Griftopia: Bubble Machines, Vampire Squids, and the Long Con That Is Breaking America

by Matt Taibbi

  The process starts out with a small-time operator like Solomon Edwards, who snares you, the schmuck homeowner, and slaps your name on a loan that gets sent up the line. In league with Edwards is the mortgage lender, the originator of the loan, who like Edwards is just in it for the fees. He lends you the money and immediately looks for a way to sell that little stake in you off to a big national or international investment bank—whose job it is to take that loan of yours and toss it into a big securitized pool, where it can then be chopped up and sold as securities to the next player in the sequence.

  This was a crucial stage in the process. It was here that the great financial powers of this country paused and placed their bets on the various classes of new homeowner they’d created with this orgy of new lending. Amazingly, these bigger players, who ostensibly belonged to the ruling classes and were fighting over millions, were even more dishonest and underhanded and petty than the low-rent, just-above-street-level grifters who bought cheap birthday presents for the kids of the Eljon Williamses of the world in pursuit of a few thousand bucks here and there.

  A trader we’ll call Andy B., who worked at one of those big investment banks and managed one of these mortgage deals, describes the process. In the waning months of the boom, in the early part of 2007, Andy was put in charge of a monster deal, selling off a billion-dollar pool of securitized mortgages. Now retired from not only that bank but from banking altogether, he can talk about this deal, which at the time was one of the great successes in his career.

  A big, garrulous family man with a wicked sense of humor, Andy B. had, for most of his career, been involved in fairly run-of-the-mill work, trading in CMOs, or collateralized mortgage obligations—“that’s like noncredit stuff, just trading around on interest-rate risk,” he says, “the blocking-the-tackle work of Wall Street.” But in the years leading up to the financial crisis he took a new job at a big bank and suddenly found himself in charge of a giant deal involving option-ARM mortgages, something he had almost no experience with.

  “Option ARMs used to be a wealthy person’s product,” he explains now. “It was for people who had chunky cash flows. For instance, on Wall Street you get paid a bonus at the end of the year,” he said, describing one of the option ARM’s traditional customer profiles, “so I’ll pay a little now, but at the end of the year I’ll pay down the principal, true everything up—a wealthy person’s product. Then it became the ultimate affordability product.”

  The option ARM evolved into an arrangement where the homebuyer could put virtually nothing down and then have a monthly payment that wasn’t just interest only, but, in some cases, less than interest only. Say the market interest rate was 5 percent; you could buy a house with no money down and just make a 1 percent payment every month, for years on end. In the meantime, those four points per month you’re not paying just get added to the total amount of debt. “The difference between that 5 percent and the 1 percent just gets tacked on later on in the form of a negative amortization,” Andy explains.

  Here’s how that scenario looks: You buy a $500,000 house, with no money down, which means you take out a mortgage for the full $500,000. Then instead of paying the 5 percent monthly interest payment, which would be $2,500 a month, you pay just $500 a month, and that $2,000 a month you’re not paying just gets added to your mortgage debt. Within a couple of years, you don’t owe $500,000 anymore; now you owe $548,000 plus deferred interest. “If you’re making the minimum payment, you could let your mortgage go up to 110 percent, 125 percent of the loan value,” says Andy. “Sometimes it went as high as 135 percent or 140 percent. It was crazy.”

  In other words, in the early years of this kind of mortgage, you the homeowner are not actually paying off anything—you’re really borrowing more. It was this perverse reality that, weirdly enough, made Andy’s collection of mortgages more attractive to other buyers.

  Again, in the kind of tiered deal that was used to pool these mortgages, Andy had to find buyers for three different levels of the pool—the “senior” or AAA stuff at the top, the B or “mezzanine” stuff in the middle, and the unrated “equity” or “toxic waste” portion at the bottom. (In reality each of these levels might in turn have been broken down into three or more sublevels, but the basic structure was threefold: senior, mezzanine, equity.)

