The Greatest Trade Ever (7 page)

By the summer of 2000, household borrowing stood at $6.5 trillion, up almost 60 percent in five years. The average U.S. household sported thirteen credit or charge cards and carried $7,500 in credit-card balances, up from $3,000 a decade earlier.
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Americans borrowed more in part because there was more money to borrow. Thanks to Wall Street’s 1977 invention of “securitization,” or the bundling of loans into debt securities, lenders could sell their loans to investors, take the proceeds, and use them to make even more loans to consumers and companies alike. Thousands of loans ended up in these debt securities. So if a few of them went sour, it might have only a minor effect on investors who bought the securities, so the thinking went.

The shift in attitude toward debt gave life to the real estate market.
More than most nations, the United States worked at getting as many people in their own homes as possible. Academic data demonstrated that private-home ownership brought all kinds of positive benefits to neighborhoods, such as reduced crime and rising academic achievements. The government made the interest on mortgage payments tax deductible, and pressure on Congress from vested interests in the real estate business kept it that way; other benefits doled out to home sellers and buyers became equally sacred cows.

Low-income consumers and those with poor credit histories who once had difficulty borrowing money found it easier, even before Alan Greenspan and the Federal Reserve started slashing interest rates. In 2000, more than $160 billion of mortgage loans were outstanding to “subprime” borrowers, a euphemistic phrase invented by lenders to describe those with credit below the top “prime” grade. That figure represented more than 11 percent of all mortgages, up from just 4 percent in 1993, according to the Mortgage Bankers Association.

Low borrower rates helped send home prices higher after the 2001 attacks. Until 2003, the climb in prices made a good deal of sense, given that the economy was resilient, immigration strong, unemployment low, and tracts of land for development increasingly limited.

Then things went overboard, as America’s raging love affair with the home turned unhealthy. Those on the left and right of the political spectrum have their favorite targets of blame for the mess, as if it was a traditional Whodunit. But like a modern version of Agatha Christie’s
Murder on the Orient Express
, guilt for the most painful economic collapse of modern times is shared by a long cast of sometimes unsavory characters. Ample amounts of chicanery, collusion, naiveté, downright stupidity, and old-fashioned greed compounded the damage.

A
S HOME PRICES SURGED
, banks and mortgage-finance companies, enjoying historic growth and eager for new profits, felt comfortable dropping their standards, lending more money on easier terms to higher-risk borrowers. If they ran into problems, a refinancing could always lower their mortgage rate, lenders figured.

After 2001, lenders competed to introduce an array of aggressive loans, as if they were rolling out an all-you-can-eat buffet to a casino full of hungry gamblers. There were interest-only loans for those who wanted to pay only the interest portion of a loan and push off principal payments. Ever-popular adjustable-rate mortgages featured superslim teaser rates that eventually rose. Piggyback loans provided financing to those who couldn’t come up with a down payment.

Borrowers hungry for riskier fare could find mortgages requiring no down payments at all, or loans that were 25 percent larger than the cost of their home itself, providing extra cash for a deserved vacation at the end of the difficult home-bidding process. “Liar loans” were based on stated income, not stuffy pay stubs or bank statements, while “ninja” loans were for those with no income, no job, and no assets. Feel like skipping a monthly payment? Just use a “payment-option” mortgage.

By 2005, 24 percent of all mortgages were done without any down payments at all, up from 3 percent in 2001. More than 40 percent of loans had limited documentation, up from 27 percent. A full 12 percent of mortgages had no down payments
and
limited documentation, up from 1 percent in 2001.

For those already in homes, lenders urged them to borrow against their equity, as if their homes were automated-teller machines. Citigroup told its customers to “live richly,” arguing that a home could be “the ticket” to whatever “your heart desires.”

“Calling it a ‘second mortgage,’ that’s like hocking your house,” said Pei-Yuan Chia, a former vice chairman at Citicorp who oversaw the bank’s consumer business in the 1980s and 1990s. “But call it ‘equity access,’ and it sounds more innocent.”
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As lenders began exhausting the pool of blue-chip borrowers, they courted those with more scuffed credit. Ameriquest, which focused on loans to subprime borrowers, ran a suggestive ad in the 2004 Super Bowl showing a woman on a man’s lap after an airplane hit sudden turbulence, saying “Don’t Judge Too Quickly … We Won’t.”

