The report itself provides many examples of on-the-ground practice during the bubble. New Century’s loan-acquisition volume nearly doubled every year from 2000 through 2004, by which time internal warning sirens were screaming. Here are samples of e-mails to senior management:
[Oct. 2004] Stated wage earner loans present a very high risk of early payment defaults and are generally a lower credit quality borrower than our self employed stated borrowers.20
[Oct. 2004] Stated Income. This has been increasing dramatically to the point where Stated Income loans are the majority of production, and are teetering on being >50 percent of production. We know that Stated Income loans do not perform as well as Full Doc loans.
[Fall 2004] I just can’t get comfortable with W2’d borrowers who are unable or unwilling to prove their income.
[Jan. 2005] To restate the obvious, a borrower’s true income is not known on Stated Income loans so we are unable to actually determine the borrower’s ability to afford a loan.
An internal memo said:
The most common subprime product is a loan that is fixed for 2 or 3 years and then become[s] adjustable. The initial rate is far below the fully-indexed rate, but the loan is underwritten to the start payment. At month 25 the borrower faces a major payment shock even if the underlying index has not changed. This forces the borrower to refinance, likely with another subprime lender or broker. The borrower pays another 4 or 5 points (out of their equity), and rolls into another 2/28 loan, thereby buying 2 more years of life, but essentially perpetuating a cycle of repeated refinance and loss of equity to greedy lenders.
Inevitably, the borrower lacks enough equity to continue this cycle (absent rapidly rising property values) and ends up having to sell the house or face foreclosure.21
Despite the sharp deterioration in loan quality, compensation plans stayed firmly focused on volume. In the end, it was sheer sloppiness that pushed New Century into bankruptcy, well before the full extent of its loan defaults and fraudulent behaviour became clear. When an auditor discovered that accounting for loan repurchases required restating, it wiped out profits for 2006. The committee of Wall Street banks that financed New Century (chaired by Morgan Stanley) stopped providing money, and the company was effectively out of business.22
Countrywide Financial Corporation
Countrywide, at first glance, was not the typical subprime lender. Founded in 1969 by David Loeb and Angelo Mozilo, it grew to become the nation’s largest and most profitable mortgage lender. Mozilo was famous for being obsessively hands-on as well as a terrifying boss. For many years the company had a reputation for conservative lending and excellent cost controls. In 2003 Fortune extolled it as one of the most successful American companies, with 23,000 percent stock appreciation since 1982.23
Mozilo was ambivalent towards the subprime strategy, and sometimes internally warned of its dangers. But in the end some combination of ego, greed, laziness, and perhaps fatigue (he underwent spinal surgery several times during the bubble) won out over both ethics and caution. As Mozilo approached retirement age in the midst of the bubble, he announced an absurdly ambitious goal for Countrywide: a 30 percent share of the whole US mortgage market. This required aggressive expansion into the whole spectrum of toxic loan products, which Mozilo pressured Fannie Mae to buy. The rest he sold to Wall Street, which didn’t have to be pressured at all.
Countrywide also lobbied intensively and used techniques verging on bribery. Mozilo created a special “Friends of Angelo” VIP unit to provide vastly improved customer service and favourable mortgage terms to dozens of Fannie Mae executives, elected members of the US Congress, congressional staff members, and various prominent people (one recipient was Tonight Show host Ed McMahon, who defaulted on his $4.8 million loan).24 Recipients included House Speaker Nancy Pelosi and Senator Chris Dodd, chairman of the Senate Banking Committee, both Democrats, as well as three successive CEOs of Fannie Mae.
By 2006 Countrywide and its practices had become pervasively fraudulent. In September 2005, Countrywide hired a woman named Eileen Foster as First Vice President, Customer Care, in Countrywide’s Office of the President. In mid-2006 she was promoted to Senior Vice President. Then, on 7 March 2007, she was promoted again—to Senior Vice President for Fraud Risk Management. In this position she was supposedly in charge of Countrywide’s fraud reduction policies and she also directly managed several dozen fraud investigators.
