Who Stole the American Dream? (32 page)

But then, rather inconsistently, Greenspan imposed a penalty on the borrowers who followed his advice and bought flexible-rate loans.
He led the Fed through fourteen interest rates hikes from mid-2004 to January 2006, quadrupling the federal funds rate from 1 to 4.5 percent. That spelled rough weather for people with 2/28 subprime loans or Option ARMs.

The push on subprime by the Clinton and Bush administrations sounded great—egalitarian, inclusive, progressive. But the strategy had a fundamental flaw that one might have expected the Federal
Reserve as the repository of financial expertise to spot: The low-income homeowner strategy did not match economic reality.

Housing prices from the late 1990s onward were rising far faster than people’s incomes, economist Robert Shiller pointed out. Millions of subprime borrowers were being thrust into a race that they were bound eventually to lose. Subprime mortgages pushed them into a cycle of refinancing, and each time they refinanced, the size and cost of their mortgage went up. But their income stayed flat or fell. Keeping up with the housing bubble was a stretch even for many prime borrowers. Starting in 1997, former IMF economist Simon Johnson observed, “
the growth of
housing prices outstripped income growth
[emphasis added]; after 1999, real median household income
fell
for five consecutive years as housing prices soared.” With a growing gap between housing prices and personal incomes,
massive defaults were inevitable. Too many people couldn’t afford their loans.

Inside the Federal Reserve, Ed
Gramlich cautioned Greenspan that the subprime market, swollen to $625 billion in 2005, 20 percent of the total U.S. mortgage market that year, was operating like “the Wild West,” with almost no regulatory protection. The Fed, Gramlich charged, had abdicated its role as sheriff, allowing “carnage” among low-income borrowers. Gramlich underscored that
51 percent of subprime loans in 2005 were originated not by banks, but by consumer finance companies or mortgage brokers, not subject to regulatory supervision. He urged the Fed to step in. Otherwise, Gramlich asserted, subprime “is
like a city with a murder law, but no cops on the beat.” Greenspan shot down Gramlich’s proposal for Fed oversight to bring the subprime market under better control.

Bush’s Treasury secretary, John Snow, later admitted, “
What we forgot in the process was that it has to be done in the context of people being able to afford their house. We now realize there was a high cost.” But Lawrence Lindsey, Bush’s first chief economics adviser, said
no Bush official wanted to raise the alarm. “No one wanted to stop that bubble,” said Lindsey. “It would have conflicted with the president’s own policies.”

Those were comments made in hindsight. But there were warnings ahead of time from outside economists. In 2003, Dean Baker and Mark Weisbrot of the Center for Economic and Policy Research in Washington cautioned that rising
mortgage debt had reached dangerous levels and this was “especially scary” because housing prices “may be inflated by as much as 20 to 30 percent.” Other warnings that the housing market was dangerously overheated came from economists Stephen Roach of Morgan Stanley and Paul Krugman of Princeton.

In 2004, Robert Shiller, whose book
Irrational Exuberance
had foretold a stock market bust in 2000, reported ominous housing bubbles in key regional markets, warning that speculative fever could bring widespread mortgage defaults. Shiller recalled that waves of mortgage defaults in 1929 had contributed to the biggest banking crisis in U.S. history in the 1930s. A few months later, in early 2005,
Shiller’s warning was more stark. The housing frenzy, he said, “
may be the biggest bubble in U.S. history”—destined to end with a crash. Renowned global investor Sir John Templeton forecast an inevitable downturn. “
When home prices do start down,” he said, “they will fall remarkably far” and cause widespread bankruptcies.

But Alan
Greenspan dismissed talk of a housing “bubble.” In June 2005, he conceded “signs of froth in some local markets,” but he rejected calls from economists like Shiller for the Fed to raise interest rates more sharply to cool speculative fevers, asserting that “the U.S. economy seems to be on a reasonably firm footing.”

A year later, the housing market began its tumble. In hindsight,
The Wall Street Journal
editorial page, normally among Greenspan’s admirers, judged that “Alan
Greenspan’s policies at the Fed contributed to the credit and housing manias that led to the financial meltdown….”

But out across the country, in the boom years, Greenspan was the oracle, the north star for bank presidents like Washington Mutual CEO Kerry Killinger. They followed his course, and their operations in the 2000 decade graphically illustrate how Greenspan’s strategies played out across the country.

