Money and Power (87 page)

New Century, formed in 1995 by three entrepreneurs, ended its first full year in business, in 1996, with 300 employees and a “loan production” volume of $350 million. In 1997, the company went public. By 2003, the company employed 3,700 people and had originated some $27 billion in mortgage loans since its inception. By 2005, New Century employed 7,200 full-time employees and had originated some 310,389 mortgages with a face value of
$56.1 billion.

Many pages in Goldman’s GSAMP Trust 2006-S2 prospectus were given over to explaining New Century’s underwriting standards as a way, presumably, to give comfort to investors about the company’s rigor (and to try to be absolved of blame if things went sour). According to Goldman, New Century’s underwriting standards “are primarily intended to
assess the borrower’s ability to repay the related mortgage loan, to
assess the value of the mortgaged property and to evaluate the adequacy of the property as collateral for the mortgage loan. All of the mortgage loans were also underwritten with a view toward the resale of the mortgage loans in the secondary mortgage market. While New Century’s primary consideration in underwriting a mortgage loan is the value of the mortgaged property, New Century also considers, among other things, a mortgagor’s credit history, repayment ability and
debt-service-to-income ratio, as well as the type and use of the mortgaged property.”

The underwriting standards of the issuers of the mortgages—such as they were—was the first line of defense against borrowers’ failure to make their mortgage payments. The next level of supposed protection for investors in these mortgage-backed securities came from the ratings agencies—primarily Standard & Poor’s and
Moody’s—which were required to rate the securities being issued and in return
received fees from the underwriters such as Goldman Sachs and Lehman Brothers. The ratings agencies were careful to caveat their ratings with the idea that investors were aware that their ratings were just opinions about the likelihood that the principal and interest on the mortgages would be paid, not any kind of guarantee that they would be paid. “Ratings on mortgage-backed securities address the likelihood of receipt by security holders of all distributions on the
underlying mortgage loans or other assets,” the Goldman prospectus said. “These ratings address the structural, legal and issuer-related aspects associated with such securities, the nature of the underlying mortgage loans or other assets and the credit quality of the guarantor, if any.” But among the many voices raised during the crisis was that of
Jules Kroll, the founder of the eponymous financial investigation firm. He told
The New
Yorker,
in October 2009, that the ratings agencies’ arguments were deeply flawed. “Credit ratings turned out to be a false god,” he said, while also acknowledging that he planned to start a competing service. “People relied on those ratings. Now they’re saying, ‘Oh, we gave it a high rating but we were just expressing an opinion.’ And that’s bullshit. These structured instruments—why shouldn’t we be able
to rely on these ratings, as investors?”

In this particular case, there were ten
tranches of securities offered for sale—A1 to A3 (the senior tranches) and then M1 to M7 (the subordinated tranches)—each with different risk profiles and thus a different interest rate. (Often, Wall Street firms were forced to keep for themselves the even
riskier
tranches of these securities because they were so difficult to sell.) All three A classes were rated AAA by both S&P
and Moody’s, meaning the likelihood of default was supposed to be minimal. Only six companies in the
United States were rated AAA—
Johnson & Johnson,
ExxonMobil,
Berkshire Hathaway,
Automatic Data Processing,
Microsoft, and
Pfizer—in 2009. The fact that both credit-rating agencies had bestowed AAA ratings on
$505.6 million—or 72.4 percent—out of the total $698.4 million of the mortgage-backed securities Goldman was selling in April 2006 no doubt conveyed a level of security to investors that probably never existed, especially since investors did not do their own detailed due diligence on the underlying mortgages but rather instead just relied upon the Goldman imprimatur and that of the ratings agencies to make their investment decisions. (Goldman’s
similar behavior vis-à-vis the ratings agencies leading up to the Penn Central bankruptcy springs to mind; it’s déjà vu all over again, as Yogi Berra would say.)

