All the Devils Are Here

by Bethany McLean; Joe Nocera

  After the meeting, a risk manager told Kim that “there’s no way” Lattanzio’s estimate was right. Kim asked the risk manager to poke around and come up with a better estimate, according to a former Merrill executive. But the risk manager couldn’t get any information out of Lattanzio and Semerci, and had to drop the effort.

  Blum couldn’t understand how the people running the CDO business could be so sanguine. They were using the same raw material he was: subprime mortgages. By early 2007, defaults were the highest they had been in six years, when subprime one had collapsed. HSBC, the big British bank, said in February that its bad debt charges would be 20 percent higher than previously anticipated, thanks to its deteriorating subprime business. And yet Merrill’s mortgage desk continued to churn out CDOs and post profits. In the first quarter of 2007, the firm underwrote twenty-six CDOs, of which nineteen were made up primarily of subprime mortgages. First Franklin was taking $50 million to $100 million in quarterly write-downs, and top management at Merrill was all over Blum about its deteriorating financials. Yet somehow the CDO business remained untouched. How could this be?

  In April, Blum gave a presentation to the board in which he put forth a downbeat and sober-minded assessment of the subprime business. Afterward, many of the board members sent him thank-you e-mails for his plainspoken presentation. What they had failed to notice, however, was that seated next to Blum at the board meeting was Osman Semerci. He never said a word about any problems he might be having with subprime mortgages. Nor did anyone think to ask him.

  All over Wall Street, an immense amount of risk was building up in the system. It wasn’t just that firms were taking on risk when they bought subprime mortgages and bundled them into securities, or when they kept some of the leftover pieces themselves, or when they bought whole subprime mortgage originators. Over the course of a decade, subprime mortgages had managed to seep into Wall Street’s bloodstream, as firms used products created out of them to increase leverage, reduce capital, generate profits, and, more generally, game the risk-based rules that were originally intended to give firms the flexibility to deal with the modern world. All of which also meant that the increasing risk was masked by layer upon layer of complexity, hidden where few on the outside could see it.

  For instance, using a loophole in Basel I, banks set up off-balance-sheet entities that came to be known as SIVs, or structured investment vehicles. In a nutshell, banks didn’t have to hold any capital—that’s right, no capital—against these vehicles as long as their outstanding debt had a term of less than a year. (That’s part of why Karen Shaw Petrou, the managing partner at Federal Financial Analytics, says: “Nothing about this crisis was in fact unforeseen. It was just unaddressed.”) By the summer of 2007, there were twenty-nine SIVs with outstanding debt totaling $368 billion, of which nearly $100 billion belonged to Citigroup-sponsored SIVs. Because SIVs were looking for yield, just like every other buyer of triple-A securities, many of them began to buy more and more mortgage-backed securities. Ostensibly, SIVs were independent from the sponsoring bank. But if there was a crisis and the debt started to default, would an institution like Citigroup really be able to sit back and let the SIVs fail? Or would it have to rush in and put that debt on its own balance sheet, which would have a crippling effect on its capital?

  Another source of hidden risk was in the plumbing of the market—plumbing that was utterly taken for granted. The big banks all had warehouse lines that the mortgage originators borrowed against to make their subprime loans. It was the primary funding mechanism for the industry. But the banks didn’t just extend a big loan to the originators. Instead, they had discovered a more modern, efficient, capital-gaming way to do it. They would set up an off-balance-sheet vehicle that issued short-term commercial paper to fund itself. That commercial paper was backed by the mortgages. It was part of a market called ABCP, or asset-backed commercial paper. According to Fitch, by the spring of 2007 this market was shockingly big: $1.4 trillion in size. The commercial paper got a top rating from the rating agencies, making it possible for money market funds to buy it. However, in order to obtain that all-important top rating, the sponsoring bank, or another bank, invariably had to provide some kind of guarantee, in the event that the vehicle found itself unable to replace the commercial paper when it came due.

