THE DOT-COM STOCK MARKET bubble peaked in the winter of 2000. Its inevitable collapse was worsened by the terrorist attacks of September 11, 2001; and yet the resulting recession was short and mild. There were two reasons for this.
First, the Bush administration embarked on a campaign of massive deficit spending. The administration employed tax cuts, particularly for the wealthy, and sharply higher spending, particularly for the military—for the war in Afghanistan, the invasion and occupation of Iraq, and counterterrorism and intelligence efforts. And second, Federal Reserve chairman Alan Greenspan aggressively reduced interest rates. Greenspan cut rates from 6.5 percent at the peak of the Internet bubble all the way down to 1 percent by July 2003, the lowest in fifty years.1
The recovery, however, was an anemic one, even if you took it at face value. And the real problem was that you couldn’t take it at face value. What followed, in fact, was a remarkable alliance of financial sector greed and political calculation. The recovery of the 2000s was fake, driven almost entirely by unsustainable behavior: massive tax cuts and federal deficits, the housing bubble, and consumer spending enabled only by borrowing. While the real economy did continue to benefit from Internet-driven productivity gains, the United States was simultaneously falling behind many other nations in the underlying educational, infrastructural, and systemic determinants of national competitiveness. America’s manufacturing sector was quietly decimated. Moreover, most of the benefits of America’s productivity gains were now appropriated by the top 1 percent of the population, not by the broader workforce—a major change from prior generations. As a result, during the 2000s, even during the bubble, real wage levels for average Americans stagnated or fell, and on a net basis very few jobs were created. Gains from the fake economy and the (real) Internet revolution were offset by massive job losses both in manufacturing (including information technology products) and in services functions susceptible to outsourcing or automation.
GIVEN THESE STRUCTURAL problems, a fake recovery driven by a financial bubble was very politically convenient. Most of the growth in consumer spending during the 2000s was driven by the bubble. As house prices rose, homeowners could borrow more against the supposedly higher value of their homes; and by spending the proceeds of their borrowing, they both pumped up the general economy and also perpetuated the housing bubble itself, as borrowed cash was used to finance further home purchases (for second homes, rental properties, etc.).
In fact, much of the 2000s-era subprime lending wasn’t about increasing home ownership at all. Fewer than 10 percent of subprime loans financed a first home purchase.2 Many subprime loans issued during the bubble were devices to take money out of a home, to refinance a prior mortgage, or to buy a second home. Some of the loans were for personal consumption (televisions, vacations, cars, home improvements); some were for trading up to a more expensive home; many were speculation driven by the bubble, for the purpose of flipping houses repeatedly; and many more were frauds perpetrated against borrowers, who were tricked into deceptive, overly expensive loans.
But all of them contributed to the bubble. As a result the Case-Shiller U.S. National Home Price Index doubled between 2000 and 2006, the largest and fastest increase in history.3
Greenspan’s rate cuts undoubtedly helped start the bubble. Most people borrow heavily to buy a house, and the amount of house they can afford is driven by monthly mortgage payments, which in turn are heavily affected by interest rates. As a result of Greenspan’s rate cuts, prime mortgage rates fell by 3 percentage points from 2000 to 2003. Assuming standard fixed-rate mortgage terms, the same monthly debt service that supported a $180,000 home in 2000 would support a $245,000 home in 2003, a 36 percent increase.4 Not surprisingly, between 2000 and 2003, the Case-Shiller U.S. National Home Price Index went up more than a third.5 So, yes, interest rates were relevant. But they don’t even come close to explaining that doubling of housing prices during the bubble, which continued even after Ben Bernanke started raising rates again.
Over the next four and a half years, from 2003 through mid-2007, America’s financial sector churned out some $3 trillion in often fraudulent mortgage-backed securities (MBSs) and even more exotic, risky, and/or fraudulent derivatives tied to those securities. The home loans underlying these securities were mostly sourced through a new breed of largely unregulated mortgage banks, as well as by several leading commercial banks. Investment banks, some of which were subsidiaries of the larger banking conglomerates (e.g., JPMorgan Chase, Citigroup, Deutsche Bank), bought these mortgages and packaged them into structured investment products—mortgage-backed securities and collateralized debt obligations (CDOs). These were rated by the ever-cooperative rating agencies, insured through either the monoline bond insurance companies or AIG’s credit default swaps, and then sold to pension funds, insurance companies, mutual funds, hedge funds, foreign banks, and many others—even, often, to the asset management arms of the same banking conglomerates that had created them.
More than half of the increase in lending volume during the bubble was accounted for by subprime, Alt-A, Option-ARM, and other high-risk or predatory loans (see Glossary).
An astonishingly large share of these loans and the resultant securities were defective. The borrowers were people under financial pressure, people who were speculating, people committing fraud, and/or people who were being defrauded (a major category, discussed below). And whatever the reason for the defects in the loans, they were pushed all the way through the securitization chain with no regard for quality control—indeed, with negative quality control, due to intense pressure to find high-yield loans regardless of risk, and to cover up the risks that existed. Some of it was mere sloppiness, but much of it was conscious and deliberate. There was massive fraud. The deception was so enormous and so obvious that senior management frequently must have known, and indeed there is growing evidence that in many cases they approved or even directed it. And if some of them didn’t know, then the enormity of their negligence would be nearly as criminal as pure fraud. It wasn’t subtle, and we shall see it was discussed widely and explicitly within the companies involved. Moreover, there is clear evidence that many CEOs and senior executives lied to their investors, auditors, regulators, and the public, both during the bubble and afterward, as their firms started to collapse.
