Bought and Paid For (6 page)

While the story may be familiar to many readers, it's perhaps worthwhile to pause and review how this system worked.

Beginning in the Clinton administration and continuing throughout the Bush years, the mortgage companies Fannie Mae and Freddie Mac started buying up mortgages from the banks, mortgages that those banks were making to riskier and riskier borrowers. Why were they making these crazy loans? Since Fannie and Freddie would buy pretty much any mortgage any bank made, and thus take all the risk off the banks' books, there was no reason for the banks not to try to lend to anyone who asked them for cash. At the height of the insanity, loans were being given to practically anyone despite obvious red flags: lies on an application, a history of bad credit ratings, even lack of a job. There's also evidence that loan officers would simply rewrite applications to change or eliminate negative information that would prevent the loan from being accepted because the banks knew they could dump the mortgage on Fannie and Freddie the minute the papers were signed.

Fannie and Freddie would then make these loans, or guarantee them, so they could be processed into bonds—combining the streams of income from many of these mortgages into a single security known as a mortgage bond, which they would sell to investors, earning enormous profits in the process for the chosen Wall Street firms that conducted the bond sales to finance Fannie's and Freddie's operations. The firms kept many of these bonds on their own books as well, because they earned such tremendous returns.

The beauty of the whole process, the thing that made investors snap these loans up whenever they could get their hands on them, was that because the mortgages that went into these bonds were made to risky borrowers, they carried high rates of interest, meaning the bonds in turn would generate high yields, or returns, for their owners. Normally in the world of finance, high returns imply high levels of risk as well, but the compliant ratings agencies happily gave these bonds their coveted triple-A rating, the same rating given to the safest bonds in existence, U.S
.
Treasury bonds. Because these bonds were composed of so many mortgages, which were unlikely to go into default at once, investors were led to believe they were safe.

But as any farmer can tell you, if you take a lot of pieces of horseshit and put them together, what you get is nothing more than a big pile of horseshit. And the bonds, no matter how many mortgages were in each of them, were still composed of thousands and thousands of shitty loans made to people who should never have been given mortgages in the first place.

What's more, the financial firms, looking to increase profits even more, got more and more creative with their financial engineering, developing new bonds composed not of mortgages themselves but of other mortgage bonds; at the peak, just before the collapse began in 2007, the firms were even selling bonds that were composed of other mortgage bonds that were in turn composed of the mortgages themselves. So one mortgage made to one risky borrower could end up as part of a whole stew of crazy financial instruments (all unbeknownst to the original borrower, of course).

While the mortgage bond opened the housing market to the masses, it ironically made housing less affordable; prices shot up because just about anyone could get a loan that would be packaged by Wall Street into a seemingly risk-free security. The rest of the story is known to anyone who's not been living in a cave for the past several years: The housing bubble created by this furious borrowing and lending eventually burst as people realized the inflated prices of so much American real estate bore little or no relation to its actual value. As a result, many of the insane subprime mortgages went belly up as well, and with that, in a chain reaction, so did the value of the bonds based on those mortgages, the value of the bonds based on those other bonds, and so on.

This, of course, is the
Reader's Digest
version of how the crisis worked. Anyone interested in exploring the sheer lunacy of the process in more detail might enjoy reading any of the many books on the crisis, which make for fascinating and depressing reading.

But my goal is not to do what these other books have already done, so let's return to Johnny's Half Shell.

As Gallogly and all investment bankers—including those at the secret meeting—know, pushing banks to make terrible loans is just one way Wall Street has made a fortune off Washington. While a fiscally conservative McCain administration would presumably be looking to lower spending, which would mean less borrowing and less money for Wall Street, Obama would not. To take just one example, which was no doubt in the minds of those in the room, if Obama became president, he would likely support a “green agenda” that would mean potentially tens of billions of dollars in federal money and incentives going into new businesses like solar and wind power, not to mention renewable energy and ethanol (as General Electric and its Republican-turned-Obama-supporting CEO, Jeffrey Immelt, would soon discover). While Big Business feasted off this largesse, the bankers would get a piece of the new action as well, namely the fees for bringing those companies public and the high stock prices for their direct investments in the nascent industries. But the green agenda was just part of it.

This is, of course, exactly the opposite of the assumption made by most Americans, thanks in large part to the left-leaning media, that because investment bankers are rich, they must favor Republicans because, by definition, Republicans favor lower taxes on the wealthy and on big business. And while, of course, no one
likes high
taxes, what's more important than the tax rate is how much income you make in the first place: paying 30 percent of your money in taxes if you make a million dollars is better than paying a 20 percent tax rate on an income of only half a million.

In fact, a year after the secret meeting, in June 2008, as the markets were getting skittish and candidate Obama's economic team was fanning out trying to cool the fires, Greg Fleming said to me as the inevitability of a Democratic president and his high-tax agenda became clear, “We're all going to have to accept taxes are going up but we can live with it.”

Fleming was not alone. He and his rich Wall Street brethren could live with those higher taxes under an Obama administration because they'd still make as much or more money under Obama than they would have under McCain or another Republican.