  As the market got crazier, money market funds became more and more enamored of this paper; they, too, were competing for that extra little bit of yield. Although money market funds were serving the role of the old-fashioned bank—they were ultimately the real lender—they weren’t regulated the way banks were. Since they were holding highly rated securities—as SEC rules required them to do—no one in the government was concerned with the quality of the collateral.

  But what would happen if the money market funds all started questioning the quality of the assets backing their paper at the same time? What if they all stopped buying it? Either the sponsoring bank would have to provide liquidity—damaging its own balance sheet—or the vehicles would all have to start dumping assets to raise cash. Neither scenario was pleasant to contemplate.

  Money market funds were also a core enabler of the deepest, darkest, least noticed part of the market’s plumbing. This was the so-called repo market, which made it possible for firms to pledge assets in return for extremely short-term loans, often as short as overnight. Yale economist Gary Gorton—the game man who did risk modeling for AIG-FP—explains the repo market this way: Suppose Fidelity has $500 million in cash that it plans to use to eventually buy securities. It wants a safe place to earn interest on that cash while making sure the money will be available the instant it wants it back. Enter the repo market. Fidelity can deposit the $500 million with an investment bank—Bear Stearns, in Gorton’s example—and be sure the money is safe, because Bear provides collateral to back up the loan. The difference between the money Fidelity gives Bear and the value of its collateral is called the “haircut,” and before the crisis a 2 percent haircut—meaning Bear could get 98 cents in cash for every $1 in assets it pledged—was a normal number.

  Secured lending, or lending against collateral, is almost always less risky than unsecured lending. On the Street, the repo market is called the last line of defense, because you can get money there when you can’t get it anywhere else.

  And yet, there were dangers in the repo market, too. It is a murky market, but a huge one: according to a report by the Bank for International Settlements, by 2007 the U.S. investment banks funded roughly half of their assets using the repo market. For firms that depended on this market, there could be a timing mismatch, because banks could pledge a long-term illiquid asset in return for short-term funding. If the short-term funds went away, they still had the asset—which needed financing. Another danger was that repo transactions are exempt from the normal bankruptcy process. Lenders didn’t have to worry about their money getting tied up—they could simply grab their collateral at the first sign of weakness. And whichever lender grabbed first did best: no bankruptcy court judge was going to come along and decide what was and wasn’t fair.

  As the bubble grew, Street firms began using riskier and riskier assets—including mortgage-backed securities—as repo collateral. They did it for the usual reason: the lender could get a bigger return by accepting mortgage-backed securities as collateral than it could by accepting Treasuries.

  But once again, what would happen if the lenders began to question the true value of the collateral? The lender might demand a bigger haircut—meaning that the loan the bank would get would shrink, and it would have to rapidly sell assets, or face a shortage of funds. Or what if the lender didn’t want any collateral from a particular firm at all? Suddenly a routine repo transaction would be transformed into something far more ominous: a vote on whether an investment bank should survive.

  Thanks to deposit insurance, the days were long gone when bank customers stood in line to pull their money out of a shaky bank, creating a run on the bank that usually ended in its coll
apse. But as Gorton and fellow Yale economist Andrew Metrick would later argue in a paper, the repo market created the conditions for the modern version of the bank run. You never saw this kind of bank run in photographs, but it was every bit as devastating.

  Where were the regulators as this buildup of risk was taking place? They were nowhere to be found. Just as the banking regulators had averted their eyes from the predatory lending on Main Street, so did they now ignore the ferocious accumulation of risk, much of it tied to subprime mortgages, on Wall Street.

  No regulator had the authority—or the ability—to systematically look across institutions and identify potential system-wide problems. That role just didn’t exist in America’s regulatory scheme. The Fed, for one, had little insight into the packaging and endless repackaging of mortgages. In part, this was because the Gramm-Leach-Bliley Act prevented it from conducting detailed examinations of the nonbank subsidiaries of the big banks. In other words, even though it was responsible for regulating the big bank holding companies, it had to rely on the SEC to oversee, for example, a bank’s trading operation.