What was going on, of course, was that Wall Street and the lenders were using fraud to create, fuel, and exploit a Ponzi scheme. During the bubble, lending standards basically disappeared. Of course, there are always some people in America who want loans to buy a house, or to take out home equity cash, when they can’t afford the loan or have no intent to repay. Suddenly, those people had no problem getting loans. Neither did anyone else. There were people who had good incomes and steady jobs, but were stretching to buy houses beyond their means; people who wanted to cash out almost all their equity; speculators buying multiple houses with no intent to occupy or rent them, hoping to flip them at a profit; people who wanted a second home or vacation house they couldn’t really afford—all with a high risk of default, especially if prices ever fell. But during the 2000s, none of that mattered. Tax policy helped too; the Clinton administration had enacted a law specifying that the first $500,000 in gains from selling a house was normally tax free if it was rolled into a new house purchase. This encouraged flipping.
But there were also many blameless people, millions of them, who just got screwed. They decided to buy a house toward the end of the bubble, when prices were severely inflated, possibly even using a traditional, conservative mortgage and a large down payment. But a few years later they lost their job, or retired, or got divorced, or had sudden medical expenses, or needed to move for a new job. And when they tried to sell their house, they suddenly discovered that they couldn’t sell it, because its value had declined by a third, and that they had just lost their life savings.
And finally, there was also massive fraud committed against borrowers, in part through the proliferation of highly deceptive loan structures and sales practices. It is no exaggeration to say that the mortgage brokerage, real estate brokerage, and subprime lending sectors became pervasively criminalized during the bubble. Mortgage brokers were usually unregulated, and during the bubble thousands of small-scale shysters put on a suit and sold loans.
The bubble period saw the rise of exotic loan structures designed to make payments artificially low for some initial period, and/or to disguise the real terms of the loan, while actually charging the high interest rates that the banks liked. Mortgage brokers pushed loans with teaser rates heavily, often telling borrowers that when the higher real rate kicked in, the value of their home would have increased so much that they could handle the new payments by refinancing—in other words, by taking out yet another loan.
Mortgage brokers also steered clients into needlessly expensive loans on a massive scale. Several studies have concluded that at least one-third of all people receiving subprime loans during the bubble actually would have qualified for a prime loan. But they were placed into subprime loans with higher interest rates and unnecessary fees by mortgage brokers, who were paid explicit cash bonuses by lenders—yield spread premiums—for placing borrowers into more expensive loans. This, of course, also made the loans harder to repay, particularly after teaser rates expired or interest rates adjusted upward, and increased hardship and defaults when the bubble collapsed.
There was also a lot of flat-out fraud, often very cruel, committed against immigrants who didn’t speak English and/or had no financial experience. They were simply lied to—about the size of the loan, the size of the payments, the real interest rate—and told to sign documents they couldn’t understand or even read. Many mortgage brokers worked with unofficial lenders, sometimes even loan sharks, who provided additional concealed loans to cover down payments or “points.” Mortgage brokers paid real estate brokers bribes for referrals to illiterate and/or illegal immigrants. Often the victims trusted their mortgage broker in part because they shared a common language or ethnic background, or had been introduced by a mutual acquaintance.
Illegal immigrants were particularly easy to defraud because they were afraid to go to the police. The presence of large numbers of non-English-speaking illegal immigrants was unquestionably one reason that so much of the bubble was concentrated in California, Arizona, and Florida, as well as parts of New York City populated by recent immigrants. The Bush administration also deliberately made it difficult for subprime borrowers to use civil remedies. In 2001, in one of the Bush administration’s first economic policy decisions, HUD interceded in a federal legal case in order to make it extremely difficult for sub-prime borrowers, including U.S. citizens, to join class-action lawsuits against predatory lenders. This forced borrowers to sue individually, which for many was prohibitively expensive and difficult.
The wave of fraud did not go unnoticed. In 2004 the FBI issued a press release warning of “an epidemic of mortgage fraud,” and held press conferences to publicize the problem. In its 2005 Financial Crimes Report to the Public, the FBI noted that “a significant fraction of the mortgage industry is void of any mandatory fraud reporting,” and that the Mortgage Bankers Association provided no estimates on fraud levels. The same FBI report also stated that “based on various industry reports and FBI analysis, mortgage fraud is pervasive and growing.” Even more interestingly, the FBI report noted that mortgage fraud was not usually committed by borrowers alone, stating that “80 percent of all reported fraud cases involve collaboration or collusion by industry insiders”—real estate brokers, mortgage brokers, lenders, or some combination thereof.
But law enforcement was AWOL and/or overwhelmed, at both the local and federal levels. The entire FBI has fewer than fourteen thousand special agents for all categories of crime; only a tiny fraction were assigned to mortgage fraud during the bubble, when the FBI was intensely focused on counterterrorism efforts. In addition, the Bush administration deliberately gutted the investigative and enforcement capacity of financial regulators such as the SEC. With good reason, mortgage lenders and Wall Street felt largely immune from criminal sanctions. There was not a single high-level prosecution during the bubble, and very few arrests even for the most flagrant, low-level frauds.
