“It got to a point where I literally got sick to my stomach,” she recalls. “Every day I got home and would think to myself, I helped set someone up for failure.”7
By 2005, “nonprime” mortgages made up nearly 25 percent of loans in the country, up from 1 percent a decade earlier. One-third of new mortgages and home-equity loans were interest-only, up from less than 1 percent in 2000, while 43 percent of first-time home buyers put no money down at all.
Rather than rein it all in, regulators gave the market encouragement, thrilled that a record 69 percent of Americans owned their own homes, up from 64 percent a decade earlier. In a 2004 speech, Federal Reserve chairman Alan Greenspan said that borrowers would benefit from using adjustable-rate mortgages, which had seemed risky to some, and were a type of loan the Bank of England was campaigning against. Greenspan clarified his comments eight days later, saying he wasn’t disparaging more conservative, fixed-rate mortgages, but his comments were interpreted as a sign that he was unconcerned with the housing market. In the fall of 2004, Greenspan told an annual convention of community bankers that “a national severe price distortion seems most unlikely.”
The Fed also chose not to crack down on the growing subprime-lending industry, even as some home loans were signed on the hoods of cars. In many states, electricians and beauticians were given more scrutiny and training than those hawking mortgages. Several years later, Greenspan said, “I did not forecast a significant decline because we had never had a significant decline in prices.”
Lenders ramped up their activity only because a pipeline of cash was pumping hard, dumping money right in front of their headquarters. The pipeline usually went through Wall Street. After New Century issued a mortgage, it was bundled together with other mortgages and sold to firms like Merrill Lynch, Morgan Stanley, and Lehman Brothers for ready cash. New Century used the money to run its operations and make new loan commitments. The quasi-government companies Fannie Mae and Freddie Mac, pushing for growth, also became hungry for the high-interest mortgages from New Century and others, egged on by politicians pushing for wider home ownership.
“I believe there has been more alarm raised about potential unsafety and unsoundness than, in fact, exists.… I want to roll the dice a little bit more in this situation towards subsidized housing,” Massachusetts Democrat Barney Frank, then the ranking minority member of the House Financial Services Committee, said about Fannie Mae and Freddie Mac in September 2003. Sen. Charles Schumer (D-New York) expressed worries that restricting the big companies might “curtail Fannie and Freddie’s [affordable-housing] mission.”
By selling its loans to Fannie and Freddie, as well as to the ravenous Wall Street investment firms, companies like New Century didn’t need to worry much if they sometimes handed out mortgages that might not be repaid. Like playing hot potato, they quickly got them off their books. Checks and balances in the system were almost nonexistent. Home appraisers, for example, placed inflated values on homes, paving the way for the mortgage deals, knowing that if they didn’t play along, their competitors would.
Banks like Lehman Brothers were eager to buy as many mortgages as they could get their hands on because the game of hot potato usually didn’t stop with them. Wall Street used the mortgages as the raw material for a slew of “securitized” investments sold to investors. Indeed, one of the things the United States excelled at was slicing up mortgages and other loans into complex investments with esoteric names—such as mortgage-backed securities, collateralized-debt obligations, asset-backed commercial paper, and auction-rate securities—and selling them to Japanese pension plans, Swiss banks, British hedge funds, U.S. insurance companies, and others around the globe.
Though these instruments usually didn’t trade on public exchanges, and this booming world was foreign to most investors and home owners, the securitization process was less mysterious than it seemed.
Here’s how it worked: Wall Street firms set up investment structures to buy thousands of home mortgages or other kinds of debt; the regular payments on these loans provided revenue to these vehicles. The firms then sold interests in this pool of cash payments to investors, creating an investment for every taste. Though the loans in the pool might have an average annual interest rate of 7 percent, some investors might want a higher yield, say 9 percent. The Wall Street underwriter would sell that investor an interest in the cash pool with a 9 percent yield. In exchange for this higher rate, these investors would be at the most risk for losses if borrowers started missing their mortgage payments and the pool’s revenue was lower than expected. Moody’s or Standard & Poor’s might give this slice, or “tranche,” of the pool a BBB rating, or just a rung above the “junk” category.