Naively, she began to investigate fraud, and to do something about it. She rapidly uncovered massive frauds, in multiple regional loan offices, perpetrated by loan officers and managers. As usual in the industry, loan officers were being compensated based on “production” volume regardless of quality, and indeed, as was also common, they were incentivized to produce loans with the highest possible interest rates and fees. They could only do this at high volume through fraud.
Nearly immediately, Foster and her organization identified a massive organized fraud operation run by Countrywide personnel in the Boston area, including a regional and division manager.25 Foster and her unit developed evidence that forced Countrywide to close six of its eight branch offices in Boston and to terminate over forty employees. Foster and her unit were told about, and developed evidence regarding, a number of other organized frauds and senior loan personnel involved in fraud. In December 2007 Foster started to warn her management that there was systematic, widespread fraud within Countrywide. Her immediate manager agreed with her.
In December 2011 the TV programme 60 Minutes ran an excellent two-part report entitled “Prosecuting Wall Street”, exploring the lack of criminal prosecution related to the bubble and crisis. In it, Foster is interviewed on camera by correspondent Steve Kroft. Here are excerpts:
STEVE KROFT: Do you believe that there are people at Countrywide who belong behind bars?
EILEEN FOSTER: Yes.
KROFT: Do you want to give me their names?
FOSTER: No.
KROFT: Would you give their names to a grand jury if you were asked?
FOSTER: Yes.
KROFT: How much fraud was there at Countrywide?
FOSTER: From what I saw, the types of things I saw, it was—it appeared systemic. It, it wasn’t just one individual or two or three individuals, it was branches of individuals, it was regions of individuals.
KROFT: What you seem to be saying was it was just a way of doing business?
FOSTER: Yes.
KROFT: Do you think that this was just the Boston office?
FOSTER: No. No, I know it wasn’t just the Boston office. What was going on in Boston was also going on in Chicago, and Miami, and Detroit, and Las Vegas and, you know—Phoenix and in all of the big markets all over Florida. I came to find out that there were—that there was many, many, many reports of fraud as I had suspected. And those were never—they were never reported through my group, never reported to the board, never reported to the government while I was there.
KROFT: And you believe this was intentional?
FOSTER: Yes. Yes, absolutely.
Foster also began to see evidence that Countrywide’s corporate Employee Relations department was protecting fraudulent activity. It did this in several ways, including not reporting it to Foster’s organization; reporting fraud allegations to the perpetrator; identifying informants and whistle-blowers to the perpetrators; failing to act on complaints of retaliation against whistle-blowers; and by retaliating directly against them itself. (She told 60 Minutes that a senior Countrywide executive had ordered the ER to circumvent her department.26) Foster complained to the senior executives in charge of Employee Relations, at which point Countrywide’s ER department began to investigate her. In May 2008 Foster spoke to the executives in charge of Countrywide’s Internal Affairs unit, describing both the pervasiveness of fraud and also ER’s conduct. As we shall see shortly, this did not go well.
When the bubble peaked and everything at Countrywide started to go bad, Angelo Mozilo resorted to various forms of deceptio
n, both personal and corporate. First, he intensified efforts to get rid of dubious loans fast, so that Countrywide wouldn’t be caught holding them when they failed. Throughout the e-mail trails, he crassly urges his subordinates to “comb the assets” and sell off the riskiest ones while there is still time. As he well knew, however, the documentation of every loan sale or securitization states that the instruments being sold are representative of all loans of that type in possession of the seller—that they have not been selectively chosen to off-load risk. So this remedial strategy was itself fraudulent.
Then Mozilo protected himself financially, as many executives did. As Countrywide started to fail, Mozilo used $2 billion of Countrywide’s borrowed money to repurchase its own stock, in order to prop up the share price. Mozilo also repeatedly made representations to analysts and investors with respect to the high quality of Countrywide’s credit and control processes, the good performance of its products, and the company’s financial soundness. One lawsuit lists some three dozen separate occasions in which Mozilo made or confirmed statements about the company’s lending and credit oversight policies. Based on what we now know, all of them were false.
