LOBBYING, CAMPAIGN FINANCE REFORM, OR TERM LIMITS: HOW TO STOP GRIDLOCK IN THE UNITED STATES CONGRESS
“For of those to whom much is given, much is required. And when at some future date the high court of history sits in judgment on each one of us—recording whether in our brief span of service we fulfilled our responsibilities to the state—our success or failure, in whatever office we may hold, will be measured by the answers to four questions:
First, were we truly men of courage—with the courage to stand up to one’s enemies—and the courage to stand up, when necessary, to one’s associates—the courage to resist public pressure, as well as private greed?
Secondly, were we truly men of judgment—with perceptive judgment of the future as well as the past—of our own mistakes as well as the mistakes of others—with enough wisdom to know that we did not know, and enough candor to admit it?
Third, were we truly men of integrity—men who never ran out on either the principles in which they believed or the people who believed in them—men who believed in us—men whom neither financial gain nor political ambition could ever divert from the fulfillment of our sacred trust?
Finally, were we truly men of dedication—with an honor mortgaged to no single individual or group, and compromised by no private obligation or aim, but devoted solely to serving the public good and the national interest?”
–John F. Kennedy in a speech delivered to a Joint Convention of the General Court of the Commonwealth of Massachusetts on January 9, 1961.
After graduating from the University of George Mason School of Law, I sat for the Virginia State Bar in 2006 and was sworn in at the Supreme Court of Virginia as a licensed attorney. Listening to the commencement speech of the Honorable Chief Justice Leroy Rountree Hassell, Sr., the first African American appointed to the court, a tremendous sense of honor came over me. I distinctly remember looking around at my fellow Juris Doctors readying to be sworn in to the sacred practice of law in the Commonwealth, thinking, “hear we are, the next agents of justice.”
However, I’d already been steeped in the practice of law since January of 2005, having petitioned the Supreme Court for permission to practice in my third year of law school under the guidance of an attorney already admitted to the bar. Petitioning the court was unfortunately necessitated by the unexpected near death of my father that winter.
In a matter of weeks, my father had gained somewhere near fifteen pounds of water weight. We later learned that this was a result of extreme heart failure brought on by the idiopathic triggering of a superfluous electrical pathway in his heart. As a result, his resting heart rate would spike upward of two-hundred, instead of the normal sixtyish beats per minute. His heart literally turned to mush, losing its elasticity and ability to pump oxygen and blood to his vital organs. His ejection fraction, the measure of how much blood the heart pumps out with each pump versus the amount it withholds, plummeted, his organs shut down and on Christmas Eve, 2004, he literally died.
My father was revived and immediately airlifted to Fairfax Hospital, renowned as having one of the best cardiology departments in the world. He underwent emergency heart surgery for the insertion of a balloon pump. The next morning, Christmas day, the on-call pulmonary specialist told me, point blank – my father would not last an hour.
Well, he did. And after nearly a month of induced coma, he came home on February 7th, my birthday, and we opened our Christmas presents with family on Easter. To this day his doctors are in awe at his recovery…he is, quite literally, a walking miracle. So let me pause to say, to all, no matter how dire a situation seems, remember, there is always hope! I digress, except to say that the exact same is true of the present and future of our great nation.
My father was the senior partner, manager and owner of my law firm, Kidwell, Kent & Curran. It’s a small, general practice firm, consisting of only three attorneys, myself, my father, and J. Charles Curran, a dear friend and mentor. As such, upon the event of my father’s sudden sickness, it fell upon me to take up the mantle by tackling his caseload and managing the firm.
When I took over, approximately eighty-five percent of the firm’s income was derived from real estate oriented revenue. In 2004, the height of the real estate boom, we were conducting an average of four residential or commercial real estate settlements a day. But, as luck would have it, in 2006, the exact summer I was sworn in to the practice of law, the real estate market collapsed in the wake of what is now commonly referred to as the sub-prime lending scandal.
Almost overnight, my firm went from conducting four settlements a day to conducting as little as four in a month. The bubble had burst and what ensued was the precipitous decline of our economy into the “Great Recession.” And now the feared – “Double Dip Recession”.
The economic fallout across our nation has been unprecedented – somewhere between seven to ten million homes now sit vacant in a rising tsunami of foreclosures as unemployment lines rap around city blocks in haunting similarity to the soup lines of the Great Depression.
Suddenly, there I was, a young, ideological attorney fresh out of law school, beyond green behind the ears and faced with the task of reviving a law firm staring down the throat of looming bankruptcy. The livelihood of my entire family hinged on the income generated by Kidwell, Kent & Curran – my sister was our Senior Real Estate Processor, my father the owner, and now my economic fortunes were equally as entwined with the success or failure of our small family business. Failure was simply not an option.
What was I to do? I decided immediately that the best thing to do was diversify. Just like any savings plan, stock portfolio or otherwise, the answer, I thought, lied in delving head first into new areas of law not previously or long since practiced at our firm.
I found myself practicing domestic relations, handling divorces, child custody and spousal abuse cases. I defended alleged drug dealers, some innocent, some not, prosecuted squatting tenants, and even “chased ambulances”, to use the term loosely, to land personal injury cases. But all of it left somewhat of a sour taste in my mouth. So, I moved on to different pastures where I hoped that my legal expertise could better serve justice.
Through friends in worship, I was invited to local churches and assisted living facilities to conduct seminars on estate planning and charitable giving, and I traveled to regional real estate brokerages to coach agents on the legal minefields of the increasingly litigious market.
