August 31, 2011

SPEAKING VOLUMES: A Review of The Subprime Virus: Reckless Credit, Regulatory Failure, and Next Steps

Dwight Golann

Imagine that the New Yorker magazine published a series of articles about the subprime lending crisis and its impact on the financial system. It did so in depth, beginning with a boarded-up block in Cleveland and going on to describe how a boom in housing led to bad loans which spread through the system, infecting our largest financial institutions and regulators. The authors wrote in engaging New Yorker style, with many fascinating details (did you know that Alan Greenspan invited Ayn Rand to attend his swearing-in as Chairman of the Fed?) The articles would include lucid explanations of complex events, with endnotes to tie everything down. And, of course, the series would have a point of view, in this case that of a consumer activist-but the kind of activist who meticulously confirms facts and understands issues. You would then have The Subprime Virus (Oxford University Press, 2011), written by Professors Kathleen Engel and Patricia McCoy.

It is the kind of book Elizabeth Warren might have written if she were not so busy regulating. It shares the perspective of the late Federal Reserve Governor Edward Gramlich's book Subprime Mortgages: America's Latest Boom and Bust, although Gramlich did not anticipate a crisis of the entire financial system.

What is the relevance of The Subprime Virus to a business lawyer? Unlike other works which focus on a single aspect of the crisis, this book examines the entire business of marketing and securitizing home mortgages. It shows how mortgage companies and banks began to ignore risk, as executives disregarded what one hopes was cautionary advice from their lawyers. It also analyzes the collapse of federal bank regulation, describing in acerbic tones how regulators, with the notable exception of the FDIC, competed for lender fees by decimating their oversight systems and shielding banks from state regulatory efforts.

Many excellent books on the bubble and ensuing crisis have appeared. Some are entertaining, like Michael Lewis' The Big Short and Gregory Zuckerman's The Greatest Trade Ever. Those books describe individuals who outsmart the system by buying up swaps and waiting for the bubble to collapse. The traders are anxious and so are we: As they keep renewing their wagers, why don't prices fall? And will the "house"-AIG and other institutions-be able to pay off winning bets?

Others, including Gretchen Morgenson and Joshua Rosner's Reckless Endangerment: How Outsized Ambition, Greed, and Corruption Led to Economic Armageddon (2011), focus on the errors and greed of single players such as Fannie and Freddie, or, like Robert Shiller's The Subprime Solution: How Today's Global Financial Crisis Happened and What to Do About It (2008), give an academic assessment of events, with recommendations for the future. There are more than a dozen similar works.

It was to The Subprime Virus, however, that the American College of Consumer Financial Services Lawyers gave its book award, most likely because of this book's unique combination of detail, coverage, and style. This may be the only book that looks at the entire business of residential lending, financial regulation, and corrective legislation. It includes capsule accounts of how individual institutions-WaMu, Lehman, and numerous subprime lenders, among others-lost their way. The authors explain why the experts were so wrong-quants, for example, used wonderfully sophisticated mathematical techniques, but failed to include in their models the possibility that housing prices would ever go down. Engel and McCoy provide a stream of intriguing details: for example, toward the end a full 90 percent of all outstanding swaps were naked-bought by people with no ownership stake in the assets they were insuring.

The Subprime Virus does have strengths and weaknesses. A strength is that it is short-only 250 pages exclusive of endnotes and bibliography. If you, like me, have trouble getting through long works of nonfiction, the brevity and engaging style of this one is a blessing. Occasional anecdotes and cartoons also provide welcome breaks from large doses of facts. As noted The Subprime Virus is comprehensive, covering business problems, regulatory reactions, and legislative responses such as TARP and Dodd-Frank. The book is also well-organized; one can read about the real estate and securities aspects of the crisis without going deeply into governmental actions and vice versa.

Weaknesses include: It is not novelistic-the authors must give up the chance to focus on individual heroes or villains. For that I recommend The Greatest Trade Ever, describing John Paulson's multi-billion dollar coup in the swaps market. Also, while The Subprime Virus describes the passage of Dodd-Frank, it could not cover the continuing regulatory aftermath. For an account of the fight over the Consumer Financial Protection Bureau, the regulation of derivatives, bank fees, and other topics, we must await books yet to be written.

Finally, the authors are unapologetically pro-consumer, and vehemently critical of now-departed CEOs and regulators. Twenty years ago the Section's Consumer Financial Services Committee decided that to give their clients the best possible advice, it was necessary for business lawyers to listen to the voices of consumer activists-at least the informed ones-and created a Consumer Fellows program. If books could be given such fellowships, this work would receive one.

Carmen Reinhart and Kenneth Rogoff's book This Time Is Different reminded us that investment bubbles have occurred regularly throughout human history. The Subprime Virus includes comments and facts which are sometimes hard to listen to, but necessary if we are to help clients prosper, navigate changing regulation, and avoid being consumed by the next, inevitable bubble.

Dwight Golann

Dwight Golann is a professor at Suffolk University Law School in Boston, where he teaches consumer law, negotiation, and mediation. He is a former chair of the Consumer Financial Services Committee and the Consumer Advisory Council to the Governors of the Federal Reserve.