Wall Street’s Best Investment: Ten Deregulatory Steps to Financial Meltdown

By Robert Weissman and James Donahue

Wall Street has no one but itself to blame for the current financial crisis. Investment banks, hedge funds and commercial banks made reckless bets using borrowed money. They created and trafficked in exotic investment vehicles that even top Wall Street executives — not to mention firm directors — did not understand. They hid risky investments in off-balance-sheet vehicles or capitalized on their legal status to cloak investments altogether. They engaged in unconscionable predatory lending that offered huge profits for a time, but led to dire consequences when the loans proved unpayable. And they created, maintained and justified a housing bubble, the popping of which has thrown the United States and the world into a deep recession, resulted in a foreclosure epidemic ripping apart communities across the country, and caused the financial crisis itself.

But while Wall Street may not have anyone else to blame, and is culpable for the financial crisis and global recession, others do share responsibility.

For the last three decades, financial regulators, Congress and the executive branch have steadily pulled back the regulatory system that restrained the financial sector from acting on its own worst tendencies. The post-Depression regulatory system aimed to force disclosure of publicly relevant financial information; established limits on the use of leverage; drew bright lines between different kinds of financial activity and protected regulated commercial banking from investment bank-style risk taking; enforced meaningful limits on economic concentration, especially in the banking sector; provided meaningful consumer protections (including restrictions on usurious interest rates); and contained the financial sector so that it remained subordinate to the real economy. This hodge podge regulatory system was, of course, highly imperfect, including because it too often failed to deliver on its promises.

But it was not its imperfections that led to the erosion and collapse of that regulatory system. It was a concerted effort by Wall Street, steadily gaining momentum until it reached fever pitch in the late 1990s and continued right through the first half of 2008. Even now, Wall Street continues to defend many of its worst practices. Though it bows to the political reality that new regulation is coming, it aims to reduce the scope and importance of that regulation and, if possible, use the guise of regulation to further remove public controls over its operations.

This article documents 10 specific deregulatory steps (including failures to regulate and failures to enforce existing regulations) that enabled Wall Street to crash the financial system. Wall Street didn’t obtain these regulatory abeyances based on the force of its arguments. At every step, critics warned of the dangers of further deregulation. Their evidence-based claims could not offset the political and economic muscle of Wall Street. The financial sector showered campaign contributions on politicians from both parties, invested heavily in a legion of lobbyists [see “By the Numbers” on page 12], paid academics and think tanks to justify their preferred policy positions, and cultivated a pliant media — especially a cheerleading business media complex.

1. The Repeal of Glass-Steagall and the Rise of the Culture of Recklessness

Perhaps the signature deregulatory move of the last quarter century was the repeal of the 1933 Glass-Steagall Act and related legislation. The repeal removed the legal prohibition on combinations between commercial banks on the one hand, and investment banks and other financial services companies on the other. Glass-Steagall’s strict rules originated in the U.S. government’s response to the Depression and reflected the learned experience of the severe dangers to consumers and the overall financial system of permitting giant financial institutions to combine commercial banking with other financial operations.

Glass-Steagall protected depositors and prevented the banking system from taking on too much risk by defining industry structure: Commercial banks could not maintain investment banking or insurance affiliates (nor affiliates in non-financial commercial activity).

As banks eyed the higher profits in higher risk activity, however, they began to breach the regulatory walls between commercial banking and other financial services. Starting in the 1980s, responding to a steady drumbeat of requests, regulators began to weaken the strict prohibition on cross-ownership. In 1999, after a long industry campaign, Congress tore down the legal walls altogether. The Gramm-Leach-Bliley Act removed the remaining legal restrictions on combined banking and financial services, and ushered in the current hyper-deregulated era.

But the overwhelming direct damage inflicted by the Glass-Steagall repeal was the infusion of an investment bank culture into commercial banking. Commercial banks sought high returns in risky ventures and exotic financial instruments, with disastrous results.

The Pecora Hearings

Banking involves the collection of funds from depositors with the promise that the funds will be available when the depositor wishes to withdraw them. Banks do not simply keep deposits in their vaults, however. Rather, they keep only a specified fraction. They lend the rest out to borrowers or invest the deposits to generate more cash. Depositors depend on the bank’s stability, and communities and businesses depend on banks to provide credit on reasonable terms. The persistent lure of higher returns from riskier investments has required government regulation to protect the safety of depositors’ money and the well being of the banking system.

In the 19th and early 20th centuries, the Supreme Court prohibited commercial banks from engaging directly in securities activities, but bank affiliates — subsidiaries of a holding company that also owns banks — were not subject to the prohibition. As a result, commercial bank affiliates regularly traded customer deposits in the stock market, often investing in highly speculative activities and dubious companies and derivatives.

The 1932-1934 Pecora Hearings, held by the Senate Banking and Currency Committee and named after its chief counsel Ferdinand Pecora, investigated the causes of the 1929 stock market crash. The committee uncovered blatant conflicts of interest and self-dealing by commercial banks and their investment affiliates. For example, commercial banks had misrepresented to their depositors the quality of securities that their investment banks were underwriting and promoting, leading the depositors to be overly confident in the banks’ stability. First National City Bank (now Citigroup) and its securities affiliate, the National City Company, had 2,000 brokers selling securities. Those brokers had repackaged the bank’s Latin American loans and sold them to investors as new securities (today, this is known as “securitization”) without disclosing to customers the bank’s confidential findings that the loans posed an adverse risk. Peruvian government bonds were sold even though the bank’s staff had confidentially warned that “no further national loan can be safely made” to Peru. The Senate committee found conflicts when commercial banks were able to garner confidential insider information about their corporate customers’ deposits and use it to benefit the bank’s investment affiliates. In addition, commercial banks would routinely purchase the stock of firms that were customers of the bank, as opposed to firms that were most financially stable.

The Pecora Hearings concluded that common ownership of commercial banks and investment banks jeopardized depositors by investing their funds in the stock market, and undermined the public’s confidence in the banks, which led to panic withdrawals. The hearings paved the way for passage of the Glass-Steagall Act.

Congress Acts

The Glass-Steagall Act addressed the conflicts of interest that the Congress concluded had helped trigger the 1929 crash by prohibiting commercial banks from owning or engaging in investment banking activity.

While the financial industry was cowed by the Depression, it almost immediately sought to maneuver around Glass-Steagall. A legal construct known as a “bank holding company” was not subject to the Glass-Steagall restrictions. Despite the prohibitions in Glass-Steagall, a single company could own both commercial and investment banking interests if those interests were held under a bank holding company. Bank holding companies became a popular way for financial institutions and other corporations to subvert the Glass-Steagall wall separating commercial and investment banking. In response, Congress enacted the Bank Holding Company Act of 1956 (BHCA) to prohibit bank holding companies from acquiring “non-banks” or engaging in “activities that are not closely related to banking.” Depository institutions were considered “banks” while investment banks (e.g., those that trade stock on Wall Street) were deemed “non-banks” under the law. As with Glass-Steagall, Congress expressed its intent to keep customer deposits in banks, which would avoid risky investments in securities or non-bank activities that might endanger deposits. The law also required bank holding companies to divest all their holdings in non-banking assets and forbade acquisition of banks across state lines.

But the BHCA contained a loophole sought by the financial industry. It allowed bank holding companies to acquire non-banks if the Fed determined that the non-bank activities were “closely related to banking.” The Fed was given wide latitude under the BHCA to approve or deny such requests. In the decades that followed passage of the BHCA, the Federal Reserve frequently invoked its broad authority to approve bank holding companies’ acquisitions of investment banking firms, thereby weakening the wall separating customer deposits from riskier trading activities.

Deference to Regulators

In furtherance of the Fed’s authority under BHCA, the Supreme Court in 1971 ruled that courts should defer to regulatory decisions that approved bank holding company acquisitions of non-bank entities. As long as a Federal Reserve Board interpretation of the BHCA is “reasonable” and “expressly articulated,” judges should not intervene, the court held. The ruling was a victory for opponents of Glass-Steagall, substantially freeing bank regulators to authorize bank holding companies to conduct new non-banking activities without judicial interference. As a result, banks whose primary business was managing customer deposits and making loans began using their bank holding companies to buy securities firms. In a series of decisions over the next two decades, the Fed progressively enlarged the scope of commercial bank ability to enter into investment banking activities.

The Financial Services Modernization Act

While the Fed had been progressively undermining Glass-Steagall through deregulatory interpretations of existing laws, the financial industry was simultaneously lobbying Congress to repeal Glass-Steagall altogether. Members of Congress introduced major deregulation legislation in 1982, 1988, 1991, 1995 and 1998.

Big banks, securities firms and insurance companies spent lavishly in support of the legislation in the late 1990s. During the 1997-1998 Congress, the three industries spent more than $85 million in campaign contributions, including soft money donations to the Democratic and Republican parties. But the Glass-Steagall rollback stalled. The Clinton administration was winding down, and the finance industries were becoming increasingly nervous that the legislation would not pass.

In the next congressional session, the industry redoubled its efforts, including by upping campaign contributions to more than $150 million, in considerable part to support a Glass-Steagall repeal, now marketed under a new and deceptive name, “Financial Modernization.”

During the Clinton Administration, Treasury Secretary Robert Rubin, who had run Goldman Sachs, enthusiastically promoted the legislation. In a 1995 testimony before the House Banking Committee, for example, Rubin argued that “the banking industry is fundamentally different from what it was two decades ago, let alone in 1933. … U.S. banks generally engage in a broader range of securities activities abroad than is permitted domestically. Even domestically, the separation of investment banking and commercial banking envisioned by Glass-Steagall has eroded significantly.” Remarkably, he claimed that Glass-Steagall could “conceivably impede safety and soundness by limiting revenue diversification.” At times, the Clinton administration even toyed with the idea of allowing a total blurring of the lines between banking and commerce (meaning non-financial businesses), but was forced to back away from such a radical move after criticism from former Federal Reserve Chair Paul Volcker and key Members of Congress. Rubin played a key role in obtaining approval of legislation to repeal Glass-Steagall, as both Treasury Secretary and in his subsequent private sector role.

