All The Devils Are Here: Unmasking the Men Who Bankrupted the World (19 page)

In 2000, Famco declared bankruptcy. A jury later found that the company had systematically defrauded borrowers. Lehman was found guilty of “aiding and abetting the fraudulent scheme.” But the firm’s punishment—a $5 million fine—was negligible. This was market discipline? Good practices driving bad ones out? It was just the opposite: bad practices were driving out the
good ones. In the mortgage industry at least, Greenspan’s beloved theory was being blown to smithereens on a daily basis. And still he refused to do anything.

Actually, that wasn’t quite true. In the spring of 2000, Greenspan announced the formation of a nine-agency task force, including all the bank supervisors, to look into predatory lending. By then, the complaints and lawsuits had become so numerous that Washington officials could scarcely keep ignoring them. The Senate had held hearings. Three prominent senators, including Paul Sarbanes, the ranking Democrat on the Senate banking committee, introduced bills to ban predatory lending. The Treasury Department and HUD put together a National Predatory Lending Task Force. Its conclusion in a 2000 report: “Treasury and HUD believe that new legislation and new regulation are both essential.” The Federal Trade Commission started bringing cases.

Sarbanes, for one, knew the terrible damage predatory loans could do; Baltimore, in his home state of Maryland, had been hit hard by rising foreclosures, many of them the result of subprime lending abuses. But the chairman of the Senate banking committee, Phil Gramm, opposed any move to regulate subprime lending. His staff at the Senate banking committee issued a report saying that it made no sense to regulate predatory lending practices because it was impossible even to say what predatory lending was. To do otherwise, the report said, “threatens to subject those regulated to the abuses of arbitrary and capricious governmental action at worst.”

For that matter, Greenspan’s task force was more a sop to Congress than a serious effort to grapple with the problem. Actions mattered more than words, and Greenspan didn’t act. The Fed’s preferable solution seemed to be more disclosure, so that borrowers could better understand the terms of their loans and make informed decisions. More disclosure appealed to his libertarian instincts. But as everyone in the mortgage business knew, increased disclosure had done virtually nothing to stamp out lender abuses. Over the years, there had been numerous disclosure requirements added to the law. Yet to the average home buyer, mortgage documents remained largely incomprehensible. “I don’t think there is such a thing as a real sophisticated borrower,” Bill Dallas, who founded a subprime company called First Franklin in the 1970s, told the
American Banker
in 1998. “Basically they put their lives in the hands of originators, and we guide them.” Phil Lehman, an
assistant attorney general in North Carolina, described disclosure statutes to Fed officials in 2000 as “the last refuge of scoundrels.”

One thing the Federal Reserve was required to do under the 1994 HOEPA law was hold hearings from time to time, to gain an understanding of the latest problems in the lending industry. In 2000, it held a series of HOEPA hearings in San Francisco, Charlotte, Boston, and Chicago. For anyone trying to understand why regulators were having so much trouble dealing with predatory lending, these hearings were an illumination.

The man who chaired them was Edward Gramlich, a Federal Reserve governor. Ned Gramlich was an unusual Fed governor. Despite a stint as a Fed research economist decades earlier, he had not spent his career steeped in the intricacies of monetary policy. Public policy was his passion. He was the author of a highly respected textbook on cost-benefit analysis. Before being named to the Fed board of governors, Gramlich had been a professor at the University of Michigan, where he taught economics and public policy. He was a bighearted, self-effacing man, much beloved inside the Federal Reserve building.

Not long after his arrival at the Fed in 1997, Gramlich was asked by Greenspan to head up the Fed’s committee on consumer and community affairs. This was not a prestigious post for a Fed governor, and Gramlich knew very little about the subject. But he dove in eagerly, becoming one of the country’s leading experts on the subprime business—and one of its leading critics. In 2007, Gramlich wrote a short book entitled
Subprime Mortgages: America’s Latest Boom and Bust
. “In the subprime market,” he wrote, “where we badly need supervision, a majority of loans are made with very little supervision. It is like a city with a murder law, but no cops on the beat.”

Gramlich, however, was not temperamentally suited to be the cop on the beat. As the hearings opened, he explained that the purpose was to see whether the HOEPA regulations should be tightened to force lenders to “consider the consumer’s ability to pay.” Given what would happen—indeed, given what was
already
happening—it would be hard to think of a more important line of inquiry. Yet Gramlich’s questions weren’t so much answered as they were parried. And he was too gentle a soul to push back.

One of the people testifying that day, for instance, was Sandor Samuels, the chief legal counsel for Countrywide. He objected to the idea that borrowers should be required to disclose their income—something you would think lenders would want to know before making a six-figure loan. “Let me just say, very briefly, that we think this is a very dangerous area to get into,” Samuels replied when asked about income disclosure. “Because the reality is
that, in many communities, including many minority communities and immigrant communities, sometimes it’s difficult to document income.”

Gramlich: “The obvious question is: If you can’t document the income, how … do you know they can pay the loan back?”

Samuels: “Right. And I would say that there are certain reality checks, let’s just say … if a waiter in a restaurant puts down that he or she is making three hundred thousand dollars a year, we’re going to ask what kind of restaurant they’re working at.”

Around and around they went. Every objection the Fed panel brought up to a subprime practice got the same response: cracking down would mean denying worthy borrowers the opportunity to own a home. Finally, Gramlich asked Samuels for his advice on the best way to keep predatory lending practices in check. “We believe increased competition is the key,” Samuels replied, echoing Greenspan. Wall Street simply wouldn’t buy bad loans in bulk. Wall Street, of course, was already doing precisely that.