Head-turning growth at Ameriquest, New Century Financial, and other firms focused on these subprime borrowers put pressure on traditional lenders to offer more flexible products of their own. Countrywide
Financial Corp.’s chairman, Angelo Mozilo, initially decried the lowered lending standards of other banks—until his company began to embrace the practices of the upstarts.

During the 1980s, Mozilo, a forceful executive and gifted salesman born to a butcher in the Bronx, taught employees how to sell mortgages quickly and efficiently, focusing on plain-vanilla, fixed-rate loans. The banking establishment didn’t give Mozilo and his California operation much of a chance, but by the early 2000s, profits were soaring, and the company was the largest mortgage lender in the country.

Mozilo didn’t so much run Countrywide Financial as rule over it. Rivals called him “The Sun God,” both for how his employees seemed to worship him as well as for his deep, permanent tan. Mozilo drove several Rolls-Royces, often in shades of gold, and paid his executives hundreds of thousands of dollars. Mozilo’s shiny white teeth, pinstriped suits, and bravado helped him both stand out and send a message: He was going to shake up the staid industry.

By 2004, competitors were biting at Mozilo’s heels, and Countrywide began to adjust its conservative stance, pushing adjustable-rate, subprime mortgages, and other “affordability products.” ARMs were 49 percent of its business that year, up from 18 percent in 2003, while subprime loans were 11 percent, up from less than 5 percent.
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Mozilo said down payments should be eliminated so more people could buy homes, “the only way we can have a better society.” He called down payments “nonsense” because “it’s often not their money anyway.”
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Mozilo was merely reacting to executives like Brad Morrice. In the early 1990s, Morrice worked at a mortgage lender in Southern California, watching housing prices in the region swing violently. In 1995, Morrice, along with two partners, pulled together $3 million to form New Century, a lender focused on borrowers with poor credit sometimes ignored by major lenders. They chose a name that seemed to foreshadow big changes on the way for the nation.

The New Century offer: People with bad credit could get loans to buy a home, albeit at much higher rates than those offered to borrowers with pristine credit. To limit their risks, New Century’s executives had the good sense to sell their loans to investors attracted to the hefty interest
rates. It was a blueprint followed by rival lenders. Orange County in Southern California quickly became the epicenter of subprime lending.

Morrice and his partners took New Century public in 1997, just as the housing market began to heat up. New Century, which billed itself as “a new shade of blue chip,” reached out to independent mortgage-brokerage firms around the country, often tiny, local outfits that found customers, advised them on which types of loans were available, and collected fees for handling the initial processing of the mortgages. Brokers favored lenders like New Century that made loans quickly, and didn’t always insist on the most accurate appraisals.

A revolution in home buying was under way: The same borrowers who once saw banks turn up their noses at them now found it easy to borrow money for a home. With immigrants rushing into Southern California, and those with heavy debt or limited or dented credit history trying to keep up with rising home prices, Morrice and his partners enjoyed a gold rush.

As profits rolled in, New Century’s executives chose a black-glass tower in Irvine, California, as their headquarters, and treated their sales force of two thousand to chartered cruises in the Bahamas. Later, they held a bash in a train station in Barcelona and offered top mortgage producers trips to a Porsche driving school. A “culture of excess” was created, says a former computer specialist at the company.

Lenders like New Century relaxed their lending standards, a sharp break with past norms in the business. Regulators gave New Century and its rivals leeway, and New Century became the nation’s second-largest subprime lender, competing head-to-head with older rivals like Countrywide and HSBC Holdings PLC. Wall Street was impressed; David Einhorn, a hedge-fund investor with a stellar record, became a big shareholder and joined the company’s board of directors.

By 2005, almost 30 percent of New Century’s loans were interest-only, requiring borrowers to initially pay only the interest part of the mortgage, rather than principal plus interest. But such loans exposed borrowers to drastic payment hikes when the principal came due. Moreover, more than 40 percent of New Century’s mortgages were based on the borrowers’ stated income, with no documentation required.

Some employees, like Karen Waheed, began having qualms about whether customers would be able to make their payments. She worried that some colleagues weren’t following the company’s rule that borrowers had to have at least $1,000 in income left over each month, after paying the mortgage and taxes.

