Ironically, it was the government itself that had helped make Wall Street skilled at securitizing riskier mortgages—specifically the Resolution Trust Corporation. In cleaning up failed thrifts, the RTC wound up with hundreds of billions of dollars worth of assets—everything from high-rise office buildings to vacant plots of land—that it took from the S&Ls it was closing down. Eventually, the RTC decided that the best way to get rid of those assets was to securitize them and sell them to investors. Much of the RTC’s raw material, though, qualified as risky and thus couldn’t be backed by Fannie Mae or Freddie Mac.
Ah, but if the securities could get a double-A or triple-A credit rating, investors like pension funds would be able to buy them, even without the GSEs’ seal of approval. It was the high rating, after all, that was required for them to hold the securities, not Fannie and Freddie’s guarantee. Even before the RTC, Wall Street had been experimenting with ways to make risky securities less risky by issuing, for instance, a letter of credit promising investors payment in the event the cash flow from the assets wasn’t enough. But the RTC allowed Wall Street to work on such techniques—“credit enhancement,” they were called—on a far broader scale. Over time, people came up with all sorts of ways to do credit enhancements. You could get insurance from a third party—a bond insurer, say. You could “overcollateralize” the structure, meaning you put in more mortgages than were needed to pay the investors, so that there was extra in case something went wrong. Or (and this would come later) you could do a so-called senior/subordinated structure, where the cash flows from the underlying mortgages were redirected so that the “senior” bonds got the money first, thereby minimizing the risk for the investors who owned those bonds. Credit enhancements helped convince the rating agencies to rate some of the tranches triple-A, which in turn helped convince investors to buy them. “The innovative techniques that the RTC developed are now in the process of being used by private sector issuers,” was the way Michael Jungman, the RTC’s director of asset sales, put it in a 1994 lecture. Indeed.
Larry Fink, obviously, had never envisioned credit enhancements. But as a 1999 paper by economists at the conservative American Enterprise Institute noted, “The attraction of this segmentation of risk is that the senior (collateralized) debts appeal to investors with limited taste for risk or limited ability to understand the risks of the underlying loans.” At last, Wall Street had a securitization business it could do on a large scale—and it didn’t have to share a penny with the GSEs.
There was a final key to the rise of the subprime business. The federal government was behind it. Not in so many words, of course—and, to be fair, it is highly unlikely that many people in government truly understood what they were unleashing. But by the 1990s, government’s long-running encouragement of homeownership had morphed into a push for increased homeownership. Thanks to the second S&L crisis, the percentage of Americans who owned their own home had actually dropped, from a historic high of 65.6 percent in 1980 to 64.1 percent in 1991. In a country where homeownership was so highly valued, this was untenable.
Thus it was that, early in his second term as president, Bill Clinton announced his National Homeownership Strategy. It had an explicit goal of raising the number of homeowners by 8 million families over the next six years. “We have a serious, serious unmet obligation to try to reverse these trends,” said Clinton, referring to the drop in the homeownership rate. To get there, the administration advocated “financing strategies fueled by creativity to help home buyers who lacked the cash to buy a home or the income to make the down payments.” Creatively putting people who lacked cash into homes was precisely what the new subprime companies purported to do.
Which also explains why the government had such a hard time cracking down on the subprime companies, even as it became apparent that there was widespread wrongdoing. Roland Arnall’s company, Long Beach Mortgage, offered a case in point. In 1993, the Office of Thrift Supervision, a new agency created by Congress to regulate the S&Ls, alleged that Long Beach was discriminating against minorities by charging them more for their loans than they charged whites. Long Beach ducked this investigation when it gave up its thrift charter, leaving the OTS with no authority over the company.
A few years later—around the same time Clinton was announcing his housing initiative—the Justice Department began its own probe. Investigators found that Long Beach’s brokers, most of them independent, were charging up to 12 percent of the loan amount over a base price. The amount they charged was “unrelated to the qualifications of the borrowers or the risk to the lender,” according to the government. Younger white males got the lowest rates, while older, single African-American women fared the worst.
In September 1996, then assistant attorney general Deval Patrick, an African-American himself, announced a settlement with Long Beach. Although Long Beach denied the government’s allegations, it agreed to pay $3 million into a fund that would go toward reimbursing borrowers who were allegedly overcharged. The Federal Trade Commission originally demanded half of Long Beach’s net worth to settle the case, but Arnall had what Daurio calls a “brilliant” idea: the company offered to put $1 million toward partnerships with community groups for consumer education. Patrick and the FTC went along.
What the case mainly showed, though, was how difficult it was for the government to crack down on companies that were offering credit to people who would otherwise never be able to own a home. On the one hand, the Clinton administration’s explicit policy was to get millions more American families into homes. Men like Arnall were making that possible. On the other hand, making it possible for poorer people to buy homes was inevitably going to mean charging higher fees and interest. Practices that banks viewed as disreputable were widely accepted in the subprime world. Cracking down too hard on the subprime companies might hurt their ability to make loans to their customer base—who were the exact same people the government was trying to help.
