The secondary market turned the New Mortgage Game into a game of musical chairs that was destined for disaster. Because of the financial disconnect, it worked like a multitrillion-dollar Ponzi scheme. The secondary market grew so enormous that it constantly needed new money to cover losses and to keep the game going. But when the music stopped, the game brought down Bear Stearns, Lehman Brothers, Washington Mutual, Countrywide, and hundreds of regional banks, and it left millions of average Americans foreclosed out of their homes and millions more vastly poorer—$9 trillion poorer—from both equity stripping and plunging home values.
The Legislative Seeds of Crisis
The New Mortgage Game and the enormous loss of wealth by middle-class Americans were the direct consequences of new policies in Washington—New Economy policies that wiped out laws and regulations that had worked well for decades.
The first major step was taken under President Jimmy Carter—the Depository Institutions Deregulation and Monetary Control Act of 1980. That law effectively abolished limits on interest rates for first mortgages that had long been imposed by state usury laws. It thus removed a basic protection for financially vulnerable borrowers and opened the door to unscrupulous subprime lenders. “More than anything else,” asserted former Federal Reserve Board governor Edward Gramlich, “this elimination of usury law ceilings [on interest rates] paved the way for the development of the subprime market.”
In 1982, Congress took an even bigger step. It adopted legislation proposed by President Reagan that authorized the exotic loans that became the pathological hallmarks of the housing craze of the 2000s. This law enabled state banks to sell adjustable-rate mortgages (national banks had gotten that authority in 1981). It also permitted something never allowed before—equity stripping loans, known in banking lingo as “negative amortization.” This meant authorizing banks to sell loans where the principal balance would go up over time, digging homeowners into ever-deepening debt. Finally, the law empowered the Office of the Comptroller of the Currency to issue rules in 1983 that permitted up to 100 percent financing, by canceling restrictions that required down payments from buyers.
These three items—ARMs, negative amortization, and 100 percent financing—in a law that President Reagan hailed as “the most important legislation for financial institutions in the last 50 years,” were the grist, as New York Times financial columnist Gretchen Morgenson observed, for home mortgages loaded “with poisonous features that made them virtually impossible to repay.”
Two years later, in 1984, the Reagan administration delivered the coup de grâce for the New Mortgage Game—the separation of Profit from Risk. In partnership with Wall Street bankers, the Reagan White House wrote the Secondary Mortgage Market Enhancement Act of 1984. This law sanctioned the “securitization” of mortgages on the secondary market, which powered the explosive growth of America’s mortgage market to the point that it outstripped even the market for U.S. Treasury bonds and bills.
For banks that originated loans, such as Washington Mutual and Long Beach Mortgage, securitization provided the avenue for selling their mortgages and the source for raising more capital to finance another round of lending. For investment banks such as Goldman Sachs, it created a new venue and new vehicles to reap lucrative fees and a casino for betting against the subprime market that they were getting their clients to finance.
The 1984 law was written to Wall Street’s specification. By several accounts, Lewis Ranieri, a legendary Salomon Brothers trader, whom some have called the father of the modern mortgage bond market, worked hand in glove with the Reagan White House to craft the legislation. From experience in the 1970s, Ranieri knew exactly what legal barriers the investment bankers needed to eliminate in order to create a grand new mortgage marketplace. Then in 1986, Ranieri and the investment banks won another round of lucrative concessions in the tax reform law that established the real estate mortgage investment conduit, or REMIC, which granted complex special tax advantages for the mortgage bond market.
Greenspan: Engineering a Turnaround
If the White House and Congress provided the legal blueprint for the New Mortgage Game, Alan Greenspan became its point man—its prime policy architect and its most influential advocate. Three elements were central to the New Mortgage Game—cheap money, subprime loans, and a portfolio of flexible interest rate mortgages—and all of them were either created by Greenspan or vigorously championed by him.