A handful of other personalities were instrumental in the effort. Senator Phil Gramm, R-Texas, the truest of true believers in deregulation, was chair of the Senate Banking Committee and drove the legislation. He was assisted by Federal Reserve Chair Alan Greenspan, an avid proponent of deregulation who was also eager to support provisions of the proposed Financial Services Modernization Act that gave the Fed enhanced jurisdictional authority at the expense of other federal banking regulatory agencies. Jake Lewis, formerly a professional staff member of the House Banking Committee, notes, “When the legislation became snagged on controversial provisions, Greenspan would invariably draft a letter or present testimony supporting Gramm’s position on the volatile points. It was a classic back-scratching deal that satisfied both players — Greenspan got the dominant regulatory role and Gramm used Greenspan’s wise words of support to mute opposition and to help assure a friendly press would grease passage.”

Also playing a central role were the CEOs of Citicorp and Travelers Group. In 1998, the two companies announced they were merging. Such a combination of banking and insurance companies was illegal under the Bank Holding Company Act, but was excused due to a loophole which provided a two-year review period of proposed mergers. Travelers CEO Sandy Weill met with Greenspan prior to the announcement of the merger, and said Greenspan had a “positive response” to the audacious proposal.

Citigroup’s co-chairs Sandy Weill and John Reed, along with lead lobbyist Roger Levy, led a swarm of industry executives and lobbyists who badgered the administration and trammeled the halls of Congress until the final details of a deal were hammered out. The Citigroup top officials vetted drafts of the legislation before they were formally introduced.

As the deal-making on the bill moved into its final phase in Fall 1999 — and with fears running high that the entire exercise would collapse — Robert Rubin stepped into the breach. Having recently stepped aside as Treasury Secretary, Rubin was at the time negotiating the terms of his next job as an executive without portfolio at Citigroup. But this was not public knowledge at the time. Deploying the credibility built up as part of what the media had labeled “The Committee to Save the World” (Rubin, Greenspan and then-Deputy Treasury Secretary Lawrence Summers, so named for their interventions in addressing the Asian financial crisis in 1997), Rubin helped broker the final deal.

The Financial Services Modernization Act, also known as the Gramm-Leach-Bliley Act of 1999, formally repealed Glass-Steagall. The new law authorized banks, securities firms and insurance companies to combine under one corporate umbrella. A new clause was inserted into the Bank Holding Company Act allowing one entity to own a separate financial holding company that can conduct a variety of financial activities, regardless of the parent corporation’s main functions. In the congressional debate over the Financial Services Modernization Act, Senator Gramm declared, “Glass-Steagall, in the midst of the Great Depression, thought government was the answer. In this period of economic growth and prosperity, we believe freedom is the answer.” The chief economist of the Office of the Comptroller of the Currency supported the legislation because of “the increasingly persuasive evidence from academic studies of the pre-Glass-Steagall era.”

Impact of Repeal

The gradual evisceration of Glass-Steagall over 30 years, culminating in its repeal in 1999, opened the door for banks to enter the highly lucrative practice of packaging multiple home mortgage loans into securities for trade on Wall Street. The practice, known as “securitization,” had virtually disappeared after it contributed to the 1929 crash, but had made a comeback in the 1970s as Glass-Steagall was being dismantled. Author Robert Kuttner told the House Banking Committee in 2008 that trading loans on Wall Street “was the core technique that made possible the dangerous practices of the 1920s. Banks would originate and repackage highly speculative loans, market them as securities through their retail networks, using the prestigious brand name of the bank — e.g., Morgan or Chase — as a proxy for the soundness of the security. It was this practice, and the ensuing collapse when so much of the paper went bad, that led Congress to enact the Glass-Steagall Act” that separated banks and securities trading.

Whereas bank deposits had been a centerpiece of the 1929 crash, mortgage loans — and the securities connected to them — are at the center of the present financial crisis.

There is mounting evidence that the repeal of Glass-Steagall led banks to suspend careful scrutiny of loans they originated because the banks knew that the loans would be rapidly packaged into mortgage-backed securities and sold off to third parties. Since the banks weren’t going to hold the mortgages in their own portfolios, they had little incentive to review the borrowers’ qualifications carefully. Former Treasury Secretary John Snow has proposed requiring lenders to retain a portion of the loans they sell to third parties in order to incentivize more responsible lending.

As banks lost billions on mortgage-backed securities in 2008, they stopped making new loans in order to conserve their assets. Moreover, instead of issuing new loans with hundreds of billions of dollars in taxpayer-footed bailout money given for the purpose of jump-starting the sputtering economy, the banks used the money to offset losses on their mortgage securities investments.

In addition, banks and insurance companies were saddled with billions in losses from “credit default swaps” created to insure against mortgage defaults and themselves traded as securities on Wall Street.

In short, the Depression-era conflicts and consequences that Glass-Steagall was intended to prevent re-emerged once the Act was repealed. The once staid commercial banking sector quickly evolved to emulate the risk-taking attitude and practices of investment banks, with disastrous results.

“The most important consequence of the repeal of Glass-Steagall was indirect — it lay in the way repeal changed an entire culture,” notes economist Joseph Stiglitz.

“Commercial banks are not supposed to be high-risk ventures; they are supposed to manage other people’s money very conservatively,” writes Stiglitz. “It is with this understanding that the government agrees to pick up the tab should they fail. Investment banks, on the other hand, have traditionally managed rich people’s money — people who can take bigger risks in order to get bigger returns. When repeal of Glass-Steagall brought investment and commercial banks together, the investment-bank culture came out on top. There was a demand for the kind of high returns that could be obtained only through high leverage and big risktaking.”

2. Hiding Liabilities: Off-Balance Sheet Accounting

A business’s balance sheet is supposed to report honestly on a firm’s financial state, by listing its assets and liabilities. If a company can move money-losing assets off of its balance sheet through accounting tricks, it will be appear to be in greater financial health.

Thanks to the exploitation of accounting rule loopholes, commercial banks were able to undertake exactly this sort of deceptive financial shuffling. Even in good times, placing mortgage loans off balance sheet had important advantages for banks, enabling them to expand lending without setting aside more reserve-loss capital. As they shunted off more loans into off-balance sheet entities, the banks’ financial vulnerability kept increasing — they had more loans outstanding, without commensurate reserve-loss capital. Then, when bad times hit, off-balance sheet accounting let banks hide their losses from investors and regulators. This allowed their condition to grow still more acute, ultimately imposing massive losses on investors and taxpayers called on for massive infusions of capital, and threatening the viability of the financial system.

The scale of banks’ off-balance sheet assets is enormous — 15.9 times the amount on the balance sheet in 2007. This ratio represent a massive surge over the last decade and half, notes Joseph Mason, a professor at Louisiana State University. “During the period 1992-2007, on-balance sheet assets grew by 200 percent, while off-balance sheet asset grew by a whopping 1,518 percent,” Mason says.

One Wall Street executive described the use of off-balance sheet accounting “as a bit of a magic trick” because losses disappear from the balance sheet, making lenders appear more financially stable than reality would dictate. A former SEC official called it “nothing more than just a scam.”

The Securities and Exchange Commission (SEC) has statutory authority to establish financial accounting and reporting standards, but it delegates this authority to the Financial Accounting Standards Board (FASB). The FASB is an independent, private sector organization whose purpose is to establish standards of financial accounting, including standards that govern the preparation of financial reports. FASB’s Statement 140 establishes rules relevant to securitization of loans (packaging large number of loans resold to other parties) and how securitized loans may be moved off balance sheet.

Pursuant to Statement 140, a lender may sell blocks of its mortgages to separate trusts or companies known as Qualified Special Purpose Entities (QSPEs), or “special investment vehicles” (SIVs), created by the lender. As long as the mortgages are sold to the QSPE, the lender is authorized not to report the mortgages on its balance sheet. The idea is that the lender no longer has control or responsibility for the mortgages. The Statement 140 test of whether a lender has severed responsibility for mortgages is to ask whether a “true sale” has taken place.

But whether a true sale of the mortgages has occurred is often unclear because of the complexities of mortgage securitization. Lenders often retain some control over the mortgages even after their sale to a QSPE. So, while the sale results in moving mortgages off the balance sheet, the lender may still be liable for mortgage defaults. This retained liability is concealed from the public by virtue of moving the assets off the balance sheet.

Under Statement 140, a “sale” of mortgages to a QSPE occurs when the mortgages are put “beyond the reach of the transferor [i.e. the lender] and its creditors.” This is a “true sale” because the lender relinquishes control of the mortgages to the QSPE. But the 2008 financial crisis revealed that while lenders claimed to have relinquished control, and thus moved the mortgages off the balance sheet, they had actually retained control in violation of Statement 140. A considerable portion of the banks’ mortgage-related losses remain off the books, however, contributing to the continuing uncertainty about the scale of the banks’ losses.

The problems with off-balance sheet accounting are a matter of common sense. If there was any doubt, however, the deleterious impact of off-balance sheet accounting was vividly illustrated by the notorious collapse of Enron in December 2001. Enron established off-balance sheet partnerships whose purpose was to borrow from banks to finance the company’s growth. The partnerships, also known as special purpose entities (SPEs), borrowed heavily by using Enron stock as collateral. The debt incurred by the SPEs was kept off the balance sheet so that Wall Street and regulators were unaware of it. Credit rating firms consistently gave Enron high debt ratings, as they were unaware of the enormous off-balance sheet liabilities. Investors pushing Enron’s stock price to sky-high levels were oblivious to the enormous amount of debt incurred to finance the company’s growth. The skyrocketing stock price allowed Enron to borrow even more funds while using the stock as collateral. At the time of bankruptcy, the company’s on-balance sheet debt was $13.15 billion, but the company had a roughly equal amount of off-balance sheet liabilities.

