CHAPTER SIX
WHEN THE FRENCH MONARCHY was strapped for money in the eighteenth century, it found more and more creative ways to raise funds.1 One of these was to sell annuities—government bonds that paid out a fixed amount until the death of the person on whom the annuity was written. Annuities were very popular with the public, for they offered beneficiaries a guaranteed income for life in a time before there were old-age pensions. The monarchy liked them because it received payment up front.
The monarchy targeted these annuities at wealthy men—typically in their early fifties—who had the means to buy an annuity and who, given low life expectancies at that time, typically did not have very long to live. Annuities were priced so that they were a fair deal for such men. However, it was possible for the buyer of the annuity to make the payments dependent not on his own life span, but on that of someone else. Perhaps this loophole was not inadvertent, for it increased demand for the annuities: for example, it might have made annuities attractive to a wealthy merchant who wanted to settle his daughters for life. But it did mean that the clever investor could make money off the government. He could pick as beneficiaries healthy young girls (then as now, women lived longer than men) whose family history suggested a genetic predisposition to long life, and who had survived early childhood (infant mortality was very high in those times) as well as the dreaded smallpox. He could then buy annuities on their lives from the French government. A carefully selected, healthy ten-year-old girl would have much higher odds of surviving for a long time than the typical beneficiary of the annuity, and the payments received during her lifetime would far exceed the cost of the annuity.
This is indeed what a group of Geneva bankers did. They selected groups of thirty suitable girls in Geneva and purchased a life annuity on each from the French government. They then pooled the annuities so as to diversify the risk of accidental early mortality among the girls and sold claims on the resulting cash inflows to fellow citizens of Geneva. This early form of securitization thus allowed the bankers to create a virtual money machine, buying policies cheaply from the French government and reselling them for a higher price to investors. The investments were popular—especially because the bankers were reputable and the underlying annuities were claims on the government—and sold well.
However, buyers had not reckoned with the risk of government default. When the French Revolution broke out in 1789, the monarchy was overthrown, and the revolutionary government soon fell behind in its annuity payments. It eventually made payments in worthless currency. The Geneva bankers, who owed investors in harder Swiss currency, did not have the wherewithal to pay, and they defaulted, as in turn did many of the investors who had borrowed to invest in the “sure” thing.
There are four important and enduring lessons from this historical minicrisis. First, few have a better nose for a good moneymaking opportunity than bankers. It is not that bankers are excessively greedy. Even though Adam Smith did put self-interest at the heart of capitalism when he wrote, “It is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from their regard to their own interest,” few businesspeople are entirely without concern for the impact of their activities on their societies.2 Rather, their willingness to exploit any advantage that will help them make money, however dodgy (albeit legal) it may be, stems partly from the nature of competitive banking, where there are few easy opportunities to make money, and partly from the way banker performance is measured—almost exclusively by how much money the banker makes rather than by her impact on real activity. The disconnect between banking and real lives and livelihoods is most apparent in the arm's-length financial systems that are found in countries like the United States and the United Kingdom.
A second lesson is that bankers invariably find the biggest edge in taking advantage of unsophisticated players or players who do not have the same incentive to make money. Clearly, individuals who are unschooled in finance are a potential target, but often these individuals realize their ignorance and give their custom only to trusted intermediaries. Moreover, they typically have too little money to be of interest to the smartest bankers. More attractive targets are the moderately schooled managers of large pools of funds, such as pension funds or foreign state-owned funds, who know not that they know not and are thus easily taken advantage of. But perhaps the most attractive target of all is the government itself. The government has nonmarket, noneconomic objectives, and however astute its representatives may be, these make it easy prey for clever bankers. Moreover, whereas a naive individual is soon relieved of all his money, the government has deep pockets, and exploiting them can sustain many a banker's luxurious lifestyle for a long time.
Third, banker behavior tends to be self-reinforcing, at least for a while. In the example of the annuities, as the profits from the first insurance scheme become apparent, they not only attract more bankers to the activity but also push up the prices of the securities issued by the first scheme, sending a still stronger signal to bankers. Similarly, as initial housing loans start to look profitable, more banks extend loans, thereby pushing up house prices and making the initial loan look even more solid. This behavior can exaggerate investment trends and move prices far away from fundamentals. Early movers may convince themselves they are geniuses, even though they are only the leaders of a herd that is rapidly headed toward a cliff. But the growth of the herd itself can make what would have been a minor loss by some adventurous bankers and their investors into a much more serious loss for the community.