Greenspan instituted the Federal Reserve’s cheap money policy after the dot.com bubble burst and the stock market collapsed in early 2000. Greenspan turned to real estate and home construction as the new driving force for the U.S. economy. He led the Fed to cut interest rates eleven times from 2001 to mid-2003. The Federal Open Market Committee cut the federal funds rate from 6.5 percent in January 2001 to 1 percent by mid-2003, providing mountains of cheap money for banks to lend and for Wall Street to invest.
Greenspan’s strategy worked. It rescued the economy from a free fall. It gave housing a kick start, and the housing sector soared, generating more than 40 percent of new private sector jobs starting in November 2001. Operating at full steam in 2005, housing, construction, and real estate were pumping an enormous stimulus into the nation’s economy—more than $1 trillion a year, by one economist’s estimate.
But danger lay in what became the meteoric rise of housing prices. Cheap money and rising home prices made people feel richer than they really were, so everyone took big risks. People borrowed more than they should have.
Yale University’s Robert J. Shiller, one of America’s premier housing economists, compared the price binge to a “rocket taking off,” a spurt without precedent, except after World War II. In the 114 years from the 1890s to 2004, Shiller reported, housing prices had risen only 66 percent, adjusted for inflation, or less than ½ percent a year on average. But from 1997 to 2004, in just eight years, prices had shot up 52 percent. Such a white-hot housing market, Shiller said, should be a warning to the Fed. Other dire prophecies came from financial experts warning that Greenspan’s cheap money was fueling a dangerous speculative fever, but Greenspan brushed aside those warnings as overblown.
Greenspan Blesses Subprime and Exotic Loans
Greenspan did more than provide cheap money. He vigorously promoted the subprime market, flexible-rate mortgages, and other exotic loans. Both Presidents Clinton and Bush had called for extending the American Dream of home ownership to those who had been left behind, especially to minorities. Greenspan became a cheerleader for that policy. “Where once more-marginal applicants would simply have been denied credit, lenders are now able to quite efficiently judge the risk posed by individual applicants and to price that risk appropriately,” Greenspan declared in April 2005.
Unfortunately, by then, lenders such as Countrywide, Washington Mutual, and the main New York banks were doing just the opposite. Instead of weeding out the bad risks, they were dropping their standards and giving loans to poor risks. But Greenspan took heart from the rapid growth in subprime mortgage lending, boasting that it had risen from just 1 or 2 percent of the U.S. mortgage market in the 1990s to 10 percent in 2005.
Greenspan also told solid middle-class homeowners that they would have been better off if they had stayed away from safe, traditional thirty-year fixed-rate loans. The Fed’s research, Greenspan said in early 2004, “suggests that many homeowners might have saved tens of thousands of dollars had they held adjustable-rate mortgages rather than fixed-rate mortgages during the past decade.” He urged bankers to be more daring: “American consumers might benefit if lenders provided greater mortgage product alternatives to the traditional fixed-rate mortgage.”
But then, rather inconsistently, Greenspan imposed a penalty on the borrowers who followed his advice and bought flexible-rate loans. He led the Fed through fourteen interest rates hikes from mid-2004 to January 2006, quadrupling the federal funds rate from 1 to 4.5 percent. That spelled rough weather for people with 2/28 subprime loans or Option ARMs.
“No One Wanted to Stop That Bubble”
The push on subprime by the Clinton and Bush administrations sounded great—egalitarian, inclusive, progressive. But the strategy had a fundamental flaw that one might have expected the Federal Reserve as the repository of financial expertise to spot: The low-income homeowner strategy did not match economic reality.
Housing prices from the late 1990s onward were rising far faster than people’s incomes, economist Robert Shiller pointed out. Millions of subprime borrowers were being thrust into a race that they were bound eventually to lose. Subprime mortgages pushed them into a cycle of refinancing, and each time they refinanced, the size and cost of their mortgage went up. But their income stayed flat or fell. Keeping up with the housing bubble was a stretch even for many prime borrowers. Starting in 1997, former IMF economist Simon Johnson observed, “the growth of housing prices outstripped income growth [emphasis added]; after 1999, real median household income fell for five consecutive years as housing prices soared.” With a growing gap between housing prices and personal incomes, massive defaults were inevitable. Too many people couldn’t afford their loans.