After Enron

In the fallout of the Enron scandal, the FASB adopted guidance to address off-balance sheet arrangements. Under its FIN 46R guidance, a company must include any SPE on the balance sheet if the company is entitled to the majority of the SPE’s risks or rewards, regardless of whether a true sale occurred. But the guidance has one caveat: QSPEs holding securitized assets may be excluded from the balance sheet. The caveat, known as the “scope exception,” means financial institutions are not subject to the heightened requirements provided under FIN 46R. The lessons of Enron were thus ignored for financial institutions, setting the stage for the 2008 financial crisis.

The Enron fiasco got the attention of Washington, which soon began considering systemic accounting reforms. The Sarbanes-Oxley Act, passed in 2003, attempted to shine more light on the murky underworld of off-balance sheet assets, but the final measure was a watered-down compromise; more far-reaching demands were defeated by the financial lobby.

Sarbanes-Oxley requires that companies make some disclosures about their QSPEs, even if they are not required to include them on the balance sheet. Specifically, it requires disclosure of the existence of off-balance-sheet arrangements, including QSPEs, if they are reasonably likely to have a “material” impact on the company’s financial condition. But lenders have sole discretion to determine whether a QSPE will have a “material” impact. Moreover, disclosures have often been made in such a general way as to be meaningless. “After Enron, with Sarbanes-Oxley, we tried legislatively to make it clear that there has to be some transparency with regard to off-balance sheet entities,” Senator Jack Reed of Rhode Island, the chairman of the Senate Securities subcommittee, said in early 2008 as the financial crisis was unfolding. “We thought that was already corrected and the rules were clear and we would not be discovering new things every day.”

The FASB has recognized for years that its Statement 140 is failing to work as intended, concluding in 2006 that the rule was “irretrievably broken.” The merits of the “true sale” theory of Statement 140 notwithstanding, its detailed and complicated rules created sufficient loopholes and exceptions to enable financial institutions to circumvent its purported logic as a matter of course.

FASB Chairman Robert Herz likened off-balance sheet accounting to “spiking the punch bowl.”

“Unfortunately,” he said, “it seems that some folks used [QSPEs] like a punch bowl to get off-balance sheet treatment while spiking the punch. That has led us to conclude that now it’s time to take away the punch bowl. And so we are proposing eliminating the concept of a QSPE from the U.S. accounting literature.”

It is not, however, a certainty that the FASB will succeed in its effort. The Board has repeatedly tried to rein in off-balance sheet accounting, but failed in the face of financial industry pressure. The commercial banking industry and Wall Street are waging a major effort to water down the rule (including on the grounds that disclosure of too much information will confuse investors) and delay adoption and implementation. These efforts are meeting with success, in part because of the fear that forcing banks to recognize their off-balance sheet losses will reveal them to be insolvent.

3. The Executive Branch Rejects Financial Derivative Regulation

Over-the-counter financial derivatives are unregulated. By all accounts, this has been a disaster. As Warren Buffett warned in 2003, financial derivatives represent “weapons of mass financial destruction” because “large amounts of risk, particularly credit risk, have become concentrated in the hands of relatively few derivatives dealers” so that “the troubles of one could quickly infect the others” and “trigger serious systemic problems.”

A financial derivative is a contract between two or more parties that calls for money to change hands at some future date, with the amount to be determined by the value of an underlying financial asset, such as a mortgage contract or a stock, bond or commodity, or by financial conditions, such as interest rates or currency values. The value of the contract is determined by fluctuations in the price of the underlying asset. Most derivatives are characterized by high leverage, meaning they are bought with enormous amounts of borrowed money.

Derivatives are not a recent invention. Traditional, non-financial derivatives include futures contracts traded on exchanges such as the Chicago Mercantile Exchange, and regulated by the Commodity Futures Trading Commission. A traditional futures contract might include, for example, futures on oranges, where buyers and sellers agree to deliver or accept delivery of a specified number of oranges at some point in the future, at a price determined now, irrespective of the price for oranges at that future time. This kind of futures contract can help farmers and others gain some price certainty for commodities whose value fluctuates in uncertain ways. Over-the-counter financial derivatives, by contrast, are negotiated and traded privately (not on public exchanges) and are not subject to public disclosure, government supervision or other requirements applicable to those traded on exchanges.

Derivatives and the Current Financial Crisis

In the 1990s, the financial industry began to develop increasingly esoteric types of derivatives. One over-the-counter derivative that has exacerbated the current financial crisis is the credit default swap (CDS). CDSs were invented by major banks in the mid-1990s as a way to insure against possible default by debtors (including mortgage holders). Investment banks that hold mortgage debt, including mortgage-backed securities, can purchase a CDS from a seller, such as an insurance company like AIG, which agrees to becomes liable for all the debt in the event of a default in the mortgage-backed securities. Wall Street wunderkinds with backgrounds in complex mathematics and statistics developed algorithms that they claimed allowed them to correctly price the risk and the CDSs.

Banks and hedge funds also began to sell CDSs and even trade them on Wall Street. Billions in these “insurance policies” were traded every day, with traders essentially betting on the likelihood of default on mortgage-backed securities. CDS traders with no financial interest in the underlying mortgages received enormous profits from buying and selling CDS contracts.

The global market value of CDS contracts (the “notional value”) reached over $60 trillion in 2007, surpassing the gross domestic product of every country in the world combined. The value of the entire global derivatives market reached $530 trillion in 2008, almost 20 times the total value of the U.S. stock market. The current financial crisis has exposed how poorly the sellers and buyers understood the value of the derivatives they were trading.

Once home values stopped rising in 2006 and mortgage default became more commonplace, the value of the packages of mortgages known as mortgage-backed securities plunged. At that point, the CDS agreements called for the sellers of the CDSs to reimburse the purchasers for the losses in the mortgage-backed securities.  Firms that had sold CDS contracts, like AIG, became responsible for posting billions of dollars in collateral or paying the purchasers.

The total dollars at risk from CDSs is a staggering $2.7 trillion. The amount at risk is far less than $60 trillion because most investors were simultaneously on both sides of the CDS trade. For example, banks and hedge funds would buy CDS protection on the one hand and then sell CDS protection on the same security to someone else at the same time. When a mortgage-backed security defaulted, the banks might have to pay some money out, but they would also be getting money back in. So, while the total value of each CDS buy and sell order equaled $60 trillion in 2007, the actual value at risk was a fraction of that — but still large enough to rock the financial markets.

The insurance giant AIG, however, did not buy CDS contracts — it only sold them. AIG issued $440 billion worth of such contracts, making it liable for loan defaults including billions in mortgage-backed securities that went bad after the housing bubble burst. In addition, the company’s debt rating was downgraded by credit rating agencies, a move that triggered a clause in its CDS contracts that required AIG to put up more collateral to guarantee its ability to pay. Eventually, AIG was unable to provide enough collateral or pay its obligations from the CDS contracts. Its stock price tumbled, making it impossible for the firm to seek investor help. Many banks throughout the world were at risk because they had bought CDS contracts from AIG. The downward financial spiral ultimately required a taxpayer-financed rescue by the Federal Reserve, which has committed $152.5 billion to the company so far, in order to minimize “disruption to the financial markets.”

Federal Agencies Reject Regulation

Some industry observers warned of the dangers of over-the-counter (OTC) derivatives. But acceding to political pressure from the powerful financial industry, the federal agencies with the responsibility to safeguard the integrity of the financial system refused to permit regulation of financial derivatives, especially the credit default swaps that exacerbated the 2008 financial meltdown.

In 1996, President Clinton appointed Brooksley Born chair of the Commodity Futures Trading Commission (CFTC). The CFTC is an independent federal agency with the mandate to regulate commodity futures and option markets in the United States.

Born was outspoken and adamant about the need to regulate the quickly growing but largely opaque area of financial derivatives. She found fierce opposition in SEC Chair Arthur Levitt, Treasury Secretary Robert Rubin and Federal Reserve Chair Alan Greenspan, all of whom felt that the financial industry was capable of regulating itself. An April 1998 meeting of the President’s Working Group on Financial Markets, which consisted of Levitt, Greenspan, Rubin and Born, turned into a standoff between the three men and Born. The men were determined to derail her efforts to regulate derivatives, but left the meeting without any assurances.

Pressing back against her critics, Born published a CFTC concept paper describing how the derivatives sector might be regulated. Born framed the CFTC’s interest in mild terms. “The substantial changes in the OTC derivatives market over the past few years require the Commission to review its regulations,” Born said. “The Commission is not entering into this process with preconceived results in mind. We are reaching out to learn the views of the public, the industry and our fellow regulators on the appropriate regulatory approach to today’s OTC derivatives marketplace.”

The publication described the growth of derivatives trading (“Use of OTC derivatives has grown at very substantial rates over the past few years,” to a notional value of more than $28 trillion) and raised questions about financial derivatives rather than proposing specific regulatory initiatives.

But the concept paper was clear that the CFTC view was that the unrestrained growth of financial derivatives trading posed serious risks to the financial system, and its probing questions suggested a range of meaningful regulatory measures — measures which, if they had been adopted, likely would have reduced the severity of the present crisis.

“While OTC derivatives serve important economic functions, these products, like any complex financial instrument, can present significant risks if misused or misunderstood by market participants,” the CFTC noted. “The explosive growth in the OTC market in recent years has been accompanied by an increase in the number and size of losses even among large and sophisticated users which purport to be trying to hedge price risk in the underlying cash markets.”

