The Watchdog That Didn’t Bark: The Financial Crisis and the Disappearance of Investigative Reporting

In early 2003, a few months after the Citigroup/Associates settlement, Mike Hudson was driving down U.S. 45, a two-lane road in northeast Mississippi, finishing up a twelve-hour drive from Roanoke across Tennessee, Georgia, and Alabama to Brooksville, a predominantly African American town of 1,100 between Tupelo and Meridian. He pulled to a single-story house built on a slab and was greeted by John Brown, who was in trouble on his mortgage.

Forty-four years old, Brown was less than five feet tall and barely came up to Hudson’s chest when he greeted him with a smile at the door. Born severely retarded, his mental development had stopped when he was a small child. He is sunny and affable. Unable to speak clearly, he relied on his mother, Catherine, to translate the sounds and hand gestures he uses to communicate. When John Brown wrote his “signature,” he printed it slowly in block capital letters, carefully copying the letters that someone had already written out for him below in the space on the loan documents. It had taken several minutes. When he demonstrated his signature for Hudson years later, Brown beamed proudly and uttered something unintelligible but that sounded like it ended with the word “cool.” A judge would later describe him as “profoundly retarded and incompetent.” His mother, who also suffers from a mild form of retardation, tried to explain why they had chosen to refinance a government-subsidized, low-interest loan and some credit card bills into an exploding subprime mortgage with punitive terms issued by the world’s largest bank. They needed money, she said, and had none. “I didn’t want my baby to starve and have nothing to eat,” Catherine Brown explained.1

This chapter looks at how outsiders were able to see what insiders did not. Hudson, of course, came at the problem of a radicalizing finance sector from the perspective of a regional investigative reporter looking at the mortgage business from the bottom up. But, as we’ll see, it was also possible within major business-news organizations to perceive profound distortions in the derivatives market—what I think of as the mortgage aftermarket. And here, again, an outsider’s perspective made the difference.

Since he had first read about Fleet Financial’s “seven dwarves” in Atlanta, Hudson had seen the subprime business balloon from the domain of Bill Runnells and “Miss Cash” to a $310 billion behemoth by 2003, the year he visited the Browns. Subprime had outgrown even large “specialty” or “consumer-finance” operations like GreenTree, Conseco, Associates, FAMCO, and Household International. Big enough in their own right, they were doing well-documented damage in lower-income neighborhoods, particularly inner cities. But now something even more profound was occurring. What was happening on the margins was spreading to the center of the financial system, indeed, to the center of the global economy. At this point, Hudson had a vague idea of what happened to mortgages once they were made. He knew that mainstream megabanks and even Wall Street firms provided financing for the hard-sell types and that they packaged and resold them into bonds known as residential mortgage-backed securities, and that the pioneer of this business had been Salomon Brothers back in the 1970s. But the uses to which these mortgages had been put, the amplifying power of derivatives, was another world to him.

What he did know was that what had once been merely immoral was now out of control. It wasn’t just that mainstream banking was taking over the subprime business. It was that the subprime values he knew so well were now taking over mainstream banking. Its hard-sales culture had overrun banking’s traditional underwriting culture. Risk managers and underwriters were being harassed, suppressed, and forced out of mortgage-lending operations at Countrywide, Citigroup, and Ameriquest and across the industry. Hudson, in turn, hunted them down. And they were talking to him.

In the conventional business press, however, the subprime business’s long-standing and well-earned reputation for hard-sell tactics and flimflammery was now starting to slip down the memory hole, helped by clever industry public-relations campaigns. The business press, as we’ll see in chapter 9, confined itself to conventional frames, describing subprime as a normal business, like conventional banking only “riskier.” The Wall Street Journal, Forbes, Fortune, and the Financial Times—when they were not publishing profiles of Wall Street leaders such as Citigroup’s Chuck Prince and Merrill Lynch’s Stan O’Neal, profiles that were generally flattering and in any case stuck in old paradigms—conveyed problems in mortgage lending in terms of unsustainable housing prices, “the bubble,” and poor-quality mortgage products. An entire journalism subculture could perceive the problem only through investor or consumer-oriented frames—frames set by the financial-services industry.

Hudson saw it for what it was: a question of misaligned incentives and asymmetrical information—in short, systemic corruption. For reasons he could barely grasp—namely the power of securitization, the fact that predatory loans would not stay on lenders’ books—the mortgage-lending system was become radicalized. Sales volume became paramount.

Years later, state and federal investigations into the foreclosure crisis would confirm that leading lenders, including Countrywide, Washington Mutual, IndyMac, New Century, Ameriquest, Wells Fargo, Citigroup—in other words, the heart of the mortgage industry—as a matter of corporate policy and on a mass scale engaged in deceptive marketing that “misrepresented” the basic terms of loans, including what the interest rates were, whether they were fixed or floating, and what fees would attach, and changed loan terms at closing. As a lawsuit against Countrywide filed by the California attorney general in 2008 would later explain: the more onerous the terms of a loan for the borrower, the more global bond investors would pay for it. This fundamental misalignment led to higher pay up and down in the loan supply chain, including the sales force, as loan terms were made more onerous. As the California suit said: “The value on the secondary market of the loans generated by a Countrywide branch was an important factor in determining the branch’s profitability and, in turn, branch manager compensation.”2

Such incentives would logically set the table for the creation of vast call centers—“loan factories,” where retail sales staff were trained in “high-pressure” sales tactics, complete with scripts, cold calls, and databases of consumer profiles, to “steer borrowers into riskier loans,” as California alleges. An eighty-one-page Illinois complaint, also filed in 2008, similarly described a culture in which traditional banking values were turned on their heads and were aimed overwhelmingly toward “selling” loans, which is the opposite of traditional underwriting.

It was a landscape of stressed “loan officers” hunched in cubicles with headsets, trying to hit their numbers, whatever it took. It was about incentives that tilted entirely toward putting borrowers into the most expensive loans possible. The car salesmen were moving in. For a broker or loan officer, a prime loan might yield a few thousand dollars. A subprime loan might yield four or five times that, sometimes $20,000 or more, for a single loan. This wasn’t about “risk” in the traditional sense. Indeed, all the risk in the end was on the borrower side and on the books of far-flung buyers of mortgage-backed securities and collateralized debt obligations (CDOs).