Being that the firm’s primary focus has for decades been on real estate law, I suppose it was natural for me to find expertise in one of the fastest expanding phenomena of the emerging real estate market: the Short Sale.
A short sale, simply put, is when a lender that has a mortgage, or Deed of Trust, secured as a lien against a particular parcel of real estate, allows the owner of that property to sell the property short of what they owe on their mortgage. The owner’s real estate agent will list the property as contingent upon third party approval, that is, the lender’s approval, of any ratified contract of purchase and sale. Once a contract is in hand, a package containing the owner’s W-2s, tax returns, pay-stubs, account statements and a letter explaining why they are in economic hardship is sent to the lender for consideration.
The short sale has become one of the largest market shares of all homes sold in the wake of the sub-prime lending scandal and is utilized as an alternative to foreclosure. The lender, in essence, reviews the hardship package and if it determines that it will yield more income on its investment by allowing the short sale than by instituting foreclosure, the lender approves the sale, often with stipulations requiring the borrower to execute a new Note promising to pay back the deficiency over time.
In one form or another, the thought had long been swelling in my head, but I will never forget the day I was driving back to the office after having conducted a seminar on the short sale process at a local Long and Foster Realty brokerage. My head was racing with recent memories of the clients crying in my conference room, pleading for me to save them from being ousted from their American Dream. The mounting pressures of scraping to cover payroll, pouring what little savings I’d accumulated into the firm to keep it afloat – it all just hit me. I pulled off the road, ironically into the parking lot of a Bank of America, and looked into the rearview mirror-
“How did this happen,” I asked myself aloud, staring at the too tired reflection of a man in his twenties. And there it is… how did this happen? How did America, what I’d grown up to know is indisputably the greatest nation on this planet, the sole remaining superpower and the epicenter of economic opulence, come to this? How were so many people out of work? And personally, how the hell was I going to survive the worst economy since the Great Depression and do so in a firm dependent on real estate, the very market that has been enduring through the Great Recession two years longer than every other industry and in many respects caused the recession?
How did this happen? The answer, of course, is multi-pronged and complex. That being said, there is one major cause of the Great Recession that speaks volumes of the rampant corruption and back-door dealing that has permeated the body politic of the United States Congress.
The corruption of which I speak is not necessarily born of malevolent intent or even self-dealing, though this certainly exists and is an issue. Unfortunately, it is a corruption that is systemic, proliferated as an inbuilt feature of our political system, and it is debilitating to the proper purpose and function of our government.
Sadly, the political underpinnings of the Great Recession, just the same as those of the Great Depression, are cases in point of this ingrained corruption of which I speak, and that is precisely why it is so absolutely imperative that we come to recognize the severity of the issue and address it with first priority!
It is against this corruption that the protestors comprising the ubiquitous and spreading Occupy Wall Street movement, should be protesting – and I hope that they read my message to assist in their finding a more enlightened voice to their cause. I understand their anger because I myself am the prototype Small Business, literally off Main Street, being stomped out in this economy. However, I do not agree with many of their destructive rioting as it is misplaced and dangerous. Most comprising the movement, and therefore the movement itself, need to better understand what they are truly fighting for – and more importantly, why it is so imperative that all of us fight for it.
The world, the economy, government and politics – they are all intertwined in a highly volatile, complex system, where one directly affects all others. Therefore, to understand the critical status of our debt ridden economy, the Walk on Wall Street members, Republicans, Democrats – every American, needs to first understand, on a deeper level, exactly how we got into this mess. While some blames and complaints are definitely well placed, it is premature to scapegoat corporations as the sole culprit. To a large extent, in fact, the Walk on Wall Street should be a Walk on Congress.
In the years leading up to the Great Recession, extensive deregulation of the financial industry opened the door for the short-term, profit motivated masterminds of Wall Street to conjure and implement exotic schemes that literally mortgaged the very security of the United States, and by extension thereof, the world economy. It was a gamble which fueled the boom of the real estate market as well as an explosion of personal credit debt, and it was every tax paying American that eventually paid the pot when the wager was lost.
How was this allowed to occur? As the Leaders of the Group of 20 cited in their “Declaration of the Summit on Financial Markets and the World Economy,” in November, 2008:
During a period of strong global growth, growing capital flows, and prolonged stability earlier this decade, market participants sought higher yields without an adequate appreciation of the risks and failed to exercise proper due diligence. At the same time, weak underwriting standards, unsound risk management practices, increasingly complex and opaque financial products, and consequent excessive leverage combined to create vulnerabilities in the system. Policy-makers, regulators and supervisors, in some advanced countries, did not adequately appreciate and address the risks building up in financial markets, keep pace with financial innovation, or take into account the systemic ramifications of domestic regulatory actions.
Quite literally, the watchdogs on Capital Hill were asleep at the wheel and in many cases they found it in their best interests to simply look the other way. Senators were relentlessly and effectively lobbied to pull the teeth from statutes aimed at quelling the foaming mouth of the profit at all cost machine that is Wall Street. The Securities and Exchange Acts of 1933 and 1934 (enacted in response to 1929 Stock Market Crash), as well as subsequent financial reforms, were simply not enforced, and a host of new legislation opened the door for moral hazard and unregulated risk. Why?
As a result of a $70 trillion “stash” of worldwide fixed income investments seeking higher yields than those offered by U.S. Treasury bonds, Wall Street rose to the occasion, bringing forth financial innovation in a move to link this glut of money to the real estate market. This represented a seemingly endless tide of gold to line the pockets of everyone in the mortgage supply chain from the mortgage broker selling the loans, the banks funding the brokers, to the goliath investment banks backing them, and as a result the behavior of lenders changed swiftly and dramatically. Lenders offered unprecedented loans, both in type and volume, even to undocumented immigrants, and the government did absolutely nothing to stop it!