Among the proposals floated in the concept paper were the following measures:

• Narrow or eliminate exemptions for financial derivatives from the regulations that applied to exchange-traded derivatives (such as for agricultural commodities);
• Require financial derivatives to be traded over a regulated exchange;
• Require registration of person or entities trading financial derivatives;
• Impose capital requirements on those engaging in financial derivatives trading (so that they would be required to set aside capital against the risk of loss, and to avoid excessive use of borrowed money);
• Require issuers of derivatives to disclose the risks accompanying those instruments.

The uproar from the financial industry was immediate. During the next two months, industry lobbyists met with CFTC commissioners at least 13 times. Meanwhile, Born faced off against Federal Reserve Chair Alan Greenspan and others in numerous antagonistic congressional hearings. Then, Senator Richard Lugar, R-Indiana, chair of the Senate Agricultural Committee, stepped into the fray. Lugar, who received nearly $250,000 from securities and investment firms in 1998, extended an ultimatum to Born: cease the campaign or Congress would pass a Treasury-backed bill that would put a moratorium on any further CFTC action. The stalemate continued.

The Treasury Department weighed in with its view that derivatives should remain unregulated. President Clinton’s Deputy Treasury Secretary, Lawrence Summers, complained that Born’s proposal “cast the shadow of regulatory uncertainty over an otherwise thriving market.”

Greenspan echoed the Treasury Department view, arguing that regulation would be both unnecessary and harmful. “Regulation of derivatives transactions that are privately negotiated by professionals is unnecessary,” he said. “Regulation that serves no useful purpose hinders the efficiency of markets to enlarge standards of living.”

In September 1998, Long Term Capital Management, a hedge fund heavily focused on derivatives, informed the Fed it was on the brink of collapse and couldn’t cover its $4 billion in losses. The New York Federal Reserve quickly recruited 14 private banks to bail out Long Term Capital by investing $3.6 billion.

“This episode should serve as a wake-up call about the unknown risks that the over-the-counter derivatives market may pose to the U.S. economy and to financial stability around the world,” Born told the House Banking Committee two days later. “It has highlighted an immediate and pressing need to address whether there are unacceptable regulatory gaps relating to hedge funds and other large OTC derivatives market participants.” But what should have been a moment of vindication for Born was swept aside by her adversaries, and Congress enacted a six-month moratorium on any CFTC action regarding derivatives or the swaps market. In May 1999, Born resigned in frustration.

Born’s replacement, William Rainer, went along with Greenspan, Summers (then Treasury Secretary) and Levitt’s campaign to block any CFTC regulation. In November 1999, the inter-agency President’s Working Group on Financial Markets released a new report on derivatives recommending no regulation, saying it would “perpetuate legal uncertainty or impose unnecessary regulatory burdens and constraints upon the development of these markets in the United States.” Among other rationalizations for this non-regulatory posture, the report argued, “the sophisticated counterparties that use OTC derivatives simply do not require the same protections” as retail investors. The report briefly touched upon, but did not take seriously, the idea that financial derivatives posed overall financial systemic risk. To the extent that such risk exists, the report concluded, it was well addressed by private parties. “Private counterparty discipline currently is the primary mechanism relied upon for achieving the public policy objective of reducing systemic risk,” the report stated. “Government regulation should serve to supplement, rather than substitute for, private market discipline. In general, private counterparty credit risk management has been employed effectively by both regulated and unregulated dealers of OTC derivatives, and the tools required by federal regulators already exist.”

4. Congress Blocks Financial Derivative Regulation

Long before financial derivatives became the darlings of Wall Street, some in Congress believed that the federal government should be given greater power to regulate derivatives.

In 1994, Senator Donald Riegle, D-Michigan, and Representative Henry Gonzalez, D-Texas, introduced separate bills for derivatives regulations; both went nowhere. Opposing regulation was a bipartisan affair and inaction ruled the day.

In 2000, a year after the outspoken Brooksley Born left the Commodity Futures Trading Commission (CFTC), Congress and President Clinton codified regulatory inaction with passage the Commodity Futures Modernization Act (CFMA). The legislation is best known for its “Enron loophole,” which prohibited regulation of energy futures contracts and thereby contributed to the collapse of scandal-ridden Enron.

CFMA formally exempted financial derivatives, including the now infamous credit default swaps, from regulation and federal government oversight. One Wall Street analyst later noted that the CFMA “was slipped into the [budget] bill in the dead of night by our old friend Senator Phil Gramm of Texas — now Vice Chairman of [Swiss investment bank] UBS.” Gramm led the congressional effort to block federal agencies from regulating derivatives, complaining that “banks are already heavily regulated institutions.” Gramm predicted CFMA “will be noted as a major achievement” and “as a watershed, where we turned away from the outmoded, Depression-era approach to financial regulation.” He said the legislation “protects financial institutions from over-regulation, and provides legal certainty for the $60 trillion market in swaps” — in other words, it offered a guarantee that they would not be regulated.

By 2008, Gramm’s UBS was reeling from the global financial crisis he had helped create. The firm declared nearly $50 billion in credit losses and write-downs, prompting a $60 billion bailout by the Swiss government.

While credit default swaps did not trigger the financial crisis, they dramatically exacerbated it. As mortgages and mortgage-backed securities plummeted in value from declining real estate values, big financial firms were unable to meet their insurance obligations under their credit default swaps.

Senator Gramm remains defiant today with no apologies, telling the New York Times, “There is this idea afloat that if you had more regulation you would have fewer mistakes. I don’t see any evidence in our history or anybody else’s to substantiate it. … The markets have worked better than you might have thought.”

Others have a more reality-based view. Former SEC Commissioner Harvey Goldschmid conceded that “in hindsight, there’s no question that we would have been better off if we had been regulating derivatives.”

Another action by Congress must be mentioned here. In 1995, bowing to the financial lobby after years of pressure, Congress passed the Private Securities Litigation Reform Act. The measure greatly restricted the rights of investors to sue the Wall Street trading, accounting and investment firms for securities fraud. The author of the legislation was Representative Christopher Cox, R-California, who President Bush later appointed Chair of the Securities and Exchange Commission.

In the debate over the bill in the House of Representatives, Representative Ed Markey, D-Massachusetts, proposed an amendment that would have exempted financial derivatives from the Private Securities Litigation Reform Act, thus insuring that investors could sue for abuses related to derivatives. Markey anticipated many of the problems that would explode a decade later: “All of these products have now been sent out into the American marketplace, in many instances with the promise that they are quite safe for a municipality to purchase. … The objective of the Markey amendment out here is to ensure that investors are protected when they are misled into products of this nature, which by their very personality cannot possibly be understood by ordinary, unsophisticated investors. By that, I mean the town treasurers, the country treasurers, the ordinary individual that thinks that they are sophisticated, but they are not so sophisticated that they can understand an algorithm that stretches out for half a mile and was constructed only inside of the mind of this 26- or 28-year-old summa cum laude in mathematics from Cal Tech or from MIT who constructed it. No one else in the firm understands it. The lesson that we are learning is that the heads of these firms turn a blind eye, because the profits are so great from these products that, in fact, the CEO’s of the companies do not even want to know how it happens until the crash.”

Representative Cox led the opposition to the Markey amendment. He was able to cite support from Alan Greenspan, chair of the Federal Reserve, and President Clinton’s SEC chairman Arthur Levitt. He quoted Greenspan saying that “singling out derivative instruments for special regulatory treatment” would be a “serious mistake.” He also quoted Levitt, who warned, “It would be a grave error to demonize derivatives.”

The amendment was rejected. The specter of litigation is a powerful deterrent to wrongdoing. The Private Securities Litigation Reform Act weakened that deterrent — including for derivatives — and today makes it more difficult for defrauded investors to seek compensation for their losses.

5. The SEC’s Voluntary Regulation Regime

Until the 2008 financial crisis, investment banks regularly borrowed funds from other banks to purchase securities and debt instruments. A “highly leveraged” bank is one that owns financial instruments that it bought with substantial amounts of borrowed money. For many years, the Securities and Exchange Commission (SEC) prohibited broker-dealers (i.e., stock brokers and investment banks) from exceeding established limits on the amount of debt used for buying securities. Banks that accrued more than $12 in debt for every dollar in bank capital (their “net capital ratio”) were prohibited from trading in the stock market. As a result, the five major Wall Street investment banks maintained net capital ratios far below 12 to one. The rule required broker-dealers to maintain a designated amount of set-aside capital based on the riskiness of their investments; the riskier the investment, the more they would need to set aside. This limitation on accruing debt was designed to protect the assets of customers with funds deposited at the investment bank, and to ensure that the investment bank could meet its contractual obligations to other firms.

In 2004, the SEC abolished its 19-year-old “debt-to-net-capital rule” in favor of a voluntary system that allowed banks to formulate their own “rule.” Under this new scheme, large investment banks would assess their level of risk based on their own risk management computer models. The SEC acted at the urging of the big investment banks led by Goldman Sachs, which was then headed by Henry Paulson, who would become Treasury Secretary two years later, and was the architect of the Bush administration’s response to the financial debacle. After a 55 minute discussion, the SEC voted unanimously to abolish the rule.

The SEC’s new policy, foreseeably, enabled investment banks to make much greater use of borrowed funds. The top five investment banks participated in the SEC’s voluntary program: Bear Steams, Goldman Sachs, Morgan Stanley, Merrill Lynch and Lehman Brothers. By 2008, these firms had borrowed $20, $30 and $40 for each dollar in capital, far exceeding the standard 12-to-one ratio. Much of the borrowed funds were used to purchase billions of dollars in subprime-related and other mortgage-backed securities (MBSs) and their associated derivatives. The securities were purchased at a time when real estate values were skyrocketing and few predicted an end to the financial party. As late as the March 2008 collapse of Bear Stearns, SEC Chair Christopher Cox continued to support the voluntary program: “We have a good deal of comfort about the capital cushions at these firms at the moment,” he said.