Inside the Federal Reserve, Ed Gramlich cautioned Greenspan that the subprime market, swollen to $625 billion in 2005, 20 percent of the total U.S. mortgage market that year, was operating like “the Wild West,” with almost no regulatory protection. The Fed, Gramlich charged, had abdicated its role as sheriff, allowing “carnage” among low-income borrowers. Gramlich underscored that 51 percent of subprime loans in 2005 were originated not by banks, but by consumer finance companies or mortgage brokers, not subject to regulatory supervision. He urged the Fed to step in. Otherwise, Gramlich asserted, subprime “is like a city with a murder law, but no cops on the beat.” Greenspan shot down Gramlich’s proposal for Fed oversight to bring the subprime market under better control.
Bush’s Treasury secretary, John Snow, later admitted, “What we forgot in the process was that it has to be done in the context of people being able to afford their house. We now realize there was a high cost.” But Lawrence Lindsey, Bush’s first chief economics adviser, said no Bush official wanted to raise the alarm. “No one wanted to stop that bubble,” said Lindsey. “It would have conflicted with the president’s own policies.”
The Warnings
Those were comments made in hindsight. But there were warnings ahead of time from outside economists. In 2003, Dean Baker and Mark Weisbrot of the Center for Economic and Policy Research in Washington cautioned that rising mortgage debt had reached dangerous levels and this was “especially scary” because housing prices “may be inflated by as much as 20 to 30 percent.” Other warnings that the housing market was dangerously overheated came from economists Stephen Roach of Morgan Stanley and Paul Krugman of Princeton.
In 2004, Robert Shiller, whose book Irrational Exuberance had foretold a stock market bust in 2000, reported ominous housing bubbles in key regional markets, warning that speculative fever could bring widespread mortgage defaults. Shiller recalled that waves of mortgage defaults in 1929 had contributed to the biggest banking crisis in U.S. history in the 1930s. A few months later, in early 2005, Shiller’s warning was more stark. The housing frenzy, he said, “may be the biggest bubble in U.S. history”—destined to end with a crash. Renowned global investor Sir John Templeton forecast an inevitable downturn. “When home prices do start down,” he said, “they will fall remarkably far” and cause widespread bankruptcies.
But Alan Greenspan dismissed talk of a housing “bubble.” In June 2005, he conceded “signs of froth in some local markets,” but he rejected calls from economists like Shiller for the Fed to raise interest rates more sharply to cool speculative fevers, asserting that “the U.S. economy seems to be on a reasonably firm footing.”
A year later, the housing market began its tumble. In hindsight, The Wall Street Journal editorial page, normally among Greenspan’s admirers, judged that “Alan Greenspan’s policies at the Fed contributed to the credit and housing manias that led to the financial meltdown….”
WaMu—Shifting Clients: From Main Street to Wall Street
But out across the country, in the boom years, Greenspan was the oracle, the north star for bank presidents like Washington Mutual CEO Kerry Killinger. They followed his course, and their operations in the 2000 decade graphically illustrate how Greenspan’s strategies played out across the country.
Bank CEOs such as Killinger took Greenspan’s cheap money policies, his advocacy of subprime, and his promotion of variable-rate mortgages as the green light for more aggressive lending through exotic loans such as Option ARMs intended for resale on the secondary market. So WaMu shifted priority from serving Main Street to serving Wall Street. Home buyers were no longer its primary customers. They were a means to an end—feeding Wall Street.
This was a pivotal shift for old-line banks such as Washington Mutual—and for American banking in general. At WaMu, it seemed a cynical shift. Killinger, in an internal email in March 2005, worried about the high level of risk in the housing market that “typically signifies a bubble.” But rather than retreat to safety, Killinger raced ahead.
Wall Street stock analysts asked Killinger in mid-2005 how he protected WaMu from losses in its large inventory of risky Option ARMs and subprime mortgages. Killinger first said WaMu had internal risk control measures, but bank documents contradict him. His real defense, Killinger admitted, was to sell off potentially toxic loans to Wall Street investors: “You’ve seen us sell in the secondary markets more than what we historically have done.”