But why did mortgage banks and Wall Street tolerate massive fraud, push so hard for subprime lending even for trustworthy borrowers, and favor exotic, toxic mortgage structures? Because that’s where the money was. Subprime loans paid much higher interest rates. They therefore sold for much higher prices to investment banks, because they could be used to construct mortgage-backed securities with much higher yields, which in turn were much easier to sell to investors—at least, until the loans defaulted. An extensive analysis of 250 million mortgage records carried out by the Wall Street Journal in 2007 showed that in the previous year “high-rate” mortgages, on average, had spreads of 5.6 percent over comparable Treasury bonds, at a time when spreads on a safe, honest, conventional loan with a real down payment were only about 1 percent.6
So how crooked did the lenders become in pursuing this strategy? Very crooked indeed.
THE COLLAPSE OF the S&L industry in the late 1980s and early 1990s, combined with the start of the housing bubble, led to the spectacular growth of highly unethical mortgage lenders, many of them in the largely unregulated shadow banking sector. These lenders, who drove the worst excesses of the bubble, were not traditional banks that took consumer deposits for savings and checking accounts. They existed solely to feed the securitization food chain, and they got their funding from Wall Street—from the same investment banks and financial conglomerates that bought their loans. Like the investment banks themselves, they relied on very short-term credit, which reduced the interest rates they needed to pay, but which also left them highly vulnerable to interest rate increases and other financial shocks. So when the bubble collapsed, they all collapsed too.
Many of these firms were in California—“mortgage banks” like New Century, Ameriquest, Golden West Financial, Long Beach Mortgage, and Countrywide. All of them made loans primarily to sell them into the securitization chain, and during the bubble their business exploded. For example, from 2000 to 2003, New Century increased its originations fivefold, from $4 billion to $21 billion, while Ameriquest’s jumped tenfold, from $4 billion to $39 billion.7 Both were highly fraudulent, and were the object of many lawsuits. However, both are now bankrupt, so substantial recoveries are impossible, even though their former executives and sales personnel remain wealthy—a story we shall encounter frequently.
As the bubble got under way, several large traditional banks, financial conglomerates, and all of the major investment banks acquired predatory or subprime mortgage lenders of their own. Citigroup snapped up Associates First in 2000, acquiring what was then the second-largest subprime lender, one that a consumer advocate called “an icon of predatory lending.” Lehman bought six subprime lenders by 2004, Washington Mutual bought eight, and Bear Stearns three. First Franklin, one of the larger subprime lenders, was taken over by Merrill Lynch in 2006. Those that remained independent formed tight relationships with the investment banks that purchased their loans and also supplied them with general financing, managed their stock and bond offerings, and invested the personal wealth of their executives. For example, a group of banks led by Morgan Stanley made large financing commitments to cement ties with New Century.
As we now know, the whole industry was extremely unethical. Here is a short survey.
Washington Mutual, or WaMu, was a longtime federally chartered savings and loan. Its CEO, Kerry Killinger, joined WaMu in 1982, and served as CEO from 1990 until the organization collapsed, was taken over, and then sold to JPMorgan Chase in 2008. Long Beach Mortgage Corporation was a California mortgage bank that was acquired by WaMu in 1999. Long Beach was just one of twenty originators acquired by WaMu in the 1990s, but was the only one allowed to continue to operate under its own name more or less independently. It had a terrible reputation, which it deserved. Losses on securities backed by Long Beach loans were among the country’s highest. The delinquency rate on Long Beach MBSs in 2005 was the worst in the country.8
WaMu’s reputation was not much better. It had grown by helter-skelter acquisition of smaller originators, without ever managing to create a well-integrated management system. But the booming housing market more than made up for executive incompetence. Killinger’s total compensation for the period 2003 through 2008 was more than $100 million.
WaMu made a decisive turn toward riskier lending in 2005 after Killinger called for a “shift in our mix of business, increasing our Credit Risk tolerance.” In a later board presentation, he said the objective was to “de-emphasize fixed rate and cease govt [Fannie/Freddie conforming loans].” While 49 percent of new originations in 2005 were already in the higher-risk categories, the objective was to achieve 82 percent higher-risk originations by 2008.9
Killinger’s board presentations carefully specified the “strong governance process” that would be required for the higher-risk strategy. But the control processes never were really implemented. Capital-based high-risk lending ceilings were violated almost from the start.
A more accurate picture of WaMu’s management style might be inferred from the “I Like Big Bucks” skit performed by the Kauai Kick It Krew at the President’s Club 2006 celebration of top loan “producers” (sales personnel) in Hawaii.10 The company had spared no expense for the event; the awards presentation was hosted by Magic Johnson, the Hall of Fame basketball star. At the event, the Krew, all top producers, backed up by a local cheerleading group, performed a rap number:
I like big bucks and I cannot lie
You mortgage brothers can’t deny
That when the dough rolls in like you’re printing your own cash
And you gotta make a splash
You just spends
Like it never ends
Cuz you gotta have that big new Benz.
WaMu’s compensation system reflected the rhetoric on Kauai. Loan officers were paid on a volume-based point system geared to loan product priorities. Of the sixteen products in the schedule, only the very last one was a traditional mortgage. The top priority was an Option-ARM product, one of the most dangerous of recent inventions. Borrowers could defer principal or interest payments during the first five years of a loan, accumulating unpaid balances that would later be added to principal. The higher principal payments would kick in at the same time as the permanent interest rate, which was much higher than the initial teaser. WaMu bragged that they were in second place in Option-ARMs, and gaining fast on the market leader, Countrywide.
