All The Devils Are Here: Unmasking the Men Who Bankrupted the World (18 page)

To compound matters, the subprime mortgage companies began taking unexpected write-downs. It had long been common industry practice for the subprime companies selling loans to Wall Street to keep what were called the residuals. These were the riskiest pieces of the securities, the ones that nobody else wanted; most of the time, they were the ones that came with the highest prepayment risk. Accounting rules required the companies to estimate the future value of the cash flows and book them as upfront profits, which they did very aggressively. But as more companies entered the business, they began to poach from each other by refinancing borrowers’ mortgages. More refinancings meant more people prepaying their mortgages—crushing the already overvalued residuals. As one subprime originator after another took big write-downs on their residuals, years of supposed profits were erased. Josh Rosner, who was then an analyst at Oppenheimer Securities, had played
a hand in taking many of these companies public. “They were all liars,” he says now.

Spooked by the write-downs, Wall Street began to pull the plug on the subprime machine, withdrawing the warehouse loans that had been its lifeblood. One after another, the companies went bankrupt. Much of their supposed profit turned out to be illusory. One company, FirstPlus, had reported $86 million in earnings in the first nine months of 1997, but had eaten through $994 million in cash and had had to raise a stunning $1 billion in Wall Street financings, according to a presentation given by hedge fund manager Jim Chanos. Those were the kinds of “results” that can exist only in a bubble. In 2000, First Union shut down the Money Store, the subprime lender it had bought just two years earlier for $2.1 billion. “At the end of the day, we’re saying we made a bad acquisition,” First Union CEO G. Kennedy Thompson told the
New York Times
.

Along with the bankruptcies came a wave of lawsuits and complaints from consumer advocates, who accused the subprime industry of engaging in predatory lending. Customers, they said, had been gulled into taking on expensive mortgages—and paying exorbitant fees—by unscrupulous lenders. Many subprime refinancings replaced simple, affordable thirty-year fixed mortgages. “We and others were saying to the Fed, state legislators, anyone who would listen in D.C., that lending was getting out of control,” says Kevin Stein, the associate director of the California Reinvestment Coalition.

Even back then, there was a legitimate debate over who ultimately was more culpable: the lender or the borrower. After all, borrowers often wanted to get their hands on the money every bit as much as lenders wanted to give it to them. Not everyone was being gulled; many borrowers were using the rising values of their homes to live beyond their means. And there were plenty of speculators, betting that they could outrun their mortgage payments by flipping the house quickly. The line between predatory lending and get-rich-quick speculating—or a desperate desire for cash—was often difficult to discern.

But in the larger scheme of things, did it really matter who was at fault? The key point was this:
A lot of people were getting loans they couldn’t pay back
. Wasn’t
that
the real problem?

Prior to securitization, lenders had to care about the creditworthiness of borrowers. They held the loans on their books, and if a borrower defaulted, they took the hit. That’s why borrowers who didn’t have much money couldn’t get mortgages: lenders were afraid they would default. Securitization severed
that critical link between borrower and lender. Once a lender sold a mortgage to Wall Street, repayment became someone else’s problem. The potential consequences of this shift were profound: sound loans are at the heart of a sound banking system. Unsound loans are the surest route to disaster. But at the time, almost no one seemed to realize that the wave of poorly underwritten loans that securitization seemed to encourage was a monstrous red flag.

The subprime business back then was still relatively small. The collapse of dozens of subprime companies didn’t remotely threaten the banking system. It didn’t have much of an effect on the housing market, either. But it was still significant. For the bank regulators charged with ensuring that the banking system remain sound, this was the canary-in-the-coal-mine moment, the signal that something was seriously wrong.

Or rather, it should have been.

In Alan Greenspan’s memoir,
The Age of Turbulence
, a five-hundred-plus-page tome published the year before the financial crisis, the phrases “subprime mortgage” and “predatory lending” don’t merit so much as a mention. Greenspan’s book is a triumphant account of his eighteen and a half years as Fed chairman—years during which, by his account, he put out economic crises, kept inflation under control, and deftly manipulated interest rates to ensure that the economy hummed and the markets rose. Before the financial crisis tarnished his reputation, Greenspan’s self-image—Fed chairman as economic Superman—was widely shared. Congressmen fell all over themselves to praise him when he made his semiannual appearances on Capitol Hill. His interest rate decisions were invariably lauded. Many economists viewed him as the greatest Fed chairman ever, even greater than Paul Volcker, who had tamed the raging inflation of the 1970s. The small handful of favored journalists who had off-the-record access to Greenspan regurgitated his pronouncements as if they had been handed down by the Oracle of Delphi. To many people, Greenspan
was
the Oracle of Delphi.

Although the country was understandably fixated on Greenspan’s handling of monetary policy, the Fed had always had other roles, too. It had supervisory authority over the big bank holding companies. It was supposed to be the guardian of the “safety and soundness” of the banking system. It even had a Division of Consumer and Community Affairs, to look after the interests
of bank customers. The Fed, in other words, was a regulator. Greenspan, however, was not.

As a young economist, Greenspan had come under the spell of Ayn Rand, the author of
The Fountainhead
and
Atlas Shrugged
, two of the most influential odes to capitalism ever written. The capitalism Rand believed in was “full, pure, unregulated, laissez-faire capitalism,” as she once put it, the kind that didn’t put regulatory roadblocks in the way of red-blooded entrepreneurs. Greenspan met Rand in the early 1950s, became part of her inner circle, and remained close to her until she died in 1982.