By spring 2006, investors were probably not aware of the growing internal doubts of analysts at both S&P and
Moody’s about the mortgage-backed securities they were rating. For instance, at a weeklong housing conference, held on Amelia Island, Florida, in April 2005, two S&P credit analysts noted that the housing market seemed to be getting a little frothy and that the financial risks to the industry were ratcheting up as housing
prices skyrocketed and lending standards deteriorated. “Despite these risks,” explained
Ernestine Warner, a director in S&P’s residential mortgage-backed securities surveillance business, “there isn’t any performance information available on any of these products just yet because they are still very new to the market. Due to the time lag associated with delinquencies and losses in RMBS”—residential
mortgage-backed securities—“pools, and the nature of these risks, it will be several years before the product performance is tested.” The
Amelia Island conference followed
Paul Volcker’s speech at Stanford University, where he had observed that the growing risks in the housing market left him thinking that “we are skating on increasingly thin ice.”

In a January 19, 2006, paper S&P stated its belief “that there are increasing risks that may contribute to deteriorating credit quality in U.S. RMBS transactions; it is probable that these risks will be triggered in 2006.” Four months later, in April 2006—just after Goldman brought GSAMP Trust 2006-S2 to market—S&P announced it was updating its “mortgage analytic model,” and then on June 1, 2006, the firm put out a
research note that said that based on a study of the results from the new model, the “propensity of low
FICO borrowers to default was higher than we previously believed”—not exactly a shocking conclusion, but one that at least acknowledged a deteriorating credit and housing environment, not that many people had noticed.

As delinquencies and defaults on both subprime and so-called Alt-A
mortgages—made to those people with better credit than
subprime—ticked up heading into the fourth quarter of 2006, S&P’s own structured finance specialists began to worry. “Ratings agencies continue to create [an] even bigger monster—the CDO Market,” E. Christopher Meyer, an associate director in the Global CDO
Group at the firm, wrote in an e-mail to a colleague on the evening of December 15. “Let’s hope we are all wealthy and retired by the time this house of cards falters.” He then used an emoticon signifying a wink and a smile. Meyers’s colleague, Nicole Billick, responded to Meyer’s e-mail, in part, by writing that if he was right, then this “is a bigger nightmare that I do not want to think about right now.”

As S&P kept slapping investment-grade ratings on soon-to-be-shaky new issues, Raymond McDaniel Jr., the CEO of
Moody’s, S&P’s major competitor, held a series of town hall–style meetings for Moody’s professionals. At one, McDaniel told his managing directors about his perception of the growing problems in the mortgage market: “The purpose of this town hall is so that we can speak as candidly as
possible about what is going on in the subprime market. What happened was it was a slippery slope. What happened in 2004 and 2005 with respect to subordinated tranches is that our competition,
Fitch and S&P, went nuts. Everything was investment grade. It didn’t really matter. We tried to alert the market. I said we’re not rating it. This stuff isn’t investment grade. No one cared, because the machine just kept going.”

At S&P, meanwhile, the inmates seemed to be running the asylum, according to one text-message exchange between two analysts,
Rahul Dilip Shah and
Shannon Mooney, on April 5, 2007. “Btw, that deal is ridiculous,” Shah wrote to Mooney about some mortgage securities they were rating.

“I know, right … model def[initely] does not capture half the risk,” she replied.

“We should not be rating it,” he answered.

“We rate every deal,” Mooney replied. “It could be structured by cows and we would rate it.”

Answered Shah, “[B]ut there’s a lot of risk associated with it. I personally don’t feel comfy signing off as a committee member.”

In a little-known lecture, in
October 2008 at
Harvard University,
Lew Ranieri said he began to realize “in late 2005” that the markets for mortgage-backed securities had entered the “insanity” phase when homes were no longer being viewed as shelter but rather as a “new form of ATM machine” where home owners were borrowing larger and larger sums against their homes,
all the while hoping their value would continue
to increase. Ranieri reminded his Harvard audience—at the Graduate School of Design, no less—that not only could housing prices fall occasionally but also that interest rates had a habit of increasing after a period of historic lows. This double whammy is precisely what happened, of course, and it helped to precipitate the crisis. Ranieri, who had once aspired to be an Italian chef but was asthmatic and
could not breathe in a smoky kitchen, said of his financial baby that he had “wanted to make a lasagna but ended up with a bouillabaisse.”

