It Takes a Pillage: An Epic Tale of Power, Deceit, and Untold Trillions
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Risk Models Built on Thin Air
There was a time when the quality of loans was better than it was between 2002 and 2007. Stricter lending practices made it tougher to get a mortgage and typically required a borrower to bring home four times more than her monthly mortgage payment. The idea was that lenders wanted to protect the money they lent, and borrowers wanted to make sure they were good for that money.
Plus, home loans were fairly bland. They had few bells and whistles, so it was easy to compute the behavior of borrowers. The first MBS was created in 1970 by Ginnie Mae, which is owned by the government. Another government sponsored entity (GSE), Freddie Mac, issued its first MBS in 1971. Bank of America issued the first MBS issued by a bank in 1977.14 Fannie Mae issued its first MBS four years later in 1981. The risk of any loan defaulting or an entire package of them defaulting was relatively easy to figure out and prepare for, or hedge.
The first adjustable rate mortgage (ARM), also called a floating-rate mortgage, was created in the 1980s, but ARMs didn’t become popular until the 1990s. They brought with them a new level of risk that had to be quantified.15
ARMs were more popular with the less affluent because when interest rates are lower, initial payments are also lower. ARM rates dropped steadily in the early 1990s before leveling off.16 Lenders were offering ARMs and balloon mortgages, in which payments grew substantially during the later years of the mortgage. When these loans were packaged and subsequently cut into pieces—securitized—they became even more prevalent. Investors in securitized products were effectively providing financing for new loans. That drove more loan creation as investors began to take a more prominent role than lenders in the mortgage business. They really soared from 2002 to 2005, spurred by the rate cut frenzy of Greenspan and securitizers on Wall Street and in Washington, including the GSEs Freddie Mac and Fannie Mae.17 By the middle of 2007, more than half of the home mortgage market was being securitized, compared with only 10 percent in 1980 and less than 1 percent in 1970.18
Because ARM loans were new, they didn’t come with a ready made behavior history. Still, they were mostly made to prime borrowers whose risk of defaulting under simpler mortgages was well established, so Wall Street figured the ARMs would also be low risk, even when extended to subprime borrowers. The lending companies that doled out these loans never had it so good, profit wise, as they did between 2002 and 2005.
Skyrocketing home prices dominated the headlines during that lending boom, but they were nothing compared to the bubble experienced by the stock prices of the firms that made up the housing sector. From 2002 through 2005, while median home prices rose about 32 percent nationwide, the paper value of Wall Street darling companies such as Countrywide Financial, Beazer Homes U.S.A., and New Century Financial skyrocketed at least ten times as fast, with their shares posting gains of 300 to 400 percent.19 See, that’s leverage!
They were also the companies that fell first—that’s the dark side of leverage. By March 27, 2007, homebuilder shares began to plummet just as the Justice Department, the U.S. Attorney’s Office in Charlotte, North Carolina, the U.S. Department of Housing and Urban Development (HUD), and the Internal Revenue Service launched a criminal investigation looking into fraud at Atlanta based Beazer Homes in its mortgage brokerage business.20 Beazer’s chief accounting officer Michael Rand was fired in June 2007 for attempting to destroy documents.21 Ian McCarthy, who has been Beazer Homes’s CEO since 1994, survived the investigation to make nearly $8 million in total compensation from 2007 to 2008.22
On April 2, 2007, New Century Financial, once the second-largest subprime lender in the United States, filed for Chapter 11 after it was forced to repurchase billions of dollars’ worth of bad loans.23 Melville, New York-based American Home Mortgage, once one of the largest independent home loan lenders, filed for bankruptcy on August 6, 2007, just days after cutting its workforce down to 750; it had started the year with 7,400 employees.24 The FBI confirmed in early October 2007 that for several weeks it had been investigating American Home Mortgage on potential conspiracy and money laundering charges, and for securities, mail, and wire fraud, all of which contributed to its collapse.25
Countrywide, the biggest U.S. mortgage lender, narrowly avoided bankruptcy by taking out an emergency $11.5 billion loan on August 16, 2007.26 By October 18, 2007, the Securities and Exchange Commission (SEC) was well into an informal secret probe of Countrywide CEO Angelo R. Mozilo regarding the questionable timing of a stock sale then believed to be worth $130 million.27
Around the same time that the SEC started to look into Mozilo’s stock sales, it joined the bevy of federal agencies investigating Beazer Homes for exaggerating its earnings since 2004. KB Home, the nation’s fifth largest homebuilder, also faced an SEC investigation over allegations that former CEO Bruce Karatz—who was paid $50 million at the boom’s pinnacle in 2005—further inflated his compensation by back-dating stock options.28
Going back a bit, the regulators and even the press maybe should have seen the subprime mess coming, at least by early 2007. A series of fraud investigations in a single industry following stupendous profits tends to foreshadow doom. On February 28, 2007, the U.S. Attorney’s Office for the Central District of California told the founders of New Century Financial that they were under investigation for dumping millions of dollars’ worth of stock, and on March 12, 2007, the SEC told New Century Financial that it would have to cooperate in a preliminary investigation of the company’s restated financial statements.29 All of this was leading up to the company’s April 2007 bankruptcy. But New Century Financial CEO Edward F. Gotschall had the good sense to get out early, cashing in $27 million worth of stock in 2005 and 2006. He died of natural causes in January 2009 at age fifty-three, while watching football, as the Justice Department was investigating his stock sale.30
Going back even further, there were other investigations opened on the firms that had been subprime darlings and Wall Street lackeys that had created the loans that Wall Street used to bundle into risky financial packages and securities. Ameriquest reached a $325 million settlement in January 2006 to end a two year investigation signed off on by all fifty state attorneys general, without admitting any fault.31 Nearly two years later, in December 2007, payments began to trickle out in the tens of millions.32 Household International reached a $484 million settlement with federal investigators in October 2002.33 That settlement was only a whiff of the havoc that subprime lending would catalyze later in the decade.
