What did you do in the Great Recession, Daddy?

I wrote mortgage-backed securities prospectuses for Citigroup, Son.

Really, I did. You may think I should be ashamed of myself, and that I must be partly responsible for the $7 billion that Citigroup will pay under its settlement with the Justice Department announced July 14. But I’m neither ashamed nor responsible, and here’s why.

I’m not defending Citigroup for doing what the Justice Department alleged, primarily lying about the quality of the mortgages in certain residential mortgage-backed securities (RMBS) it sold. But the size of the settlement seems to be largely motivated by a set of myths about the recession, most importantly that it was caused by nefarious doings in the RMBS market.

(There may have been another motivation for that enormous settlement. As the New York Times reported, the settlement included $2.5 billion for “the financing of rental housing, mortgage modifications, down payment assistance and donations to legal aid groups, among other measures intended to provide relief to consumers.” None of this has much to do with the harm alleged—defrauding investors—but may have a lot to do with AGs getting to fund their own policy hobby-horses without the bother of going through an elected legislature. One would have thought prosecutors would be more sensitive to the ethical problems involved in using other people’s money for one’s own purposes.)

My side of Citigroup’s RMBS business seems to have come off well in the settlement. Citigroup had several RMBS programs. One (Citigroup Mortgage Loan Trust Inc., or “CMLTI”) was housed in Citigroup’s investment bank, and another (Citicorp Mortgage Securities Inc., or “CMSI”) in CitiMortgage, a Citigroup subsidiary headquartered in O’Fallon, Missouri. CMSI originated and serviced mortgages, selling off a good many as RMBS but also holding a substantial portfolio. CMLTI, in contrast, simply bought mortgages and packaged them into RMBS. I worked exclusively for CMSI, and don’t know much about what went on at CMLTI, whose prospectuses were written by Thacher Proffitt, a major law firm in the RMBS world that went under in the recession.

If there was any hanky-panky at CMSI in O’Fallon, I probably wouldn’t have seen it from my perch in New York City. But in any case, none of the five examples of Citigroup skullduggery recited in the Justice Department’s statement of facts involved CMSI; four involved CMLTI and one involved Citigroup acting purely as an underwriter. Whatever went on at CMSI, it apparently didn’t rate a marquee appearance.

Back to the Great Recession. I don’t know what caused it—I’m not sure anyone does at this point—but I’m pretty sure that blaming conniving issuers in the RMBS market is strictly from Hollywood (Inside Job, for example, which is actually a pretty good movie if you don’t take it too seriously). I’m backed in this belief by a convincing (and surprisingly readable) paper by a trio of economists at the Federal Reserve Banks in Boston and Atlanta. They wrote that

“The facts refute the popular story that the crisis resulted from financial industry insiders deceiving uninformed mortgage borrowers and investors. … Borrowers and investors made decisions that were rational and logical given their ex post overly optimistic beliefs about house prices.”

I’m not going to walk you through all of this myth-busting paper, but two of the 12 facts the authors present are particularly relevant for this unapologetic prospectus writer: “Mortgage investors had lots of information” (Fact 6), and “Investors understood the risks” (Fact 7).

A typical RMBS prospectus presented pages of information summarizing the credit scores of the borrowers and the methods used to evaluate their credit, the ratio of loans to sale prices, scenarios describing the results if various percentages of mortgages were to go into foreclosure (more about this below), and much else that the investors—all substantial institutions—wanted to know. Nor did investors stop there. Many demanded and received spreadsheets showing this information for each loan (loan-level detail), which they analyzed using their own proprietary techniques or off-the shelf analytic packages. (The spreadsheets were publicly available on the SEC’s website as “free-writing prospectuses.”) Investors who bought RMBS could also track their investments on a website showing each month’s payment information at loan level.

RMBS weren’t sold like stocks and bonds, where the characteristics of the security are determined before the buyers are found. For RMBS, the underwriter essentially bought a pool of mortgages and then devised a “structure”—that is a system of various “classes” of securities that would absorb all the principal and interest payments thrown off by the mortgage loans. For example, a pool of mortgage loans might be structured so that one class paid 5.5% interest while another paid 6%, and one class might be expected to pay off between 4 and 8 years while another paid off between 8 and12 years, in each case given assumptions stated in the prospectus about the rate at which homeowners would prepay their loans. From about 5% to 20% of the classes, depending on the quality of the loans, would be rated anywhere from AA to junk and would absorb all of the losses on the mortgages until their principal was wiped out; only then would any loss be visited on the AAA-rated classes.

