It Takes a Pillage: An Epic Tale of Power, Deceit, and Untold Trillions

by Nomi Prins

  Markets weren’t yet constrained for credit. Because lenders were assured money through securitizations on Wall Street, they didn’t have to worry about guidelines on individual loans. If rating agencies would certify trillions of dollars worth of collateralized packages of loans with the highest possible rating, AAA, Wall Street investment banks could sell them to a wider pool of investors, which included pension funds, university endowments, and municipalities. High interest loan volume, which includes most subprime loans, soared to a combined $1.5 trillion between 2004 and 2006, representing 29 percent of home loans made in 2006.57 Home equity loans bulged simultaneously. It was a loan lending fest until adjustable rates ultimately kicked in, and prices topped out. At the same time that housing values were faltering, borrower mortgage payments jumped by 25 to 30 percent as adjustment periods began. Then the foreclosures ramped up to levels last seen during the Great Depression.

  More about Making Simple Loans into Complex Securities

  The first ABSs were issued in the United States in 1985 to help savings and loan associations get risky loans off their books. Credit card companies issued their first ABSs in 1987.58 The U.S. ABS market grew steadily through the early 1990s.59

  ABSs were stuffed with risky assets, such as subprime mortgages and subprime home equity loans, but in the beginning there weren’t enough of these to make a huge difference. The financial wizardry of securitization gathered up bunches of loans, and used them as lining for new securities. These new securities were sliced into two (or more) parts. The top part was called a senior slice, or tranche. Senior slices would receive any interest payments coming from the underlying loans first. The bottom slice, called a subordinated (or “sub”) tranche would protect the senior one from the risk of not receiving interest payments, if borrowers defaulted on their loans. The sub tranche only received whatever loan payments were left after the senior investors were paid. Most ABSs had more than two tranches, but the principle worked the same. The bottom slices were like bodyguards. They took the hit of any losses, so the top ones would be assured of payment. In return for taking this extra risk that not enough payments would come in, subordinate bond holders got more interest than senior ones. This process worked only if the sub tranche was big enough to absorb anticipated losses. If its size was miscalculated or defaults were massive, the whole security could collapse. Not only would the sub piece not get paid, but the pieces above it might not either. As the years went on, it was common to have three, four, thirty or more tranches for each security, but no matter how many there were the hierarchy worked the same.

  Prudential Securities created the first CDO obligation backed by ABSs or mortgage loans in 1999. During that time, most CDOs simply contained corporate, mostly high yield, bonds or assets.60 As corporate fraud was exposed and bankruptcies rose, different kinds of stuffing were needed for the CDO technology. Prudential became one of the leaders on a dangerous path that would lead the CDO market, worth $275 billion in 2000, to a value of $4.7 trillion by 2006.61

  Fannie Mae, established in 1938, and Freddie Mac are the GSEs that originally had tight restrictions on the types and the quality of mortgages they were allowed to securitize. The credit risk for subprime loans rested just above the level these GSEs would accept, so subprime loans were off limits. Standards fell on Bill Clinton’s watch. What happened was that HUD required Fannie and Freddie to buy up a certain percentage of affordable loans, and in 1995, it allowed them to purchase subprime loans to count toward that total.62 Fannie Mae then eased its credit requirements even further in 1999.

  “If they fail, the government will have to step up and bail them out the way it stepped up and bailed out the thrift industry,” Peter Wallison, a resident fellow at the American Enterprise Institute, presciently told the New York Times in September 1999.63

  With Wall Street profits to be made, HUD under President Bush upped the affordable loan requirement in 2004 to 56 percent of Fannie’s and Freddie’s total loans. Although Fannie and Freddie tried to buy loans with the least amount of risk (on the surface), they still provided capital to the entire loosely regulated subprime market.64