  In any case, the Fed wasn’t all that eager to look too deeply. Like all the regulators, the Fed believed that the risk was off the banks’ books and distributed into the all-knowing market. The attitude was: “Not our role to tell the market what it should and should not buy,” in the words of a former Fed official. This was true even after Alan Greenspan retired in early 2006 and was replaced by Princeton economist Ben Bernanke.

  The Fed also had enormous—and unwarranted—faith in bank management. A GAO report would later find that all the regulators “acknowledged that they had relied heavily on management representation of risks.” In 2006, the Fed had conducted reviews of stress-testing practices at “several large, complex banking institutions,” according to the GAO. It found that none tested for scenarios that would render them insolvent and that senior managers “questioned the need for additional stress testing, particularly for worst-case scenarios that they thought were implausible.” From 2005 through the summer of 2007, the Fed issued internal reports called “Large Financial Institutions’ Perspectives on Risk.” The report for the second half of 2006, issued in April 2007, stated, “There are no substantial issues of supervisory concern for these large financial institutions” and that “Asset quality across the systemically important institutions remains strong.”

  In at least one notable case, regulators reached for responsibilities that they weren’t capable of handling. It took place in 2004 and involved the Securities and Exchange Commission, whose chairman at the time was William Donaldson.

  Historically, the SEC oversaw everything that had to do with the buying and selling of stocks. The five big American investment banks—Bear Stearns, Goldman Sachs, Morgan Stanley, Merrill Lynch, and Lehman Brothers—all came under the regulatory purview of the SEC. But they had all formed holding companies and had affiliates engaged in all kinds of activities—such as derivatives trading—that had nothing to do with selling stocks. Astonishingly, no government agency regulated the holding companies.

  In 2002, the European Union ruled that these holding companies had to be supervised by a U.S. regulator, or the EU would do the job itself for the subsidiaries that fell under their jurisdiction. This was not something the American investment banks wanted to have happen, so they asked the SEC to set up a program called Consolidated Supervised Entities, or CSE. It created a voluntary supervisory regime, thus getting around the SEC’s lack of statutory authority to regulate the holding companies.

  It would become part of the lore of the financial crisis that the CSE somehow abolished a previously held limit of 12 to 1 leverage at the broker-dealer level and allowed the banks to use their internal models to determine the capital they should hold. But the first part of that wasn’t really true. The 12 to 1 limit hadn’t been in place since 1975. At the end of 2006—that is, well after the implementation of the CSE—the investment banks’ leverage was no higher than it had been at the end of 1998, when LTCM went down. In fact, according to the GAO, three firms had more leverage at the end of 1998 than they did at the end of 2006.

  No, the SEC’s real failure was something else. By setting up CSE, the SEC gave the impression that it had the manpower, the skill, and the savvy to see risks developing at the holding company level. It did not—something even its own commissioners seemed to understand at the time. In a recording of the fifty-five-minute meeting in which the five members of the SEC signed off on the CSE, commissioners can be heard saying things like, “This is going to require a much more complicated compliance, inspection, and understanding of risk than we’ve ever had to do…. You think we can do this?” and “What if someone doesn’t give us adequate information? How will we enforce it?” The greatest note of caution came from Harvey Goldschmid, a Democratic commissioner. “We’ve said these are the big guys and clearly that’s true,” he said. “But that means if anything goes wrong, it’s going to be an awfully big mess.”13

  “I equate the CSE regime to the USDA putting its imprimatur on rancid meat,” says a former Bush administration official. “Bad regulation is much worse than no regulation because you create conditional expectations of safety. It helped feed the fiction that these risks could be quantified or even understood.”

