A Colossal Failure of Common Sense

I couldn't get Lawrence McDonald's book about the demise of Lehman Brothers out of my mind, so I went back and re-read some parts. McDonald cites the starting point of "America's living in a false economy" as the Greenspan Fed's "free money" that was issued in "defiance of the natural laws of the universe." This is not from a metaphysicist, but from a hugely successful Wall Street trader. As he notes in June 2003, Greenspan pushed rates down to 1%, and this was the beginning of the bubble's rapid inflation.

McDonald writes vividly about the Stockton, California market, east of San Francisco. This area was a market that originated the NINJA ("No Income, No Job") mortgage. "Body builders," working with the home builders generated annual incomes of $300-$600,000 selling mortgages to financially unsophisticated and sometimes illiterate customers. Some of the mortgages were for 110% of the inflated, appraised value, and so the buyer was actually "paid" to take on the mortgage. These instruments went to more traditional, middle class buyers and their workout stories are now turning up in California newspapers. As buyers flocked to Stockton, its population increased by 5,000 per year from 2000-2005, all driven by real estate speculation.

New Century Financial was the largest sub-prime mortgage lender in the United States by 2007. Between 2003-2004, it was one of the fastest growing companies in the United States and listed on the New York Stock Exchange. By 2006, it was clear that the residential mortgage market was turning sour. Congress called for hearings. At one of the hearings, the hapless, inept head of the SEC, Christopher Cox (Harvard MBA and Harvard Law), assured Congress that all was well with corporate governance, financial reporting, and corporate disclosures. How could the head of the most powerful securities regulation body in the world be so clueless? How did he neuter all the internal analytical capabilities and any dissent in his own organization?

Meanwhile, Lehman's distressed debt trading desk, and with the foundation provided by analysts like Christine Daley, aggressively shorted paper issued by players like New Century and made tens of millions. They did it by just looking at public documents, and by asking the penetrating questions! Ironically, in the post-mortem on the New Century bankruptcy, the Delaware Court special examiner wrote, "(New Century's auditor) contributed to these accounting and financial reporting deficiencies by enabling them to persist and, in some instances, precipitated the company's departure from applicable accounting standards."

The culture and internal safeguards of a Big 4 auditing firm had failed once again, just as it had when Arthur Andersen was blessing the voodoo accounting at Enron. In fact, the failures during this crisis have been across the board. Start at the top with the Federal Reserve and its abandonment of rational monetary policy and its failure to supervise bank lending and capitalization. Move down to the boards, analysts, auditors, attorneys, rating agencies, appraisers, real estate agents and no one said "No, I am not going to approve this document or this way of doing business." As Charles Prince said, "As long as the music's playing, I've got to dance." The problem started when the music stopped, and we are all living with the aftermath, for which no one is accountable.

The problem now is that there is no natural constituency for meaningful, fundamental reform. If there were, the first step would have been to hold people accountable. CPA's who blessed the bogus statements of players like Countrywide and New Century are still practicing their craft. The armies that put together and sold the securitizations that went radioactive are probably looking into securitizing payday loans. The body builder salesmen are probably back in the gym, which they probably own. We are now off tackling the window dressing issues, like "say on pay."

Unfortunately, our markets are built to have these kinds of cataclysmic events and now that the surviving global financial investment banking industry is more concentrated and needs to generate bigger profits to feed the machine, we have to see which market will produce the next bubble.