All The Devils Are Here: Unmasking the Men Who Bankrupted the World (57 page)

On March 18, one unnamed employee at S&P sent this in an e-mail: “To give you a confidential tidbit among friends the subprime brouhaha is reaching serious levels—tomorrow morning key members of the RMBS rating division are scheduled to make a presentation to Terry McGraw CEO of McGraw-Hill Companies and his executive committee on the entire subprime situation and how we rated the deals and are preparing to deal with the fallout (downgrades).”
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At Moody’s, the story was similar. The company’s own subsidiary,
Economy.com
, issued a prescient report in October 2006 called “Housing at the Tipping Point,” in which it reported, “Nearly twenty of the nation’s metro areas will experience a crash in house prices: a double-digit peak-to-trough decline.” A double-digit decline in housing prices is precisely what the rating agencies’ models said could never happen. In addition, big investors had started complaining that the ratings were flawed. At one point, Josh Anderson, who managed asset-backed securities at PIMCO, the giant bond manager, confronted Moody’s executive Mary Elizabeth Brennan. In an internal e-mail, Brennan reported, “PIMCO and others (he mentioned BlackRock and WAMCO) have previously been very vocal about their disagreements over Moody’s rating methodology.” She continued, “He cited several meetings they have had … questioning Moody’s rating methodologies and assumptions. He found the Moody’s analyst to be arrogant and gave the indication that ‘We’re smarter than you’ …” Anderson went on to say, Brennan wrote, that “Moody’s doesn’t stand up to Wall Street … In the case of RMBS, its mistakes were ‘so obvious.’ ”

And
still
the agencies continued to stamp their triple-As on mortgage-backed securities. The evidence didn’t seem to matter. In late December 2006, Moody’s analyst Debashish Chatterjee was shocked by his own graph of the number of mortgages at the top ten issuers that were more than sixty days delinquent. Fremont Investment & Loan, in particular, was drowning in
them. “Holy cow—is this data correct? I just graphed it and Freemont [sic] is such an outlier!!” he wrote in an e-mail to colleagues. A month later, when S&P was rating a Goldman CDO that contained Fremont loans, the analyst on the deal asked a colleague, “Since Fremont collateral has been performing not so good, is there anything special I should be aware of.” The response: “No, we don’t treat their collateral any differently.” Both Moody’s and S&P rated five tranches of that offering triple-A; not surprisingly, two of the five were later downgraded to junk, according to analysis by the Senate Permanent Subcommittee on Investigations.

It wasn’t until July 2007—the same month the Bear hedge funds collapsed—that the rating agencies made their first major move toward downgrading. E-mails imply that they had been considering such a move among themselves for months. It also appears that they were discussing it with at least some Wall Street firms as well. “It sounds like Moody’s is trying to figure out when to start downgrading, and how much damage they’re going to cause—they’re meeting with various investment banks,” a UBS banker had written back in May. A judge overseeing a lawsuit involving UBS would later find “probable cause to sustain the claim that UBS became privy to material non-public information regarding a pending change in Moody’s rating methodology.”

Yet even in July, the rating agencies still weren’t ready to go all in and actually downgrade triple-A tranches. Instead, on July 10, 2007, S&P placed 612 tranches of securities backed by subprime mortgages on “review” for downgrade; almost immediately, Moody’s followed, placing 399 tranches on review. Both agencies made a great point of saying that the downgrades affected only a sliver of the mortgage-backed securities they had rated.

Why had it taken so long? Sheer overwork played a part, as did paralysis. But it was also because the rating agencies feared the consequences of a widespread downgrade of mortgage-backed securities. With ratings so embedded in regulations, downgrades would force many buyers to sell. That forced selling, in turn, would put more pressure on prices, which would create a downward spiral that would be nearly impossible to reverse. With subprime mortgages, that situation was exacerbated a thousandfold, because the flawed ratings of residential mortgage-backed securities had been used to create countless CDOs—and synthetic CDOs. Downgrades of the underlying mortgage-backed securities could cause the CDOs to default even before any losses had shown themselves. The ripple effect was bound to be enormous.

Later that day, S&P held a conference call for investors to discuss the pending downgrades. Most people were fairly polite. But one man on that conference call, a hedge fund manager named Steve Eisman, who had taken a big short position in mortgage-backed securities, was not.

“Yeah, hi, I’d like to know why now?” Eisman began. “I mean, the news has been out on subprime now for many, many months. The delinquencies have been a disaster now for many, many months. Your ratings have been called into question for many, many months. I’d like to know why you’re making this move today when you— And why didn’t you do this many, many months ago?” S&P’s Tom Warrack, a managing director in the RMBS group, tried to break in. “We took action as soon as possible given the information at hand …” But Eisman wouldn’t be stopped. “I mean, I track this market every single day. The performance has been a disaster now for several months. I mean, it can’t be that all of a sudden, the performance has reached a level where you’ve woken up. I’d like to understand why now, when you could’ve made this move many, many months ago. I mean, the paper just deteriorates every single month like clockwork. I mean, you need to have a better answer than the one you just gave.”