“It got to a point where I literally got sick to my stomach,” she recalls. “Every day I got home and would think to myself, I helped set someone up for failure.”
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By 2005, “nonprime” mortgages made up nearly 25 percent of loans in the country, up from 1 percent a decade earlier. One-third of new mortgages and home-equity loans were interest-only, up from less than 1 percent in 2000, while 43 percent of first-time home buyers put no money down at all.

Rather than rein it all in, regulators gave the market encouragement, thrilled that a record 69 percent of Americans owned their own homes, up from 64 percent a decade earlier. In a 2004 speech, Federal Reserve chairman Alan Greenspan said that borrowers would benefit from using adjustable-rate mortgages, which had seemed risky to some, and were a type of loan the Bank of England was campaigning against. Greenspan clarified his comments eight days later, saying he wasn’t disparaging more conservative, fixed-rate mortgages, but his comments were interpreted as a sign that he was unconcerned with the housing market. In the fall of 2004, Greenspan told an annual convention of community bankers that “a national severe price distortion seems most unlikely.”

The Fed also chose not to crack down on the growing subprime-lending industry, even as some home loans were signed on the hoods of cars. In many states, electricians and beauticians were given more scrutiny and training than those hawking mortgages. Several years later, Greenspan said, “I did not forecast a significant decline because we had never had a significant decline in prices.”

Lenders ramped up their activity only because a pipeline of cash was pumping hard, dumping money right in front of their headquarters. The pipeline usually went through Wall Street. After New Century issued a mortgage, it was bundled together with other mortgages and sold to firms like Merrill Lynch, Morgan Stanley, and Lehman Brothers for
ready cash. New Century used the money to run its operations and make new loan commitments. The quasi-government companies Fannie Mae and Freddie Mac, pushing for growth, also became hungry for the high-interest mortgages from New Century and others, egged on by politicians pushing for wider home ownership.

“I believe there has been more alarm raised about potential unsafety and unsoundness than, in fact, exists.… I want to roll the dice a little bit more in this situation towards subsidized housing,” Massachusetts Democrat Barney Frank, then the ranking minority member of the House Financial Services Committee, said about Fannie Mae and Freddie Mac in September 2003. Sen. Charles Schumer (D-New York) expressed worries that restricting the big companies might “curtail Fannie and Freddie’s [affordable-housing] mission.”

By selling its loans to Fannie and Freddie, as well as to the ravenous Wall Street investment firms, companies like New Century didn’t need to worry much if they sometimes handed out mortgages that might not be repaid. Like playing hot potato, they quickly got them off their books. Checks and balances in the system were almost nonexistent. Home appraisers, for example, placed inflated values on homes, paving the way for the mortgage deals, knowing that if they didn’t play along, their competitors would.

Banks like Lehman Brothers were eager to buy as many mortgages as they could get their hands on because the game of hot potato usually didn’t stop with them. Wall Street used the mortgages as the raw material for a slew of “securitized” investments sold to investors. Indeed, one of the things the United States excelled at was slicing up mortgages and other loans into complex investments with esoteric names—such as mortgage-backed securities, collateralized-debt obligations, asset-backed commercial paper, and auction-rate securities—and selling them to Japanese pension plans, Swiss banks, British hedge funds, U.S. insurance companies, and others around the globe.

Though these instruments usually didn’t trade on public exchanges, and this booming world was foreign to most investors and home owners, the securitization process was less mysterious than it seemed.

Here’s how it worked: Wall Street firms set up investment structures to buy thousands of home mortgages or other kinds of debt; the regular payments on these loans provided revenue to these vehicles. The firms then sold interests in this pool of cash payments to investors, creating an investment for every taste. Though the loans in the pool might have an average annual interest rate of 7 percent, some investors might want a higher yield, say 9 percent. The Wall Street underwriter would sell that investor an interest in the cash pool with a 9 percent yield. In exchange for this higher rate, these investors would be at the most risk for losses if borrowers started missing their mortgage payments and the pool’s revenue was lower than expected. Moody’s or Standard & Poor’s might give this slice, or “tranche,” of the pool a BBB rating, or just a rung above the “junk” category.