By
Ben Steverman and
David Bogoslaw 
U.S. Treasury Secretary Henry Paulson, Federal Reserve Board Chairman Ben Bernanke, Chairman of the Securities and Exchange Commission Christopher Cox, and Director of the Federal Housing Finance Agency James Lockhart III. Chip Somodevilla/Getty Images
Tune in to Anderson Cooper on CNN and watch as he counts down the "10 Most Wanted Culprits of the Collapse." Pick up the New York Post and read about FBI investigations of top financial firms under the headline "Fraud Street." With a bewildering and frightening financial crisis in full swing, the new national pastime is finding someone to blame.
As markets crash and retirement dreams fade away, media and the public are full of outrage at everyone from mortgage brokers and Wall Street CEOs to real estate investors to experts who failed to predict the crisis was coming. Congress hauls the most prominent executives before tough committee hearings, while political candidates blame each other. Pundits proffer lists of the mustache-twirling villains who caused the whole thing.
An Epic Whodunit
Investigators will undoubtedly uncover fraud, cheating, and other criminal behavior. But for now, there is no shortage of players who stand accused of having a hand in the crisis. It just depends on where you think the landslide began or who gave it the biggest push.
If you blame loosened financial regulations, maybe former Sen. Phil Gramm (R-Tex.) or Securities & Exchange Commission Chairman Christopher Cox are your men.
Think that a political push to boost homeownership handed too many people mortgages they couldn't afford? Why not single out Franklin Raines, former CEO of Fannie Mae?
Maybe you think the whole housing bubble could have been avoided with an interest rate increase (Alan Greenspan, step right up). Or, that folks should never have signed up for no-doc, interest-only loans, no matter how many silhouettes danced across their computer screen in a Web ad. In that case, the villain may be no further than your bathroom mirror.
(For a walk through some of those people who are blamed for having a hand in the meltdown, go to our slide show.)
"Whole System" at Fault
Of course, all of these people had something else in mind other than wrecking the U.S. economy. Some of them were making lots and lots of money—for themselves, of course, but also for their investors. Others truly believed in the virtue of freeing the marketplace's animal spirits from the cold hand of government regulation. And how many people were arguing against the virtues of homeownership?
Just the fact that one can assemble such a long list of possible villains gives a hint as to how many institutions, officials, and regular Americans made mistakes. "It's so difficult to pinpoint one person or two people," says Georgetown University finance professor Reena Aggarwal. "It really was the whole system."
Even Presidential candidates eager for votes have acknowledged there's no easy scapegoat. "Part of the reason this crisis occurred is that everyone was living beyond their means—from Wall Street to Washington to even some on Main Street," Senator Barack Obama (D-Ill.) said on Oct. 13.
Indeed, it was a series of bad ideas, surprising linkages, and all-too-predictable blunders that came together to send the U.S. financial system, and then the entire world economy, into a serious credit crunch and global stock panic. That's not to say that it couldn't have been prevented.
A Sign: Soaring Home Price-to-Income Ratio
First, there was a bubble in the U.S. housing market as home prices hit unsustainable levels. We should have recognized a bubble when we saw it: Just a few years before, another market bubble collapsed—in technology stocks. And all the signs were there in housing.
If you ever drove through row after row of new tract homes sprouting from the California desert and wondered, "How can all these people afford $500,000 houses?" the answer was, they couldn't. For the two decades until 2001, the national median home price went up and down, but it remained between 2.9 and 3.1 times the median household income, according to the Harvard Joint Center for Housing Studies. By 2004, however, the ratio of home prices to income hit 4.0, and by 2006 the ratio was 4.6. Or consider this statistic: in 2006, at the height of the bubble, more than four in every 10 California households owning a home spent 30% or more of their incomes on housing.
"As a system, we were pressing beyond what the economics were suggesting people could afford," says Michael Strauss, chief economist at Commonfund. Nonetheless, nearly everyone in the system had a "false sense of security that housing prices would always go up."
That included home buyers and real estate and mortgage professionals.
Another Sign: The Securitization Monster
But what turned a nasty housing downturn into an extinction-level event for the whole economy was a Wall Street innovation called securitization.