The SEC had abolished the net capital rule with the caveat that it would continue monitoring the banks for financial or operational weaknesses. But a 2008 investigation by the SEC’s Inspector General (IG) found that the agency had failed in its oversight responsibilities.

The IG concluded that “it is undisputable” that the SEC “failed to carry out its mission in its oversight of Bear Stearns,” which collapsed in 2008 under massive mortgage-backed securities losses, leading the Federal Reserve to intervene “to prevent significant harm to the broader financial system.” The IG said the SEC “became aware of numerous potential red flags prior to Bear Stearns’ collapse,” including its concentration of mortgage securities and high leverage, “but did not take actions to limit these risk factors.”

Moreover, concluded the IG, the SEC “was aware ... that Bear Stearns’ concentration of mortgage securities was increasing for several years and was beyond its internal limits.” Nevertheless, it “did not make any efforts to limit Bear Stearns’ mortgage securities concentration.”

The IG said the SEC was “aware that Bear Stearns’ leverage was high” but made no effort to require the firm to reduce leverage “despite some authoritative sources describing a linkage between leverage and liquidity risk.” Furthermore, the SEC “became aware that risk management of mortgages at Bear Stearns had numerous shortcomings, including lack of expertise by risk managers in mortgage-backed securities” and “persistent understaffing; a proximity of risk managers to traders suggesting a lack of independence; turnover of key personnel during times of crisis; and the inability or unwillingness to update models to reflect changing circumstances.”

Notwithstanding this knowledge, the SEC “missed opportunities to push Bear Steams aggressively to address these identified concerns.”

The much-lauded computer models and risk management software that banks had used in recent years to calculate risk and net capital ratios had been overwhelmed by human error, overly optimistic assumptions — including that the housing bubble would not burst — and a failure to contemplate system-wide asset deflation. Similar computer models failed to prevent the demise of Long Term Capital Management, a heavily leveraged hedge fund that collapsed in 1998, and the stock market crash of October 1987. The editors at Scientific American magazine lambasted the SEC and the investment banks for their “overreliance on financial software crafted by physics and math PhDs.”

By Fall 2008, the number of major investment banks on Wall Street dropped from five to zero. All five banks either disappeared or became bank holding companies in order to avail themselves of taxpayer bailout money. JP Morgan bought Bear Stearns, Lehman Brothers filed for bankruptcy protection, Bank of America announced its rescue of Merrill Lynch by purchasing it, and Goldman Sachs and Morgan Stanley became bank holding companies with the Federal Reserve as their new principal regulator.

On September 26, 2008, as the crisis became a financial meltdown of epic proportions, SEC Chair Cox, who spent his entire public career as a deregulator, conceded “the last six months have made it abundantly clear that voluntary regulation does not work.”

6. No Predatory Lending Enforcement

Subprime loans are those made to persons with a poor credit history. Predatory loans are a subset of subprime loans. A bank is engaged in predatory lending when it takes advantage of unsophisticated borrowers and gives them bad loan rates or terms. Common predatory terms include high fees and charges associated with the loan; low teaser interest rates, which skyrocket after an initial grace period; and negative amortization loans, which require, for a time, monthly payments less than the interest due.

Preventing predatory lending practices would not have prevented the housing bubble and the subsequent financial meltdown, but it would have taken some air out of the bubble and softened the economic crisis — and it would have saved millions of families and communities across the country from economic ruin.

Unlike the housing bubble itself, predatory lending was easily avoidable through sound regulation.

But federal regulators were asleep at the switch, lulled into somnolence by cozy relationships with banks and Wall Street and a haze-inducing deregulatory ideology.

Reviewing the record of the past seven years shows that:

1. Federal regulators were warned at the outset of the housing bubble about the growth in predatory lending, and public interest advocates pleaded with them to take action.
2. Federal regulators refused to issue appropriate regulatory rules to stem predatory lending.
3. Action at the state level showed that predatory lending rules could limit abusive loans.
4. Federal regulators failed to take enforcement actions against predatory lenders.
5. After the housing bubble had popped, and the subprime lending industry collapsed, federal regulators in 2008 proposed new rules to limit predatory practices. While highly imperfect, the new rules evidence what might have been done in 2001 to prevent abuses.

Early warnings yield no action

There are only limited federal substantive statutory standards regarding predatory lending. These are established in the Home Ownership and Equity Protection Act (HOEPA), which was adopted in 1994. HOEPA effectively put an end to certain predatory practices, but only for loans containing upfront fees or charges of more than 8 percent of the loan amount, or interest rates above a varying, very high threshold. Predatory lenders easily devised ways to work around these limitations.

In 2000 and 2001, the Federal Deposit Insurance Corporation (FDIC), the Federal Reserve and the Office of Thrift Supervision, among other federal agencies, adopted or considered rules to further restrict predatory lending. However, the adopted binding rules, issued by the Federal Reserve pursuant to HOEPA, focused very narrowly on certain egregious practices. More expansive statements on predatory lending were issued only as non-binding guidelines. The reliance on non-binding guidelines continued through the decade.

As regulators were issuing non-binding guidelines, public interest advocates were praising their recognition of the problem — but urging that more forceful action be taken.

“Clearly, the FDIC recognizes that there is a grave problem throughout the U.S., particularly affecting low income and minority households and neighborhoods,” wrote the National Consumer Law Center and the Consumer Federation of America in January 2001 comments submitted to the FDIC. “While many regulators recognize the gravity of the predatory lending problem, the appropriate — and politically feasible — method of addressing the problem still appears elusive.”

What was needed, the consumer groups argued, was binding regulation. “All agencies should adopt a bold, comprehensive and specific series of regulations to change the mortgage marketplace,” the groups wrote, so that “predatory mortgage practices are either specifically prohibited, or are so costly to the mortgage lender that they are not economically feasible;” and that “necessary credit is made available with appropriate rates and terms to all Americans.”

Public interest groups would repeat this advice again and again over the subsequent years, pointing to growing abuses and proposing specific remedies.

But federal agencies declined to issue any binding regulations in response to mushrooming predatory lending. They did issue additional guidance statements, but these were non-binding and consistently behind the curve of evolving lender abuses. Not surprisingly, they failed to curtail predatory lending practices.

A Failure to Enforce

Federal regulators also failed to enforce the rules that were on the books.

From 2003 through the start of 2007, the Federal Reserve, which has jurisdiction over the entire banking industry, took a mere three formal enforcement actions to stop predatory lending, a Bloomberg news service analysis found. The Office of the Comptroller of the Currency (OCC), which has regulatory authority over roughly 1,800 nationally chartered banks, similarly took three public enforcement actions from 2004 to 2006, Bloomberg determined. These numbers reflect a startling failure by regulators during the peak period of abusive subprime lending.

Although Federal Reserve officials acknowledge that they should have done more, the OCC says it took appropriate action. Both agencies insist that they also addressed abuses on an informal, bank-by-bank basis, ordering improved practices in connection with the agency’s routine examinations of individual banks. The informal and non-public nature of this approach means that Fed and OCC’s claims cannot be easily verified.

Even if there were extensive private enforcement actions or conversations, such moves fail to perform important public functions. They do not signal appropriate behavior and clear rules to other lenders; and they do not provide information to victimized borrowers, thereby depriving them of an opportunity to initiate follow-on litigation to recover for harms perpetrated against them.

State Action Shows what Could Have Been Done

While federal regulators sat on their hands, some states adopted meaningful anti-predatory lending laws and brought enforcement actions against abusive lenders. The ability of some states to regulate and address abusive lender behavior demonstrates what federal regulators might have done.

A comprehensive review of subprime loans conducted by the nonprofit Center for Responsible Lending found that aggressive state regulatory action greatly reduced the number of predatory loans, without affecting borrowers’ access to subprime credit. “States with anti-predatory lending laws reduced the proportion of loans with targeted terms by 30 percentage points,” the study determined. Even this number masked the superior performance of those with the toughest laws. “States with the  strongest laws — Massachusetts, New Jersey, New  Mexico, New York, North Carolina and West  Virginia — are generally associated with the largest declines in targeted terms relative to states without significant protections,” the study found.

The Center for Responsible Lending study also concluded that lending continued at a constant rate in states with anti-predatory lending laws, and that “state laws have not increased interest rates and, in some cases, borrowers actually paid lower rates for subprime mortgages after their state laws became effective compared to borrowers in states without significant protections.” In other words, eliminating abusive fees did not translate into higher interest rates.

Partially Closing the barn door (after the horses left and a foreclosure sign is posted)     

After years of inaction, and confronted with signs of the economic meltdown to come, the Federal Reserve in January 2008 finally proposed binding regulations that would apply to all lenders, not just nationally chartered banks.

The Federal Reserve proposal noted the growth of subprime mortgages, claimed the expansion of subprime credit meaningfully contributed to increases in home ownership rates (a gain quickly unraveling due to the subprime-related foreclosure epidemic) and modestly suggested that “recently, however, some of this benefit has eroded. In the last two years, delinquencies and foreclosure starts have increased dramatically and reached  exceptionally high levels as house price growth has slowed or prices have  declined in some areas.”

With slight modification, the Fed adopted these proposed rules in July 2008. The new regulations establish a new category of “higher-priced mortgages” intended to include virtually all subprime loans. The regulations prohibit a number of abusive practices in connection with these newly defined “higher-priced mortgages.” They also apply some measures — such as specified deceptive advertising practices — for all loans, regardless of whether they are subprime.

