All The Devils Are Here: Unmasking the Men Who Bankrupted the World (49 page)

Ranieri, however, has a much dimmer view of the state of the subprime mortgage industry than most others speaking today. Over the past few years, he has become horrified by what has happened to the mortgage-backed securities business he helped invent in a more innocent time. The lack of proper underwriting, Wall Street’s unending desire for poor-quality loans, the way triple-B tranches are being repackaged into new triple-A securities: this is not what Ranieri envisioned when he and Larry Fink and others were starting up the market. He had always just assumed that the vast majority of loans in securitizations would be good loans, not bad ones. Why would investors want to buy
bad
loans? The fact that no one seems to care anymore is shocking to him.

And that’s what he tells this roomful of subprime experts, bluntly and
forcefully. The man who spent much of the 1980s trying—unsuccessfully—to minimize Fannie and Freddie’s role in the securitization business now laments the way they have been rendered irrelevant by the subprime securitizers. He can see now what an important and useful role they played: they were, he says, the “gatekeepers,” forcing mortgage companies to adhere to their underwriting standards. “If a mortgage originator didn’t follow Fannie and Freddie’s underwriting standards, nobody would buy them,” says Ranieri. “That standard has completely gotten pushed aside.”

Who now can keep the market in check? The rating agencies? Hardly. Government regulators? A joke. The private mortgage-backed securities market, says Ranieri, “is unchecked by today’s regulatory framework.”

He bemoans the layering of risk in subprime mortgages (“One of my favorites is a negative amortization ARM, combined with a simultaneous second lien and a stated-income loan”). He sneers at the phrase “affordability products,” the industry’s euphemism for subprime mortgages. He dwells at length on the rise of CDOs as a “major distribution mechanism” and laments their bewildering complexity. It is nearly impossible, he says, for investors to understand what they are buying. And he makes a crucial point that Wall Street itself has largely missed: the CDO business has become a kind of daisy chain. “Who is buying the subordinated tranches?” he asks. “Who is taking all that risk? The answer in many cases is nobody. No person. It is a thing—another CDO. Imagine taking the support tranches of the CDO and putting it in another CDO, further diluting the information flow. Does the buyer really understand the risks entailed? They buy senior tranches—I know, I buy senior tranches. But I like senior tranches to remain senior tranches. I like triple-A to remain triple-A.”

The poor level of disclosure in CDO prospectuses, Ranieri says, “makes the risk levels neither readily apparent nor easily quantifiable.” You can hear the anger in his voice. “This. Is. A. Private. Securities. Market,” he says evenly. “It gets sold to the public. It gets sold to foreign investors who, I will tell you, don’t have a clue. It is supposed to be equal information that is available to all.”

When Ranieri finishes, an audience member asks a simple question: “What do you see as the less than rosy scenario when the mortgage market goes into the toilet?”

“I don’t understand what the ripple effects would be,” he replies. “All sorts of people are holding risks that would be hard to track down. And in some cases they wouldn’t even know they are holding the risk.”

Scene 4: Same place, same morning.
“Finally,” Josh Rosner thinks to himself as he listens to Ranieri. “Someone is calling it as it is.”

Rosner is the skeptical analyst who back in 2001 wrote the prescient paper “A Home without Equity Is Just a Rental with Debt.” In mid-2005, his sources at the Fed start telling him that rates are going to rise significantly, in no small part to “cure” the excess speculation in housing. He is soon warning clients that the housing market has peaked.

In recent years, Rosner has continued to dig into the numbers underlying the housing boom. It is apparent, he says, that “we’ve bumped up against the law of large numbers in homeownership.” At the end of 2000, the official homeownership figure stood at 67.4 percent. Four years later, with the subprime bubble well under way, the homeownership rate hits 69 percent. That is as high as it will ever go. All of that craziness—not just the bad loans themselves, but the devastated neighborhoods, the people thrown out of their homes, the huge buildup of debt on both Main Street and Wall Street—for a gain of 1.6 percent? Is it really worth it?

To Rosner, the answer is clear: no. His data shows that most of the frenzy hasn’t even been about purchasing a place to live. Rosner’s eureka moment comes when he sees data showing that about 35 percent of the mortgages used to purchase homes in 2004 and 2005 are not for primary residences, but for second homes and investment properties. And as he has been saying for years, the number of people borrowing to buy an actual home is dwarfed by the number of people borrowing to refinance. The refis, in turn, are made possible by rising home values—which may not even be real, given all the inflated appraisals. (In fact, Alan Greenspan himself noted in a study he co-authored in 2007 that about four-fifths of the rise in mortgage debt from 1990 to 2006 was due to the “discretionary extraction of home equity.”)

