All The Devils Are Here: Unmasking the Men Who Bankrupted the World (42 page)

A Senate investigation later concluded that during the drafting of the guidance, the OTS had argued for less stringent standards. It was very much in keeping with the turn the agency had taken. Under James Gilleran, the agency’s director from late 2001 to the spring of 2005, the OTS had shrunk disastrously: Gilleran chopped 20 percent of its staff in 2002. The OTS’s new goal, it said, was to “place emphasis on institutions, not the regulator, to ensure compliance with all existing laws, including consumer protection statutes.”

What’s more, the OTS was funded from fees paid by the thrifts themselves, based on their size. When Gilleran had taken the job, the OTS had been, as he later put it, “in a deficit financial position.” WaMu’s rapid growth, thanks to its exploding subprime business, meant that it was becoming an ever more important source of funds for its regulator. Between 2003 and 2008, for instance, WaMu’s fees represented 12 to 15 percent of the agency’s revenue, according to the Senate Permanent Subcommittee on Investigations. Perhaps that explains why John Reich, Gilleran’s replacement at OTS, once described Kerry Killinger, WaMu’s CEO, as “my largest constituent asset-wise.”

When Washington Mutual executives analyzed the consequences of implementing the regulators’ guidance, they concluded that it would reduce volume by 33 percent. So they didn’t do it. As late as June 2008, an FDIC examiner found that WaMu was “not in compliance with Interagency Guidance on Nontraditional Mortgages.”

That it took regulators until so late in the subprime madness to announce the guidance can’t be blamed only on the OTS. There was another culprit: the Federal Reserve. The Fed’s mind-set was on display in a late 2004 piece, published by the New York Fed, entitled, “Are Home Prices the Next ‘Bubble’?” The answer: “As for the likelihood of a severe drop in home prices, our examination of historical national home prices finds no basis for concerns.” Even after Ben Bernanke had replaced Greenspan as chairman in February 2006, it remained, in spirit, Greenspan’s Fed. The market still knew best. The market knew better than career bureaucrats how to properly price risk. Market discipline would prevent truly bad things from happening. The most important task of the banking regulators was to get out of the market’s way.

The president of the New York Fed by then was one of Rubin’s protégés from the Clinton Treasury: Tim Geithner, who had risen to be undersecretary for international affairs while still in his thirties. When he was named to head
the New York Federal Reserve in 2003, he was all of forty-two. Having studied at the feet of Rubin, Summers, and Greenspan, it was perhaps inevitable that he would share their mind-set about the virtues of the market. As the guidance was being discussed within the government, there were bank supervisors who were arguing that the Fed needed to clamp down on both mortgage lending and commercial real estate practices, especially given the rapid growth of both asset classes since 2000. But there were, shall we say, alternate concerns, which were expressed by Geithner and others who shared his views. What would the effect be on the mortgage and housing market if the Fed were heavy-handed? What would the effect be on the bottom lines of banks? “The Fed slowed down the guidance,” says one person. “It was slowed down by internal debates about how far the regulators should go since most of the mortgages were sold into the market—and this guidance would replace investor risk appetites with regulatory standards.”

As the mania reached its peak, an odd problem loomed: who was left to borrow money? Historically, the subprime lending business had leaned heavily toward refinancings. Sometimes that meant persuading people who had a thirty-year fixed loan—or had paid off their old mortgage entirely—to remortgage their home. Other times the homeowner was already a subprime borrower who needed to refinance after a few years, when the interest rate on his loan ratcheted up beyond his means to pay. But by 2006, 40 percent of actual home purchases in the United States were made with a subprime or Alt-A loan, according to Deutsche Bank. Why? Because soaring real estate values had priced legitimate buyers out of the market, and because brokers were seeking out borrowers who had never even thought about owning a home and who, under normal circumstances, would have no hope of doing so. Loans were being made to people who couldn’t even afford the teaser rate, much less the reset rate. Borrowers would sign the papers, get the loan, move into the house—and stop paying within the first few months.

At the same time, the rapid rise in home values finally began to slow. That meant that homeowners who had known from day one that they would need to refinance before the loan reset didn’t get the appreciation they needed to make a refinancing possible. “Whoever made that last loan, they were the lender of last resort,” says an industry veteran. In other words, both the borrower and the lender were stuck with the bad loan.

In loan offices around the country, the tension grew, particularly for those lonely souls whose job it was to prevent bad loans from being made. Such as veteran appraiser John Ferguson, who had gotten his start at the Money Store (“the sleazy edge of subprime,” he says) and then moved to BankUnited, a Florida-based bank whose exposure to subprime mortgages would eventually help bankrupt it. Ferguson had started rejecting more and more deals as he saw the quality declining. In the spring of 2006, he wrote to his boss at BankUnited’s Walnut Creek, California, office: “When everything is going great guns and you kill a couple of deals then so what. But when it gets to be crunch time … every time you become an obstacle to someone getting their pay check things get ugly. It becomes sales vs. the review department. In this office in CA everyone knows that when I cut/kill a deal then that hurts the production numbers.”

By the following spring, the panic was evident in the office-wide e-mails sent by the sales manager of the office Ferguson worked in. On April 2, 2007, he wrote, “We almost broke 36 million for 92 units, which is lower than February’s numbers, which is the lowest we have been since we opened, almost…. I never thought we would get to this low number … but we did and hopefully we can learn from what we have done and do better…. WE JUST HAVE TO…. We are moving in the wrong direction folks and something has got to change.”