Ultimately, this was a heavily politicized gray area, difficult to police. It raised difficult questions about which practices were legitimate and which were not. The government’s dilemma was obvious in the statement Patrick released when he announced the settlement. “We recognize that lenders understand the industry in ways we don’t,” he said. “That is why there is so much flexibility in the decree.”
Clearing up the gray required a willingness to tackle the hard questions about what subprime lending was, and what was the proper way to conduct it. But that willingness was always in short supply, both then and later.
By the mid-1990s, the subprime market was exploding. Companies like Long Beach had shown how much money could be made, but the business got another kick from a different source: the Federal Reserve. In 1994, the Fed began to raise rates, and refinancings plummeted. That left “prime” lenders, whose loan volume dropped by as much as 50 percent, looking for a new source of loans. Guess what they found? Subprime.
The changes in interest rates also left Wall Street firms searching for a new product to sell. They had been making huge sums selling mortgage-backed securities that were tranched according to their interest rate and prepayment risk. When rates had fallen, so many people refinanced that the riskier tranches of the mortgage-backed securities lost much of their value.
Just in time came this new product: bonds backed by subprime mortgages, goosed by those “credit enhancements.” For Wall Street, this new business presented a trifecta of opportunity. Street firms could make money selling and trading the mortgage-backed securities. But they could also make money by providing a warehouse line of credit so that the mortgage companies could make the loans in the first place. And they could make money by taking subprime specialists public.
It quickly became a frenzy. Traditional hard-money lenders like Associates, Household, and the Money Store saw their stocks soar. Subprime founders got very rich. For instance, the Money Store, which had been started by Alan Turtletaub in 1967 and became a household name after signing up Hall of Fa
mer Phil Rizzuto to be its spokesman (1-800-LOAN-YES), went public in 1991 at $16 a share. By the spring of 1997, its stock had risen fivefold. In 1998, First Union bought the Money Store for $2.1 billion. Turtletaub’s stake was estimated at $710 million.
There was also a proliferation of start-ups, making mortgage finance, for a brief moment, as hot as Internet companies. Dan Phillips, an ex-Marine who had been a loan officer at Beneficial, founded a company called FirstPlus Financial. The stock soared. Phillips, who once described old-school bankers as “accountants who make loans,” made a fortune as well. He began building a 31,000-square-foot estate in North Dallas, complete with a pool house and lighted tennis court, according to the Dallas Morning News. Right around that time, Dan Quayle joined the board of FirstPlus.
There were plenty of others: First Alliance, Cityscape, Aames, and more. Steve Holder, who had been an executive at Long Beach, co-founded a company called New Century. Robert Dubrish, another Long Beach alum, founded Option One, which was bought by H&R Block in 1997. (Both Option One and New Century had former Guardian executives in key positions.) They were freewheeling entrepreneurs, grabbing for the brass ring; they didn’t spend a lot of time worrying about crossing every t and dotting every i. As Paul Mondor, the director of regulatory compliance for the Mortgage Bankers Association, told the American Banker in 1997, “It’s a high-risk, high-return market … it stands to reason you’ll have flashier types who worry less about bending the rules.”
From 1994 to 1999, the number of loans made by companies that identified themselves as subprime lenders increased roughly six times, from about 138,000 to roughly 856,000, according to the Federal Reserve. Over the same period, the dollar volume of subprime mortgage originations increased by a factor of nearly five, from $35 billion to $160 billion, or almost 13 percent of all mortgage originations, according to a joint study by HUD and the Treasury. Economists, including those at the Federal Reserve, credited subprime lending with the increased rate of homeownership, which by 1999 hit a record 66.8 percent. What tended to be forgotten, though, was that most subprime mortgages did not go toward the purchase of a new house, but rather were refinancings by existing homeowners. (According to a joint HUD-Treasury report, a staggering 82 percent of subprime mortgages were refinancings, and in nearly 60 percent of those cases the borrower pulled out cash, adding to his debt burden.)
It wasn’t just the Democratic administration that saw a reason to applaud the rise of subprime lending, either. Conservatives were applauding, too. For instance, in that same 1999 American Enterprise Institute paper, the authors touted the virtues of something called high loan-to-value lending, or HLTV. That was industry jargon for loans with low or no down payments. (A loan with a 100 percent loan-to-value ratio has no down payment; a 90 percent LTV ratio has a 10 percent down payment; and so on.) “Consumer debt collateralized by the borrower’s home is effectively a senior claim on his income, backed by an asset that would otherwise be protected from seizure by creditors if he were to file for bankruptcy,” wrote the authors, Charles Calomiris and Joseph Mason. “Because HLTV lending can rely on securitization for the bulk of its financing, it provides a more diversified, and thus a more stable, source of consumer credit.” They concluded, “HLTV lending is good for the American consumer and for the U.S. economy.”
And all the while, Angelo Mozilo watched with amazement as subprime lending took off. It’s not that he didn’t believe in the virtue of increased homeownership. He did, passionately. The government’s desire to get more people into their own homes aligned not just with Mozilo’s business model but with his psyche. When he started in the business, after all, redlining—the practice of not making loans in poor neighborhoods—was standard practice in the banking industry. People with minority or immigrant background, like himself, had a harder time buying new homes than middle-class WASPs. Women had a harder time getting loans than men.