These measures are not inconsequential. They show the kind of action the Federal Reserve could have taken at the start of this decade — moves that could have dramatically altered the subsequent course of events.

But the July regulations remain inadequate, as a coalition of consumer and housing groups has specified in great detail, because they fail to break with longstanding deregulatory nostrums. The Fed continues to emphasize the importance of enabling lenders to make credit available to minority and lower-income communities — historically, a deep-rooted community development concern — while failing to acknowledge that the overriding problem has become lenders willing to make credit available, but on abusive terms.

“The proposed regulations continue to be most protective of the flawed concept that access to credit should be the guiding principle for credit regulation. These regulations need to be significantly strengthened in order for consumers to be adequately protected,” argue the consumer and housing groups. They provide an extensive list of needed revisions to the proposed regulations, including that the regulations:

• Cover all loans, including prime loans;
• Require an ability to repay analysis for each loan;
• Ban prepayment penalties;
• Address lender and originator incentives for appraisal fraud; and
•   Provide effective private litigation remedies for victimized borrowers.

7. Federal Preemption of State Regulation and Consumer Protection Laws

In 2003, the Comptroller of the Currency John  Hawke, announced that he was preempting state predatory lending laws. This ruling meant that nationally chartered banks — which include the largest U.S. banks — would be subject to federal banking standards, but not the more stringent consumer protection rules adopted by many states.

The Comptroller’s decision was a direct response to a request from the nation’s biggest banks. It was prompted by a petition from Cleveland-based National City Bank, which challenged the application of the Georgia Fair Lending Act to its operations in Georgia.

In its petition, National City argued that the effect of the Georgia law “is to limit National City’s ability to originate and to establish the terms of credit on residential real estate loans and lines of credit, including loans or lines of credit submitted by a third party mortgage broker. GFLA [the Georgia Fair Lending Act] has significantly impaired National City’s ability to originate residential real estate loans in Georgia.”

The Georgia law, a pathbreaking anti-predatory lending initiative, included a wide range of consumer protections that consumer groups applauded but which National City complained would interfere with its freedom to operate.

The Office of the Comptroller of the Currency’s (OCC’s) 2003 preemption decision followed a long series of actions by the agency to preempt state law. Following passage of the Garn-St. Germain Depository Institutions Act of 1982, the OCC had by regulation specifically preempted a number of state law consumer protections, including the minimum requirements for down payments, loan repayment schedules and minimum periods of time for loans. These state rules afforded consumers greater protection than federal statutes.

The 2003 decision concluded that Georgia’s rules transgressed some of these longstanding regulatory preemptions, but then went further and preempted the Georgia rules entirely, as they applied to national banks.

In conjunction with the OCC’s announcement on the Georgia case, it launched a rulemaking on the general issue of federal preemption of all state regulation of national banks. In January 2004, it issued rules fully preempting state regulation of national banks. The OCC also announced rules prohibiting state regulators from exercising “visitorial powers” — meaning inspection, supervision and oversight — of national banks.

The stated rationale for these preemptive moves was that differing state standards subjected national banks to extra costs and reduced the availability of credit.

“Today,” said Hawke in announcing the new rules, “as a result of technology and our mobile society, many aspects of the financial services business are unrelated to geography or jurisdictional boundaries, and efforts to apply restrictions and directives that differ based on a geographic source increase the costs of offering products or result in a reduction in their availability, or both. In this environment, the ability of national banks to operate under consistent, uniform national standards administered by the OCC will be a crucial factor in their business future.”

Hawke argued that national banks were not engaged in predatory lending on any scale of consequence; that federal regulation was sufficient; and that federal guidance on predatory lending — issued in conjunction with the preemptive moves — provided additional and satisfactory guarantees for consumers.

Former New York State Attorney General (and former Governor) Eliot Spitzer put these actions in perspective in a February 2008 opinion column in the Washington Post.

“Predatory lending was widely understood [earlier in the decade] to present a looming national crisis,” Spitzer wrote. “This threat was so clear that as New York attorney general, I joined with colleagues in the other 49 states in attempting to fill the void left by the federal government. Individually, and together, state attorneys general of both parties brought litigation or entered into settlements with many subprime lenders that were engaged in predatory lending practices. Several state legislatures, including New York’s, enacted laws aimed at curbing such practices.”

Referring to the OCC’s preemptive measures, Spitzer wrote, “Not only did the Bush administration do nothing to protect consumers, it embarked on an aggressive and unprecedented campaign to prevent states from protecting their residents from the very problems to which the federal government was turning a blind eye. … The federal government’s actions were so egregious and so unprecedented that all 50 state attorneys general, and all 50 state banking superintendents, actively fought the new rules.”

But, Spitzer noted, “The unanimous opposition of the 50 states did not deter, or even slow, the Bush administration in its goal of protecting the banks.”

When state law enforcement agencies tried to crack down on predatory lending in their midst, the OCC intervened to stop them. “In fact, when my office opened an investigation of possible discrimination in mortgage lending by a number of banks, the OCC filed a federal lawsuit to stop the investigation,” wrote Spitzer.

John Hawke’s successor as Comptroller John Dugan, objected to Spitzer’s writings. “The OCC established strong protections against predatory lending practices years ago, and has applied those standards through examinations of every national bank,” he said.  “As a result, predatory mortgage lenders have avoided national banks like the plague. The abuses consumers have complained about most — such as loan flipping and equity stripping — are not tolerated in the national banking system.  And the looser lending practices of the subprime market simply have not gravitated to national banks: They originated just 10 percent of subprime loans in 2006, when underwriting standards were weakest, and delinquency rates on those loans are well below the national average.”

Even if it is true that federal banks originated fewer abusive loans (although they clearly financed predatory subprime loans through bank intermediaries, securitized predatory subprime loans and held them in great quantities), the scale of the problem was still substantial. Margot Saunders and Alys Cohen of the National Consumer Law Center note that Wachovia was a national bank that collapsed in significant part because of the unaffordable mortgage loans it originated.

Saunders and Cohen note as well that the OCC’s preemptive actions protected federal banks from three distinct sets of consumer protections. First, they were immunized from state banking laws that offered consumers greater protection than the OCC’s standards. Second, the national banks were protected from private lawsuits brought under state law to enforce consumer rights. As noted above, federal voluntary standards made it difficult for victimized borrowers to file suit. Third, the OCC preempted the application of general state consumer protection law (as distinct from banking-specific rules) to national banks. This includes even basic contract and tort law.

Meanwhile, the federal agency responsible for regulating federally chartered thrifts (savings and loans), the Office of Thrift Supervision (OTS), adopted parallel preemptive actions, with similar if less elaborated logic.

In 2003, OTS announced its determination that New York and Georgian anti-predatory lending laws did not apply to federal thrifts. Like OCC, OTS took an aggressive posture, arguing that it “occupied the field” for regulation of federally chartered institutions.

OTS was explicit that it wanted to preserve “maximum flexibility” for thrifts to design loans. The agency said its objective was to “enable federal savings associations to conduct their operations in accordance with best practices by efficiently delivering low-cost credit to the public free from undue regulatory duplication and burden.”

“Federal law authorizes OTS to provide federal savings associations with a uniform national regulatory environment for their lending operations,” said OTS Director James E. Gilleran in announcing the preemptive decision. “This enables and encourages federal thrifts to provide low-cost credit safely and soundly on a nationwide basis. By requiring federal thrifts to treat customers in New York differently, the New York law would impose increased costs and an undue regulatory burden.”

This gentle regulatory treatment ultimately boomeranged on the regulated institutions. With the popping of the housing bubble, predatory loans proved a disaster not just for borrowers but for lenders or those having purchased subprime mortgage contracts. IndyMac and Washington Mutual are two federal thrifts that collapsed as a result of bad subprime mortgage loans that they administered.

8. Escaping Accountability: Assignee Liability

“Assignee liability” is the principle that legal responsibility for wrongdoing in issuing a loan extends to a third party that acquires a loan. Thus, if a mortgage bank issues a predatory loan and then sells the loan to another bank, assignee liability would hold the second bank liable for any legal claims that the borrower might be able to bring against the original lender.

Competing in the law with assignee liability is the “holder-in-due-course” doctrine, which establishes that a third party purchasing a debt instrument is not liable for problems with the debt instrument, so long as those problems are not apparent on the face of the instrument. Under the holder-in-due-course doctrine, a second bank acquiring a predatory loan is not liable for claims that may be brought by the borrower against the original lender, so long as those potential claims are not obvious.

The Home Ownership and Equity Protection Act (HOEPA) is the key federal protection against predatory loans. Passed in 1994, HOEPA does establish assignee liability, but it only applies to a limited category of very high-cost loans (i.e., loans with very high interest rates and/or fees). For those loans, a borrower may sue an assignee of a mortgage that violates HOEPA’s anti-predatory lending terms, seeking either damages or rescission (meaning all fees and interest payments will be applied to the principle of the loan, after which the borrower could refinance with a non-predatory loan). For all other mortgage loans, federal law applies the holder-in-due-course doctrine.

The rapid and extensive transfer of subprime loans, including abusive predatory loans, among varying parties was central to the rapid proliferation of subprime lending. Commonly, mortgage brokers worked out deals with borrowers, who then obtained a mortgage from an initial mortgage lender (often a non-bank lender, such as Countrywide) with which the broker worked. The mortgage lender would then sell the loan to a larger bank with which it maintained relations. Ultimately, such mortgages were pooled with others into a mortgage-backed security, sold to a large commercial bank or investment bank.