Accolades for Fraud, Not Penalties
What Killinger didn’t reveal was how rapidly the tide of rotten—even fraudulent—liars’ loans was rising, based on bogus information on loan applications. This was happening not just at Long Beach, which had the highest loan delinquency rate of any bank in the country in February 2005 and had to be shut down entirely and absorbed into WaMu in June 2007 after being forced to buy back $837 million worth of mortgages it had sold to Wall Street. But by then the infection of predatory marketing had spread to WaMu itself.
What is surprising in retrospect is that Wall Street was so slow to detect the poison in the New Mortgage Game that it had fostered and financed. Wall Street banks were so hungry for WaMu’s Option ARMs that WaMu sold a staggering $130 billion worth in 2004 and 2005. But by mid-2006, more and more borrowers were defaulting, and much later, Ronald Cathcart, WaMu’s chief risk management officer, admitted in hindsight that too many Option ARMs had been recklessly approved and, ultimately, they “were a significant factor in the failure of WaMu and the financial crisis generally.”
Worse, WaMu’s internal investigators in 2005 confirmed what Lili Sotello and her staff of lawyers at the Los Angeles Legal Aid Foundation had reported. They found massive broker fraud and abuse inside Washington Mutual at two of the bank’s highest-volume loan offices, near Los Angeles. Like Sotello, WaMu’s internal memos blamed the fraud not on borrowers, but on the bank’s loan officers. “Virtually all of it [is] … attributable to some sort of employee malfeasance,” WaMu investigators reported.
The prime offenders, investigators said, were two of the bank’s all-time high-volume champion loan officers—Thomas Ramirez, the top mortgage loan salesman in Downey, California, and Luis Fragoso, the kingpin loan performer in Montebello, California. Both were experts in affinity marketing within the Hispanic community.
In a year-long probe, WaMu investigators found documentary evidence of “an extremely high incidence of confirmed fraud”—58 percent of the loans handled by Ramirez and 83 percent of those managed by Fragoso. The fraud, investigators said, covered a gamut of bogus information on loan applications—false credit records, phony employment information, inflated income figures, false statements about owner occupancy of homes, and illegal Social Security numbers. In one file, investigators reported: “The credit package was found to be completely fabricated.”
But no firings or shake-ups at Wa
Mu followed the probe. In fact, eighteen months later, in June 2007, the insurance giant AIG, which had insured WaMu’s loans, protested about the new fraudulent loans from Luis Fragoso in WaMu’s Montebello office. AIG demanded that WaMu buy back these “Fragoso loans,” and it filed formal complaints with federal and California bank regulators. When WaMu investigators went back to Montebello, they verified “the elements of fraud found by AIG.” Still, WaMu’s top brass did nothing to root out the fraud or penalize its perpetrators, according to an investigation by the Senate Permanent Subcommittee on Investigations.
In fact, just the opposite happened. WaMu’s leaders showered Fragoso and Ramirez with accolades, despite the fraudulent loans linked to them by WaMu’s investigators. Fragoso and Ramirez were not only paid handsomely, they were given WaMu’s highest corporate honor, year after year, from 2004 to 2007—selection to the bank’s highly touted President’s Club. This gave them all-expenses-paid first-class trips to Hawaii, private suites at a swanky hotel, and a cornucopia of valuable gifts as well as personal praise from CEO Kerry Killinger and home loans president David Schneider.
“Arts and Crafts Weekends”
By many accounts, this kind of insider fraud was pervasive. Fannie Mae, the quasi-governmental guarantor of many mortgage loans, was getting fraud warnings about the mortgage industry as early as 2003. The FBI first publicly warned of mounting fraud in 2004—and that was only reported fraud; most fraud went unreported. Once the bubble burst, insiders such as Richard Bitner, a wholesale mortgage lender in Texas, disclosed that fraud was epidemic because the financial temptations were so immense.
Who Stole the American Dream? Page 24