Those classes didn’t just happen; the underwriter structured them to satisfy its clients’ demands for securities with certain payment, maturity, and risk characteristics. To imagine RMBS being sold to a bunch of passive ignoramuses is sheer fantasy.

What went wrong, of course, is that the worst-case scenarios in the prospectuses and the investors’ models, while extreme by post WW II historical standards, were nowhere near as bad as the situation that actually overwhelmed us in 2007-8. But even using the prospectus scenarios, anyone could project that if housing prices went much lower than the prospectus assumptions, things could get very dicey indeed.

Actually, even for subprime RMBS, the tsunami left most AAA investors high and dry: 90% of the AAA-rated classes, often 80% of the offering, rode out the storm without loss. Floyd Norris in one of the Times articles linked above tracked a CMLTI series and found that its AAA classes (89% of the total) had cumulative losses of about 4%. Holders had been reaping interest income of around 6% a year in a very low-interest environment, so their pain was somewhat mitigated. But holders of lower-rated classes suffered a good bit more: The AA classes were wiped out in less than six years, the BBBs in less than three.

The real devastation, however, was in a different form of asset-backed security, the now-infamous collateralized debt obligations (CDOs), whose AAA classes were savaged. (The Fed trio offer an interesting explanation of why the RMBS analysts got it mainly right while the CDO analysts, often working in the same building for the same employer, got it so wrong.)

The Great Recession originated in a huge bubble in housing prices. That’s an unsatisfying explanation because we don’t have much understanding of bubbles. For unexplained reasons, sophisticated observers come to believe that the price of an asset will continue to rise. In that climate much that would normally not be reasonable—like lending to homeowners without checking their income or assets—becomes perfectly sensible. (You can learn all you need to know about the frenzy by checking out the documentary The Queen of Versailles, where a rich couple’s chauffeur mentions that he owns six houses, all in foreclosure.) While many saw a bubble, few thought its bursting would be anywhere near as cataclysmic as it was.

(In 2005, I inserted the following paragraph in the “Risk Factors” section of CMSI’s prospectuses

"Housing price cycle

"A number of commentators have recently suggested that home prices in the United States are at a cyclical high, and likely to fall substantially in the near future. A substantial fall in housing prices could cause an increase in defaults on the mortgage loans, and would reduce the amount that could be realized on foreclosure."

In late 2006 I added that “There have been reports that housing prices in some areas are currently declining.”

           I wasn’t psychic; I’d simply read a cover story in The Economist on the asset bubble.)

When things go terribly wrong we hunt for the persons responsible. But often there is no one responsible, and our demand for heads to put on pikes simply reflects something primitive in our psychological makeup—an inchoate feeling that all events are the result of human passion and calculation, a leftover perhaps from ancient systems that saw all natural phenomena as imbued with spirits having human wants and desires. ‘Taint so, but it takes constant vigilance to keep from falling for this sort of emotional logic.

Even as wary an observer as Floyd Norris can get caught up in the passion of the time. While realizing that the Citigroup settlement did nothing for the ostensible victims—the investors—and that the prosecutors never established a link between Citigroup’s dodgy practices and the investors’ losses, Norris still finds “a sense in which Citigroup’s punishment seems reasonable”:

“Many of those most responsible for the worst abuses are long gone or simply untraceable. That includes the mortgage companies that failed early in the crisis and the loan officers and borrowers who lied to get loans approved.

“The big banks are the survivors of a crisis that they helped to create, and they survived in part because the government chose to bail them out. The direct cost to the government of those bailouts may have been recovered, but the indirect costs—in the form of lost tax revenue and increased spending on the social safety net—are still enormous. The big banks are now doing reasonably well, and the effect of settlements like this one can be seen as providing partial reimbursement of those indirect costs.”

But unless Citigroup’s illegal actions to some extent caused the crisis, there can be no argument for “reimbursement.” And here, as Norris understands full well, the verdict seems to be “unproved.”

—Stan

Hobby Lobby: Why all the fuss?

The Supreme Court’s June 30 decision in Burwell v. Hobby Lobby Stores has produced more commotion than can be explained by either the holding or its likely effects. A good deal of the hubbub can be ascribed to the subject matter: contraceptive services. 