  This, then, was the situation in May 2006: risk was building up everywhere in the system; the housing bubble was reaching its frenzied finale; Wall Street firms were madly churning out CDOs; subprime originators were making loans to anyone with a pulse; everything was interconnected in ways that were dangerous for the financial system; and the regulatory apparatus, charged with protecting the safety and soundness of the banking system, was in complete denial. This was what Henry Paulson Jr. was going to have to deal with, as his nomination to be secretary of the Treasury was announced late that month.

  To the outside world, the news that Paulson was leaving Goldman Sachs to become Treasury secretary could not have been less surprising. Didn’t every senior Goldman Sachs executive eventually join the government? By that point, the list included John Whitehead (deputy secretary of state in the Reagan administration), Steve Friedman (National Economic Council), Joshua Bolten (OMB director and George W. Bush’s chief of staff), Jon Corzine (senator and later governor of New Jersey), Robert Rubin (of course), and many others.

  Yet to Goldman insiders, Paulson’s departure was startling. He had never expressed the slightest interest in the job. He didn’t make lavish campaign contributions, or serve as finance chairman for ambitious politicians, or even hang around politicians. He told everyone, whether they were close confidants or passing acquaintances, that he was staying put at Goldman. Head fakes had never been his style. As he later related in his memoir, when he first got the call from the White House in the spring of 2006, he agreed to a meeting with the president, but then quickly canceled when John Rogers, the firm’s veteran Washington hand, told him that going to the meeting was tantamount to accepting the offer.

  Having been through several ineffectual Treasury secretaries, Bush wanted Paulson badly, largely because his Goldman Sachs credential gave him a stature his predecessors had lacked. Paulson was initially deterred by “fear of failure, fear of the unknown,” he later wrote. But he finally said yes. “I didn’t want to look back and have been asked to serve my country and declined,” he later explained. “So I just took the plunge.” He did so after getting an unprecedented agreement from Bush that he would have real power: regular access to the president, on a par with the secretaries of State and Defense, and the ability to bring in his own people.

  For Paulson, one of the toughest parts of his decision was telling his mother. His entire family, including his wife, Wendy, and his mom, Marianna, was deeply opposed to the Bush administration. In his book, Paulson recalls standing in the kitchen of his house in Barrington, Illinois, announcing the news. “You started with Nixon and you’re going to end with Bush?” his mother replied. “Why would you do such a thing?”<
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  In some ways, Paulson was an odd choice for Bush. As an ardent environmentalist, Paulson believed that climate change was real, a view not embraced by the White House. More important, he was neither a partisan Republican nor a free-market ideologue. He would later cite the pressure on him to get rid of Sarbanes-Oxley, the law passed in the wake of the Enron scandal, which Republicans in Congress hated. Paulson refused. “I don’t find a single provision bad,” he said.

  He also worried about the widening gap between rich and poor—also not a subject often discussed in the Bush White House. In a speech at Columbia on August 1, 2006, he said that “amid this country’s strong economic expansion, many Americans simply aren’t feeling the benefits.” The comments sent Republicans into a tizzy.

  Like all captains of industry who join the Treasury, Paulson was in for a bit of a shock after his nomination was approved by the Senate in July 2006. He hadn’t understood how outdated Treasury’s systems were—there was no real-time access to market information, and the voice mail system was antiquated. (Voice mail has long been Paulson’s primary method of communication.) As he recounts in his book, he was shocked to discover that “an extraordinary civil servant named Fred Adams had been calculating the interest rates on trillions of dollars in Treasury debt by hand nearly every day for thirty years, including holidays.” Nor had Paulson fully appreciated how limited Treasury’s tools were: Treasury was not a bank regulator. It had moral suasion, but no supervisory levers, and it couldn’t spend money unless it had been appropriated. “At Goldman, he had the responsibility, but also unbridled command over thousands,” says one Treasury employee. “Here, he had the responsibility times a thousand, but no ability to command.”