I Am John Galt

by Donald Luskin

  In his capacity as risk officer, McMurray repeatedly lobbied the financial reporting department to disclose more information about Countrywide’s credit risks. He was unsuccessful.67 In 2007, well before that year’s first-half earnings call, he presented Mozilo and other top executives with a summary of where the company was likely to suffer losses and urged them to report it publicly. They didn’t.

  Mozilo himself often personally approved loans that were in direct contravention of Countrywide’s own credit policies and underwriting guidelines. When McMurray attempted to intervene in one instance, Mozilo berated him for becoming involved in loans that Mozilo had “already approved” and asserted that Countrywide’s balance sheet was “big enough” to handle his exceptions.68

  By Force or by Fraud

  In the final days, Mozilo, like James Taggart in the climactic final scenes of Atlas Shrugged, seems to have suffered a complete break from business reality. No businessman truly interested in success would have done the things either man did. “When I look a homeowner in the eye, I can tell if they’ll pay,” Mozilo would tell his staff. Never mind that eye contact isn’t a proven method for measuring default risk any more than it can ID serial killers in a lineup; Countrywide didn’t even conduct personal interviews any longer as part of the loan application process.

  In other instances, Mozilo seemed to genuinely believe his own irrational assumptions that the party would continue, propped up by permanently increasing asset values. “Over the entire history of this country, housing prices have never gone down nationally,” he told CNBC in early 2005, a few months before a peak in prices preceding a 35 percent drop.69

  Then, in other cases, he allegedly lied outright to cover knowingly fraudulent activities of his company and their collaborators. According to a lawsuit filed by the Mortgage Guaranty Insurance Corporation (MGIC), Countrywide deliberately disregarded signs of fraud in order to increase its market share.70 By about 2006 Countrywide’s internal risk assessors knew that in a substantial number of its stated-income loans—fully a third—borrowers overstated income by more than 50 percent. Mozilo also knew that many appraisers were overstating property values to drive originations by making loans appear less risky.

  “I think the primary issue has been an issue of speculation, rather than fraud,” Mozilo would tell investors in 2007. “I mean, I think, it’s probably nonexistent today, because everything has tightened up so much, that everybody’s antenna has been so sensitized to all the possibilities here that it’s pretty hard to get through the system now if you’re not telling us the truth.”71 Later evidence would reveal a dramatically different reality, including facilitation of rampant borrower, broker, appraiser, and other fraud stemming from documents riddled with materially false information.

  In one case, a part-time Chicago housekeeper applied for a mortgage, truthfully telling a Countrywide loan officer that she earned just $200 per week. Instead of rejecting her application outright, the loan officer prepared a false document stating that the borrower was an employee of Paulen Auto Body Shop earning $6,833 per month. Based on the falsified paper trail, she was given a $339,000 mortgage loan; she then promptly left the United States and returned to her home in Poland without ever making a single payment.72

  In another case, Countrywide gave a $350,000 loan to an illiterate California dairy worker making just $1,100 per month, by deliberately misstating his income. The loan payment alone represented four times his actual monthly pay. Another Countrywide lender gave a $398,050 loan to a woman in Ceres, California, who had been unemployed since 1988.73 These were just a few of the many jokers dealt out by Countrywide’s originators that were holding up Mozilo’s house of cards.

  The Rats Flee the Ship

  By 2007, the housing engine, pumped full of cheap high-octane government fuel and then run all-out for years well beyond the redline on the tachometer, finally started to sputter and smoke. Some of the latest, most egregiously reckless loans signed by the greatest fools from the dregs of the market began defaulting almost immediately, even before the ink was dry on their contracts. Housing prices in the hottest sunshine states of California, Nevada, Arizona, and Florida began to slow and then decline.