Other investors, though, might be content with that 7 percent yield; they wouldn’t see any losses until the BBB slice was hit. As such, these claims might command a higher, AA rating. Still other investors might want a safer investment yet and be comfortable getting only 5 percent a year; they would receive a slice of the pool with a much higher rating, say AAA.
Dozens of tranches, or claims on the packaged pools of assets, were created in a typical securitization, most rated AAA or close to it, and each paying investors interest based on expected payments of the pool. When Joe Sixpack sent his $1,500 monthly mortgage payment to New Century, the check, along with those of other home owners, would find its way to these “structured” vehicles, where they’d start paying off holders like a cascading waterfall. Part of Joe’s payment first would go to satisfy holders of the AAA slice at the top of the pool, and then trickle down to holders of the tranches rated BBB, BBB– and BB–, each getting paid in full along the way. Losses would infiltrate up from the bottom. So the highest-rated pieces got the first chance at income but the lowest rate of return, while the lowest got the first losses and the highest potential return.
To try to ensure that losses wouldn’t result, Wall Street firms made sure there was more revenue coming into the vehicle than it needed to pay out, just in case there were problems. Or they mixed in other kinds of revenue, such as claims on auto loans or even aircraft leases. To ensure proper diversification, loans were acquired from all over the country and from a variety of different lenders. The resulting investment product was called an asset-backed bond because it was a bond backed by a pool of mortgage loans or other assets.
Through these structures, Wall Street took piles of risky mortgages and created shiny AAA-rated investments—handsome new bonds made from much uglier bonds. The banks usually designed the securities to just barely achieve the credit agencies’ requirements for their top ratings. They had created gold from dross.
Over three decades, as the market to “securitize” loans into investments grew, securities firms, investment banks, and commercial banks searched high and low for mortgages and other financial assets to package into new investments. After stocks tumbled in 2000, fees from the securitization market became even more important to the firms, making them more willing to buy up all kinds of mortgage loans, especially those with high interest rates, to serve as linchpins for these investments.
FOR INVESTORS, securitized investments were enticing. Stocks were on the ropes and it seemed a better option to plow money into anything housing related, since many other bond investments had skimpier yields. As comedian Jon Stewart later joked, just the aroma of a mortgage was enough to get investors salivating. An ingrained belief arose that the securitization process, by chopping up tens of thousands of loans of varying quality from all over the country into small investments, effectively spread risk from lenders to tens of thousands of investors around the globe. They might catch a cold but no one would likely be killed by a flu outbreak.
One key reason investors were so taken with mortgage-related investments was that companies like Moody’s Investors Service and Standard & Poor’s that were paid to place ratings on it all, blessed the pools of loans with top ratings. Analysts at these firms scrutinized all these debt investments, laboring for we
eks before even warning that they might adjust a rating a smidgen. If these prestigious firms placed ratings as high as AAA on the mortgage-related investments, how bad could they really be? investors asked. (In truth, the rating firms tacked on disclaimers, in really fine print, that their ratings were just opinions.) Many investors didn’t even realize they were making housing-related investments. They just focused on the top rating. Some had standing orders at various Wall Street trading desks to buy any U.S. debt rated AAA and sold with an attractive yield.
The real estate bubble would have burst early on were it not for overeager home buyers, of course. Surging housing prices created an illusion of wealth for home owners, encouraging them to save very little and spend more than they were making. Wages were stagnant, making it hard for first-time home owners determined to buy their own home. Undeterred, many borrowed heavily to afford their first home, or to move up to their dream home, complete with granite kitchen counters, stainless-steel appliances, flat-screen televisions, and surround-sound systems. Borrowers often asked for loans much larger than they could afford, sometimes exaggerating their salaries and other financial information to qualify.
