Reckless Endangerment and the Mortgage Crisis Narrative

by devteam August 3rd, 2011 | Share

Originally published in the August 2011 issue of Asset Securitization Report ( </p

Irnrecently completed the book RecklessrnEndangerment, a widely discussed and heavily promoted perspective on thernmortgage and financial crisis. While the book is quite interesting andrnilluminating at times, it is a poorly written, incomplete and flawed analysisrnof recent events.</p

Thernbook’s strength is its description of how the fixation on affordable housingrnwas allowed to morph into a goal that eclipsed other issues such as loanrnquality and institutional safety and soundness. It also describes how FanniernMae, Freddie Mac and the lending industry exploited this to dominate housingrnfinance and, for many years, defeat all attempts to circumscribe theirrnactivities.  (Full disclosure: I workedrnfor Countrywide Securities from 1996 to 2008.)</p

However,rnI thought the book was the weakest of the works I’ve read on the activities andrnevents leading to the mortgage and MBS collapse. The writing is poor; itsrnannoying and condescending tone is combined with an inability to explainrnrelatively simple concepts without indulging in caricatures.  While it’s common for writing to be tailoredrnto a non-technical audience, describing the Glass-Steagall Act as a measurernthat “protected consumers and individual investors from rapacious bankers” isrnludicrous. (As the authors must surely know, it essentially protected one setrnof bankers from another.)  It also has arnstrange pace, as if the authors were rushing to meet a deadline. One of thernbook’s better sections discussed the GSEs’ accounting scandals in depth, whilernthe subsequent events leading to their being placed into conservatorship wererncrammed into a few paragraphs.</p

Thernauthors are clearly trying to stoke anger and outrage at the various playersrnthat they view as being responsible for the financial crisis. However, theirrnarguments and credibility are undermined by a large number of errors andrnmisconceptions that betray a limited grasp of the mortgage market andrnsecuritization practices.  Among thesernmistakes:</p<ul class="unIndentedList"<liThey repeatedly confuse different types of loanrnproducts. They describe the subprime market as the issuance of "nonconforming"rnloans, although huge amounts of non-agency securities backed by prime loansrnwere issued over the same period of time. They also incorrectly categorize allrnadjustable-rate loans as subprime in nature, with interest rates "…that adjustrnto sky-high levels in a few years." Inrnfact, the bulk of ARMs issued during the period were prime hybrid ARMs with 225-basis-pointrngross margins, and many prime ARM borrowers have recently seen their ratesrndecline. (Only subprime products hadrngross margins in the 400-700 basis point area.)</li<liThey write that the rating agencies defendedrnthemselves from legal liability by arguing for First Amendment protection. ("A more important defense was theirrninsistence that investment ratings were simply opinions. This meant that thernagencies should be shielded from lawsuits just as a journalist's views arernprotected by the First Amendment.") Inrnfact, the rating agencies had an exemption from liability that was included inrnthe Securities Act of 1933. Moreover,rnthe removal of this protection by the Dodd-Frank Act has hindered the recoveryrnof the non-agency MBS market, since the rating agencies subsequently stoppedrnallowing their ratings to be included in deal documents. (The SEC has issued arnseries of no-action letters that allow non-mortgage ABS to be issued withoutrnratings.) </li<liTheir statement that by 2002 "the vast majorityrnof mortgages were cash-out refinancings" is incorrect. The majority of refinancings involved taking out cash, according to industryrnfigures.</li<liThe authors follow a discussion of affordabilityrnproducts such as interest-only and negative amortization loans (which theyrncorrectly pinpoint as a major factor in skyrocketing home prices) byrnincorrectly asserting that "(b)y creating these loans…, Wall Street's bankersrnhad allowed institutions extending credit to consumers in the form of a secondrnmortgage to share in the collateral backing all the loans without asking forrnpermission from lenders…" These twornissues are completely unrelated. Theyrnalso assert that bankers "were careful to bundle them with more traditionalrnmortgages in the securities they were selling to investors." While interest-only and amortizing loans wererntypically securitized together, option ARMs were securitized in separaterntransactions.</li<liThey claim that "by the summer of 2005, almostrn40% of subprime mortgage originations were for amounts exceeding the value ofrnthe underlying properties." In fact, thernmarket for loans with original LTVs greater than 100% was very small.</li<liMore than once, the authors state thatrn"prevailing rates" were at 1% in 2003, leaving "little room for furtherrndeclines." While short interest ratesrn(i.e., Fed Funds and LIBOR) were at or around 1% at that time, mortgage ratesrnwere much higher – the lowest rate for the Freddie Mac survey rate in 2003 wasrnaround 5.25% in June.</li</ul