Finally, there is safety in numbers, because the responsible government cannot let all its bankers fail, given the likely collateral damage to the citizenry. So even the revolutionary government in France continued paying the hated monarchy's debts for as long as it was able. This is not necessarily to imply that bankers start out with the expectation that they will fail and be bailed out: bankers understand that failure is never pleasant, however forgiving the government. It may well be that the thought of a bailout really does not cross their minds. Rather, the problem created by the anticipation of government intervention is that the bankers, caught up in the herd's competitive frenzy to cash in on the seemingly lucrative opportunity, are not slowed by more dispassionate market forces—what I have referred to as the unintentional guidance of the key actors’ actions by markets or voters. In such a situation, lenders to banks do not demand proper compensation for the risks the banker takes, because they know the blow will be softened by the government—and in behaving thus, lenders facilitate risk taking and herd behavior. The normal disciplinary role of markets (which themselves may sometimes be caught up in the frenzy) is dulled by repeated government intervention.
I draw modern parallels in this chapter and the next. The sophisticated U.S. financial sector responded to the government's desire to promote low-income housing, as well as to foreign demand for highly rated debt securities. The edge the financial sector exploited was the unthinking, almost bureaucratic, way both the mortgage agencies and foreign investors evaluated the issued securities. Market discipline broke down as mortgage brokers found they could peddle all sorts of junk, especially because the deterioration in credit quality was masked by the immense amount of money pouring into the sector. When the crash eventually came, the government and the Federal Reserve, unable to stand by and see homeowners suffer, stepped in to prop up the price of homes and of mortgage-backed securities, validating much of the extraordinary insouciance of the market.
In this chapter, I explain why the fault lines we have examined earlier, acting on an amoral financial sector with a finely honed eye for opportunity, combined to cause a steady deterioration in the quality of mortgage lending. In the next, I explain why banks held on to so many of the risky asset-backed securities on their own balance sheets.
Most of us do not work for money alone. Some want to change the world, others to create objects of art and culture that will endure. Some strive to gain fame, while others are content to do good anonymously. For many people, though, the visible effects of one's work are its greatest reward. For the teacher, witnessing the eureka moment when understanding finally dawns on a student; for the doctor, the incredible joy of saving a patient's life; for the farmer, the sight of acres and acres of golden wheat swaying gently with the breeze—for all these people, their primary motivation is the knowledge that their work makes the world a better place.
A simple experiment done by researchers at MIT and the University of Chicago verifies the importance of larger meaning to motivation and work. Harvard students, the subjects in the experiment, were asked to put together Lego Bionicle models (small snap-together models) from kits they were given (the MIT researchers probably thought this would be a real challenge for Harvard students!). Subjects were paid at a declining rate for each additional model built, so that eventually they would stop because the effort involved in building an additional model was not worth the pay. In one version of the experiment, each completed model was placed in front of the subject, and the subject was given another identical box from which to build another. In the second version of the experiment, the subject was handed a second box, but even while he or she was putting the model together, the researcher dismantled the just-completed model and put it back in the first box, so that this box could be handed to the subject when the model built from the second box was complete.
The simple difference of whether the subject's work was allowed to endure (at least for the duration of the subject's participation) or whether it was undone immediately, leaving not a trace, made an enormous difference in the willingness to work, even though the monetary benefits were identical. Subjects completed an average of 10.6 Bionicles when the completed models were left standing in front of them and only 7.2 when the completed ones were dismantled in front of their eyes. Thus they continued to make Bionicles for lower wages when the experiment was structured to give the work more meaning. Seeing the fruits of your labor, even in something as trivial as model building, seems important for motivation!3
In some jobs, it is very hard to see the effects of one's work. On an assembly line, a worker is just one cog in a huge production machine, and her role in the final product may be small. No wonder modern management techniques try to make each worker feel important both individually and as part of a team: the Japanese kaizen system of continuous improvement, for example, involves all workers in making changes to enhance productivity, no matter how small the changes might be.
Many jobs in a competitive, arm's-length financial system are problematic for two reasons: First, like the worker on an assembly line, the broker who sells bonds issued by an electric power project rarely sees the electricity that is produced: she has little sense of any material result of her labors. She is merely a cog in a gigantic machine. Second, the most direct measure of a financial sector worker's contribution is the money—the profits or returns—she makes for the firm. Money here is the measure of both the work and her worth, and this is where both the merits of the arm's-length financial system and its costs arise.
