One observer painted a remarkable picture for me of powerful opponents working together. “I looked at Jamie Dimon sitting across from Lloyd Blankfein, and I thought I’d love to write a book called Lloyd Blankfein vs. Jamie Dimon,” he said. “Those two were the giants in the room, and they hated each other so much it was impossible to believe they were sitting there. But you know what? They were very good, very willing to cooperate. And through the whole process I thought Jamie Dimon came off looking better than anybody. He was the guy that always rose above the pettiness with common sense and good ideas.” He was also the one who probably knew more than the others, being the healthiest bank at the table. No surprise later when his competitors railed at him for turning up the screws and demanding more collateral just when it hurt the most.
The men at the Fed working on the Lehman crisis had been divided into three groups. The first group was tasked with examining Lehman’s financials and determining how much capital would be needed. The second group was assigned to figure out a rescue structure. And the third group was assigned to figure out what would happen if Lehman could not be saved. “You’ve got to try harder,” Geithner warned them, his temper frayed. They seethed—no one appreciated being lectured to by Geithner. But they went off to their groups to get started.
TWO
The Bubble Machine
“Although a ‘bubble’ in home prices for the nation as a whole does not appear likely, there do appear to be, at a minimum, signs of froth in some local markets where home prices seem to have risen to unsustainable levels.”
—ALAN GREENSPAN, TESTIFYING BEFORE CONGRESS, JUNE 9, 2005
The most common question people ask me, looking back on the financial meltdown of September 2008 from the perspective of 2010, is, “How did it happen?” How could the financial markets go from such euphoric highs to such desperate lows? And where were the guardians at the gates—those investment banking geniuses with their perfect instincts and fat bonuses who were supposed to predict trouble and make course corrections? Where were the congressional watchdogs on Capitol Hill or the regulators at the SEC? There were some skeptics, hedge funds that resisted the euphoria and bet against the boom and made huge profits. There were some worrisome signs, but only in retrospect did we understand the systemic nature of the crisis. However, there is no question that the tsunami that hit Wall Street started with a trickle of unconventional mortgage loans that nobody imagined could mean such big trouble.
The euphoria of the housing-boom years was intoxicating, and it fueled a sense of urgency with a pulsing mantra: Buy, buy, buy! Home ownership had always been a cornerstone of the American dream, but in the past it was possible only for those who fit certain criteria. Everyone understood that in order to qualify for a home mortgage you had to have a secure job with an income that could comfortably accommodate a monthly mortgage payment, a good credit rating, and a cash down payment of 10 to 20 percent of the purchase price. But fueled by low interest rates and a booming housing market, nonbanks started getting in on the mortgage action. These entities were not as strictly regulated as conventional banks, and soon the mortgage business became tainted as brokers dropped the qualification standards and began writing loans for people with poor credit who couldn’t come up with down payments. They were dubbed “liar loans” because they required practically no verification. You could have claimed to be the Queen of England and walked away with a loan and a “Thank you, Ma’am” without a second look. We all remember the commercials touting the miraculous news: nothing down, no credit check, no requirements, everybody qualifies. It seemed too good to be true, and it was. Usually, subprime mortgages were pumped-up versions of adjustable rate mortgages (ARMs). That is, the interest rates were very low or nonexistent in the early years but then were adjusted to a much higher rate later on. The effect was that monthly mortgage payments shot up; some even doubled. The bitter irony of the setup was that subprime borrowers were the least able to withstand a sudden financial hit.
By 2007 large numbers of borrowers were facing default as the terms of their loans reset, and they were no longer able to afford their monthly payments. Massive defaults put a strain on lenders, but the fallout went far beyond them. By the time the subprime defaults began to pile up, the risk had imbedded itself into the financial system, through mortgage-backed securities.
Mortgage-backed securities are debt obligations on mortgage loans, which are purchased from banks or mortgage companies. During the height of the mortgage boom, investment banks started devising innovative “products”—in particular, the means of packaging subprime mortgages into securities that would be sold to other investment banks and presented to investors. These mortgage securities were quite lucrative when times were good, but when people began defaulting on their loans, the securities plummeted in value. The concept of mortgage-backed securities was originally developed by Lewis Ranieri, a Salomon Brothers bond trader, in the 1980s. During his career, Ranieri received wide acclaim for the concept, which produced huge profits for Wall Street.