The real estate market became the hobby that swept the nation, extended around the globe, and then back again. Reflecting the speculative frenzy, reality television shows debuted, including Flip That House and its competitor, Flip This House. Even the upper echelon got carried away. In the spring of 2004, Lakshmi Mittal, an Indian steel magnate, bought a twelve-bedroom house with a twenty-car garage in Kensington Palace Gardens, London, for an eye-popping $126 million.
Investors like Jeffrey Greene also drove prices higher. Greene, an old friend of John Paulson, had a voracious appetite for real estate in the early 2000s, purchasing hundreds of apartment buildings in Southern California, often at a rapid-fire clip. Greene never asked for a commission from real estate brokers bringing him deals, unlike some of his competitors. Instead, he hoped to be their first call when a new property came on the market. Because he had done so much buying, Greene became familiar with wide swaths of the San Fernando Valley and Hollywood. Within five minutes of getting a new offer for an apartment building or a home, Greene usually agreed to a deal at full price, forgoing time-consuming negotiations or inspections so he could be the first in the door.
“I could tell within five minutes, just from a phone call, if it was a good price,” Greene recalls. “I knew the streets, I knew the rents, and I could picture the buildings. The brokers knew what I wanted.”
By 2005, lenders had granted $625 billion of subprime loans, a fifth of all home mortgages that year, according to Inside Mortgage Finance, a trade publication. U.S. home prices had jumped 15 percent in the previous year and were on average almost 2.4 times annual incomes, compared with a seventeen-year average of about 1.7.8
Bulls were convinced that prices would continue to trend up, noting that homes hadn’t fallen on a national basis in generations. A flattening of prices was as bad as it had gotten since the 1930s. Many experts at most conceded there might be bubbles in some local markets.
A December 2004 interview with Countrywide’s Angelo Mozilo on the Kudlow & Cramer show on the cable-business network CNBC captured the tenor of the times:
LARRY KUDLOW, COHOST: Mr. Mozilo, again, happy holidays to you.
MR. MOZILO: Thank you.
KUDLOW: You can’t see it, sir, but underneath you, it says “bubble shmubble,” which has sort of been our view … People buy homes, ’cause they like to and they can afford to. And …
CRAMER: Right.
KUDLOW: … homes are in short supply relative to demand.
MR. MOZILO: Right.
KUDLOW: Are you in the bubble shmubble camp?
MR. MOZILO: No, I’m probably in the bubblette camp to be honest with you.… There’s a few areas of the country where we have some inventory, but on balance, as you said, Larry, the demographics are clear, there’s tremendous demand for housing, and it’s becoming more and more difficult to build housing and to get land and title than the capital that’s needed to do it.… And so I think that we’re going to have a very healthy housing market.
CRAMER: I have a quick question to ask Angelo. Angelo, fifty-one years. Did you get into the housing business when you were, like, eight?
MR. MOZILO: Fourteen, right—not far from you. I was in 25 West 43rd Street, fourteen years old, as a messenger boy.
KUDLOW: That’s a great story.…
MR. MOZILO: It’s a great country.
CRAMER: Yeah, it is.
KUDLOW: Number one.
CRAMER: It’s a great American story.
KUDLOW: And earnings look great.
MR. MOZILO: It’s a great country.
KUDLOW: Share looks great.
CRAMER: Yeah.
KUDLOW: No, really, it’s a wonderful American story.
CRAMER: It’s a great country, great country.
KUDLOW: And we wish you all the best in the holidays and the new year.9
It became hard to miss the excesses, though. When Alberto and Rosa Ramirez began looking for a home in late 2005, they had realistic expectations. The couple, strawberry pickers who each made $300 a week in the fields around Watsonville, California, near Santa Cruz, pooled resources with another couple working as mushroom farmers and determined they could afford payments of $3,000 a month. When an agent showed them a four-bedroom, two-bath home in the city of Hollister for $720,000, they blanched. They had no assets, six children, and no money for a down payment.