And while Hudson didn’t know about the CDO business developing in London and New York, he did understand that the financial system was losing its bearings. The lawlessness on the fringe was heading into the mainstream, and he was going to show it. The key was picking the biggest, most visible, most familiar target.

He got in touch with a small periodical called Southern Exposure based in Durham, North Carolina, and pitched a major investigation into how a national bank was moving into subprime, how subprime was taking over the bank, and how it was hurting normal people in the South. For the muckraking magazine, published by the Institute for Southern Studies, a think tank for grassroots organizers and community groups, the story was a natural.

“How much do we need?” Ashwill replied.3

All told, Hudson interviewed more than 150 people: whistleblowers, regulators, borrowers like the Browns, and their lawyers. He found Citigroup accused of all the bait-and-switch scams that mark subprime plus a couple of new wrinkles. One bank officer in Mississippi told him of “closed-folder closings,” with documents inside and the check placed tantalizingly on top. “The whole time you have the check on top of the folder,” the officer said, a reminder that the cash that would solve a borrower’s money troubles (temporarily before making them much worse) was only a signature away.

Hudson chose a lender with a subprime unit that boasted 4.3 million customers and more than 1,600 branches in 48 states. He found a study that calculated that nearly three of every four mortgages originated within the company’s lending empire were made by one of its higher-interest subprime affiliates—nearly 180,000 loans out of more than 240,000 mortgages in a single year. The lender was Citigroup. “Citigroup has established itself as perhaps the most powerful player in the subprime market by swallowing competitors and employing its vast capital resources and its name-brand respectability,” Hudson wrote.⁴

Hudson’s 6,000-word piece, with several sidebars and graphics and photos, represented what can only be called an alternative—albeit true and relevant—history of both the bank and its driving force, Sanford I. Weill, then finishing his transformative and much-documented career. Conventional accounts of the bank had traced its roots to its notorious predecessor company, National City Bank. Founded in postrevolutionary America, the City Bank of New York provided capital for the country’s industrial expansion, then recklessly expanded during 1920s under its imperious chief, Charles E. Mitchell, who presided over a boom in margin loans for stock purchases that helped to inflate the era’s enormous stock market bubble. National City’s actions are seen by historians as a prime cause of the Great Crash and subsequent Depression.5 The story continues with the rise in the late 1960s of Walter B. Wriston, considered a banking revolutionary, who changed the name to Citibank (part of the renamed holding company Citicorp), set wildly ambitious growth targets of 15 percent annually, and proceeded to meet them via a combination of brilliant innovation (Citibank was a leader in the expansion of credit cards and ATMs) and unforgivable recklessness (the bank suffered catastrophic losses on Latin American loans made in the 1970s and early 1980s). The company suffered another near-death experience in the early 1990s from bad commercial real estate loans. Citi’s long history, even in conventional accounts, is bad enough.

Mainstream business reporting on Weill, meanwhile, told a rags-to-riches story, albeit with an undercurrent of recklessness and ruthlessness. Born in the Bensonhurst section of Brooklyn, Weill earned an ROTC scholarship to Cornell, started as a runner on Wall Street, and later built his own brokerage called Shearson Loeb Rhoades. He sold it to American Express, clashed with its leadership, and went into the wilderness in 1985 to restart his career (along with his protégé, Jamie Dimon). There he bought a small finance company and, via series of mergers, bought Travelers Group then, in a coup for the ages, merged with Citicorp in 1998. This is widely seen as forcing the repeal of the Glass-Steagall Act the next year, which ratified the joining of commercial banking and investment banking. Weill expanded Citi and drove it to historic levels of profitability (it was one of the world’s the most profitable companies in 2000 with $13 billion in net income) before stepping aside as CEO in 2003 and chairman in 2006.⁶ True, even conventional accounts couldn’t help but note that Weill’s hard-driving style had fostered a culture that created a series of scandals, most notably, its central role in publishing bogus stock research and financing fraud-ridden companies including Enron, WorldCom, and Adelphia Communications.

It is fair to call Hudson’s piece humorless and not a lot of fun to read. It rambles some and doesn’t work as a profile of Weill, who is so remote as to be almost invisible. It reads, rather, like an indictment. It also fails to grasp the mortgage aftermarket that was fueling the lawlessness at CitiFinancial (originally Associates) and doesn’t even mention the repeal of Glass-Steagall, which allowed Citi to make lawless loans in Natchez and resell them as toxic CDOs in Nice.

While the financial sector grew, the real economy, average annual growth, sagged in the United States, as in most developed countries. Wages have famously stagnated even as productivity has risen. And with wages stagnant, consumer and mortgage debt rose. Mortgage debt increased by a factor of 24 during the financialization era to $12 trillion by 2005 and from 48.7 percent to 97.5 percent of GDP. Credit-card debt rose from a few billion to nearly a $1 trillion.7

From 1973 to 1985, as Simon Johnson has observed, the financial sector never earned more than 16 percent of domestic corporate profits. In 1986, that figure reached 19 percent. In the 1990s, it oscillated between 21 percent and 30 percent. In the 2000s, it reached 41 percent. From 1948 to 1982, average compensation in the financial sector ranged between 99 percent and 108 percent of the average for all domestic private industries. From 1983, it shot upward, reaching 181 percent in 2007.⁸

But numbers tell only part of the story. In the 1980s and into the 1990s, Wall Street was powerful, but so were countervailing forces, particularly financial regulation and white-collar-crime enforcement. Where powerful prosecutors had exercised independent authority, smaller figures, many coming directly from the financial-services industry, would take their place. The arms-length relationship between regulated and regulator changed to a revolving door as Wall Street powerbrokers occupied high-level government positions. Robert Rubin and Henry Paulson moved from Goldman Sachs to take over the Treasury Department. Alan Greenspan stepped down as Fed chairman to consult for Pimco. Regulatory control over the financial system began to give way, with the 1999 repeal of Glass-Steagall only the most visible sign. The tilt toward the financial sector could be subtle—the SEC, at the behest of Wall Street banks, agreed to change the “net-capital rule” to allow investment banks to dramatically increase the amount of debt on their books—or not so subtle: at a 2003 news conference on reducing banking regulation, the head of the Office of Thrift Supervision, James Gilleran, wielded a chainsaw over a stack of rules.