Take, for instance, a trader who sells short the stock of a company he feels is being mismanaged (that is, he borrows and sells stock he does not have, anticipating the price will go down and that he will be able to buy the stock back later at a lower price to close out his position at a tidy profit). Few people are more vilified than short sellers, who are seen as vultures feasting on the misfortune of others. But they perform a valuable social function by depriving poorly managed companies of resources. A company whose stock price tanks will not be able to raise equity or debt finance easily and could be forced to close down. The trader who shorts the stock does not see the workers who lose their jobs or the hardship that unemployment causes their families; all he sees are the profits he will make if he turns out to be right in his judgment. But it is his very oblivion to the larger consequences of his trades that makes him such an effective and dispassionate tool of change.
Despite the protestations of the management of targeted firms and their political backers, the trader does not cause the firm to go out of business. If the trader is wrong and the firm is well managed, other traders will take the opposite side, buy shares, push up the share price, and make the short seller lose money. It is typically only when the short seller's opinions are widely shared, and firm management is awful, that the share price tanks. Mismanagement is the source of the firm's troubles; the trader merely holds up a mirror to reflect it. Indeed, the more disconnected the trader is from the people in the firm, the more reliable a mirror he is able to provide. But herein lies the rub. Because the trader is at a distance from the real consequences of his actions, the best measure of the trader's value to society is whether he made money from the trade: a profit indicates that he was right to short the firm short and that society will benefit from his actions.
Although market opinion is not always right, more often than not, it is. Management at the energy giant Enron lashed out at short sellers, but the short sellers, like James Chanos at Kynikos Associates, understood there was something deeply wrong with its accounting. Essentially, Enron had set up off–balance sheet entities to which it “sold” its failing projects at a hefty profit, thus creating the appearance of both profitability and growth, even though the reality was just the opposite. It was the short sellers who made Enron's stock price plummet and forced the company to shut down even while the firm's traditional bankers supported its creative accounting with yet more creative loans. As Chanos later wrote, defending the short seller's role as professional skeptic: “We spoke with a number of analysts at various Wall Street firms to discuss Enron and its valuation. We were struck by how many of them conceded that there was no way to analyze Enron, but that investing in Enron was instead a ‘trust me’ story. One analyst, while admitting that Enron was a ‘black box’ regarding profits, said that, as long as Enron delivered, who was he to argue?”4
Chanos made millions and acquired fame from his analysis and his willingness to challenge the herd on the question of Enron's value, but it is this very strength of the arm's-length system—that money is the measure of all things—which also is its weakness. An old Latin saying, Pecunia non olet, translates as “Money has no odor.” The very anonymity of money, the fact that it is fungible and its provenance hard to trace, also makes it a poor mechanism for guiding employees’ activities toward socially desirable ends. Did the trader make her returns by being more astute than others like her, or did she make it by frontrunning her clients (trading ahead of a large client order so as to make money when that client's order moved prices)? Did the mortgage broker make his fees through offering a variety of sensible options to the professional couple who were looking to upgrade their house, or by urging an elderly couple to refinance into a mortgage they could not afford? Although the former course is preferable in each case, the latter is easier for the trader or broker; and because the wrong choice also makes money, has few immediate consequences, and sets off few alarm bells, it is the one that is most tempting.
In sum, bankers are not the horned, greedy villains the public now sees them to be. In the classes I have taught over the years, the future bankers were as eager, friendly, and ready to share as the other students in class, although perhaps a little smarter (remember, this was a time when the financial sector paid far more than other professions and attracted the best talent). I have no doubt they continue to be decent, caring human beings. But because their business typically offers few pillars to which they can anchor their morality, their primary compass becomes how much money they make. The picture of bankers slavering after bonuses soon after they had been rescued by government bailouts was not only outrageous but also pitiable—pitiable because they were clamoring for their primary measure of self-worth and status to be restored.
Usually, competitive market mechanisms keep the search for profits on a track that also ensures it enhances value to society. This is the fundamental reason why free-market capitalism works and why bankers usually do good even as they do very well for themselves. However, the fault lines we have identified can warp the tracks. The finely incentivized financial system can then derail rapidly. By putting all the blame on the financial system, we fail to recognize the role played by the fault lines. Excoriating the immorality of bankers has made for good rhetoric and politics throughout history, but it is unlikely to address the fundamental reason why they can cause so much harm. Let us see how these effects were at work in the origination of dubious subprime mortgages.