  After a mess of accounting scandals—Fannie Mae was forced to correct its books by $11 billion in 2004, and Freddie Mac misreported its earnings by $5 billion from 2000 to 2002—the government mortgage darlings needed to get back into secure business, so they dove headlong into the next big thing and became the largest buyers of subprime and Alt-A mortgages from 2004 to 2007.65 At a total of nearly half a trillion dollars, Fannie and Freddie occupied between 20 and 44 percent of the total subprime market each year during that time.66

  As subprime and Alt A originations in the United States rose from less than 8 percent of all mortgages in 2003 to a high of more than 20 percent in 2006, their quality also deteriorated.67 Various metrics show that the subprime saturation might have been even worse than that—the Kansas City Federal Reserve calculated in July 2008 that nationally, the 2006 subprime loan origination alone was as high as 38 percent of the market.68 But that didn’t make a difference. If GSEs and investors had demand, lenders would make sure there was supply.

  Meanwhile, investment banks were on a never ending hunt for new profit sources. And investors were looking for a better asset class, because the stock market wasn’t doing the trick anymore. Investors set their sights on subprime assets that could be scrambled up and spooned out to achieve high quality ratings.

  Based on the possibility that some part of the batch of subprime loans would default, rating agencies assigned separate ratings to the senior and the subordinate tranches. Tranches that were AAA rated were considered to be virtually risk free. A BBB tranche had a higher chance of defaulting but, in theory, would protect the AAA tranches from losses on a default. The way that rating agency models worked, if there was a default on the BBB tranche, it didn’t necessarily trigger a downgrading of the AAA tranche, although it certainly should have.69 To make matters worse, hedge funds gradually got used to not taking on subordinated tranches at all. Their securities were selling, so why should they absorb any of the risk?70

  Global investors were buzzing. They could buy assets that looked superior and get spreads that were higher than other similarly rated assets, such as Treasury bonds or investment-grade corporations like IBM and GE. That hunger fueled global ABS issuance, which nearly doubled, from roughly 1,600 issues in 2003 to more than 3,000 in 2006. Companies were printing ABSs as if they were money, even though they were worth less than the paper they were printed on (metaphorically speaking).71

  Assets were worth far less than the ratings indicated because of a risk catch. A security that might have been a perfectly good AAA, if risk assumptions were correct, could take on the risk characteristics of a BBB security if defaults increased, even though it was still called AAA. Which is what started to happen in late 2005. Credit spreads on AAA-rated ABSs were repriced as BBB corporate bonds by August 2007.72 It wasn’t long before investors realized that they’d bought a lemon, and their appetites started to sour.

  Making Complex Securities into Incomprehensible Securities

  To add more complexity to the mix and produce more AAA tranches, banks started to issue a new batch of securities: the CDO. Instead of simply being a scrambled mix of subprime loans backed by homes, CDOs were a rescrambled mix of ABSs and subprime loans and sometimes credit derivatives, which were unregulated securities that paid out a premium if the assets they were linked to didn’t default. Somewhere in there, CDOs were backed by those same subprime home mortgages, but it was more difficult to see how.

  Globally, proceeds from CDOs surged in the mid- and late 2000s. In 2003, proceeds from CDOs were at a paltry $86.5 billion, hitting a peak in 2006 of $478.8 billion and decreasing slightly in 2007 to $442.3 billion. Tragically, subprime loan packages were the fastest growing segment of ABSs, up to 26 percent in June 2007 from 14 percent in 2000.73 This meant that the financial products that were seeing the most growth were also the ones that contained
the most inherent risk.

  Demand remained insatiable through 2006. Issuing banks began to drum up synthetic CDOs backed only by credit derivatives linked to ABSs, not even by the ABSs themselves. Among other creative risk hiding schemes, CDOs were squared, taking the most risky parts of CDOs and rescrambling them among less risky parts. Each time the same technology was applied, the risk was amplified that the whole thing would collapse if more loans at the bottom deteriorated. That didn’t stop the profit-fest.