Mulling the disconnect between finance as it really was and the journalism that purported to cover it, Tett sketched a “cognitive map,” a tool used by scholars to delineate the difference between a social reality and the discourse about it, of the City of London, the U.K. version of Wall Street. She noticed something strange: While most business-news reporting centered on glamour beats, like the stock market and mergers and acquisitions, those were far from the biggest part of the financial system. In terms of sheer dollars, including investment-banking profits, the credit markets dwarfed them by an order of magnitude. These were bonds issued by governments and corporations and others that investment banks had created by pooling together various loans—auto loans, corporate loans, credit card loans, and mortgages—into securities that were then sold to investors, such as pension funds, or traded around the globe and used as collateral for other loans. For one thing, there was this roaring business in a thing known as collateralized debt obligations, or CDOs, and other “derivatives,” so called because they were derived from some other security, like bonds backed by mortgages, known as residential mortgage-backed securities. Looking at her map, Tett thought of an iceberg—not in the sense that the financial system was heading for one. She just found it remarkable that only a bit of the financial world—stocks, M&A—was visible in the press and the public discourse while the vast bulk of it lurked below, out of view, and out of the discussion.

At first Tett sensed not danger for financial markets but an opportunity for the newspaper. If other outlets ignored this vast and hidden sector, perhaps the FT could stand out by helping its readers profit from it. She wrote a series of memos, which became known as the “iceberg memos,” pushing for more coverage of debt markets. This kind of advocacy is not always popular around newspapers, which tend to be set in their ways, and in this case led to Tett’s transfer from the Lex job to the Capital Markets team, which was not a promotion. Capital Markets stuff typically appeared in the back of the paper, and its desks were in a remote part of the building that overlooked garbage bins and bike racks. The group was about as far away from the top editor’s office “as it was possible to be and still be in the same building,” Tett would later say. A colleague seeking to console Tett, who was pregnant with her second child at the time, told her, “Capital Markets is a great place to go and have a baby. Nothing ever happens.” Here was Bourdieu’s theory of “social silences” played out in a working newsroom.9

Tett discovered that the debt business, too, held its own paradoxes. The “fixed-income” or “credit” business, as it was also known, fashioned itself as tantamount to a science. Increasingly populated with math Ph.D.’s, its methodology bristled with mathematical terms and elaborate formulas that purported to predict outcomes under every imaginable economic and financial scenario. Underpinning the mortgage-backed securities business, for instance, was a formula known as the Gaussian copula function, which allowed financiers to perform, in the language of quantitative finance, “stress tests” and “robustness checks” on a portfolio of securities under various scenarios that mirrored events in the real world, including “panic regimes.” The paradox, though, was that a superstructure that mimicked the hard sciences—like physics—was being built on a very human activity. As Tett noted, the actual word, “credit,” came from the Latin credere, “to believe.” Beliefs, of course, have little to do with math and are based more on shifting sands of consensus, interpersonal relations, and other intensely human activities. The multi-trillion-dollar market was based on someone’s belief in someone else’s ability and willingness to do something (in this case, pay their debts). That human behavior, and not scientific law, lay at the debt markets’ foundation was, as Tett put it, “a flipping obvious point to anyone with a background in social anthropology” (or anyone else, for that matter), but it “came as a tremendous surprise to most people who work in money.”10

On taking over Capital Markets, which was then turning out other, mostly desultory work, Tett urged her small reporting staff to get out of the office and study bond dealers “in their natural habitat.” In early 2005 Tett traveled to the European Securitization Forum in Nice, France, where the talk was all about CDOs, CDSs (credit-default swaps), and other strange acronyms. Walking around the conference, with its PowerPoint presentations, cocktail parties, and strange idioms, she thought of it as a kind of giant Tajik wedding, where members of a particular type of tribe, isolated from the wider financial system, gathered to speak their common language and restate common values and shared myths. One of the myths, stated over and over, was that the participants were involved in a technological revolution of sorts, innovation so profound it would have as much impact on the financial system as the Internet was having on communications media. This myth held that these innovations would benefit not just bankers but society as a whole, expanding credit while at the same time making the system safer. The idea that banks once kept the loans they made on their own books was thought to be an archaism, the bad old days. This was a new era in which risks were distributed among sophisticated parties to the benefit of all. It all sounded good, but what struck Tett was that amid all the discussions of money, math, and models, it almost never came up at these conferences that the system everyone was working on involved human decisions and contracts made under human circumstances.¹¹

Tett returned to London determined to write about this strange, new, exploding market. One of her earlier, longer pieces ran to 2,300 words on April 19, 2005, under the headline “Clouds Sighted Off CDO Asset Pool.” The lead anecdote featured a lawyer who had just completed a contract to sell some of these ultracomplex securities and was surprised to learn that the buyer was not a hedge fund or bank but an Australian charity. Tett reported that the CDO market had already reached $120 billion in 2004, about as much as all European corporate bonds issued that year. Did investors really know what they were buying? Another piece, in May, tried to pin down even the size of the market, which was still unclear. By July 2005 she had traced the boom back to the U.S. mortgage market, which was providing the raw material for most of the explosion in derivatives and, by March 2006, she had traced the origins of these new financial “products,” as they are known, back to a small cadre of bankers and financial engineers at J.P. Morgan, specifically to an “offsite” brain-storming session in Boca Raton, Florida, in 1994, where the idea for an insurance contract against bond defaults, to become known as “credit-default swaps,” was first bruited. She learned that this “Morgan Mafia” had since dispersed to other banks to spread the gospel.12