Hobby Lobby is a corporation owned and operated by a family (parents and three children) with sincere religious objections to abortion. Health and Human Services (HHS) regulations implementing Obamacare require coverage for some 20 contraceptive services, including four methods—two “morning-after” pills and two IUDs—that prevent a fertilized egg from surviving (so-called “abortifacients”). The Court, by a depressingly familiar 5–4 margin, allowed Hobby Lobby to opt out of paying for coverage for the abortifacients. (Hobby Lobby did not seek to deny coverage for the 16 other contraceptive methods that merely prevent fertilization, though future objectors may do so.)

Hobby Lobby is an easy case. The Religious Freedom Restoration Act of 1993 (RFRA) provides that a governmental rule may not “substantially burden a person’s exercise of religion.” However, that principle may be overridden if the rule is “the least restrictive means” of furthering “a compelling governmental interest.” 

Refusing to pay for contraceptive insurance may not be an “exercise of religion” in normal parlance, but RFRA defines “religious exercise” broadly to include “any exercise of religion, whether or not compelled by, or central to, a system of religious belief.” 

So the question came down to whether the HHS regulations were the “least restrictive means” of furthering what was assumed for purposes of the case to be the compelling governmental interest in providing contraceptive coverage. But here HHS had basically conceded the issue: It had earlier devised a way for insurers to provide contraceptive coverage (including abortifacients) to employees of religious organizations without requiring those organizations to pay for the coverage. The Court saw no reason the same work-around could not be offered to for-profit corporations whose owners had similar religious objections. With that issue out of the way, the Court had little difficulty concluding that the Hobby Lobby owners’ exercise of their religion—by declining to pay for the four abortifacients—would be substantially burdened, since there were massive financial penalties for noncompliance. 

 A good deal of the Court’s opinion, and a spirited dissent by Justice Ginsburg, deals with a different question: Can a corporation be the kind of “person” that can engage in an exercise of religion? Plainly “No,” and some in the media have seized on this impossibility to argue that Hobby Lobby is irredeemably wrong-headed. (The same criticism is often leveled at the decision in Citizens United: that it gives corporations free speech rights.) But the question, clearly dealt with in the Court’s opinion, is whether individuals who own or operate a corporation can engage in an exercise of religion, and here the answer is plainly “Yes.” Whatever you think of the results in Hobby Lobby or Citizens United, they show a commendable tendency of the Court’s conservatives to look through corporate “personhood” to ask what individual rights and values are at stake. As Justice Alito wrote in Hobby Lobby,

     "A corporation is simply a form of organization used by human beings to achieve desired ends. An established body of law specifies the rights and obligations of the people (including shareholders, officers, and employees) who are associated with a corporation in one way or another. When rights, whether constitutional or statutory, are extended to corporations, the purpose is to protect the rights of these people."

(Justice Ginsburg nonetheless argued that a corporation is not the type of “person” covered by RFRA, but only Justice Sotomayor was willing to join that part of Ginsburg’s dissent.)

Given RFRA, and the HHS regulations granting an exception for religious organizations, the result in Hobby Lobby seems inescapable. Why then did the Court’s four liberal Justices not see it that way? 

The current Court has an odd religious makeup: six nominal Catholics (the five conservative Justices plus Sotomayor) and three nominal Jews. (“Nominal” because I don’t know the depth of their actual religious beliefs.) One suspects that some in the majority may have been swayed by pro-life and anti-Obamacare views, just as some of the dissenters may have been swayed by pro-choice, pro-Obamacare views. 

A great deal of what we call argument is really just after-the-fact rationalization. Something happens that requires us to take a stand, we react viscerally, and then concoct an argument to justify our initial response. No one—not me, not you, not the Supreme Court—is immune from such psychological pressures. The trick is to be self-aware enough to see your emotional responses—“Protect Religion,” “Protect Women’s Rights”—for what they are, and then to be as dispassionate as you can about the arguments. 

Contraception in general, and abortion in particular, are hot-button issues. I’m pro-choice and (with reservations) pro-Obamacare, and I’m an atheist as well, so my visceral reaction to the Hobby Lobby decision was negative. But after reading RFRA, I found it difficult to fault the Court’s reasoning. 

Unfortunately, constitutional law with all its vagaries gives the judiciary lots of leeway to construct arguments to support their gut reactions. But Hobby Lobby involved statutory interpretation, which should be less susceptible to this sort of monkey business. Here the liberal minority, especially Ginsburg and Sotomayor, ignored the statue and went off the deep end. (The conservative majority have had their own fair share of jurisprudential cockups, but Hobby Lobby gave them a better shot at an argument that could pass dispassionate intellectual muster.)