There were plenty of examples of horrendous mortgage loans made in the runup to this most recent crisis. Many were made by New Century Financial, which was founded in 1995 with about $3 million of venture capital, as government support to the subprime market increased. Because subprime lending was an innovation with enormous potential opportunities, it attracted ample venture capital funding. New Century went public in 1997. After surviving a scare the next year, when Russian loan defaults caused investors to flee risky businesses and some subprime lenders went out of business, it grew rapidly.
Companies like New Century reached customers mainly through small, independent mortgage brokerages. Mortgage brokers found customers, advised them on available loans, and collected fees for handling the initial processing. With New Century and its rivals competing fiercely for business, brokers often favored lenders who were able to make loans quickly. As one broker put it, he liked working with New Century because it was “very easy.”5 New Century rarely demanded reviews of the appraisals on which loans were based. Because it outsourced business to brokers, it could ramp up its business quickly, without having to hire a lot of employees or find office space. Brokers worked out of their own homes and cars and were often willing to go to customers’ homes in the evening or on the weekend. As a result of such rapid expansion, New Century was the second largest subprime mortgage lender in the country at one time, originating nearly $60 billion in mortgages in 2006.
It does not take a genius to push loans to those who have credit problems, and New Century did not penalize brokers for the quality of loans they originated until in early 2007, when it was too late.6 The Wall Street Journal highlighted an example of the kind of loans being made.7 Ruthie Hillery was struggling to make the $952 monthly mortgage payment for her three-bedroom home in California. In 2006, a mortgage broker persuaded the 70-year-old Hillery to refinance into a “senior citizen's” loan from New Century that she thought would eliminate the need to make any payments for several years. Instead, the $336,000 adjustable-rate loan started out with payments of $2,200 a month, more than double her income. By the end of the year, when she could not keep up payments, Ms. Hillery received notice that New Century intended to foreclose on the property. As her lawyer put it: “You have a loan application where the income section is blank. How does it even get past the first person who looks at it?” According to Ohio's assistant attorney general, Robert M. Hart, New Century's underwriting standards were so low “that they would have sold a loan to a dog.”8
New Century was immensely successful for a while in spite of its appalling credit standards. And despite the prominence given in the media to such cases, it grew not primarily because it preyed on vulnerable retirees but because of rising house prices and securitization. With house prices rising, New Century's brokers could make loans with affordable initial teaser rates, anticipating that by the time borrowers had to make higher payments, their house prices would have risen, and they could refinance once again into a low rate. Indeed, this scheme was a virtual money machine, because the cost of refinancing could repeatedly be swept into the new, larger, mortgage—until house prices stopped rising. At that point, all those mortgages with resets to higher rates would turn into real debt—the kind that actually has to be repaid—and the high required repayments would resemble the balloon repayments that proved so burdensome to homeowners during the Depression.
New Century's management must have known that house prices would not rise indefinitely. So why did they continue making risky mortgage loans almost until the day they filed for bankruptcy? One answer is that the company did not hold on to the mortgages it made but sold them to investment banks who packaged them together and sold securities (which were vastly overrated by the rating agencies) against the package to Fannie and Freddie, pension funds, insurance companies, and banks around the world.
So did no one care about credit quality? The investment banks (and their rating agencies) did care, after a fashion. To sell the mortgages on, they had to satisfy themselves that the underlying credit quality was sound. In the past, when a bank made a mortgage loan that it intended to hold on its books, it called the prospective borrower in. The loan officer interviewed him, sought documents verifying employment and income, and assessed whether the borrower was able and willing to carry the debt. These assessments were not just based on hard facts; they also included judgment calls such as whether the borrower seemed well mannered, cleanly attired, trustworthy, and capable of holding a job. Cultural cues such as whether the applicant had a firm handshake or looked the loan officer in the eye when answering questions no doubt played a role—as, unfortunately, did race. But many of these judgment calls did seem to add value to credit evaluations. So did the loan officer's knowledge that his client would be back to haunt his conscience if he put him in an unaffordable house.
But as investment banks put together gigantic packages of mortgages, the judgment calls became less and less important in credit assessments: after all, there was no way to code the borrower's capacity to hold a job in an objective, machine-readable way.9 Indeed, recording judgment calls in a way that could not be supported by hard facts might have opened the mortgage lender to lawsuits alleging discrimination. All that seemed to matter to the investment banks and the rating agencies were the numerical credit score of the borrower and the amount of the loan relative to house value. These were hard pieces of information that could be processed easily and that ostensibly summarized credit quality. Accordingly, the brokers who originated loans focused on nothing else. Indeed, as the market became red-hot, they no longer even bothered to verify employment or income. Part-time gardeners became tree surgeons purportedly earning in the middle six figures annually.
