Inside Job

by Charles Ferguson

  What was going on, of course, was that Wall Street and the lenders were using fraud to create, fuel, and exploit a Ponzi scheme. During the bubble, lending standards basically disappeared. Of course, there are always some people in America who want loans to buy a house, or to take out home equity cash, when they can’t afford the loan or have no intent to repay. Suddenly, those people had no problem getting loans. Neither did anyone else. There were people who had good incomes and steady jobs, but were stretching to buy houses beyond their means; people who wanted to cash out almost all their equity; speculators buying multiple houses with no intent to occupy or rent them, hoping to flip them at a profit; people who wanted a second home or vacation house they couldn’t really afford—all with a high risk of default, especially if prices ever fell. But during the 2000s, none of that mattered. Tax policy helped too; the Clinton administration had enacted a law specifying that the first $500,000 in gains from selling a house was normally tax free if it was rolled into a new house purchase. This encouraged flipping.

  But there were also many blameless people, millions of them, who just got screwed. They decided to buy a house towards the end of the bubble, when prices were severely inflated, possibly even using a traditional, conservative mortgage and a large down payment. But a few years later they lost their job, or retired, or got divorced, or had sudden medical expenses, or needed to move for a new job. And when they tried to sell their house, they suddenly discovered that they couldn’t sell it, because its value had declined by a third, and that they had just lost their life savings.

  And finally, there was also massive fraud committed against borrowers, in part through the proliferation of highly deceptive loan structures and sales practices. It is no exaggeration to say that the mortgage brokerage, property brokerage, and subprime lending sectors became pervasively criminalized during the bubble. Mortgage brokers were usually unregulated, and during the bubble thousands of small-scale shysters put on a suit and sold loans.

  The bubble period saw the rise of exotic loan structures designed to make payments artificially low for some initial period, and/or to disguise the real terms of the loan, while actually charging the high interest rates that the banks liked. Mortgage brokers pushed loans with teaser rates heavily, often telling borrowers that when the higher real rate kicked in, the value of their home would have increased so much that they could handle the new payments by refinancing—in other words, by taking out yet another loan.

  Mortgage brokers also steered clients into needlessly expensive loans on a massive scale. Several studies have concluded that at least one-third of all people receiving subprime loans during the bubble actually would have qualified for a prime loan. But they were placed into subprime loans with higher interest rates and unnecessary fees by mortgage brokers, who were paid explicit cash bonuses by lendersyield spread premiums—for placing borrowers into more expensive loans. This, of course, also made the loans harder to repay, particularly after teaser rates expired or interest rates adjusted upward, and increased hardship and defaults when the bubble collapsed.

  There was also a lot of flat-out fraud, often very cruel, committed against immigrants who didn’t speak English and/or had no financial experience. They were simply lied to—about the size of the loan, the size of the payments, the real interest rate—and told to sign documents they couldn’t understand or even read. Many mortgage brokers worked with unofficial lenders, sometimes even loan sharks, who provided additional concealed loans to cover down payments or “points”. Mortgage brokers paid estate agents bribes for referrals to illiterate and/or illegal immigrants. Often the victims trusted their mortgage broker in part because they shared a common language or ethnic background, or had been introduced by a mutual acquaintance.

  Illegal immigrants were particularly easy to defraud because they were afraid to go to the police. The presence of large numbers of nonEnglish-speaking illegal immigrants was unquestionably one reason that so much of the bubble was concentrated in in the states of California, Arizona, and Florida, as well as parts of New York City populated by recent immigrants. The Bush administration also deliberately made it difficult for subprime borrowers to use civil remedies. In 2001, in one of the Bush administration’s first economic policy decisions, the US Department of Housing and Urban Development interceded in a federal legal case in order to make it extremely difficult for subprime borrowers, including US citizens, to join class-action lawsuits against predatory lenders. This forced borrowers to sue individually, which for many was prohibitively expensive and difficult.