Bank CEOs such as Killinger took Greenspan’s cheap money policies, his advocacy of subprime, and his promotion of variable-rate mortgages as the green light for more aggressive lending through exotic loans such as Option ARMs intended for resale on the secondary market. So WaMu shifted priority from serving Main Street to serving Wall Street. Home buyers were no longer its primary customers. They were a means to an end—feeding Wall Street.

This was a pivotal shift for old-line banks such as Washington Mutual—and for American banking in general. At WaMu, it seemed a cynical shift. Killinger, in an internal email in March 2005,
worried about the high level of risk in the housing market that “typically signifies a bubble.” But rather than retreat to safety, Killinger raced ahead.

Wall Street stock analysts asked Killinger in mid-2005 how he protected WaMu from losses in its large inventory of risky Option ARMs and subprime mortgages. Killinger first said WaMu had internal risk control measures, but bank documents contradict him. His real defense, Killinger admitted, was to sell off potentially toxic loans to Wall Street investors: “
You’ve seen us sell in the secondary markets more than what we historically have done.”

What Killinger didn’t reveal was how rapidly the tide of rotten—even fraudulent—liars’ loans was rising, based on bogus information on loan applications. This was happening not just at Long
Beach, which had
the highest loan delinquency rate of any bank in the country in February 2005 and
had to be shut down entirely and absorbed into WaMu in June 2007 after being forced to buy back $837 million worth of mortgages it had sold to Wall Street. But by then the infection of predatory marketing had spread to WaMu itself.

What is surprising in retrospect is that
Wall Street was so slow to detect the poison in the New Mortgage Game that it had fostered and financed. Wall Street banks were so hungry for WaMu’s Option ARMs that WaMu sold a staggering $130 billion worth in 2004 and 2005. But by mid-2006, more and more borrowers were defaulting, and much later, Ronald Cathcart, WaMu’s chief risk management officer, admitted in hindsight that too many
Option ARMs had been recklessly approved and, ultimately, they “were a significant factor in the failure of WaMu and the financial crisis generally.”

Worse, WaMu’s internal investigators in 2005 confirmed what Lili Sotello and her staff of lawyers at the Los Angeles Legal Aid Foundation had reported. They found massive broker fraud and abuse inside Washington Mutual at two of the bank’s highest-volume loan offices, near Los Angeles. Like Sotello, WaMu’s internal memos blamed the fraud not on borrowers, but on the bank’s loan officers. “Virtually all of it [is] … attributable to some sort of
employee malfeasance,” WaMu investigators reported.

The prime offenders, investigators said, were two of the bank’s all-time high-volume champion loan officers—Thomas Ramirez, the top mortgage loan salesman in Downey, California, and Luis Fragoso, the kingpin loan performer in Montebello, California. Both were experts in affinity marketing within the Hispanic community.

In a year-long probe, WaMu investigators found documentary evidence of “an
extremely high incidence of confirmed fraud”—58 percent of the loans handled by Ramirez and 83 percent of those managed by Fragoso. The fraud, investigators said, covered a gamut of bogus information on loan applications—false credit records, phony employment information, inflated income figures, false statements about owner occupancy of homes, and illegal Social Security
numbers. In one file, investigators reported: “The credit package was
found to be completely fabricated.”

But no firings or shake-ups at WaMu followed the probe. In fact, eighteen months later, in June 2007, the
insurance giant AIG, which had insured WaMu’s loans, protested about the new fraudulent loans from Luis Fragoso in WaMu’s Montebello office. AIG demanded that WaMu buy back these “Fragoso loans,” and it filed formal complaints with federal and California bank regulators. When WaMu investigators went back to Montebello, they verified “the
elements of fraud found by AIG.”
Still, WaMu’s top brass did nothing to root out the fraud or penalize its perpetrators, according to an investigation by the Senate Permanent Subcommittee on Investigations.

In fact, just the opposite happened.
WaMu’s leaders showered Fragoso and Ramirez with accolades, despite the fraudulent loans linked to them by WaMu’s investigators. Fragoso and Ramirez were not only paid handsomely, they were given WaMu’s highest corporate honor, year after year, from 2004 to 2007—selection to the bank’s highly touted President’s Club. This gave them all-expenses-paid first-class trips to Hawaii, private suites at a swanky hotel, and a cornucopia of valuable gifts as well as personal praise from CEO Kerry Killinger and home loans president David Schneider.

