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INTRODUCTION
These days America is looking like the Bernie Madoff of economies: For many years it was held in respect, even awe, but it turns out to have been a fraud all along.
Nobel economist Paul Krugman1
The role of charisma in the global financial crisis has been referred to as a neglected topic (Kakaletris and Rauha, 2011), with âimportant gapsâ (Walter and Bruch, 2009) observed in the charismatic leadership literature, reflecting the necessity of further research (Avolio et al., 2009). The raison dâĂȘtre of this book, consequently, is to address this neglected and important gap, and in so doing, to elucidate in the mind of the reader the vital, enthralling and substantive role of charisma in the origins and executions of market fragility, booms and busts. Such an engaging journey cannot be undertaken, however, without first providing the reader with an overview of the 2008 financial crisis itself.
An overview of the 2008 financial crisis
At a London School of Economics event in 2008, the Queen of England famously asked of the global crisis âWhy did no one notice it?â2 The answer, clearly, is that many people did. Whether many of those people cared is another matter.
On 22 June 2007, Bear Stearns pledged a collateralized loan of up to $3.2 billion to bail out one of its funds, the Bear Stearns High-Grade Structured Credit Fund. The bail-out, despite its size, was not successful. By 16 July 2007, the bank announced that both its flagship funds â the Bear Stearns High-Grade Structured Credit Fund, and the Bear Stearns High-Grade Structured Credit Enhanced Leveraged Fund â were declared bankrupt. Both funds had invested heavily in subprime debt (mortgage-backed securities (MBS)), exotic securitized vehicles such as collateralized debt obligations (CDOs3) that had declined in value so extensively (as a result of widespread mortgage defaults and foreclosures across low-income households in the US) that they had wiped out the entire value of the assets held by both funds.4 Trading of subprime assets had become almost endemic across the sector by this point â between 2004 and 2007, global CDO sales grew exponentially from $144.5 bn to $503.3 bn.5 Bear Stearns sparked widespread concerns of contagion, prompting a mark-down of similar assets in other portfolios, and raised widespread fears for those financial institutions (particularly Bear Stearns and Lehman Brothers, but also Morgan Stanley and other institutions) that were, at the time, also heavily exposed to subprime debt.
In the same month that the Bear Stearns $3.2 bn bailout failed, a special edition of Bloomberg Markets hit the newsstands. The front page was emblazoned with the words âToxic Debtâ, stamped across its front page in bold, red type, directing the reader to a 36-page special feature that focused on the risk of an imminent catastrophic financial meltdown, attributable exclusively to the massive increase in foreclosures and mortgage defaults that were occurring across the US, and which rendered the subprime CDOs â which by now had flooded the market, and which sat in their billions on the balance sheets of almost every firm on Wall Street â effectively valueless. Sub-headings of the special edition included the titles âThe Subprime Sinkholeâ, âThe Poison in your Pensionâ and âThe Ratings Charadeâ and clearly illustrated the extent to which the knowledge of the likelihood of an imminent market collapse had infiltrated the market. Yet despite this, Lehman Brothers continued to gorge on subprime and ill-advised real-estate acquisitions almost until the date of its filing for Chapter 11 bankruptcy in September 2008, over a year later.
Warnings of a subprime CDO meltdown actually began to emerge far before the decline in Bear Stearns funds. As early as 2005, Raghuram G. Rajan, Economic Counsellor and Director of the IMFâs Research Department, warned of the âprobability of a catastrophic meltdownâ of the financial system, owing principally to the development of, and innovations in, complex financial instruments such as CDOs, and the way in which fund and bank managers were remunerated. This combination of factors, noted Rajan, encouraged the adoption of more risk and the tendency for herding behaviour among fund managers, a potential risk to the stability of the market. Addressing an audience (that included Alan Greenspan) at a symposium entitled âFinancial Markets, Financial Fragility, and Central Bankingâ, Rajan commented in 2005 that âWhile it is hard to be categorical about anything as complex as the modern financial system, itâs possible that these developments are creating more financial-sector induced pro-cyclicality than in the past. They may also create a greater (albeit still small) probability of a catastrophic meltdown.â6
In the same month that the Bear Stearns High-Grade Structured Credit and High-Grade Structured Credit Enhanced Leveraged Funds declared bankruptcy, and Bloomberg Markets hit the newsstands, the Securities and Exchange Commission (SEC) forged a different direction entirely, focusing not on concerns of increased market volatility and the rampant devaluation of financial institutionsâ balance sheets, but instead on the decision to repeal the Uptick Rule. The Uptick Rule7 was a law passed in a Great Depression-era US, and effectively banned the shorting of stock whose value was already in descent. The purpose of this legislation was to help safeguard market stability in a time of marked market volatility. Repealing the law in a period of marked market volatility in 2007 was to ultimately lead to the aggressive shorting of stock whose value was already in descent, ultimately accelerating the descent into bankruptcy of both Bear Stearns and Lehman Brothers. A governmental volte face followed swiftly, with a ban on short selling imposed in 2008.