By the end of 2006, Tett’s writing, while still mostly appearing in the back of the paper, became more explicit and more urgent. “Time to Decode Derivatives,” from September 20, 2006, linked the big demand for “derivatives” (collateralized debt obligations aren’t mentioned) to low central bank rates. “Take Care When the Sweet Taste of CDS Starts to Turn Sour,” on November 3, warned that some of the technical kinks in the market hadn’t been worked out. A piece in December probed the vital role played by rating agencies in assigning top ratings to even the most exotic instruments. By the spring of 2007, when the financial world, including the rest of the business press, first began to awaken to the unfurling financial crisis, Tett was bluntly warning that the CDO threat was far more dangerous than investors and regulators understood.¹³

Tett later said that she all along feared that competitors would discover the story and jump in. Before going on a six-month pregnancy leave, in October 2005, she drew up plans for how to respond if other outlets caught on, but when she returned they still hadn’t. The CDO market became more frenetic, with $271 billion issued in 2005; $520 billion in 2006. But all she saw in the business discourse was the same iceberg: reporting about the stock market and M&A—business press as usual. The press “didn’t have the foggiest idea the revolution had happened at all,” she marveled.14

To be sure, even Tett’s work, as singular as it was, reads today as somewhat tentative, given the calamity to come. The stories, understandably, contained the usual caveats and hedges (“In some respects, this startling growth is a potentially positive step for global markets”) along with probing questions (“if a shock occurs, will it turn out that investors have not understood the potential dangers?”).¹⁵ Some followed blind alleys (one piece worried about the role of hedge funds in the CDO market, which turned out to be a different problem than the one she had anticipated); most stories weren’t prominently displayed. The piece linking CDOs to mortgages, for instance, ran at 300 words on page 23. Her 4,000-word profile of the “Morgan mafia” doesn’t actually mention the term “credit-default swap,” which was still gaining currency, or “collateralized debt obligations,” the principal instrument that credit-default swaps would insure. The idea that the U.S. subprime mortgage market had something to do with the Morgan invention was even more remote.

But the fact that these stories appeared at all, particularly in 2005 and 2006, made them remarkable. Other news outlets produced stories on the derivatives markets, some of them quite fine, as we’ll see, but no one pursued the beat with such penetrating focus. That’s why Tett would earn “Business Journalist of the Year” honors from the British Press Association in 2008 and then “Journalist of the Year” in 2009, as the scale of the crisis became more fully understood. She was promoted to managing editor of U.S. operations at the Financial Times in 2010 and won global recognition as one of a handful of professionals, inside and outside of journalism, who called attention to looming dangers. All these accolades were well deserved.

While grateful for the recognition, Tett herself would refer to these prizes as “guilt awards,” a tacit admission, as she would say, that, by and large, the business media “had missed one of the biggest stories of the decade.” She doesn’t exempt the FT or herself in the critique, despite her lonely work, and has since devoted considerable thought to trying to understand what happened. “Why had no one covered it? Why was this allowed to happen?” she asked. She thought about Bourdieu’s “social silences,” the patterns of conformity, ideology, and assumption that delineate what is discussed and what isn’t—what is deemed irrelevant or beyond question. It was at this “semiconscious level,” she would later observe, that social silences are most insidious, particularly when they serve the interests of a particular group, in this case, financial elites. She would later quote Bourdieu in an article for a finance journal (likely the first Bourdieu citation in such a venue): “‘The most successful ideological effects are those which have no need of words, and ask no more than complicitous silence.’”16

She also developed a theory of silos, later of “geeky silos,” the idea that small cadres of technical experts, hidden from public view, are pushing the frontiers of their particular disciplines in ways that could in fact be quite dangerous. In her 2010 speech to the American Anthropological Association, Tett warned that society was increasingly vulnerable because of intellectual and structural fragmentation, with geeky silos in industries from oil drilling to nuclear power, yet also increasingly interconnected. Who, she asked, will serve as watchdogs? Who will be the generalists who will act as cultural interpreters, break social silences, ignore the ridicule and impatient sighs of the cognoscenti, connect dots, see the systemic changes, and warn of them? Worse, she said, the growing danger from geeky silos comes at a time when the power and reach of traditional watchdogs, including the press, is being eroded.¹⁷ Here, Tett echoes the thinking of McClure, Steffens, Baker, Tarbell, and other muckrakers, generalists, and investigators whose work looked at issues systemically.

The subprime-CDO story was an example of Bourdrian theory brought to terrifying reality. Here were a few hundred experts on a handful of derivatives desks, secluded from society, from the financial world, and within their own individual firms by their arcane language and secretive culture. Yet they had demonstrated the capacity to do grievous harm to the global financial system. These financial engineers had sat at flickering screens, seeing the world much as the prisoners in Plato’s cave, not reality but shadows of reality. The most unnerving aspect of the derivatives business was that while it cranked out hundreds of billions of dollars in subprime-mortgage-backed CDOs, almost none of the Wall Street and City of London executives Tett knew had encountered a “real-life subprime borrower in the flesh.”18

But high finance, at least, doesn’t pretend to speak to and for the public. Journalism does. It is notable that Tett, a generalist, new to the derivatives beat, was able to see anomalies that others could not. Indeed, she attributes her success to her status as an outsider and a generalist. This freed her from preconceptions, peer pressure, intellectual capture, and the frames accepted by the people and institutions she was covering. It allowed her to move from silo to silo, examining different parts of the system holistically and, most of all, to think about “social silences,” the blank spaces on the map.

Hudson and Tett were two points on a spectrum. Hudson roamed the mortgage market; Tett, the aftermarket. To connect the dots, each would have had to follow the money—up, in Hudson’s case, down, in Tett’s. Hudson would eventually get there, but before he did, another reporter doing similar work on the subprime business—indeed, a friend of Hudson’s—would make the connection between systemic corruption on the ground and its ultimate destination in global debt markets through a remarkable book few have ever heard of.