The subprime companies were like rats racing on a wheel, going faster and faster, knowing that if they stopped, the jig was up. They
had
to keep their volume up; their very survival depended on it. They needed a constant influx of cash—either from the sale of loans to Wall Street or from selling equity and debt—to keep going. Slowing volume would be a sign that the party was coming to an end. Investors and lenders would bolt.

By comparison, the fact that the loans were getting worse and worse was a nonissue.
Who cared?
Regulators and executives alike assumed they had kicked the can to someone else—namely, the investors who purchased the mortgage-backed securities where most of these loans wound up. In a 2005 memo about Washington Mutual, the FDIC summed up the prevailing sentiment: “Management believes, however, that the impact on WMB [of a housing downturn] would be manageable, since the riskiest segments of production are sold to investors, and that these investors will bear the brunt of a bursting housing bubble.”

And what did Wall Street think about the way the subprime business had gone mad? Wall Street didn’t care, either. If anything, Wall Street was
encouraging
the subprime companies in their race to the bottom. Lousier loans meant higher yields. “A company would come to us and say, ‘We can’t believe your FICO doesn’t go to 580,’ ” recalls a former Morgan Stanley executive. “ ‘You’re 620, but Lehman will go to 580.’ ”

Here was the ultimate consequence of the delinking of borrower and lender, which securitization had made possible: no one in the chain, from broker to subprime originator to Wall Street, cared that the loans they were making and selling were likely to go bad. In truth, they were all taking on huge risks in granting these terrible loans. But they were all making too much money to see it. Everyone assumed that someone else would be left holding the bag.

B
y 2006, there was a distinct Dr. Jekyll and Mr. Hyde–like quality to Angelo Mozilo. The good Angelo had been warning for a surprisingly long time that his industry was heading into dangerous territory. “I’m deeply concerned about credit quality in the overall industry,” he said in the spring of 2005. “I think that the amount of capacity that’s been developed for subprime is much greater than the quality of subprime loans available.” A year later, he said to a group of analysts, “I believe there’s a lot of fraud” in stated-income loans. And he flatly told CNBC’s Maria Bartiromo that a housing recession was on the way. “I would expect a general decline of 5 percent to 10 percent [in housing prices] throughout the country, some areas 20 percent. And in areas where you have had heavy speculation, you could have 30 percent,” he said.

The bad Angelo insisted that none of this would be a problem for Countrywide. Countrywide wasn’t just some fly-by-night subprime lender; it was “America’s Number One Home Loan Lender!” Mozilo and other executives repeatedly stressed the high standards that Countrywide used to make its mortgages. Countrywide’s “proprietary technology” would help it “avoid any foreclosure,” Mozilo told investors, according to the
Los Angeles Times
.

Inside Countrywide, however, Mozilo was not so sanguine. In the spring of 2006, he wrote an e-mail describing Countrywide’s 80/20 subprime loan as “the most dangerous product in existence and there can be nothing more toxic.” Around the same time, Mozilo sent another e-mail saying that he had “personally observed a serious lack of compliance within our origination system as it relates to documentation and generally a deterioration in the quality of loans originated versus the pricing of those loan[s].” He clearly seemed worried.

The discrepancy between private worry and public proclamation would later cause the SEC to charge Mozilo and several of his top aides with fraud for not disclosing Countrywide’s growing risks to investors. In Mozilo’s case, the government also charged him with insider trading: from November 2006 through August 2007, he got total proceeds of almost $140 million from cashing in stock options. A judge overseeing a class action lawsuit filed against Countrywide wrote in one ruling that it was “extraordinary” how the “company’s essential operations were so at odds with the company’s public statements.” Countrywide later paid $600 million to settle the suit, while denying the allegations.

There is little question that the money, and the accolades, had come to matter too much to Mozilo. And yet it’s unclear whether Mozilo was, in fact, trying to deceive Countrywide’s investors, or whether he was so desperate to win the market share battle that he simply couldn’t see the ultimate cost of the bad loans Countrywide was making. He remained, quite simply, the truest of true believers, both in his company and in the transcendent virtue of subprime loans Countrywide made. He used to say that if 10 percent of subprime borrowers defaulted, that meant 90 percent were paying their mortgages on time, every last one of them a borrower who wouldn’t have otherwise had a shot at the American Dream. “Angelo, he totally believed,” says a former executive. “He’d say, ‘When I look a homeowner in the eye, I can tell if they’ll pay.’ We’d say, ‘Angelo, we don’t even do a personal interview anymore—would you stop saying you can see it in their eyes?’ ”

As for Countrywide, Mozilo was convinced that it had become so big and so strong that it was impregnable. By 2006, it ranked 122 on the Fortune 500, with $18.5 billion in 2005 revenue, $2.4 billion in profits, and a mortgage origination engine that had generated a staggering $490 billion in loans. Surely, a company with that kind of financial might could weather even a severe housing downturn. It might even help Countrywide in the long run, by putting some of its subprime-only competitors out of business. During an investor presentation in 2006, Mozilo read the names of some of the companies that had exited the business: Great Western, Home Savings, GlenFed, American Residential, and others. “These are the very ones that equity analysts told me that I should be fearing … all gone,” he said. “And ten years from now when we read this list, you’ll see that most of the players today will be gone. Except for Countrywide.”

Yes, Mozilo saw that Countrywide was making some risky loans, but what he didn’t see—what he couldn’t see—was that these loans could make his
company every bit as vulnerable as the competitors he disparaged. “If you’re a true believer, you can ignore things you shouldn’t ignore!” says one former Countrywide executive. “That was Angelo Mozilo’s problem.” Another puts it a little differently: “He’s a great salesman, and great salesmen are often the guys who get sold.”