The repeal of the Uptick Law actually reflected a raft of US governmental deregulation that, arguably, remained central to creating the conditions under which the subprime crisis was allowed to occur, and which stretched back a number of decades. Such legislative changes began principally in 1970, when Congress enabled the Federal Loan Mortgage Corporation (Freddie Mac) to buy mortgages on the secondary market and to sell them on as MBS. The Communities Reinvestment Act of 1977 further encouraged banks and savings and lenders to extend credit to minority groups and low-income borrowers, including small businesses. In 1980, the Depository Institutions Deregulation and Monetary Control Act further accelerated lending to low-income and minority groups by granting all savings and loan associations the power to issue loans. Critically, however, the law lacked meaningful regulatory oversight of loan issuers, and included an exemption for all federally chartered savings banks, instalment plan sellers and chartered loan companies from state usury limits. Such lax regulatory oversight, combined with additional regulatory changes that allowed the lowering of capital requirement limits from 5% to 3%, contributed directly to the savings and loan crisis that originated in the mid-1980s.
The 1990s ushered in a period of an acceleration of lending to low-income home owners, the scale of which necessitated a concomitant widescale deregulation of banks and lenders. Firstly, the Federal Housing Enterprises Financial Safety and Soundness Act of 1992 required the government-sponsored Fannie Mae and Freddie Mac to ring fence a significant percentage of lending to low-income borrowers. In 1994, Fannie Mae facilitated Bear Stearns and First Union in their launch of the first publicly available securitization of Community Reinvestment Act (CRA) loans, acting as guarantor for $384.6 m of securities. The New Community Reinvestment Act of 1995 further accelerated low-income lending by providing capital gains relief to both married and single individuals. This had the effect of ramping up spending on Main Street which led to a trend for the purchase of more expensive first homes, and often the acquisition of a second property by homeowners.
In 1999, the Clinton Administration passed an action to provide $2.4 trillion in affordable housing mortgages for 28.1 million families. The passing of the Gramm-Leach-Bliley Act in 2000, otherwise known as the Financial Services Modernization Act, repealed the Glass-Steagall Act of 1933, and enabled banking, securities and insurance companies to act as any combination of a commercial bank, investment bank or insurance company. The Glass-Steagall Act had constituted a cornerstone of 1930s legislation, and its repeal has since been blamed by many as one of the founding causes of the 2008 global financial crisis. The Commodity Futures Modernization Act of 2000 further allowed the trade of credit-default swaps by hedge funds, investment banks or insurance companies with minimal oversight. The following year, Fannie Mae committed to the purchase and securitization of $2 bn of Community Investment Act-eligible loans, reflecting government requirements to dedicate 50% of its business to low- and moderate-income family loans. Such legislative movements were designed to facilitate banks to trade ever-growing numbers of mortgage-backed securities that were flooding the market, enabling significant growth in lending to low-income families.
By 2002, the Bush Administration further raised the goal for minority home ownership by a minimum of 5.5 million by 2010. That same year, the head of the Federal Reserve, Alan Greenspan, lowered interest rates to their lowest level in 45 years (to 1%), further accelerating spending and home acquisitions. The passing of the American Dream Downpayment Act further reflected, and facilitated, the ongoing political drive by the Bush Administration to achieve historically high levels of home ownership for Americans. By 2004, the SEC had removed the Net Capital rule, further relaxing regulatory requirements for the financial sector for all banks with a capitalization of $5 bn or higher. This meant that Goldman Sachs, Merrill Lynch, Lehman Brothers, Bear Stearns and Morgan Stanley were became subject to far laxer capital requirements. This led eventually to a situation where some banks were leveraging (mostly subprime) debt up to 40 times the value of their balance sheets. That same year, Congress announced that Fannie Mae and Freddie Mac were required to increase their affordable-housing goals from 50 to 56%. As a result, both companies had, by 2006, purchased approximately $434 bn in securities that were backed by subprime loans.
