Commentary: The mega-banks behind the meltdown

Introduction

There is something of a myth surrounding the current economic crisis, how it unfolded, and the precise role of the world’s largest financial institutions in the global meltdown. That myth suggests these banks and investment houses were somehow surprised “victims” of unscrupulous subprime mortgage lenders, and that they could not have anticipated the damaging toxic assets that have so infected their balance sheets.

What’s missing from this story is the fact that this was a self-inflicted wound for which the rest of us are picking up a massive tab. The largest American and European banks and investment houses were not the unwitting “victims” of an unforeseen financial collapse, as they have so often been portrayed. The mega-banks not only invested in subprime lending institutions — they were the enablers, bankrollers, and instigators driving high-interest lending, and they did so because it was so lucrative and unregulated.

Worse, in many instances these are the same financial institutions the government is now bailing out with tax revenues. How these bottomed-out banks helped cause the financial meltdown can be clearly seen in a new study by the Center for Public Integrity. The Center ran a computer analysis of every high-interest loan reported by the industry to the U.S. government from 2005 through 2007, a period that marks the peak and collapse of the subprime market. From this pool of 7.2 million loans, our investigators identified the top subprime lenders. The “Subprime 25” were responsible for nearly a trillion dollars of subprime lending, or 72 percent of all reported high interest loans.

The “Subprime 25”, which are mostly no longer in business, were largely non-bank retail lenders that needed outside financing to make their subprime loans. So where did that financing come from? The Center’s study found that at least 21 of these Subprime 25 lenders were either owned outright by the biggest banks or former investment houses, or had their subprime lending hugely financed by those banks, either directly or through lines of credit. In other words, the largest American and European banks made the bubble in subprime lending possible by financing it on the front end, so they could reap the huge rewards from securitizing and selling mortgage-backed securities on the back end. The demand was insatiable, and the backing excessive. Between 2000 and 2007, underwriters of subprime mortgage-backed securities — primarily Wall Street and European investment banks — poured $2.1 trillion into the business, according to data from trade publication Inside Mortgage Finance.

Did these major financial institutions not understand what kind of lending was taking place? The poor quality of these loans was no secret. Many of these subprime lenders, the Center found, were forced to pay billions of dollars to settle government charges of abusive or predatory lending practices. This was a period of some of the worst mortgage lending in American history, in which regulators were nowhere to be seen, and normal income documentation and loan standards were thrown out the window. In many cases, though, the big banks really didn’t care if the loans were bad. That’s because they’d bought “insurance” against them — those infamous “credit default swaps.” The swaps sounded good, except they were unregulated, and those selling them — like American International Group Inc. — didn’t have to maintain reserves to guard against unforeseen losses.

It was all a house of cards, and some tried to sound the alarm. A look at the historical record shows that Washington was warned repeatedly over the last decade — by consumer advocates and a handful of regulators and lawmakers — that these high-cost loans represented a systemic risk to the economy. It is hard to believe the major banks were unaware of what was going on, or what the consequences might ultimately be.

A typical warning came from William Brennan, an attorney with the Atlanta Legal Aid Society. Brennan had watched as subprime lenders earned enormous profits making mortgages to people who clearly couldn’t afford them. The loans were bad for borrowers — Brennan knew that. He also knew the loans were bad for the Wall Street investors who invested in these loans, and then bought the shaky mortgages by the millions. “I think this house of cards may tumble some day, and it will mean great losses for the investors who own stock in those companies,” Brennan told a Senate committee. That was in 1998. Many other unheeded warnings followed.

Despite such warnings, Congress, the White House, and the Federal Reserve all dithered while the subprime disaster spread. Long forgotten congressional hearings and oversight reports, as well as interviews with former officials, reveal a troubling history of missed opportunities, thwarted regulations, and abject lack of oversight. Instead, the financial industry supported more deregulation, along with an extraordinary disregard for the damage being done. This was accompanied by millions of dollars in political contributions to leading lawmakers of both parties from the same financial industry that is in such trouble today.

The truth is these mega-banks invested trillions, made billions, and took risks with their eyes wide open. Now, because they are deemed “too big to fail,” they need trillions in government bailouts and guarantees to solve problems they helped create. But let’s look at it another way: perhaps these mega-banks are simply “too politically connected to fail.” Their unbridled political contributions and massive lobbying created the lack of regulation and oversight that led to this crisis. Where is the accountability — of management and boards, of auditors and regulators — for what has happened? It is time to set aside the myth of the mega-bank as victim.