em —and the economy smiled. There were no serious Great Depression level meltdowns from Fannie’s founding—until 2008.
A little more background.
In the 1980s, investment banker Lewie Ranieri at Salomon Brothers invented a new financial instrument based on the success of the Fannie Mae mortgage backed security— but in an new financial instrument that would include other types of mortgage-backed loans than those on homes. For example: loans to corporations with a lean on corporate assets. And while these other loans were riskier, he had devised a way to reduce the risk so that they were AAA rated, safe enough even for pension funds.
This instrument became the famous CDO — collateralized debt obligation. The loan is the debt obligation and the mortgage is the collateral.
One CDO was one package of all of these various mortgages with various levels of risk combined into one cash flow directed to a manager. The right to the cash flow was divided into tranches (French for slice). The highest level tranch would take first, and the second level would have the next call on the cash flow and so on down the line.
The trade-off to get this first call meant these investors got the lowest interest rate. Those on the lower tranches were accepting the risk, and so got a higher interest rate. Thus, the salesmen proclaimed, there was really no risk in the higher tranches. It would take a massive default in the home mortgage market. And all those defaults would have to happen all at once. That was as improbable as the proverbial teacup that might be circulating around the moon.
Pension funds bought.
Both the Fannie Mae securities and the investment bank CDOs proved wonderful investments, thus building confidence in the mortgage-backed security. The market for them exploded!
The wealthy investors hungered for these AAA safe derivatives.
But as the demand increased, both commercial and investment banks ran out of supply. There weren’t enough people who could meet Fannie’s standards or traditional bank lending standards.
That’s when private mortgage lenders and commercial banks sent out mobile mortgage brokers to recruit pretty well any warm body that was capable of signing its own name.
So, what about these ninja loans? you ask again.
Important fact: the lenders were charged with checking into the applicant’s background and certifying that they met Fannie Mae’s lending requirements.
Both at the commercial bank and investment bank level, bank employees forged, or knowing approved fraudulent, applications so they would appear as if they met the lending standards. The ninja loans were passed off as if they were Fannie Mae conforming mortgages.
As well, the lending banks indulged in predatory lending. They would lure applicants into signing for mortgages on the basis of a 3% rate that would jump to 6% in two years.
We have Michael Lewis to thank for the best dramatization of the true main cause of the 2008 meltdown. In his The Big Short, his antiheroes see the dates that the higher rates will kick in and they short the housing market. They know massive defaults will start on those fateful days.
Lewis showed one of his main characters, Mark Baum (played by Steve Carell), knocking on doors discovering the mortgagors’ ninja qualities. The only factor Lewis missed was the role of lending standards, these ninjas did not meet them. How in the hell did they get their loans approved?
Shorting the housing market is pure gambling. It means betting that the housing market will fall. Many of the investment banks took that bet to the tune of billions of dollars. When the higher rates kicked in and the market collapsed, the investment banks were bust and had to appeal to the government for bailouts to pay the wealthy hedge fund investors.
This was probably the biggest, fastest, direct transfer of wealth from the pockets of the middle and working classes into the bank accounts of the wealthy in history.
Were there no bank employees of conscience? You ask. Yes, there were — and several. But the government ignored them all. Actually, it did much worse and helped the banks to cover up the fraud — as did any of the economists of influence who wrote about the banking crisis. That’s why you won’t see this analysis up front on Wikipedia or in any publication by an academic economist.
Who were the whistleblowers, which government departments ignored them and which government departments helped to cover up the fraud so skillfully — next blog.
One last comment:
The truly surprising thing is that these ninja borrowers could actually make the payments at 3%. Thus, the solution was really very simple. Direct the banks that they had to keep the 3% rate until the Federal Bank rate exceeded that amount (it still hasn’t). These people would’ve kept their houses, the wealthy investors would have gotten today’s rate, there may have been a slight housing market correction, there would not have been the need for a bailout.