All The Devils Are Here: Unmasking the Men Who Bankrupted the World (48 page)

Paulson also embarked on a hugely ambitious project to revamp the regulatory system. In the spring of 2008, when he rolled out a 228-page blueprint, observers said it would be the most radical overhaul of the laws in eighty years. Among other things, he advocated merging the SEC and the CFTC, getting rid of the OTS, imposing stricter rules on the leverage that investment banks could employ, setting up a federal Mortgage Origination Commission—which would finally institute rules for subprime originators—and giving the Fed the power to serve as a systemic regulator that could “go wherever in the system it thinks it needs to go for a deeper look,” as Paulson explained at the time.

Yet the blueprint did not make much mention of the issue that was causing Paulson such deep concern: regulation of over-the-counter derivatives. Some would see this as evidence that Paulson—Goldman’s former CEO, after all, who had never worried about the dangers of derivatives while running the firm—was as reluctant to force the industry to change as his predecessors had been. But Paulson would later insist that wasn’t true, and that he wanted changes in the regulation of derivatives. He and Geithner had gotten the industry to document its existing trades and to agree on a set of operational rules. These fixes would prove critical in the crisis that was coming.
But Paulson didn’t feel they were sufficient. In fact, derivatives were a deeply frustrating issue for him, because he felt more oversight was necessary, but he also knew he wasn’t going to get a legislative solution in the waning years of the Bush administration. Besides, other regulators worried that if they took on more oversight of derivatives, their agencies, already stretched on budgets, staff, and capability, would be blamed if something went wrong.

Instead, Paulson began using the President’s Working Group—the same group that Rubin had used to keep Brooksley Born away from derivatives regulation—as a way of “persuading, jawboning, and sometimes pressuring industry participants to take actions they were reluctant to take,” as he later put it. Paulson and Geithner quietly began pushing other regulators to agree on language calling for an industry cooperative to clear derivatives trades. They pushed the industry to agree as well. The new clearinghouse would set capital requirements, and it would also serve as a buffer that would insulate others should a big counterparty fail. After the crisis, Paulson would insist that the Treasury and the New York Fed had done everything that was possible to deal with what he called “a messy legacy derivative situation.”

There was one big problem Paulson missed, however. When he made his Camp David presentation, he didn’t mention any potential problems in housing or mortgages. That’s because Paulson didn’t suspect that housing or mortgages could be the catalyst for a crisis.

This was Paulson’s blind spot—though not because he was a free-market ideologue. Perhaps because he had spent his entire career on Wall Street, he thought the way others on Wall Street did and the way economists did: Housing prices hadn’t declined on a nationwide basis since the Great Depression! People always paid their mortgages! He didn’t see the boarded-up homes that were blackening neighborhoods like rotten teeth in places like Cleveland. His was a bloodless view, the world as seen from the perch of high finance.

Besides, why would Paulson suspect that Wall Street’s securitization process was deeply flawed? After all, Goldman Sachs had moved into this business on Paulson’s watch. Paulson was part of the machine, not outside it. That also meant, for all of Paulson’s worries about derivates, he didn’t understand the dangerous potential of credit default swaps on mortgages. (Though he’d later say, “If I had known some of the things that were happening, I wouldn’t have been able to sleep at night.”)

Paulson certainly wasn’t alone. Everyone else on Wall Street and in Washington shared his views. In late 2005, Bernanke said that home prices, rather than being in bubble territory, “reflect strong economic fundamentals.” In 2006, he said that he expected the housing market to “cool but not to change very sharply.” He went on to tell CNBC, “We’ve never had a decline in house prices on a nationwide basis. So what I think more likely is that house prices will slow, maybe stabilize.” As late as the spring of 2007, he said, “[W]e believe the effect of the troubles in the subprime sector on the broader housing market will likely be limited, and we do not expect significant spillovers from the subprime market to the rest of the economy or the financial system.”

Another reason for Paulson’s blind spot, say people who worked with him, was that he had too much faith in regulators. “He thought the regulators were more capable than they were,” says a staffer. Paulson today concedes he’d put too much faith in regulation itself. During his time in office, Paulson would change his tune. “The system was so outdated and screwed up, you just couldn’t have imagined it,” he’d later say. A big part of the problem, of course, was that both the regulators and Paulson assumed that financial institutions were more competent than they were. Paulson spent his career at Goldman, which at least didn’t need anyone else to tell it how to protect its own bottom line. He had no idea that other firms weren’t as capable of looking out for their own interests. “No financial institution wants to blow itself up,” he’d later explain. “So I’ve always taken some confidence in the fact that their survival instinct would help protect the system. But I was shocked by how bad risk management was in some institutions. And many banks thought they were smarter than they were.”

By 2006, John Dugan, the comptroller of the currency, was fretting to other regulators about the growth in nontraditional—i.e., subprime—mortgages, according to several former Treasury officials. But here was a “disconnect,” says one official. “The people in the Treasury building who spent most of their time on housing were the economists. The people on the market side were the ones dealing with leverage. Even in this building, with a small senior staff, people were not talking every day. Looking back, you can see how one thing would lead to another—how mortgages were used to create instruments that were used to create leverage.” But no one made the connection at the time.

