During the bubble, the Bush administration and the Federal Reserve were essentially AWOL; if anything, they made matters worse. In 2004 the SEC voted unanimously to allow the five largest investment banks to calculate their own leverage limits, based on their internal risk models. This meant that by the time the party ended, several of them were leveraged at more than thirty to one, meaning that if the value of their assets declined by just 3 percent, they would be bankrupt. As a result, when the crisis occurred, three of the banks, Bear Stearns, Lehman Brothers, and Merrill Lynch, were insolvent by 2008. Only Goldman Sachs and Morgan Stanley survived, and that by grace of government rescue operations.1 During this time, the SEC and other government regulators reduced their risk analysis and enforcement staffs, and basically left the investment banks unsupervised. The same was true of the industry’s several “self-regulatory” organizations, such as the Financial Industry Regulatory Authority (FINRA), the Securities Investor Protection Corporation (SIPC), and others. FINRA, for example, describes its mission thus on its website:
FINRA is the leading non-governmental regulator for all securities firms doing business with the US public—nearly 4,495 firms employing nearly 635,515 registered representatives. Our chief role is to protect investors by maintaining the fairness of the US capital markets. We carry it out by writing and enforcing rules, examining firms for compliance with the rules, informing and educating investors, helping firms pre-empt risk and stay in compliance.2
Well, FINRA didn’t do too well. (The head of FINRA during the bubble? Mary Shapiro, who became chair of the SEC in 2009, appointed by President Obama.) As a result of the failure of both government and private regulation, during the entire bubble the inmates were in charge of the asylum. Given their incentives, a massive fraud was entirely rational for most of them, even if they had known in advance of all the damage it would cause.
Was it all really that naked? Yes, it was. Some of what follows might be a little dry. But I ask readers to bear with me because later in this book, I will be saying some rather strong things—things like, these people should be in jail, they should have their wealth taken from them and given to people whose lives they destroyed, they should live in disgrace for the rest of their lives, it is shocking that they have not been prosecuted, and it is obscene and dangerous that they still occupy prominent positions in government, universities, companies, and civic institutions. So in the next couple of chapters, there will be some rather detailed stuff, because when we come to the punch line, I want it to be convincing.
Let us start our survey of the investment banking industry’s conduct with a lawsuit filed by the discount brokerage and asset management firm Charles Schwab, Inc. The case provides an unusually broad statistical picture of the securities that Wall Street produced, and also helps provide context for some of the truly stunning conduct we shall encounter later.
The Schwab Complaint
SCHWAB SUED THE broker-dealer divisions of twelve major financial institutions. The suit is based on the representations made in the offering materials for thirty-six securitizations—mortgage-backed securitiesthat were purchased from these banks by various units of Schwab between 2005 and 2007. The defendants are BNP Paribas, Countrywide, Bank of America, Citigroup, Credit Suisse, Deutsche Bank, Goldman Sachs, Greenwich Capital, HSBC, Wells Fargo, Morgan Stanley, and UBS.
Investors in residential mortgage-backed securities do not have access to individual loan files when they make the purchase; they are shown only summary data for each mortgage on the “loan tapes” that accompany a sales prospectus. But when Schwab sued, it analysed the summary data for 75,144 loans included in the securitizations it had purchased. While not a random sample, it is a broad one.3 If anything, the sample is probably substantially above average in quality, because Schwab invested conservatively, and the defendants in this lawsuit do not include Bear Stearns and Merrill Lynch, two firms that produced much of the worst junk. As we’ll see shortly, some of it was much worse.
Still, Schwab’s analysis estimated that 45 percent of the loans violated the representations made in selling the securities. Schwab used four separate tests; most of the suspect loans failed more than one of them.
1. Loan-to-Value Representations. The prospectus for every security that Schwab had purchased contained detailed representations about the average loan-to-value ratio (LTV) of the mortgages supporting the security. All but one of the prospectuses stated that no individual loan had an LTV greater than 100 percent. Schwab tested those statements with a model that is widely used in the industry, based on 500 million home sales, in zip codes covering 99 percent of the population.
The results of Schwab’s tests suggest that all securitizers significantly understated LTV ratios, and that all of the securities included substantial numbers of loans with LTV ratios of more than 100 percent—in other words, loans for more than the home was worth. In one security comprising 1,597 loans, the model estimated that 626 loans were overvalued by more than 5 percent, with only 69 undervalued by as much. The pool’s weighted-average LTV rose from a represented 73.8 percent to 90.5 percent, and the model estimated that 196 loans had LTVs of more than 100 percent, although the documents represented that none did. Roughly similar outcomes applied to all the other pools. A second test was applied to properties that were subsequently sold. The sales prices were consistently below the values implied by the claimed LTVs, in a pattern consistent with the model. Schwab notes that given the average leverage of the loans, a 10 percent LTV overstatement implies an 80 percent reduction in stated equity.2
2. Stated Liens. All of the securities’ offering materials stipulated that all property liens were fully disclosed. No mortgage loan, supposedly, is ever funded without a title search to spot any lien that might be senior to the bank’s lien. Schwab did new title searches on the properties. In one pool of 2,274 loans, 669 had undisclosed liens that, on average, reduced stated equity by 91.5 percent. In some pools, as many as half the loans had undisclosed liens.
