Who Stole the American Dream?

by Hedrick Smith

  The Switch on Bre Heller

  In 2003, fresh out of Seattle Pacific University with a major in business and sociology, Bre Heller had joined Long Beach Mortgage and had ridden its rocket growth until suddenly, in 2006, Heller found herself a casualty of her own business.

  Heller had applied for a half-million-dollar loan in September 2006 when she was easily making enough to cover that loan. But just two months later, in November 2006, her salary had fallen off a cliff. Washington Mutual, spotting big trouble at Long Beach, had suddenly put restrictions on the riskiest—and most profitable—loans in the Long Beach portfolio. The Long Beach mortgage business hit a wall. Suddenly, loan officers in Florida were doing only one-fifth the volume they had done a month or two earlier. Incredibly, Heller’s pay fell from $13,374 in September to $2,288 in November.

  Bre Heller figured her loan and her dream house were history. She knew that Washington Mutual required an updated review of all loan applications prior to closing to make sure that the borrower’s income and bank balances had not changed and the borrower could still afford the loans. She also knew that as a Washington Mutual employee, her pay information was instantly accessible to the bank’s loan officers; they would see that under the bank’s loan standards, she no longer qualified for her loan, and it would be rejected. “If this had been done the way it is supposed to be done,” Heller told me, “my loan should have been declined.”

  Instead, without telling her, WaMu rewrote her loan application, stated her income as $1 a year, shifted her into a totally different kind of loan—a no-document, no-questions-asked loan—and charged her a higher interest rate. When Heller talked to the WaMu loan officer, she was told that using a so-called $1 stated income loan was a courtesy to employees. That kind of high-interest, high-fee loan was also widely used with other customers who had irregular income.

  This was not unusual. I have talked to several other people who also had their loan terms altered by the bank, without being informed, and to lawyers who represented dozens of other borrowers caught by similar bank switches on their loans. During the go-go years of the housing boom, altering loan applications to qualify people improperly was a fairly routine maneuver by banks and mortgage loan companies to generate high loan volume and higher profits.

  When Bre Heller was told about her new loan, she felt trapped by her bank and her building contractor, both of whom had a financial interest in pushing the deal through. Personally, she was in a jam. She had sold the home she was living in and had to move out. She had a signed contract with the builder and had put down a $24,000 deposit as a guarantee of her serious intent to buy. If the bank had blocked her loan and denied her financing, that would have annulled her builder’s contract and she would have recovered her $24,000. “But if I were to walk away on my own,” she explained, “I was going to lose that $24,000.” Plus, she might have faced a lawsuit for breach of contract.

  So she took a risk. She went ahead with the deal, gambling at the age of twenty-six on the hope that the real estate market—and her salary—would recover. “We knew things were changing rapidly, but we didn’t know if this was temporary or whether it would turn around,” Heller told me. “We didn’t know at that time, at the end of November 2006, that our industry would die.”

  Her personal plot unfolded inexorably like a Greek tragedy. Heller spent much of the money she made from selling her first home to help pay for the big mortgage on her second home. She struggled gamely for a couple of years to make her payments, with the help of a boyfriend who moved in with her. But she couldn’t keep it up for years to come. Finally, she had to bow to the inevitable—the forced sale of her house in the spring of 2010 at a crushingly low price. Her home, by then in a neighborhood of foreclosed homes, was deep “under water”—its market value well below her loan balance, like eleven million other homes across America at that time.

  “Considering that I lost $250,000 on that house,” Heller admitted in hindsight, “I would have been better off to have walked away and left that $24,000.”

  From Family-Friendly to “The Power of Yes!”

  The irony in that episode is that Washington Mutual had carefully cultivated the reputation since 1889 as a bank that was a “friend of the family”—a bank that earned the trust of its customers by knowing them personally, treating them like neighbors, and taking their interests to heart. But in the New Mortgage Game, Washington Mutual’s character and mantra morphed into “The Power of Yes!”—a tagline in its TV ads that meant you got a loan no matter what.