WaMu’s Long Beach subsidiary was the worst. WaMu’s chief operating officer, Steve Rotella, reported to Killinger in the spring of 2006, when the bubble started to slow down: “Here are the facts: the portfolio (total serviced) is up 46 percent … but delinquencies are up 140 percent and foreclosures close to 70 percent.… First payment defaults are way up and the 2005 vintage is way up relative to previous years. It is ugly.”11 But the problems went far beyond Long Beach. WaMu sold almost all forms of high-risk loans—80/20 piggyback loans in which a first and a second mortgage covered the purchase price, the down payment, and the settlement costs; subprime loans; Option-ARMs; and subprime home equity loans. All of those were combined with “stated income” loans—loans with no income verification. Half of WaMu’s subprime loans, three-quarters of its Option-ARMs, and almost all of its home equity loans were stated income. High-risk loans with stated income were used for properties that were obviously being bought for speculation. Nobody seemed to blink when babysitters claimed executive salaries. To top it off, like most high-risk lenders, WaMu required that income be adequate only against the initial teaser rate, not the far higher permanent rate.
Two high-production centers in poor sections of Los Angeles were found to have high levels of fraud—of eighty-five loans reviewed at one center, 58 percent had confirmed fraud; in forty-eight reviewed at another, all were fraudulent. The two managers were deeply involved in the frauds. Both of them, of course, were longtime President’s Club honorees. The frauds included straw purchasers, forged documents, and the like. An investigation conducted in 2005 was brought to the attention of senior management but never followed up, and the managers continued their President’s Club run. A high level of fraudulent activities was disclosed in a third center—mostly production officers forging borrower data—but another investigation went nowhere. WaMu, of course, never notified investors who had purchased loans from these centers that the documentation was fraudulent.12
Former WaMu employees, who are serving as confidential witnesses in various civil suits, have testified that every originator was required to underwrite nine loans a day, with cash bonuses beyond that; that lending standards were changed almost daily; and that loans that combined FICOs* (credit scores) in the 500s (very low), Option-ARM structures, and high loan-to-value ratios (LTVs) were sometimes treated as prime. A senior underwriter testified that loans she had turned down frequently reappeared as approved by higher management. Dozens of former employees have testified in the same vein. The New York State attorney general has also sued WaMu for using financial pressure to cause appraisers to inflate property values.13
Even in 2007 and 2008, Killinger wanted to ramp up high-risk lending. In late 2007 he announced that WaMu was “adding some $20 billion in loans this quarter, increasing its loan portfolio by about 10 percent.” This at a time when losses on Option-ARMs in its portfolio had jumped from $15 million in 2005 to $777 million in the first half of 2008.14 Then the firm collapsed and was sold to JPMorgan Chase. Afterward, when asked at a Senate hearing why he had adopted a high-risk lending strategy, Killinger blandly answered that he had done no such thing.15
In March 2011 the FDIC sued Killinger and two other senior WaMu executives for $900 million, alleging that they had taken excessive risk for purposes of short-term personal enrichment. In December 2011 the executives agreed to settlements totaling $64 million. However, all but $400,000 was covered by their insurance; their personal assets remained nearly untouched, and they were not required to admit any guilt. Earlier in 2011, the Justice Department had already announced that it was closing its criminal investigation of WaMu, stating “the evidence does not meet the exacting standards for criminal charges.”16
New Century Financial Corporation was founded in 1995 as an independent mortgage lender concentrating on the subprime segment of the market. It was listed on the Nasdaq exchange in 1997. Its annual originations had grown to $3.1 billion by 2000, and shot up to $20.8 billion in 2003, making it the second-largest subprime originator. By 2006, its originations had grown to $51.6 billion. Three-quarters of its loans were purchased by Morgan Stanley and Credit Suisse, who also provided much of its financing.17
In early 2007 it announced both that it would restate its earnings from the first three quarters of 2006, previously announced as $276 million, and that for the full year, 2006 would show a loss. Securitizing banks withdrew their finance lines in March, effectively shutting down the business, and the company filed for bankruptcy in April. The salaries and bonuses of its three senior officers in 2005 were approximately $1.9 million each, and that same year each of the three cashed out between $13 million and $14 million in vested stock options.18
Interestingly, in 2008, a hedge fund manager named David Einhorn became famous for betting against Lehman Brothers, while questioning its finances and conducting a public campaign against it. Einhorn accused Lehman of deceptive accounting and of maintaining falsely high valuations on its real estate holdings. Mr. Einhorn certainly knew his subject; but he had been considerably less vocal about mortgage-related accounting irregularities when he had been a member of New Century’s board of directors throughout the bubble. An examiner later appointed by New Century’s bankruptcy trustee conducted an extensive investigation of the company and its auditor, KPMG. A 581-page report filed in February 2008 found substantial causes of action against company officers for “improper and imprudent” business practices and against KPMG for “professional negligence” and “breach of its professional standard of care.”19
The report itself provides many examples of on-the-ground practice during the bubble. New Century’s loan-acquisition volume nearly doubled every year from 2000 through 2004, by which time internal warning sirens were screaming. Here are samples of e-mails to senior management:
[Oct. 2004] Stated wage earner loans present a very high risk of early payment defaults and are generally a lower credit quality borrower than our self employed stated borrowers.20
[Oct. 2004] Stated Income. This has been increasing dramatically to the point where Stated Income loans are the majority of production, and are teetering on being >50 percent of production. We know that Stated Income loans do not perform as well as Full Doc loans.