By many accounts, this kind of
insider fraud was pervasive. Fannie Mae, the quasi-governmental guarantor of many mortgage loans, was getting fraud warnings about the mortgage industry as early as 2003.
The FBI first publicly warned of mounting fraud in 2004—and that was only reported fraud; most fraud went unreported. Once the bubble burst, insiders such as Richard Bitner, a wholesale mortgage lender in Texas, disclosed that
fraud was epidemic because the financial temptations were so immense.

“The level of fraud we experienced as a lender … was unprecedented,” Bitner told the Financial Crisis Inquiry Commission. “In
my firm’s experience, between the years of 2003 to 2005,
more than 70 percent
of all brokered loan files that were submitted for initial review were somehow
deceptive, fraudulent or misleading
[emphasis added].”

The problem was not individual bad apples, but a system run amok, according to University of Missouri’s William Black, executive director of the Institute for Fraud Prevention. Most liars’ loans, Black reported, were generated by bank insiders using false information to get loan applications approved. “They had these sessions where they would rework the applications—what in the trade were called ‘
arts and crafts weekends,’ where they would cut out the bad numbers and paste in the good numbers to hit the needed ratios [to qualify borrowers for loans]. They actually kept the original numbers, so that we know that the lies came from loan officers and brokers.”

Come 2006, even the Mortgage Bankers Association admitted that “stated income and reduced documentation loans … are
open invitations to fraudsters.” In November 2007, the Fitch bond-rating agency bucked the silence in the bond-rating industry that consistently gave mortgage bond pools AAA ratings and notified its clients that when it checked loan records in detail, “there was the appearance of
fraud or misrepresentation in almost every file
[emphasis added].”

Most of Wall Street, as well as two Fed chairmen, Alan Greenspan and Ben Bernanke, failed to anticipate the pathological danger in the stream of toxic loans flowing into America’s financial system. But a handful of hedge fund mavericks saw disaster coming. They realized that if millions of poor-credit-risk borrowers were sold 2/28 subprime loans in 2004, 2005, and 2006, then two years later, when their low teaser rates ran out and their monthly payments ballooned, they would default en masse. This would bust the secondary mortgage
market. So they bought insurance on mortgage bonds, in the form of credit default swaps, and cashed in big-time when the market collapsed.

Hedge fund managers such as John Paulson, Mike Burry of Scion Fund, and Steve Eisman of FrontPoint Partners made a mint betting against the flimsy promise of home ownership for virtually everyone. Eventually, traders at Goldman Sachs smelled blood in the water and made a killing, too.

For the most devious minds on Wall Street,
Long Beach Mortgage loans were attractive precisely because they were so unreliable. They figured prominently in Goldman’s high-profile mortgage loan pool, the $2 billion Abacus 2007–AC1, for which Goldman was fined $550 million by the SEC.
Goldman was accused of duplicity by regulators for failing to disclose to investors that Abacus 2007–AC1 had been put together by John Paulson, who had designed the loan package to fail.
Paulson had included six Long Beach Mortgage loan trusts. By betting against such loan pools, Paulson & Company made $15 billion in 2007, and Paulson himself made $4 billion.

Goldman Sachs, too, bet against Abacus 2007–AC1 after selling it to investors such as the Royal Bank of Scotland, IKB Deutsche Industriebank, and the Dutch bank ABN Amro, which lost huge sums.
Goldman’s double-dealing caused an uproar among investment experts. “The simultaneous selling of securities to customers and shorting them because they believed they were going to default,” said Sylvain R. Raynes of R&R Consulting, “is the most cynical use of credit information that I have ever seen.”

In a highly publicized resignation from Goldman Sachs in March 2012, Greg Smith, a veteran of twelve years in Goldman’s derivatives business, claimed that disregard for client interests had become the norm at Goldman. “
It makes me ill how callously people still talk about ripping off clients,” Smith wrote in an op-ed in
The New York Times
. “To put the problem in the simplest terms, the interests of the client continue to be sidelined in the way the firm operates and thinks about making money.” Smith charged Goldman CEO Lloyd C. Blankfein with overseeing “the decline in the firm’s moral fiber”
and urged the firm’s leaders to restore Goldman’s integrity by “weed[ing] out the morally bankrupt people, no matter how much money they make for the firm.”
Goldman executives took issue with Smith, saying that his version did not accurately reflect how Goldman treats its clients.