As a result, the sub-prime lending scandal ensued. The unbridled deregulation and outright failure to enforce the laws already on the books allowed lenders to loan money to individuals or companies looking to invest in residential or commercial properties with “teaser” interest rates below prime (the prime interest rate as reported by the Wall Street Journal bank survey). Commercials blitzed our televisions and soon millions of Americans were looking to take out a second or third line of credit on their home or to purchase as many properties as they could with hopes of flipping them for a profit. We were enticed with interest only loans or adjustable rate mortgages, (ARMs), with beginning teaser rates so amazing, how could we not jump into the pot?
Even more, when we clicked on the site of the newest internet brokerage ready to lend us money, we found we weren’t even required to prove our financial solvency. Traditionally, borrowers taking out conventional loans would be required to put somewhere around 20% of the value of the property down, but, by 2005 the median down payment for first-time homebuyers was around 2%, with nearly 50% of loans made with no down payment at all. We were almost being provoked to mortgage our futures.
But, the enticement didn’t stop there! We flocked to the brokers when they first offered stated income, verified assets (SIVA) loans, requiring only that we state our income without providing any proof other than having some money in the bank.
Then, the no income, verified assets (NIVA) loans came out. Unbelievably, lenders no longer even required proof of employment. Borrowers just needed to show proof of money in their bank accounts. Finally came NINA, or No Income No Assets loans. These NINA loans, often referred to as “Ninja” loans, allowed us to borrow money without having to prove or even state any owned assets. All that was required for a mortgage was a credit score, and not even a good one!
Another industry was primed to capitalize on the seemingly endless flow of financing to the common consumer, the residential home builder. Demand exploded into full out frenzy and builders began throwing up houses at record pace. Better yet, with demand soaring, housing prices were skyrocketing for the already invested, and homeownership reached an all-time high. All seemed beautiful in the boom world of supply and demand.
But, as we all now know… it was all horribly wrong!
I distinctly recall one particular mortgage offered from a fly-by night brokerage to first-time clients of my law firm. It took me literally an hour to decipher the convoluted terms of the Note being offered to my clients and what I read was beyond alarming. So, when my clients came to the settlement table, I asked them what they thought the terms of their loan were. As you might have guessed, what they thought they were signing up for was completely different from what they were actually being asked to sign.
My clients explained that they were purchasing their first home, recently married and willing to extend themselves a little as she was expecting and they needed the extra room. They were under the impression they were getting a thirty year loan with a fixed interest rate at 2.75% per annum with interest only payments required for the first three years. Not even close!
In reality, the circuitous Note they were presented with was interest only for the first thirty days, fixed at 2.75% interest for the first year, and adjustable every six months thereafter, at prime plus 5% and with a cap at 18% interest per annum.
This Note was alarming on multiple levels. To start, the margin, being the lender’s scope of profit on the loan, at the time, was usually set at prime plus 2.5% to 2.75%, this was prime plus 5%. Second, and more alarming, the loan was amortized over thirty years at the greater of the margin plus 5% or 9.25%, and was due, in full, in fifteen years. This meant that while the interest rate was kept artificially low, as a teaser, for thirty days of only interest and then principal and interest at 2.75% for a year, the principal balance would actually increase at a startling rate. After paying on their loan for two years they would have owed tens of thousands more than the amount of their original loan and greater the value of their house.
Why not just refinance immediately? They could, but, by the very terms of the Note’s prepayment penalty clause, they would have been required to pay a hefty fine if they did so within two years and especially if they did so with another lender.
And third, as the stack of forms for them to sign ambiguously indicated, the loan had already been sold, twice, to two different loan servicing providers, prior to their signing. This Note was a product of predatory lending to say the least.
The worst part about this scenario was the fact that my clients had absolutely no idea what they were about to sign and would not have had any idea unless I had taken the time, in my capacity as an attorney at law, to explain the terms of the Note at settlement. These were well educated individuals, both with masters degrees, and settled in well respected professions. I advised them not to sign the documents and, to date, they remain as clients.
But, imagine if these two individuals were a young, entrepreneurial minority couple tantalized at the prospect of finally being able to attain the very icon of the American Dream – their first home. Imagine further that they were told that their mortgage payment for a $600,000 residence, a home large enough for themselves, their children and their parents, would only run them $1,200 a month. Even better, if they went with the settlement company that the builder of their brand new American Dream recommended, the builder would contribute $5,000 to their closing costs. A sweet deal, right? No!
First, the settlement company recommended by the builder would most certainly be a subsidiary or otherwise be affiliated with the parent, builder company, and the settlement company would “kick back” a majority of the title insurance earned at closing. To make a personal gripe, this is allowed only through a loophole in the Real Estate Settlement Procedures Act that the Housing of Urban Development (HUD) continually fails and refuses to properly police!
Because of the affiliation between the builder and settlement company, the settlement company had no care for the interests of the borrower/purchaser. Not representing the borrower, the settlement agent, even if asked about the terms of a Note or Deed of Trust at settlement, would not be bound by any fiduciary duty to accurately explain the documents to the borrower. In fact, they are barred in doing so because doing so constitutes the unauthorized practice of law. And, as for the $5,000 in settlement costs, well, the builders simply upped the price of their new homes to cover this amount, charging a little more here and there for extras or even deliberately excluding a necessity from the initial offer to entice the buyer to upgrade from the base model. Brilliant capitalism in grand excess!