[Fall 2004] I just can’t get comfortable with W2’d borrowers who are unable or unwilling to prove their income.
[Jan. 2005] To restate the obvious, a borrower’s true income is not known on Stated Income loans so we are unable to actually determine the borrower’s ability to afford a loan.
An internal memo said:
The most common subprime product is a loan that is fixed for 2 or 3 years and then become[s] adjustable. The initial rate is far below the fully-indexed rate, but the loan is underwritten to the start payment. At month 25 the borrower faces a major payment shock even if the underlying index has not changed. This forces the borrower to refinance, likely with another subprime lender or broker. The borrower pays another 4 or 5 points (out of their equity), and rolls into another 2/28 loan, thereby buying 2 more years of life, but essentially perpetuating a cycle of repeated refinance and loss of equity to greedy lenders.
Inevitably, the borrower lacks enough equity to continue this cycle (absent rapidly rising property values) and ends up having to sell the house or face foreclosure.21
Despite the sharp deterioration in loan quality, compensation plans stayed firmly focused on volume. In the end, it was sheer sloppiness that pushed New Century into bankruptcy, well before the full extent of its loan defaults and fraudulent behavior became clear. When an auditor discovered that accounting for loan repurchases required restating, it wiped out profits for 2006. The committee of Wall Street banks that financed New Century (chaired by Morgan Stanley) stopped providing money, and the company was effectively out of business.22
Countrywide, at first glance, was not the typical subprime lender. Founded in 1969 by David Loeb and Angelo Mozilo, it grew to become the nation’s largest and most profitable mortgage lender. Mozilo was famous for being obsessively hands-on as well as a terrifying boss. For many years the company had a reputation for conservative lending and excellent cost controls. In 2003 Fortune extolled it as one of the most successful American companies, with 23,000 percent stock appreciation since 1982.23
Mozilo was ambivalent toward the subprime strategy, and sometimes internally warned of its dangers. But in the end some combination of ego, greed, laziness, and perhaps fatigue (he underwent spinal surgery several times during the bubble) won out over both ethics and caution. As Mozilo approached retirement age in the midst of the bubble, he announced an absurdly ambitious goal for Countrywide: a 30 percent share of the whole U.S. mortgage market. This required aggressive expansion into the whole spectrum of toxic loan products, which Mozilo pressured Fannie Mae to buy. The rest he sold to Wall Street, which didn’t have to be pressured at all.
Countrywide also lobbied intensively and used techniques verging on bribery. Mozilo created a special “Friends of Angelo” VIP unit to provide vastly improved customer service and favorable mortgage terms to dozens of Fannie Mae executives, members of Congress, congressional staff members, and various prominent people (one recipient was Tonight Show host Ed McMahon, who defaulted on his $4.8 million loan).24 Recipients included House Speaker Nancy Pelosi and Senator Chris Dodd, chairman of the Senate Banking Committee, as well as three successive CEOs of Fannie Mae.
By 2006 Countrywide and its practices had become pervasively fraudulent. In September 2005, Countrywide hired a woman named Eileen Foster as First Vice President, Customer Care, in Countrywide’s Office of the President. In mid-2006 she was promoted to Senior Vice President. Then, on March 7, 2007, she was promoted again—to Senior Vice President for Fraud Risk Management. In this position she was supposedly in charge of Countrywide’s fraud reduction policies and she also directly managed several dozen fraud investigators.
Naively, she began to investigate fraud, and to do something about it. She rapidly uncovered massive frauds, in multiple regional loan offices, perpetrated by loan officers and managers. As usual in the industry, loan officers were being compensated based on “production” volume regardless of quality, and indeed, as was also common, they were incentivized to produce loans with the highest possible interest rates and fees. They could only do this at high volume through fraud.
Nearly immediately, Foster and her organization identified a massive organized fraud operation run by Countrywide personnel in the Boston area, including a regional and division manager.25 Foster and her unit developed evidence that forced Countrywide to close six of its eight branch offices in Boston and to terminate over forty employees. Foster and her unit were told about, and developed evidence regarding, a number of other organized frauds and senior loan personnel involved in fraud. In December 2007 Foster started to warn her management that there was systematic, widespread fraud within Countrywide. Her immediate manager agreed with her.
In December 2011 60 Minutes broadcast an excellent two-part report entitled “Prosecuting Wall Street,” exploring the lack of criminal prosecution related to the bubble and crisis. Foster is interviewed on camera by 60 Minutes correspondent Steve Kroft. Here are excerpts:
STEVE KROFT: Do you believe that there are people at Countrywide who belong behind bars?
KROFT: Do you want to give me their names?
FOSTER: No.
KROFT: Would you give their names to a grand jury if you were asked?
FOSTER: Yes.
KROFT: How much fraud was there at Countrywide?
FOSTER: From what I saw, the types of things I saw, it was—it appeared systemic. It, it wasn’t just one individual or two or three individuals, it was branches of individuals, it was regions of individuals.
KROFT: What you seem to be saying was it was just a way of doing business?
FOSTER: Yes.
KROFT: Do you think that this was just the Boston office?
FOSTER: No. No, I know it wasn’t just the Boston office. What was going on in Boston was also going on in Chicago, and Miami, and Detroit, and Las Vegas and, you know—Phoenix and in all of the big markets all over Florida. I came to find out that there were—that there was many, many, many reports of fraud as I had suspected. And those were never—they were never reported through my group, never reported to the board, never reported to the government while I was there.