However, at the same time that Countrywide was buying back its shares and Mozilo was telling the world that everything was fine, Mozilo was actually selling his own Countrywide stock—over $100 million in the year before the firm collapsed. His total compensation during the bubble was more than $450 million, and as a result of his stock sales over the years he remains extremely wealthy, with a net worth estimated at $600 million.
When collapse could no longer be postponed, Countrywide sold itself to Bank of America; the deal was signed in January 2008 and finally completed in July. The acquisition was to prove a very costly mistake for Bank of America, causing many billions of dollars in further losses. By 2012 Countrywide’s losses and legal liabilities were so severe as to threaten Bank of America’s continued viability.
In July 2008, when Bank of America officially took over Countrywide, Eileen Foster was offered the position of Senior Vice President, Mortgage Fraud Investigations Division Executive, which she accepted. However, the Employee Relations organization continued to investigate Foster and question her colleagues, one of whom warned Bank of America executives, including its general counsel and its chief operating officer. On 8 September 2008, Eileen Foster was told by senior Bank of America executives that she had been terminated. She filed a whistle-blower lawsuit, which she won; OSHA ordered her reinstatement and awarded her damages of over $900,000. In her interview with 60 Minutes, Foster stated that the immediate cause of her firing was that she refused to be coached appropriately about what to say to government regulators. She also stated on camera that as of the time of the interview in 2011, she had never been interviewed by any US law enforcement official.
Other Subprime Lenders
While WaMu, New Century, and Countrywide were among the largest subprime lenders, there were many others just as bad. Fremont, for example, was one the country’s largest, and sold its loans to the top banks in securitization—Goldman Sachs, Merrill Lynch, Bear Stearns, Deutsche Bank, Credit Suisse, Lehman Brothers, Morgan Stanley. That is, it did so until March 2007, when the FDIC forced it out of business, and into bankruptcy, for multiple violations of law and regulations. In 2008 the Massachusetts Supreme Court, on an action brought by the state attorney general, affirmed a prohibition on foreclosures of many Fremont mortgages, on the ground that they had been designed to be predatory.27
In lawsuits, a long list of confidential witnesses drawn from former employees recited the usual frauds. Allegedly, underwriters were instructed “to think outside the box”, and “make it work”.28 If borrowers’ actual incomes were not sufficient to support a mortgage, loans were converted to stated income loans at whatever level was necessary. A series of forty loans was allegedly accepted from one broker even though all of them had identical bank statements.
WMC was yet another. It was the sixth-largest subprime originator in the country in 2004, when it was sold to GE Capital (yes, General Electric) by its owner, the private equity investment firm Apollo Management, whose CEO, Leon Black, spent $1 million to have Elton John play at his birthday party. For several years GE made lots of money, but it shut the company down in September 2007, swallowing a $400 million charge.
WMC’s lineup of Wall Street securitizers was much like Fremont’s—the largest and most prestigious firms on Wall Street. Yet WMC was fourth on the Comptroller of the Currency’s 2010 “Worst Ten in the Worst Ten” list—the ten worst lenders in the ten most decimated housing markets in the US. A postmortem conducted as part of a civil fraud suit by PMI, Inc., a mortgage insurer like MBIA, found the usual story—widespread breaches of securitization warranties, missing or obviously falsified documentation, and so forth.29
Ameriquest was yet another, and the US leader in subprime lending in 2003, having driven its volume to $39 billion, up from just $4 billion in 2000. An assistant attorney general in Minnesota requested Ameriquest files in 2003, and was amazed to see file after file list the applicant’s occupation as “antiques dealer”. Borrowers told of signing a loan application and finding at closing that an entire financial recordtax forms and everything—had been fabricated for them. Ameriquest, too, was on the “Worst Ten in the Worst Ten” list. It speaks volumes for the cluelessness of Citigroup senior management that it purchased Ameriquest in the summer of 2007, even as the subprime bubble was collapsing.30 Ameriquest was the object of major lawsuits filed by more than twenty state attorneys general during the bubble, while government regulators and law enforcement agencies did nothing. In 2005 its CEO, a major Republican donor, was appointed US ambassador to the Netherlands by President Bush.