  The wave of fraud did not go unnoticed. In 2004 the FBI issued a press release warning of “an epidemic of mortgage fraud”, and held press conferences to publicize the problem. In its 2005 Financial Crimes Report to the Public, the FBI noted that “a significant fraction of the mortgage industry is void of any mandatory fraud reporting,” and that the Mortgage Bankers Association provided no estimates on fraud levels. The same FBI report also stated that “based on various industry reports and FBI analysis, mortgage fraud is pervasive and growing.” Even more interestingly, the FBI report noted that mortgage fraud was not usually committed by borrowers alone, stating that “80 percent of all reported fraud cases involve collaboration or collusion by industry insiders”—estate agents, mortgage brokers, lenders, or some combination thereof.

  But law enforcement was AWOL and/or overwhelmed, at both the local and national levels. The entire FBI has fewer than fourteen thousand special agents for all categories of crime; only a tiny fraction were assigned to mortgage fraud during the bubble, when the FBI was intensely focused on counterterrorism efforts. In addition, the Bush administration deliberately gutted the investigative and enforcement capacity of financial regulators such as the SEC. With good reason, mortgage lenders and Wall Street felt largely immune from criminal sanctions. There was not a single high-level prosecution during the bubble, and very few arrests even for the most flagrant, low-level frauds.

  But why did mortgage banks and Wall Street tolerate massive fraud, push so hard for subprime lending even for trustworthy borrowers, and favour exotic, toxic mortgage structures? Because that’s where the money was. Subprime loans paid much higher interest rates. They therefore sold for much higher prices to investment banks, because they could be used to construct mortgage-backed securities with much higher yields, which in turn were much easier to sell to investors—at least, until the loans defaulted. An extensive analysis of 250 million mortgage records carried out by the Wall Street Journal in 2007 showed that in the previous year “high-rate” mortgages, on average, had spreads of 5.6 percent over comparable US Treasury bonds, at a time when spreads on a safe, honest, conventional loan with a real down payment were only about 1 percent.6

  So how crooked did the lenders become in pursuing this strategy? Very crooked indeed.

  The Rise of Subprime Mortgage Lenders and the Shadow Banking Sector

  THE COLLAPSE OF the S&L industry in the late 1980s and early 1990s, combined with the start of the housing bubble, led to the spectacular growth of highly unethical mortgage lenders, many of them in the largely unregulated shadow banking sector. These lenders, who drove the worst excesses of the bubble, were not traditional banks that took consumer deposits for savings and current accounts. They existed solely to feed the securitization food chain, and they got their funding from Wall Street—from the same investment banks and financial conglomerates that bought their loans. Like the investment banks themselves, they relied on very short-term credit, which reduced the interest rates they needed to pay, but which also left them highly vulnerable to interest rate increases and other financial shocks. So when the bubble collapsed, they all collapsed too.

  Many of these firms were in California—“mortgage banks” like New Century, Ameriquest, Golden West Financial, Long Beach Mortgage, and Countrywide. All of them made loans primarily to sell them into the securitization chain, and during the bubble their business exploded. For example, from 2000 to 2003, New Ce
ntury increased its originations fivefold, from $4 billion to $21 billion, while Ameriquest’s jumped tenfold, from $4 billion to $39 billion.7 Both companies were the object of numerous lawsuits. However, both are now bankrupt, so substantial recoveries are impossible, even though their former executives and sales personnel remain wealthy—a story we shall encounter frequently.

  As the bubble got under way, several large traditional banks, financial conglomerates, and all of the major investment banks acquired predatory or subprime mortgage lenders of their own. Citigroup snapped up Associates First in 2000, acquiring what was then the second-largest subprime lender, one that a consumer advocate called “an icon of predatory lending.” Lehman bought six subprime lenders by 2004, Washington Mutual bought eight, and Bear Stearns three. First Franklin, one of the larger subprime lenders, was taken over by Merrill Lynch in 2006. Those that remained independent formed tight relationships with the investment banks that purchased their loans and also supplied them with general financing, managed their stock and bond offerings, and invested the personal wealth of their executives. For example, a group of banks led by Morgan Stanley made large financing commitments to cement ties with New Century.