  WaMu CEO Kerry Killinger was not satisfied with the plodding, modestly profitable business of plain vanilla thirty-year fixed-rate mortgages to carefully screened borrowers (the old “Power of No”). That strategy wasn’t getting WaMu or its CEO rich enough, fast enough. Killinger heard the siren call of Wall Street’s new mortgage money machine and its voracious appetite for high-interest, high-risk, high-profit mortgage bonds—in reality, “junk mortgages,” like the high-interest junk bonds of the 1980s.

  Moving into junk mortgages required a radical shift in thinking at WaMu, but the financial calculus was seductive. Instead of the old business of selling mortgages, hanging on to them, and collecting interest, a home loan bank such as WaMu could make much more money by originating high-interest loans and then selling them off to Wall Street.

  Killinger’s fastest way of getting into the new junk mortgage game was to buy an existing subprime lender. So in 1999, WaMu bought Long Beach Mortgage Company, a high-flying, aggressive pioneer in junk mortgages.

  Killinger was warned in advance that buying Long Beach was a dangerous, perhaps fatal, mistake. That warning came from WaMu executive vice president Lee Lannoye, whose job as WaMu’s chief credit officer was to protect the bank against bad credit risks. Within WaMu’s inner circle, Lannoye told me, he had vigorously opposed buying Long Beach. He said he had warned Killinger—prophetically—that the go-for-broke subprime culture at Long Beach would corrupt the “Friend of the Family” culture at Washington Mutual and would ultimately destroy WaMu.

  As an old-line credit officer, Lannoye contended that the subprime business had to be predatory to succeed. Lending to borrowers with bad credit histories, as subprime did, was bound to lead many of those borrowers to default on their mortgages. Those defaults would cause losses to the bank in the long run, even though selling subprime loans netted some short-term gains. That system would not work, Lannoye warned, because it violated the rules of sound lending, under which banks require a creditworthy record for someone to obtain a loan.

  But if credit standards are relaxed and poor credit risks are accepted, Lannoye asserted, the only way to cover the losses from bad credit risks would be to unfairly sucker solid middle-class prime borrowers into taking subprime loans at higher interest rates. “Predatory lending means finding uneducated, uninformed borrowers to take subprime loans—people who qualify for a prime loan,” Lannoye explained. “You have to charge them a higher rate and a higher fee in order to subsidize the losses that will occur [on loans] to people with bad credit. This kind of lending did not fit the character and culture of our bank. It would have violated our family-friendly motto.”

  Twice, Lannoye fought against buying Long Beach, and it got him fired. Not literally—he got pushed into premature retirement by Killinger, who not only bought Long Beach in 1999, but also changed WaMu’s operations. “He put underwriting and quality assurance under sales management,” Lannoye said. “When you put credit under someone whose responsibility is sales, credit quality goes out the window, you eliminated the checks and balances. There was nobody to say ‘No…. Hey, wait a minute. We’re out of control.’ ”

  Long Beach: Volume over Reliability

  Long Beach Mortgage Company may not have been out of control in 1999, but it was pushing the limits. Congress had opened the door for high-cost subprime loans in 1980 by effectively eliminating the ceiling on mortgage interest rates set by state usury laws. In the 1990s, subprime had been a
n iffy business. It often lacked the capital to make large volumes of loans. But in 2001, Federal Reserve Board chairman Alan Greenspan gave subprime banking a shot in the arm. By dramatically cutting interest rates, Greenspan opened wide the profit margins on lending, especially subprime lending, and ignited the real estate and financial boom that powered the U.S. economy up to the financial bust of 2008.

  Subprime lending was heavily promoted by Presidents Bill Clinton and George W. Bush. Clinton’s White House had urged Fannie Mae (the Federal National Mortgage Association), Freddie Mac (the Federal Home Loan Mortgage Corporation), and other lenders to ease credit requirements and offer subprime loans to lower-income Americans, especially to ethnic minorities whose credit records were too weak to qualify for prime. In the late 1990s, Fannie Mae and Freddie Mac, the quasi-governmental companies that guarantee about half of the nation’s home mortgages, pressed banks to lend to minorities and to be more flexible on loan standards. In the next administration, President Bush championed the “ownership society” for lower-income Americans, later boasting that home ownership reached record levels in his tenure—temporarily.