Another subprime lender, Option One, was a subsidiary of H&R Block, the tax preparer. Tax preparers were incented, in effect, to say, “Your interest on that mortgage seems high, why don’t you visit our mortgage consultant before you leave. We may be able to find you a better deal.”31
So the lenders wanted everyone to borrow ever more, and actively preferred borrowers who didn’t understand mortgages, shouldn’t have them, could be defrauded, and/or couldn’t fight back after being screwed. For a while, the bubble covered all this up, at least to naive investors outside the industry. Ironically, the huge increase in lending and the collapse of lending standards made subprime loans and mortgage securities seem much safer than they really were because it kept driving up home prices. Rising home prices allowed even unemployed, fraudulent, and/or delinquent borrowers to avoid (or simply postpone) default through refinancing, home equity loans, or selling at a profit. As the bubble progressed, teaser rates, deception, and/or unsustainable mortgages became normal. A standard broker sales pitch was “Don’t worry about the high post-teaser payments.” When it was time, the broker would refinance you—at another teaser rate—because the value of your home would already have gone up.
This kept money flowing through the system to naive investors such as municipal pension funds and small overseas banks, which collected high returns without any defaults for a few years until the music finally stopped. In the meantime these high returns led them, of course, to purchase even more of the same junk. The same mechanism also allowed fully knowledgeable but unethical investment managers—hedge funds, private wealth managers within investment banks—to do the same thing. The temporarily high returns kept their clients happy for several years, and kept their annual bonuses high. When the music stopped, the fund managers closed the fund or resigned, taking their money with them and leaving the losses to their clients.
Fannie Mae and Freddie Mac
Fannie Mae and Freddie Mac are not, of course, literally mortgage lenders. They purchased, insured, and securitized loans sourced from mortgage lenders; Countrywide was their largest single source of loans. They also bought and held enormous portfolios of mortgage-backed securities for investment purposes, which caused a major fraction of their losses during and after the cri
sis.
Fannie and Freddie are both government-sponsored enterprises (GSEs) created by the US government to support home ownership and affordable mortgage lending. But over the three decades prior to the crisis, Fannie and Freddie had gradually freed themselves from regulatory constraint in the pursuit of profits. They went public and, more important, masterfully neutered both congressional oversight and Office of Federal Housing Enterprise Oversight (OFHEO), their ineffective and understaffed regulator. They accomplished this through a combination of extraordinarily aggressive lobbying, patronage, revolving-door hiring, and flat-out deceit. Their hires ranged from Newt Gingrich ($1.6 million from Freddie Mac’s chief lobbyist for “strategic advice” and “outreach to conservatives”) to Tom Donilon, who was Fannie Mae’s chief lobbyist for years and is now President Obama’s national security advisor. Both firms appeared to have neutered effective corporate governance by stacking their boards of directors with the compliant and the politically connected, who were overpaid and who were expected to keep quiet. And they instituted the same compensation structures found universally in the financial sector, which provided large bonuses based upon short-term performance.
And, just to leave no stone unturned, they also allegedly engaged in accounting fraud to ensure that their publicly reported performance enabled them to collect those bonuses.
Concerns about Fannie and Freddie’s accounting were first publicly raised in congressional hearings in 2000, before a subcommittee of the House Financial Services Committee. In those hearings, Fannie Mae and its then-CEO, Franklin Raines, were defended by congressional Democrats, including Barney Frank of Massachusetts. Other defenders included Representative Maxine Waters of Los Angeles (and other members of the Black Caucus), in part because Raines was a well-connected African American (Clinton’s former budget director), and in part simply because Fannie Mae was so politically powerful in urban congressional districts where it operated, lobbied heavily, and was a major campaign contributor.
Inside Job Page 8