The result: borrowers signed documents they simply did not understand, and in three months, a year, maybe two or even three, suddenly they were not required to pay the promised $1,200 a month for their mortgage, but rather, $4,200 a month. When the clock tolled and their mortgages shot up, millions of borrowers across the country were suddenly unable to pay, and this dawned the crash of the real estate market.
Between 1997 and 2006, the average value of real estate in the United States increased by an astonishing near 125%. The mentality, then, was that houses would increase in value not primarily on par with inflation as they had historically, but rather, as super-investments promising the highest rates of return around. You could refinance your house, take out a second or third line of credit, with no proof of income, buy a car with the change in your pocket, put your kid through college, and in six months your house would be worth another sixty thousand. For a period of years, in fact, this was the reality, but it was nothing more than a thin and beautiful veil masking the inexorable and ugly truth.
While the price of real estate skyrocketed, the average income of an individual in that same timeframe did not. In fact, it stayed absolutely flat! From 1980-2000 the national median home price range averaged approximately three times median household income. This ratio accelerated to over four and a half times median household income by 2006.
It was not long before the builders that were throwing up homes at record pace on the naïve speculation that demand for homes would continue to climb without an attendant rise in income, simply outpaced demand. Suddenly, there were too many homes and too few people willing or able to make the investment. Supply and demand had finally broken through the frenzy to unveil the dreadful truth.
The coalescence of these factors resulted in a sudden downward pressure on the value of real estate across the United States. The nail in the coffin, so to speak, would come when the first wave of adjustable rate mortgages (ARMs) re-set. Countless homeowners found themselves suddenly unable to pay their mortgage and when they turned to their lenders to refinance to a lower, more manageable rate, they were now being told that the principal balance on their outstanding loans were in excess of the plummeting value of their home. Since the lender could not sufficiently secure the loan necessary to refinance the outstanding adjustable rate mortgage, they would not extend the necessary financing. The housing bubble had officially burst!
A positive feedback loop began whereby those unable to refinance defaulted on their loans and foreclosures spread like wildfires, further driving down the value of forest after forest of homes. Second, third, fourth and continuing waves of adjustable rate mortgages re-set, and those homeowners were also unable to refinance. They defaulted and the foreclosure of their homes fed right back into the downward spiraling market, further pulling the value of real estate into the tank.
By fourth-quarter 2007, over 15% of sub-prime ARMs were in foreclosure or over ninety days delinquent. By second-quarter 2008, a staggering 25% were delinquent. In 2007, lenders instituted foreclosure proceedings on over 1.2 million properties, a dramatic 79% increase over the year prior. In 2008, lenders instituted 2.3 million foreclosures and 2.8 million in 2009.
The saga, as we all know, does not end there. We’ve unfortunately become all too familiar with the terminology that has been thrown around in the wake of the sub-prime lending scandal. Toxic loans, mortgage-backed securities, and credit default swaps, to name a few. This is because an additional and major catalyst of the sub-prime crisis, beyond the abovementioned predatory and deregulated lending practices, was the advent of banks entering into the mortgage bond market.
The traditional mortgage model involved a bank originating a loan to the borrower and retaining the entirety of the default risk. The significant risk of losing their investment in the secured real estate understandably forced banks to lend cautiously. But, this traditional model crumbled under a new “originate to distribute” model as a result of banks entering the mortgage bond market.
Banks were now able to sell the mortgages and distribute credit risk to investors through what we all now know as the mortgage-backed security (MBS). Suddenly the lenders issuing mortgages no longer retained any risk and by selling the mortgages to investors, they could immediately replenish their funds, enabling them to issue more loans and generate mountains of transaction fees. This unfortunately created a moral hazard in the industry as loan originators were now only concerned with generating money for their pockets via origination charges without parallel regard for the quality of the underlying credit.
But, even with the advent of the MBS, the regulated banking industry had only so much money to go around. As such, the security market from 1992 to 2004 expanded at a steady but marginal rate. But now, in order to satiate the demand of foreign and domestic investors Wall Street was going to have to come up with something genius. Millions of lobbying dollars spent and in comes the 2004 United States Securities and Exchange Commission (SEC) decision on the Net Capital Rule allowing United States investment banks to issue substantially more debt. It was this exact debt that was utilized by the investment banking industry to purchase volumes of mortgage-backed securities.
The share of sub-prime mortgages passed to third-party investors via mortgage-backed securities increased to approximately 75% in 2006. American homeowners, consumers, and corporations owed nearly $25 trillion in debt with traditional depository banks retaining only $8 trillion of that total and an astonishing $10 trillion came from the securities markets.
Now, my aim is not to delve into the pros and cons of allowing investment banks to issue debt and purchase mortgage-backed securities. In fact, aside from the debt element, I am not so sure that I do have any theoretical problem with it if properly regulated. But, what is extremely important to understand is why the securities bazaar comprising the lion’s share of the market was and remains such a crisis from a policy standpoint, especially insofar as it contributed to the Great Recession.
Politically speaking, the problem is a complete and utter lack of regulation of what is commonly referred to as the shadow banking system. The shadow banking system is a network of lenders, brokers and opaque financing vehicles such as hedge funds and investment banks which by definition do not accept deposits like the common depository bank and are therefore not subject to the same regulations.