Like Ranieri, Rosner has become worried about the CDO market. Around the same time as Ranieri’s speech, Rosner approaches a finance professor at Drexel University, Joseph Mason, to co-author a paper with him. They deliver it in February 2007 at the Hudson Institute. The title is a mouthful: “How Resilient Are Mortgage Backed Securities to Collateralized Debt Obligation Market Disruptions?” Their conclusions, however, are straightforward. The issuance of CDOs, which have mushroomed to more than $500 billion in 2006, is propping up the housing market by buying almost all of the riskier
tranches of mortgage-backed securities. Investors—real investors, who are not part of the daisy chain—no longer want them. Even investment-grade CDOs will lose money if home prices begin to fall substantially, Rosner and Mason write. If that happens, it could set off a contagion of fear, as investors rush to unload their CDO positions. A vicious circle would then start that would have terrible ramifications, not just for the housing market but for the economy.

Rosner and Mason have also pondered some larger questions. If housing is such an important component of U.S. social policy, and the funding mechanism for housing has become this shaky pyramid of debt, does it really make sense to have the housing market at the mercy of this hugely unstable funding? And inasmuch as investors around the world have sunk their money into U.S. mortgage-backed securities, what are the implications if that market starts to crack? “Perhaps of greater concern is the reputational risk posed to the U.S. capital markets,” they write.

Scene 5: February 7, 2007.
New Century files what’s called an 8-K, a document that conveys important news that can’t wait until the next quarter’s results. The headline is stark: “New Century Financial Corporation to Restate Financial Statements for the Quarters Ended March 31, June 30 and September 30, 2006.” Part of the reason for the restatement, the company says, is to “correct errors” in the way it has accounted for its many repurchase requests. The stock, which had hit its high of $51.22 just a few months earlier, plunges 36 percent in one day. By March, the company admits that it is unable to file any financial reports. By then, its repurchase claims have risen to a staggering $8.4 billion. The stock falls to about a dollar. By April, New Century is bankrupt. Never once, during the entire housing bubble, did the company report a quarterly loss before filing for bankruptcy.

By the end of 2006, anyone could have found his or her own data points to know that the subprime market was in trouble. The clues were everywhere. The staggering rise in home appreciation, which in some parts of the country had averaged 10 to 15 percent a year, was slowing down. In places like Arizona, California, Florida—the states where the housing bubble had been
most pronounced—housing prices were already declining. Subprime borrowers with option ARMs, the ones who were counting on an increase in their home equity to refinance, were suddenly out of luck. With their homes no longer increasing in value, they had no way to refinance. Foreclosures were nearly double what they had been three years earlier. Delinquencies: up. Stated-income loan defaults: up. And of course those early payment defaults—the ones that signaled just how reckless the subprime originators had become—were
way
up. Subprime originators had created the conditions for “the perfect storm,” said John Taylor at that OTS housing symposium.

Sheila Bair, who had been sworn in as the new chair of the FDIC that summer, was shocked to discover how far underwriting standards had fallen in the four years since she left the government. Back in 2002, when she had been assistant secretary of the Treasury for financial institutions, there had been problems with predatory lending, for sure, but nothing like this. Nothing even close. One of the first things Bair did upon taking office was order up a database that included every securitized subprime mortgage. It was immediately obvious when she looked at it that there was going to be a massive problem when the ARMs reset.

Meanwhile, a risk manager at one of the big Wall Street firms started noticing something unprecedented: people were walking away from their homes. “Historically,” this risk manager said, “people stopped paying their credit cards first, then their cars, and only then their homes. This time, people with $50,000 cars and $300,000 mortgages would get in their cars and drive away from their homes.”

The newspapers offered further evidence of the looming problems. All through the fall, the business press wrote article after article about the rise in foreclosures and the troubles suddenly hitting the subprime companies. “Payments on Adjustable Loans Hit Overstretched Borrowers,” declared the
Wall Street Journal
in August of 2006. “Foreclosure Figures Suggest Homeowners in for Rocky Ride,” the
Journal
said a month later. A month after that, Washington Mutual reported that its home loan unit had lost $33 million in the third quarter. HSBC, which had been a major buyer of second-lien mortgages, announced huge losses and shut down its purchases. And on and on.

On Main Street, the subprime bubble was grinding to a halt. There was going to be a great deal of pain, for both the borrowers and the subprime companies. But Wall Street had one more trick up its sleeve. This was a mechanism created by Wall Street to allow investors to short the housing market similar to the way investors can bet against stocks. It was a natural
development—at least from Wall Street’s point of view—but it evolved into one of the most unnatural and destructive financial products that the world has ever seen: the synthetic CDO.

The key ingredient in a synthetic CDO was our old friend the credit default swap. For that matter, the key to shorting the mortgage market was the credit default swap. By 2005, credit default swaps on corporate bonds were ubiquitous, with a notional value of more than $25 trillion. (The notional value of credit default swaps peaked in 2007 at $62 trillion.) They were used by companies to protect against the possibility that another entity it did business with might default. They were used by banks to measure the riskiness of a loan portfolio, because their price reflected the market’s view of risk. And they were used in the mortgage-backed securities area by CDO underwriters to wrap the super-senior tranches. The AIG wrap, you’ll recall, was the key to allowing banks with triple-A tranches on their books to reduce their capital.