  Long Beach Mortgage thrived in this New Mortgage Game. It was an edgy lender, always testing the limits, cutting corners, riding the fast track. So fast that in a confidential report to Washington Mutual, the Federal Deposit Insurance Corporation (FDIC) said that in reviewing four thousand Long Beach loans made in 2003, they found that only one in four qualified for sale to investors; half were deficient and needed to be corrected; the final quarter were totally disqualified for resale. As Lee Lannoye had warned Killinger, Long Beach’s record was so bad that WaMu’s legal department stopped all Long Beach securitizations, or sales of its bundled mortgages, to Wall Street. But the suspension was temporary. Long Beach was soon tripling its loan volume from $11.5 billion in 2003 to nearly $30 billion in 2006.

  Just Out of College: $200,000 a Year

  As a mortgage loan officer at Long Beach, Bre Heller worked frenetic, fourteen-hour days. She was constantly on the road, dealing with one hundred different mortgage broker firms, all pushing loans as fast as possible. The incentives at Long Beach and Washington Mutual were all based on volume—volume, not reliability or prospects for the loans’ being repaid.

  “We were paid by the total volume of loans that we handled, and the [commission] percentage was tiered,” Heller explained. “The larger the volume, the higher the percentage. If you handled $5 million a month, that would pay you $20,000 a month. In a normal month, we would each handle from $3 million to $10 million worth….

  “At twenty-three and twenty-four, I was making $200,000 a year,” she said proudly. “I bought my first house in 2004. I had it only two years, sold it, and made over $100,000 on it.”

  Strange as it may sound, Heller almost never met a live borrower. Banks such as Long Beach and Washington Mutual were by then doing the bulk of their sales through legions of independent mortgage brokers, most of whom were hustling newcomers in their twenties and thirties with little experience in finance.

  Brokers: The Engine of Subprime

  Brokers were the powerhouses of the subprime market. Like Long Beach account executives, they were paid on loan volume, and they got fat bonuses for talking borrowers into high-interest junk mortgages. The bonus could go as high as 3 percent: On a single $300,000 loan, a broker could make $9,000. Turn fifty or sixty of those loans in one year, and a hustling young broker could make $500,000 a year.

  Brokers learned how to game the system to get loans approved; often, instead of filtering out bad loans, Long Beach loan officers would coach brokers on how to jimmy loan applications for easy approval. Then both broker and loan officer would get bonuses. “A lot of coaching takes place,” Bre Heller reported. “As a sales rep I could tell the broker, ‘This is how to get a loan passed. If you bring us this, this, and this, your loan will go through.’ You’re pointing out the loopholes. Every bank has loopholes.”

  The loopholes, the exotic loans, and the aggressive marketing by New Economy mortgage firms such as Long Beach were planting a time bomb in the nation’s financial system that blew up on Wall Street in 2007. How? By creating volumes of explosive loans headed toward default and foreclosure and then selling them to distant investors who couldn’t see the flaws in the loans. The brokers and the banks didn’t care whether the mortgages would ever be paid back. They made their money by pushing volume and ignoring bad quality. Brokers got paid up front for floating the loan. Its ultimate fate was of no consequence to them.

  “It was a fast-buck business,” former Salomon Brothers mortgage bond trader Sy Jacobs told Michael Lewis in The Big Short. “Any business where you can sell a product and make money without having to worry how the product performs is going to attract sleazy people.”