KROFT: And you believe this was intentional?
FOSTER: Yes. Yes, absolutely.
Foster also began to see evidence that Countrywide’s corporate Employee Relations department was protecting fraudulent activity. It did this in several ways, including not reporting it to Foster’s organization; reporting fraud allegations to the perpetrator; identifying informants and whistle-blowers to the perpetrators; failing to act on complaints of retaliation against whistle-blowers; and by retaliating directly against them itself. (She told 60 Minutes that a senior Countrywide executive had ordered the ER to circumvent her department.26) Foster complained to the senior executives in charge of Employee Relations, at which point Countrywide’s ER department began to investigate her. In May 2008 Foster spoke to the executives in charge of Countrywide’s Internal Affairs unit, describing both the pervasiveness of fraud and also ER’s conduct. As we shall see shortly, this did not go well.
When the bubble peaked and everything at Countrywide started to go bad, Angelo Mozilo resorted to various forms of deception, both personal and corporate. First, he intensified efforts to get rid of dubious loans fast, so that Countrywide wouldn’t be caught holding them when they failed. Throughout the e-mail trails, he crassly urges his subordinates to “comb the assets” and sell off the riskiest ones while there is still time. As he well knew, however, the documentation of every loan sale or securitization states that the instruments being sold are representative of all loans of that type in possession of the seller—that they have not been selectively chosen to off-load risk. So this remedial strategy was itself fraudulent.
Then Mozilo protected himself financially, as many executives did. As Countrywide started to fail, Mozilo used $2 billion of Countrywide’s borrowed money to repurchase its own stock, in order to prop up the stock price. Mozilo also repeatedly made representations to analysts and investors with respect to the high quality of Countrywide’s credit and control processes, the good performance of its products, and the company’s financial soundness. One lawsuit lists some three dozen separate occasions in which Mozilo made or confirmed statements about the company’s lending and credit oversight policies. Based on what we now know, all of them were false.
However, at the same time that Countrywide was buying back its stock and Mozilo was telling the world that everything was fine, Mozilo was actually selling his own Countrywide stock—over $100 million in the year before the firm collapsed. His total compensation during the bubble was more than $450 million, and as a result of his stock sales over the years he remains extremely wealthy, with a net worth estimated at $600 million.
When collapse could no longer be postponed, Countrywide sold itself to Bank of America; the deal was signed in January 2008 and finally completed in July. The acquisition was to prove a very costly mistake for Bank of America, causing many billions of dollars in further losses. By 2012 Countrywide’s losses and legal liabilities were so severe as to threaten Bank of America’s continued viability.
In July 2008, when Bank of America officially took over Countrywide, Eileen Foster was offered the position of Senior Vice President, Mortgage Fraud Investigations Division Executive, which she accepted. However, the Employee Relations organization continued to investigate Foster and question her colleagues, one of whom warned Bank of America executives, including its general counsel and its chief operating officer. On September 8, 2008, Eileen Foster was told by senior Bank of America executives that she had been terminated. She filed a whistle-blower lawsuit, which she won; OSHA ordered her reinstatement and awarded her damages of over $900,000. In her interview with 60 Minutes, Foster stated that the immediate cause of her firing was that she refused to be coached appropriately about what to say to federal regulators. She also stated on camera that as of the time of the interview in 2011, she had never been interviewed by any federal law enforcement official.
While WaMu, New Century, and Countrywide were among the largest subprime lenders, there were many others just as bad. Fremont, for example, was one the country’s largest, and sold its loans to the top banks in securitization—Goldman Sachs, Merrill Lynch, Bear Stearns, Deutsche Bank, Credit Suisse, Lehman Brothers, Morgan Stanley. That is, it did so until March 2007, when the FDIC forced it out of business, and into bankruptcy, for multiple violations of law and regulations. In 2008 the Massachusetts Supreme Court, on an action brought by the state attorney general, affirmed a prohibition on foreclosures of many Fremont mortgages, on the ground that they had been designed to be predatory.27
In lawsuits, a long list of confidential witnesses drawn from former employees recited the usual frauds. Allegedly, underwriters were instructed “to think outside the box,” and “make it work.”28 If borrowers’ actual incomes were not sufficient to support a mortgage, loans were converted to stated income loans at whatever level was necessary. A series of forty loans was allegedly accepted from one broker even though all of them had identical bank statements.
WMC was yet another. It was the sixth-largest subprime originator in the country in 2004, when it was sold to GE Capital (yes, General Electric) by its owner, the private equity investment firm Apollo Management, whose CEO, Leon Black, spent $1 million to have Elton John play at his birthday party. For several years GE made lots of money, but it shut the company down in September 2007, swallowing a $400 million charge.
WMC’s lineup of Wall Street securitizers was much like Fremont’s—the largest and most prestigious firms on Wall Street. Yet WMC was fourth on the Comptroller of the Currency’s 2010 “Worst Ten in the Worst Ten” list—the ten worst lenders in the ten most decimated housing markets in the country. A postmortem conducted as part of a civil fraud suit by PMI, Inc., a mortgage insurer like MBIA, found the usual story—widespread breaches of securitization warranties, missing or obviously falsified documentation, and so forth.29
Ameriquest was yet another, and the U.S. leader in subprime lending in 2003, having driven its volume to $39 billion, up from just $4 billion in 2000. An assistant attorney general in Minnesota requested Ameriquest files in 2003, and was amazed to see file after file list the applicant’s occupation as “antiques dealer.” Borrowers told of signing a loan application and finding at closing that an entire financial record—tax forms and everything—had been fabricated for them. Ameriquest, too, was on the “Worst Ten in the Worst Ten” list. It speaks volumes for the cluelessness of Citigroup senior management that it purchased Ameriquest in the summer of 2007, even as the subprime bubble was collapsing.30 Ameriquest was the object of major lawsuits filed by more than twenty state attorneys general during the bubble, while federal regulators and law enforcement agencies did nothing. In 2005 its CEO, a major Republican donor, was appointed ambassador to the Netherlands by President Bush.
