The first major allegations of misbehaviour came in 2003, when OFHEO sued the executives of Freddie Mac. Freddie Mac paid a $125 million fine. (Later, in 2006, Freddie Mac was also fined $3.8 million by the Federal Election Commission for making illegal campaign contributions.) In 2004, OFHEO and the SEC both released extremely critical reports on Fannie Mae. Then, in 2006, OFHEO sued Raines and two other former executives of Fannie Mae in an attempt to recover bonuses linked to the accounting frauds. Raines alone had received more than $90 million; he was also one of many executives and government officials who received favourable loans from Countrywide’s VIP programme. Later settlements for all three executives allowed them to keep the majority of their bonuses, and did not require any of them to admit guilt. Fannie Mae paid a $400 million corporate fine to settle the SEC lawsuit. No criminal cases were brought.
Both Fannie and Freddie certainly contributed to the bubble, although they were late to the party. In part due to the discovery of their accounting frauds, in the early years of the bubble they remained fairly conservative with regard to the loans they were willing to purchase and/ or insure. Starting in 2004, however, they began to increase the number of Alt-A loans they purchased, and to relax their credit standards. They remained a minority of the market for junk loans, and such loans constituted only a small percentage of their total loan purchases. However, they were such large firms that their losses were huge, comparable to those of the worst firms in the purely private sector.
Fannie and Freddie also contributed to the bubble in another way—as massive investors in mortgage-backed securities. From 2004 through 2006, Fannie and Freddie purchased $434 billion in mortgage-backed securities that had been created by Wall Street.32 They did this primarily because their executives had the same toxic incentives as everyone else, and these securities paid high interest rates. Both Fannie and Freddie had AAA credit ratings, of course, and so they could borrow money at very low interest rates and use it to purchase much higher-yielding mortgage securities. It was insanely easy and insanely profitable—until it wasn’t. In the end, the two firms’ investment losses were almost as large as their losses on mortgages that they had purchased or insured.
They started losing money in 2007. By the end of 2010, between them Fannie and Freddie had $71.9 billion in investment losses and $75.1 billion in mortgage credit losses, for a combined total of $147 billion. They have continued to lose money since then. Even in 2012 they were still losing money, because the Obama administration has forced them to provide mortgage payment relief for unemployed homeowners.33
In 2011 the SEC sued the former CEOs of both firms and four other former senior executives for securities fraud, charging that both firms had misrepresented their exposure to subprime mortgages to investors.34 The complaint alleged that both firms started purchasing larger quantities of high-risk loans in order to meet short-term profit targets related to the executives’ annual bonus payments. At the same time, the SEC entered into nonprosecution agreements with both firms. No criminal charges have ever been filed against either the firms or any of their former executives.
Did Fannie and Freddie Cause the Bubble?
Republican conservatives, firmly supported of course by Wall Street banks, have asserted that the housing boom was caused by government overregulation, which forced Fannie and Freddie to subsidize unwise mortgage lending to unqualified borrowers, by which they mean poor people, minorities, and immigrants. The usual villains in this story are liberal Democrats in Congress and the Community Reinvestment Act, a US law that sets targets for mortgage lending to disadvantaged groups and neighbourhoods. But that story doesn’t hold up, for many reasons.
First, the numbers simply don’t support this argument. It was not Fannie and Freddie, but rather the pure private sector, especially its least-regulated shadow banking components, which drove the bubble. In fact, the default rate on loans that the GSEs bought or guaranteed remains lower than those created and packaged by the mortgage lenders and Wall Street.
It wasn’t overregulation that pushed Fannie and Freddie into their disasters. In fact, if anything Fannie and Freddie’s regulator slightly reduced the damage the GSEs did, by stopping at least one of the ways that they had been gaming the system, namely their massive accounting frauds. Until those scandals, and even to a great extent after them, Fannie and Freddie behaved largely as they pleased, their conduct driven far more by thoroughly private-sector forces (i.e., annual bonuses and stock options) than by regulation or affordable housing goals. Moreover, their worst behaviour occurred at a time when the Republicans controlled the White House and both houses of Congress, making it unlikely that liberal Democratic pressure affected them very much.
Furthermore, almost half of their eventual losses came from being investors, not loan buyers, insurers, or securitizers. Fannie and Freddie didn’t buy those securities out of social responsibility or liberal political pressure; they bought them because their executives and traders had the same toxic incentives as everyone else, based on short-term performance, and with no “clawbacks” if things went bad later. For the same reasons, they started buying higher-risk, higher-yield mortgages after the bubble was under way. Political pressure probably played a small role in their mortgage purchases, but it wasn’t the primary factor.
So the bubble wasn’t caused by too many poor people buying houses because of do-gooder government regulators. Fannie and Freddie were certainly major participants, but they neither started the bubble nor were its major beneficiaries. Merely because of their size, however, they did a lot of damage.