  The hedge fund community was a willing accomplice, providing equity capital to line these CDOs. Then, of course, the CDO market, along with everything else, hit rock bottom in 2008, with proceeds falling 88 percent to $52.6 billion. Growth in the CDO market ceased with a whimper, and there were no more investors to hose. CDO proceeds fell to $20 billion in the United States that year.74

  The CDO market and the leverage taken on top of pieces of CDOs ultimately brought down Lehman Brothers, Bear Stearns, and other hedge funds. The lawsuits poured in. On March 17, 2008, Bear Stearns shareholders filed a class action lawsuit alleging that they were misled about the firm’s true financial condition leading up to its takeover by JPMorgan Chase on March 16.75 Beverly Hills billionaire H. Roger Wang sued Bear Stearns for fraud the next month, after losing more than $5.6 million on 150,000 shares he’d bought in the weeks and days leading up to Bear’s collapse.76 Other lawsuits against Bear and other funds remain in the air.

  Everyone Was Invited, Everyone RSVP’d, and Everyone Showed Up

  Before the funeral, there was the party. European banks, global insurance companies and stateside pension funds, and, to a lesser extent, U.S. banks inhaled the AAA securities on the top layers of CDOs. Investors assumed that their risks were tiny. They weren’t the only ones. From pension funds in Ireland to private banking and insurance specialists in Belgium, everyone was buying CDOs.77

  The largest public pension fund in the United States, the California Public Employees’ Retirement System, bought $140 million in CDO equity (the riskiest, unrated CDO slice) from Citigroup by July 2007.78 Of all the CDO equity slices sold in the United States, 7 percent went to pension funds, endowments, and religious organizations, which bought up half a billion dollars’ worth of the riskiest pieces of CDOs between 2002 and 2007.

  The investors who needed to keep their money the most ended up taking the first hit when CDOs failed. In 2008, the New Mexico State Investment Council, which manages investments for twenty state agencies, including the New Mexico Retiree Health Care Authority and the New Mexico School for the Blind and Visually Impaired, had more than $500 million invested in equity tranches, while the General Retirement System of Texas had $62.8 million and the Missouri State Employees’ Retirement System had a $25 million tranche.79

  But all the investors discovered that they would face a major liquidity problem if they wanted to get rid of any of this stuff. In markets, if buyers stop buying, sellers can’t sell. Demand and liquidity began to dry up in the middle of 2007. New ABS CDOs were practically halted by October 2007.80 By February 2008, only one new CDO had been created in the United States.81 Losses racked up.

  The AAA ratings given by the major rating agencies, including Standard and Poor’s, Moody’s Investors Service, and Fitch Ratings, were bought and paid for by the investment banks, which were also their clients.82 Based on a historical gauge of default probabilities—the likelihood that payments on loans or bonds would stop—these agencies would rate tiers of newly fashioned securities depending on whether the tier below them would default or not. If the agencies did not provide good scores, CDOs weren’t created, and the agencies wouldn’t get paid.

  “In my view there are very few institutions that can remain objective given such a compensation scheme,” Andrew Davidson, who runs a risk management firm, told the now defunct New York Sun in September 2007.83

  The rating agencies, despite having contributed to the global economic meltdown that impacted the greater public, didn’t consider themselves responsible for any of it.84

  When one of my researchers for this book called to ask one of the three major rating agencies a simple question—“What kind of fees were made on these deals?”—its response was not, “Sure, let’s get that information for you ASAP.” It was something along the lines of, “Tell us which company you work for, and we’ll get back to you.” In other words, “If you don’t pay us or get us paid, we won’t help you.” So much for transparency. That’s reason enough to nationalize rating agencies.