A conservative economist like Greenspan is always going to tilt against regulation. But Rand gave his leaning a philosophical underpinning and helped turn him into a true free-market absolutist. He came to believe that regulation always had unforeseen negative consequences, and that the market itself was far better at embracing the good and driving out the bad than any well-meaning government mandate. That’s what he meant by market discipline.

Greenspan’s antiregulatory philosophy did not prevent him from working for the government, however. As an adviser to Richard Nixon’s presidential campaign in 1968, he reasoned that it was better “to advance free-market capitalism from the inside, rather than as a critical pamphleteer,” he says in
The Age of Turbulence
. In 1974, President Ford asked Greenspan to become the chairman of the president’s Council of Economic Advisers. “I knew I would have to pledge to uphold not only the Constitution but also the laws of the land, many of which I thought were wrong,” he writes. (He concludes, “Compromise on public issues is the price of civilization, not an abrogation of principle.”)

When he was nominated to be Fed chairman, Greenspan took the job knowing that he was “an outlier in [his] libertarian opposition to most regulation.” Therefore, he says, his plan was to focus on monetary policy and let other Fed governors take the lead on regulatory matters. That’s not really how it played out, however. Greenspan was too dominating a presence, and his views were too well known. Fed economists who believed in the superiority of market discipline tended to do well in Greenspan’s Fed; those who didn’t languished.

There is no question, looking back, that Greenspan’s Federal Reserve could have taken steps to cure the growing problems with subprime lending before they got worse. It had the authority. There was a law on the books called the Home Ownership and Equity Protection Act, or HOEPA, that gave the
Federal Reserve the power to flatly prohibit mortgage lending practices that it concluded were unfair or deceptive—or designed to evade HOEPA. “The Federal Reserve [has] ample authority to encompass all types of mortgage loans within the scope of any regulation it promulgates,” wrote Raymond Natter, a lawyer who had worked on the bill when he was on the staff of the Senate banking committee.

There is also no question that the problems with subprime lending weren’t a secret. After the crisis of 2008, a common refrain arose that no one saw it coming. But that was never true. State attorneys general had filed lawsuits. Housing advocates had continually beaten the tom-toms. Repeatedly and in graphic detail, Congress and the regulators—including Greenspan—had been told what was happening on the ground.

Robert Gnaizda, then the general counsel of the Greenlining Institute, which, among other things, advocates for consumer protections for people of diverse backgrounds, started meeting with the Fed chairman in the early 1990s. He raised the problem of the many mortgage originators that existed outside the banking system and were unsupervised by any federal agency. “We won’t argue about whether federal regulators are doing a good job,” Gnaizda says he told Greenspan. “Let’s look at the unregulated lenders.”

“He had no objections other than saying he wouldn’t do anything,” Gnaizda says now. “He was very gracious and polite, but there was also an imperious quality to him.”

A few years later, Gnaizda and John Gamboa, Greenlining’s executive director, met with Greenspan again. In advance of the meeting, Gnaizda had sent the Fed a pile of loan documents, which Greenspan had read. “Even if you had a doctorate in math, you wouldn’t understand these instruments and their implications,” Greenspan acknowledged during the meeting. The Fed chairman had just given a speech in which he had famously recommended adjustable-rate mortgages. Gamboa asked Greenspan if he had an adjustable-rate mortgage. “No,” replied Greenspan. “I like certainty.”

John Taylor, of the National Community Reinvestment Coalition, was another housing activist who used to meet with the Fed. “Their response was that the market would correct any problems,” Taylor says. “Greenspan in particular believed that the market would not produce, and investment banks would not buy, loans that did not make sense. He genuinely believed that.”

But anyone who knew anything about the subprime business could see that wasn’t true. A prototypical example was First Alliance Mortgage Company,
or Famco. A star of the early subprime scene, Famco went public in 1996, allowing its founder and his wife to take $135 million out of the company. Within two years, however, its abuses had become so widespread, and so well known, that several state attorneys sued to force the company to stop.

Famco’s abuses were not the result of a few bad apples; they were baked into the company’s business model. As former loan officer Greg Walling explained in an affidavit, Famco recruited top auto salesmen who knew nothing about mortgages and had them memorize something called the “Track,” which was a how-to for the hard sell. They were taught never to tell customers that a teaser rate meant their interest rate would increase. They were never to divulge the actual principal amount of the loan; if they did, the customers would be able to see the enormous fees that Famco had tacked on. The sales force, meanwhile, was highly motivated to charge the highest fees it could get away with: big commissions kicked in when the fees exceeded fifteen points. According to the Massachusetts lawsuit, an incredible 35 percent of Famco mortgages in Massachusetts had fees over 20 percent.

Did Wall Street know what was going on? You bet it did. Famco
told
its investors that most of its subprime loans went to people with relatively good credit—which meant borrowers were essentially being ripped off, since they didn’t need to pay a big fee to get a good rate. In 1995, Eric Hibbert, a Lehman Brothers executive, wrote a memo, later obtained by both the
Wall Street Journal
and the
New York Times
, describing Famco as a “sweat shop” specializing in “high-pressure sales for people who are in a weak state.” He added, “It is a requirement to leave your ethics at the door.”

Did Lehman Brothers then decide it couldn’t do business with a company as sleazy as Famco? Of course not. Starting in 1998—the same year the states filed suit—Lehman gave Famco a warehouse line of $150 million and helped it sell $400 million in mortgage-backed securities, according to one lawsuit. The shoddy quality of the loans seems to have been as much of a nonissue for Lehman as it was for Famco; since Wall Street was just passing the loans along to investors, it didn’t have to care whether the money would be paid back, either.