What started and drove the bubble, in short, was a combination of very low interest rates, pervasive dishonesty throughout the financial system, massive lending fraud, speculation, demand for high-yield securities, and, not insignificantly, a squeezed American consumer desperate to maintain living standards and told by everyone—including George W. Bush and Alan Greenspan, as well as the brokers and banks—that home borrowing was the way to do it. From 2000 through 2007, net cash extractions from homes pumped $4.2 trillion into the US economy,35 and by 2005 half of all American GDP growth was related to housing.36 By the end of the bubble in 2007, American household debt had jumped to 130 percent of GDP, a historical record, up from just 80 percent in 2000.
All of this could happen only because of the securitization food chain, combined with the collapse of ethics and the spread of toxic incentives throughout the entire financial sector. In fact, once the investment banks had invented the CDO, they didn’t even need to confine themselves to mortgages—any kind of loan could be fed into CDOs, and the result sold as an utterly safe “structured product”. There were parallel but smaller bubbles, showing equal levels of dishonesty, in other credit assets such as car loans, student loans, credit card debt, Icelandic bank debt, commercial property, and private equity (aka leveraged buyouts). These loans, too, were sold and fed into Wall Street’s securitization machine, sometimes placed into the very same CDOs that contained subprime mortgages. Indeed this is further evidence that it was the greed and dishonesty of the financial sector, rather than a general mania for housing or do-gooders pressuring Fannie and Freddie, that drove the bubble.
Of course, none of this would have been possible if Wall Street’s largest and best financial institutions had refused the business. The lenders were wholly dependent on the wholesale corruption of the core of the financial system—the Wall Street banks, the rating agencies, the mortgage insurance companies, the industry analysts, and, of course, the regulators. Let us now turn to them.
CHAPTER 4
* * *
WALL STREET MAKES A BUBBLE AND GIVES IT TO THE WORLD
Investment Banking During the Bubble: World Without Limits
WE HAVE JUST SEEN what mortgage lending was like during the bubble. What was Wall Street thinking when they bought these loans and turned them into trillions of dollars of supposedly ultrasafe, but actually quite toxic, products? Assuming that most investment bankers were not cret
inously stupid, they were either: 1) innocents, being defrauded by brilliantly evil mortgage bankers; 2) stunningly complacent and oblivious, not bothering to look at or understand what they were buying and selling; and/or 3) in on the scam.
Well, it wasn’t door number one. For many of them, it wasn’t door number two, either, although there was some staggering obliviousness, particularly among very senior management and boards of directors; this is an interesting subject explored later. But the people actually doing the work, as well as many senior managers, knew perfectly well that they were dealing in manure. Often they simply didn’t care what it was, or what damage it might cause, as long as they could sell it. But they were not innocent. Quite often they actively pressured the mortgage lenders to supply even more manure that smelled even worse, lied about its known characteristics when they sold it, and profited again by betting against it.
But defenders of the banks (and rating agencies, and insurance companies, and hedge funds) raise one seemingly powerful objection to this view: many of the banks collapsed, causing CEOs, senior executives, and board members to lose their jobs and a lot of money. Even many traders and department heads were fired or laid off. This supposedly demonstrates that they couldn’t have realized what they were doing since they were hurting themselves, too. Joe Nocera of the New York Times, Laura Tyson (on the board of Morgan Stanley), and C. Michael Armstrong (a former board member of Citigroup, during the bubble) all have made this argument to me personally. Richard Parsons (Citigroup’s chairman during the bubble) and Angelo Mozilo both made this argument in their congressional testimony—Parsons described the crisis as “when they hit this iceberg.” How on earth, they and others have asked, could bankers possibly have been knowingly committing fraud when it was so clearly contrary to their self-interest? After all, they destroyed their institutions, lost their jobs, and their shares became worthless almost overnight. They—er, we—wouldn’t knowingly do that, would we? Even if we’re selfish, that’s just not logical, is it?
Well, actually, it is logical, and quite often it wasn’t contrary to their rational self-interest. Stunningly enough, Wall Street was set up in such a way that for many bankers, destroying their own firms was completely rational, self-interested behaviour. Consider the following.
First, the money. If you created, sold, or traded fraudulent junk securities, indeed even if you bought them for your institution, you got paid huge annual bonuses, mostly in cash, based on your performance that year. How long will a major bubble last? Five to seven years seems to be the recent average: the S&L and junk bond bubble lasted from 1981 or 1982 until 1987 or 1988; the Internet bubble lasted from about 1995 until the middle of 2000; the housing bubble went from roughly 2001 until 2006 or 2007. (Some last even longer: Japan’s property and stock market bubble lasted nearly the full decade of the 1980s, and Bernard Madoff’s Ponzi scheme lasted over twenty years.) Until the collapse, not only are you making money, but your firm is making money too, lots of it. The more you contribute to the bubble, the more money you make. When the crash comes, even if your firm goes under, you’re still rich. You don’t have to give back any of the money; very possibly, you can retire or change careers. But even if you want another job, your track record won’t disqualify you—quite the contrary, as we shall see.
