Inside Job (9 page)

More than half of the increase in lending volume during the bubble was accounted for by subprime, Alt-A, Option-ARM, and other highrisk or predatory loans (see Glossary).

An astonishingly large share of these loans and the resultant securities were defective. The borrowers were people under financial pressure, people who were speculating, people committing fraud,
and/or people who were being defrauded (a major category, discussed below). And whatever the reason for the defects in the loans, they were pushed all the way through the securitization chain with
no regard for quality control—indeed, with
negative
quality control, due to intense pressure to find high-yield loans regardless of risk, and to cover up the risks that existed. Some
of it was mere sloppiness, but much of it was conscious and deliberate. There was massive fraud. The deception was so enormous and so obvious that senior management frequently must have known, and
indeed there is growing evidence that in many cases they approved or even directed it. And if some of them didn’t know, then the enormity of their negligence would be nearly as criminal as
pure fraud. It wasn’t subtle, and we shall see it was discussed widely and explicitly within the companies involved. Moreover, there is clear evidence that many CEOs and senior executives
lied to their investors, auditors, regulators, and the public, both during the bubble and afterwards, as their firms started to collapse.

What was going on, of course, was that Wall Street and the lenders were using fraud to create, fuel, and exploit a Ponzi scheme. During the bubble, lending standards basically disappeared. Of
course, there are always
some
people in America who want loans to buy a house, or to take out home equity cash, when they can’t afford the loan or have no intent to repay. Suddenly,
those people had no problem getting loans. Neither did anyone else. There were people who had good incomes and steady jobs, but were stretching to buy houses beyond their means; people who wanted
to cash out almost all their equity;
speculators buying multiple houses with no intent to occupy or rent them, hoping to flip them at a profit; people who wanted a second home
or vacation house they couldn’t really afford—all with a high risk of default, especially if prices ever fell. But during the 2000s, none of that mattered. Tax policy helped too; the
Clinton administration had enacted a law specifying that the first $500,000 in gains from selling a house was normally tax free if it was rolled into a new house purchase. This encouraged
flipping.

But there were also many blameless people, millions of them, who just got screwed. They decided to buy a house towards the end of the bubble, when prices were severely inflated, possibly even
using a traditional, conservative mortgage and a large down payment. But a few years later they lost their job, or retired, or got divorced, or had sudden medical expenses, or needed to move for a
new job. And when they tried to sell their house, they suddenly discovered that they
couldn’t
sell it, because its value had declined by a third, and that they had just lost their life
savings.

And finally, there was also massive fraud committed
against
borrowers, in part through the proliferation of highly deceptive loan structures and sales practices. It is no exaggeration to
say that the mortgage brokerage, property brokerage, and subprime lending sectors became pervasively criminalized during the bubble. Mortgage brokers were usually unregulated, and during the bubble
thousands of small-scale shysters put on a suit and sold loans.

The bubble period saw the rise of exotic loan structures designed to make payments artificially low for some initial period, and/or to disguise the real terms of the loan, while actually
charging the high interest rates that the banks liked. Mortgage brokers pushed loans with teaser rates heavily, often telling borrowers that when the higher real rate kicked in, the value of their
home would have increased so much that they could handle the new payments by refinancing—in other words, by taking out yet another loan.

Mortgage brokers also steered clients into needlessly expensive loans on a massive scale. Several studies have concluded that at least one-third of all people receiving subprime loans during the
bubble
actually would have qualified for a prime loan
. But they were placed into subprime loans with higher interest rates and unnecessary fees by mortgage brokers, who
were paid explicit cash bonuses by lendersyield spread premiums—for placing borrowers into more expensive loans. This, of course, also made the loans harder to repay, particularly after
teaser rates expired or interest rates adjusted upward, and increased hardship and defaults when the bubble collapsed.

There was also a lot of flat-out fraud, often very cruel, committed against immigrants who didn’t speak English and/or had no financial experience. They were simply lied to—about the
size of the loan, the size of the payments, the real interest rate—and told to sign documents they couldn’t understand or even read. Many mortgage brokers worked with unofficial
lenders, sometimes even loan sharks, who provided additional concealed loans to cover down payments or “points”. Mortgage brokers paid estate agents bribes for referrals to illiterate
and/or illegal immigrants. Often the victims trusted their mortgage broker in part because they shared a common language or ethnic background, or had been introduced by a mutual acquaintance.

Illegal immigrants were particularly easy to defraud because they were afraid to go to the police. The presence of large numbers of nonEnglish-speaking illegal immigrants was unquestionably one
reason that so much of the bubble was concentrated in in the states of California, Arizona, and Florida, as well as parts of New York City populated by recent immigrants. The Bush administration
also deliberately made it difficult for subprime borrowers to use civil remedies. In 2001, in one of the Bush administration’s first economic policy decisions, the US Department of Housing
and Urban Development interceded in a federal legal case in order to make it extremely difficult for subprime borrowers, including US citizens, to join class-action lawsuits against predatory
lenders. This forced borrowers to sue individually, which for many was prohibitively expensive and difficult.

The wave of fraud did not go unnoticed. In 2004 the FBI issued a press release warning of “an epidemic of mortgage fraud”, and held press conferences to publicize the problem. In its
2005
Financial
Crimes Report to the Public
, the FBI noted that “a significant fraction of the mortgage industry is void of any mandatory fraud reporting,”
and that the Mortgage Bankers Association provided no estimates on fraud levels. The same FBI report also stated that “based on various industry reports and FBI analysis, mortgage fraud is
pervasive and growing.” Even more interestingly, the FBI report noted that mortgage fraud was
not
usually committed by borrowers alone, stating that “80 percent of all reported
fraud cases involve collaboration or collusion by industry insiders”—estate agents, mortgage brokers, lenders, or some combination thereof.