In allowing investment banks to underwrite massive amounts of debt they were in reality given cart blanche permission to procure mortgage-backed securities and essentially intertwine themselves into the same pool as depository banks without the requirement of adhering to nearly as stringent of regulations. And they capitalized on this opening!
In the years leading up to the crisis, the top four U.S. depository banks moved over $5 trillion in assets and liabilities “off-balance sheet” into the shadow banking system, enabling them to bypass scores of regulations. Why would they do this? Money!
The ability to issue large amounts of debt opened the door, but the investment banks were investing in mortgage-backed securities based upon a false assumption that housing prices would continue to rise in the foreseeable future, and that borrowers would also continue to make their mortgage payments. In doing so, the investment banks were engaging in financial leverage: borrowing at a lower interest rate and investing the proceeds at a higher interest rate. This strategy proved profitable during the housing boom. In fact, the New York State Comptroller’s Office reported that Wall Street executives took home bonuses totaling $23.9 billion in 2006 alone.
Now, hindsight is 20/20, sure, but given the stagnation of individual income as compared to the staggering escalation in housing affordability, it should have been clear to the investment banks that their bet was, in the very least, a short lived risk. In reality, though, lenders certainly didn’t care because they were raking in processing fees. And the investment banks, they were concerned only with short-term profit and the executives, it seems, concerned more with their year-end bonus rather than the long term financial viability of their firms, let alone the consequences of a predictable real estate meltdown.
The entire financial system, from mortgage brokers to investment bank executives and Wall Street risk managers, was undeniably tilted toward short-term risks for the sake of the almighty buck while ignoring long-term obligations and underlying risks to main street America. They were playing with trillions of dollars, all held as debt over each American’s head, and our government failed completely to regulate their actions – actions which evidently were governed by greed and reeked of moral hazard. This is what the Walk on Wall Street movement is protesting – even if they don’t realize it.
Then, it hit the fan! The investment banks’ brilliant financial leverage strategy, as we now know, resulted in almost incalculable losses when real estate values plummeted and mortgages began to default. Unregulated, these shadow banking entities were unconscionably vulnerable because they borrowed short-term in liquid markets to purchase long-term, illiquid and risky mortgage-backed securities. The downturn in housing and rising foreclosure rates resulted in investment banks being subject to rapid deleveraging, requiring them to sell their long-term assets at depressed prices.
The extent of the vulnerability the investment banks were allowed to risk is astonishing. The top five investment banks in the United States reported over $4.1 trillion in debt for fiscal year 2007 alone, nearly a third of total U.S. gross domestic product! And as a result, the top three U.S. investment banks, institutions “too big to fail”, faced financial meltdown in the wake of the sub-prime lending scandal. Lehman Brothers went bankrupt, sending the stock market into a downward spiral and Bear Sterns and Merrill Lynch were sold at fire sale prices.
What was the result for the average American? In the first three quarters of 2008 alone, owners of stocks in U.S. corporations suffered nearly $8 trillion in losses.
Unfortunately, the rabbit hole spirals deeper. As I said before, Wall Street was literally betting on our economy, and doing so with our money. More concisely, while underwriting trillions in bad debt to purchase mortgage-backed securities, they were hedging their bets by simultaneously wagering with the other hand that the very mortgages leveraged as a carrot to the masses as a means to buy into the American Dream would fall into default and a “credit event” would occur. These loans, doomed for default, were understood by this other hand to be “toxic” and they were betting that we’d fail to make our mortgage payments!
Quite literally, this other “hand” of Wall Street wanted us to fail to meet our mortgage obligations and fall into default. They didn’t care if this meant foreclosure for countless hard working families, that wasn’t their problem, because the pushers of the Credit Default Swaps (CDS) made their money at sale of the product and investors raked in the doe the instant default became reality.
Now, when I said that deregulation of the financial industry resulted in exotic products, perhaps the starkest example would be the credit default swap. The credit default swap is an extremely complicated product, one that requires a mathematical formula spanning the length of numerous blackboards to set out. But, boiled down to its roots, a credit default swap is a bilateral contract between the buyer of the contract and the seller of the contract, for protection. The protection buyer, purchases the contract from the seller of the CDS and is required to pay a quarterly spread or fee to the seller. The CDS contract then references a third-party, or “reference obligor”, such as a borrower on any mortgage loan, and if that third party, which, by the way, is in no way shape or form a party to the CDS contract, defaults on their mortgage payment, the seller of the CDS pays the buyer par value for return of the subject CDS bond, an amount that usually reaches into the many millions. In short, we fail to pay our mortgage, and some investor gets filthy rich!
According to a 2010 International Swaps and Derivative Association (ISDA) Market Survey, over $62 Trillion of outstanding credit default swaps have flooded the financial industry, but this approximation is likely low as not all of them are documented using the ISDA standard promulgated forms – not to mention the additional proliferation of Basket Default Swaps, Credit Linked Notes and Loan Only Credit Default Swaps. All of these exotic products are not traded on the open exchange and are therefore not reported to any government agency tasked to regulate them.
So, while wildly unregulated in the sale of the CDS, the same Wall Street companies were simultaneously selling the mortgage-backed securities to other investors – perhaps one of the most sickening displays of moral turpitude imaginable! Not even the best of magicians could pull off this slight of hand! With one hand Wall Street was convincing investors that the underlying credit comprising trillions of dollars worth of mortgage-backed securities were sound, and with the other hand they were convincing their other clients to invest in a CDS, a product with its value fundamentally linked to mortgage default.
Was everyone asleep at the wheel, or were heads just turning in the other direction? Why would any congressman allow this to happen? Unfortunately, the answer, plainly and simply, is systemic corruption!