  High ratings meant high demand everywhere in the world, so that the failed Belgian Dutch bank Fortis and others came to own a piece of Stockton. If one Stockton home defaulted, the global effect was miniscule. But when lots of home loans went under and their interest payments stopped funneling through the massive leveraged pyramid scheme that Wall Street had created, the damage from a simple butterfly wing flap turned seismic. The SEC, late as always to every party, voted to formally propose rating agency reforms to increase transparency and constrain the practices that awarded high ratings to low assets on June 11, 2008.85

  Three months later, on October 22, 2008, the House Committee on Oversight and Government Reform held a hearing titled, “Credit Rating Agencies and the Financial Crisis.” In his opening statement, Chairman Henry Waxman (D CA) remarked, “The credit rating agencies occupy a special place in our financial markets. Millions of investors rely on them for independent, objective assessments. The rating agencies broke this bond of trust, and federal regulators ignored the warning signs and did nothing to protect the public. The result is that our entire financial system is now at risk—just as the CEO of Moody’s predicted a year ago.”86 Party over.

  Making Incomprehensible Securities into Inconceivable Insurance

  The orgy of toxic securities was made worse by a financial product called a credit default swap (CDS), which was invented in 1997 by JPMorgan Chase.87 In the unregulated CDS market, the seller of a CDS gets paid a premium from the buyer, who in return gets protection from a bad credit event. In an incestuous frenzy, institutions bought and sold credit protection to one another, with money they borrowed from one another. Since 2000, the CDS market exploded from $900 billion to more than $45.5 trillion. That’s about twice the size of the entire U.S. stock market.88 The CDS boom continued until liquidity in the contracts dried up earlier this year and lenders called in their money.

  The global fallout might have been manageable if banks hadn’t entered this massively interconnected circle of privately negotiated CDSs. Even when banks were starting to post losses in 2007 and credit funds like those at Bear Stearns were tanking, the unregulated, over the counter derivatives market kept growing in the second half of 2007, particularly in the credit arena.89 Fear seeping through Wall Street translated into a rush to buy credit protection, most notably from the American International Group (AIG), which was later on the hook for more protection than it could handle and had to ask the government for handouts.90

  Fortunately, even though banking practices are usually shrouded in secrecy, certain whistle blowing heroes emerged. One of them, Deepak Moorjani, an employee and a shareholder at Deutsche Bank AG, could have told you this crisis was coming. In fact, he warned his bosses of just that back in 2006. Moorjani had come out of the private equity world and had served on the boards of several small companies. It had been his job to ensure that those companies were run efficiently and honestly. When Moorjani joined the Deutsche Bank Commercial Real Estate Division, he saw that pay incentives and lack of oversight from management had led to excessive risk taking.

  “I was kind of doing what I was trained to do, but you get yourself into a sort of environment like Deutsche Bank and that’s not highly appreciated,” he said in a phone interview.91

  Deutsche Bank was only one of the big name companies tied up in AIG’s collapse and subsequent bailout. Insurance companies such as AIG provided insurance on CDOs through CDSs. AIG was providing insurance on securities that everyone assumed would keep churn
ing out money, based on constantly rising housing prices. Once the CDOs, or what was inside them, started to default, AIG had to pay back these insurance claims.92

  When the government bailed out AIG, it was really acting as the insurance company AIG had claimed to be. AIG took taxpayer money and gave $90 billion of it to fifteen of the counterparties it had promised to insure against credit defaults written on super senior (even better then AAA) tranches of CDOs backed by mortgage securities, some of them subprime.93

  Deutsche Bank was one of the companies AIG paid off with taxpayer billions—$1.8 billion, to be exact. That was more than 50 percent of Deutsche Bank’s market capitalization at the time, according to Moorjani, who has since applied for a position with the SEC Division of Enforcement.

  “If you’re a bank, you can write these contracts all day long and there’s no transparency,” he said. The employees writing and signing off on the contracts get paid in the short term, even if, in the long term, losses from those contracts amount to a hard slap across the face of the world economy.

  “You have to track managers using the company’s resources for personal gain because they’re not owners, they’re not shareholders,” he said. “It’s OPM—it’s other people’s money—and that is the problem.”94