There’s a 1998 Brookings book by Bob Litan and Jonathan Rauch, American Finance for the 21st Century. Originally prepared as a report to Congress by the Treasury Department, it provides the arguments that were used as the justification for the repeal of Glass-Steagall. I think it’s a great document for how Washington people saw the remaining parts of the New Deal-era financial regulatory architecture going into the housing bubble:
To use a transportation analogy, the twentieth-century model of financial policy has, for the most part, set a slow speed limit, specified a few basic models for cars, separated different kinds of cars into different lanes, and demanded that no one leave home without a full tank of gas and a tune-up. Better suited for the mercurial financial world now emerging is a model that, while not abandoning all that went before, focuses less on preventing mishaps and more on ensuring that an accident at any one intersection will not paralyze traffic everywhere else.
Those two focuses, preventing fraud (mishaps) and contagion (paralyzed traffic) is exactly what the financial system and regulators turned out to be worst at in the 2000s.
What kind of new cars were going to hit the road? There’s one company that gets particular attention, GE.
In the recent past, for example, newcomers in the credit business, such as GE Capital and GMAC, were offshoots of manufacturing companies that discovered-learning, in effect, by doing-that they could see credit as profitably as could the traditional providers. Tomorrow’s companies “spinning” in to financial services will be drawn from the sectors holding the keys to the information revolution: software and communications.
Another key they held was the ability to destroy the careers of internal people flagging fraud and abuse. It paid to be outside the formal regulatory architecture and also outside the informal ethics network put them in a place where anything went.
The excellent financial reporter Michael Hudson, author of the book The Monster: How a Gang of Predatory Lenders and Wall Street Bankers Fleeced America–and Spawned a Global Crisis, wrote a fantastic piece investigating fraud and abuse at WMC, the subprime mortgage wing GE purchased. GE Capital (and its bailout) is a particular fascination of mine, so I was excited to read this piece. I wasn’t disappointed.
Here’s Fraud and folly: The untold story of General Electric’s subprime debacle. Here’s an excerpt:
Dave Riedel, a former compliance manager at WMC, says sales reps intent on putting up big numbers used falsified paperwork, bogus income documentation and other tricks to get loans approved and sold off to Wall Street investors…
Riedel, who worked as quality-control manager for the lender’s largest production division, claims that after he informed a GE official about fraud inside the lender, WMC’s management demoted him — reorganizing him out of his job, taking away his office and his staff and forcing him to sit at a desk for months without a job title…
Questions about WMC’s lending tactics were also raised by an academic study that looked at a pool of 5,610 loans the company had made around the country in 1998. By December 1999 almost 25 percent of the loans were facing foreclosure or were seriously delinquent — more than five times the rate for loans originated by other major subprime lenders, the study found….
He helped put together a presentation in May 2006 aimed at giving GE officials a sense of how serious WMC’s fraud problems were. Riedel says an audit of soured loans that investors had asked WMC to repurchase indicated that 78 percent of them had been fraudulent; nearly four out of five of the loan applications backing these mortgages had contained misrepresentations about borrowers’ incomes or employment.
By October 2007 — as Riedel had predicted — WMC Mortgage was effectively out of business, dead after having pumped out roughly $110 billion in subprime and “Alt-A” loans under GE’s watch, according to industry data tracker Inside Mortgage Finance…
A study by federal regulators, “Worst Ten in the Worst Ten,” found WMC’s loans accounted for the second-highest number of foreclosures on subprime and “Alt-A” mortgages in the nation’s 10 hardest-hit foreclosure hotspots, trailing only New Century Financial.
I do like happy endings – what happened to the person who put $110 billion dollars worth of poison into the capital markets?
WMC’s former CEO had a 30-acre ranch outside Los Angeles where she kept a dozen horses. She’d used some of the millions she’d earned at the lender, the magazine said, to start an independent record label, YMA Music Group, which signed such artists as former Limp Bizkit guitarist Wes Borland. She’d also become CEO of Vantium Capital, a private equity fund that planned to make money off distressed mortgages.
Make the disease, sell the cure. Brilliant. A crucial question: how would this person, or anyone in the article, do anything differently if they had to repeat it all? The only exception would be the fraud whistleblowers, who wouldn’t even flag what they saw as they would know it would destroy their careers.
I recommend reading the whole article, but expect to wonder why nobody has gone to jail.