The Real Cause Of The Crisis

I have always believed that housing was only a manifestation of the real problems with the capital markets. Subprime mortgages is just the easy thing for politicians and reporters to talk about because they have no understanding of what really went on. Now 60 Minutes is trying to claim it was all caused by CDS on home mortgages which they try to claim is just like illegal gambling. The reality is there were much bigger and worldwide things going on which all coalesced to create a massive bubble.

Following the recession of 2001-2, the whole world seems to have gone on a debt binge the likes of which the world has never seen. It was not just US residential and subprime paper, it was everything. Iceland decided to become a hedge fund and loaned money or invested in assets all over the world with no expertise in Iceland to know anything at all about what they were doing. The head of their central bank was a poet by training. The finance minister was a veterinarian. The Spaniards built enough housing for two or three generations. The PIIGS ramped up entitlement programs to a degree that makes the US entitlement crisis look moderate. Leveraged loans were increased to levels sufficient to buy almost any company. Through all of this there was a sense that, we can sell the paper so let’s do it. Sound finance and underwriting was tossed aside, and by 2007, there was absolutely no discipline left anywhere. It was as though everyone knew they were going to die soon, so why not party like hell into the night. It was a massive bacchanal.

Despite Greenspan claiming only five people knew what was happening and saw it coming, that is either his attempt to excuse his own ignorance or his own failure. I knew many senior people in the capital markets that knew exactly what was happening, and as early as 2005 were predicting the eventual collapse. Paulson is not the only guy who got wealthy by correctly predicting the collapse. The end just took longer than most of us grey-haired guys ever thought possible. I even heard various experienced bankers say at conferences in 2005 and 2006, that the end was near, but nobody wanted to listen so long as the bonus pools kept growing. Two of my friends, who were very senior in the CMBS world, said it best. One ran CMBS for a major bank, and when I asked in early 2007-“what are you doing, surely you know better”- he responded that the chairman wants him to grow the revenue, so he was doing that. The other one I asked after the collapse, why he made a specific loan which I had intimate knowledge of and had refused to work on. His response- “I had it sold, so I made the loan”. None of this had anything at all to do with subprime or residential or CDS. It had to do with just pumping out more CMBS and other garbage paper, and growing the volume. Clearly the Greeks felt they could lie about their balance sheet and cash flows, and the Italians and the Spaniards felt they could just keep the game going because they thought they were sort of sizable countries and investors and the European banks would just keep buying their low quality paper. Dick Fuld thought leveraging 33-1, and then creating misleading financials at quarter end would somehow work out OK. Although CDS probably accelerated the size of the collapse, it was again, a manifestation, and not the cause.

One fair question is, who or what was one of the real triggers, and where did subprime play in all of this. The answer is Barney Frank. In 2002, when John Snow stated in a hearing that Fannie and Freddie needed major reform, Barney flat out refused. When Franklin Raines cooked the books at Fannie, Barney covered for him and refused any effort to prosecute for securities fraud. It is instructive that the guy who really cooked the books walked away with a huge bonus, but Daniel Mudd is charged with non-disclosure when, in fact, he provided an enormous amount of detailed disclosure. Once Wall St and the residential brokers in Vegas, Phoenix, Florida and California saw there was no end to what could be done with subprime and securitization, and Barney was demanding through CRA, that banks were threatened with very bad consequences if they did not make more bad loans in neighborhoods where large numbers of residents could not afford home ownership, then the game was on. With low rates from Greenspan, who claims he had no idea what was happening, then it was easy to move from residential, to commercial, to leveraged loans and onward to sovereign debt. While Barney Frank was likely the arsonist to put the match to much of it, the fire spread to all areas of the world, and all types of debt instruments and derivatives. The cause of the collapse was worldwide hubris and a wealth creation system which got out of control everywhere. Nobody made homeowners use their houses as a piggy bank. It was a massive failure of risk management at all levels that caused underwriting to essentially become non existent for CMBS. Nobody made the European banks buy all that crappy paper. Greece chose knowingly that it lied to get into the Euro. Lehman was simply what had to happen to bring an end to the insanity. If it had not been Lehman, it would have been Merrill, or Countrywide, or AIG, or someone else. There was no way to save Lehman, and Paulson did not tank it just to help Goldman. That is a ridiculous assumption that he blew up the world financial markets to help his former firm. Likewise, the populist message that the TARP bailouts were only to save Wall St and the fat cats, is equally an ignorant statement, and simply demonstrates the gross lack of understanding even now of what was really happening. Had it not been for TARP and all of the other emergency programs from Treasury and the Fed at that moment, we would have had a complete collapse of the entire system.

