WE HAVE JUST SEEN what mortgage lending was like during the bubble. What was Wall Street thinking when they bought these loans and turned them into trillions of dollars of supposedly ultrasafe, but actually quite toxic, products? Assuming that most investment bankers were not cretinously stupid, they were either: 1) innocents, being defrauded by brilliantly evil mortgage bankers; 2) stunningly complacent and oblivious, not bothering to look at or understand what they were buying and selling; and/or 3) in on the scam.
Well, it wasn’t door number one. For most of them, it wasn’t door number two, either, although there was some staggering obliviousness, particularly among very senior management and boards of directors; this is an interesting subject explored later. But the people actually doing the work, as well as many senior managers, knew perfectly well that they were dealing in manure. Often they simply didn’t care what it was, or what damage it might cause, as long as they could sell it. But they were not innocent. Quite often they actively pressured the mortgage lenders to supply even more manure that smelled even worse, lied about its known characteristics when they sold it, and profited again by betting against it.
But defenders of the banks (and rating agencies, and insurance companies, and hedge funds) raise one seemingly powerful objection to this view: many of the banks collapsed, causing CEOs, senior executives, and board members to lose their jobs and a lot of money. Even many traders and department heads were fired or laid off. This supposedly demonstrates that they couldn’t have realized what they were doing since they were hurting themselves, too. Joe Nocera of the New York Times, Laura Tyson (on the board of Morgan Stanley), and C. Michael Armstrong (a former board member of Citigroup, during the bubble) all have made this argument to me personally. Richard Parsons (Citigroup’s chairman during the bubble) and Angelo Mozilo both made this argument in their congressional testimony—Parsons described the crisis as “when they hit this iceberg.” How on earth, they and others have asked, could bankers possibly have been knowingly committing fraud when it was so clearly contrary to their self-interest? After all, they destroyed their institutions, lost their jobs, and their stock became worthless almost overnight. They—er, we—wouldn’t knowingly do that, would we? Even if we’re selfish, that’s just not logical, is it?
Well, actually, it is logical, and quite often it wasn’t contrary to their rational self-interest. Stunningly enough, Wall Street was set up in such a way that for many bankers, destroying their own firms was completely rational, self-interested behavior. Consider the following.
First, the money. If you created, sold, or traded fraudulent junk securities, indeed even if you bought them for your institution, you got paid huge annual bonuses, mostly in cash, based on your performance that year. How long will a major bubble last? Five to seven years seems to be the recent average: the S&L and junk bond bubble lasted from 1981 or 1982 until 1987 or 1988; the Internet bubble lasted from about 1995 until the middle of 2000; the housing bubble went from roughly 2001 until 2006 or 2007. (Some last even longer: Japan’s property and stock market bubble lasted nearly the full decade of the 1980s, and Bernard Madoff’s Ponzi scheme lasted over twenty years.) Until the collapse, not only are you making money, but your firm is making money too, lots of it. The more you contribute to the bubble, the more money you make. When the crash comes, even if your firm goes under, you’re still rich. You don’t have to give back any of the money; very possibly, you can retire or change careers. But even if you want another job, your track record won’t disqualify you—quite the contrary, as we shall see.
Second, there is the “public goods” problem—in this case, however, a public bad. Suppose you’re one of the twenty or forty (or five hundred) people creating, trading, selling, buying, insuring, or rating mortgage-backed junk at Merrill Lynch, Morgan Stanley, Lehman, Moody’s, AIG, wherever. You see a horrific train wreck in the making, with all your coworkers contributing to it. But they are all making a fortune, and their manager—who is your boss too—is making even more money by keeping it going. Quite obviously, they’re going to keep doing it whether you participate or not; so even if you refuse to participate, the firm will be dead anyway. You can try to stop it by going over your boss’s head to the CEO; but your boss won’t like that at all, and he and the entire department will tell the CEO whatever they need to tell him in order to keep it all going. And if—speaking purely hypothetically—your CEO is an oblivious, selfish, obnoxious egomaniac nearing retirement age, heavily focused on his golf game and art collection, with a few hundred million in cash already stashed away, scheduled to rake in another $50 million this year, whose contract guarantees him another $100 million if he loses his job—well, then he probably won’t be very sympathetic to you, either. You could try going to the board of directors, but even if you could reach them, it will turn out that they are old pals of the CEO, often stunningly clueless, picked largely so that they won’t rock the boat.
So if you try to stop the party, you’ll probably get marginalized or fired, as happened to a number of serious, ethical people who tried to warn their management and curtail unethical and illegal conduct at Merrill Lynch, Lehman, Citigroup, AIG, and elsewhere. So you’d gain nothing by acting ethically—quite the contrary, you’d ostracize yourself and lose your chance to build (or, rather, transfer to yourself) some real personal wealth—possibly a once-in-a-lifetime opportunity.
Third, consider the partitioning of information. Many people knew that they were doing something dishonest and taking advantage of a bubble, but often they didn’t know its scale or impact on the industry or even their own firm. How much stuff did the firm hold, how was it being valued, did they intend to keep it or sell it, had they hedged it already, and so forth—many people in investment banks, even at a fairly high level, did not have access to enough information to know how much damage their firm would suffer. Nor did they know when the bubble would end; but they did know that as long as it continued, they could keep making a lot of money.
They certainly didn’t know the size of the entire industry’s exposure, nor the distribution (or concentration) of risk across firms. This last consideration was an important one even for CEOs. There was no single institution anywhere—the regulators and the Treasury Department very much included—that possessed a comprehensive view of the financial system’s positions and exposures. Only very late in the bubble did it become clear that so much fraudulent junk had been created, with so many deep interdependencies across firms, that it could threaten the entire global financial system; even then, it was not publicly known (or knowable) until the crisis itself how much further risk had been created through totally unregulated, opaque derivatives transactions.
Fourth, there is the “getting a little bit pregnant” problem: once you’re in, no matter how you got there, you might as well stay in. Say you’re a senior trader, department head, or even CEO, and after a completely blameless life, you wake up one day to find that you’re stuck with a pile of fraudulent junk that was created by your department or company over the previous several years. What do you do at that point? You probably don’t call a press conference to announce that your firm is built on sand and is doomed to collapse. Rather, you keep the machine going as long as you can—to maximize your own income, try to work your firm out of its hole, or simply, as in Bernard Madoff’s case, to delay the inevitable day of reckoning as long as possible. Maybe you try to wind down your positions, or hedge them. Or maybe you can start trying to profit by betting against the bubble, including your own customers. If you sense that the bubble is about to end, you can make serious money by betting on the failure of your own securities—and yes, people did this, in a huge way.
But finally, there is the problem of reality—both in general, and specifically in relation to this bubble. The fact is that people do commit fraud, even when they know that it is personally risky for them. To take an extreme example, we know that people still perpetrate literal Ponzi schemes (Allen Stanford, $8 billion; Bernard Madoff, $20 billion), even though every Ponzi scheme is mathematically guaranteed to collapse at some point, with inevitable imprisonment to follow. And now, thanks primarily to private lawsuits and secondarily to a few government investigations, we also know that during the housing bubble many people were, in fact, consciously committing fraud and selling defective products.
Moreover, in the case of the housing bubble—and unlike isolated noninstitutional Ponzi schemes—everyone got away with it. The people responsible for the bubble are still wealthy, out of jail, socially accepted, and either retired or not, as they prefer. Even those who really did lose something—CEOs, eminences on boards of directors, business unit heads, people such as Richard Fuld, Robert Rubin, Angelo Mozilo, Stan O’Neal, or Joseph Cassano—are still enormously wealthy as a result of having taken lots of cash out during the bubble, and/or from their severance payments.
In fact on a net basis, many of these people made far more money by creating and participating in the bubble than they would have made by staying out of it, even though they destroyed their firms. It is true that they lost the value of whatever stock they owned when their firms collapsed in 2008. But over the previous seven years their incomes had been hugely inflated by the bubble, and they cashed a lot of it out—behavior, incidentally, not suggestive of deep faith in (or concern for) their firms’ futures. Some of them also received enormous severance payments when they were fired, even after the nature and effects of their conduct became known. To a remarkable extent they have avoided social disgrace, and still occupy positions of prestige, even power. So the defenders of the banks are in effect saying: who are you going to believe, me or your own lying eyes?
During the bubble, the Bush administration and the Federal Reserve were essentially AWOL; if anything, they made matters worse. In 2004 the SEC voted unanimously to allow the five largest investment banks to calculate their own leverage limits, based on their internal risk models. This meant that by the time the party ended, several of them were leveraged at more than thirty to one, meaning that if the value of their assets declined by just 3 percent, they would be bankrupt. As a result, when the crisis occurred, three of the banks, Bear Stearns, Lehman Brothers, and Merrill Lynch, were insolvent by 2008. Only Goldman Sachs and Morgan Stanley survived, and that by grace of federal rescue operations.1 During this time, the SEC and other federal regulators reduced their risk analysis and enforcement staffs, and basically left the investment banks unsupervised. The same was true of the industry’s several “self-regulatory” organizations, such as the Financial Industry Regulatory Authority (FINRA), the Securities Investor Protection Corporation (SIPC), and others. FINRA, for example, describes its mission thus on its website:
FINRA is the leading non-governmental regulator for all securities firms doing business with the U.S. public—nearly 4,495 firms employing nearly 635,515 registered representatives. Our chief role is to protect investors by maintaining the fairness of the U.S. capital markets. We carry it out by writing and enforcing rules, examining firms for compliance with the rules, informing and educating investors, helping firms pre-empt risk and stay in compliance.2
Well, FINRA didn’t do too well. (The head of FINRA during the bubble? Mary Shapiro, who became chair of the SEC in 2009, appointed by President Obama.) As a result of the failure of both government and private regulation, during the entire bubble the inmates were in charge of the asylum. Given their incentives, a massive fraud was entirely rational for most of them, even if they had known in advance of all the damage it would cause.
Was it all really that naked? Yes, it was. Some of what follows might be a little dry. But I ask readers to bear with me because later in this book, I will be saying some rather strong things—things like, these people should be in jail, they should have their wealth taken from them and given to people whose lives they destroyed, they should live in disgrace for the rest of their lives, it is shocking that they have not been prosecuted, and it is obscene and dangerous that they still occupy prominent positions in government, universities, companies, and civic institutions. So in the next couple of chapters, there will be some rather detailed stuff, because when we come to the punch line, I want it to be convincing.
Let us start our survey of the investment banking industry’s conduct with a lawsuit filed by the discount brokerage and asset management firm Charles Schwab, Inc. The case provides an unusually broad statistical picture of the securities that Wall Street produced, and also helps provide context for some of the truly stunning conduct we shall encounter later.
SCHWAB SUED THE broker-dealer arms of twelve major financial institutions. The suit is based on the representations made in the offering materials for thirty-six securitizations—mortgage-backed securities—that were purchased from these banks by various units of Schwab between 2005 and 2007. The defendants are BNP Paribas, Countrywide, Bank of America, Citigroup, Credit Suisse, Deutsche Bank, Goldman Sachs, Greenwich Capital, HSBC, Wells Fargo, Morgan Stanley, and UBS.
Investors in residential mortgage-backed securities do not have access to individual loan files when they make the purchase; they are shown only summary data for each mortgage on the “loan tapes” that accompany a sales prospectus. But when Schwab sued, it analyzed the summary data for 75,144 loans included in the securitizations it had purchased. While not a random sample, it is a broad one.3 If anything, the sample is probably substantially above average in quality, because Schwab invested conservatively, and the defendants in this lawsuit do not include Bear Stearns and Merrill Lynch, two firms that produced much of the worst junk. As we’ll see shortly, some of it was much worse.
Still, Schwab’s analysis estimated that 45 percent of the loans violated the representations made in selling the securities. Schwab used four separate tests; most of the suspect loans failed more than one of them.
1. Loan-to-Value Representations. The prospectus for every security that Schwab had purchased contained detailed representations about the average loan-to-value ratio (LTV) of the mortgages supporting the security. All but one of the prospectuses stated that no individual loan had an LTV greater than 100 percent. Schwab tested those statements with a model that is widely used in the industry, based on 500 million home sales, in zip codes covering 99 percent of the population.
The results of Schwab’s tests suggest that all securitizers significantly understated LTV ratios, and that all of the securities included substantial numbers of loans with LTV ratios of more than 100 percent—in other words, loans for more than the home was worth. In one security comprising 1,597 loans, the model estimated that 626 loans were overvalued by more than 5 percent, with only 69 undervalued by as much. The pool’s weighted-average LTV rose from a represented 73.8 percent to 90.5 percent, and the model estimated that 196 loans had LTVs of more than 100 percent, although the documents represented that none did. Roughly similar outcomes applied to all the other pools. A second test was applied to properties that were subsequently sold. The sales prices were consistently below the values implied by the claimed LTVs, in a pattern consistent with the model. Schwab notes that given the average leverage of the loans, a 10 percent LTV overstatement implies an 80 percent reduction in stated equity.*
2. Stated Liens. All of the securities’ offering materials stipulated that all property liens were fully disclosed. No mortgage loan, supposedly, is ever funded without a title search to spot any lien that might be senior to the bank’s lien. Schwab did new title searches on the properties. In one pool of 2,274 loans, 669 had undisclosed liens that, on average, reduced stated equity by 91.5 percent. In some pools, as many as half the loans had undisclosed liens.
3. Occupancy Status. Owner-occupied homes have lower default and foreclosure risk than second homes or investment properties. For this reason, all of the securities’ offering materials contained representations as to the percentage of loans in the security that were for owner-occupied (primary) residences. Schwab researched the properties listed as primary residences for indications that they were really not, including:
• Does owner have a different property tax address?
• Does owner not take advantage of local homestead tax exemptions?
• Does owner have three or more houses?
• Is there a shorter-than-normal time lapse from current pay to foreclosure?
• Has owner not updated personal billing addresses six months after closing?
Using these tests, in one pool of 1,498 loans, in which only 99 were alleged to be nonprimary residences, the correct total was estimated to be 598, with most of those failing more than one test. Roughly similar results prevailed throughout all the securities.
4. Internal Guideline Compliance. Schwab collected data on early payment defaults (EPDs) on all securitized loans issued by the originators of the mortgages in these securities from 2001 through 2007. In well-underwritten mortgages, the rate of EPDs, defined as default during the first six months of the loan, should be vanishingly small. Schwab investigated whether and when EPD rates changed during the bubble, and if so, whether stated credit guidelines changed at the same time.
None of the lenders changed its represented credit guidelines during this period. Despite this, every lender experienced a sharp upward break in its EPD rate at some point, a trend that persisted thereafter in every case. But the date at which the break occurred was different for each originator. For Countrywide, for example, EPDs suddenly quadrupled starting in the first quarter of 2005 and stayed at consistently high rates from then on. All the other lenders showed comparable upward EPD breaks; the starting dates ranged from mid-2003 to mid-2007.
Since the breaks occurred at different times for different originators, they were not likely to have been caused by general economic conditions. Rather, they probably reflected an internal policy change; but those policy changes were never reflected in the lending guidelines officially represented to investors. (Credit guideline representations were usually detailed and specific.) The obvious interpretation is that, one by one, originators chose to go aggressively down-market to make more money, while officially denying that they had done so.
The banks, of course, could allege—and indeed have alleged—that they were scammed, just as Schwab was. But in their securities prospectuses all the securitizers also claimed that they carefully underwrote the loans they purchased from originators. The representations they made were about the quality of their own credit processes, not those of the originators. And, unlike final investors like Schwab, they did have access to all the detailed backup records. Furthermore, most of them were deeply in bed with several major lenders—they provided the lenders’ financing, managed their securities offerings, and so forth.
And finally, in order to justify the representations made to investors, all of the securitizing banks hired outside firms to review the quality of the loans they bought. The largest and most comprehensive reviewer was Clayton Holdings, which examined 911,000 mortgages for twenty-three different securitizing banks, including all of the largest securitizers, between January 2006 and July 2007. In testimony and documents provided to the Financial Crisis Inquiry Commission (FCIC), senior Clayton executives revealed that 28 percent of the loans they examined did not meet even the securitizers’ own internal guidelines. Despite this, 39 percent of all loans that failed the securitizers’ guidelines were purchased and securitized anyway, a fact never disclosed to the investors purchasing the final securities.4
But were the banks just sloppy passive conduits, or active co-conspirators? Did they understand the full implications of their actions? To understand that, we need to look inside them. This has not been done nearly enough, because the federal government hasn’t really tried. There have been no criminal prosecutions using large-scale subpoena power and sworn testimony. All we have are civil suits, in which the banks ferociously (and often successfully) resist subpoenas and often succeed in keeping records sealed. Even the FCIC established by the Obama administration had extremely limited subpoena power, and a tiny budget. If there ever were to be a truly serious investigation, I have no doubt that we would learn much, much more than we currently know.
But what we currently know is still quite impressive.
BEAR STEARNS WAS one of the most experienced mortgage players on Wall Street. In the three years from 2004 through 2006, Bear securitized nearly a million mortgage loans with a total value of $192 billion—serious money, even for Wall Street.
Bear Stearns had been in the mortgage-backing business for nearly two decades, mostly securitizing high-quality loans. But in 2001 it created a new mortgage conduit, EMC Mortgage, to securitize Alt-A loans. In 2003 EMC started to securitize subprime, stated income, and “no doc” loans, then in 2005, second-lien loans, of the type that even Angelo Mozilo called the “most toxic” he had seen in his entire career.
Bear Stearns gives us a lurid peek at a white-shoe investment bank turned boiler room, using a succession of strategies to extract money from the bubble in every possible way. We know about it because of a lawsuit filed by the Ambac Financial Group, a bond insurer now in bankruptcy. Ambac’s suit against Bear Stearns and its successor company, JPMorgan Chase, is one of the few cases in which plaintiffs were able to obtain the internal documents, e-mails, and loan files of defendants to use in evidence.5
The history of the lawsuit indicates the banks’ strategy, and their ferocious opposition to every attempt to shed light on their conduct. Ambac filed suit in November 2008, and as of this writing—February 2012—the case has still not come to trial. Bear Stearns and its new owner, JPMorgan Chase, have used a long succession of procedural tricks to delay the case. They also tried hard to prevent Ambac from being able to subpoena records and depose witnesses, but eventually lost. They are still trying to delay the trial, presumably hoping that Ambac’s bankruptcy trustee will eventually give up or run out of money to pursue the case.
Of course, what follows is a partisan account based on materials assembled by Ambac’s attorneys. During the bubble, Ambac and the other major insurers (MBIA and AIG) were not angels themselves; their former executives and salespeople (now long gone) had the same toxic incentives and destroyed their own firms, just like everyone else. But now, an independent bankruptcy trustee appointed by the courts is trying to recover as much as possible. Ambac’s lawsuit is part of a gigantic post-crisis food fight in which dozens of firms are trying to recover money, often while being sued themselves for their own highly unethical behavior. And JPMorgan’s answer to the Ambac suit, when it becomes available, may cast some of the quotes below in a different light. But the accuracy of the quotes has not been challenged, and they make for interesting reading.
Ambac is suing to recover losses from payouts it made on failed Bear Stearns securitizations; Ambac argues that it agreed to insure them only due to gross misrepresentations by Bear Stearns. Many of the loans in the securitizations came from a wonderful company called American Home Mortgage, Inc. (AHM), also now bankrupt. We can get a taste of AHM’s enthusiastic approach to home lending from the official description of its “Choice” loan programs:
Offering financing for borrowers with more serious credit issues, these programs provide solutions for multiple mortgage lates, recent bankruptcies or foreclosures, little or no traditional credit, and FICO scores as low as 500. These programs are also offering 100 percent financing on all doc types for borrowers who do not meet the credit criteria of the standard Choice programs.6
Now, over to Bear Stearns. Its mortgage securitization program was run by four executives: Mary Haggerty and Baron Silverstein, coheads of Mortgage Finance, and Jeffrey Verschleiser and Michael Nierenberg, coheads of mortgage trading. Haggerty and Silverstein underwrote the suitability of mortgages from originators, and pushed them through the steps to get to a sale. Verschleiser and Nierenberg traded loans in and out of Bear Stearns’s portfolio and also constructed the securitizations. These people were emphatically not obscure file clerks whose machinations went unnoticed by management. All four were senior managing directors—in all of Bear Stearns, a fourteen-thousand-person company, only ninety-eight people were at that level. They would have all been paid millions of dollars per year.
The first thing they did, of course, was simply to package and sell a lot of trash (while concealing this fact). The record shows that loan delinquencies were already rising sharply in early 2005. John Mongelluzzo, the due diligence manager in Mortgage Finance, and therefore junior to Haggerty and Silverstein, was pushing for stricter standards and tighter underwriting reviews. The response to his actions indicates the futility of being ethical in American investment banking during the bubble. Instead of tightening standards, in February 2005 Mary Haggerty ordered a reduction in due diligence “in order to make us more competitive on bids with larger sub-prime sellers.” She reduced the size of the loan samples used to test compliance and, most important, postponed the due diligence review until after Bear had bought the loans, and often even after the loans had been bundled into securities.7
This change in procedure was made almost by stealth. A year later, in March 2006, a conduit manager wrote that “until yesterday we had no idea that there was a post close dd [due diligence] going on.” Loans “were not flagged appropriately and we securitized many of them which are still to this day not cleared.” In other words, loans were going out with no due diligence at all.8
Later that spring, Mongelluzzo wrote to Silverstein, “I would strongly discourage doing post close [due diligence] for any trade with AHM. You will end up with a lot of repurchases”—a “repurchase” was a buyback from a sold securitization, and was always expensive. The advice was ignored. Two pools of 1,600 loans were purchased from AHM and quickly securitized. A review the following year showed that 60 percent were delinquent, and 13 percent had already defaulted.9
At the same time, Verschleiser was pushing hard for more volume. One of the conduit managers e-mailed her staff:
I refuse to receive any more e-mails from [Verschleiser] … questioning why we’re not funding more loans each day. I’m holding each of you responsible for making sure we fund at least 500 each and every day.… If we have 500+ loans in this office we MUST find a way to underwrite them and to buy them.… I was not happy when I saw the funding numbers and I knew that NY would NOT BE HAPPY.
Later that year, the same executive e-mailed her staff: “I don’t understand that with weekend overtime why we didn’t purchase more loans.… Our funding needs to be $2 billion this month.… I expect to see ALL employees working overtime this week to make sure we hit the target number.”10
An early warning of declining quality was a 2005 spike in EPDs, which Bear Stearns defined as a missed payment in the first ninety days. Bear Stearns’s policy had previously been to hold purchased loans in inventory for ninety days before securitizing them, in order to ensure their quality. But in 2005 the team decided to shorten the holding period, so loans could be pushed into securities before an EPD occurred. Verschleiser told the unit that he wanted all “the subprime loans closed in December” to be in securitizations by January—in effect, within a month of purchase. He confirmed that policy in mid-2006, reminding staff “to be certain we securitize the loans with 1 month epd before the epd period expires.” Later, he demanded to know why specific loans that experienced early delinquencies “were dropped from deals and not securitized before their epd period expired.”11
The predictable consequence was a flood of EPDs in securitized loans. Bear assured its investors that they would diligently police EPDs, because these usually indicated a seriously defective loan. In their presentations to Ambac, Bear Stearns had touted their aggressive follow-up to assert claims on behalf of investors if a securitized loan went bad soon after the close of a securitization deal. The usual protocol was to buy back the bad loan from the investor and force the originator either to replace it with a good equivalent or to return the cash.
But you can’t keep a good investment banker from innovating, and in 2006 Bear Stearns came up with another bright idea, initiating a second scam. Whenever Bear Stearns learned of a loan default, instead of repurchasing the defective loan, it made a cash settlement with the originator at a discount, without informing the investors of either the breach or the cash settlement. So Bear kept the settlement cash, leaving the investors to discover the default later, which likely did not occur until after the investors’ contractual option to return the loan had expired. When a Bear Stearns manager specifically asked her boss if the policy was to make settlements with lenders without checking for violations of the representations and warranties that Bear Stearns had made to the investors, she confirmed that it was.12
At first Bear Stearns was overwhelmed by the flood of loan defaults, but it soon created a system to process them efficiently, generating $1.25 billion in settlements. Bear kept it all, and investors later learned that they owned securities backed by thousands of loans that Bear had officially listed as defaulted. The entire EPD process and the cash gains from the settlements were reported in detail to the most senior managers in the firm, so they were fully aware that investment agreements were being flouted and knew how bad the underlying loans were. Both the Bear Stearns auditor and legal counsel eventually insisted on stopping the one-sided settlements, although it seems that they continued for some months after the order.13
Underscoring that Bear managers well understood what they were selling, the deal manager on an August 2006 securitization called the deal a “shitbreather” and a “SACK OF SHIT.” In deposition, he said he intended those phrases as “a term of endearment.”14
All of the investment banks tried to maintain an appearance of propriety for a combination of legal and sales reasons. So, like all of them, Bear Stearns did not entirely ignore due diligence on the loans it bought, and as usual, had contracted with outside reviewing firms. But internal Bear Stearns e-mails mocked the low quality of the reviews, and managers consistently blocked proposals for tightened reviews. The head of one of the reviewing firms said in deposition that in a 2006 review, up to 65 percent of his rejection recommendations were ignored. Another reviewer said that about “75 percent of the loans that should have been rejected were still put in the pool and sold.”15
In 2006 Bear hired a third outside firm to check a sample of loans that had already been securitized. The review was subject to strict limitations: do not count occupancy violations (i.e., a declared prime residence not owner occupied); there could be no employment check; no credit report verifications; and no review of appraisals. Even with all those restrictions, 42.9 percent of the sampled loans were found to be in breach of the securitization conditions. Bear Stearns did not notify investors of those findings.16
By mid-2007 the impending collapse of the subprime housing bubble was becoming apparent. This initiated the third phase of the mortgage unit’s strategy. Instead of warning customers and investors, the unit went on an all-out drive to clear out its inventory—“a going out of business sale,” one manager called it. A rule against securitizing loans from suspended or terminated lenders was summarily dropped, without this fact being disclosed. Verschleiser railed about one $73 million batch of loans, three-quarters of which did not meet securitizing guidelines. He couldn’t understand “why any of these positions were not securitized … why were they dropped from deals and not securitized before their epd period.” And another senior trader demanded to know “why are we taking losses on 2nd lien loans from 2005 when they could have been securitized?????”17
In late 2007 Ambac managers became aware of the growing number of defaulted loans in the portfolios they had insured and requested a delivery of detailed loan files. Without telling Ambac, Bear Stearns hired one of its outside credit reviewers to look at the loans. The review found that 56 percent had material breaches. Bear did not share this information with Ambac.18
Then came the fourth phase of Bear Stearns’s mortgage strategy—one practiced on a far larger scale by others, as we shall see. Verschleiser realized that as the bubble ended, the resulting avalanche of loan defaults would have a catastrophic effect on Ambac, their insurer. Far from being a disaster, this was an enormous opportunity. Verschleiser realized that he could make a fortune—by betting on Ambac’s failure by shorting its stock. As he recounted in his 2007 self-evaluation:
[At] the end of October, while presenting to the risk committee on our business I told them that a few financial guarantors were vulnerable to potential writedowns in the CDO and MBS market and we should be short a multiple of 10 of the shorts I had put on.… In less than three weeks we made approximately $55 million on just those two trades.19
Bear Stearns took his advice, and by 2008 Verschleiser was consulting with other traders on other banks’ exposure to Ambac, so Bear Stearns could profit from its bad loans coming and going. In fact, the worse the loans, the more money Bear Stearns made. In mid-2007 Bear Stearns stock peaked at $159 a share, its all-time record.
But all good things must end. On March 16, 2008, Bear Stearns was facing bankruptcy, and its board agreed to sell the company to JPMorgan Chase for $2 a share (later revised to $10 after shareholder protests).
But if these guys were so good at being devious, why did Bear Stearns fail? At one level, the answer is simple: Bear Stearns ran out of money. It is very difficult to forecast with precision the end of a bubble, or the exact rate at which various market participants—banks, rating agencies, investors, insurers, executives—will catch on. So Bear Stearns got caught holding a lot of junk—bad loans, pieces of securitizations, stocks and bonds of other institutions also being decimated by the crisis—and couldn’t get rid of it fast enough, at high enough prices, because everybody else was waking up (and going down the drain) at the same time. Moreover, like all the investment banks, Bear Stearns was very heavily leveraged, dependent on huge quantities of dangerously short-term loans from money market funds and large banks. This funding needed to be rolled over weekly or even daily. When these funding sources sensed trouble, they stopped lending, and Bear Stearns ran out of cash very fast.
But why was the firm so dangerously exposed? Knowing the risks, knowing that a huge bubble would inevitably end, why had the firm continued to buy and hold so much junk, and why was it so reliant on such huge amounts of short-term funding? Well, the working-level people directly exploiting and profiting from the bubble didn’t have much incentive to end it, or warn anyone. As long as they could sell junk, they made money. When it started to go bad, many of them even made money by betting against it—by betting against specific securities, against indexes of mortgage-backed securities, and against firms likely to fail in the crash. And while they shared in the gains, all of the losses were someone else’s problem.
But that logic mainly applies to those who were most directly profiting from annual cash bonuses and could move to other firms. What about senior management and boards of directors, not just of Bear Stearns but of the others that collapsed—Lehman, Merrill Lynch, AIG, Citigroup, and even the lenders (WaMu, Wachovia, Countrywide, etc.)? In the event of failure, the CEOs and boards of these firms would unquestionably lose jobs and wealth not easily replaced. The answer to this question reveals a great deal, and we will consider it shortly. For now, let us continue our tour of Wall Street conduct.
We know more about Bear Stearns than we do about most other banks, due to the lack of federal investigation and because the civil suits are being delayed. But sufficient material is available on other lenders to confirm the generality of bad behavior. Some examples follow.
GOLDMAN SACHS IS the other major bank for which there is a substantial internal record, thanks to documents obtained by the Senate Permanent Subcommittee on Investigations. The most interesting parts of Goldman’s behavior are considered in the next chapter, because they pertain to what happened after the bubble ended. For now, I will simply provide one example to make the point that Goldman created junk like everyone else.
In the October 15, 2007, issue of Fortune magazine, Allan Sloan published his superb article “House of Junk,” which focused on a series of securities, the GSAMP Trust 2006-S-3, totaling $494 million out of the $44.5 billion in mortgage-backed securities that Goldman Sachs sold in 2006. The GSAMPs were issued in April 2006 (during Hank Paulson’s final months as CEO before becoming treasury secretary), having been assembled from second mortgages sourced from among the worst subprime lenders, including Fremont and Long Beach. Since they were all second mortgages, the lender could not foreclose in the event of default. The average loan-to-value ratio of the pool was 99.29 percent, meaning that borrowers had essentially zero equity in the homes, and 58 percent of the loans had little or no documentation. Despite this, 93 percent of the securities were rated investment grade, and 68 percent were rated AAA, the highest possible rating, by both Moody’s and Standard & Poor’s, the two largest rating agencies. Yet by October 2007, 18 percent of the loans had already defaulted, and all of the securities had been severely downgraded.20
So it was junk. But did they know it was junk? They most certainly did; they started betting against it in late 2006, and by late 2007 they were already making net profits on their bets against mortgage securities. We’ll return to Goldman Sachs later in discussing how the financial sector handled the end of the bubble, the crisis, and the post-crisis environment. It’s interesting, and hasn’t been sufficiently publicized.
MORGAN STANLEY WAS one of the leading global securitizers. In the first quarter of 2007 alone, MS created $44 billion of structured securities backed by mortgages and other assets. One modest deal sold to an unsophisticated institutional investor, the pension fund for Virgin Islands government employees, is a good illustration of banking ethics in the twenty-first century.21
The security in question was a particularly toxic thing called a synthetic CDO. A synthetic CDO is a kind of virtual, imitation CDO, not backed by actual loans or debts, but essentially a collection of side bets on other securities, constructed to track their performance. As with any bet, it takes two parties—someone betting that the securities will work, and someone else betting that they will fail.
The synthetic CDO in question here, Libertas, referenced, or made side bets on, some $1.2 billion of mostly mortgage-backed securities, a large share of them sourced from New Century, WMC, and Option One, all of them notoriously bad subprime lenders. The Virgin Islands pension fund bought $82 million worth of AAA-rated notes forming part of Libertas. The deal closed in late March 2007, and before the year was out, the securities were nearly worthless. But it gets better.
Morgan Stanley owned the short side of the entire deal—in other words, the people who created and sold these securities were betting that they would fail. So they did very well indeed when the pension fund’s notes defaulted, as they did within months. Since Morgan Stanley owned the short side, they kept the entire $82 million principal of the Virgin Islands pension investment. Nice work. You sell a deal, collect your sales commission, then you get to keep the customer’s entire investment when the securities fail.
That much is not in dispute. But, stunningly enough, it is not per se illegal to create and sell a security with the intention of profiting from its failure—a state of affairs that the investment banking industry is in no rush to publicize, much less change. So the question in the Virgin Islands lawsuit is whether Morgan Stanley knowingly misrepresented the quality of the securities. Here is the pension fund’s side of the story.
Morgan Stanley had long been New Century’s largest “warehouse” lender—supplying funds for New Century to assemble loans for securitization. As such, it carefully monitored conditions at the lender. We saw in the previous chapter that as the bubble ended and accounting problems surfaced, New Century rapidly declined into bankruptcy.
Morgan Stanley disclosed in the Libertas prospectus that New Century had been accused of trading and accounting violations, but did not mention the mounting claims for breaches of warranties. They also mentioned that “several published reports also speculated that [New Century] would seek bankruptcy protection or be liquidated.” Still, like all securitizers, they claimed they had vetted the loans and that they met standard quality guidelines.22
But Morgan Stanley knew a great deal more than it had disclosed. It had participated in a March 6 conference call with New Century and its creditors. After the call, Citigroup decided to invoke its default rights against New Century. About a week after the Libertas deal closed, Morgan Stanley seized $2.5 billion in New Century assets; New Century declared bankruptcy soon thereafter. The bankruptcy examiner later wrote: “[The] increasingly risky nature of New Century’s loan originations created a ticking time bomb that detonated in 2007.”23
The question in the lawsuit is whether Morgan Stanley deliberately withheld material information. But that was habitual for them. Like those of all the other securitizers, Morgan Stanley’s loans had been examined by Clayton Holdings, which, as usual, found that many of them violated even Morgan Stanley’s internal guidelines, and that many defective loans were securitized anyway.
In June 2010 Morgan Stanley agreed to pay $102 million to settle a lawsuit brought by the attorney general of Massachusetts. While not admitting wrongdoing, Morgan Stanley executed an “Assurance of Discontinuance” specifying a long list of improper acts and referencing a long list of past bad practices.
According to the settlement, when Morgan Stanley had been faced with a choice of maintaining its credit standards or continuing to source New Century loans, it chose to jettison standards. Morgan Stanley began to accept loans that didn’t comply with the Massachusetts “best interest” law, and progressively discarded its remaining internal quality rules. Even after Morgan Stanley declared New Century to be in default, it continued to provide funding for its mortgages—as long as the money was wired deal by deal to settlement accounts with availability only upon mortgage execution.24
And what about Option One? They were the H&R Block subsidiary, one of the “Worst of the Worst” subprime lenders. By the first part of 2007, delinquency rates on the loans from Option One that were used for Libertas were more than double the company’s earlier default rates even before the deal was closed. It does not appear that Morgan Stanley shared that information with the investors.25
During the bubble, Morgan Stanley had record profits, like everyone. As for the crisis, well, they survived, despite coming close to collapse in 2008. But Morgan Stanley would have done much better had it not been for one man, Howie Hubler, a senior trader whose erroneous bets on the mortgage market cost Morgan Stanley $9 billion.
But the nature of Mr. Hubler’s bets is far more revealing than the size of the loss, particularly when compared to the rest of Morgan Stanley’s behavior. Mr. Hubler didn’t lose money because he innocently thought that mortgage securities were good things. Quite the contrary.
Like the people at Bear Stearns, Mr. Hubler was anything but an obscure rogue trader. He ran a fifty-person group, and his decisions were reviewed by senior management. Mr. Hubler realized by late 2004 that the housing market was a huge bubble, that it would burst, and that when that happened, thousands of mortgage-backed securities based on awful subprime loans would fail. Mr. Hubler talked to his management about this, and they agreed with him.
Did Morgan Stanley then warn its customers? No. Did it stop selling tens of billions of dollars of crappy subprime mortgage-backed securities? No. Did it tighten its loan standards? No—indeed, as we have just seen, it lowered them. Did it warn the regulators? No. Did it stop financing the worst subprime lenders? No.
What Morgan Stanley did do, however, was give Howie Hubler permission to begin betting against subprime mortgage-backed securities, massively. Using credit default swaps—we’ll get to them—he placed enormous bets that very low-quality, but nonetheless highly rated, mortgage securities would fail.26
But there was a problem. The bubble lasted longer than anyone at Morgan Stanley predicted that it could. And as 2004 became 2005 and then 2006, maintaining Mr. Hubler’s bets became expensive. But Mr. Hubler was absolutely certain that the bubble would eventually burst, and he wanted above all to maintain his bets against those really awful subprime mortgage securities.
And so, with Morgan Stanley’s knowledge and approval, Howie made a huge mistake. In order to pay for his bets against the lowest-quality mortgage securities, he started writing insurance for other, supposedly higher-quality mortgage securities—securities that Mr. Hubler thought would not default until much later than the really awful ones. But insurance on these higher-quality securities was much cheaper, so in order to sell enough insurance (to obtain enough premium income) to fund his bets against the obviously crappy securities, he needed to write insurance on a lot of them.
For a short time it worked, and in the first quarter of 2007 Morgan Stanley made $1 billion from Hubler’s strategy. But when the shit hit the fan, the supposedly higher-quality securities failed rapidly, too. Just as Morgan Stanley had underestimated the size and duration of the bubble, so too it had underestimated the severity of the collapse. Internal politics and/or sexism probably also interfered; an article published in New York magazine in April 2008 described power struggles and institutional sexism involving Hubler, other traders, John Mack (the CEO), and Zoe Cruz, Morgan Stanley’s highest-ranking female executive. Cruz was not a saint; she too endorsed the idea of secretly shorting the subprime market. But Cruz, to whom Hubler reported, apparently became alarmed about the potential risks of Hubler’s strategy.
But Hubler apparently ignored her. And so Howie lost $9 billion for Morgan Stanley. Of course, he kept his previous bonuses—tens of millions of dollars. He was forced to resign but was not officially fired, so he also collected his deferred compensation.
With wonderful irony, during its crisis in 2008, Morgan Stanley’s CEO campaigned publicly and angrily against one group that, he said, represented a danger to financial stability and a menace to society. After a tough public fight, Morgan Stanley persuaded the SEC to restrict the actions of this group. Who were these evil people, and what was this dangerous activity that needed emergency regulation?
Short sellers, of course—people betting against Morgan Stanley stock, who therefore had an incentive for the company to fail. In late 2008 Laura Tyson, a member of Morgan Stanley’s board of directors whom I have known for twenty-five years, told me with an utterly straight face, in what was probably my final conversation with my former friend, that hedge funds were conspiring against Morgan Stanley, shorting its stock while spreading malicious rumors and withdrawing their money in order to weaken the firm. Laura also told me that she and Stephen Roach, Morgan Stanley’s chief economist during the bubble, had both warned senior management that the bubble would burst. When I asked her whether the bonus system had contributed to the crisis, she said no, and told me that those who had caused Morgan Stanley’s own losses had themselves suffered greatly. “Those people were crushed,” she said. “They have lost everything.”
Laura did not tell me that her firm had been constructing and selling securities with the intent of profiting from their failure, nor that Morgan Stanley’s losses in 2008 were caused principally by a tactical error in implementing a massive bet against the bubble that it had helped create—a strategy that had provided a huge incentive not to warn its customers, the regulators, or the public of the impending crisis. Did she know about it? I don’t know, although during the bubble she had been in frequent contact with Zoe Cruz and Morgan Stanley’s senior management.
In early 2009 I also spoke with Stephen Roach, whom I had also known (slightly) for a long time. To his credit, Mr. Roach had warned publicly about America’s unsustainable debt levels, and of a coming recession. But he was careful never to blame his firm or industry; the culprit was Alan Greenspan, for keeping interest rates too low. When I asked Mr. Roach if the structure of financial sector compensation had contributed to the bubble, he said no, and argued that regulating compensation would be a bad idea. He didn’t mention Morgan Stanley’s betting against the mortgage market either. Given that it cost his employer $9 billion, I find it difficult to believe that he didn’t know.
THE EVIDENCE SUGGESTS that Citigroup behaved as unethically as Morgan Stanley and Bear Stearns did. But they weren’t as smart, or at least their senior management wasn’t, so when the music stopped they were caught without a chair.
Although Citigroup had earlier applied fairly strict credit standards, when the bubble accelerated they held their noses and accepted whatever the originators sent them. By mid-2006 Richard Bowen, the recently promoted chief underwriter of Citigroup’s consumer division, grew seriously alarmed. He discovered that 60 percent of the loans that Citigroup was buying from lenders failed to meet its own internal standards. He warned everyone around him, including senior management. But not only was nothing done, things actually got worse. By 2007 he said, “defective mortgages … [were] over 80 percent of production.”27 He testified to the FCIC that he and other credit officers repeatedly complained to the senior executives in the bank. In October 2007 Bowen wrote a very explicit e-mail, marked “URGENT—READ IMMEDIATELY,” about the failure and violation of Citigroup’s internal controls, and their possible financial consequences. Bowen sent this e-mail message to four senior executives, including Citigroup’s CFO and also Robert Rubin, the former treasury secretary who was vice chairman of the board and chairman of the board’s executive committee. As a result, Bowen was demoted and his 220-person group reassigned, leaving him with only two employees.
During the bubble, Citigroup purchased and resold huge volumes of mortgages, and also created and sold huge amounts of toxic mortgage securities. It sold many of these to the usual victims, including Fannie, Freddie, and the Federal Housing Administration. But it also retained many of them, even though it pretended that it had not done so. Like the other securitizers, Citigroup made use of highly deceptive accounting. In this case, it used a loophole in the accounting rules governing structured investment vehicles (SIVs). Actually it wasn’t a loophole at all, in the sense of being an initially unintentional oversight later used for unanticipated purposes. Rather, it was a provision for which the banks had specifically lobbied hard (and won).
By placing its toxic mortgage securities in SIVs, Citigroup could take current profits and temporarily pretend that the securities weren’t on its own balance sheet—that is, until the securities lost money, when it became necessary for Citigroup to pay up. In the meantime, of course, many people collected large bonuses, including Citigroup’s senior management. In the end it turned out that Citigroup had ownership or liability for over $50 billion of the stuff, which was why it had to be rescued by the federal government. Late in the bubble, Citigroup’s CDO unit did start to bet against the bubble, by creating synthetic CDOs that it could dishonestly sell to fools, thereby profiting by holding the short side of the bet. One such synthetic CDO resulted in a civil fraud lawsuit filed by the SEC.28 But the profits thereby obtained were dwarfed by losses on Citigroup’s holdings and the obligations it had to its SIVs.
Citigroup’s CEO during most of the bubble, Chuck Prince, was forced to resign in late 2007, replaced by Vikram Pandit, who remains CEO as of 2012. Rubin resigned in January 2009, forced out when Citigroup became heavily dependent upon federal rescue funds, which gave the government over 30 percent ownership.
UBS is one of Switzerland’s three big banks, and one of the largest banks in the world. It was both perpetrator and victim—some parts of UBS purchased huge quantities of mortgage securities and lost billions on them, while others created and sold them to unsophisticated victims. In 2001—quite early—UBS created a hybrid CDO (part real, part synthetic) called North Street 4. UBS sold it to a small, local German bank, HSH Nordbank.
The bank’s lawsuit against UBS alleges that contrary to representations, UBS and a subsequent acquisition, Dillon Read Capital Management (a small U.S. investment bank), later used the structure to dump poorly performing assets from its internal books. The last investment made on behalf of the investors was made by Dillon Read in February 2007. This investment was to go long on an index of subprime mortgage CDOs (i.e., bet that they would perform well), so that Dillon Read could take the opposite position, betting against them. As of the date of the court filing, HSH had lost half its investment.29
Essentially these same patterns of behavior have been alleged against all the other major securitizers—Merrill Lynch, Deutsche Bank, Credit Suisse, Lehman. All of them sold securities backed by high-risk residential mortgages sourced from the same universe of subprime originators. All of them had the same compensation practices. And all the cases against the big Wall Street firms we have met in this narrative come down to the simple proposition that no competent securitizer could have financed the loan originators, purchased tens or hundreds of thousands of mortgages from them, structured and sold the securities, and made elaborate representations and warranties in their sales material without ever understanding the toxic nature of the instruments they were selling.
In many cases, we have the additional evidence that they started betting against the market and even sometimes their own securities, while continuing to tell customers to buy. For example, late in the bubble, traders at Merrill Lynch went to the extent of creating a new unit within Merrill to buy securities that the real market wouldn’t touch. Since that was obviously a losing game, the traders split their bonuses with the fake purchasing group. In effect, the traders were financing bonuses by bribing their fellow traders, and all of them were ripping off the company’s shareholders.
But there were two other major sets of players who were essential to the scam—the rating agencies and the insurers.
THE BUSINESS OF rating debt securities was and remains an oligopoly, a quasi-cartel, of three firms—Moody’s (the largest); Standard & Poor’s (S&P); and Fitch. For many years, they used their power to establish remarkable legal positions for themselves. The SEC recognized a limited number of Nationally Recognized Statistical Ratings Organizations, and many government pension funds could only invest in securities that had high NRSRO ratings. The rating agencies avoided legal liability for their numerous misjudgments by claiming that ratings were merely “opinions,” expressions of free speech protected by the First Amendment, and not subject to liability claims. When state legislatures occasionally threatened to reduce their power or increase their liability, the rating agencies threatened to stop rating bonds issued in those states.
For the last quarter century, the rating agencies have been paid by issuers, and as the investment banking industry itself consolidated, the banks increasingly called the tune, and the rating agencies happily danced, all of them joined in corruption, cynicism, and exploitation. For the entire period of the bubble, and through 2007 as the bubble peaked and started to deflate, Wall Street had pretended to ignore the impending crash. The rating agencies carried on issuing their triple-As with abandon.30
At both Moody’s and S&P, the volume of ratings processed on residential mortgage-backed securities (RMBS) doubled between 2004 and 2007. Mortgage-backed CDO ratings increased tenfold, and each year the instruments grew far more complex. There was a similar boom in other bubble-related debt—instruments such as collateralized loan obligations (CLOs), auction-rate securities, synthetic securities, and even more exotic objects, all of them routinely receiving extremely high ratings. The rating agencies became insanely profitable as a result. The relative stock price gains for Moody’s outstripped even those of the best-performing financial services company, Goldman Sachs, by a factor of ten; during the bubble, Moody’s was the most profitable company in the Fortune 500.
In the first week of July 2007, S&P rated 1,500 new mortgage-backed securities, or 300 per working day. It was an assembly line. In 2010 the former president of Clayton Holdings testified to the FCIC that in 2007 he had approached all three major rating agencies, asking if they wanted the results of Clayton’s reviews of the loans being used by the securitizers. All three declined.
By 2009 more than 90 percent of all 2006- and 2007-vintage AAA subprime-backed securities were rated as “junk.”
Even more striking, however, was how the rating agencies treated the investment banks—their principal clients. Did they warn the world when Bear Stearns and Lehman became wildly overleveraged, when the industry shifted to unstable, ultra-short-term borrowing? No. Did they worry about the exposure of AIG and the other bond insurers? No. Even as the crisis deepened, all of the securitizers and insurers, including all of those who failed or were rescued by the federal government, continued to have high-investment-grade ratings—in several cases, AAA.
Here is an excerpt from my interview with Jerry Fons, a former managing director at Moody’s who departed in 2007:
CF: And if I recall correctly, Bear Stearns was rated AAA, like, a month before it went bankrupt.
FONS: More likely A2.
CF: A2. Okay. A2 is still not bankrupt.
FONS: No, no, no, that’s a high investment grade, solid investment-grade rating.
CF: Tell us about that.
FONS: Not only Bear Stearns. You also had Lehman Brothers A2 within days of failing. AIG, AA within days of being bailed out. Fannie Mae and Freddie Mac were AAA when they were rescued. Citigroup, Merrill. All of them had investment-grade ratings. Even WaMu, the bank that went under, wound up having a BBB- or AA3 rating at the time it was rescued.
CF: How can that be?
FONS: Well, that’s a good question. [laughter] That’s a great question.
ONE LAST PART of the system deserves comment: the protection racket, which in this context means selling insurance on mortgage-backed securities, making investors feel even more confident that they were safe. This insurance came in two forms, bad and worse.
The less malignant form was literal insurance, sold by specialized monoline insurance companies, the largest of which were MBIA and Ambac. They depended heavily on their own AAA ratings, helpfully supplied as usual by the rating agencies. As everywhere, their salespeople and executives made lots of money during the bubble, which they kept even after securities started to fail and the companies faced an avalanche of claims; both companies suffered disastrously. But at least they had previously been known principally for writing actual insurance, purchased by the actual owners of actual bonds. For true insanity, one needs to look at the business of selling derivatives called credit default swaps (CDSs), the most famous practitioner of which was, of course, AIG.
Credit default swaps are pure gambling, and they differ from insurance in extremely important ways. You can use CDSs to bet that any security will fail, and you can make your bets as large as you want. The reverse is true as well: if you’re crazy enough, you can sell as much “protection” as you want, far beyond the real value of the securities in question. AIG sold around $500 billion of it—and it didn’t work out too well.
CDSs were (and remain) particularly dangerous for several reasons. First, courtesy of the Commodity Futures Modernization Act of 2000, the law championed by Larry Summers, Robert Rubin, and Alan Greenspan, CDSs were totally unregulated and extremely opaque. Nobody knew the total size and distribution of CDS ownership or risk, and the government did not have the legal right to control it. Second, CDSs generated dangerous incentives—if you owned enough of them, then you had powerful incentives to cause something to fail, and also to remain silent about risks in the financial system.
CDSs also provided the illusion, and sometimes the reality, of total protection against even the riskiest, most dangerous financial behavior. Real insurance policies guard against irresponsibility and fraud by having deductibles, policy limits, higher premiums for people with bad records, and other constraints. You cannot buy an insurance policy on your house for twenty times its real value, especially if your house has conveniently burned down five times in the last decade. You also cannot buy a home insurance policy if you don’t own a home. If you have five convictions for drunk driving, you may not be able to buy automobile insurance at all, and if you can, it will be very expensive.
Unlike real insurance, CDSs had no deductibles or policy limits, and placed no constraints on buyers. As long as you had the money, you could buy as many of them as you wanted, even on securities that you did not own—in other words, you could bet that a security, and/or the company issuing it, would fail. If you were the creator and issuer of such securities, you could therefore profit by creating and selling junk, and then betting against it.
You could also buy junk, and ignore its risks, as long as you could buy CDS protection on it. One major additional reason that Wall Street was able to sell so many toxic mortgage securities was that they could point to CDS sellers, especially AIG, and say: Look, this stuff is great. But if you’re worried about it, no problem; all you need to do is walk over to those great folks at AIG, pay them a small fraction of your annual returns, and you’ll be totally protected.
Moreover, the total amount of risk created in the market was potentially limitless. Consider real insurance again. In the event of a disaster—an earthquake, a hurricane, or a tornado—the total liability of a real insurance company is limited to the actual damage caused by the disaster. But in the case of CDSs, as long as someone was willing to sell them, there was no limit to the size of the liabilities and risks that could be created.
Of course, selling gigantic amounts of such “insurance” on risky, even fraudulent, securities would be unwise. But AIG did it, for three reasons. The first was the complexity and opacity of the market, even—a cynical person might say especially—to AIG senior management. The second reason was that AIG’s senior management and board of directors were out to lunch. I invite readers to compare AIG’s investor presentations from the late bubble era—late 2007 and early 2008 especially—to the post-crisis congressional testimony of AIG’s ex-CEO Martin Sullivan. The investor presentations are absurdly optimistic and misleading, but they are also incredibly complex, whereas Mr. Sullivan appears to be rather … simple. He was the handpicked successor to Maurice (Hank) Greenberg, who chose him as a pliable fellow when Greenberg was forced out as CEO by Eliot Spitzer’s fraud investigations in 2005. AIG’s board, which had also been largely handpicked by Greenberg, was as pliable and clueless as Mr. Sullivan.
But the third reason is that AIG used the same toxic bonus system that destroyed everyone else. The company’s CDS business was insanely profitable—until it wasn’t—with profit margins of over 80 percent in its “best” years. It was run by a highly autonomous 375-person London-based unit, AIG Financial Products (AIGFP), which was the personal fiefdom of a man named Joseph Cassano. AIGFP kept 30 percent of each year’s profits as cash bonuses, passing the rest to the parent company. During the bubble, AIGFP paid itself over $3.5 billion in cash bonuses (Cassano personally made over $200 million) and handed $8 billion to AIG, by 2005 accounting for 17 percent of AIG’s total corporate profits.
In 2007, when the bubble started to deflate, the CDS buyers started to come knocking, demanding their money. Cassano resisted, while publicly telling investors in late 2007 that he could not see AIG losing “even one dollar” on the CDSs. Cassano blocked both external and internal auditors from reviewing AIGFP’s books. In 2007 AIGFP’s vice president for accounting policy, Joseph St. Denis, grew concerned about the CDSs and how they were being valued. Cassano angrily and obscenely denied him access to the information, telling St. Denis that he would “pollute the process.” St. Denis eventually resigned in protest, telling AIG’s chief auditor in late 2007 that he could not support AIGFP’s CDS accounting. Cassano stayed in place until AIG collapsed in September 2008. In response to public pressure, AIG terminated him, but then immediately rehired him as a consultant at the rate of $1 million per month, until that arrangement too was ended after being publicized in congressional hearings.
As of this writing (early 2012), credit default swaps have resurfaced as a factor in the sovereign debt crisis of Europe, and the potential spread of that crisis throughout the United States and European banking sector. Some people never learn.…
HAVING CONSIDERED THE investment banking industry’s behavior, let us return to the question of how and why CEOs and boards of directors could have tolerated this, and in particular why they could have allowed it to destroy their own companies. In part, the same financial incentives operated for them, and made them indifferent to the fate of their firms, employees, and customers. In some other cases, however, destroying their firms was clearly contrary to their self-interest, at least to some extent. Why did they let it happen? For there is no question that to some extent, the senior management of some of the banks did indeed behave irrationally.
Here, we must leave pure economics and ponder the toxic effects of too much wealth, too much power, the new culture of American investment banking, and a life conducted within the cocoon of America’s new oligarchy. Let us consider, for example, Jimmy Cayne. For those who might find what follows just slightly difficult to believe, I invite you to Google a phrase along the lines of “Jimmy Cayne helicopter Plaza Hotel bridge golf megalomaniac marijuana.”
Jimmy Cayne became CEO of Bear Stearns in 1993, and assumed the additional role of chairman in 2001, remaining in both positions until he was finally forced out as CEO in January 2008, by which point it was too late to save the company.
Mr. Cayne, who appears to have been very widely disliked, was not someone you were likely to feel comfortable telling that he was destroying his firm and the world economy. Former employees have told me a variety of stories. He would convene early morning meetings in the office, order a nice hot breakfast from a waiter, and consume it during the meeting, offering nothing to his subordinates, who waited for him to finish. He would invite someone into his office, make a show of taking out two cigars, light one up, and then put the other one in his pocket. He insulted subordinates in public, using extreme profanity. His predecessor as CEO of Bear Stearns, Ace Greenberg, described him as “a dope-smoking megalomaniac.”
But that’s his good side. As Bear Stearns’s profits and stock price soared as a result of the bubble, Mr. Cayne became a billionaire, and he went from being merely obnoxious to being seriously disconnected. He routinely took three- and four-day weekends, as well as extended vacations. For his long weekends, he frequently commuted from Bear Stearns headquarters by helicopter to his New Jersey golf club, where he had permission to land his helicopter on the grounds, and where he kept a house. At Bear Stearns, he reserved an elevator for his sole use. A serious bridge player, he paid two Italian professionals $500,000 per year to play with him. He traveled to many bridge tournaments and also spent a great deal of time playing bridge on his computer. Despite being a staunch Republican, he also smoked a lot of marijuana, with bridge partners, fellow hotel guests, and others frequently seeing and smelling it.
When the bubble started to implode in 2007 and Bear Stearns started to come under pressure, Mr. Cayne was frequently AWOL at critical times. Even on weekdays, and even when his company was collapsing in 2007 and 2008, he never carried a phone or pager when he was playing golf or bridge. He traveled repeatedly to bridge tournaments during this period, sometimes remaining away from the office a week or more. He would not participate in conference calls or meetings if they conflicted with his bridge schedule.
Bear Stearns’s troubles started for real in mid-2007, with the collapse of two of its investment funds that had been heavily concentrated in real estate. On Thursday, June 14, 2007, when Bear Stearns publicly reported its first worrisome financial results, Cayne was playing golf in New Jersey; he played the following day as well. One month later, on July 17, 2007, Bear Stearns told investors that the two real estate investment funds were now worthless. The next day, July 18, Mr. Cayne flew to Nashville for a bridge tournament, joined by Bear Stearns’s head of fixed-income products, Allen Spector, and stayed there for most of the following ten days, playing bridge. Mr. Cayne was in the office for only eleven days that month. Even when he participated in conference calls, he would sometimes drop off without warning.
This did not seem to disturb the board of directors. Indeed, the impetus for Cayne’s removal as CEO seems not to have been his performance, but the increasing publicity, particularly a Wall Street Journal article in November 2007 that described his golf and marijuana habits, and his being unreachable while indulging them. Even after being forced out as CEO in January 2008, Cayne remained chairman of the board. In early March 2008, about a week before his firm collapsed and was sold to JPMorgan Chase, Mr. Cayne closed on his purchase of two adjoining apartments in the Plaza Hotel for $24 million. On March 13, when Bear Stearns entered its final death spiral, he was in Detroit, playing bridge again; he joined the board’s conference call late so that he could finish his game first.
On May 10, two months after his firm’s collapse, Mr. Cayne attended a party held at the Plaza for new residents. The party included caviar and cognac bars, as well as a buffet that replicated paintings from a Metropolitan Museum exhibit, “The Age of Rembrandt.”
Mr. Cayne did suffer, of course. He lost his job; but when Bear Stearns collapsed he was seventy-four years old, near retirement age anyway, and it seems likely that in his head, he had already been retired for quite some time. The value of his Bear Stearns stock declined from about $1 billion at its peak to a mere $65 million when JPMorgan Chase bought it. But Mr. Cayne had thoughtfully taken out lots of cash over the previous years, so his estimated net worth remains about $600 million, probably sufficient to support his golf, bridge, helicopter, and marijuana habits. He still lives at the Plaza (at least when he’s in Manhattan—he has several other homes, including the one next to his golf club).
Certainly extreme, I hear you say, but could such behavior possibly be common, much less representative?
Well, yes, actually.
So, yes, it is true that some of the destruction caused by the bubble and crisis cannot be attributed entirely to rational self-interest and fraud. But that doesn’t mean that the rest was caused by innocent, well-intentioned error. Rather, it was symptomatic of a culture, and a governance system, that was seriously out of control.
During the bubble, many Wall Street executives constructed surreal little universes around themselves. The essential components of these worlds were physical isolation via private environments off-limits to their employees (limousines, elevators, planes, helicopters, restaurants), sycophantic employees and servants both at work and at home, and a compliant, clueless board of directors. Often their worlds also included trophy wives, mistresses, prostitutes, and/or drugs. Leisure activities were divided generationally. Young traders and salesmen focused on nightclubs, strip clubs, parties, gambling, cocaine, and escorts; New York investment bankers certainly spend over $1 billion a year in nightclubs and strip clubs, much of it charged to their firms as reimbursable, and tax-deductible, business entertainment. The older generation of senior executives, most of them married, tend to favor golf, bridge, expensive restaurants, charity events, art auctions, country clubs, and Hamptons estates.
Jimmy Cayne wasn’t the only one with a private elevator and a taste for helicopter commuting; in fact he was comparatively reasonable. After complaints, he eventually agreed to reserve the elevator for his private use only between 8 a.m. and 9 a.m. every day. Richard Fuld, Lehman’s CEO, had a different system. Whenever Fuld’s limousine approached Lehman headquarters, his chauffeur would call in; a specially programmed elevator would descend to the garage, held there by a guard until he arrived. Then the elevator took Fuld straight to the thirty-first floor, with no stops, so he didn’t have to see any of his employees. Here’s how a former Lehman employee described it (part of this is in my film):
This man never appeared on the trading floor. We never saw him. There was a joke on the trading desk. The H. G. Wells series, the Invisible Man … Now, a lot of CFOs are disconnected on the Street, but he had his own private elevator. He went out of his way to be disconnected.
Stan O’Neal at Merrill Lynch had a private elevator too—namely, any elevator that happened to be around when he arrived. A security guard would hold the next elevator that appeared, preventing anyone else from entering and, if necessary, ordering others already in the elevator to leave.
Lehman and most of the other banks also had corporate art collections, which sometimes absorbed considerable executive energy. All of the banks maintained chefs for their elegant private dining rooms, usually several of them, with access strictly controlled for executives and guests of differing levels of seniority and wealth. I’ve eaten in a few of them (Morgan Stanley, JPMorgan Chase); they’re very nice.
Everyone had limousines and drivers, of course, but there were serious toys, too. When Lehman went bankrupt, it owned a helicopter and six corporate jets. Two of the jets were 767s, which normally seat over 150 people when used by airlines, and cost more than $150 million when purchased new. In addition, however, Joe Gregory, Lehman’s president (the number two position under Fuld, the CEO), had his own personal helicopter, in which he commuted daily to Lehman from his mansion in the Hamptons. (In bad weather, he sometimes used a seaplane.) Gregory had a household staff of twenty-nine people. Citigroup owned two jets, and tried to take delivery on a new $50 million plane after it had collapsed and been rescued by the federal government.
Okay, so they had toys. But what were their financial incentives, how did their boards of directors compensate them, examine their conduct, reward and discipline them? Were others as bad as Bear Stearns and Jimmy Cayne?
Yes, they were. Professor Lucian Bebchuk of Harvard Law School examined the conduct of the most senior executives of Bear Stearns and Lehman Brothers in the years prior to their collapse. In both cases the top five employees had collectively taken out over $1 billion in cash (that is, a billion from each firm) in the several years immediately preceding the collapse. This does not suggest that these men (and all ten were men) had unlimited faith in the future of their firms, nor powerful incentives to avoid risk.
Or consider Stan O’Neal. He had been CEO of Merrill Lynch for four years by the end of 2006, and had pushed Merrill aggressively into subprime securities. In 2006 O’Neal’s take-home compensation was just over $36 million, of which $19 million was in cash. But this was not his total compensation. To avoid taxes, much of his compensation was deferred, to be paid upon retirement.
In 2006 Merrill Lynch had revenues of $33.8 billion and pretax earnings of $9.8 billion. In January 2007 Merrill paid its annual bonuses—just under $6 billion, of which one-third went to people involved in mortgage securities. Dow Kim, the head of Merrill’s fixed-income unit and therefore in charge of subprime securitizations, received $35 million. As late as the second quarter of 2007, ending June 30, Merrill Lynch was still profitable, reporting earnings of $2.1 billion. But as with Bear Stearns, in the middle of 2007 the bubble started to deflate. In the very next quarter, the third quarter of 2007, Merrill reported a net loss of $2.6 billion caused by over $8 billion in losses on subprime loans and securities. Then the company went off a cliff. For the full year 2007, Merrill’s revenues declined by 67 percent and it lost $8.6 billion. It would subsequently lose much, much more, nearly all of it stemming from decisions made while O’Neal was CEO. So what was Stan O’Neal doing during the third quarter of 2007, when Merrill Lynch was falling apart?
He was playing a lot of golf. In the last six weeks of the third quarter, O’Neal played twenty rounds of golf, sometimes with his cell phone switched off. Usually he played on weekends, but not always. Shortly afterward, as Merrill’s condition drastically worsened, O’Neal made unauthorized overtures to other banks regarding a potential merger. This, finally, led Merrill Lynch’s board of directors to fire him.
Except they didn’t fire him. They allowed him to resign, thereby enabling him to collect an additional $161 million, representing deferred compensation and severance—$30 million in cash, $131 million in stock. Nor has Mr. O’Neal been banished from the business world; after leaving Merrill, he was invited to join the board of directors of Alcoa, on which he now sits. In fact, he also sits on two committees of Alcoa’s board. Which ones? Audit and governance. Rewards for a job well done.
Finally, consider Robert Rubin. As treasury secretary, Mr. Rubin oversaw the elimination of the Glass-Steagall separation between investment banking and consumer banking. This change greatly benefited Citigroup; and shortly after leaving the Treasury, Mr. Rubin became Citigroup’s vice chairman. At Citigroup, Rubin displayed disconnection from both reality and ethical standards. In 2001, acting on Citigroup’s behalf, he had called his former colleague Peter Fisher at the Treasury Department, asking Fisher for help in preventing Enron’s credit rating from being downgraded, very shortly before Enron went bankrupt. (Citigroup was a major Enron creditor, and was later fined for helping Enron conceal its losses.)
During the bubble, Rubin pressed Citigroup to take on more risk, even after being warned of the increasing dangers and dishonesty of housing loans and mortgage-backed securities. He does not seem even to have been aware of his company’s financial structure and obligations. In his testimony before the FCIC, Rubin said that it was only post-crash that he learned about “liquidity puts,” the contract provisions by which Citigroup was obligated to repurchase CDOs if they lost money or couldn’t be sold. These agreements with the structured investment vehicles (that Citigroup itself had created) added over $1 trillion to Citigroup’s real balance sheet, and caused billions of dollars in losses during the crisis. It’s too bad that Rubin didn’t read the footnotes in his own company’s financial statements, for he might have noticed the puts and raised an alarm.31
After a decade at Citigroup, during which he was paid over $120 million, Rubin resigned under pressure in January 2009. But this does not seem to have interfered with him much. He remains cochairman of the Council on Foreign Relations; is still a member of the Harvard Corporation, the small group that is effectively Harvard’s board of directors; and both he and his son were active in the Obama transition team, helping to select a new batch of unethical policymakers. (Who turned out mostly to be the old batch, recycled; but we’ll get to that later.)
Unquestionably, none of these men made a deliberate decision to destroy their firms. But, equally unquestionably, personal incentives and personal risk focus the mind in a way that golf and bridge generally don’t. These people had way too much money outside of their companies to care as much as they should have about what was going on inside them. But the psychological atmospherics were just as important as the direct incentives. They became corporate royalty, with all the absurd arrogance, disconnection from reality, ego poisoning, and cults of personality thereby implied.
However, there were others—most famously, Goldman Sachs—who didn’t allow the temptations of helicopter golf to cloud their thinking. These very disciplined and predatory people therefore made money not only from the bubble, but also from the collapse. We will now consider them, and the implications of their behavior for financial stability, in looking at the warnings, the end of the bubble, the crisis, its impact, and government responses to it. It is not a pretty, or reassuring, picture.
* That calculation was across all the securities. In the pool example used here, the 73.8 percent LTV implied equity of 26.2 percent. If LTV was really 90.5 percent, the equity falls to 9.5 percent, which is 64 percent lower.