With interest rates low, investors around the world were eager for places to put their money that offered substantial returns. While the federal funds rate was at 6.5% for much of 2000, by the end of 2001 Federal Reserve Chairman Greenspan had lowered the rate to below 2%. It remained there until late 2004. In 2003, the yield on the one-year Treasury bill dipped well below 2%, its lowest level in the past 40 years. Securitization, and the new investment products it could spawn, seemed to be the answer for a Wall Street seeking a bigger payoff.
Through securitization, Wall Street firms would buy up mortgages, bundle them together, and sell them off to investors. These mortgage-backed securities were highly complex and hard to price accurately. But selling them offered returns for financial firms far above those of safer investments. And with home prices continuing to rise, many, including ratings agencies, assumed that assets backed by U.S. mortgages were safe.
"The development of the securitization pipeline [meant] there was a lot of pressure to create the loans," says University of Kansas finance professor George Bittlingmayer. Mortgages were given to buyers with low credit scores—so-called subprime borrowers—and other high-risk borrowers, with little concern that they wouldn't be able to pay the loans off. The easy money, in turn, contributed to an "upward spiral" of home prices, Bittlingmayer says—"until the bubble collapsed."
Most of the mortgage brokers who originated these loans weren't "bad people," Bittlingmayer adds. "They were doing what the system was asking them to do."
Wall Street was eager to buy up, bundle, and securitize the mortgages. Washington, in turn, had urged the mortgage industry to give more loans to low-income home buyers. During the Clinton and Bush Administrations, "there was a push to try to put homes within reach of everyone," says Larry Tabb, founder and chief executive of the TABB Group, a capital markets research and advisory firm.
No "Skin in the Game"
That led some lawmakers to overlook serious problems at federally chartered mortgage giants Fannie Mae (FNM) and Freddie Mac (FRE). Major players in the securitization process, both were taken over by the government in early September after it became clear the firms wouldn't have enough capital to cover mounting losses from defaulting mortgages.
"Everybody thought they were passing on the risk to someone else through securitization," Aggarwal says. When the housing bubble collapsed, the folly of the securitization process and the mortgage craze became apparent.
The problem was that investment banks didn't have "skin in the game," says Dan Lufkin, one of the founders of Donaldson, Lufkin & Jenrette. Banks "made plenty of money putting [mortgage-backed securities] out on the marketplace. But they could explode a day later and you are not impacted one single iota."
That means that unlike the old-fashioned community savings and loan officer who pored over your pay stubs to make sure you'd make the monthly payments, Wall Street had little incentive to ensure the quality of the underlying loans in its mortgage-backed securities. Credit agencies awarded high ratings to mortgage-backed securities, giving investors more confidence that they were safe investments.
All the large Wall Street investment banks were enthusiastic participants in the securitization process. But two firms, Lehman Brothers and Bear Stearns, were most aggressive about their mortgage investments. According to Thomson Reuters (TRI), Lehman issued more U.S. mortgage-backed securities than any other firm in 2007, $95.8 billion out of an industry total of $922.1 billion. Bear Stearns had the top spot in 2006, issuing $100 billion in U.S. mortgage-backed securities out of an industry total above $1 trillion. Both firms' reliance on the mortgage business helped lead to their failures in 2008.
"A Lot of Smoke and Mirrors"
With all the brainpower on Wall Street—and many of those who created securitized products had doctorates in math or physics—few made the connection between the trillions of dollars in real estate assets held by financial firms and what would happen if the value of those assets suddenly dropped.
But this might not have created a serious economic crisis without other ingredients.
Wall Street had become increasingly sophisticated in the past few decades, and this complexity made the entire system extremely fragile. In addition to securitizing mortgages and other assets, financial firms created a vast array of other products, called derivatives. The buying and selling of these obligations, such as credit default swaps, was supposed to be "a way of reducing risk, not adding risk," Strauss says.
However, "there was a lot of smoke and mirrors," says Bob Ried, president of Ried Thunberg ICAP, a financial research firm. For example, because the products were highly complex, there was no central marketplace, making it difficult to know how much they were worth.