After all, it was under a Democratic administration (with the help of prominent Republicans like free-marketer Senator Phil Gramm) that the Glass-Steagall Act, a Depression-era law that prevented certain kinds of banks from combining, was repealed, allowing the big firms to swiftly grow in size.

While many of these characteristics (love of Big Government, “green agenda,” etc.) are hardly unique to Barack Obama among Democrats, he alone seemed to have the complete combination of characteristics the bankers were looking to purchase. And make no mistake about it, “purchase” is the right word to use: These men, used to evaluating the characteristics of multibillion-dollar deals, approach politics as they do any other trade, and Obama, with his perceived probusiness outlook on life and charisma, not to mention his seeming moderateness and his close ties to Wall Streeters such as Gallogly and those who for years had been perfecting the Wall Street-Big Government link, seemed like a sure bet.

Knowing all this, it's no wonder Gallogly was able to convince his high-powered colleagues to meet this fresh-faced candidate from Illinois as they sipped some wine at a Washington hot spot.

To be sure, all the attendees were looking for a president who represented something new, even if they each came with their own agenda. In the case of Larry Fink, the CEO of what would become the largest money-management firm in the world, BlackRock, it was a quest for something other than the sleaze of the Clintons and for someone who could play favorably internationally, where the Republican brand was toxic (Fink did much of his business overseas as a money manager for large foreign pension funds).

In the case of Dick Fuld, CEO of Lehman Brothers, it was a search for someone who appeared to believe in the free markets but also understood the need for government to fund projects and initiatives, especially those close to Fuld's heart, such as the federal housing agencies Fannie Mae and Freddie Mac, whose mission it was to expand homeownership to the masses and, incidentally, keep Lehman's mortgage bond business alive. But as it turned out, that mission may have been the primary cause of the housing bubble and subsequent collapse. Fuld didn't seem to mind: When these agencies weren't guaranteeing loans to people who couldn't repay them, they were issuing massive amounts of debt to finance these activities, and Lehman Brothers earned huge fees assisting in this effort before it imploded later in 2008 as the third casualty of the financial crisis after Bear Stearns and mortgage lenders Fannie and Freddie.

And Warren Spector, Bear Stearns's president, was simply searching for someone whom he could believe in. These were tough times for Spector. Despite a net worth that exceeded $300 million, he was in the crosshairs at Bear Stearns, where he had made his mark as one of the top traders of mortgage bonds, the complicated securities that would lead to Bear's massive losses and ultimate demise a year later.

At issue for Spector was how he had managed—or failed to manage—the two large Bear Stearns hedge funds packed with mortgage debt, the High-Grade Structured Credit Fund and High-Grade Structured Credit Enhanced Leverage Fund. They weren't exactly household names, not even on Wall Street, but that would change as the funds became the first casualties of the declining market. For that reason, Spector's job was now clearly in jeopardy, and that was a humiliating blow to someone who just months earlier had been seen as the likely successor to Bear's CEO, James “Jimmy” Cayne. (And indeed, just a couple of months after this June meeting, Spector would be fired from Bear Stearns.)

With his Wall Street career in decline, Spector now turned to politics. On paper he supported Hillary Clinton, even inviting her for a private meeting with senior executives at Bear Stearns. But based on everything he knew about Obama, he thought the young senator was someone he should be listening to. And like Gallogly, Spector had been impressed immediately after his first meeting with Obama which had occured back in 2004 at a private lunch in Bear's gleaming Midtown Manhattan headquarters. In fact, he had been so impressed that years later, when Gallogly arranged the Washington dinner, he flew down from New York on a private jet to make sure he could attend.

Paul Volcker, the former Federal Reserve chairman, thought he should be listening to Obama as well, but for different reasons. He was looking for someone—anyone—who he thought had a clue about the excesses of Wall Street. Despite his long years in the financial markets, and most famously his years as Fed chairman, when he had shown the political will to raise interest rates and put a halt to the massive inflation of the 1970s, Volcker hated what most of the men in the room stood for: making money—sacks of it—simply by trading all sorts of financial products, but most notably the toxic bonds that were at the heart of the then-burgeoning crisis. Volcker had believed that the financial innovations of the past two decades had been setting the stage for a massive implosion—the beginnings of which were already happening. He hated that the men in that room who took all this risk were basically protected by the Federal Reserve and the federal government, and Volcker had watched in dismay as his successors at the Fed, Alan Greenspan and Ben Bernanke, did all they could to preserve that status quo. Knowing that the bankers at the Fed and the politicians on Capitol Hill would backstop them in the event of trouble, Wall Street's risk taking rose to enormous heights.

Volcker and Gallogly knew each other from Democratic Party circles, and when Gallogly called and asked if he would like to attend the private sit-down, Volcker asked for some literature—articles, maybe a book or two—on the young junior senator from Illinois. There was, of course, a myth already being created about Obama—the notion that he was postpartisan, something that Obama himself had promoted in his two autobiographies, putting himself forward as a man who could see virtue in all sides of the argument and then, after reasoned consideration, come to an independent conclusion about the right way to go.