Under existing federal law, none but the original mortgage lender are liable for any predatory and illegal features of the mortgage. This arrangement effectively immunized acquirers of the mortgage from any problems with the initial loan, and relieved them of any duty to investigate the terms of the loan. It also left the borrowers with no cause of action against any but the original lender. In many cases, this lender may no longer exist as a legal entity. And, even where the initial lender still exists, while it can pay damages, it no longer has the ability to cure problems with the mortgage itself; only the current holder of the mortgage can modify it. Thus, a borrower could not exercise a potential rescission remedy, or take other action during the course of litigation to prevent the holder of her mortgage from foreclosing upon her or demanding unfair payments. A hypothetical recovery of damages from the original lender long after the home is foreclosed upon is of little solace to the homeowners.

The severe consequences of not applying assignee liability in the mortgage context have long been recognized. HOEPA established assignee liability in 1994. Consumer advocates highlighted the problem early in the 2000’s boom in predatory lending.

Margot Saunders of the National Consumer Law Center explained the problem in testimony to the House Financial Services Committee in 2003. “Take, for example, the situation where homeowners sign a loan and mortgage for home improvements secured by their home,” she said. “The documents do not include the required FTC Notice of Preservation of Claims and Defenses, and the contact information provided by the home improvement contractor is useless. The home improvement work turns out to be shoddy and useless, but the assignee of the loan claims to have no knowledge of the status of the work, instead claiming it is an innocent third party assignee that merely wants its monthly payments. When the homeowners refuse to pay, the assignee claims the rights of a holder in due course and begins foreclosure proceedings.”

The absence of assignee liability enabled Wall Street interests to bundle subprime loans — including many with predatory terms — and securitize them, without fear of facing liability for unconscionable terms in the loans. Had a regime of assignee liability been in place, securitizers and others up the lending chain would have been impelled to impose better systems of control on brokers and initial mortgage lenders, because otherwise they would have faced liability themselves.

For community development and consumer advocates, the case for expanded assignee liability has long been clear. “Most importantly consider the question of who should bear the risk in a faulty transaction,” testified Saunders in 2003. “Assume 1) an innocent consumer (victim of an illegal loan), 2) an originator guilty of violating the law and profiting from the making of an illegal loan, and 3) an innocent holder of the illegal note. As between the two innocent parties — the consumer and the holder — who is best able to protect against the risk of loss associated with the making of an illegal loan? It is clear that the innocent party who is best able to protect itself from loss resulting from the illegality of another is not the consumer, but the corporate assignee.”

Making the case even more clear, players in the secondary market — the acquirers of mortgages — were not innocent parties. They were often directly involved in enabling predatory lending by mortgage brokers and were well aware of the widespread abuses in the subprime market. “Brokers wouldn’t even exist without wholesalers, and wholesalers wouldn’t be able to fund loans unless Wall Street was buying,” explain reporters Paul Muolo and Mathew Padilla, authors of Chain of Blame: How Wall Street Caused the Mortgage and Credit Crisis. “It wasn’t the loan broker’s job to approve the customer’s application and check all the financial information; that was the wholesaler’s job, or at least it was supposed to be. Brokers didn’t design the loans, either. The wholesalers and Wall Street did that. If Wall Street wouldn’t buy, then there would be no loan to fund.”

The securitizers had a counter-argument against calls for assignee liability. They claimed that assignee liability would impose unrealistic monitoring duties on purchasers of mortgage loans, and would therefore freeze up markets for securitized loans. The result, they said, would be less credit for homebuyers, especially those with imperfect credit histories.

Lenders and securitizers opposed proposals to require subsequent purchasers of mortgage debt to bear legal responsibility. “Legislators must be extremely cautious in making changes that upset secondary market dynamics,” warned Steve Nadon, chair of the industry group the Coalition for Fair and Affordable Lending (CFAL) and Chief Operating Officer of Option One Mortgage, an H&R Block subsidiary, in 2003 Congressional testimony, “because unfettered access to the capital markets is largely responsible for having dramatically increased nonprime credit availability and for lowering costs for millions of Americans. Lenders and secondary market purchasers believe that it is very unfair to impose liability when there is no reasonable way that the loan or securities holder could have known of the violation. In any case, we feel that liability generally should apply only if the assignee by reasonable due diligence knew or should have known of a violation of the law based on what is evident on the face of the loan documents.”

“Predatory lending is harmful and needs to be stopped,” echoed Micah Green, president of The Bond Market Association, two years later. “Imposing open-ended liability on secondary market participants for the actions of lenders, however, will ultimately have the effect of limiting credit for those who need it most.”

Securitizers not only defended the default federal application of the holder-in-due-course doctrine for non-HOEPA loans, they supported legislation introduced by Representative Bob Ney, R-Ohio — who subsequently went to prison in connection with the Jack Abramoff scandal — that would have preempted state rules applying assignee liability. “Using anything but a single set of objective and readily detectable standards to determine whether an assignee has liability is a regulatory approach that threatens to undermine many of the benefits of the secondary market,” Green testified before the House Financial Services Committee in 2005. “Faced with this type of environment, secondary market participants may find it less attractive to purchase and repackage subprime loans.”

Ney’s preemptive legislation regarding assignee liability never became law, but it helped frame the debate so that the mortgage lenders, banks and Wall Street were on the offensive, demanding even reduced standards of assignee liability, rather than a legal standard that would place responsibility on securitizers — the banks and investment banks that bundled loans into mortgage-backed securities — for predatory loans and give predatory loan victims a timely opportunity in court to prevent foreclosure.

Securitizers continue to defend what is effectively the same position on assignee liability that helped fuel the subprime mess.

In a June 2007 paper, the American Securitization Forum (ASF) argues that “in addition to being largely unnecessary, any federal legislation that would expose secondary market participants to assignee liability that is very high or unquantifiable would have severe repercussions.” The ASF repeats the arguments of yesterday: that securitization has increased capital available to subprime markets and helped expand homeownership; that assignees have an economic incentive to ensure acquired loans are unlikely to default; that it is unreasonable to ask assignees to investigate all securitized loans; and that assignee liability would dry up the secondary loan market with dire consequences.

“The imposition of overly burdensome and potentially unquantifiable liability on the secondary market — for abusive origination practices of which assignees have no knowledge and which were committed by parties over whom they have no control — would therefore severely affect the willingness of investors and  other entities to extend the capital necessary to fund subprime mortgage lending,” asserted the ASF. “As a result, at precisely the time when increased liquidity is essential to ensuring the financial health of the housing market, schemes imposing overly burdensome assignee liability threaten to cause a contraction and deleterious repricing of mortgage credit.”

That these arguments are overblown and misplaced was clear at the start of the subprime boom. They are now utterly implausible. As a fairness matter, assignees will often be the only party able to offer relief to victims of predatory loans, and victims often need to be able to bring claims against assignees in order to prevent unjust foreclosures; the hypothetical incentives for assignees to avoid loans that could not be paid off proved illusory; assignees have ample capacity to police the loans they acquire, including by hiring third party investigators or by contractual arrangement with mortgage originators; and the problem for lower-income families and communities since 2001 has not been too little credit, but too much poor quality credit.

9. Merger Mania

Merger mania in the financial industry has been all the rage for more than 25 years. “Bigger is indeed better,” proclaimed the CEO of Bank of America in announcing its merger with NationsBank in 1998.

In the United States, about 11,500 bank mergers took place from 1980 through 2005, an average of about 440 mergers per year. The size of the mergers has increased to phenomenal levels in recent years: In 2003, Bank of America became a $1.4 trillion financial behemoth after it bought FleetBoston, making it the second-largest U.S. bank holding company in terms of assets. In 2004, JPMorgan Chase agreed to buy Bank One, creating a $1.1 trillion bank holding company. By the end of 2008, it was worth $2.2 trillion.

From 1975 to 1985, the number of commercial banks was relatively stable at about 14,000. By 2005 that number stood at 7,500, a near 50 percent decline.

Regulators rarely challenged bank mergers and acquisitions as stock prices skyrocketed and the financial party on Wall Street drowned out the critics. But many argued that “bigger is not better” because it raised the specter that any one individual bank could become “too big to fail” (TBTF) or at least “too big to discipline adequately” by regulators. The 2007-2008 financial crisis confirmed these fears.

In the modern era, “TBTF” reared its head in 1984, when the federal government contributed $1 billion to save Continental Illinois Bank from default. As the seventh largest bank in the United States, Continental held large amounts of deposits from hundreds of smaller banks throughout the Midwest. The failure of such a large institution could have easily forced many smaller banks into default. As a result, the U.S. Comptroller of the Currency orchestrated an unprecedented rescue of the bank, including its shareholders. During Congressional hearings on the matter, Representative Stewart McKinney, R-Connecticut, pointedly observed, “We have a new kind of bank. It is called too big to fail, TBTF, and it is a wonderful bank.” The Comptroller of the Currency admitted at the time that the 11 largest U.S. banks were “too big to fail,” implying they would be rescued regardless of how much risk they took on.

Seven years later, U.S. banking law recognized TBTF with passage of the Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA). The Act authorizes federal regulators to rescue uninsured depositors in large failing banks if such action is needed to prevent “serious adverse effects on economic conditions or financial stability.” FDICIA effectively establishes that any bank whose failure poses a serious risk to the stability of the U.S. banking system is exempt from going bankrupt and thus qualifies for a taxpayer-financed rescue. It constitutes a significant exception to the FDICIA’s general rule prohibiting the rescue of uninsured depositors.

The FDICIA also acts as an implicit insurance program for large financial institutions and an incentive for banks to gain TBTF status by growing larger through merger and acquisition. In 1999, economists within the Federal Reserve System warned that “some institutions may try to increase the value of their access to the government’s financial safety net (including deposit insurance, discount window access, payments system guarantees) through consolidation. If financial market participants perceive very large organizations to be ‘too big to fail’ — i.e., that explicit or implicit government guarantees will protect debtholders or shareholders of these organizations — there may be incentives to increase size through consolidation.” International comparisons over a 100-year period show that changes in the structure and strength of safety net guarantees may incentivize additional financial institution risk-taking, and by extension, the motive to consolidate to increase the value of access to the safety net.