  Residential real estate flippers and speculators betting on an ever greater high by chain-smoking an escalating series of unaffordable mortgages quit cold turkey, defaulted on their obligations, and walked away to suffer their own personal financial withdrawal. More than 2.2 million foreclosure filings—default notices, auction sale notices, and bank repossessions—were reported during 2007, up 75 percent from 2006.74

  Countrywide saw its loan default rates spike alarmingly. As word leaked out, $15 billion of Countrywide shareholder value evaporated during the first eight months of 2007 in a major stock market sell-off. After Countrywide tapped its entire $11.5 billion line of credit, Bank of America stepped forward to inject another $2 billion just to keep Countrywide afloat. Mozilo announced plans to eliminate 10,000 to 12,000 jobs—approximately 20 percent of his workforce—and take a $125 million to $150 million pretax restructuring charge resulting from the downsizing.75

  For his efforts in catapulting millions of households into homelessness and financial ruin, Mozilo was awarded a $1.9 million salary in 2007, $20 million in stock and option awards, $44,454 for use of company aircraft, $8,581 for country club fees, and $23,755 for automobile use.76

  Bank of America finally bought the struggling Countrywide outright in January 2008 for an all-stock deal valued at $4.1 billion. Shareholders who had purchased Countrywide shares during the summer of 2007 after Mozilo’s conference call lost more than 80 percent of their investment. All told, Countrywide shareholders saw more than $20 billion in value go up in smoke.

  Bank of America CEO Kenneth Lewis probably thought he was quite the lion of Wall Street, picking off a juicy piece of prey by acquiring a red-hot mortgage originator on the cheap in a time of turmoil. He didn’t know yet that he was to be Mozilo’s next victim, when a year later Countrywide’s toxic sludge would bring Bank of America begging to the federal government for a bailout. For now, Lewis basked in the idea of taking the reins of Countrywide from Mozilo: “Angelo has told me that he will do anything that we want him to do. I would guess that he’ll want to go have some fun.”77 Fun indeed. After the Bank of America buyout, Mozilo took home another $44 million on top of the $140 million in Countrywide stock he sold off during 2006 and 2007.78

  But there was one more victim for Countrywide—the biggest one of all.

  Washington, We Have a Problem

  On June 30, 2008, Fannie guaranteed $619 billion—approximately 23 percent of Fannie’s book of single-family business—in so-called junk loans (i.e., subprime, Alt-A, or other risky loans knowingly misclassified in the prime category). It is likely that up to 40 percent of the mortgage volume Fannie Mae added to its single-family book of business during 2005 to 2007 consisted of these junk loans.79 Much of that volume was purchased directly from Countrywide.

  Just a year earlier, Fannie had reserved less than $1.2 billion—just 0.05 percent of its entire book of business—to cover potential credit losses. In the second quarter of 2008 alone it reported $5.35 billion in credit-related expenses. At least 85 percent of its losses were related to its holdings of both subprime and Alt-A loans. It was a financial Hurricane Katrina that burst Fannie’s feeble cash levies. Worse was yet to come.80

  On July 7, 2008, a Lehman Brothers research report indicated Fannie Mae and Freddie Mac were grossly undercapitalized, suggesting the two might need as much as $75 billion in new capital between them. Knowing what we know now, it’s ironic that this report would come from Lehman, which itself was so grossly undercapitalized that it would go bust two months later. Be that as it may, in July panicked stockholders dumped Fannie and Freddie shares, sending them to 16-year lows. Fannie tumbled more than 16 percent.81

  Former St. Louis Federal Reserve Bank President William Poole said in a Bloomberg interview on July 10 that Fannie an
d Freddie were insolvent and might need a U.S. government bailout.82 A sell-off of their stocks was furious and spread into their bonds, long perceived as having the implicit backing of the U.S. government. That day Fannie shares ended down by another 14 percent. The next day, shareholder panic reached a crescendo even as both companies insisted they were adequately capitalized. Fannie bottomed out at less than $7, off from the mid-$60s just a year earlier. All told, Fannie and Freddie would deliver a shocking loss of $100 billion in shareholder value over the first eight months of 2008.83

  Later that month, Treasury Secretary Henry Paulson urged Congress to grant him new authority to seize Fannie and Freddie should further catastrophe strike, arguing, “If you’ve got a bazooka, and people know you’ve got it, you may not have to take it out.”84 His words backfired as soon as they escaped his lips.