——

I
N THE MONTHS
following Goldman’s March 2006 sale of the GSAMP securities, a U.S. affiliate of
Deutsche Bank, the large German bank—in its role as the trustee of the trust that held the mortgages—issued monthly reports about the performance of the underlying mortgages, essentially a running catalog of the interest and principal payments and whether or not they were being paid on time, if at all. At
first, not surprisingly, all went mostly well. In April 2006, 282 of the second mortgages were prepaid voluntarily, leaving a pool of 12,176 mortgages with an outstanding loan amount of $721.9 million. There were no
foreclosures by that date, but there was one troubling sign: after just one month, 362 of the mortgages were already delinquent on their payments by at least thirty-one days.

And then the deterioration began to accelerate. By the end of October 2006, some 799 of the mortgages, or 7.62 percent of the total number, valued at $50.8 million, or 8.3 percent of the total value, were at least thirty-one days delinquent in their payments. By the end of December 2006, 927 mortgages—worth $59.1 million, 10.2 percent of the total—were at least thirty-one days delinquent in their payments. Another 26 homes had been foreclosed
upon and another 75 of the borrowers were in bankruptcy proceedings. Some seven months after the mortgages were packaged up by Goldman and sold into the marketplace, 1,029, or 11.2 percent, of the loans were either delinquent, foreclosed upon, or subject to bankruptcy proceedings. The graph of the number of mortgages three months or more behind in their payments looked like a hockey stick and represented 10.3 percent of the total number of loans. By May 2009, according to the lawsuit
filed by an investor in GSAMP Trust 2006-S2 against Goldman Sachs (and others), some 12.25 percent of the underlying mortgages in the trust were delinquent. (A subsequent Goldman offering, GSAMP Trust 2006-S3, which followed S2 by only a couple of weeks, had an even worse performance, with some 18 percent of its mortgages in trouble after around nine months, even though the ratings agencies had rated some 73 percent AAA.) Within weeks of the December
update,
Deutsche Bank had filed a notice “of suspension of duty to file reports” and that was the end of the monthly reports.

By December 2006, not only had Goldman sold the GSAMP securities—and probably made around $10 million, and likely more, for its trouble (after selling the cakes in the bakery for more than the cost of the ingredients)—but the firm had also made a fundamental decision about the dangers that appeared to be lurking in the mortgage securities market: the time had come for Goldman to get out of the mortgage market.

B
y the middle of 2006, Josh Birnbaum, and his colleagues Swenny and
Deeb Salem, had been buying and selling the ABX index for some six months, mostly just on behalf of the firm’s clients. Birnbaum described this as, “A client says, ‘Where do you bid the index?’ and you give him the price. If he says, ‘Where are you going to sell the index?’ you give a price. Just try to buy as many at lower prices as the ones you sell. In other words, a classic Wall Street market-making model.” (Whatever they were doing seemed to be working. Birnbaum’s desk would make $288 million in the first quarter of 2007, compared with $163 million for the
full year
in 2006.)

By around June 2006, Birnbaum started to notice a rise in the number of borrowers becoming delinquent in their mortgages, thanks to the monthly reports filed publicly by the trustees of the mortgage-backed securities such as GSAMP-S2.
“There were some early cracks in the subprime market,” he said. “In terms of the early cracks, the way people were looking at stuff back then wasn’t in terms of losses but it was just the borrowers going delinquent.” Prior to that, he said, “many people had qualms and concerns about what was going on in mortgages—and specifically in mortgage credit—but they were more theoretical concerns than corroborated concerns.” Among the concerns being voiced were that borrowers were taking out mortgages they knew they were unlikely to repay, that they didn’t “have any skin in the game,” or that their down payments and
FICO scores were too low.

Hedge-fund manager
John Paulson was one of the first to start trading the ABX index aggressively in early 2006, consistent with his utterly bearish macro bet on the U.S. housing market. At first, he did the bulk of his trading through
Deutsche Bank. “He was a bit of an enigma to many people at that time,” Birnbaum said, “because he wasn’t anything close to the John Paulson we all know today.” In February or March, Paulson contacted Birnbaum’s desk at Goldman to inquire about trading the
index with Goldman as well. “It was one of these things where we get the call on the desk,” Birnbaum recalled, “and it’s Paulson. [People were wondering,] ‘Who is that? Who is this guy? What’s he doing?’ Most people had never met him before. Even the senior guys in the bank. We didn’t know what he was up to.”