It was a confluence of many things in various parts of the world. Low rates, less regulation, massive greed, excessive bonuses, US subprime, Greece wanting to keep the people happy with more and more entitlements and wanting to play like a grown up and join the Eurozone. Germany went along because the Euro was the driver of German exports. Meantime all of the banks around the world saw all of this fee generation and securitization and lending as the road to riches, and everyone piled in. Borrowers seeing the desperate drive for more and more volume from lenders, took advantage and bid everyone against everyone else to drive up proceeds, drive down rates and get off bad boy carve outs. In time it just became a feeding frenzy that was unsustainable and insane. The tulip and South Sea bubbles had nothing on this bubble frenzy. It was the exact same suspension of reality in favor of greed. There were very few who stepped back and said no, I do not want to get on the train, it is headed for the cliff. As my friend running CMBS at the major bank said- If I did what I knew was good fundamental underwriting, I would be fired for not building volume, and so I built volume while trying to keep some semblance of underwriting. At firms like Lehman and Bear, there was simply the drive for all out volume and profit, even at the expense of reality. A lot of very smart guys forgot the basics throughout the world. A few people saw the cliff and made huge fortunes from the impending crash. Now Congress wants to castigate people like Goldman for taking correct actions to mitigate their losses.

So now we get Dodd Frank and the Obama administration blaming the banks for the irresponsible behavior of borrowers and using the banks as the way to shift the blame from the politicians who were at the genesis of the issue. As usual, Congress has no idea what happens in the capital markets or the private sector and so they passed a law which has a few good aspects, but a lot of bad or unworkable aspects. All of the homeowners who really need help are the losers because now very few can get mortgages even with a decent credit record. Why would any bank reach to make a mortgage that was not perfect in every respect. The economy is stagnant because of all the uncertainty caused by the politicians and by all of the irresponsible actions of governments around the world. The Europeans tried to blame the US subprime as the cause of the crash, but they refuse to acknowledge their own disgraceful behavior on sovereign debt. The most ironic part is that Obama has now made the US deficit an out of control repeat of the capital markets mess, and he, Pelosi and Reid refuse to act responsibly-just like happened by the people they vilify. The Republicans who scream for deficit reduction and responsible legislation are called radicals who don’t know how to compromise. The Europeans can’t bite the bullet and do what is needed. The really scary part is the US is actually headed for a very bad crash if something is not done. What started with a few home mortgages has escalated to the US economy and credit being at risk.

What really happened was the entire world went on a giant binge and it ended as it always has, very disastrously. In the end the turtle wins. Rogoff was right. It is never different.

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Joel Ross began his career in Wall St as an investment banker in 1965, handling corporate advisory matters for a variety of clients. During the seventies he was CEO of North American operations for a UK based conglomerate, and sat on the parent company board. In 1981, he began his own firm handling leveraged buyouts, investment banking and real estate financing. In 1984 Ross began providing investment banking services and arranging financing for real estate transactions with his own firm, Ross Properties, Inc. In 1993 Ross and a partner, Lexington Mortgage, created the first Wall St hotel CMBS program in conjunction with Nomura. They went on to develop a similar CMBS program for another major Wall St investment bank and for five leading hotel companies. Lexington, in partnership with Mr. Ross established a hotel mortgage bank table funded by an investment bank, and making all CMBS hotel loans on their behalf. In 1999 he formed Citadel Realty Advisors as a successor to Ross Properties Corp., focusing on real estate investment banking in the US, UK and Paris. He has closed over $3.0 billion of financings for office, hotel, retail, land and multifamily projects. Ross is also a founder of Market Street Investors, a brownfield land development company, and has been involved in the acquisition of notes on defaulted loans and various REO assets in conjunction with several major investors. Ross was an adjunct professor in the graduate program at the NYU Hotel School. He is a member of Urban Land Institute and was a member of the leadership of his ULI council. In 1999, he conceived and co-authored with PricewaterhouseCoopers, the Hotel Mortgage Performance Report, a major study of hotel mortgage default rates.