  While Paulson climbed the parapet to defend the GSEs and rally the market troops, investors recoiled in horror and deserted the ranks in droves. What they quickly and correctly realized was that rather than serving to protect private investment capital, Hank’s finger on the government takeover trigger guaranteed a sort of unilaterally assured destruction. If Uncle Sam nationalized the GSEs to save them, any remaining private investment interest would be instantly incinerated by the back-blast, rendering it financially worthless. Hank’s gambit, then, became a self-fulfilling prophecy. With the threat of government intervention, private investment fled. Yet without private investment, government intervention was inevitable.

  As if to prove once and for all that once greater discretionary government powers are granted they will be exercised, just a few weeks later, on September 6, 2008, the U.S. government placed Fannie Mae and Freddie Mac into conservatorship—essentially a full-blown nationalization of the businesses. Together, the two GSEs guaranteed around half of the entire $12 trillion mortgage market. It was an amount equal to the entire U.S. mortgage market just seven years earlier. The very government forces that set them up to fail now deemed them too big to fail. Yet the shareholder losses would be dwarfed by the total wealth that American homeowners saw evaporate since the credit crisis started—an amount in the trillions.

  By early 2010, Fannie and Freddie had received more than $126 billion in taxpayer infusions, a number that is likely to grow even greater as mortgage defaults continue to rise. Douglas Holtz-Eakin, a former director of the Congressional Budget Office, said that the collapse of Fannie and Freddie would leave taxpayers with the “single largest bill we will face in this episode.”85

  In the months that followed, inquiries were launched and fingers were pointed. Opinions varied widely about the major culprit in an attempt to pin blame for the collapse on a single source. Few got it right.

  Armando Falcon, the former head of Fannie’s federal regulator, the Office of Federal Housing Enterprise Oversight (OFHEO), said the collapse of the companies “was clearly a failure of management” and reflected a “deeply rooted . . . culture of arrogance and greed.” Mr. Falcon asked how a business “with the most generous government subsidies possible” could be run “into the ground.”86

  Ayn Rand could have explained it. As one of the heroes of Atlas Shrugged said, “There’s a way to solve every dilemma of that kind. . . . Check your premises.” In this case, the implicit premise is that government subsidies ought to help businesses prosper. But just the opposite is true: Subsidies corrupt businesses, virtually guaranteeing that they will be run “into the ground.”

  Indeed, they corrupt the entire world in which businesses operate. That’s why Countrywide was destroyed under Angelo Mozilo, just as in Atlas Shrugged Taggart Transcontinental was destroyed under James Taggart. Though Taggart “had obtained a subsidy from Washington for every train that was run, not as a profit-making carrier, but as a service of ‘public equality,’” in doing so, he sucked the life out of the economy whose health was ultimately necessary for his railroad to thrive.

  BB&T CEO John Allison had this principle in mind when he declared that his bank wouldn’t make loans to real estate developers whose property had been acquired by eminent domain. Sure, on paper it sounds great to back projects where otherwise unobtainable land is acquired on the cheap by government fiat. It’s the ultimate subsidy. But in the process, the sanctity of property rights is destroyed, because the original owner’s property is taken against his or her will and handed over to the developer. If there are no property rights, then of what value is the collateral banks hold against their loans? Without a legal claim on its borrowers, banks cannot exist. Some subsidy.