Richard Lord, a reporter for the Pittsburgh City Paper, had read Hudson’s Merchants of Misery and was struck, as Hudson had been, not so much by the predatory nature of the subprime lending business but by the fact it was going mainstream. In the early 2000s, Lord began to look into foreclosure filings in the Allegheny County Protonotary’s Office, which covers Pittsburgh. He found the numbers had risen sharply between 1995 and 2000, from 1,000 to 2,500, and that driving the spike were subprime mortgages, which had risen from a tenth of the foreclosures to more than a third, about 900. He found anecdotal cases of mortgage abuse that were literally hard to believe: the ninety-two-year-old, blind-in-one-eye, ninety-pound, housebound Albert Blank, whose undoing came when he answered to door to a home-contracting salesman with brokers in tow from the Money Store. “I signed it,” Blank told Lord. “I was a damned fool.” Lord wrote a series of stories for City Paper then looked outside Pittsburgh and found similarly soaring foreclosure rates in other urban centers: Newark’s Essex County, Detroit’s Wayne County, Cleveland’s Cuyahoga County, Chicago, and elsewhere. “The foreclosure tsunami suggests that the very concept of working class homeownership could be in jeopardy,” he wrote.19

The result was a peculiar, undeniably muckraking work published in late 2004: American Nightmare: Predatory Lending and the Foreclosure of the American Dream. The 230-page book has no index or footnotes and is a pastiche of anecdotes and data that ranges over contractor scams; profiles of Conseco, Household, and CitiFinancial; a chapter on mortgage servicers; and an appendix of advice on how to avoid a subprime loan and what to do if you have one. It opens with an anecdote about the Eselmans from the rustbelt town of Evans City, Pennsylvania, a musician making $10,000 a year and his wife, who ran a failing home-based business advising others how to build a home-based business. They had gotten in too deep with Conseco, a $96,000 loan with $18,000 in fees. The book is remarkable in the matter-of-fact way it traces the chaos of this household’s dilemma—and the spike in inner-city foreclosures, generally—directly to the MBS market and its sponsors on Wall Street. In a chart, the book uses Federal Reserve and mortgage-trade publication data to document a tenfold increase in subprime lending from the mid-1990s to 2003, which were the most recent data available, and the parallel rise in subprime securitization (32 percent, or $11 billion, of the $35 billion in subprime loans in 1994 and 61 percent of the $203 billion in subprime loans in 2003).²⁰ Another chart details the spike in subprime-related foreclosures. Chapter 2, “This Little Loan Went from Main Street to Wall Street,” describes the technical advances made in the early 1990s in the secondary market for subprime loans that allowed for their securitization and explains how high rates and other onerous terms, such as prepayment penalties, actually increased the value for Wall Street, incentivizing predatory lending. Lord makes this commonsense observation:

The paragraph, as simple as it is, contains great insight. Like Hudson, and unlike the great bulk of the financial press elite, Lord understood the subprime market not just from a financial point of view but from a human one. He understood it as a phenomenon he had personally experienced through traditional news reporting. Lord had walked the streets, knocked on doors, sat scribbling with notebook in hand as borrowers poured out their stories, their anxieties, their anger, their sense of betrayal, as well as the misrepresentations, frauds, flim-flams, and tacked-on fees they confronted.

Then, using publicly available Securities and Exchange Commission filings, Lord traced the path of subprime mortgages like that of the Eselmans. He found a Bloomberg terminal at a University of Pittsburgh library (in fact, he had had to sneak in posing as a student) where he discovered a list of likely purchasers of the Conseco residential MBS of that vintage, including Great-West Life & Annuity Insurance and other insurers, foreign and domestic. Investors, Lord reports, earned between 3.8 percent and 8 percent, depending on the tranche. “I want to know if they have any thoughts about what they helped to do, and the lives they helped to crumble,” Lord quotes the borrower, Jill Eselman, after reading her the names of the investors.²²

Once he understood subprime lending for the racket that it was, Lord, who had no previous financial-reporting experience, was able, without much fanfare, to trace the funding to its source, Wall Street. His book doesn’t show awareness of the emerging market in CDOs, which were made from the residential MBS, the derivatives, or what might be called the after-aftermarket. But he understood that this was a big, global business based on loans to families like the Eselmans and the others he met in inner-city Pittsburgh and rural Pennsylvania. He understood that the MBS market had been stable for years but that this was a different kettle of fish. This was, “predatory lending and the foreclosure of the American dream,” as his book’s title would put it.

Beyond the relative importance of these and other elements, conservative arguments place the blame primarily on federal housing policy, centering on Fannie and Freddie (the GSEs) and federal housing agencies, whom they blame for an “intensive effort to reduce mortgage underwriting standards,” which in turn eroded standards across the board. A related school of thought, represented by the columnists David Brooks and George Will and some elements of the business commentariat, advances the argument of cultural decline: that public attitudes toward debt over the years became casual to the point of irresponsibility, leading millions of Americans to take out mortgages without taking into account their ability to repay. Why this happened spontaneously and en masse sometime around 2003 is not explained.23

While government certainly contributed to the crisis, chiefly by failing to adequately regulate the financial sector, the argument that it drove the subprime market has been rejected by the main official investigations and debunked elsewhere. As many commentators have noted, there are a number of things to be mad at the GSEs about—their use of political clout to ward off oversight, their mid-2000s accounting scandals, their purchases of Wall Street–created subprime securities, their huge losses caused by the sheer size of their portfolio—but data show they never bought subprime mortgages per se. They did buy Alt-A (poorly documented) loans but did so late, most aggressively in 2006, and only after losing market share to the private sector, which had vastly expanded and dominated the subprime/Alt-A market. And even after they lowered standards, the loans the GSEs bought or backed significantly outperformed those in the private sector: Even for a subset of borrowers with similar credit scores—below 660—FCIC data show that GSE mortgages were far less likely to be seriously delinquent than non-GSE securitized mortgages: 6.2 percent versus 28.3 percent as of the end of 2008. As for the Carter-era Community Reinvestment Act—another conservative target—the argument for the centrality of a 1977 law in a mortgage boom three decades later is even more far-fetched, but suffice it to say that the FCIC found that only 6 percent of all “high-cost” (subprime) loans had any connection to the law, which didn’t even cover some of the worst actors—non-banks like Ameriquest, Countrywide, and the rest.24

While the causes of the financial crisis are obviously complex, no one seriously doubts that U.S. mortgages were at its center. And at the center of the mortgage crisis was subprime, along with its deformed cousin, Alt-A. There is no escaping the mortgages, always the mortgages, and at the beating heart of the crisis: subprime.²⁵

In 2004, soon after wining the Polk Award for his Citigroup exposé, Michael Hudson was asked by film producer James Scurlock to redo some of his interviews from “Banking on Misery” in front of a camera for an antidebt documentary that would become Maxed Out. Followed by a camera crew, Hudson returned to Aberdeen, Georgia, to talk to John Brown and his mother; visited other borrowers in the outer boroughs of New York City; and then headed to Pittsburgh, where he linked up with Richard Lord, who had just finished American Nightmare. One night, after a day’s interviewing, the two reporters sat in Lord’s basement office, trying to figure out what to do next.

