All the Devils Are Here

By Bethany McLean and Joe Nocera

You can follow all the steps to catastrophe. There was a steady rise in the price of real estate, leading to a bubble. Many mortgages were taken out by people who couldn’t pay them, on properties that had been overvalued. These mortgages were junk, but were bundled together with other debts and “securitized” (a way of trading the cash flow from the debt). This had the effect of camouflaging the risk, which was further disguised by delinquent rating agencies who graded the resulting debt as investment grade. Compounding things, as collapse became all the more apparent, the risk of default was insured against, several times over. When real estate prices began to fall, so did the dominoes.

Why did it happen? Wall Street is always looking for the latest fool-proof way to get rich quick. Regulations had helped protect the finance industry from itself for decades, but the regulatory system had been stripped by reforms brought in by both Republicans and Democrats. Once there was no longer any adult oversight, it became a mad dash for cash, with grossly unbalanced incentives. Win, and you won big. Lose and you cashed out, walking away and leaving the government with the bill.

We see this double-whammy of disabled regulation and perverse incentivization triggered several times in All the Devils Are Here, a workmanlike account of the mortgage crisis. We might think of these as moments of financial original sins. The first was the growth of the secondary mortgage market through the development of mortgage-backed securities. This led to a fundamental, and dangerous, disconnection because once a lender had sold a mortgage further down the security food chain that lender no longer had any stake in whether the mortgage was ever going to be paid off. Mortgage risk became hidden, leading one mortgage director to describe mortgages as the new “neutron bomb of financial products.” The end result was a situation where

no one in the chain, from broker to subprime originator to Wall Street, cared that the loans they were making and selling were likely to go bad. In truth, they were all taking on huge risks in granting these terrible loans. But they were all making too much money to see it. Everyone assumed that someone else would be left holding the bag.

A second original sin (to strain the metaphor) occurred when the ratings agencies abandoned the subscriber model of revenue to one where they charged the issuers of securities. This made good business sense but came with an obvious conflict of interest: the rating agencies being paid by the same people whose securities they were rating. Not surprisingly, indeed predictably, the ratings agencies became the great enablers of the disaster to come.

Notoriously, after the music stopped no one went to jail. This is the other half of the incentive problem. Not only was irresponsible risk rewarded, but improvidence was not punished. One might question the authors’ comment that Wall Street was “making too much money to see” the risk. That may have been the case, but it might also have been that the risk was seen but discounted. There was a sense of security, perversely reinforced by slapdash regulation. As one former Bush administration official puts it, “Bad regulation is much worse than no regulation because you create conditional expectations of safety.” Then there was the power of free market ideology, which attributed to markets a power of omniscience and ultimate efficiency. By definition, the market could not be wrong.

As things went to pot the incentives also inverted, as many players, big and small, began betting against the system (or for the system to fail). This is the story told in The Big Short, among other accounts. It is also the area of murkiest legality, as Wall Street was knowingly involved in selling products that it knew were worthless and that it was actively betting against. Some people became very rich off of the big short. Others . . . became very rich. Meanwhile, the men at the top made out like bankers. Stan O’Neal, CEO of Merrill Lynch, walked away with $161 million in retirement benefits and Merrill stock “feeling at once embittered, embarrassed, and frustrated.” He blamed others, naturally. Angelo Mozilo, CEO of Countrywide Financial and dubbed by TIME magazine one of the “25 People to Blame for the Financial Crisis,” and by Condé Nast Portfolio ranked second on a list of “Worst American CEOs of All Time” received over $400 million in total compensation during the period leading up the collapse. He later settled with the SEC for a $67.5 million fine, $20 million of which was paid by Countrywide as part of an indemnification agreement.

As McLean and Nocera point out, the chances of criminal prosecution were always slim: “Much of what took place during the crisis was immoral, unjust, craven, delusional behaviour — but it wasn’t criminal.” And even if it were, the expense and difficulty of bringing a case against any of the big names was prohibitive. The banks were too big to fail, their officers too big (or at least too well insulated) to jail. And so in the wake of the crisis little changed. To some extent, the crisis itself had been business as usual. It will happen again.

Review first published online April 10, 2016. For some other takes on the mortgage crisis, see my reviews of John Lanchester’s I.O.U. and Charles Ferguson’s Predator Nation.