Another subprime lender, Option One, was a subsidiary of H&R Block, the tax preparer. Tax preparers were incented, in effect, to say, “Your interest on that mortgage seems high, why don’t you visit our mortgage consultant before you leave. We may be able to find you a better deal.”31
So the lenders wanted everyone to borrow ever more, and actively preferred borrowers who didn’t understand mortgages, shouldn’t have them, could be defrauded, and/or couldn’t fight back after being screwed. For a while, the bubble covered all this up, at least to naive investors outside the industry. Ironically, the huge increase in lending and the collapse of lending standards made subprime loans and mortgage securities seem much safer than they really were because it kept driving up home prices. Rising home prices allowed even unemployed, fraudulent, and/or delinquent borrowers to avoid (or simply postpone) default through refinancing, home equity loans, or selling at a profit. As the bubble progressed, teaser rates, deception, and/or unsustainable mortgages became normal. A standard broker sales pitch was “Don’t worry about the high post-teaser payments.” When it was time, the broker would refinance you—at another teaser rate—because the value of your home would already have gone up.
This kept money flowing through the system to naive investors such as municipal pension funds and small overseas banks, which collected high returns without any defaults for a few years until the music finally stopped. In the meantime these high returns led them, of course, to purchase even more of the same junk. The same mechanism also allowed fully knowledgeable but unethical investment managers—hedge funds, private wealth managers within investment banks—to do the same thing. The temporarily high returns kept their clients happy for several years, and kept their annual bonuses high. When the music stopped, the fund managers closed the fund or resigned, taking their money with them and leaving the losses to their clients.
Fannie Mae and Freddie Mac are not, of course, literally mortgage lenders. They purchased, insured, and securitized loans sourced from mortgage lenders; Countrywide was their largest single source of loans. They also bought and held enormous portfolios of mortgage-backed securities for investment purposes, which caused a major fraction of their losses during and after the crisis.
Fannie and Freddie are both government-sponsored enterprises (GSEs) created by the federal government to support home ownership and affordable mortgage lending. But over the three decades prior to the crisis, Fannie and Freddie had gradually freed themselves from regulatory constraint in the pursuit of profits. They went public and, more important, masterfully neutered both congressional oversight and Office of Federal Housing Enterprise Oversight (OFHEO), their ineffective and understaffed regulator. They accomplished this through a combination of extraordinarily aggressive lobbying, patronage, revolving-door hiring, and flat-out deceit. Their hires ranged from Newt Gingrich ($1.6 million from Freddie Mac’s chief lobbyist for “strategic advice” and “outreach to conservatives”) to Tom Donilon, who was Fannie Mae’s chief lobbyist for years and is now President Obama’s national security advisor. Both firms also neutered effective corporate governance by stacking their boards of directors with the compliant and the politically connected, who were overpaid and who were expected to keep quiet. And they instituted the same compensation structures found universally in the financial sector, which provided large bonuses based upon short-term performance.
And, just to leave no stone unturned, they also engaged in massive accounting fraud to ensure that their publicly reported performance enabled them to collect those bonuses.
Concerns about Fannie and Freddie’s accounting were first publicly raised in congressional hearings in 2000, before a subcommittee of the House Financial Services Committee. In those hearings, Fannie Mae and its then-CEO, Franklin Raines, were defended by congressional Democrats, including Barney Frank. Other defenders included Representative Maxine Waters and other members of the Black Caucus, in part because Raines was a well-connected African American (Clinton’s former budget director), and in part simply because Fannie Mae was so politically powerful in urban congressional districts where it operated, lobbied heavily, and was a major campaign contributor.
The first major allegations of accounting fraud came in 2003, when OFHEO sued the executives of Freddie Mac. Freddie Mac paid a $125 million fine. (Later, in 2006, Freddie Mac was also fined $3.8 million by the Federal Election Commission for making illegal campaign contributions.) In 2004, OFHEO and the SEC both released extremely critical reports on Fannie Mae. Then, in 2006, OFHEO sued Raines and two other former executives of Fannie Mae in an attempt to recover bonuses linked to the accounting frauds. Raines alone had received more than $90 million; he was also one of many executives and government officials who received favorable loans from Countrywide’s VIP program. Later settlements for all three executives allowed them to keep the majority of their bonuses, and did not require any of them to admit guilt. Fannie Mae paid a $400 million corporate fine to settle the SEC lawsuit. No criminal cases were brought.
Both Fannie and Freddie certainly contributed to the bubble, although they were late to the party. In part due to the discovery of their accounting frauds, in the early years of the bubble they remained fairly conservative with regard to the loans they were willing to purchase and/or insure. Starting in 2004, however, they began to increase the number of Alt-A loans they purchased, and to relax their credit standards. They remained a minority of the market for junk loans, and such loans constituted only a small percentage of their total loan purchases. However, they were such large firms that their losses were huge, comparable to those of the worst firms in the purely private sector.
