Origins of the Subprime Scandal

If there's a word that is universally invoked in the world of finance, it’s “transparency.” The word comes to us from the 16th century with the connotation of “shining through,” The idea is simple. Transparency is about being able to see what is going on and to have key practices disclosed. Without that, it is believed, financial markets can’t function because of a lack of trust and clear rules that all the players adhere to. It is a market fundamental, a primary rule of principle.

Or so you would think.

When it began, subprime lending was even not a term that most people outside the financial markets understood. (By 2007, the American Dialect Society would call it the most used term of the year.) The Wikipedia would describe it this way:

Subprime lending, also called B-paper, near-prime, or second chance lending, is the practice of making loans to borrowers who do not qualify for the best market interest rates because of their deficient credit history. The phrase also refers to paper taken on property that cannot be sold on the primary market, including loans on certain types of investment properties and certain types of self-employed individuals. Subprime lending is risky for both lenders and borrowers due to the combination of high interest rates, poor credit history, and adverse financial situations usually associated with subprime applicants.

In early February 2008, almost a decade after the birth of what would become the subprime industry, the Securities and Exchange Commission, the nominal regulators of financial markets, found the courage to admit that they didn’t really know what was going on in their multi-billion-dollar securities market.

They announced an investigation.

One of their “enforcers” explained: “The big question is, who knew what when, and what did they disclose to the marketplace?” These were the words of Cheryl Scarboro, an associate director in the SEC’s enforcement division in charge of the subprime working group. This working group, composed of one hundred lawyers, which seems to have only begun working after the scandal erupted, is investigating how banks, credit rating firms, and lenders valued and disclosed complex mortgage-backed securities.

Reuters reported they were looking into three areas: “the securitization process, the origination process nd the retail area. Insider trading, which is one of the SEC’s highest priorities, is also a key area.”

Bear in mind that they are not operating in the interests of borrowers who were victimized by deceptive loans, but inquiring whether shareholders – i.e., investors – were kept in the dark through inadequate disclosures.

Their scope is narrow: “We do have to work very hard at bringing the right cases,” says SEC enforcement division chief Linda Chatman Thomsen. “We work on the most ‘impactful’ cases.... At the end of the day we have to be about deterrence.”

Deterrence? That was a concept born in the nuclear age to prevent/deter war. How it’s relevant after the collapse of the industry itself was not addressed. What is there now to deter?

This SEC group was reportedly “talking with” but not coordinating with oversight bodies like the Federal Reserve, Federal Deposit Insurance Corporation, Office of the Comptroller of the Currency, and Office of Thrift Supervision. Is it significant that the FBI, which also announced its own investigation into criminal conduct by mortgage firms, is not on this list!

If the regulators who should be in the know about these practices are not, it’s not surprising that most of the media and the public share this plight.

The whole area is murky. Even George Miller, the Executive Director of the industry’s own trade association and lobby group the American Securitization Forum, told CNBC as this investigation was announced that one of the reforms his organization was advocating was “taking steps to enhance where necessary the transparency in the marketplace.” Note the qualifying phrase “where necessary.”

While reporting from the Forum’s meeting in Las Vegas, CNBC’s correspondent joked they had “gambled away our economy.” Ha, ha. The Forum has not always been a joke. When the Treasury Department announced, with great fanfare, a program to help distressed homeowners in December 2007, it was widely reported that this industry group had actually written it. The plan offered no help to
families facing foreclosure.

They also played a very powerful role in holding off government scrutiny. They were the influential behind-the-scenes player rationalizing the industry and its exotic derivative financial instruments. Their website, which lists their impressive membership list of big banks and funds, describes its work this way: “The American Securitization Forum (ASF) is a broadly-based professional forum through which participants in the U.S. securitization market can advocate their common interests on important legal, regulatory and market practice issues.”

According to the New York Times, the Forum’s Las Vegas Meeting could be considered a “predator’s ball.” The newspaper did not remind readers that 16 years earlier this same phraseology was used widely about an earlier scandal on Wall Street. This account was published on August 15, 1991:

They call it the Creditors’ Ball: a hundred or so bankruptcy lawyers, bankers and investors, sipping cocktails and feasting on shrimp in the Hamptons in an unabashed celebration of the impoverished 1990’s.

This party of the well-paid, the well-connected, and the well-coiffed is quickly becoming the social event of the bankruptcy set, just as the Predators’ Ball was a highlight of Wall Street’s social calendar. That Beverly Hills extravaganza, sponsored by Drexel Burnham Lambert Inc., ended with the brokerage’s downfall in 1990.

So much for lessons being learned.

THE IMPORTANCE OF DISCLOSURE

At least now, the industry’s public face and the regulators have come around to agreeing with a growing army of critics that inadequate disclosure was at the root of the problem, i.e., a lack of transparency.

And not only in the housing industry!

Well-known banks had also been admitting a little, while hiding a lot. When the finance ministers from the Group of the 7 top industrialized countries met in Tokyo on February 9, 2008, they issued a call to banks to fully disclose their losses from the subprime meltdown. The German Minister Peer Steinbruck said that these write-offs could reach a whopping $400 billion, four times previous estimates.

It must be noted that just a month earlier, in late December, Wall Street firms paid out more record bonuses to the bankers who had made them a vast fortune.

Why the secrecy, why the lack of disclosure?

A top-level corporate reputation consultant, who asked to remain anonymous but who has worked on the issue, summed it up for me in one word: greed. “They were making so much money that they didn’t have time for due diligence or transparency. It was just pouring in.”

Yet, oddly enough, one of the industry’s big traders was still not remorseful. “We need to step back and take a breather,” John Devaney told the New York Times. “I don’t think there is anything fundamentally wrong.”

No one asked him about the findings of the Senate’s Joint Economic Committee:

Approximately $71 billion in housing wealth will be directly destroyed through the process of foreclosures.

States and local governments will lose more than $917 million in property tax revenue as a result of the destruction of housing wealth caused by subprime foreclosures.

No one thought about that at the beginning of the subprime boom either.