  Selling the AAA stuff was never a problem, because there was no shortage of institutional investors and banks that needed large percentages of AAA-rated investments in their portfolios in order to satisfy regulatory requirements. And since the AAA-rated slices of these mortgage deals paid a much higher rate of return than traditional AAA investments like Treasury bills, it was not at all hard to find homes for that section of the deal.

  Selling the mezzanine level or “tranche” of the deal was another story, one outrageous enough in itself—but let’s just say for now that it wasn’t a problem, that a trader like Andy B. would always be able to find a home for that stuff.

  That left the bottom tier. The key to any of these huge mortgage deals was finding a buyer for this “equity” tranche, the so-called toxic waste. If the investment banks could sell that, they could make huge up-front money on these deals. In the case of the $1 billion pool of mortgages Andy was selling, the toxic waste represented the homeowners in the pool who were the worst risks—precisely the people buying those insane negative amortization mortgage deals, making 1 percent payments against a steadily growing debt nut, borrowing against money they had already borrowed.

  But Andy was fortunate: there were indeed clients out there who had some appetite for toxic waste. In fact, they were friends of his, at a hedge fund. “There were two companies that were buying tons of this stuff, Deutsche Bank and this hedge fund,” he says now. “These were smart guys. In fact, [the hedge fund guys] taught me about tiering this kind of risk—they were actually teaching my traders as we were buying these packages.”

  The reason this hedge fund wanted to buy the crap at the bottom was that they’d figured that even a somewhat lousy credit risk could make a 1 percent monthly payment for a little while. Their strategy was simple: buy the waste, cash in on the large returns for a while (remember, the riskier the tranche, the higher rate of return it pays), and hope the homeowners in your part of the deal can keep making their pathetic 1 percent payments just long enough that the hedge fund can eventually unload their loans on someone else before they start defaulting. “It was a timing game,” Andy explains. “They figured that these guys at the bottom would be able to make their payments even later than some of the guys higher up in the deal.”

  Before we even get to why these “smart guys” got it wrong, it’s worth pointing out how consistent the thinking is all along this chain. Everybody involved is thinking short-term: Andy’s hedge fund clients, Andy himself and his bank, certainly the originator-lender, and in many cases even the homeowner—none of them actually believed that this or that subprime loan was going to make it to maturity, or even past 2008 or 2009. Everybody involved was, one way or another, making a bet not on whether or not the loan would default, but when (and specifically when in the near future) it would default. In the transaction between Andy and his hedge fund clients, Andy was betting short and his clients were betting long, “long” in this case being a few months or maybe a year. And even that proved to be too long in that market.

  Meanwhile a lot of the homeowners taking out these loans were buying purely as a way of speculating on housing prices: their scheme was to keep up those 1 percent payments for a period of time, then flip the house for a profit before the ARM kicked in and the payments adjusted and grew real teeth. At the height of the boom this process in some places was pushed to the level of absurdity. A New Yorker article cited a broker in Fort Myers, Florida, who described the short resale history of a house that was built in 2005 and first sold on December 29, 2005, for $399,600. It sold the next day for $589,900. A month later it was in foreclosure and the real estate broker bought it all over again for $325,000. This cle
arly was a fraudulent transaction of some kind—the buyers on those back-to-back transactions were probably dummy buyers, with the application and appraisal process rigged somehow (probably with the aid of a Solomon Edwards type) to bilk the lenders, which in any case probably didn’t mind at all and simply sold off the loans immediately, pocketing the fees—but this is the kind of thing that went on. The whole industry was infested with scam artists.

  Neither Andy nor his clients were even aware of the degree of that infestation, which was their crucial mistake. In this new world they should’ve realized they could no longer trust anything, not even the most seemingly solid pillars of the traditional lending infrastructure.

  For example, part of the reason Andy’s hedge fund clients had such faith in these homeowners in the toxic-waste tranche is that their credit scores weren’t so bad. As most people know, the scores used in the mortgage industry are called FICO scores and are based on a formula invented back in the late fifties by an engineer named Bill Fair and a mathematician named Earl Isaac. The Fair Isaac Corporation, as their company was eventually called, created an algorithm that was intended to predict a home loan applicant’s likelihood of default. The scores range from 300 to 850, with the median score being 723 at this writing. Scores between 620 and 660 are considered subprime, and above 720 is prime; anything in between is considered “Alt-A,” a category that used to be a catchall term for solid borrowers with nontraditional jobs, but which morphed into something more ominous during the boom.

