Here are the money quotes:
Wall Street’s use of the synthetic CDO—an investment device used to bet that mortgage bonds would perform and that Americans would keep paying their house payments—proved to be a weapon of mass destruction for our financial system. But no exotic CDO bet caused any Americans to quit paying their bills. Wall Street’s error was not in causing Americans on Main Street to stop paying their bills, but in making the wrong bet as to whether or not they would.And here's the gist of it in context:
In October of 2009, I sat in the thirty-fifth floor conference room in the Fifth Avenue offices of one of the premier credit hedge funds in the industry. As I talked to the portfolio manager about the crazy twelve months we had just experienced, he said one of the most chilling things I have ever heard. “We had a financial crisis, David,” he said to me, “because 10 percent of the society had no conscience. The financial crisis only ended because it proved to be 10 percent and not 20 percent.” The implication was clear. Ten percent of the population walking away from responsibility was enough to cause the crisis. We managed to barely emerge from the other side at 10 percent. Had the number been 20 percent, we would not have been so lucky.
Society’s collective response thus far has been a sort of convoluted blame game, divided almost entirely along political lines. Most on the Right have accurately but incompletely focused their attentions on the flaws of government housing policy. A subset has gone after Fannie Mae and Freddie Mac for their excesses. Another subset has focused on the broader social policy objectives so instrumental in driving the housing mania. Still another subset has focused on easy monetary policy that proved to be gasoline thrown on the housing crisis fire. None of them are wrong, per se; they just aren’t enough. They are an incomplete assessment of the big picture necessary for a crisis of this magnitude.
But the monster at the core is the same—envy. While one is of a more institutional variety (corporate envy in the halls of Lehman) and one is of a more retail variety (neighborhood envy of “keeping up with the Joneses”), both capture the root cause of the 2008 financial crisis in a word we don’t hear much anymore: covetousness.
The bubble-like behavior—while doused with kerosene by a reckless monetary policy, accelerated by a dangerous government housing agenda, enabled by a failed regulatory framework, and facilitated by a short-sighted and incompetent financial system—was still fundamentally at its root a byproduct of human irresponsibility in a culture of insufficient thrift and virtue.
You can think of the Main Street players as four unique actors: 1. The Swindled. These actors were the very poor and naïve who truly did not understand any part of what they were doing when they signed loan documents obligating them to payments they could not afford. In short, they were duped by predatory lenders. 2. The Reckless. These people irresponsibly encumbered themselves through mortgages or cash-out borrowing they could not afford. But they understood the risk associated and proceeded anyway, out of either the belief that continuously rising home prices would fix everything or out of callous disregard for consequences.
Gamblers. This group was financially capable and reasonably educated. They rolled the dice and speculated all the way. When they lost the bet, they recognized the economic convenience of a strategic default. They chose to walk away from their obligations with the presumption that there would be no negative consequences to their income or balance sheet. And they were right. 4. The Diligent. The final players were those who missed no payments in the financial crisis and, therefore, added no stress to the financial system. They faithfully made the payments they had promised to make. The Diligent bear no responsibility for the financial crisis for the obvious reason that they fulfilled (and continue to fulfill) their financial responsibilities. In an indirect way, however, they may deserve some criticism for being inadequately agitated at the Reckless and the Gamblers. The Diligent seem to lack an appreciation for just how unfair the actions of the other players really were. Instead, many have joined the chorus criticizing easy institutional targets of earlier chapters. But my desire for righteous indignation doesn’t address the culpability of the other Main Street players, so I focus on the remaining three.
The Swindled refers to those cases where any reasonable person would see the borrower as a victim—where there was paper switching, direct lying, exploitation of language deficiencies, mental incapacity, and so forth. Let’s acknowledge that rare and despicable incidents such as these took place, but at nowhere near the level required to fuel a financial crisis.
The sad reality is that predatory borrowing was a far more systemic problem than predatory lending. The fact is that 70 percent of defaulted loans had blatant misrepresentations on their mortgage applications.13 The FBI estimates that mortgage fraud (by borrowers) increased 1,000 percent from 2001 to 2007. In other words, borrowers frequently made false claims to get loans, yet why did that reality not become part of the postcrisis narrative? Why is “predatory lending” a commonly used term, whereas “predatory borrowing” is the odd contraption of a free market economist?
If we combined all predatory loans—cases where the lender perpetrated fraud against the borrower by deceiving him or her about the loan—and all cases of predatory borrowing—cases where the borrower perpetrated fraud against the lender—we still have only 25 percent of the total defaults in the financial crisis according to the Journal of Financial Economics.14 That means 75 percent of all defaults came from people who did legitimately qualify for a loan yet defaulted anyway—the Reckless and the Gamblers.
Gamblers are most likely to engender irritation and least likely to gain your sympathy. Some were extremely bad actors, confident they could speculate en masse, keeping 100 percent of any upside and passing along 100 percent of any downside to their lending institutions and, eventually, to the taxpayers.
An intelligent and financially capable borrower simply walked away from debt they could afford. This morally questionable activity was not rare. It was commonplace. And this activity did not have a minor financial impact. The Gamblers on Main Street were major actors in the financial crisis drama.
The national credit bureau Experian worked with the consulting outfit Oliver Wyman in late 2009 to conduct an analysis on these strategic defaults.15 The results were damning for the Gamblers. Using a sample of twenty-four million credit files, they found that borrowers with high credit scores were 50 percent more likely to strategically default, thus debunking the myth that it was less creditworthy and capable people struggling through the financial crisis.
The proof for the Gamblers’ existence on Main Street and their role in first creating and then exacerbating the financial crisis can be found in two empirical facts: 1. 41 percent of all mortgage defaults took place in California and Florida, states that mandated nonrecourse financing (meaning, the borrowers could not be held personally liable for a failure to perform on their mortgage loans). In fact, the vast majority of all mortgage defaults came in nonrecourse lending states. Are we to believe that the exact conditions blamed for the financial crisis somehow magically plagued these few states, with no correlation to the fact that these states allowed borrowers to walk away scot-free?
And there was a crisis of culture that exacerbated the crisis, walking away from obligations without concern for personal integrity or collective economic impact.