Allow me to once again indulge in an analogy with the predicate of an axiom that we all know, “history repeats itself”.
The 1929 stock market crash which signaled the beginning of the Great Depression was in large part caused by problematic stock trading practices permitted under a laissez faire regulatory scheme. Perhaps the most notorious of these practices was the unchecked convention of buying stocks on the margin.
Buying on the margin consists of purchasing stocks or other securities with capital borrowed from a broker and utilizing other securities as collateral. The aim, of course, is to amplify profit on the positive equity potentially earned on any particular holding. To begin, the net value, or the difference between the value of the security and the broker’s loan, is equivalent to the amount of one’s own cash used. This disparity is required to stay above a minimum margin requirement designed to protect the broker against a fall in the value of the security.
Here is an example:
James purchases stock in a corporation for $1,000, using $200 of his own savings, and $800 borrowed from his broker. Here, the net value (share minus loan) is $200. As a requirement of the loan, the broker demands a minimum margin requirement, or leverage rate, of $100.
Suppose the stock, for whatever reason, drops to $850. The net value is suddenly only $50 (net value ($200) – stock value loss of ($150)). James is forced by the terms of the broker’s loan to either sell the stock or pay out of his pocket to bring the investment back to the minimum margin requirement.
As a byproduct of laissez faire regulation, margin requirements were extremely loose in the 1920s. Brokers required investors to put down only 5-10% of their own money, whereas today, in response to the Great Depression, the Federal Reserve’s margin requirement limits debt to 50%. So, when the stock market began to contract at the tail of the roaring twenties, many investors received margin calls. If these investors could not deliver their own money to their brokers within a certain timeframe their shares would be sold. Unfortunately, the market was quickly saturated with market call after market call and as many individuals did not have the equity to cover their margin positions, their shares were sold at rapidly declining prices. A positive feedback loop ensued, causing further market declines and additional margin calls.
Sound familiar? The fall of the real estate market which pulled us into the Great Recession is analogous to the crash of the stock market which lead to the Great Depression in that the sub-prime lending scandal ostensibly was all about buying stock, investment in real estate, on the margin, with money that was not truly in existence but speculated to eventually, if not soon, arrive. Both the boom of the roaring twenties and the boom of the early 2000s were built upon speculative equity.
Sure, the details are quite different, and unquestionably contemporary financial markets are vastly more complex, but the root cause for the meltdowns, in both the Great Depression and Great Recession, remain strikingly similar.
The Securities and Exchange Acts of 1933 and 1934 were promulgated in order to guard against exactly the economic fallout that has occurred in the Great Recession. Yet, despite being privy to the lessons of history’s past, statute after statute was pushed through Congress to give entire swathes of the financial industry exemptions from regulation, and almost unfettered freedom to conjure and implement exotic products as well as expand into supplementary markets without regard for the intrinsic conflicts of interest therein created or the long-term risks to the stability of the financial market as a whole.
It is critical to the analysis of the current economic crisis, however, to note that the government’s release of their necessary regulatory grip on the financial industry did not happen merely over night. Instead the deregulation and adoption of ill-advised legislation has been a steady process lead by a gloriously mounted lobbying effort of major Wall Street firms and a concomitant and growing lack of political will to enforce or enact legislation to guard against market excess and conflicts of interest.
For example, Jimmy Carter’s Depository Institutions Deregulation and Monetary Control Act of 1980 (DIDMCA) phased out a number of banking restrictions, expanded their lending powers, and raised the deposit insurance limit from $40,000 to $100,000, thereby reducing the lender’s risk per loan. In 1982, Congress passed the Alternative Mortgage Transactions Parity Act (AMTPA), which allowed non-federally chartered housing creditors to write adjustable-rate mortgages. The Act was the subject of major criticisms surrounding banking industry deregulation argued to have contributed to the savings and loans crisis, yet it remains in full force and effect. By 2006, approximately 80% of all sub-prime mortgages were adjustable-rate mortgages.
The 106th Congress, under Bill Clinton, passed the Gramm-Leach-Bliley Act in 1999, effectively repealing major portions of the Glass-Steagall Act of 1933. The Glass-Steagall Act was enacted after the Great Depression with the purpose of separating commercial banks and investment banks in order to avoid latent conflicts of interest amid the lending activities of the former and rating activities of the latter. Economist Joseph Stiglitz criticized the repeal of the Act, blasting its repeal as the “culmination of a $300 million lobbying effort by the banking and financial services industries…” (Stiglitz – Vanity Fair – Capitalist Fools). The Act’s repeal has been central to the proliferation of complex and opaque financial instruments such as the credit default swap.
Deregulation (which, I will hereinafter use when referring both to the failure of our government to enforce existing laws and the enactment of ill-advised legislation) of the financial industry has been steady and deliberate at the lobby of major market players. Finance, insurance and real estate sectors spent over $2.5 billion lobbying congress between 1998 and 2006, leading all other sectors, including the health sector. Is it any wonder why Wall Street got its way, despite the glaring signs of impending doom?
It depends only upon the lobby, the National Rifle Association or any one union for example, and in whose “pocket” they lie, whether the Democrats or Republicans will vote in favor of any particular lobby and their special interests. So, while it is convenient to point across the isle at the other side, the reality is that the problem permeates both political parties. At the push of lobbies, our elected officials, more and more, are persuaded to deregulate in the name of free market capitalism, and further seem to believe that deregulation is necessary.