  Wall Street believed in FICO scores and over the years had put a lot of faith in them. And if you just looked at the FICO scores, the homeowners in Andy’s deal didn’t look so bad.

  “Let’s say the average FICO in the whole deal, in the billion dollars of mortgages, was 710,” Andy says. “The hedge fund guys were getting the worst of the worst in the deal, and they were getting, on average, 675, 685 FICO. That’s not terrible.”

  Or so they thought. Andy’s bank assembled the whole billion-dollar deal in February 2007; Andy ended up selling the bottom end of the pool to these hedge fund clients for $30 million in May. That turned out to be just in the nick of time, because almost immediately afterward, the loans started blowing up. This was doubly bad for Andy’s clients, because they’d borrowed half of the money to buy this crap … from Andy’s bank.

  “Yeah, we financed fifteen million dollars of it to them at a pretty attractive rate,” he recalls. Which for Andy’s clients wasn’t even enough, apparently, compared to other similar deals they’d done. “We’re lending fifty percent, and they’re getting better rates from other guys. Like they’re bitching about us only giving fifty percent.”

  But now all that borrowing would come back to kill them. “So now they’ve got all this leverage, and the loans start coming on line,” Andy says. “And we’re noticing there are guys going delinquent. And we’re thinking, why are they going delinquent? They only have to make a one-percent payment!”

  It turns out that the FICO scores themselves were a scam. A lot of the borrowers were gaming the system. Companies like TradeLine Solutions, Inc., were offering, for a $1,399 fee, an unusual service: they would attach your name to a credit account belonging to some stranger with a perfect credit history, just as the account was about to close. Once this account with its perfect payment history was closed, it could add up to 45 points to your score. TradeLine CEO Ted Stearns bragged on the company’s website: “There is one secret the credit scoring granddaddy and the credit bureaus do not want you to know: Good credit scores can be bought!”

  In an alternative method, an applicant would take out five new credit cards with $5,000 limits and only run a $100 balance. “So FICO goes, oh, this guy’s got $25,000 of available credit, and he’s only drawing down $500,” Andy explains. “He’s very liquid.”

  What was happening, it turned out, was that many of these people with their souped-up credit scores had bought their houses purely as speculative gambles—and once they saw home prices start to go down, they abandoned ship rather than pay even the meager 1 percent payment. Andy’s hedge fund clients were toast, and within a few months they were selling huge chunks of their portfolio to raise cash to cover their losses in the deal. “I’m looking at [the list of the holdings up for sale], and I’m thinking, they’re done,” recalls Andy.

  Even crazier was how Andy sold off the middle tranche of the pool. The AAA portion was never really a problem to sell, as the institutional investors like pension funds back then had a nearly unlimited appetite for the less-risky part of these deals. And the bottom of the deal, the toxic stuff, he’d sold off to his hedge fund guys. “I’m kind of stuck with the middle pieces,” says Andy.

  Which theoretically was a problem, because who wanted the middle portion of a billion-dollar package of option-ARM mortgages? After all, the market for this portion—the mezzanine—was kind of limited. “The AAA guy can’t buy them, because they’re only triple-B, and the hedge funds, there’s not enough juice in them to buy that stuff,” says Andy.

  So what did they do with the BBB part? That’s easy: they re-rated it as AAA paper!

  How? “They would take these BBBs, and then take the BBBs from the last five deals or so,” says Andy, “and put it into a CDO squared.”

  What’s a CDO squared? All it is is a CDO full of … other CDOs!

  It’s really an awesome piece of financial chicanery. Say you have the BBB tranche from that first deal Andy did. You lump it in with the BBB tranches from five, six, seven other deals. Then you just repeat the same tiering process that you started with, and you say, “Well, the first hundred thousand dollars of the revenue from all these BBB tiers that goes into the box every month, that goes to the AAA investors in this new CDO.”