The next day, Mabel Yu, an analyst at Vanguard, told Mary Elizabeth Brennan at Moody’s that when Eisman started talking, “my phone was on mute but I jumped up and down and clapped my hands and screamed. He was the only one to say it, but all the investors were all feeling the same way.” Yu went on to tell Brennan that Vanguard had stopped buying mortgage-backed securities in early 2006 because they were less and less comfortable with the ratings.

Although S&P and Moody’s wouldn’t actually begin downgrading CDOs until October, the party effectively ended that day in July. “[P]ut today in your calendar,” wrote Robert Morelli, who was in charge of the CDO business at UBS, to colleagues. When he was later asked what he meant by that, he explained, “to the day was essentially the beginning of the end of the CDO business.”

A few weeks later, Moody’s Eric Kolchinsky forwarded some UBS research to colleagues. It showed that in a sample of 111 mezzanine asset-backed securities CDOs, the triple-B tranches could expect losses of 65 percent and that the losses would extend into the triple-A tranches. Kolchinsky quoted the UBS report to his colleagues: “This is horrible from a ratings and risk management point of view; perhaps the biggest credit risk management failure ever,” it said.

On July 24, 2007, two weeks after the rating agencies made their first big downgrade move and one week before the bankruptcy of the Bear Stearns hedge funds, Countrywide announced its results for the first half of the year. In a last, desperate grab for market share, Countrywide had waited until March 2007 to stop offering “piggyback” loans that allowed borrowers to purchase a home with no money down. As other, weaker correspondent lenders—those that made loans themselves but then sold their loans to bigger lenders—began to go under, Countrywide ramped up its business of buying loans. Since Countrywide was no longer entering into agreements to sell its loans before they were made or purchased, the company was bearing all the risk that the market would crack on its own books.

The rot Mozilo had long insisted wouldn’t infect Countrywide had started to spread. Although the company announced a profitable quarter, investors were shocked to hear that its earnings had declined for the third quarter in a row on a year over year basis—and that delinquency rates on Countrywide’s subprime mortgages had more than doubled, to 23.7 percent, from less than 10 percent at the end of March. Delinquencies in prime mortgages—
prime
mortgages—also spiked. And the company revealed that it was taking several other hits, including $417 million worth of impairments, mostly due to declines in the value of home equity residuals, and another $293 million in losses in loans held on its balance sheet.

“We are experiencing home price depreciation almost like never before, with the exception of the Great Depression,” said Mozilo on the company’s conference call that day.

Morgan Stanley analyst Ken Posner was startled by the news. “That is just not a charge-off ratio one would expect for a—at least for an old-fashioned prime portfolio,” he said on the conference call.

“Countrywide is a mortgage supermarket,” responded chief risk officer John McMurray. “So it is my belief that the portfolio that we have for the most part is going to be a good reference for what exists on a broader basis.”

At another point during the conference call, McMurray noted, “So the way I think about prime is that it covers a very vast spectrum….” The implication was clear. Countrywide was acknowledging that prime and subprime weren’t as clearly delineated as most had believed. While investors who dug through the prospectuses for Countrywide’s mortgage-backed securities might have known that, it came as a shock to many.

McMurray also had two messages that were contrary to everything Mozilo had preached over the years. “Leverage at origination matters,” he said. “More leverage means more serious delinquencies.” That is, the more debt the customer borrowed, the more likely he was going to default. And he said, “Documentation matters. The less documentation, the higher the serious delinquency, all else equal.”

That day Countrywide’s stock fell more than 10 percent, to close at $30.50. Research analysts at Stifel Nicolaus, which had turned bearish on Countrywide earlier in the year, wrote in a report to clients, “[G]iven the magnitude of credit problems in the bank, we think mgmt made serious miscalculations (and possibly misrepresentations) about the quality of the loans added to the bank.” They found that Countrywide’s supposedly prime home equity securitizations were performing in line with a competitor’s subprime deals.

Soon after that conference call, McMurray resigned. Later that fall, Walter Smiechewicz, the senior executive in charge of enterprise risk assessment, met with Countrywide’s audit committee. Smiechewicz had been warning since 2005 that the residuals and the loans Countrywide had retained on its balance sheet posed a much bigger risk than was being acknowledged. According to several former executives, he said that if nothing was going to change, then he had no choice but to resign. He, too, left the company.

IKB—the German bank that was on the other side of John Paulson’s Goldman-arranged Abacus trade—was beginning to spook the market. Over the weekend of July 28 and 29, state-owned German banks brokered a bailout of the bank that would eventually rise to $13.5 billion. It was the first bank to be rescued because of the securitized mortgages on its books. It would not be the last.

Then came August. On August 8, BNP Paribas, France’s largest bank, suspended redemptions from three of its investment funds because it couldn’t value some of its subprime mortgage-backed securities. Australia’s Basis Yield Fund, which had bought into Goldman’s Timberwolf deal, suffered severe losses. It would soon go into liquidation because of its exposure to subprime assets.

August home prices fell 4.4 percent from the previous year, the largest decline in six years. Youyi Chen, the head of mortgage portfolio management at Washington Mutual, sent an e-mail to a group of colleagues entitled
“Scenarios.” He wrote, “A 20 percent down in HPA. From today’s meeting, I understand that we don’t have the courage to evaluate this scenario.”