All the Devils Are Here

by Bethany McLean; Joe Nocera

  But even as they were holding on by their fingertips, the massive changes that would transform the mortgage business had begun. Rising interest rates were starting to kill the S&Ls. More important, not long after Countrywide was born, Fannie Mae was granted the right to buy conventional mortgages.

  Almost overnight, mortgage originators like Countrywide began to dominate the home lending business. From a standing start, the market share of nonbank mortgage companies rose to 19 percent by 1989. Just four years later, it stood at an astonishing 52 percent, according to Countrywide’s financial statements. By buying up the mortgages of companies like Countrywide, the GSEs made that growth possible, something Mozilo never forgot. As he once told the New York Times, “If it wasn’t for them, Wells [Fargo] knows they’d have us.”

  Under the rules, Mozilo could sell only so-called conforming loans—those that met the GSEs’ strict underwriting criteria. Loans were underwritten based on what was known in the business as the four Cs: credit, capability, collateral, and character. If you had late payments on a previous mortgage, and maybe any other debt, you didn’t get a mortgage. The monthly payments for your home—the principal, interest, taxes, and insurance—couldn’t exceed 33 percent of your monthly income. All of which was fine by Mozilo. It was the way he’d always done business.

  On the other hand, Mozilo also pushed Countrywide to begin using independent brokers instead of relying on its own staff to make loans. This was decidedly not the industry norm. It was also one of the rare times Mozilo had an open disagreement with his mentor, Loeb, who protested that if Countrywide began relying on independent brokers, it would be hard to control the quality of the loans. In the days before the collapse of the S&Ls, says one industry veteran, “brokers’ stock-in-trade was falsifying documentation.” At least, that was the rap. And nonstaff brokers had no skin in the game; once they’d sold their loan to Countrywide and gotten their fee, they were out. “I think it’s going to be a big mistake,” Loeb said, according to Chain of Blame.” But with S&Ls closing down by the hundreds, there was a cheap, ready-made workforce: out-of-work loan officers. Using them could help Countrywide grow faster. Loeb’s resistance faded as brokers’ reputation began to change, and as the company got aggressively behind this idea, all its competitors began using independent brokers as well. It soon became standard practice.

  By 1992, just twenty-three years after its founding, Countrywide had become the largest originator of single-family mortgages in the country, issuing close to $40 billion in mortgages that year alone. Just as rising rates had crushed the S&Ls a decade before, so did falling interest rates now turbo-charge Countrywide’s growth. Lower interest rates helped more people afford homes, of course. But Countrywide began advertising a technique that allowed people who already owned their home to take advantage of lower rates. Refinancing, it was called. Often borrowers didn’t just refinance their home, they pulled out additional cash against the equity in their homes. For the fiscal year ending in February 1992, refinancings accounted for 58 percent of Countrywide’s business; two years later, they accounted for 75 percent of its business. Although refinancing allowed consumers to take advantage of lower interest rates, it really didn’t have much to do with homeownership. Countrywide wasn’t putting people into homes so much as it was making it possible for homeowners to use their homes as piggy banks.

  During 1991 and 1992, Mozilo served as the chairman of the Mortgage Bankers Association. It was a sign that whatever lingering resentments Mozilo still felt, Countrywide was now part of the in-crowd.

  What everyone remembers about Mozilo was how passionate he was about the business, about its success. He cared deeply about every aspect—he wanted to know everything, had to know everything. If he walked into a branch and saw that a fax machine was broken, he would stop everything and try to fix it himself. According to the American Banker, the thrift H. F. Ahmanson, desperate to compete with Countrywide, commissioned a report on the company in the early 1990s in an effort to understand its secret sauce. Mozilo, the report concluded, was a “hands-on manager, totally consumed by the business, a perfectionist.” It also said he was a “dictatorial” boss who “is known to fire employees the first time they make a mistake.” If this wasn’t exactly true—longtime Countrywide executives often said that Mozilo’s bark was worse than his bite—it was all part of his aura.

  He did drive his employees incredibly hard, or those who succeeded drove themselves incredibly hard. He was both highly emotional and mercurial, and he operated from his gut. It wouldn’t be uncommon for him to have “an allergic reaction to things,” as a former executive puts it, before eventually coming around. He was perfectly capable of telling an employee that what he’d just said was the stupidest thing in the world. He expected those who worked for him to take whatever he dished out in the heat of the moment—and then do the right thing, even if it contradicted his command. If they did the wrong thing, following orders wasn’t an excuse. Countrywide was not an easy place to work. “It was very, very competitive,” recalls one person who knew the company well. “The politics were brutal. You had to eat, sleep, and drink Countrywide. It was a boys’ club. There were a few women, but it was very autocratic.” But employees took great pride in the company—and Mozilo. At getaways for top producers, people would clamor for a moment with him. He was the classic underdog who had achieved big things, after all.

  He instilled something akin to fear in the investment community. Mike McMahon, a Wall Street analyst who followed Countrywide for more than twenty years, once took a group of investors to see Mozilo. During the meeting, one of them said that Countrywide’s stock would be valued more highly if Mozilo disclosed more about its operations. Most CEOs would have dismissed the questioner with a platitude. Not Mozilo. He had a bad back that day, so he had to stiffly turn his whole body toward the man—“like Frankenstein,” McMahon recalls. “No,” Mozilo replied. “Fuck ’em.” Then, ever so slowly, he turned his body back, almost menacingly, as if to say, “Who else wants to take me on?”

  What everyone could see, though, was that Mozilo drove himself harder than anyone. For a long time he had a classic case of entrepreneurial paranoia—that gnawing fear that, someday, everything he had built would suddenly vanish. That’s why he couldn’t relax, even for a second. The company, after all, was in a boom-and-bust business, one that hit hard times when interest rates rose. It competed not just against other mortgage brokers but against giants like Wells Fargo and Bank of America. Margins were always tight. Securitization may have made the business possible, but it didn’t make it easy. McMahon says that mortgage origination was a “negative cash flow business,” meaning that the slim profits were eaten up by costs and commissions. There was profit in servicing mortgages, but that was realized over time. “The more they originated, the less cash they had,” he says. In addition, because Countrywide had to appease the rating agencies in order to borrow money at a good rate, the company actually had to put aside more capital than banks did. “They were in a really, really, really competitive, low-margin commodity business with one hand tied behind their back on capital,” says McMahon. Is it any wonder Mozilo’s motto was “We don’t execute, we don’t eat”? According to The New Yorker, he once told a Countrywide executive, “If you ever stop trying to make your division the biggest and the best, that’s the day you die.”

  Over time, Loeb faded into the background. Early on, Mozilo had moved Countrywide to California; the state represented a huge percentage of the mortgage market and accounted for as much as 50 percent of Countrywide’s revenues in some years. Loeb, however, often worked from one of his homes in Manhattan or Squaw Valley, where he focused on managing Countrywide’s risks. Mozilo became the public face of the company—and in some ways the public face of the industry as well.

  With his trademark tailored suits and crisp blue shirts with white collars—which accentuated his perfectly white teeth and dark skin—Mozilo would testify before Congress, give interviews to repo
rters, make speeches at conferences, and meet investors. He took great pride in the business model he had helped create; he had, indeed, “showed them.” By 2003, Countrywide was one of the best-performing companies in the country, with a stock price that had risen 23,000 percent in the twenty-one years since the start of the bull market that began in 1982. A glowing article in Fortune magazine noted that Countrywide had outperformed not just other mortgage companies and banks, but such storied stock market performers as Walmart and Warren Buffett’s Berkshire Hathaway. Mozilo would later describe the publication of that article as one of the proudest moments of his life.

  At precisely the same time Mozilo was building Countrywide, another entrepreneur was building a different kind of mortgage empire. His name was Roland Arnall. He was never in the limelight like Mozilo, and he never wanted to be. But he made far more money; by 2005, he was worth around $3 billion, according to Forbes. Arnall got rich by making loans to the borrowers that had long served as the customer base for the hard-money lenders: people who had bad credit, didn’t make much money, or both. Though his companies never got the blame that would later be heaped on Countrywide, Arnall was the real subprime pioneer; in fact, his first company, Long Beach Mortgage, trained a slew of executives who would later go on to found their own subprime companies. “The Long Beach Gang,” housing insiders used to call them. One of Arnall’s subsequent companies was called Ameriquest. By 2004, it had become the largest subprime lender in the country.

  A native of France, Arnall was born in Paris in 1939, on the eve of World War II. His mother was a nurse; his father, a tailor by trade, was in the army. Not long before Paris fell to the Germans, Arnall’s father returned to Paris and warned his extended family they should leave as quickly as possible. Most of them refused. But Arnall’s father took his wife and young son to the south of France, where they waited out the war using false papers that hid the fact that they were Jews. Arnall himself discovered that he was Jewish only after the war, a fact that stunned him. With the war ended, the family moved first to Montreal, where Arnall attended Sir George Williams College, and then, in 1950, to California, where Arnall sold flowers on street corners to make money for his family. “I know firsthand the precious gift of freedom,” he once said.

  Arnall exerted a powerful effect on those who came into his orbit. “He was scarily smart and charismatic,” says Jon Daurio, who worked for Arnall from 1992, when Arnall recruited him to be the corporate counsel of Long Beach, until 1997. (Daurio would go on to found several other subprime lenders.) Daurio and his wife had dinner with Arnall when he was trying to convince Daurio to join Long Beach. “My wife is a lawyer, and smart,” says Daurio. “She said, ‘I don’t understand 90 percent of what you talked about, but you’re an idiot if you don’t go work for him.’”

  Even more than Mozilo, Arnall was known for running his companies with an iron fist. “He was very demanding, and not very tolerant,” recalls a former executive. He had a penchant for enticing people to work for him, extracting what he wanted from them, and then losing all interest in them. “When he got what he wanted out of you, you were done,” this person added.

  Unlike Mozilo, Arnall was extremely secretive. He never gave press interviews. The documents his companies filed with the SEC divulged only the bare minimum required under the law. Arnall did not attend industry conferences, and his name was never on the door of his companies. He hated even having to talk to securities analysts. “I met with him once,” recalls a former banking analyst. “We all had to sign forms agreeing not to disclose anything before we were allowed into the conference room. That never happened any other time in my twenty-plus-year career.”

  Yet he was never, ever rude to people the way Mozilo sometimes could be; that wasn’t his style. On the contrary, he was gracious and polite to everyone, from janitors to community activists. He had old-world manners, was an avid reader and an intellectual. He was the sort who liked to remind people that if they had their health and their family, they had everything. And he gave away millions to charity. “He was quite concerned with society as a whole,” says Robert Gnaizda, the former general counsel of the Greenlining Institute, a public policy and advocacy group, who spent a great deal of time dealing with Arnall’s companies and came to know him well. “Except,” Gnaizda added, “for this little niche, where he wasn’t.”

  That little niche, of course, was subprime lending.

  The way hard-money lenders had always made their money was simple: knowing that the default rate among their borrowers was likely to be high, they imposed onerous terms on their customers, who had no choice but to agree to them. They claimed collateral on anything they could haul away—cars, household goods, you name it. They extracted high fees just for making the loan. And they charged as much interest as they could get away with. They were also extremely tough-minded about collecting what was owed them, which meant they usually got paid back. And the high fees meant that those who paid up more than made up for those who defaulted.

  The biggest hard-money lenders, finance companies like the Associates, Beneficial, and Household Finance, also made second-lien mortgages, which allowed strapped consumers to borrow against their homes to raise cash. But hard-money lenders had never offered first-lien mortgages, because the economics of a thirty-year fixed mortgage with a sizable down payment simply made no sense in that sector of the market.

  What changed was the law. Specifically, a series of laws passed in the early 1980s, intended to help the S&Ls get back on their feet, wound up having profound unintended consequences. (They also backfired spectacularly and helped create a second S&L crisis within a decade.) The first law, passed in 1980, was the Depository Institutions Deregulation and Monetary Control Act; among other things, it abolished state usury caps, which had long limited how much financial firms could charge on first-lien mortgages. It also erased the distinction between loans made to buy a house and loans, like home equity loans, that were secured by a house, which would prove critical to the subprime industry.

  Two years later came the Alternative Mortgage Transaction Parity Act, which made it legal for lenders to offer more creative mortgages, such as adjustable-rate mortgages or those with balloon payments, rather than plain vanilla thirty-year fixed-rate instruments. It also preempted state laws designed to prevent both these new kinds of mortgages and prepayment penalties. The rationale, needless to say, was promoting homeownership. “Alternative mortgage transactions are essential … to meet the demand expected during the 1980s,” read the bill.

  As the rules changed, the “Big Three” hard-money lenders—the Associates, Beneficial, and Household—began to expand into first-lien mortgages, which made economic sense for the first time. S&Ls, of course, had also gained new freedoms from the series of laws designed to get them back on their feet. The new breed of thrift operators started lending to consumers who would have never previously qualified for a mortgage. Thus was the subprime mortgage industry born.

  One of the first to take advantage of the new opportunities was a thrift called Guardian Savings & Loan, run by a flashy, aggressive couple named Russell and Rebecca Jedinak. As federal thrift examiner Thomas Constantine would later write, “It started at Guardian. Ground zero, baby.”

  The Jedinaks moved into an aggressive form of hard-money lending. They offered loans—mostly refinancings—to people with bad credit, as long as those people had some equity in their house. “If they have a house, if the owner has a pulse, we’ll give them a loan,” Russell Jedinak told the Orange County Register. Kay Gustafson, a lawyer who briefly worked at Guardian, would later say that the Jedinaks didn’t really care if the borrower couldn’t pay the loan back because they always assumed they could take over the property and sell it. “They were banking on a model of an ever-rising housing market,” she told the Register. In June 1988, Guardian sold the first subprime mortgage-backed securities. Over the next three years, the Jedinaks sold a total of $2.7 billion in securities backed by mortgages made to le
ss-than-creditworthy borrowers, according to the Register. Fannie and Freddie were most decidedly not involved.

  By early 1991, federal regulators had forced the Jedinaks out. The Resolution Trust Corporation, which had been established to clean up the second S&L mess, took over the thrift. Standard & Poor’s noted that Guardian’s securities were “plagued by staggering delinquencies.” In 1995, the government fined the Jedinaks $8.5 million, accusing them of using Guardian’s money to fund their lifestyles. They didn’t admit to or deny the charges, and anyway, they’d already started another lender, Quality Mortgage. After the Jedinaks were barred from the business, they sold Quality Mortgage to a company called Amresco, which itself became a fixture of the 1990s subprime lending scene.

  Roland Arnall was right behind the Jedinaks. Unlike them, he built businesses that would last—at least, for a while. Arnall got a thrift license in 1979, just as the rules were changing, and he named his thrift Long Beach Savings & Loan. Initially, he built multifamily housing and other real estate developments, but he soon spotted a much better opportunity. Taking note of the exorbitant fees charged by the hard-money guys, he realized he could cut those fees in half and still make plenty of money. In 1988, Long Beach began to use independent brokers, just like Mozilo, to make mortgages to people with impaired credit. By the early 1990s, Long Beach was also selling mortgage-backed securities—which Wall Street was eagerly buying. The company grew exponentially; between 1994 and 1998, Long Beach would almost quintuple the volume of mortgages it originated, to $2.6 billion.

  In 1994, Long Beach chucked its thrift charter. The charter had outlived its usefulness. Now that a mortgage originator could sell the loans to Wall Street, there was no particular need to be a deposit-taking institution.

  But how could it be that Wall Street was willing to buy and securitize mortgages that Fannie and Freddie wouldn’t touch—mortgages made to people with a far higher chance of defaulting than traditional middle-class homeowners? This was something the founding fathers of mortgage-backed securities had never imagined was possible. Once, when Larry Fink was testifying before Congress in the 1980s, he was asked whether Wall Street might try to securitize risky mortgages. He dismissed the idea out of hand. “I can’t even fathom what kind of quality of mortgage that is, by the way, but if there is such an animal, the marketplace … may just price that security out.” By that, he meant that investors would require such a high yield to take on the risk as to make the deal untenable. And yet, less than a decade later, that is exactly what was happening.