In addition, thernbook makes a number of dubious and unsupported claims.  For example, the authors state thatrn”(b)orrowers who could prove that their incomes and assets were ample werernpushed into more expensive loans that required no documentation…These and otherrntricks hurt borrowers.”  Without somernelaboration, this contention is highly questionable:  Why would rational borrowers takernunnecessarily expensive loans?</p

Thernapparently weak and unsophisticated understanding of market practices exhibitedrnby the authors also contributes to one of the book’s glaring deficiencies -rntheir unwillingness to examine critical issues in anything but superficialrnterms.  For example, they write thatrninvestors bought securities backed by subprime loans (in this case, originatedrnby Fremont)rn”because they offered a higher income stream than more conservative mortgagesrnbacked by Fannie Mae or Freddie Mac.” rnThis statement overlooks the fact that the largest tranches in subprimerndeals (about 75%, in most cases) were generally LIBOR-based floaters with resetrnmargins of 20-25 basis points.  (Thernlarge amounts of interest thrown off by the loans were primarily utilized asrncredit support for the senior bonds. rnOnly the more junior tranches and interests in subprime ABS receivedrnrelatively large income streams.)  Thisrnbegs a series of questions, the most important of which is why large numbers ofrninstitutional investors found the senior securities attractive and continued tornpurchase them even as collateral performance noticeably weakened in 2006.  (An ABS trader once told me that he was askedrnthe same two questions at every client meeting:  1) “When’s your next deal?” and 2) “How can Irnget my full allocation?”)  The notionrnthat ostensibly sophisticated investors were simply “stuffed” with securities,rnas the book relates, is at best highly simplistic and ignores the differentrnclienteles that were active in the MBS market.</p

There are numerousrnother examples of the book’s superficial treatment of complex issues.  For example, what were the actualrnramifications of the repeal of Glass-Steagall on the financial system?  (I’d argue that it ratified a reality thatrnhad evolved over the previous 20 years.) rnIs the securitization process itself inherently corrupt?  Can it be policed successfully, and how?  Anyone seeking an intelligent discussion ofrnthese issues will need to look elsewhere.</p

Finally, the authorsrnare unwilling or unable to forthrightly address the roles that borrowers andrnhome buyers played in the mortgage debacle. rnThese actions included massive amounts of speculation on real estate,rnincome misrepresentation, overleveraging (through both the cash-outrnrefinancings cited by the authors and loans taken with absurdly high DTIs), andrnthe pervasive mishandling of personal finances. rnEconomists and financial advisors have been warning for decades aboutrnAmericans’ low savings rate, dependence on debt, and irrational activitiesrn(such as utilization of expensive credit card debt).  Unfortunately, Americans have exhibited arnshort-sighted propensity to buy the things they want (whether they are housesrnor consumer items such as cars and vacations) whether or not they canrnrealistically afford them.</p

An alternative tornthe look-what-those-evil-people-did-to-us narrative advanced by books like Reckless Endangerment is to view thernmortgage debacle as an economic disaster that resulted when the home financingrnindustry (which includes both lenders and Wall Street firms) figured out how tornmake enormous amounts of money by helping borrowers carry over their dangerousrnfinancial practices into their residential real estate under the guise ofrnexpanding home ownership opportunities. rnHowever, the exceedingly complex web of activities leading to thernmortgage crisis defies any single explanation.</p

Booksrnsuch as Reckless Endangerment</irepresent the zenith of the finger-pointing game that, in my mind, is dangerousrnand delusional.  At this point, the rightrnapproach is to work toward restructuring and rehabilitating the mortgage andrnhousing markets.  A good first step wouldrnbe to implement Dodd-Frank without destroying the mortgage market, as thernrecent interagency proposals on risk retention would do.

All Content Copyright © 2003 – 2009 Brown House Media, Inc. All Rights Reserved.nReproduction in any form without permission of is prohibited.

About the Author


Steven A Feinberg (@CPAsteve) of Appletree Business Services LLC, is a PASBA member accountant located in Londonderry, New Hampshire.

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