Studies have shown that compared to smaller banks, large banks take on greater risk in the form of lower capital ratios (i.e., increased leverage), more investments in derivatives, higher percentages of uninsured deposits, lower levels of core deposits, higher percentages of loans, and lower levels of cash and marketable securities. TBTF policy effectively operates as a government subsidy — and worse, an incentive — for this kind of risk-taking, thereby increasing the vulnerability of the entire banking system and the likelihood of massive taxpayer-funded bailouts. Federal Reserve economists found that the banking crisis of the late 1980s occurred because “large banks adopted a riskier stance, beyond what could sensibly be explained by scale economies.”

Supporters of bank consolidation argue that bigger banks create greater efficiencies because of their larger economies of scale. But several studies have shown that large bank mergers during the 1980s and 1990s failed to improve overall efficiency or profitability. Indeed, most studies found that post-merger cost increases and revenue losses offset any savings that the resulting banks accrued from cutting staff or closing branches.

Evidence indicates executive compensation plays a central role in the quest for larger banks. This “empire-building,” as Federal Reserve economists put it, occurs because compensation tends to increase with firm size, “so managers may hope to achieve personal financial gains by engaging in [mergers and acquisitions].” George Washington University banking law professor Arthur Wilmarth, Jr. agrees. “Not surprisingly,” he says, “studies have shown that managerial self-interest plays a major role in determining the frequency of mergers among both corporations and banks.”

In words that appear prescient today, Wilmarth aptly observed in 2002 that “the quest by big banks for TBTF status — like their pursuit of market power — should be viewed as a dangerous flight from discipline that will likely produce inefficient growth and greater risk.” Reliance on financial derivatives, for example, is extremely concentrated among the largest commercial banks (the five largest commercial banks own 97 percent of the total amount of notional derivatives), and limited almost entirely to the biggest 25. All of these banks are of a size — and most the product of mergers — that would not have been tolerated a quarter century ago.

Taxpayers are now footing the bill for the financial industry’s investment in risky, overleveraged and poorly understood financial schemes. By the end of 2008, the federal government pledged $8.5 trillion in economic assistance for financial institutions — primarily large commercial banks, that the federal government says were too big to fail. 

10. Rampant Conflicts of Interest: Credit Ratings Firms’ Failure

The stability and safety of mortgage-related assets are ostensibly monitored by private credit rating companies — overwhelmingly the three top firms, Moody’s Investors Service, Standard & Poor’s and Fitch Ratings Ltd. Each is supposed to issue independent, objective analysis on the financial soundness of mortgages and other debt traded on Wall Street. Millions of investors rely on the analyses in deciding whether to buy debt instruments like mortgage-backed securities. As home prices skyrocketed from 2004 to 2007, each agency issued the highest quality ratings on billions of dollars in what is now unambiguously recognized as low-quality debt, including subprime-related mortgage-backed securities (MBSs). As a result, millions of investors lost billions of dollars after purchasing (directly or through investment funds) highly rated MBSs that were, in reality, low quality, high risk and prone to default.

The phenomenal losses had many wondering how the credit rating agencies could have gotten it so wrong. The answer lies in the cozy relationship between the agencies and the financial institutions whose mortgage assets they rate. Specifically, financial institutions that issue mortgage and other debt had been paying the three agencies for credit ratings. In effect, the “referees” were being paid by the “players.” One rating analyst observed, “This egregious conflict of interest may be the single greatest cause of the present global economic crisis. ... With enormous fees at stake, it is not hard to see how these [credit rating] companies may have been induced, at the very least, to gloss over the possibilities of default or, at the worst, knowingly provide inflated ratings.” A Moody’s employee stated in a private company email that “we had blinders on and never questioned the information we were given [by the institutions Moody was rating].”

The CEO of Moody’s reported in a confidential presentation that his company is “continually ‘pitched’ by bankers” for the purpose of receiving high credit ratings and that sometimes “we ‘drink the kool-aid.’” A former managing director of credit policy at Moody’s testified before Congress that, “Originators of structured securities [e.g., banks] typically chose the agency with the lowest standards,” allowing banks to engage in “rating shopping” until a desired credit rating was achieved. The agencies made millions on MBS ratings and, as one Member of Congress said, “sold their independence to the highest bidder.” Banks paid large sums to the ratings companies for advice on how to achieve the maximum, highest quality rating. “Let’s hope we are all wealthy and retired by the time this house of cards falters,” a Standard & Poor’s employee candidly revealed in an internal email obtained by congressional investigators.

Other evidence shows that the firms adjusted ratings out of fear of losing customers. For example, an internal email between senior business managers at one of the three ratings companies calls for a “meeting” to “discuss adjusting criteria for rating CDOs [collateralized debt obligations] of real estate assets this week because of the ongoing threat of losing deals.” In another email, following a discussion of a competitor’s share of the ratings market, an employee of the same firm states that aspects of the firm’s ratings methodology would have to be revisited in order to recapture market share from the competing firm.

The credit rating business was spectacularly profitable. Moody’s had the highest profit margin of any company in the S&P 500 for five years in a row. Its ratings on MBSs and CDOs — heavily weighted with toxic subprime mortgages — contributed to more than half of the company’s ratings revenue by 2006.

Although the ratings firms are for-profit companies, they perform a quasi-public function. Their failure alone could be considered a regulatory failure. But the credit rating failure has much more direct public connections. Government agencies explicitly relied on private credit rating firms to govern all kinds of public and private activities. And, following the failure of the credit ratings agencies in the Enron and related scandals, Congress passed legislation giving the Securities and Exchange Commission (SEC) regulatory power, of a sort, over the agencies. However, the legislation prohibited the SEC from actually regulating the credit ratings process.

The SEC was the first government agency to incorporate credit rating requirements directly into its regulations. In response to the credit crisis of the early 1970s, the SEC promulgated the net capital rule which formally approved the use of credit rating firms as National Recognized Statistical Ratings Organizations (NRSROs). The net capital rule requires investment banks to set aside certain amounts of capital whenever they purchase a bond from a corporation or government. By requiring “capital set asides,” a financial “cushion” is created on which investment banks can fall in the event of bond default. The amount of capital required to be set aside depends on the risk assessment of each bond by the credit rating firms. Purchasing bonds that have a high risk of default according to one of the credit rating companies requires a larger capital set aside than bonds that are assessed to present a low risk of default. The “risk” or probability of default is determined for each bond by a credit rating company hired by the issuer of the bond.

Since the SEC’s adoption of the net capital rule, credit ratings have been incorporated into hundreds of government regulations in areas including securities, pensions, banking, real estate and insurance.

Moody’s Investor Service gives a rank of “C” for the lowest rated (i.e., high risk) bonds and a rank of “Aaa” — “triple A” — for bonds that are low risk and earn its highest rating. Examples of highly rated bonds include those issued by well-capitalized corporations, while bonds issued by corporations with a history of financial problems earn a low rating.

If a bank begins experiencing financial problems, Moody’s may downgrade the bank’s bonds. Downgrading bonds can trigger a requirement imposed by regulations or private contracts that require the corporation to immediately raise capital to protect its business. Banks might be forced to raise capital by selling securities or even the real estate it owns.

Credit rating agencies increasingly focus on structured finance and new complex debt products, particularly credit derivatives (complicated instruments providing a kind of insurance on mortgages and other loans). That portion of the ratings business grew to generate a substantial share of the firms’ revenues and profits.

Evidence of falling home values began emerging in late 2006, but there were no downgrades of subprime mortgage-related securities by credit rating agencies until June 2007. Indeed, the credit ratings firms had failed to recognize the housing bubble, and the inevitability that when the enormous bubble burst, it would lead to massive mortgage defaults and the severe depreciation in value of mortgage-backed securities. The firms also failed to consider that many mortgage-backed securities were based on dubious subprime and exploitative predatory loans that could not conceivably be repaid.

The 2007-2008 financial crisis was not the first time credit rating agencies had dropped the ball. During the dot-com bubble of the late 1990s, rating agencies were the “last ones to react, in every case” and “downgraded companies only after all the bad news was in, frequently just days before a bankruptcy filing,” writes University of San Diego law professor Frank Partnoy in Infectious Greed: How Deceit and Risk Corrupted the Financial Markets. In addition, the agencies were criticized in 2003 for failing to alert investors to the impending collapse of Enron and WorldCom. As a result, Congress passed the Credit Rating Agency Reform Act of 2006 which requires disclosure to the SEC of a general description of each agency’s procedures and methodologies for determining credit ratings, including historical downgrade and default rates within each of its credit rating categories. It also grants the SEC broad authority to examine all books and records of the agencies. However, intense lobbying by the rating firms blocked any further reforms, and the law expressly states that the SEC has no authority to regulate the “substance of the credit ratings or the procedures and methodologies” by which any agency determines credit ratings. In 2007, SEC Chairman Christopher Cox said, “It is not our role to second-guess the quality of the rating agencies’ ratings.”

In the highly deregulated financial markets of the last few decades, the credit rating firms were supposed to be the independent watchdogs that carefully scrutinized corporations and the financial products that they offered to investors. Like the federal agencies and Congress, the credit rating companies failed their mission to protect the public.

Robert Weissman is editor of Multinational Monitor. James Donahue is an attorney with the Washington, D.C.-based Essential Action. This article is based on a February report, available in full with citationns at www.wallstreetwatch.org, published by the Consumer Education Foundation and Essential Information, the parent organization of Multinational Monitor. Harvey Rosenfield, Jennifer Wedekind, Marcia Carroll, Peter Maybarduk, Tom Bollier and Paulo Barbone assisted with writing and research.