In February 2009, the FBI had thirty eight corporate fraud investigations open related to the financial crisis, with only 240 agents investigating mortgage fraud, compared to 1,000 investigators during the Savings and Loan Crisis in the 1980s.34 By the end of April 2009, the FBI had 2,440 pending mortgage fraud investigations and for fiscal year 2008 there were 574 indictments that led to 354 convictions.35 So far, FBI investigations have yielded one high profile criminal case related to allegedly subprime lending—the indictment of two hedge fund executives from Bear Stearns—which was announced along with more than four hundred other mortgage fraud indictments on June 19, 2008.36
Lazy Lending Legislation
The greedy predatory lending that fueled the Second Great Bank Depression could have been avoided. Back in 1994, there was actually enough popular pressure to introduce legislation that would have ushered in controls on lending and other banking activities. As is par for the course, a handful of consumer oriented congresspeople and watchdog groups initially faced an uphill battle against a band of well funded, well-placed politicians such as Florida’s Bill McCollum, Texas’s Phil Gramm, and Iowa’s James Leach and Charles Grassley, who were carrying Wall Street’s torch toward deregulation.
But a burgeoning predatory lending crisis reached a very public head in 1994 amid allegations that Fleet Finance Group had gouged hundreds of low-income and minority consumers. Busloads of irate anti-loan-shark-T shirt-sporting citizens rallied through the halls of Congress to chronicle lending abuses.
HOEPA contained several provisions that curbed “reverse redlining,” in which nonbank lenders target low-income and minority borrowers. But it didn’t reinstate full interest rate caps, which had been deregulated during the previous two decades, or limit fees or tighten requirements to determine the ability of borrowers to repay their loans.38 As you can imagine, the industry and certain Republicans bitterly opposed the original House bill.
“Why can’t the lenders police themselves?” Senator Richard C. Shelby (R AL) asked.39 Sure, and while we’re at it, why not let power companies determine what’s pollution and what isn’t? Why not let agribusiness make the rules about what farms can do? Why not put lions in charge of your gazelle sanctuary or hire a fox to guard the henhouse? Shelby, as you may recall, later sprouted an activist streak in 2009 and took the Treasury Department to task for lying to Congress about TARP.
Even with the best intentions, HOEPA’s passage had dire consequences. First, it left a huge gap between the first and second tier of rates and fees a lender could charge. If lenders didn’t want to hit the new caps, they had plenty of fertile ground to play on by extending loans with rates and fees just beneath the HOEPA triggers. Because lenders would make less money from each loan, due to the reduced rates and fees, they’d have to find more borrowers to make the same profits. Voilà, the quiet birth of predatory subprime lending.
During those early and middle years of the Gingrich revolution, there was no talk of regulation. The market zoomed, and even though a spate of corporate fraud was percolating, it didn’t look broke, so no one in Congress fixed it.
As the late 1990s stock market boom headed into the new millennium, there were renewed legislative attempts to rein in the lending industry. Notably, in April 2000, the dynamic duo of Representative John LaFalce (D NY) and Senator Paul Sarbanes (D MD) introduced the Predatory Lending Consumer Protection Act of 2000 (PLCPA) to strengthen the Truth in-Lending Act.40
PLCPA would have brought down the HOEPA triggers and cut origination fees so that profit from home mortgages had to come from payments, ensuring that everyone in the chain had an interest in homeowners’ ability to repay loans. Sarbanes and Senate staffer Jonathan Miller worked feverishly to line up cosponsors.
The industry attacked the bill and won, with help from McCollum and Connie Mack III (R FL). What did pass, however, was Phil Gramm’s Commodity Futures Modernization Act of 2000 (CFMA). That act ushered in tremendous growth of unregulated commodity trades through its “Enron Loophole,” which allowed companies to trade energy and other commodity futures on unregulated exchanges.41
It also sparked growth in the unregulated credit derivative trades that bet on defaults of corporations or loans, which became the main ingredient in the hot new Wall Street financial gumbo. Credit derivatives were a type of insurance contract written against not just one corporation or loan but on investments that scarfed up bunches of subprime loans and stuffed them into the unregulated CDOs that imploded and hastened the greater lending crisis. The problem was that they weren’t regulated (even half heartedly) like insurance policies were.