  To make matters worse, mortgage brokers pressured banks to ease their credit standards, thus generating more defaulted loans and foreclosures. In the New Mortgage Game, brokers had the whip hand. As the frontline salespeople promoting junk mortgages, they were the point of contact with buyers, scouring phone books and ethnic groups, finding borrowers, hawking loans. They could take their customers to any lender they chose—to Long Beach, to WaMu, to competitors such as Countrywide and Ameriquest, or to affiliates of big Wall Street banks. Competition was fierce. To keep brokers at their door, Long Beach and WaMu kept loosening their loan standards.

  The Exotic Loans Arsenal: From No Doc to Ninja

  The mortgage banks had an arsenal of exotic loans that were far from the traditional thirty-year fixed-interest loan, where borrowers had to put 20 percent down and file pay stubs or W-2 forms to prove their income. In the New Mortgage Game, the banks’ loans of choice were Option ARMs, subprime loans, 100 percent financing, teaser rates, serial refinancing, negative amortization, yield spread premiums, or home equity loans, almost all of which carried a sting that few borrowers understood.

  To qualify risky borrowers, a favorite tactic of high-volume brokers was to sell a “stated income loan”—the kind of loan Bre Heller was given. Originally, such loans made sense. Banks had invented them for self-employed business consultants, contractors, writers, actors, and others with good earnings but not a steady income recorded on W-2 forms. The borrowers stated their income and then submitted tax returns or bank statements to show enough assets to pay off the loan, and they provided a business license or some official document to prove that they were actually working as stated.

  But in the fever of the housing boom, the stated income loan was corrupted. WaMu and Long Beach dropped their safeguards. They let practically anyone apply for a stated income loan. Instead of requiring a state license, Heller said, they would accept letters of recommendation from anyone—easy to forge or fictionalize. Even when people had real documents, such as W-2 forms, checking on them slowed down the loan process, and that interfered with volume. So the trade gravitated in 2004, 2005, and 2006 to “no doc” loans, where no documents were required. One variation was the NINA loan—no income, no assets given. And finally came the NINJA loan—no income, no job, and no assets required.

  “Loan officers dropped their duty to truly qualify home buyers for homes,” Heller reported. “Instead, the loan officer did whatever was necessary to get them qualified. The system was very wishy-washy. We were pushing the boundaries.”

  The obvious potential for fraud troubled Heller, but as she told me, lowering the bank’s standards “brought us a lot more customers.” Risk was piled on risk, increasing the odds that the borrowers would default and the house of cards would crash.

  The 2/28 Arm and the Piggyback Loan

  At Long Beach Mortgage, the vintage subprime loan was the 2/28 ARM—an adjustable-rate mortgage that lured borrowers with a low initial “teaser rate” that after two years abruptly shot up to the normal “fully indexed rate.” Some senior officials later admitted that these loans were designed to fail and to force borrowers into refinancing.

  Often, to get poor credit risks appro
ved, mortgage officers would grant loans on the borrower’s ability to pay the teaser rate, rather than making sure they could afford the normal monthly payment. So pervasive was this practice that one senior WaMu executive admitted that one-third of the bank’s refinancing loans would have been rejected if loan officers had properly qualified borrowers. In other words, savvy WaMu loan officers understood that borrowers who were qualified by the lender only on their ability to pay the teaser rate were headed for inevitable default, but the loan officers often ignored that reality to keep loan volume and profits rising.

  Most buyers suffered severe “payment shock” when the interest rate reset after two years, potentially doubling their mortgage payments or worse. Unable to meet that steep bill, they got talked into refinancing their mortgage with a larger loan principal and a new low teaser rate. As Bre Heller explained, this started a refinancing cycle, with borrowers going deeper into debt each time, while the brokers and bankers kept pocketing handsome fees on each new loan.

  With low-income borrowers, the 2/28 ARM was often combined with “the piggyback loan”—a second 20 percent mortgage piled on top of an 80 percent first mortgage. That dramatically increased the risks of default, but the sales pitch was almost irresistible—no money down. The downside was that this dangerously eliminated the time-tested credit requirement that the buyer have some financial stake in the home as protection for the bank. But by 2000, that requirement had largely gone by the boards at Long Beach, WaMu, and elsewhere.