Ironically, the huge number of derivative contracts between institutions actually increased the chances that problems at one firm would ripple through the financial system, causing a chain reaction of losses. That's what prompted Berkshire Hathaway (BRKA) Chief Executive and legendary investor Warren Buffett to call derivatives "financial weapons of mass destruction" in 2003.
Too Much Leverage
Another big risk that financial firms took was in borrowing heavily. Many firms were employing leverage—debt used in investing—of 30 to 40 times their core holdings. Previously, the SEC had kept firms to leverage ratios of 10 to 15 times their core holdings, but the agency loosened the rules for investment banks in 2004. With leverage, "you can make fantastic income when things are going the right direction," Tabb says. "When things go against you, it unwinds very quickly."
Why did Wall Street ever take such dangerous risks?
The big reason, obviously, is greed. Wall Street bankers were taking home a lot of money by making these gambles. The chief executive of Lehman, Richard Fuld Jr., for example, earned $34.4 million in 2007. "Once this business model gets going, it's very hard to stop," Tabb says. Firms had hired risk managers who should have spoken up, but they were not supposed to "get too much in the way of generating revenue."
Many also have criticized the way Wall Streeters are paid. "People [were] compensated on the returns they got, and so there was a motivation to take more risk," Aggarwal says. In the record year of 2006, Wall Street executives took home bonuses totalling $23.9 billion, according to the New York State Comptroller's Office. Wall Street traders were thinking of the bonus at the end of the year, not the long-term health of their firm, Tabb says.
The whole system—from mortgage brokers to Wall Street risk managers—seemed tilted toward making short-term risks while ignoring long-term obligations. The most damning evidence is that most of the people at the top of the banks didn't really understand how those credit default swaps and other instruments worked.
"Regulators Didn't Regulate"
Finally, all this risk-taking by firms added up to a big gamble for the entire financial system, which only became fully apparent as the crisis unfolded. Because no firm knew of other firms' exposures to toxic assets or complex derivatives, it was difficult to predict how problems would flow through the system. "It's very hard to tell the risks various parties are exposed to," says Bittlingmayer. "We don't have transparency."
As the crisis approached, few in government spotted these problems. And no one in a position of power moved to prevent them.
"The regulators as a whole didn't regulate," Ried says. Some officials, often at the state or even city level, did warn of the risk but were ignored (BusinessWeek, 10/9/08). Ried blames regulators for relying on a "free market philosophy" that "just let things go."
But Wall Street also made it worth Congress' while to look the other way. According to the Center for Responsive Politics, the securities and investment industry, including donors at Goldman Sachs (GS), Morgan Stanley (MS), Merrill Lynch (MER), Lehman, and Bear Stearns, gave $97.7 million to federal political candidates for the 2004 election, and another $70.5 million for the 2006 congressional election.
A big reward for Wall Street came in 1999, when Congress passed, and President Bill Clinton signed, legislation loosening New Deal-era bank rules, including the Glass-Steagall Act creating strict separation between investment banks and commercial banks. Commercial banks, which rely on deposits for funding, were allowed to encroach on investment banks' turf. That, in turn, spurred investment banks to take on even more leverage and risk to survive.
"Investment banks started operating more like hedge funds," Aggarwal says.
In the End, Basic Bad Banking
The complexity of the people, actions, and instruments behind the meltdown are truly mind-boggling. But strip things down to their essence and you are left with some surprisingly simple notions.
Investment banks and corporations engaged in basic bad banking, says Robert Ellis of the financial consulting firm Celent. They broke a cardinal rule: "Never borrow short to lend or invest long." Firms were relying on short-term funding sources for long-term obligations. When the crisis froze up short-term markets, these institutions ran dangerously short of cash.
Even more basic was the mistake of taking too much risk. More risk allows for bigger payoffs for participants, but it put the whole system in jeopardy.
Finally, even as problems were becoming apparent, few spoke up. Maybe it was because everyone assumed that someone smarter than them understood how it all worked.
"There were so many financial incentives and political incentives that were aligned toward making this work," Tabb says. "It was very difficult to stop it."
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