  “And now the ratings agencies would say, okay, let’s do a first, second, and third loss,” referring to the same three-part structure of the overall pool, “and now let’s call seventy percent of these AAA,” says Andy.

  This sounds complicated, but all you have to do is remember the ultimate result here. This technique allowed Andy’s bank to take all the unsalable BBB-rated extras from these giant mortgage deals, jiggle them around a little using some mathematical formulae, and—presto! All of a sudden 70 percent of your unsalable BBB-rated pseudo-crap (“which in reality is more like B-minus-rated stuff, since the FICO scores aren’t accurate,” reminds Andy) is now very salable AAA-rated prime paper, suitable for selling to would-be risk-avoidant pension funds and insurance companies. It’s the same homeowners and the same loans, but the wrapping on the box is different.

  “You couldn’t make this stuff up if you tried, in your most diabolical imagination,” says Andy now.

  But it wasn’t the toxic waste or the mezzanine deals that blew up the financial universe. It was the AAA-rated tiers of the mortgage-backed deals that crushed America’s financial hull, thanks to an even more sophisticated and diabolical scam perpetrated by some of the wealthiest, most powerful people in the world.

  At around the same time Andy was doing his billion-dollar deal, another trader at a relatively small European bank—let’s call him Miklos—stumbled on to what he thought, at first, was the find of a lifetime.

  “So I’m buying bonds,” he says. “They’re triple-A, supersenior tranche bonds. And they’re paying, like, LIBOR plus fifty.”

  Jargon break:

  LIBOR, or the London Interbank Offered Rate, is a common reference tool used by bankers to determine the price of borrowing. LIBOR refers to the interest rate banks in London charge one another to borrow unsecured debt. The “plus” in the expression “LIBOR plus,” meanwhile, refers to the amount over and above LIBOR that bankers charge one another for transactions, with the number after “plus” referring to hundredths of a percentage point. These hundredths of a point are called basis points.

  So when Miklos says, “LIBOR plus fifty,” he means the rate London banks charge to borrow money from one another, plus 0.50 percent more. If the LIBOR rate is 0.50 per
cent that day, then LIBOR plus fifty means, basically, 1 percent interest.

  So Miklos was buying the AAA portions of deals like Andy’s at LIBOR plus fifty, and all you really need to know about that price is that it is slightly higher than what he would have been paying back then for a Treasury bill. The whole bubble game in the years leading up to the financial meltdown was driven by this small difference in the yield between Treasuries, which are more or less absolutely safe, and the AAA-rated slices of these collateralized securities.

  Why? Because what few regulations there are remaining are based upon calculations involving AAA-rated paper. Both banks and insurance companies are required by regulators to keep a certain amount of real capital on hand, to protect their depositors. Of course, these institutions do not simply hold their reserves in cash; instead, they hold interest-bearing investments, so that they can make money at the same time they are fulfilling their reserve obligations.

  Knowing this, the banking industry regulators—in particular a set of bylaws called the Basel Accords, which all major banking nations adhere to—created rules to make sure that those holdings these institutions kept were solid. These rules charged institutions for keeping their holdings in investments that were not at least AAA rated. In order to avoid these capital charges, institutions needed to have lots of “safe” AAA-rated paper. And if you could find AAA-rated paper that earns LIBOR plus fifty, instead of buying the absolutely safe U.S. Treasury notes that might earn LIBOR plus twenty, well, then, you jumped on that chance—because that was 0.30 more percentage points you were making. In banks and insurance companies with holdings in the billions, that subtle discrepancy meant massive increases in revenue.

  It was this math that drove all the reckless mortgage lending. Thanks to the invention of these tiered, mortgage-backed, CDO-like derivative deals, banks could now replace all the defiantly unsexy T-bills and municipal bonds they were holding to fulfill their capital requirements with much higher earning mortgage-backed securities. And what happens when most of the world’s major financial institutions suddenly start replacing big chunks of their “safe” reserve holdings with mortgage-backed securities?