Hudson and Lord were dumbfounded by the rise of the street-corner consumer-finance industry and its move to the center of the U.S. financial system. Hudson was particularly struck by the emergence of Ameriquest, one of the so-called new generation of subprime lenders that promised to clean up an industry that had seen virtually all its market leaders—Associates, First Alliance, Conseco, GreenTree, Household—embroiled in scandal or collapse or both. The Orange County, California, lender had done a remarkable job of cleaning up its own image.

Roland Arnall, Ameriquest’s founder, was one of the more complex and ruthless figures of the mortgage era. Born in 1939, he was the child of Eastern European Jews who fled to Paris to escape Nazi persecution. Arnall and his family moved to Montreal and, in the late 1950s, to Los Angeles. Arnall started out selling eggs door to door then flowers as a street vendor. Eventually, he found his way into real estate. Associates describe him as a man driven to dominate but with a disarming side as well—“the biggest bastard in the world and the most charming guy in the world, and it would be minutes apart,” a former executive said. Describing the outcome of a deal he’d struck with Arnall, a former partner conveyed the ambivalence Arnall could provoke: “He fucked me. But within reason.”26

Considered the father of modern subprime, Arnall was “obsessed with volume” and believed “volume solved all problems.” He pushed his loan officers to meet aggressive sales targets and, whatever the target, was prone to say, “We can do twice that.” In 1980 Arnall founded Long Beach Savings & Loan, which later morphed into Long Beach Mortgage, a portion of which he sold off to Washington Mutual (fatefully for that lender, it would turn out), a portion of which he changed into Ameriquest. He pioneered the use of computers to find potential borrowers and to speed the loan-approval process. By 2005, Arnall ranked seventy-third on Forbes’s list of the richest Americans with a personal net worth of $3 billion.²⁷

Ameriquest had its share of scrapes with regulators, including a $4 million settlement with the Justice Department in 1996 over a suit alleging the lender had gouged older, female, and minority mortgage borrowers. In the late 1990s, the FTC launched a new predatory-lending investigation, and the company attracted the ire of housing activists, including ACORN, which denounced the lender as a collection of “slimy mortgage predators.” Ameriquest resolved its standoff with ACORN in 2000 by agreeing to establish a fund, administered by ACORN, for needy borrowers and adhere to a list of “best practices.” ACORN, in turn, held up the company as an industry model. As it contemplated a public stock offering and a move into the highly competitive market for prime loans, Ameriquest bolstered its political ties. It donated heavily to various political campaigns, including those of Arnold Schwarzenegger, who as California’s governor would oversee Ameriquest’s main regulator, and George W. Bush. Arnall would be one of the top ten donors to Bush’s 2004 reelection campaign. Ameriquest committed $75 million to have the Texas Rangers ballpark dubbed Ameriquest Field. In 2005, it would sponsor the Super Bowl XXXIX halftime show. It owned two blimps.28

But that was PR. Insiders knew Ameriquest to be at the center of the boiler-room culture that was then overtaking the mortgage-lending industry. Even as it became the nation’s leading subprime lender, in 2004, Ameriquest became notorious among regulators, housing activists, plaintiffs’ lawyers, and borrowers—precisely the sources that Hudson talked to and mainstream news organizations ignored. Customers were filing complaints with the Federal Trade Commission against Ameriquest four and five times more frequently than against Countrywide’s and New Century’s subprime units, respectively, and both of these lenders were already notorious among insiders. Lawsuits and class actions were popping up around the country, alleging a culture of corruption within the lender. According to the affidavit of one former employee, the lender encouraged employees to “promise certain interest rates and fees, only to change those rates at the time of the closing.” By the end of 2004, attorneys general were conducting what would be a fifty-state investigation into abusive lending at Ameriquest.²⁹

Like a lot of newspapers around the country, the Roanoke Times, where Hudson worked, had lost some of the élan of the 1980s heyday. It had cut back on staff, and, in Hudson’s view, its appetite for muckraking had slackened. Hudson wanted to move into other types of reporting and to avoid being associated with a single subject. But that wasn’t happening. The sight of the subprime industry, and the likes of Ameriquest, rising from its “Miss Cash” origins to dominate the financial system with Wall Street backing it all was too mind-blowing to leave alone.

In 2004, he put together a pitch on Ameriquest and contacted a friend who knew someone at the Los Angeles Times, who put him in touch with Rick Wartzman, the business editor, and John Corrigan, a deputy editor. The paper approved the idea—unusual enough for a major newspaper to agree to a green-light an investigative story from a freelancer—and paired Hudson with E. Scott Reckard, one the Times’s most respected reporters. Together, Hudson and Reckard produced a series that peeled the façade from Ameriquest’s carefully devised public-relations campaign and, to devastating effect, exposed the lender as a lawless marketing machine.

To business reporters of a certain age, boiler rooms are associated with the notorious stock swindlers of the late 1990s, many criminally indicted, including A.R. Baron, Stratton Oakmont, and First Jersey Securities. These firms specialized in promoting penny stocks to unsuspecting investors, many of them elderly, who lost their entire investment when the stocks inevitably crashed. The signature of boiler rooms were “pump and dump” schemes—salesmen (and they were mostly men) working from scripts touting the stocks of companies with plausible sounding names (e.g. Health Professionals Inc.) and plausible-sounding stories (temporary health-care staffing)—and the trappings of legitimacy, stock-ticker symbols, financial statements, and so on. The stocks would rise on the manipulation and crash after the brokerage had taken its profits, ignoring the frantic calls of investors.