As a registered Republican, though, and it pains me to say – many of Congress’ misguided behests are personifications of an absolutely precarious philosophy that exists as a staple within the contemporary Republican platform. It exists on both platforms, as I just mentioned, but I speak here of the mentality within the party of which I am a devout member.
I’ve volunteered in a number of Republican campaigns in the Northern Virginia region; from local Board of County Supervisor, School Board, Delegate and State Senate races to campaigns for election to the United States Congress. At every committee meeting, fundraiser or local rally I hear one version or another of the same pronouncement. An absolute decree that government, as a whole, both at the state and federal level, should not in any way shape or form regulate the free market. This, obviously, is a subset of the cry for smaller government, both of which I happen to agree with… to a degree.
A very real problem within the Republican Party exists in the fact that many seem to blindly believe that ANY regulation is tantamount to socialism. There is absolutely no question that the ever expansion of government is entirely corrosive of the economy. However, there is a fine line between over-regulation and under-regulation. To espouse the removal of all regulatory “schemes” as a platform, is ill-informed, short-sited, and simply dangerous. To do so is to espouse anarchy.
As a lawyer, I am perhaps uniquely aware of the need for “regulation”. Regulation is simply another word for law, which I have already said is created to protect persons, liberties, and properties; to maintain the right of each, and to cause justice to reign over us all. With the exception of the Almighty in the afterlife, there can be no justice if not by way of man enforcing the laws of man.
Practicing in criminal law highlights it most perhaps, but a truism of man’s nature is equally as apparent in varying degrees when I sit as a mediator between a husband and wife beyond reconciliation and well down the unfortunate road to divorce: Homo Homini Lupus – Man to man is wolf! It is unfortunate that this platitude necessitates regulation, but it is naïve to promote resultant anarchy through the espousal of the absolute removal of government regulation of the free market. Unfortunately, so many of us are doing this in order to win a vote.
Reducing the size of government is a big ticket item today, and it ought to be. I believe in it so ardently that I tackled the issue first and foremost in this thesis. But, reduction in government does not necessarily mean or require the eradication of regulation. To argue as such is simply illogical and presents a false choice. Nevertheless, let me clarify.
There are basically two types of regulation: 1) regulation to protect; and 2) regulation requiring action or inaction. The former is within the true and proper purpose of government. The latter is beyond the scope of government function and in all cases ought to be abolished*. Taxes, I suppose, would fit into the second category, and so I asterisk my statement to note that there are certain limited, and I do mean absolutely limited, exceptions to that rule which must be strictly defined and instituted to perform a clearly identifiable and narrow purpose.
The Great Recession was caused by a deregulation of the first type of abovementioned regulation – regulation to protect. What ensued?
By November 2008, individual Americans lost more than 25% of their net worth, the S&P 500 was down 45% from its 2007 high, and housing prices had dropped 20% from their peak two years earlier, shedding nearly $5 trillion in speculated value. Total retirement assets dropped by 22%, from approximately $10 trillion in 2006 to $8 trillion in 2008. In short, just as in the wake of the 1929 stock market crash, we were left out to dry.
In response, the Federal Government announced a $600 billion program in November 2008, to purchase the mortgage-backed securities financed by Fannie Mae and Freddie Mac in the hopes of lowering mortgage rates. By March 2009, the Federal Reserve’s balance sheet was expanded to further purchase agency (GSE) mortgage-backed securities, bringing its total purchase of toxic securities up to $1.25 trillion and counting. OnFebruary 17, 2009, the American Recovery and Reinvestment Act was signed into law by President Obama, with $787 billion earmarked for spending. All of this is at the enormous expense of the individual American taxpayer. We have been caught paying the wager lost by corporate America!
Now, let me pause. Reading to this point, you may think that I am 100% against free market capitalism and that you may as well stop reading this and turn to Karl Marx’s Communist Manifesto. Quite to the contrary! I belive that in order for liberty to prevail, all men and women must be free to attain to the fullest stature of which they are innately capable and that in order to do so free market capitalism must rein supreme. The most essential pillar to build upon liberty’s foundation is that of free market capitalism!
As I said before, America is built upon the idea that if one works hard enough, if he or she is willing to roll up their sleeves, society should leave the individual free to reach his or her full potential. This philosophy, this potent and powerful mind-set, undeniably, is the backbone of America’s success, for it is the blood, sweat and tears of the individual that has engineered our nation’s prosperity. I am absolutely, 100% against the abolition of free market capitalism, in any way, shape or form!
Can you tell I’m a lawyer? Now that I’m through with my disclaimer…
Above, I’ve used terms to describe Wall Street as the profit-at-all-cost machine and thrown executives under the bus by highlighting their exorbitant bonuses and terming their lemming’s as the short-term, profit motivated masterminds of Wall Street who conjured and implemented the exotic schemes that literally mortgaged the very security of the United States, and by extension thereof, the world economy. Do I question their motives? Do I question their moral compass? Do I question their risk assessments? Yes! But, to be frank, as a business man myself, I not only understand, but appreciate their position.
You see, Wall Street, when you boil it down to its most fundamental roots, is not so different from Main Street, despite what CNN would like us to believe. Just like my small, family-run, general practice law firm, Wall Street goliaths are motivated by one overriding concern – money! Quality of product and customer loyalty aside (which is of utmost importance at Kidwell, Kent & Curran = shameless plug), Wall Street is, by the very nature of free market capitalism, married to the profit margin. Who will buy stocks if their futures are forecast to deteriorate? Nobody! (Except for the ridiculous practice of shorting stocks which, as a side note, is in itself a moral dilemma).