But their agent assured them they could handle it, even though the initial monthly payment would be $4,800. The zero-down mortgage from New Century had a “teaser rate” that would put monthly payments at $5,378, but the agent said they could refinance and “get the payments down to $3,000 or less,” Rosa Ramirez recalls.
The refinancing never happened, though, and cutting back on expenses didn’t help much. About a year after buying the home, they could no longer make the payments.10
A Washington Mutual loan representative made a loan to a borrower claiming a six-figure income from an unusual profession: mariachi singer. The representative couldn’t verify the income so he just had the singer photographed in front of his home dressed in his mariachi outfit. The loan was approved.11
EVERYONE seemed to be drinking the housing Kool-Aid, right? Well, not exactly.
A number of traders saw a real estate bubble forming, but precious few bet that it would burst. There was little incentive for even skeptics to make a radical wager against housing. Traders bucking the bullish consensus risked squandering big profits and ruining their careers if they were wrong. They might make money in a downturn, but who knew how long it would take for any slowdown to materialize? Any profits they might generate with a bearish stance likely would be offset by losses elsewhere at their firms, limiting their paycheck. Radical moves didn’t lead to long careers on Wall Street. So even the bears sat on their hands, letting the bulls run wild.
For those utterly convinced a housing crash was in the offing, there was precious little they could do, anyway. Sure, you could sell a home and move into a rental, but that meant packing up the family and kids, and leaving behind neighbors and friends, never a fun task. A futures market on housing prices never took off. Shorting home builders and lenders was a possibility. Some bears favored a “derivative” investment called a credit-default swap, or CDS, that served as insurance protection for the debt of companies in the subprime-lending business. But these companies didn’t always suffer when housing fell, because some of them benefited in a weak market by grabbing business from rivals or by selling out to larger companies. Besides, there weren’t that many of these corporate bonds in the market; it was difficult to create CDS contracts to protect bonds that didn’t exist.
Shorting risky mortgage loans seemed like the most obvious move for financial traders, but it was even more difficult to get one’s hands on these “mortgage-backed bonds,” or claims on pools of hundreds of diff
erent risky loans, to short them or create a CDS contract to protect this debt. Sometimes a bullish investor would buy an entire issue of mortgage-backed securities and resist lending it out, making it impossible for investors to short.
As a result, a shocking few pros in the mortgage-bond world bothered to predict where home prices were going. The direction of interest rates and inflation seemed more crucial to these bonds than the health of housing, which never seemed to hit big problems, anyway. Most analysts didn’t even have basic data about things like the levels of foreclosures around the country, and how home-price appreciation differed, preferring to opine on whether one collection of mortgages looked more attractive than another. They were so involved with analyzing the limbs of each tree in the mortgage world that they didn’t seem to know the forest even existed.
Bearish investors tend to act as a speed bump for a racing market, levying downward pressure by ganging up against a sector or company, and by sending a message of skepticism to those in the market. But until a group of bankers got together for a historic dinner in the winter of 2005, it was nearly impossible for investors to bet against housing or the growing pool of subprime-mortgage bonds. That was part of the reason housing was able to soar.
John Paulson, ever interested in a big score that could change his standing on Wall Street, would look to find a way to bet against the housing market. But how? Making his task even more challenging: While real estate was surging, Paulson had his hands full elsewhere.
3.
JOHN PAULSON AT FIRST EYED THE HOUSING FRENZY WITH LITTLE MORE than passing interest; it was an express train bulleting by as he waited for his trusty local. He didn’t play mortgages, derivatives, or real estate, missing out on much of the real estate mania. He had more than enough to deal with: When the stock market crumbled during the early part of the new millennium, mergers dried up, making it difficult for Paulson and others who invested in these deals.
The Greatest Trade Ever Page 6