Mozilo felt that he and Countrywide were helping to democratize the housing market. “He always felt like he was compelled to help people get into homes,” says Howard Levine. Once, during the administration of the first George Bush, Jack Kemp, Bush’s HUD secretary, tried to scale back some government assistance for the mortgage market. Mozilo publicly denounced him as “the worst person who could possibly have been put in that position.” It was a very impolitic thing to say, but Mozilo couldn’t help himself.
When Clinton announced his housing initiative, Mozilo was an enthusiastic supporter. In 1994, he signed a pledge—part of an agreement between the Mortgage Bankers Association and HUD—to increase lending to minorities. He pushed hard to get Fannie and Freddie to guarantee mortgages with lower down payments, because the traditional 20 percent down payment, he believed, was the single biggest barrier preventing people from owning their own home.
And early on, Mozilo had made a commitment that his company would fund $1.25 billion of loans explicitly tailored to meet the needs of lower-income borrowers. But this program was a long way from subprime lending. The standards were fairly strict. The mortgages were all thirty-year fixed-rate loans. The losses were low. And it was a tiny percentage of Countrywide’s business.
Mozilo, in truth, was horrified by the rise of subprime lending. It was a business, he groused, that made its money overcharging unsuspecting customers. Most subprime executives were “crooks,” he railed to friends. But the growth was so dramatic that stock analysts started asking why Countrywide wasn’t part of it. Meanwhile, the company’s program aimed at lower-income customers, small to begin with, started to shrivel: loan volume dropped from $1.3 billion in 1996 to $600 million in 1997 to $400 million in 1998. Where were those customers going? There wasn’t much doubt. They were going to companies like Long Beach.
In 1995, Countrywide hired Paul Abbamonto, himself a former executive at Long Beach, to help establish a subprime lending business at Countrywide. The new business was named Full Spectrum, and its goal, executives said, was to be less aggressive with margins than other subprime lenders were—meaning it would push its way into the business by charging less, even if it meant making smaller profits. “There was plenty of skepticism when Countrywide started Full Spectrum,” recalls McMahon, the Wall Street analyst. “But I thought it was wise. Mozilo said that the mortgage business was morphing from one where there was prime and subprime into a home loan industry. There were borrowers at both ends of the spectrum, and Countrywide, being this company with a grandiose name, wanted to offer a product that filled all needs.”
Countrywide didn’t officially launch Full Spectrum until 1997, and the new division didn’t make any loans until 1998. That year, it did $140 million in mortgage originations and home equity loans—which didn’t even qualify as a drop in the bucket of subprime lending.
Much later, Countrywide’s critics would claim that the company was responsible for starting the business of subprime lending. Some would even say that Mozilo did so out of a do-gooder’s desire to get people who couldn’t afford mortgages into homes. Neither of those things was true. Countrywide didn’t start it, and Countrywide didn’t get in because Mozilo wanted to do good. He got in because he felt he had no choice. If he stayed out of subprime, Countrywide would never be number one—and that was unacceptable.
As Howard Levine told Business Week in 1992: “Angelo will do whatever it takes to be number one.”
3
The Big, Fat Gap
In 1991, David Maxwell retired as the chief executive of Fannie Mae. He was sixty-one years old and had held the post one day short of ten years. He walked away with a lump sum of $27.5 million, most of it accrued retirement benefits but still a shocking sum of money for Washington during that era. (He also turned down an additional $5.5 million that was owed him, fearing it would ignite criticism of Fannie Mae—and himself.) Fannie’s shareholders, however, had no complaints. Maxwell had taken a troubled institution on the brink of insolvency and turned it into a well-oiled profit machine—professionally managed, financially strong, and politi
cally powerful. Years later, Jim Collins, the well-known management guru, would name Maxwell the seventh greatest CEO of all time. (Charles Coffin, the first president of General Electric, was number one.) “If turnaround is an art,” wrote Collins of Maxwell, then he “was its Michelangelo.”
Maxwell had never been one to brag. His speeches always sought to cast Fannie Mae as merely one player among many making housing more affordable, rather than as the company with a dominant position in a critical market. But shortly after his retirement he gave an interview to the Washington Post in which he reflected on what he had accomplished. “It would take an event of such cataclysmic proportions as to result in a change of our form of government to put this company under,” he concluded.
At the time, that statement didn’t seem like much of an exaggeration. The year before, Fannie Mae’s profits had exceeded $1 billion for the first time. Its market value had exploded. And perhaps most important, Fannie, along with Freddie Mac, had a virtual stranglehold over the market for conforming mortgages—a bit of industry jargon that directly reflected the power of the GSEs. Conforming mortgages, after all, were mortgages that conformed to the strict underwriting standards Fannie and Freddie demanded in return for their guarantee. Everyone in the mortgage business who could conform did so. They had little choice.
All the Devils Are Here Page 6