3. Occupancy Status. Owner-occupied homes have lower default and foreclosure risk than second homes or investment properties. For this reason, all of the securities’ offering materials contained representations as to the percentage of loans in the security that were for owner-occupied (primary) residences. Schwab researched the properties listed as primary residences for indications that they were really not, including:
• Does owner have a different property tax address?
• Does owner not take advantage of local homestead tax exemptions?
• Does owner have three or more houses?
• Is there a shorter-than-normal time lapse from current pay to foreclosure?
• Has owner not updated personal billing addresses six months after closing?
Using these tests, in one pool of 1,498 loans, in which only 99 were alleged to be nonprimary residences, the correct total was estimated to be 598, with most of those failing more than one test. Roughly similar results prevailed throughout all the securities.
4. Internal Guideline Compliance. Schwab collected data on early payment defaults (EPDs) on all securitized loans issued by the originators of the mortgages in these securities from 2001 through 2007. In well-underwritten mortgages, the rate of EPDs, defined as default during the first six months of the loan, should be vanishingly small. Schwab investigated whether and when EPD rates changed during the bubble, and if so, whether stated credit guidelines changed at the same time.
None of the lenders changed its represented credit guidelines during this period. Despite this, every lender experienced a sharp upward break in its EPD rate at some point, a trend that persisted thereafter in every case. But the date at which the break occurred was different for each originator. For Countrywide, for example, EPDs suddenly quadrupled starting in the first quarter of 2005 and stayed at consistently high rates from then on. All the other lenders showed comparable upward EPD breaks; the starting dates ranged from mid-2003 to mid-2007.
Since the b
reaks occurred at different times for different originators, they were not likely to have been caused by general economic conditions. Rather, they probably reflected an internal policy change; but those policy changes were never reflected in the lending guidelines officially represented to investors. (Credit guideline representations were usually detailed and specific.) The obvious interpretation is that, one by one, originators chose to go aggressively down-market to make more money, while officially denying that they had done so.
The banks, of course, could allege—and indeed have alleged—that they were scammed, just as Schwab was. But in their securities prospectuses all the securitizers also claimed that they carefully underwrote the loans they purchased from originators. The representations they made were about the quality of their own credit processes, not those of the originators. And, unlike final investors like Schwab, they did have access to all the detailed backup records. Furthermore, most of them were deeply in bed with several major lenders—they provided the lenders’ financing, managed their securities offerings, and so forth.
And finally, in order to justify the representations made to investors, all of the securitizing banks hired outside firms to review the quality of the loans they bought. The largest and most comprehensive reviewer was Clayton Holdings, which examined 911,000 mortgages for twenty-three different securitizing banks, including all of the largest securitizers, between January 2006 and July 2007. In testimony and documents provided to the Financial Crisis Inquiry Commission (FCIC), senior Clayton executives revealed that 28 percent of the loans they examined did not meet even the securitizers’ own internal guidelines. Despite this, 39 percent of all loans that failed the securitizers’ guidelines were purchased and securitized anyway, a fact never disclosed to the investors purchasing the final securities.4
But were the banks just sloppy passive conduits, or active co-conspirators? Did they understand the full implications of their actions? To understand that, we need to look inside them. This has not been done nearly enough, because the US government hasn’t really tried. There have been no criminal prosecutions using large-scale subpoena power and sworn testimony. All we have are civil suits, in which the banks ferociously (and often successfully) resist subpoenas and often succeed in keeping records sealed. Even the FCIC established by the Obama administration had extremely limited subpoena power, and a tiny budget. If there ever were to be a truly serious investigation, I have no doubt that we would learn much, much more than we currently know.
But what we currently know is still quite impressive.
Bear Stearns
BEAR STEARNS WAS one of the most experienced mortgage players on Wall Street. In the three years from 2004 through 2006, Bear securitized nearly a million mortgage loans with a total value of $192 billion—serious money, even for Wall Street.
Bear Stearns had been in the mortgage-backing business for nearly two decades, mostly securitizing high-quality loans. But in 2001 it created a new mortgage conduit, EMC Mortgage, to securitize Alt-A loans. In 2003 EMC started to securitize subprime, stated income, and “no doc” loans, then in 2005, second-lien loans, of the type that even Angelo Mozilo called the “most toxic” he had seen in his entire career.