Boiler-room telephone operations date to at least the 1980s and got their name because many were originally near the actual boiler rooms of office buildings, a cheaper location that had the added advantage of being hidden from prying eyes. The name stuck because the idea of heat became central to boiler-room culture. A telephone operation was said to run at “full burn” when every phone station was manned by salesmen. It generated “heat” when the sales force was working with urgency, cold-calling vigorously and riffing effectively on the scripted sales pitch. “It’s a numbers game,” Hudson would later quote a longtime sales person. “Make enough calls, and you sooner or later get the deals.”30

Boiler-room culture, driven by young men earning tens of thousands of dollars a month, is traditionally associated with high living and louche behavior. A lawsuit filed by a bankruptcy trustee of A.R. Baron alleged that former executives charged on corporate credit cards or were reimbursed for “several million dollars” in expenses for prostitutes, vacations, evenings at strip clubs in which “‘tens of thousands of dollars were spent,’” orgies that caused thousands of dollars in damage to New York hotel rooms, wine collections, and $50,000 per-seat season tickets to New York Knicks professional basketball games.31 In Born to Steal: When the Mafia Hit Wall Street (2003) Gary Weiss, a former Businessweek reporter and specialist in financial fraud, documents epic parties thrown by boiler-room operators, including an amusing anecdote about one who often ended coke-and-prostitution binges by tearfully watching a videotape of The Lion King. (“Benny used to have this thing about watching The Lion King after we did coke,” Weiss quoted a cohort. “I put in the video, and he’s crying watching the fucking Lion King.”)³²

Ameriquest was all about “the energy, the impact, the driving, the hustling,” the LA Times quoted Lisa Taylor, a former Sacramento-based employee, who also told the paper she had witnessed other employees tracing forged signatures by the light of a brightly lit Coke machine in the office. One former employee described being threatened with firing nearly every day. Another described the twelve-hour workdays punctuated by “power hours”: nonstop cold-calling sessions to lists of prospects burdened with credit card bills; the goal was to persuade these people to roll their debts into new mortgages on their homes. Anecdotes conveyed the idea of an institution out of control: A Spanish-speaking woman in East Palo Alto, California, was put in a mortgage with payments—$2,494 a month—that exceeded the entire income she earned cleaning houses. The only Spanish-language document she ever received was a foreclosure notice.³³

In May 2005, another story explored how Ameriquest and other big lenders (including Citigroup) had given hundreds of thousands of dollars in donations to community housing groups, including ACORN, muting their criticism and, in effect, buying respectability. Hudson and Reckard reported that their earlier story, in February, had prompted at least one of the groups, the Greenlining Institute, in Berkley, California, to return $100,000 to Ameriquest.³⁴

With the LA Times series going well, Hudson stepped back and pulled together a story list with eight items—probably five too many, in retrospect, given a typical newsroom’s capacity to deal with any single subject. One tried to get at the special nature of subprime—highlighting the particularities of an industry that, unlike conventional lending, seemed to prone to a cycle of rapid growth ending in either collapse, scandal, or both. Hudson proposed to look to the source of subprime funding: Wall Street. “The role of the securities market in producing the 20-fold increase in subprime mortgages over the past decade is an important story that no other news organization has addressed,” Hudson wrote LA Times editors. “Ameriquest as we know it wouldn’t exist without the mortgage-backed securities market, which funnels tens of billions in ready, fast-turn-around cash into the company. Who are the investors that buy Ameriquest’s securities? Have they—or any of the ratings agencies—begun to experience concerns about the quality of Ameriquest’s portfolios?”35 Good questions—but they wouldn’t be explored until later.

Even so, the Times muckraking series continued to good effect throughout 2005, including another story on Hudson’s list, which ran on October 24 and struck even closer to the heart of the lawlessness that by then had overrun the mortgage-lending business. Under the headline “More Homeowners with Good Credit Getting Stuck with Higher-Rate Loans,” the story pointed to a study of hundreds of thousands of loans by Freddie Mac showing that more than 20 percent of subprime borrowers actually qualified for prime mortgage loans. Since no one would voluntarily agree to a higher-priced mortgage or more onerous terms, the findings pointed toward what might be called the “boiler-room effect”: deception, confusion, and fraud. The 2,500-word story included interesting support from IndyMac, at the time a prime lender (later bankrupt and seized). It had examined the books of several subprime lenders it was considering acquiring and made a startling finding: at Ameriquest, as many as 40 percent of borrowers in subprime loans had credit scores that actually qualified them for prime loans. Of course, the presence of good-credit customers in bad-credit loans is not proof of lawless lending. There are good reasons that some borrowers with good credit—the self-employed, for instance—might still be penalized with a subprime loan. But Hudson and Reckard raise the possibility of corruption stemming from subprime’s takeover of the lending system.

Whether by skill or chance, Hudson and Reckard were right to focus not just on subprime lending in general but on Ameriquest in particular. By this point Ameriquest and its affiliates had become the subprime market leader, making $83 billion in loans in 2004, more than 15 percent of subprime market that had reached over $530 billion, about 18 percent of all mortgages in the United States.36 Ameriquest’s boiler-room sales tactics and anything-goes “underwriting” forced the rest of the market to play catch-up. Ameriquest was a practical example of Gresham’s Law, or bad money driving out the good, and William K. Black’s theory of how unregulated markets create criminogenic environments.³⁷

It was later discovered that no less a figure than Angelo Mozilo, chairman and CEO of Countrywide Financial, had complained about Arnall and Ameriquest and blamed them for driving down standards across the entire subprime mortgage market. Chain of Blame, an early history of the financial crisis published in 2008, describes a telling summit of sorts in the early 2000s (the location and date are not specified) between the two mortgage titans, Arnall, then the rising subprime star, and Mozilo, head of overall mortgage-market leader Countrywide, which, to that point, had trodden carefully in the subprime market. Mozilo wanted to know the secret of Ameriquest’s runaway growth. He came away appalled:

“He plays by his own rules,” Mozilo told an associate. “He’s the guy who started stated-income, the guy who started no-documentation loans. All of his people were on commission.” Mozilo learned more details about Arnall’s tactics after Countrywide hired a group of former Ameriquest employees in New York. He became so concerned, he said, that he forwarded the information to the state’s attorney general, Eliot Spitzer. It may seem ironic that Mozilo, the public face of a lawless mortgage era, would turn to law enforcement to police a competitor. But Mozilo merely recognized that, in an unregulated environment, one bad actor could destroy an entire market. In All the Devils Are Here, McLean and Nocera also find evidence that Mozilo saw the problem that Arnall’s Ameriquest posed during the early 2000s as it captured an increasing share of the market: “‘If you had said, “Nope, I’m not going to do this because it’s not prudent,” you would have had to tell shareholders, “I’m shutting down the company.”’ ‘“Ameriquest,”’ Mozilo told a friend, ‘“changed the game.”’”³⁸

It should be recognized that for its trouble, the LA Times faced relentless resistance from Ameriquest, which was then at the height of its influence and political power. But despite its political clout, aggressive public relations, and leading market share in the subprime industry, Ameriquest would become yet another subprime lender shuttered in the wake of aggressive press and regulatory investigations. Concurrent with (but separate from) the Hudson/Reckard series, Tom Miller of Iowa and Prentiss Cox (then an assistant attorney general) of Minnesota were leading forty-nine state attorneys general in an investigation of systemic fraud and misrepresentation in Ameriquest’s lending operation. In early 2006, Ameriquest agreed to pay $325 million in penalties and restitution. The settlement also imposed sweeping reforms on its lending practices, requiring Ameriquest, among other things, to disclose truthfully what a loan’s interest rate was. The company also agreed to stop “the practice of encouraging homeowners to falsify” their incomes and to eliminate compensation incentives that paid loan officers for putting customers in loans with the most onerous terms. The company also agreed to provide “accurate, good-faith” property appraisals, instead of fraudulently inflated ones. These changes led to its sale to Citigroup when it could not operate both profitably and honestly.

This is not to say that Hudson was alone in detecting the systemic shift in U.S. mortgage lending; some regional papers sounded the alarm that something had changed in the financial culture. The Atlanta Journal-Constitution, for instance, published a lengthy series in early 2005 that broadly looked at an array of lending abuses—high-cost used-car, personal, and tax loans—and rising personal bankruptcy and foreclosure rates in the state.39

Starting in August 2005, the Charlotte Observer zeroed in on the problem of subprime mortgage lending with a massive effort that over two years would alert its readers to deep structural problems in the subprime market. A keystone of the then-prestigious Knight-Ridder chain and one of the South’s marquee regional dailies, the Observer analyzed data on more than 2.2 million loan applications from across the country that had been released that year by the Federal Reserve under the Home Mortgage Disclosure Act of 1975. A 1989 amendment had required lenders to disclose data based on race (in response, partly, to the anti-redlining journalism and activism of the era), and, in 2002, the Fed added loan-pricing data (in response, again, to the journalism and activism of the turn of the decade). The data came from the nation’s twenty-five largest lenders, including Wachovia and Bank of America (now combined and bailed out), as well the other large lenders, Countywide, Ameriquest, etc.

The Observer, too, turned up signs of an industry gone rogue: Blacks, regardless of income, were far more likely to wind up in a subprime loan (the series called them “high-rate” loans) than whites. And brokers “often … can make more money by increasing the interest rate.” And so on. The three-day series, “The Hard Truth in Lending,” written by Binyamin Appelbaum, Ted Mellnik, and Rick Rothacker, started with a huge display across the Sunday front page and included all the accoutrements of a classic newspaper investigation—photos, graphics, pie charts, and tables. The series went onto describe the rise of the subprime industry and the patchwork nature of federal lending regulation.40

Interestingly, the series reported that the lending industry was bracing for a “deluge” of bad publicity following the formal release of the Home Mortgage Disclosure Act data later that year. The Consumer Bankers Association had already scheduled a conference that fall to deal with what it believed would be negative publicity resulting from the data. The conference title was “Preparing for the Storm.” For whatever reason, the “storm” of coverage, in the national business press, at least, didn’t materialize. The Wall Street Journal’s story on the release of the HMDA data, for instance, ran at 1,000 words on page A2 under the headline: “Blacks Are Much More Likely to Get Subprime Mortgages—Weaker Lender Competition in Some Low-Income Areas Is Cited as Part of Problem.”

So once again he put together a story list and at the top included a pitch for a piece about the multi-trillion-dollar market for mortgage-backed securities and how it was founded on loans made to people such as Carolyn Pittman—a sickly widow from Jacksonville, Florida, who accused her lender, Ameriquest, of fraud—and thousands of others who had filed similar complaints in one venue or another. While the dangers to the financial system were less clear, it didn’t take a finance degree to know that a securities market built on such sold-not-bought mortgages was unsustainable. His pitch quoted a scholar who said the MBS market was “flying blind” because of the scant data on subprime lending and pointed to risks for the market, including the fact that the loans were filled with exploding rate adjustments and pocked with shoddy documentation, inflated appraisals, and worse. “At a minimum,” Hudson wrote in the pitch, “we could do a story that explores whether mortgage-backed securities encourage lenders to make risky or predatory loans. The second, more speculative part of the story—what happens if the housing bubble bursts?—would be harder to pull off. But if we could muster enough evidence and analysis to do so, it would take the story to another level.”41

One target that seemed particularly ripe was Lehman Brothers. After all, it had been a leader in underwriting subprime since the 1990s and had already accumulated a trail of litigation, including a judgment against it in the case the New York Times and ABC News had publicized in 2000, implicating it in the predatory practices of First Alliance Mortgage. After a few more letters, a series of serendipitous contacts, and a few interviews, Hudson’s hunt paid off. In May of 2006, he began covering the bond market, including mortgage-backed securities, for the Wall Street Journal.