Major investment banks were caught holding the bag—billions of dollars worth of so-called tier-three assets, the riskiest mortgage assets. Quarter after quarter, investment banks were forced to take write-downs against earnings. But even huge write-downs weren’t enough because the market never loosened up. No one wanted mortgage securities anymore.
In retrospect, the fact that so few people saw the danger building during the boom years is remarkable. There are many explanations for why this is so. Ed Lazear was an insider throughout the panic, as chairman of President Bush’s Economic Council. (He’d replaced Ben Bernanke in 2006, when Bernanke became chairman of the Fed.) “It’s not that events like this hadn’t happened before,” he said, “but events of this magnitude had not happened before. So if you look at the housing data you’ll see a nearly uninterrupted pattern of housing-price increases. And it wasn’t like these guys were fools. They were performing stress tests; they were doing analysis. But their models were based on the historical precedent, and, unfortunately, we hadn’t seen an event like this historically. When they set up their models and asked what were the right numbers, the right parameters, these were not the ranges we saw in this particular collapse.”
That was all well and good, but on the ground, people were struggling to get their heads around such a devastating failure on the part of those who were supposed to know better. Lazear recalled that he saw it frequently. “When I was working at the White House, I used to commute home to California every second or third weekend,” he said. “So I was on planes a lot. And I always talked to the flight attendants because flight attendants know everything. They’re like the cab drivers of the air. They’re in touch with people. So I was talking to this one flight attendant, and he was disgusted, saying, ‘I can’t understand how people could be so stupid. They’re making these loans to these guys who have no income, no jobs, no ability to pay. That’s totally nuts. Any idiot could see it.’ And my answer was that he was right. Any idiot could see it, and, in fact, the market saw it. That’s why it was called subprime. And so it wasn’t that these guys didn’t see it. They surely saw it. They understood that the default risk was much higher on those loans, and that’s why the interest rates were also much higher. What they didn’t see was that the default rates would be significantly higher.”
I got his point, but all explanations seemed feeble. One thing was unmistakable: By 2007, the boom times were effectively drawing to an end. No more lavish parties. No more euphoria. It was Judgment Day.
Angelo Mozilo was never one to show fear. I interviewed the chairman of Countrywide Financial on several occasions during 2007, and he was determinedly optimistic, as if by force of personality and will he could halt the rapid decline of Countrywide’s stock. Mozilo, the rough-hewn son of a butcher from the Bronx, had started the company in 1969, and by 2007 it was the largest lender in America, with sixty-two thousand employees and nine hundred offices. Mozilo was the king of home loans, and d
uring the phenomenal housing boom, being number one also meant doing substantial business in subprime loans. As one investor remarked to me, “Mozilo was the Crazy Eddie of the housing market. No deal was impossible. He was giving it away.” He wasn’t, of course, giving it away. Over a period of years, as the fees multiplied and the ARMs came due, these were extremely lucrative loans, far more so than conventional mortgages—until they began to default in high numbers.
When I spoke with Mozilo in March 2007, as the cracks were starting to appear in the real estate industry, he was on the defensive, feeling misunderstood and wrongly targeted. Like some of his counterparts, he was quick to blame the media for creating the aura of crisis where he felt none existed. “It’s distressing to me to see the piling on that’s taking place by the media and regulators,” he complained. “This was a system that was working very well, providing an opportunity for people to get over that barrier of entry to owning a home. Now what you have is panic setting in.”
But the system was hardly “working very well” by that time. I pointed out to Mozilo that it wasn’t the media that was to blame for an epidemic of home foreclosures. Mozilo brushed me off. Throughout our interview he touted his company’s affinity for the little guy with aspirations of home ownership. The question was, could the little guy afford the loan that Countrywide and other lenders were selling him? “Countrywide for forty years has been on a mission to lower the barriers of entry for the American people to have the opportunity of home ownership,” he said with emotion. “And every application we take is within that framework of making certain as best we can that these individuals can afford the home. And so my response is simply that we have not been an opportunist, but have created opportunities for individuals and families to own a home.”