Fannie and Freddie also contributed to the bubble in another way—as massive investors in mortgage-backed securities. From 2004 through 2006, Fannie and Freddie purchased $434 billion in mortgage-backed securities that had been created by Wall Street.32 They did this primarily because their executives had the same toxic incentives as everyone else, and these securities paid high interest rates. Both Fannie and Freddie had AAA credit ratings, of course, and so they could borrow money at very low interest rates and use it to purchase much higher-yielding mortgage securities. It was insanely easy and insanely profitable—until it wasn’t. In the end, the two firms’ investment losses were almost as large as their losses on mortgages that they had purchased or insured.
They started losing money in 2007. By the end of 2010, between them Fannie and Freddie had $71.9 billion in investment losses and $75.1 billion in mortgage credit losses, for a combined total of $147 billion. They have continued to lose money since then. Even in 2012 they were still losing money, because the Obama administration has forced them to provide mortgage payment relief for unemployed homeowners.33
In 2011 the SEC sued the former CEOs of both firms and four other former senior executives for securities fraud, charging that both firms had misrepresented their exposure to subprime mortgages to investors.34 The complaint alleged that both firms started purchasing larger quantities of high-risk loans in order to meet short-term profit targets related to the executives’ annual bonus payments. At the same time, the SEC entered into nonprosecution agreements with both firms. No criminal charges have ever been filed against either the firms or any of their former executives.
Republican conservatives, firmly supported of course by Wall Street banks, have asserted that the housing boom was caused by federal overregulation, which forced Fannie and Freddie to subsidize unwise mortgage lending to unqualified borrowers, by which they mean poor people, minorities, and immigrants. The usual villains in this story are liberal Democrats in Congress and the Community Reinvestment Act, a federal law that sets targets for mortgage lending to disadvantaged groups and neighborhoods. But that story doesn’t hold up, for many reasons.
First, the numbers simply don’t support this argument. It was not Fannie and Freddie, but rather the pure private sector, especially its least-regulated shadow banking components, which drove the bubble. In fact, the default rate on loans that the GSEs bought or guaranteed remains lower than those created and packaged by the mortgage lenders and Wall Street.
It wasn’t overregulation that pushed Fannie and Freddie into their disasters. In fact, if anything Fannie and Freddie’s regulator slightly reduced the damage the GSEs did, by stopping at least one of the ways that they had been gaming the system, namely their massive accounting frauds. Until those scandals, and even to a great extent after them, Fannie and Freddie behaved largely as they pleased, their conduct driven far more by thoroughly private-sector forces (i.e., annual bonuses and stock options) than by regulation or affordable housing goals. Moreover, their worst behavior occurred at a time when the Republicans controlled the White House and both houses of Congress, making it unlikely that liberal Democratic pressure affected them very much.
Furthermore, almost half of their eventual losses came from being investors, not loan buyers, insurers, or securitizers. Fannie and Freddie didn’t buy those securities out of social responsibility or liberal political pressure; they bought them because their executives and traders had the same toxic incentives as everyone else, based on short-term performance, and with no “clawbacks” if things went bad later. For the same reasons, they started buying higher-risk, higher-yield mortgages after the bubble was under way. Political pressure probably played a small role in their mortgage purchases, but it wasn’t the primary factor.
So the bubble wasn’t caused by too many poor people buying houses because of do-gooder federal regulators. Fannie and Freddie were certainly major participants, but they neither started the bubble nor were its major beneficiaries. Merely because of their size, however, they did a lot of damage.
What started and drove the bubble, in short, was a combination of very low interest rates, pervasive dishonesty throughout the financial system, massive lending fraud, speculation, demand for high-yield securities, and, not insignificantly, a squeezed American consumer desperate to maintain living standards and told by everyone—including George W. Bush and Alan Greenspan, as well as the brokers and banks—that home borrowing was the way to do it. From 2000 through 2007, net cash extractions from homes pumped $4.2 trillion into the U.S. economy,35 and by 2005 half of all American GDP growth was related to housing.36 By the end of the bubble in 2007, American household debt had jumped to 130 percent of GDP, a historical record, up from just 80 percent in 2000.
All of this could happen only because of the securitization food chain, combined with the collapse of ethics and the spread of toxic incentives throughout the entire financial sector. In fact, once the investment banks had invented the CDO, they didn’t even need to confine themselves to mortgages—any kind of loan could be fed into CDOs, and the result sold as an utterly safe “structured product.” There were parallel but smaller bubbles, showing equal levels of dishonesty, in other credit assets such as car loans, student loans, credit card debt, Icelandic bank debt, commercial real estate, and private equity (aka leveraged buyouts). These loans, too, were sold and fed into Wall Street’s securitization machine, sometimes placed into the very same CDOs that contained subprime mortgages. Indeed this is further evidence that it was the greed and dishonesty of the financial sector, rather than a general mania for housing or do-gooders pressuring Fannie and Freddie, that drove the bubble.
Of course, none of this would have been possible if Wall Street’s largest and best financial institutions had refused the business. The lenders were wholly dependent on the wholesale corruption of the core of the financial system—the Wall Street banks, the rating agencies, the mortgage insurance companies, the industry analysts, and, of course, the regulators. Let us now turn to them.
* FICO is the stock ticker symbol for the Fair Isaac Corporation, the company that pioneered the three-digit credit score.