There was another component to the thinking, too. The leverage in the system had built up slowly. “It was a gradual process that got us to where we were,” says a former Treasury official. “So you’d think it would be a gradual process that got us out.”

In this assumption, however, they could not have been more wrong.

S
cene 1: Summer 2006.
Seemingly out of nowhere, New Century Financial, the country’s second largest subprime-only originator, has a pressing need for cash. Having made $51.6 billion worth of subprime loans in 2005, it is discovering that too many of its loans are going sour way too fast. Particularly troubling: early payment defaults are spiking. Those are loans where the borrowers are in default practically from the moment they agree to the loan. Early payment defaults can often trigger repurchase requests from investors, requiring the lender to buy them back. That is happening to New Century. In 2004, it repurchased $136.7 million worth of bad loans. In 2005, that number rose to $332.1 million. By June of 2006, it has been forced to repurchase an additional $315.7 million in defaulted loans.

Worse, one of New Century’s tried-and-true techniques for recirculating its repurchased loans is no longer working. In previous years, after buying defaulted mortgages out of securitizations, it would simply stick them into a new sale, according to one close observer. This worked because New Century’s loan volume was growing so rapidly that the bad mortgages could be buried as a small part of a big new sale. But by 2006, volume is starting to slow. New Century’s perpetual motion machine is grinding to a halt.

Meanwhile, New Century is running low on cash. On August 17, CFO Patti Dodge sends an e-mail to Brad Morrice, the CEO: “We started the quarter with $400mm in liquidity and we are down to less than $50mm today,” she writes. In explaining the problem to the company’s board, Morrice cites “continued difficult secondary market conditions leading to warehouse line margin calls, higher investors kick outs [meaning that wary investors are refusing to purchase loans] and loan repurchases.” Internally,
top management begins receiving a weekly report monitoring its problems. It is entitled “Storm Watch.”

Does Wall Street know about New Century’s problems? Of course it does! One Wall Street banker tells New Century that its problems aren’t all that unusual, according to a report done later by a bankruptcy examiner. There are, the examiner will write, “dramatic industry-wide increases in early payment defaults and lower origination volumes.”

Amazingly, Wall Street is still willing to extend a lifeline to New Century: the company raises $142.5 million in the second half of 2006. Yet investors are largely left in the dark. New Century doesn’t disclose either the big increase in early payment defaults or the staggering $545 million backlog of repurchase claims—i.e., claims that the company has received but hasn’t yet paid. Instead, New Century tells investors that it believes that repurchase requests “will stabilize, then decline.”
^*

Scene 2: Fall 2006.
Larry Litton is a mortgage servicer. In 1988, he and his father, Larry Litton Sr., founded Litton Loan Servicing, building it into one of the nation’s largest mortgage servicers. Inevitably, they service a lot of mortgages for subprime originators, including Bill Dallas’s Ownit and WMC, which was founded by Amy Brandt and which GE Capital bought in 2004. The two combined are cranking out more than $40 billion worth of loans a year.

Litton also notices that early payment defaults are soaring. The mortgage originators are freaking out and blaming him. “The WMC guys are saying, ‘You suck,’ ” Litton recalls. He remembers thinking, “Maybe we’re doing something wrong.” So Litton comes up with what he calls an “ultra-aggressive move”: hand delivering welcome packages to new homeowners, so there will be no confusion over where the mortgage checks should be mailed. But when the Litton employees arrive at the newly purchased homes, they discover something truly startling. “My people came back and said, ‘Thirty percent of the houses are vacant,’ ” Litton recalls. In other words, borrowers who closed on mortgages had so little means to make even the first payment that they never bothered to move in. Litton calls Amy Brandt at WMC. “It’s
kinda hard to collect payment when someone ain’t there! You might want to take a look at it,” he tells her.

Scene 3: December 11, 2006.
Midmorning. An auditorium at the Office of Thrift Management. Lew Ranieri—yes,
that
Lew Ranieri—is giving a speech. His tone of voice may be mild, but his words convey something else entirely: anger, dismay, worry.

The occasion is an all-day housing symposium the OTS is putting on. The room is filled with bank regulators, housing lobbyists, economists, community activists, and members of the subprime mortgage establishment. Sheila Bair, the new chairman of the FDIC, is there. So is David Berson, the chief economist at Fannie Mae, and John Taylor, the longtime subprime critic from the National Community Reinvestment Coalition. Hank Paulson makes the welcoming remarks. Congressman Barney Frank gives the luncheon speech.

The main topic is the subprime business, which now accounts for around a quarter of the nation’s mortgages but which is clearly slumping. Ranieri is on a panel with Berson from Fannie Mae, a banker representing the Mortgage Bankers Association, and the deputy comptroller of the currency. Their presentations are full of on-the-one-hand, on-the-other-hand equivocations. There is general agreement that subprime mortgages are here to stay. A panel devoted to subprime fraud focuses entirely on
borrower
fraud; incredibly, not a single word is mentioned about the widespread fraud being perpetrated by the companies themselves.