  As we now know, the whole industry was extremely unethical. Here is a short survey.

  WaMu/Long Beach

  Washington Mutual, or WaMu, was a longtime US government chartered savings and loan institution. Its CEO, Kerry Killinger, joined WaMu in 1982, and served as CEO from 1990 until the organization collapsed, was taken over, and then sold to JPMorgan Chase in 2008. Long Beach Mortgage Corporation was a California mortgage bank that was acquired by WaMu in 1999. Long Beach was just one of twenty originators acquired by WaMu in the 1990s, but was the only one allowed to continue to operate under its own name more or less independently. It had a terrible reputation, which it deserved. Losses on securities backed by Long Beach loans were among the country’s highest. The delinquency rate on Long Beach MBSs in 2005 was the worst in the country.8

  WaMu’s reputation was not much better. It had grown by helter-skelter acquisition of smaller originators, without ever managing to create a well-integrated management system. But the booming housing market more than made up for executive incompetence. Killinger’s total compensation for the period 2003 through 2008 was more than $100 million.

  WaMu made a decisive turn toward riskier lending in 2005 after Killinger called for a “shift in our mix of business, increasing our Credit Risk tolerance.” In a later board presentation, he said the objective was to “de-emphasize fixed rate and cease govt [Fannie/Freddie conforming loans].” While 49 percent of new originations in 2005 were already in the higher-risk categories, the objective was to achieve 82 percent higher-risk originations by 2008.9

  Killinger’s board presentations carefully specified the “strong governance process” that would be required for the higher-risk strategy. But the control processes never were really implemented. Capital-based high-risk lending ceilings were violated almost from the start.

  A more accurate picture of WaMu’s management style might be inferred from the “I Like Big Bucks” skit performed by the Kauai Kick It Krew at the President’s Club 2006 celebration of top loan “producers” (sales personnel) in Hawaii.10 The company had spared no expense for the event; the awards presentation was hosted by Magic Johnson, the Hall of Fame basketball star. At the event, the Krew, all top producers, backed up by a local cheerleading group, performed a rap number:

  I like big bucks and I cannot lie

  You mortgage brothers can’t deny

  That when the dough rolls in like you’re printing your own cash

  And you gotta make a splash

  You just spends

  Like it never ends

  Cuz you gotta have that big new Benz.

  WaMu’s compensation system reflected the rhetoric on Kauai. Loan officers were paid on a volume-based point system geared to loan product priorities. Of the sixteen products in the schedule, only the very last one was a traditional mortgage. The top priority was an Option-ARM product, one of the most dangerous of recent inventions. Borrowers could defer principal or interest payments during the first five years of a loan, accumulating unpaid balances that would later be added to principal. The higher principal payments would kick in at the same time as the permanent interest rate, which was much higher than the initial teaser. WaMu bragged that they were in second place in OptionARMs, and gaining fast on the market leader, Countrywide.

  WaMu’s Long Beach subsidiary was the worst. WaMu’s chief operating officer, Steve Rotella, reported to Killinger in the spring of 2006, when the bubble started to slow down: “Here are the facts: the portfolio (total serviced) is up 46 percent . . . but delinquencies are up 140 percent and foreclosures close to 70 percent. . . . First payment defaults are way up and the 2005 vintage is way up relative to previous years. It is ugly.”11 But the problems went far beyond Long Beach. WaMu sold almost all forms of high-risk loans—80/20 piggyback loans in which a first and a second mortgage covered the purchase price, the down payment, and the settlement costs; subprime loans; Option-ARMs; and subprime home equity loans. All of those were combined with “stated income” loansloans with no income verification. Half of WaMu’s subprime loans, three-quarters of its Option-ARMs, and almost all of its home equity loans were stated income. High-risk loans with stated income were used for properties that were obviously being bought for speculation. Nobody seemed to blink when babysitters claimed executive salaries. To top it off, like most high-risk lenders, WaMu required that income be adequate only against the initial teaser rate, not the far higher permanent rate.