It was true that Mozilo was helping to open up home ownership to a broad range of people. The question was, should they have had this opportunity if they did not have the means to be homeowners?
Was Mozilo putting a bright spin on a troubling situation? A later investigation uncovered e-mails that suggested Mozilo knew his lending program was deeply, even fatally, flawed. An April 17, 2006, e-mail, uncovered by federal investigators in 2009, found Mozilo complaining to Countrywide president David Sambol about the subprime lending program:
In all my years in the business I have never seen a more toxic product…. With real estate values coming down…the product will become increasingly worse. There has to be major changes in this program, including substantial increases in the minimum FICO.
So, although Mozilo knew back in 2006 that the subprime loans were, in his word, “toxic,” he was still defending them in 2007. He insisted that Countrywide did not arrange loans for unqualified buyers. He took a blame-the-victim approach, saying that no one forced consumers to sign up for the risky adjustable rate mortgages. Yet by the time we spoke a second time, in August 2007, almost one in four subprime loans that Countrywide serviced was delinquent. Critics were saying that Countrywide was determined to write mortgages at any cost—and while they weren’t alone in that, they were out in front. Ignoring the fault lines in his own company, Mozilo boasted to me that Countrywide would actually be a beneficiary of the subprime crisis, because all the bad players (presumably the competition) would be forced out of the lending business. He even spun a $2 billion cash infusion from Bank of America that summer as a sign of Countrywide’s strength. “We had a lot of people approach us over the months [wanting to invest], but Bank of America is the best—a marquee name. There’s only one Bank of America. For them to attach themselves to Countrywide is priceless.”
“Yes,” I pressed, a bit puzzled, “but why would they not want to do it? Look at the terms.” BofA’s stock purchase valued Countrywide at a paltry $18 a share. “Let’s face it, Angelo, people are saying, ‘Sure, it’s great for Bank of America, but the terms are not great for Countrywide.’”
“Yeah, they’re great for Countrywide,” Mozilo protested. “They’re fantastic for Countrywide!”
It didn’t help Mozilo’s case that he was busy dumping his own stock—reportedly $140 million worth in a matter of months. I asked him, “Don’t you worry that shareholders will say, ‘He’s selling. He must be losing confidence. Maybe I should sell?’” The suggestion angered him. “As a CEO, the only way to eliminate that issue is to never sell stock, just die. Die owning stock,” he snapped. He felt it was perfectly acceptable for a CEO to diversify and to cash in. That may have been true, but he ignored how the timing of the sale was sure to raise eyebrows.
By December, with conditions continuing to worsen, Mozilo was a bit chastened but still undaunted. He told me in an emotional statement, “Every day I’d wake up and say, ‘Okay, we’re through that problem.’ And then I’d go to work around four in the morning, and there was another problem, two problems, three problems. It was incredible because it began feeding itself. And what I’ve found out in this process—because I’ve never been through anything like this before—I’ve been through a lot in fifty-five years, but nothing like this—is that people are lemmings. They just keep on attacking because fear sets in. And everybody’s fearful. ‘I don’t want to be the last one left behind in this burning house, so I’m going to get out of here.’” He was angry at the media’s role in raising the alarm. “It’s like yelling fire in a very, very crowded theater,” he said bitterly.
At the beginning of 2008, shares were down more than 83 percent, and Countrywide had been forced to draw on its entire credit line of $11.5 billion in order to stay afloat. On January 11, 2008, Bank of America swept in with a surprise announcement that it would purchase Countrywide for $4.1 billion in stock, a rock-bottom price at only $7.16 a share. I asked Bank of America CEO Ken Lewis why he would buy such a troubled business since many analysts believed things would only get worse. Lewis was a measured guy, not the least bit flamboyant. Risk taking wasn’t his thing but deal making was. Steadily and quietly, he’d built Bank of America through a string of acquisitions, including Fleet and MBNA. Now his sights were on Countrywide. From Lewis’s perspective, Bank of America wanted a deal, and it got a deal. He figured that a year earlier his company would have forked over around $26 a share for Countrywide. So he was comfortable that Bank of America had done due diligence—more, he told me, than had ever been done before with other deals. And he stressed that Bank of America was not getting into subprime. There would be no more subprime business from Countrywide.