The judgment calls historically made by loan officers were, in fact, extremely important to the overall credit assessment. As they were dispensed with, the quality of mortgage-origination decisions deteriorated, even though the hard numbers continued to look good till the very end. It really does matter if the borrower is rude, shifty, and slovenly in the loan interview, for it says something about his capacity to hold a job, no matter what his credit score indicates. Moreover, brokers and New Century had an immense incentive to keep the volume of originations up so that they could collect fees—and they now knew which numbers to emphasize. So brokers felt little compunction in helping willing borrowers massage their credit scores, and they recruited pliant appraisers who would keep the loan-to-value ratio down by offering outrageously high appraisals for the house.10 Because they seemed willing to do virtually anything to close the deal, New Century's loan department became known as “Close More University.”11
Eventually, though, New Century's weak standards caught up with it. Increasingly, its borrowers could not even make their first few payments and defaulted. These defaults were problematic because the banks buying the mortgages for packaging could return mortgages that defaulted early to New Century. With more and more mortgages returning onto its books, and lenders withdrawing their lines of credit, New Century eventually filed for bankruptcy. One has to marvel at the sheer chutzpah of New Century's founder, Brad Morrice, who said in a news release announcing the company's bankruptcy on April 2, 2007, that it had “helped millions of Americans, many who might not otherwise have been able to access credit or to realize the benefits of homeownership.”12 He neglected to mention that for millions of these homeowners, their houses were like millstones around their necks, drowning them in a sea of debt.
The private financial sector bears an enormous responsibility for what happened. But did the brokers act immorally? Clearly, misleading retirees about their payments was wrong and bordered on the illegal. But although these are the cases that still make the headlines, it is not obvious that predatory lending of that sort was the norm. Brokers and firms like New Century provided many a homeowner with what they were asking for: refinancing at low rates, with little thought for the future. Should the broker have counseled the debt-ridden homeowners they were working with to cut back on consumption, pay off credit card debts, and move to a smaller, more affordable house? Perhaps some would have done so had they thought they would see their clients again. Knowing, however, that the mortgages they originated would be packaged and sold, they had little stake in the relationship, other than the fees—fees that indicated to them they were doing God's work. Arm's-length transactions do not foster empathy or a long-term focus.
There is, however, another check on arm's-length transactions—a wellfunctioning competitive market. If New Century had been forced to sell its originations for fair value, it would never have originated the risky mortgages it did or put so many borrowers into unaffordable houses. The competitive market would have provided the mechanisms to keep First Century on track. Somehow, and unfortunately, the market was willing to pay much higher values for these mortgages than they were worth and did not exercise its customary discipline.
One reason might be that the market was irrationally exuberant and believed the poppycock that house prices would never go down. There is, however, mounting evidence that much of the boom and bust was concentrated in low-income housing, suggesting that this was not generalized irrationality and that other factors may have been at play.13
A more plausible argument is that the strong government push for home ownership by lower-income households led to an enormous increase in the volume of money poured into this sector. The brokers, lenders, packagers, and rating agencies simply did not have the personnel or capacity to manage the enormous workloads effectively. Although they may have worried about potential damage to their reputation from the slipshod work they were doing, the enormous fees they generated apparently allayed those worries.14 For example, many of New Century's senior managers were industry veterans who knew they had the license to print money only for a limited time: even as New Century's liquid assets fell in the period 2005–2007, as it was forced to absorb losses on loans it had to take back on its books, its dividends per share increased.15
This is not a complete argument, for it only kicks the conundrum one step down the road. It explains why the investment banks (and rating agencies) acted as boosters for New Century's faulty mortgages, but not why they could sell them to others at a hefty premium. Either the final buyers were fooled by ratings or there was strong demand for these originations, without much thought to underlying price or quality.