Corporations trading on the open market, and the board members sworn to uphold the salient interests of their firm, then, are beholden to the stockholder. Stop, then, and put yourself in the shoes of a stockholder. Many of us, in fact, should find this easy, as we do, in one form or another, own stocks. They might be in mutual funds, held in a brokerage account, or casually traded on our iPhone apps. What do we all wish for, and ultimately demand? We demand that the stock turn us a profit or we dump it, period, no ifs ands of buts!
Multiply our individual want of short-term profit on any particular stock by $70 trillion worldwide. This is what Wall Street was looking at. And some of the smartest people in our nation, graduated from the likes of Yale and Harvard, conjured schemes to make you and I money as we demanded. Fortuitously, of course, they also made themselves heaps of cash.
Simply put, Wall Street did what free market capitalism demanded – they met demand by providing supply, of money! On this factor alone, I cannot and will not fault them. In fact, to an extent, I applaud them.
You see, those of us who are stockholders, in any form, can be broken down into two selves: 1) the stockholder; and 2) the individual. I point this out because our stockholder self, demanding short-term, if not long-term profit, but profit nonetheless, has interests inherently contrary to that of our individual self. Allow me to explain.
Our stockholder self wants whatever corporation we have invested in to do all it can to make a profit. We’d like to think, in theory, that this means pure innovation to out do the competitor. But, in reality, our stockholder self knows this may include investing in risky endeavors that yield a short-term profit, skirting environmental regulations, or increasing profit margins by cutting employee wages or procuring cheaper materials.
Meanwhile, our individual self wants higher wages even though our company is cutting costs to cow-tow to their investors, and we complain when they outsource to India or look to China for cheaper materials.
We go to Walmart to buy clothes on the cheap, but complain when they come into our town and destroy the small businesses comprising our downtowns. Why? Because, on each end, whether as the consumer or as the supplier, money seems to be our governor.
Look at the price of a Hybrid vehicle. On average it is three to five thousand dollars more than the same car without a hybrid engine. If it were the same cost, aside from adrenaline junkies, we’d all probably buy the Hybrid. But even most “tree huggers” can’t choke down the extra green involved in purchasing the same car, with less horsepower, for thousands more. Why? Because money talks!
So, given an opening in the law, which allows you to make money, perhaps even a lot of money, and do so 100% legally, will you take it? What if it is perhaps morally questionable and the risks are exceptional? What if nobody questions it? Will you go for it and become rich? I know you’d like to say no.
So, imagine you are a board member, one of, say, twelve, elected to your position with the solitary direction of finding ways for your company to make money for those invested. Now this opening presents itself; an opening that means millions and millions to your stockholders, and, oh yes, yourself. The unbridled risks that eventually backfired and thrust us into the Great Recession are proof that those on Wall Street, in any case, went for it.
It is a function of man that we try to better our position always, and, unfortunately, will do so at the cost of our fellow man if necessary. Homo Homini Lupus – Man to Man is Wolf! This animalistic instinct necessitates government, law, regulation! The history of the Great Depression taught us many lessons and, if headed, many warnings could have prevented the Great Recession. Why did Congress not listen? Why did they allow such extensive deregulation despite the lessons of history? Again, the answer is Faction!
As James Madison argued in Federalist Paper 10, the problem of faction is, “most likely, not least, severe in a small republic, for it is in a small republic that a self-interested private group would be most likely able to seize political power in order to distribute wealth or opportunities in its favor!” He was arguing that the policies of a federal government, comprised of the states, would not easily be hijacked by the interests of any one state, whereas, the states, individually, would be at risk of falling prey to noxious factions within.
The problem is this: Wall Street, and the individual corporate conglomerates that comprise it, being so “in bed” with the federal government is tantamount to a small republic. In making the federal government a “good ol boys” network indebted to their money, lobbies are able to pull the strings of our congressman and bring them into their very fold. The result is a faction, a small republic if you will, (many of them with a workforce the size of any one of the 13 colonies), that is divorced from the reality of its constituents and more concerned with distributing the common wealth to itself. Money for power, power for money! And such is the nature of politics. But it does not have to be so.
“The Journey from Congress to K Street,” was published in 2005 by Public Citizen, a non-profit government watchdog group. Their report analyzed hundreds of lobbyist registration documents filed in compliance with the Lobbying Disclosure Act and the Foreign Agents Registration Act, finding that, since 1998, 43% of the 198 members of Congress who left government to join “private life” have registered to lobby Not only is there a job awaiting our elected officials after their term is through, but there is a seemingly endless parade of money thrown their way to convince them to vote in favor of the lobby while in office. Between 1998 and 2006, the top thirteen lobbying sectors spent a combined $15 billion plus on persuading Congress this way and that, not even including campaign contributions.
The lamentable, clear fact is that corporate interests are taken into consideration by dint of their unmatched spending power at the apparent disregard of concern for the common constituent. Money does buy access in Washington, access that amplifies corporate influence which often results in swaying congress to promote the interests of the few at the immediate or eventual expense of the many. The question that presents itself, then, is how can this be dealt with?
There are three distinct avenues, and all of which, by their very nature are intrinsically entwined, I believe the corrupting weight of corporate money on the federal legislative process can be pacified:
- Lobbying Reform;
- Campaign Finance Reform; and
- Term Limits
I will tackle each proposed course in order, analyzing the need for each, the debates surrounding them, and then make specific proposals respectively.
(Please see upcoming post for part two of Chapter Three- LOBBYING REFORM)