And what of Angelo Mozilo? Here Ken Lewis displayed a thin pretense of warmth. “I know there have been criticisms of Angelo,” he said, “but beneath the surface there is a wonderful human being. I think he’s gotten a bad rap at times.”
“But he won’t be staying with the company, right?” I asked.
“Right,” Lewis said. “He’s sixty-nine years old. He would like to see this through and spend more time with his grandchildren.”
But the picture of Angelo Mozilo, serenely retired with grandchildren perched on his knees, was not to be. On June 4, 2009, the SEC, in a civil suit, charged Mozilo, David Sambol, and former chief financial officer Eric Sieracki with securities fraud; Mozilo was also charged with insider trading, but as of this writing the court cases have failed to materialize.
Countrywide wasn’t the only early victim of subprime lending. Companies such as New Century Financial Corporation and American Home Mortgage Investment Corporation, leading subprime lenders, filed Chapter 11, with more bankruptcies anticipated. If the fallout had been limited to the lenders themselves it might have been contained. But by the time Countrywide was acquired by Bank of America, the worthless mortgage securities bundles were embedded in the system, pulling down some of the giants of investment banking from the United States to Europe and Asia.
The story of the financial industry’s collapse is still being written, but looking back we can pinpoint the warning signs. Nobody was paying attention to the interconnectedness of all the industries. Problems in the housing market were viewed as severe, but pe
ople were talking about it as if it were just the health of one industry that was at stake. Not true. The housing market was linked to the investment banks and ultimately to the newly globalized financial system, and when the thread was pulled, everything began to unravel.
Even those in the top echelon of the nation’s economy failed to recognize the looming crisis presented by subprime. Before he stepped down as Fed chairman, Alan Greenspan disputed suggestions of a housing bubble, calling it nothing more than “froth” in certain markets. Ben Bernanke, then chairman of the president’s Council of Economic Advisers and soon to replace Greenspan, told Congress that he believed the boom reflected positive aspects in the economy, like job and housing growth. Neither Greenspan nor Bernanke expressed any real concern that a housing bubble might be growing that could place the economy in peril if it burst.
To be fair, not everyone was swept up in the subprime craze. A small but potent movement was emerging, composed of traders who had no confidence in subprime assets. Leading the charge was John Paulson, a former managing director of Bear Stearns, who in 2006 set up his company, Paulson Credit Opportunities Fund, for the sole purpose of shorting subprime mortgage-backed assets. Paulson was an early predictor that the subprime market would crash. With his colleague, Paolo Pellegrini, he made $2.7 billion in 2007, betting against subprime.
Short selling involves borrowing stock (usually from a brokerage), selling, and then waiting for the price to drop. When (and if) it does, you buy it back at the lower price, replace the stock, and pocket the difference. Short-sellers are rarely looked upon fondly by corporate America—and why would they be? Short-sellers essentially bet against the system. They predict failure, and they earn profits when stocks sink.
A colleague of mine once compared short selling to Pete Rose betting against baseball. Some people believe it is unethical. Short-sellers like Paulson and Pellegrini would argue that they actually perform a valuable service by injecting an honest evaluation of worth into the process. My own view is that there is nothing wrong with short selling. This is what makes a market: a buyer and a seller. Short-sellers do not create a crisis in confidence. It is ludicrous to blame short-sellers, unless they are behaving fraudulently. And I have often seen short-sellers do much more research than “long” analysts. Short selling is just one more strategy, so long as the investor is not spreading false information and creating a run on institutions, the way some Wall Street executives charged during the 2008 period.
The Weekend That Changed Wall Street Page 4