Gramlich ended the hearings by more or less throwing up his hands. “There are many practices that might be good most of the time, but end in abuse some of the time, so it’s difficult to simply ban practices,” he said. Should the government try to discourage house flipping? If it did that, it might also prevent people from taking advantage of falling interest rates. Should it forbid balloon payments? For certain borrowers, a balloon payment might make sense. And on and on. The hearings didn’t so much end as they sputtered, ignominiously, to a close.

There came a moment—it’s not clear exactly when—when Ned Gramlich went to see Alan Greenspan. He wanted the Fed to take a more active role in policing the subprime business. And he had a specific policy idea. According to the
Wall Street Journal
, Gramlich thought the Fed should “use its discretionary authority to send examiners into the offices of consumer finance lenders that were units of Fed-regulated bank holding companies.” (The GAO recommended the same thing, but the Fed had formally adopted a policy of not conducting such exams in early 1998.) Such companies were major subprime lenders. Gramlich had toyed with idea of placing his proposal in front of the entire seven-member Fed board. But he decided to see Greenspan privately so as not to put the Fed chairman in an awkward spot in front of the other Fed governors.

The details of that meeting have never emerged. Gramlich died of cancer in 2007, at the age of sixty-eight. Greenspan told the
Wall Street Journal
that he didn’t remember much about the conversation, but it was certainly not a heated discussion. Gramlich presented his idea; Greenspan turned it aside. “He was opposed to it, so I didn’t pursue it,” Gramlich told the
Journal
three months before his death. He, too, proffered few details.

Yet that meeting would later become a touchstone for Greenspan’s critics. It was proof, they would say, that the Fed chairman wouldn’t take on the subprime lenders—or the larger problem of too many people getting loans they could never repay—even when asked to do so by a fellow Fed governor. And they were right. But Gramlich’s unwillingness to push Greenspan any further than the Fed chairman was willing to be pushed made it easy for Greenspan to ignore him. Shamefully, Greenspan would later publicly blame
Gramlich
for failing to bring the issue to the board, which, as he surely knew, Gramlich had done to save Greenspan from embarrassment.

Not long before he died, Gramlich, upset at the criticism Greenspan was starting to receive, penned a note to his old boss. “What happened was a small incident,” he wrote, “and as I think you know, if I had felt that strongly at the time, I would have made a bigger stink.” But he hadn’t made a stink. That was the point. Making a stink was simply not how Gramlich led his life, even with something that mattered to him as much as subprime lending.

Josh Rosner had also begun complaining to the Fed about subprime mortgages. By 2000, he had left his job at a mainstream Wall Street investment bank and joined a small independent research firm. Once a huge believer in the new subprime companies, he had become deeply critical of them. Companies he had invested his clients’ money in had gone out of business. He had watched the lawsuits pile up over their seamy business practices. “I unintentionally helped kill my clients,” he says today. “I was so dispirited.”

Rosner had a foreboding that went well beyond that of most subprime critics. Gramlich worried about subprime lending because it took advantage of unsophisticated buyers and often cost people their homes. But Rosner saw that the delinking of borrower and lender could have more far-reaching consequences. Well connected in Washington, he began showing up at the Fed to express his concern. Fed officials would respond by saying that it wasn’t their job to determine who should or shouldn’t get a mortgage. “I’d say, but it
is
the Fed’s job to ensure that the system is stable,” Rosner recalls.

There were two essential reasons for Rosner’s fears. The first was that his
close reading of the data showed that most of this frenetic mortgage lending really had nothing to do with getting people into homes, since the vast majority of subprime loans were refinancings. That was true of the prime market as well. He calculated that the dollar volume of refinancings during the 1990s was $3.4 trillion, more than the entire volume of mortgage origination in the 1980s! A little-noticed Freddie Mac study noted that more than 75 percent of homeowners who refinanced in the last three months of 2000 had taken out mortgages at least 5 percent higher than the ones they retired. They were using their homes as piggy banks. “Refinancing offers the potential to increase the absolute debt burden of the average U.S. household without materially reducing other consumer debts,” Rosner wrote at the time. Surely, he thought, all this additional consumer debt was likely to end badly.

The second reason for Rosner’s fears was that he could also see from the data that fewer and fewer home buyers were putting down 20 percent, which had long been the standard to get a mortgage. By 1999, in fact, more than 50 percent of mortgages had down payments of less than 10 percent. Angelo Mozilo, who was becoming an increasingly prominent figure in the mortgage industry, believed passionately that big down payments prevented otherwise capable borrowers from being able to own a home. For much of his career, he had fought to be able to originate mortgages with little or no down payments. And mostly, he had won. Wall Street now regularly securitized loans with down payments of 10 percent or less, and even Fannie and Freddie were allowed to buy low-down-payment mortgages (although they required a private insurer to absorb some of the risk). But Rosner picked up on yet another little-noticed study, this one by Fannie Mae, showing that low-down-payment loans triggered greater losses. “Put simply, a homeowner with little or no equity has little or no reason to maintain his/her obligations,” Rosner wrote. Having equity in one’s home was much more than a barrier keeping people from buying a home, he came to believe. It was the key to homeownership. Down payments, more than any single thing, meant that you were a homeowner.

On June 29, 2001, Rosner published a research piece that summed up his thinking, entitled, “A Home without Equity Is Just a Rental with Debt.” No one seemed to take much notice. He was working from home one day when the phone rang. On the other end was an elderly man. “I just read your paper and want to discuss it with you, but I can’t hear very well on the phone,” he said. “Would you be able to sit down with me in person?”