During the 1997â2005 period, throughout this time of marked deregulation and aggressive lending to low-income families, house prices rose to unsustainable levels. By 2004 and 2005, US houses prices â in addition to mortgage fraud â had hit a record high. In 2005, a housing market correction occurred, and the housing bubble burst. By year end 2005, 846,982 houses were involved in foreclosure â rising to 1,259,118 in 2006.8
By 2006, the federal government had deigned to only pursue mortgage fraud cases of $1 m or more as they had become so inundated with mortgage fraud cases. The US Senate Committee on Commerce/Labor expressed concerns at this time that mortgage lenders were following a strategy of persuading inexperienced buyers to sign loans that were not compatible with their income (i.e. to commit to an overly expensive property), and that a significant growth in âcreative financingâ was destabilizing the financial system. Creative financing included the origination of âpiggy backâ, interest-only and âno docâ (Alt-A) loans, which accounted for 47% of all loans originated in 2006, a startling growth if one considers that they represented only 2% of all loans originated in 2000. Worryingly, by 2006, 80% of all subprime mortgages constituted ARMs (Adjustable Rate Mortgages), recorded as âexploding ARMsâ, in government documents,9 due to the explosive nature of the effect that they stood to wield on the economy.10 A 35% increase in national mortgage loan fraud was recorded by the US Treasury Departmentâs Financial Crimes Enforcement Network (FinCEN) from 2006â7, with 1.2 m foreclosures filed in 2006 (a 42% rise since 2005), and a 1,411% increase in Suspicious Activity Reports (SARs) filed with respect to mortgage loan fraud between 1997 and 2005.11
By 2007, the US Senate Committee on Commerce/Labor12 were reporting that over 23 major mortgage lenders had imploded, and that âSeveral credible reports say they are facing a tidal wave of defaults and foreclosures, which could strip these families of their major, if not their only, source of wealth and long-term economic securityâ (Ben Bernanke, Federal Reserve Chairman).
Compounding the subprime problem was the fact that the securitizations used to buy subprime debt (MBS) had been incorrectly, and far too generously, rated, often as AAAs (particularly in the case of mezzanine tranches) by credit ratings agencies (CRAs). These ratings agencies (Standard & Poorâs, Fitch and Moodyâs) were often alluded to as regulators, but were, in actuality, paid by originators to provide ratings. As such, their focus lay in protecting the interests of investors. A significant conflict of interest thus existed via the fact that originators themselves (Lehman Brothers, Bear Stearns) paid the ratings agencies. At a time of rampant escalation of subprime securitization, competition became particularly fierce, which set the scene for significantly overly-generous ratings in a bid to win and retain the vast volume of business being generated. The continual generation of AAA/highly rated loans continued to spur interest in, and trading of, these securitized vehicles, which ultimately exacerbated the eventual market crash. Following a spike in foreclosures around 2006, CRAs ultimately downgraded 80% of tranches,13 sparking a contagion in the markets that subprime debt held on the balance sheets of most banks was vastly over-valued.14 It is interesting to note that the CRAs retained their investment grade ratings for Lehman Brothers and Bear Stearns up to a few weeks before the implosion of both.
In summary, the extensive deregulation of both mortgage lending and financial markets sectors that had taken place pre-2008 reflected the US governmentâs aim to both extend lending to low-income households, and to trade those securities on the open market. This set the stage for banks such as Lehman Brothers, and independent and institutional mortgage lenders (for example, CountryWide Financial), to benefit extensively from the trading of mortgage-backed securities.
A key question to ask is why markets continued to demonstrate extensive investment in subprime debt throughout 2007 and 2008 when clear economic and financial indicators (for example, steep rises in foreclosures of low-income loans, mortgage loan company bankruptcies) became publicly available. Why did Lehman Brothers and other banks, for example, not seek to restructure their balance sheets and reduce their massive leverage? After all, the failed $3.2 bn bailout of the Bear Stearns funds and extensive warnings (i...