But law enforcement was AWOL and/or overwhelmed, at both the local and national levels. The entire FBI has fewer than fourteen thousand special agents for all categories of crime; only a tiny
fraction were assigned to mortgage fraud during the bubble, when the FBI was intensely focused on counterterrorism efforts. In addition, the Bush administration deliberately gutted the
investigative and enforcement capacity of financial regulators such as the SEC. With good reason, mortgage lenders and Wall Street felt largely immune from criminal sanctions. There was not a
single high-level prosecution during the bubble, and very few arrests even for the most flagrant, low-level frauds.

But why did mortgage banks and Wall Street tolerate massive fraud, push so hard for subprime lending even for trustworthy borrowers, and favour exotic, toxic mortgage structures? Because
that’s where the money was. Subprime loans paid
much
higher interest rates. They therefore sold for much higher prices to investment banks, because they could be used to construct
mortgage-backed securities with much higher yields, which in turn were much easier to sell to investors—at least, until the loans defaulted. An extensive analysis of 250 million mortgage
records carried out by the
Wall Street Journal
in 2007 showed that in the previous year “high-rate” mortgages, on average, had spreads of 5.6 percent over comparable US Treasury
bonds, at a time when spreads on a safe, honest, conventional loan with a real down payment were only about 1 percent.
⁶

So how crooked did the lenders become in pursuing this strategy? Very crooked indeed.

THE COLLAPSE OF
the S&L industry in the late 1980s and early 1990s, combined with the start of the housing bubble, led to the
spectacular growth of highly unethical mortgage lenders, many of them in the largely unregulated shadow banking sector. These lenders, who drove the worst excesses of the bubble, were
not
traditional banks that took consumer deposits for savings and current accounts. They existed solely to feed the securitization food chain, and they got their funding from Wall Street—from the
same investment banks and financial conglomerates that bought their loans. Like the investment banks themselves, they relied on very short-term credit, which reduced the interest rates they needed
to pay, but which also left them highly vulnerable to interest rate increases and other financial shocks. So when the bubble collapsed, they all collapsed too.

Many of these firms were in California—“mortgage banks” like New Century, Ameriquest, Golden West Financial, Long Beach Mortgage, and Countrywide. All of them made loans
primarily to sell them into the securitization chain, and during the bubble their business exploded. For example, from 2000 to 2003, New Century increased its originations fivefold, from $4 billion
to $21 billion, while Ameriquest’s jumped tenfold, from $4 billion to $39 billion.
⁷
Both companies were the object of numerous lawsuits. However,
both are now bankrupt, so substantial recoveries are impossible, even though their former executives and sales personnel remain wealthy—a story we shall encounter frequently.

As the bubble got under way, several large traditional banks, financial conglomerates, and
all
of the major investment banks acquired predatory or subprime mortgage lenders of their own.
Citigroup snapped up Associates First in 2000, acquiring what was then the second-largest subprime lender, one that a consumer advocate called “an icon of predatory lending.” Lehman
bought six subprime lenders by 2004, Washington Mutual bought eight, and Bear Stearns three.
First Franklin, one of the larger subprime lenders, was taken over by Merrill
Lynch in 2006. Those that remained independent formed tight relationships with the investment banks that purchased their loans and also supplied them with general financing, managed their stock and
bond offerings, and invested the personal wealth of their executives. For example, a group of banks led by Morgan Stanley made large financing commitments to cement ties with New Century.

As we now know, the whole industry was extremely unethical. Here is a short survey.

Washington Mutual, or WaMu, was a longtime US government chartered savings and loan institution. Its CEO, Kerry Killinger, joined WaMu in 1982, and served as CEO from 1990
until the organization collapsed, was taken over, and then sold to JPMorgan Chase in 2008. Long Beach Mortgage Corporation was a California mortgage bank that was acquired by WaMu in 1999. Long
Beach was just one of twenty originators acquired by WaMu in the 1990s, but was the only one allowed to continue to operate under its own name more or less independently. It had a terrible
reputation, which it deserved. Losses on securities backed by Long Beach loans were among the country’s highest. The delinquency rate on Long Beach MBSs in 2005 was the worst in the
country.
⁸

WaMu’s reputation was not much better. It had grown by helter-skelter acquisition of smaller originators, without ever managing to create a well-integrated management system. But the
booming housing market more than made up for executive incompetence. Killinger’s total compensation for the period 2003 through 2008 was more than $100 million.

WaMu made a decisive turn toward riskier lending in 2005 after Killinger called for a “shift in our mix of business, increasing our Credit Risk tolerance.” In a later board
presentation, he said the objective was to “de-emphasize fixed rate and cease govt [Fannie/Freddie
conforming loans].” While 49 percent of new originations in 2005
were already in the higher-risk categories, the objective was to achieve 82 percent higher-risk originations by 2008.
⁹

Killinger’s board presentations carefully specified the “strong governance process” that would be required for the higher-risk strategy. But the control processes never were
really implemented. Capital-based high-risk lending ceilings were violated almost from the start.

A more accurate picture of WaMu’s management style might be inferred from the “I Like Big Bucks” skit performed by the Kauai Kick It Krew at the President’s Club 2006
celebration of top loan “producers” (sales personnel) in Hawaii.
¹⁰
The company had spared no expense for the event; the awards presentation
was hosted by Magic Johnson, the Hall of Fame basketball star. At the event, the Krew, all top producers, backed up by a local cheerleading group, performed a rap number: