At another point during the conference call, McMurray noted, “So the way I think about prime is that it covers a very vast spectrum….” The implication was clear. Countrywide was acknowledging that prime and subprime weren’t as clearly delineated as most had believed. While investors who dug through the prospectuses for Countrywide’s mortgage-backed securities might have known that, it came as a shock to many.
McMurray also had two messages that were contrary to everything Mozilo had preached over the years. “Leverage at origination matters,” he said. “More leverage means more serious delinquencies.” That is, the more debt the customer borrowed, the more likely he was going to default. And he said, “Documentation matters. The less documentation, the higher the serious delinquency, all else equal.”
That day Countrywide’s stock fell more than 10 percent, to close at $30.50. Research analysts at Stifel Nicolaus, which had turned bearish on Countrywide earlier in the year, wrote in a report to clients, “[G]iven the magnitude of credit problems in the bank, we think mgmt made serious miscalculations (and possibly misrepresentations) about the quality of the loans added to the bank.” They found that Countrywide’s supposedly prime home equity securitizations were performing in line with a competitor’s subprime deals.
Soon after that conference call, McMurray resigned. Later that fall, Walter Smiechewicz, the senior executive in charge of enterprise risk assessment, met with Countrywide’s audit committee. Smiechewicz had been warning since 2005 that the residuals and the loans Countrywide had retained on its balance sheet posed a much bigger risk than was being acknowledged. According to several former executives, he said that if nothing was going to change, then he had no choice but to resign. He, too, left the company.
IKB—the German bank that was on the other side of John Paulson’s Goldman-arranged Abacus trade—was beginning to spook the market. Over the weekend of July 28 and 29, state-owned German banks brokered a bailout of the bank that would eventually rise to $13.5 billion. It was the first bank to be rescued because of the securitized mortgages on its books. It would not be the last.
Then came August. On August 8, BNP Paribas, France’s largest bank, suspended redemptions from three of its investment funds because it couldn’t value some of its subprime mortgage-backed securities. Australia’s Basis Yield Fund, which had bought into Goldman’s Timberwolf deal, suffered severe losses. It would soon go into liquidation because of its exposure to subprime assets.
August home prices fell 4.4 percent from the previous year, the largest decline in six years. Youyi Chen, the head of mortgage portfolio management at Washington Mutual, sent an e-mail to a group of colleagues entitled “Scenarios.” He wrote, “A 20 percent down in HPA. From today’s meeting, I understand that we don’t have the courage to evaluate this scenario.”
On August 9, five central banks around the world coordinated to increase liquidity for the first time since 9/11. Within a week, the Federal Reserve would begin cutting interest rates in an attempt to prop up the market.
It didn’t work. The securitization market for mortgage loans shut down. First Magnus, a lender of mostly Alt-A mortgages, collapsed seemingly overnight. It had funded $17.1 billion worth of loans in the first half of the year, according to Inside Mortgage Finance.
And the entire market for asset-backed commercial paper—a market of more than $1 trillion worth of securities, and the primary means by which originators financed mortgage lending—began to seize up. Goldman Sachs chief risk officer Craig Broderick later explained in a presentation to the firm’s tax department that between August and October 2007, the “unprecedented loss of investor confidence” had quickly shrunk the asset-backed commercial paper market by more than 30 percent. “For someone who has seen this market grow on a stable, steady basis for as long as I’ve been in the business, this is really remarkable,” Broderick said.
Suddenly, no one wanted anything to do with securitization, or any form of asset-backed commercial paper, or anything that depended on credit ratings. In the all-important repo market, the “haircuts” on asset-backed securities began to increase, from between 3 and 5 percent in April 2007 to 50 and 60 percent by August 2008, according to an IMF report. “The market began searching for anything that smelled like something it didn’t like,” said one banker.
Most companies file their official quarterly documents with the SEC several weeks after announcing their results to Wall Street. Thus it was that on August 9, several weeks after its disastrous conference call, Countrywide filed its quarterly report with the SEC. In it Countrywide cited “unprecedented market conditions” and wrote that while “we believe we have adequate funding liquidity… the situation is rapidly evolving and the impact on the Company is unknown.” The next day, Countrywide held a special board meeting, the board members participating by phone. Countrywide had always assumed that in desperate times it would be able to pledge its prime mortgages as collateral for a loan. But they couldn’t. Street firms “in almost every case had a very large exposure to mortgages,” as Countrywide treasurer Jennifer Sandefur later put it, and they didn’t want more. Plus everyone was suddenly asking Wall Street for money. “It was an Armageddon… scenario,” Sandefur said. “It was—you know, a worst-case scenario of kind of epic proportions.”
As soon as he read Countrywide’s filing, Kenneth Bruce, the Merrill Lynch analyst who followed the company, knew that it was at risk. “Liquidity Is the Achilles Heel,” read the headline of his report to his clients. “We cannot understate the importance of liquidity for a specialty finance company like CFC,” wrote Bruce. “If enough financial pressure is placed on CFC”—Countrywide’s ticker—“or if the market loses confidence in its ability to function properly, then the model can break.” His shocking conclusion: “[I]t is possible for CFC to go bankrupt.”
Within days, Countrywide drew down its entire $11.5 billion credit facility—an obvious sign of desperation. It also tried to get the Fed to use its emergency lending authority, but the Fed refused. Maybe things would have been different if Countrywide were still regulated by the Fed. But it wasn’t. “They burned their bridges,” says one person who is familiar with the events.
On August 23, 2007, shortly before the market opened, Countrywide announced that Bank of America would invest $2 billion, giving the market the confidence that Countrywide had access to the deep pockets it needed to keep running. (Ironically, the bank had loaned Mozilo $75,000 in 1969, allowing him to start up Countrywide.) In an interview with CNBC’s Maria Bartiromo, Mozilo blasted Bruce’s report: “[T]o yell fire in a very crowded theater where you had, you know, panic was already setting in… was totally irresponsible and baseless.” He added, “At the end of the day, we’re the only game left in town.”
After watching Mozilo, Kerry Killinger sent an e-mail to Steve Rotella, Washington Mutual’s chief operating officer. “By the way,” he wrote, “that great orange skinned prophet from Calabasas was in fine form today on CNBC. He went after the analyst at Merrill, predicted housing would lead us into a recession, said the chance of CFC bankruptcy was no greater than when the stock was at 40 and said ‘what doesn’t kill us makes us stronger.’ He continues to give the class action lawyers good fodder for their stock drop lawsuits.”
In his inimitable way, Mozilo tried to fend off the inevitable. In the fall of 2007, Countrywide hired a public relations firm to help launch a “game plan to regain control of the agenda,” according to a memo obtained by the Wall Street Journal. Although the memo was meant to serve as talking points for another top Countrywide executive—Drew Gissinger—the pugnacious tone had all the earmarks of Angelo Mozilo.
“Our position in the industry makes us a huge and very visible target,” the memo read. “[W]e’re being attacked from all sides today in large part because we’re ♯1. Not just ♯1 overall, but for the first time in mortgage banking history, we’re ♯1 in each of the 4 major divisions—Wholesale, Retail, Correspondence, and Consumer Direct. This is what makes us s
uch a huge threat to our competitors.”
“[I]t’s gotten to the point where our integrity is being attacked,” the memo continued. “NOW IT’S PERSONAL!… WE’RE NOT GOING TO TAKE IT.”
It ended by asking Countrywide’s employees to sign a pledge that they would “protect our house”—that is, defend the company from the growing storm of accusations about its lending practices. The stock continued to fall.
In January 2008, Countrywide hired Sandler O’Neill, a boutique investment bank, to explore its options. According to one person who was there, Countrywide CFO Eric Sieracki presented a “base-case scenario,” a “stress scenario,” and a “severe scenario.” Jimmy Dunne, Sandler’s blunt CEO, dismissed the base-case scenario out of hand. What was coming was likely to be even worse than Countrywide’s severe scenario, he said. Countrywide needed to sell. And the best—maybe the only—buyer was Bank of America. “Ken Lewis, when he covets a target, cannot say no,” Dunne said. (Lewis, the CEO of Bank of America, would become infamous for buying Merrill Lynch during the height of the crisis in a deal that was surrounded by controversy and criticism. Ultimately, that acquisition would cost him his job.)
Says one person who was there: “Mozilo and all these guys, they thought they were making widgets. They got too far away from understanding the real risk in the balance sheet. Even at the end, they were saying that things were okay. They believed it. They were crazy.”
In January 2008, Bank of America acquired Countrywide for $4 billion; less than a year earlier its market capitalization had been more than six times that amount, at nearly $25 billion. During the second half of 2007, Countrywide took $5.2 billion in write-downs and increases to loan loss reserves, according to a shareholder lawsuit later filed against the company. The write-downs essentially wiped out Countrywide’s earnings for 2005 and 2006.
Just before the acquisition, Mozilo told investors, “I believe very strongly that no entity in this nation has done more to help American homeowners achieve and maintain the dream of homeownership than Countrywide.”
Wouldn’t you know it? Moody’s and S&P downgraded Countrywide on August 16—a week after the company filed its quarterly documents with the SEC. The day before, S&P had announced that structured investment vehicles—which had hundreds of billions of dollars in triple-A-rated debt among the $400 billion outstanding at the peak—were weathering the market disruption well. (A month earlier Moody’s called SIVs “an oasis of calm in the subprime maelstrom,” according to a lawsuit that was later filed by CalPERS, the giant California pension fund.) But just a week and a half later, on August 28, Cheyne Capital Management, a $7 billion SIV, sent both rating agencies a letter notifying them that it had breached one of its requirements, and would have to wind down as a result. S&P abruptly downgraded Cheyne’s debt, including its triple-A paper. According to the CalPERS lawsuit, Moody’s didn’t react until September 5, which was the day that Cheyne was forced into receivership. “If the rating agencies have to downgrade six notches in a single day, it undermines investor confidence,” wrote a J.P. Morgan analyst. “It… makes investors wonder whether the rating agencies were paying attention to what was going on in the portfolio.”
In addition to owning mortgage-backed securities, SIVs had 30 percent of their assets in financial corporate debt, according to a report done by the congressional Joint Economic Committee. In other words, banks were setting up off-balance-sheet vehicles that they could then use to buy not just slices of CDOs but possibly also their own debt—all without incurring any capital charges. It was a free fee machine and a self-funding mechanism—until it wasn’t. In the wake of Cheyne’s collapse, the SIV market cratered; Citi eventually absorbed $58 billion in troubled, but supposedly off-balance-sheet, SIV debt onto its own balance sheet at the worst moment imaginable. In addition, Citi, Bank of America, and other banks that had written liquidity puts ended up taking those assets back onto their own balance sheets. “Thus the sponsoring banks implicitly acknowledged that these… SIVs should never have been considered as separate entities from either an accounting or a regulatory perspective,” wrote the Joint Economic Committee in its report to Congress. Thus did another source of funding disappear from the market.
As the world would soon discover in spectacular fashion, the rating agencies weren’t wrong just about RMBS, CDOs, and asset-backed commercial paper.17 They were also wrong about the entire global financial system. In July 2007, Moody’s issued a special comment entitled “Another False Alarm in Terms of Banking Systemic Risk but a Reality Check.” “There is no easy way to predict whether a financial shock is systemic by nature,” Moody’s wrote. “The best way remains to look at the main financial institutions, i.e., the pillars of the system. In our view, their ability to withstand shocks is very high, perhaps higher than ever.” Although Moody’s conceded that “model risk has inexorably mushroomed,” it said that most global financial institutions had a “rather high degree of risk awareness.”
A few weeks later, in an “update,” Moody’s said that “there are currently no negative rating implications… as a result of [the banks’] involvement in the subprime sector.” The truly shocking thing is that Moody’s was willing to make this pronouncement even while acknowledging, in the very same paper, that there was no way the agency, or anyone else, could really know anything about the risks these institutions were holding. (“Public disclosures and position transparency make it virtually impossible for investors to accurately quantify each firm’s credit, market and liquidity exposure.”)
That was precisely the problem. The issue wasn’t actual cash losses. It was uncertainty. No one knew where the subprime problem would pop up next, no one could figure out what any of this stuff was worth, no one believed what anyone else said about what it was worth, and no one believed that anyone who was supposed to know something actually did. That included the nation’s top regulators. “I’d like to know what those damn things are worth,” Federal Reserve chairman Ben Bernanke said during an appearance at the Economic Club of New York in October 2007.
Bernanke’s comment infuriated an outspoken, deeply skeptical Georgia mutual fund manager named Michael Orkin. Not long after the Fed chairman’s speech, Orkin wrote in his monthly letter to investors, “Since the first shot was fired across the credit bow in February 2007, investors have been force-fed a constant diet of half-truths and whole lies regarding the nature and status of the mammoth mortgage-based derivative machine and the housing market bubble it inflated… The fact that the credit crisis has now turned into a confidence crisis should serve as a wake-up call to Wall Street, the Treasury and the Fed.”
In late November 2007, a senior vice president in structured finance at Lehman Brothers, Deepali Advani, who had previously worked at Moody’s, forwarded an e-mail from one of the firm’s traders to a handful of his contacts. “The wheels on the bus are falling off, falling off, falling off… The wheels on the bus are falling off, all over Wall Street.” William May, a managing director at Moody’s, wrote back, “I think he’s too optimistic.”
“Bill, who ever thought CDOs would be WMD?” Advani wrote back. “Though have to say—every day more bad news—would be much too bad for the world to end—but that’s sure how it feels.”
20
The Dumb Guys
The collapse of the Bear Stearns hedge funds in June 2007 should have been a terrifying moment for Stan O’Neal. Merrill Lynch had been the first to make a grab for Bear’s triple-A subprime collateral, which began the run on the bank that brought down the two funds. Yet it had been unable to sell that collateral because nobody wanted it. Nobody could say anymore what it was worth.
Dale Lattanzio, who ran Merrill’s CDO business, and his boss, Osman Semerci, responded in exactly the way you would expect of two people whose multimillion-dollar bonuses were completely dependent on their ability to continue manufacturing CDOs. They told their superiors that the market was in the middle of a little rough patch, but there was nothing to worry about. De
spite their obvious vested interest, O’Neal appeared to accept their analysis. According to The New Yorker magazine, the two men told O’Neal that “the CDO market would eventually stabilize, allowing Merrill to sell its holdings.” The magazine added, “O’Neal seemed reassured.” He did, however, ask them to try to hedge the position, which they insisted they were already doing. Indeed, in late 2006—around the same time Goldman Sachs concluded that it needed to get closer to home—Dow Kim was telling Semerci and Lattanzio the same thing. At a board meeting in July, the two men claimed the risk on the firm’s books amounted to no more than $83 million—a claim that other Merrill executives viewed as implausible. Yet O’Neal didn’t question them. When others tried to warn O’Neal that Semerci’s loss estimates were too low, they were met with a steely glare, according to several former Merrill executives.
Shortly after that board meeting, Merrill announced its second-quarter earnings. On the surface, the numbers were terrific: $2.1 billion in profits on $9.7 billon in revenues; the profit number was 31 percent higher than Merrill’s second-quarter profits in 2006. In the accompanying press release, Merrill specifically pointed to the success of its “credit products.” During the conference call with investors, CFO Jeff Edwards put it even more explicitly: the growth in fixed income was due in large part to “a substantial increase from structured finance and investment, which primarily reflects a better performance from our U.S. subprime mortgage activities.” Acknowledging that the market for CDOs “has yet to fully stabilize” after the collapse of the Bear Stearns hedge funds, Edwards added that “[r]isk management, hedging, and cost controls in this business are especially critical during such periods of difficulty, and ours have proven to be effective in mitigating the impact of our results.” Within three months, every one of these claims would prove to be delusional.
All the Devils Are Here Page 41