  Two high-production centres in poor sections of Los Angeles were found to have high levels of fraud—of eighty-five loans reviewed at one centre, 58 percent had confirmed fraud; in forty-eight reviewed at another, all were fraudulent. The two managers were deeply involved in the frauds. Both of them, of course, were longtime President’s Club honourees. The frauds included straw purchasers, forged documents, and the like. An investigation conducted in 2005 was brought to the attention of senior management but never followed up, and the managers continued their President’s Club run. A high level of fraudulent activities was disclosed in a third centre—mostly production officers forging borrower data—but another investigation went nowhere. WaMu, of course, never notified investors who had purchased loans from these centres that the documentation was fraudulent.12

  Former WaMu employees, who are serving as confidential witnesses in various civil suits, have testified that every originator was required to underwrite nine loans a day, with cash bonuses beyond that; that lending standards were changed almost daily; and that loans that combined FICOs1 (credit scores) in the 500s (very low), Option-ARM structures, and high loan-to-value ratios (LTVs) were sometimes treated as prime. A senior underwriter testified that loans she had turned down frequently reappeared as approved by higher management. Dozens of former employees have testified in the same vein. The New York State attorney general has also sued WaMu for using financial pressure to cause appraisers to inflate property values.13

  Even in 2007 and 2008, Killinger wanted to ramp up high-risk lending. In late 2007 he announced that WaMu was “adding some $20 billion in loans this quarter, increasing its loan portfolio by about 10 percent.” This at a time when losses on Option-ARMs in its portfolio had jumped from $15 million in 2005 to $777 million in the first half of 2008.14 Then the firm collapsed and was sold to JPMorgan Chase. Afterwards, when asked at a Senate hearing why he had adopted a high-risk lending strategy, Killinger blandly answered that he had done no such thing.15

  In March 2011 the FDIC sued Killinger and two other senior WaMu executives for $900 million, alleging that they had taken excessive risk for purposes of short-term personal enrichment. In December 2011 the executives agreed to settlements totalling $64 million. However, all but $400,000 was covered by their insurance; their personal assets remained nearly untouched, and they were not required to admit any g
uilt. Earlier in 2011, the US Justice Department had already announced that it was closing its criminal investigation of WaMu, stating “the evidence does not meet the exacting standards for criminal charges.”16

  New Century

  New Century Financial Corporation was founded in 1995 as an independent mortgage lender concentrating on the subprime segment of the market. It was listed on the Nasdaq exchange in 1997. Its annual originations had grown to $3.1 billion by 2000, and shot up to $20.8 billion in 2003, making it the second-largest subprime originator. By 2006, its originations had grown to $51.6 billion. Three-quarters of its loans were purchased by Morgan Stanley and Credit Suisse, who also provided much of its financing.17

  In early 2007 it announced both that it would restate its earnings from the first three quarters of 2006, previously announced as $276 million, and that for the full year, 2006 would show a loss. Securitizing banks withdrew their finance lines in March, effectively shutting down the business, and the company filed for bankruptcy in April. The salaries and bonuses of its three senior officers in 2005 were approximately $1.9 million each, and that same year each of the three cashed out between $13 million and $14 million in vested stock options.18

  Interestingly, in 2008, a hedge fund manager named David Einhorn became famous for betting against Lehman Brothers, while questioning its finances and conducting a public campaign against it. Einhorn accused Lehman of deceptive accounting and of maintaining falsely high valuations on its property holdings. Mr Einhorn certainly knew his subject; but he had been considerably less vocal about mortgagerelated accounting irregularities when he had been a member of New Century’s board of directors throughout the bubble. An examiner later appointed by New Century’s bankruptcy trustee conducted an extensive investigation of the company and its auditor, KPMG. A 581-page report filed in February 2008 found substantial causes of action against company officers for “improper and imprudent” business practices and against KPMG for “professional negligence” and “breach of its professional standard of care.”19