Certainly some of the bureaucratic pension funds and foreign banks did not care what they bought so long as it promised a high yield and was rated AAA, though they should have wondered why they seemed to be getting return without risk. Hindsight suggests they should have trusted less and verified more, even if they believed in the institutions of arm's-length markets, such as rating agencies. But the damage was also done by agencies like Fannie and Freddie, which had to buy an enormous fraction of subprime mortgage-backed securities to meet a government-imposed quota, and by government organizations like the Federal Housing Administration, which contributed to the unsustainable demand in this segment of the housing market. As Peter Wallison of the American Enterprise Institute points out: “As of the end of 2008, the Federal Housing Administration held 4.5 million subprime and Alt-A loans. Ten million were on the books of Fannie Mae and Freddie Mac when they were taken over, and 2.7 million are currently held by banks that purchased them under the requirements of the Community Reinvestment Act (CRA). These government-mandated loans amount to almost two-thirds of all the junk mortgages in the system, and their delinquency rates are nine to fifteen times greater than equivalent rates on prime mortgages.”16
As problematic as the mandates was the rapidity of the ramp-up. Given the volumes that the agencies and government organizations were pushed to buy quickly, they could not have exercised a lot of quality control, beyond focusing on the obvious hard parameters such as credit scores, which, as we have seen, proved problematic. Perhaps if politicians had been in less of a hurry to extend home ownership to the poor, the mortgage originations could have been more careful, the oversight by rating agencies more thorough, and buyers more circumspect about what they were buying.
Where did the buck stop? Not with New Century's founders, who sold their stock holdings as the firm's fortunes deteriorated. Not with the brokers, who made fat commissions while the gravy train chugged along. Not with the rating agencies, who did not notice, or chose to ignore, the deterioration in the underlying quality of mortgages. Not with some of the homeowners, who spent to excess while treating homes they should never have owned as virtual ATMs. It stopped with the retiree who was fooled into taking out an expensive mortgage and, at an age when she should be without worries, is now facing eviction. It stopped with the pension funds and insurance companies who are now sitting on sizeable losses that will depress the investment returns of every household that relies on them. And above all, it stopped with the taxpayer, whose dollars bailed out Fannie and Freddie, and who stands behind the Federal Housing Administration.
Financial sector performance, especially in an arm's-length system where the financier does one-off transactions and rarely has a long-term relationship with the final customer, can often only be measured by how much money the financier makes. The personal checks and balances that most of us bring to bear when we are employed in other activities—we ask ourselves if we are producing a socially useful product—operate less well in finance because, with few exceptions, making money is the raison d’être for the financier. In this competitive environment, small distortions to prices can make the financial sector go significantly off track.
Many have attributed the excesses to greed. But greed, or more prosaically, self-interest, is the driving force in any type of arm's-length transaction. It is a constant, and it cannot explain boom and bust. The private sector did what it always does: look for the edge. Unquestioning foreign money and domestic money partly driven by government mandates may have given it the impetus to take subprime lending to its disastrous conclusion. This is not meant to hold the private sector blameless but simply to argue that there are enormous risks in bringing together deep-pocketed investors who are not adequately conscious of prices and risks, and the highly motivated private financial sector.
The role of foreign investors is particularly interesting. Foreign central banks were confronted with vast dollar inflows as exports to the United States expanded, and as U.S. investors looked abroad to escape from low U.S. interest rates. As the central banks bought dollar assets in an attempt to keep the domestic exchange rate from appreciating, they looked for a little extra return. Being conservative, they had to invest their dollars in debt, and the implicit protection that Fannie and Freddie's debt enjoyed led them to gravitate toward it. Thus the money pushed out to developing countries by the Fed's low-interest policy came back to help expand the agencies’ purchase of subprime mortgage-backed securities. Knowing that the agencies enjoyed the implicit guarantee of the government, the foreign central banks really did not care about the risks the agencies took. Somewhat ironically, the developing country central banks did to the United States what foreign investors had done to them in their own crises.
Equally problematic were private foreign investors like the German Landesbanks, which trusted the ratings on mortgage-backed securities and, together with Fannie and Freddie, bid up the prices for these securities, making them far more attractive to create than they should have been. The emerging market crises that I described in Chapter 3 indicated the difficulties that arise when a relationship-based system is financed with arm's-length money. To some extent, what we see in the recent crisis are the problems created when the arm's-length system is financed with foreign and domestic quasi-government money that is less sensitive to price and risk.
The story of the current crisis does not end here. Somehow the private financial sector contrived to convert its edge into an instrument of self-destruction, for the commercial and investment banks that packaged the mortgages together and sold mortgage-backed securities ended up holding large quantities of them. More than anything else, this phenomenon is what transformed what would otherwise have been a contained U.S. housing bust into a devastating global financial crisis. To understand why this happened, we have to delve deeper into the motivation of the modern banker, going beyond returns to the nature of risk. I investigate that question in the next chapter.