  SEC v. Angelo Mozilo

  On June 4, 2009, the Securities and Exchange Commission (SEC) filed civil charges against Angelo Mozilo in U.S. District Court for fraud and insider trading. According to court filings:

  Defendant Mozilo made numerous public statements from 2005 through 2007, praising the quality of Countrywide’s underwriting and distinguishing Countrywide from subprime lenders, stating, for example:

  “[w]e don’t see any change in our protocol relative to the quality of loans that we’re originating”;

  he “was not aware of any change of substance in [Countrywide’s] underwriting policies”;

  “Countrywide had not taken any steps to reduce the quality of its underwriting regimen”;

  Countrywide “backed away from the subprime area because of our concern over credit quality”;

  “pay option loan quality remains extremely high”;

  Countrywide’s “origination activities [we]re such that the consumer is underwritten at the fully adjusted rate of the mortgage and is capable of making a higher payment, should that be required, when they reach their reset period”;

  “Countrywide views the product as a sound investment for our Bank and a sound financial management tool for customers”; and

  “Performance profile of [the Pay-Option ARM loan] is well-understood because of its 20-year history, which includes ‘stress tests’ in difficult environments.”

  In addition, Countrywide’s 2006 Form 10-K stated “[w]e believe we have prudently underwritten” Pay-Option ARM loans.

  The paper trail reveals that Mozilo knew full well that his public statements were outright lies. On May 19, 2006, Mozilo wrote an internal e-mail to his lieutenants stating that pay-option loans presented a long-term problem “unless [interest] rates are reduced dramatically from this level and there are no indications, absent another terrorist attack, that this will happen.”87 On June 1, 2006, Mozilo advised in an e-mail that he had become aware that the pay-option ARM portfolio was largely underwritten on a reduced documentation basis and that there was evidence that borrowers were lying about their incomes in the application process.

  On September 25, 2006, Mozilo wrote another e-mail, stating, “We have no way with reasonable certainty, to assess the real risk of holding these loans on our balance sheet.” In the fall of 2006, Mozilo even recommended selling Countrywide’s portfolio of pay-option ARM loans, recognizing the risks of retaining them on Countrywide’s balance sheet. Pay-option ARMs represented approximately 14 percent of Countrywide’s total loan production and 46 percent of Countrywide’s loans held for investment for the 2006 fiscal year.88

  Caught on record, Mozilo couldn’t very well deny his own statements or the rock-solid time line of events. Instead, he tried to weasel his way out of the charges using what the prosecutors called “sleight of hand.” For instance, Mozilo would claim that despite his knowingly false statements, the truth about Countrywide’s mortgage loans could be found by the public in separately filed documents from four indirect subsidiaries under names like CWALT, LLC and CWHEQ, LLC.89

  According to court filings, the documents contained aggregated and raw data about hundreds or thousands of loans that Countrywide had securitized while maintaining a residual financial interest. It’s a bit like saying a pharmacy rep could sell you a vial of cyanide and arsenic as a safe and effective remedy as long as raw statistics proving this claim to be a lie were buried in a canister
somewhere in the state of New Jersey. Besides, even Mozilo’s statistics failed to address the bad loans Countrywide had retained in full.

  The court rejected Mozilo’s spurious and desperate arguments. Rather than face a jury trial with such damning evidence stacked against him, Mozilo agreed to settle the charges of fraud and insider trading by paying $22.5 million in civil penalties in October 2010. Bank of America made up the balance of his $67.5 million total fine. It surely would have galled that would-be lion of Wall Street, Ken Lewis, to write that check—but at that point he was gone, ousted over controversies swirling around another of his toxic acquisitions, Merrill Lynch.

  During his career at Countrywide, Angelo Mozilo reaped over $400 million in compensation. Even after he and his insurers paid his penalties,90 he took home a net of over a third of a billion dollars in exchange for destroying trillions of dollars of America’s wealth.

  James Taggart was not so lucky; at the climax of Atlas Shrugged, he went mad. But who knows what private hell Mozilo lives in now and for the rest of his days? He knows that, like Taggart, he was never a real creator, but only a parasite. Yes, he justified himself to the world—and to himself, we suspect—with highfalutin talk about the virtues of home ownership. History’s worst despoilers have always used the language of altruism and collectivism to disguise the reality of their actions and deflect the forces that might challenge them.