Meanwhile, the quixotic Sarbanes and LaFalce soldiered on, trying to avert lending disaster through appropriate regulation. They reintroduced their bill as the Predatory Lending Consumer Protection Act of 2001, but the mortgage industry and its mouthpieces were relentless. In July 2001, Stephen W. Prough, chairman of Ameriquest Mortgage Company, said at the Senate’s Banking Committee hearings, “‘Predatory’ is really a high-profile word with no definition.”42 In August 2001, Senate Banking Committee chairman Gramm concurred, “Some people look at subprime lending and see evil,” he said. “I look at subprime lending and I see the American dream in action.”43 The 2001 version of PLCPA also died.
Down and nearly out, Sarbanes and LaFalce tried to pass their act again in May 2002.44 It failed again and then again, for the final time, on November 21, 2003.45 Bush’s ownership society ideology was in full swing by then, and the country was at war. Any hope for regulation or transparency in the lending or banking sector was basically dead.
The culmination of years of minor and significant acts of deregulation coalesced with mortgage industry sycophants beating back solid attempts at regulation or transparency. Loans that lenders pushed on homeowners were the perfect fodder for Wall Street, which eagerly packaged the loans and profited. House prices, in turn, skyrocketed.
How Lenders Created a Risk Free Business
Meanwhile, lending practices had gotten really wild. Alan Greenspan had chopped rates dramatically to bolster the economy following the stock market plunge in 2001 and 2002. Lower rates meant that it was cheaper for banks to borrow more money from the Fed and from one another. It also meant that lenders had more funds to play with. Because prime loan rates fell in tandem, these loans weren’t funneling as much profit to lenders. To make up for it, lenders extended riskier (nonprime) loans at higher rates to more borrowers.
With cheaper money, lenders were able to fund more mortgages for those riskier borrowers. If some loans didn’t go well, it wouldn’t matter. Lenders bet that they could either sell the underlying homes for higher prices, which would more than cover the defaulted loans, or convince the borrowers to take out equity loans backed by the homes’ presumably rising value.
That increased the risk of default and, more so, the potential loss to the lender: the same house could now back two loans instead of one, so if its value fell and the borrower couldn’t pay up, both loans were screwed. Super low teaser interest rates lasted for two or three years and begged to be refinanced (for which lenders got extra fees) before they zoomed up.46 This added more risk to the system: loans couldn’t be refinanced, and borrowers couldn’t make the high rate payments. But as long as home prices kept rising as they had since at least the early 1960s, systemic loan defaults weren’t a huge concern.47
While rates remained fairly low, there was always more cash for lenders to dole out. Lenders pushed an ongoing cycle of refinancing and new home purchases, both of which could be classified as new mortgages on their books, which was good for stock prices. Between 2002 and 2005, the stock price of the once largest independent mortgage lender, Countrywide Financial, had tripled—well before Bank of America agreed on January 11, 2008, to buy its remains.48 The firm created $434 billion in new loans in 2003, a 75 percent increase over 2002, securing a post in Forbes America’s top twenty five fastest growing big companies for 2003.49 The number three home lender, Washington Mutual, issued $384 billion in loans that year. (Emulating Countrywide’s rapid descent later in the decade, Washington Mutual lost a combined $4.44 billion in the first and second quarters of 2008, before JPMorgan Chase swooped in to buy it, with the government’s help, on September 25, 2008.)50 Wells Fargo, which hung on to buy Wachovia in October 2008, topped the charts in 2003 with $470 billion in new loans.51 That’s a combined $1.3 trillion in new home loans created by the big three mortgage lenders in 2003.
As home prices spiked amid low rates, demand increased for securitized loans, and more loans were offered. In 2003, the securitization rate of subprime loans matched that of prime loans in the mid-1990s.52 From 2002 to 2006, subprime loan originations went from 8.6 percent of all mortgages to 20.1 percent.53
The more subprime loans there were in the market, the more the securities piled on top of them became exposed to the risk that a larger number of loans than expected might default. Of course, this risk was hidden until home prices started to fall and defaults started to rise. Subprime
defaults decreased to 5.37 percent in 2005 (nearly half of what they’d been during the 2001 recession), right before those seeds of risk between lenders and borrowers began to sprout like Audrey II, the alien plant in Little Shop of Horrors.54
Consumer protections were simultaneously chucked. On April 20, 2005, President George W. Bush signed the 2005 Bankruptcy Abuse and Consumer Protection Act, sponsored by Senator Charles Grassley (R IA), which worsened the quietly growing housing crisis for consumers. 55 Borrowers facing bankruptcy could no longer negotiate down the principal of their mortgages with their creditors if the market declined, meaning that they had no way to avoid foreclosure, even if they wanted to.
On September 1, 2005, two years after the final Sarbanes LaFalce bill failed to gain traction, Office of Federal Housing Enterprise Oversight (OFHEO) chief economist Patrick Lawler said, “There is no evidence here of prices topping out. On the contrary, house price inflation continues to accelerate, as some areas that have experienced relatively slow appreciation are picking up steam.”56