In any event, and despite what you may have read, Hobby Lobby is unlikely to affect employees’ access to contraception, especially if HHS extends its current religious organization exception to for-profit corporations. Even if HHS doesn’t act, few for-profit corporations will be able to follow Hobby Lobby’s lead; there would have to be virtual unanimity among the owners, which is rarely possible outside of family-owned corporations. Unlike Hobby Lobby (which has 13,000 employees), most family-run corporations are small affairs. Corporations with fewer than 50 employees are already exempt from Obamacare, so Hobby Lobby is unlikely to be of much practical importance.

* * *

Extended Postscript: Two days after Hobby Lobby came down, the Court enjoined HHS from requiring Wheaton College to send its insurer the HHS form that allows religious organizations to opt out of contraceptive coverage. Wheaton argued that sending the required form to the insurer would involve it in authorizing the insurer to cover the contraceptive practices Wheaton objected to (again, abortifacients). Wheaton argued that it should only be required to notify HHS (not the insurer) by letter. 

It sounds like a perfectly silly argument to me, but these are matters of faith, not reason. And in any case, Hobby Lobby spoke plainly to the issue: HHS had argued that the connection between the required actions and the end that Hobby Lobby’s owners believed to be morally wrong was too attenuated. But since the families asserted that providing the insurance coverage lay on the forbidden side of the line, the Court held that its only function was to determine whether the line drawn reflected an honest conviction; it was not for the Court to say that the belief was “mistaken or insubstantial.” 

The Wheaton College order would not have attracted my attention were it not for a noisy dissent from Justice Sotomayor (in which Justices Ginsburg and Kagan joined) that became the New York Times two-day lead story (July 4 and 5—both slow news days). While part of Sotomayor’s dissent was a technical legal argument about the appropriate grounds for issuing a preliminary injunction, her more eye-catching claim was that the majority had ignored its own still-warm precedent from Hobby Lobby. 

Sotomayor made two arguments, both flawed. First, she argued that Wheaton’s having to send the innocuous form to the insurer wasn’t a “substantial” burden, as required by RFRA. But for Wheaton to exercise its religious principles, it would, in lieu of sending the form to its insurer, have had to cancel the insurance, which would have led to massive fines. Those fines were the substantial burden in Hobby Lobby, and would have been the substantial burden for Wheaton. Sotomayor’s real argument is just that HHS wasn’t asking all that much of Wheaton, but it’s clear from Hobby Lobby that it’s Wheaton that gets to decide how serious the moral issue is.

Sotomayor’s second argument is that the Court in Hobby Lobby had approved the HHS regulation for religious organizations (with its requirement for notice to the insurer) as satisfying RFRA by providing a least restrictive means of achieving the governmental interest in contraceptive coverage. Therefore, Wheaton was obliged to accept it. But Hobby Lobby was (presumably) willing to sign the HHS form and send it to the insurance company, whereas Wheaton was not. The issue was therefore whether there was a less restrictive means of allowing Wheaton to exercise its religious principles, not Hobby Lobby’s. The Court was able to approve Wheaton’s simply sending a letter to HHS as providing that less restrictive means.

The July 5 New York Times article began as follows:

"WASHINGTON—The Obama administration, reeling from back-to-back blows from the Supreme Court this week [Hobby Lobby and Wheaton College], is weighing options that would provide contraceptive coverage to thousands of women who are about to lose it or never had it because of their employers’ religious objections."

Given that HHS need only offer a limited number of family owned corporations the same procedures it grants to the larger number of religious organizations (Hobby Lobby), and will in some cases have to notify the insurance company itself rather than relying on the organization to do so (Wheaton College), there seems little cause for this sort of panic. The Times gets closer to the real issue eight paragraphs down:

 

"[T]he administration has another motivation to act as quickly as possible: It is eager to court the votes of women dismayed by the rulings. The Democratic National Committee is already urging voters to fight back against the Hobby Lobby decision and to “stand up for Obamacare” in the November elections"

So while the Hobby Lobby and Wheaton College decisions are virtually compelled by RFRA and current HHS regulations, and while their effects on insurance coverage are likely to be limited, the decisions can be spun as attacks on women’s contraceptive rights, especially since the Times did not highlight that Hobby Lobby employees would retain coverage for contraceptive services other than abortifacients. That the DNC and the Times might want to use a legally unobjectionable decision to rally women in favor of Obamacare and contraceptive rights is understandable. A Supreme Court Justice is also entitled to feel deeply about these issues, but should not let his or her personal feelings prevail over a thoroughly sensible reading of the law.

     —Stan