Second, there is the “public goods” problem—in this case, however, a public bad. Suppose you’re one of the twenty or forty (or five hundred) people creating, trading, selling, buying, insuring, or rating mortgage-backed junk at Merrill Lynch, Morgan Stanley, Lehman, Moody’s, AIG, wherever. You see a horrific train wreck in the making, with all your coworkers contributing to it. But they are all making a fortune, and their manager—who is your boss too—is making even more money by keeping it going. Quite obviously, they’re going to keep doing it whether you participate or not; so even if you refuse to participate, the firm will be dead anyway. You can try to stop it by going over your boss’s head to the CEO; but your boss won’t like that at all, and he and the entire department will tell the CEO whatever they need to tell him in order to keep it all going. And if—speaking purely hypotheticallyyour CEO is an oblivious, selfish, obnoxious egomaniac nearing retirement age, heavily focused on his golf game and art collection, with a few hundred million in cash already stashed away, scheduled to rake in another $50 million this year, whose contract guarantees him another $100 million if he loses his job—well, then he probably won’t be very sympathetic to you, either. You could try going to the board of directors, but even if you could reach them, it will turn out that they are old pals of the CEO, often stunningly clueless, picked largely so that they won’t rock the boat.
So if you try to stop the party, you’ll probably get marginalized or fired, as happened to a number of serious, ethical people who tried to warn their management and curtail unethical and illegal conduct at Merrill Lynch, Lehman, Citigroup, AIG, and elsewhere. So you’d gain nothing by acting ethically—quite the contrary, you’d ostracize yourself and lose your chance to build (or, rather, transfer to yourself) some real personal wealth—possibly a once-in-a-lifetime opportunity.
Third, consider the partitioning of information. Many people knew that they were taking advantage of a bubble, but often they didn’t know its scale or impact on the industry or even their own firm. How much stuff did the firm hold, how was it being valued, did they intend to keep it or sell it, had they hedged it already, and so forth—many people in investment banks, even at a fairly high level, did not have access to enough information to know how much damage their firm would suffer. Nor did they know when the bubble would end; but they did know that as long as it continued, they could keep making a lot of money.
They certainly didn’t know the size of the entire industry’s exposure, nor the distribution (or concentration) of risk across firms. This last consideration was an important one even for CEOs. There was no single institution anywhere—the regulators and the US Treasury Department very much included—that possessed a comprehensive view of the financial system’s positions and exposures. Only very late in the bubble did it become clear that so much fraudulent junk had been created, with so many deep interdependencies across firms, that it could threaten the entire global financial system; even then, it was not publicly known (or knowable) until the crisis itself how much further risk had been created through completely unregulated, opaque derivatives transactions.
Fourth, there is the “getting a little bit pregnant” problem: once you’re in, no matter how you got there, you might as well stay in. Say you’re a senior trader, department head, or even CEO, and after a completely blameless life, you wake up one day to find that you’re stuck with a pile of fraudulent junk that was created by your department or company over the previous several years. What do you do at that point? You probably don’t call a press conference to announce that your firm is built on sand and is doomed to collapse. Rather, you keep the machine going as long as you can—to maximize your own income, try to work your firm out of its hole, or simply, as in Bernard Madoff’s case, to delay the inevitable day of reckoning as long as possible. Maybe you try to wind down your positions, or hedge them. Or maybe you can start trying to profit by betting against the bubble, including your own customers. If you sense that the bubble is about to end, you can make serious money by betting on the failure of your own securities—and yes, people did this, in a huge way.
But finally, there is the problem of reality—both in general, and specifically in relation to this bubble. The fact is that people do commit fraud, even when they know that it is personally risky for them. To take an extreme example, we know that people still perpetrate literal Ponzi schemes (Allen Stanford, $8 billion; Bernard Madoff, $20 billion), even though every Ponzi scheme is mathematically guaranteed to collapse at some point, with inevitable imprisonment to follow. And now, thanks primarily to private lawsuits and secondarily to a few government investigations, we also know that during the housing bubble many people were, in fact, consciously committin
g fraud and selling defective products.
Moreover, in the case of the housing bubble—and unlike isolated noninstitutional Ponzi schemes—everyone got away with it. The people responsible for the bubble are still wealthy, out of jail, socially accepted, and either retired or not, as they prefer. Even those who really did lose something—CEOs, eminences on boards of directors, business unit heads, people such as Richard Fuld, Robert Rubin, Angelo Mozilo, Stan O’Neal, or Joseph Cassano—are still enormously wealthy as a result of having taken lots of cash out during the bubble, and/or from their severance payments.
In fact on a net basis, many of these people made far more money by creating and participating in the bubble than they would have made by staying out of it, even though they destroyed their firms. It is true that they lost the value of whatever shares they owned when their firms collapsed in 2008. But over the previous seven years their incomes had been hugely inflated by the bubble, and they cashed a lot of it outbehaviour, incidentally, not suggestive of deep faith in (or concern for) their firms’ futures. Some of them also received enormous severance payments when they were fired, even after the nature and effects of their conduct became known. To a remarkable extent they have avoided social disgrace, and still occupy positions of prestige, even power. So the defenders of the banks are in effect saying: who are you going to believe, me or your own lying eyes?
Inside Job Page 9