Bear Stearns gives us a lurid peek at a white-shoe investment bank turned boiler room, using a succession of strategies to extract money from the bubble in every possible way. We know about it because of a lawsuit filed by the Ambac Financial Group, a bond insurer now in bankruptcy. Ambac’s suit against Bear Stearns and its successor company, JPMorgan Chase, is one of the few cases in which plaintiffs were able to obtain the internal documents, e-mails, and loan files of defendants to use in evidence.5
The history of the lawsuit indicates the banks’ strategy, and their ferocious opposition to every attempt to shed light on their conduct. Ambac filed suit in November 2008, and as of this writing—February 2012—the case has still not come to trial. Bear Stearns and its new owner, JPMorgan Chase, have used a long succession of procedural tactics to delay the case. They also tried hard to prevent Ambac from being able to subpoena records and depose witnesses, but eventually lost. They are still trying to delay the trial, presumably hoping that Ambac’s bankruptcy trustee will eventually give up or run out of money to pursue the case.
Of course, what follows is a partisan account based on materials assembled by Ambac’s attorneys. During the bubble, Ambac and the other major insurers (MBIA and AIG) were not angels themselves; their former executives and salespeople (now long gone) had the same toxic incentives and destroyed their own firms, just like everyone else. But now, an independent bankruptcy trustee appointed by the courts is trying to recover as much as possible. Ambac’s lawsuit is part of a gigantic post-crisis food fight in which dozens of firms are trying to recover money, often while being sued themselves for their own highly unethical behaviour. And JPMorgan’s answer to the Ambac suit, when it becomes available, may cast some of the quotes below in a different light. But the accuracy of the quotes has not been challenged, and they make for interesting reading.
Ambac is suing to recover losses from payouts it made on failed Bear Stearns securitizations; Ambac argues that it agreed to insure them only due to gross misrepresentations by Bear Stearns. Many of the loans in the securitizations came from a wonderful company called American Home Mortgage, Inc. (AHM), also now bankrupt. We can get a taste of AHM’s enthusiastic approach to home lending from the official description of its “Choice” loan programmes:
Offering financing for borrowers with more serious credit issues, these programs provide solutions for multiple mortgage lates, recent bankruptcies or foreclosures, little or no traditional credit, and FICO scores as low as 500. These programs are also offering 100 percent financing on all doc types for borrowers who do not meet the credit criteria of the standard Choice programs.6
Now, over to Bear Stearns. Its mortgage securitization programme was run by four executives: Mary Haggerty and Baron Silverstein, coheads of Mortgage Finance, and Jeffrey Verschleiser and Michael Nierenberg, coheads of mortgage trading. Haggerty and Silverstein underwrote the suitability of mortgages from originators, and pushed them through the steps to get to a sale. Verschleiser and Nierenberg traded loans in and out of Bear Stearns’s portfolio and also constructed the securitizations. These people were emphatically not obscure file clerks whose machinations went unnoticed by management. All four were senior managing directors—in all of Bear Stearns, a fourteen-thousand-person company, only ninety-eight people were at that level. They would have all been paid millions of dollars per year.
The first thing they did, of course, was simply to package and sell a lot of trash (while concealing this fact). The record shows that loan delinquencies were already rising sharply in early 2005. John Mongelluzzo, the due diligence manager in Mortgage Finance, and therefore junior to Haggerty and Silverstein, was pushing for stricter standards and tighter underwriting reviews. The response to his actions indicates the futility of being ethical in American investment banking during the bubble. Instead of tightening standards, in February 2005 Mary Haggerty ordered a reduction in due diligence “in order to make us more competitive on bids with larger sub-prime sellers.” She reduced the size of the loan samples used to test compliance and, most important, postponed the due diligence review until after Bear had bought the loans, and often even after the loans had been bundled into securities.7
This change in procedure was made almost by stealth. A year later, in March 2006, a conduit manager wrote that “until yesterday we had no idea that there was a post close dd [due diligence] going on.” Loans “were not flagged appropriately and we securitized many of them which are still to this day not cleared.” In other words, loans were going out with no due diligence at all.8
Later that spring, Mongelluzzo wrote to Silverstein, “I would strongly discourage doing post close [due diligence] for any trade with AHM. You will end up with a lot of repurchases”—a “repurchase” was a buyback from a sold securitization, and was al
ways expensive. The advice was ignored. Two pools of 1,600 loans were purchased from AHM and quickly securitized. A review the following year showed that 60 percent were delinquent, and 13 percent had already defaulted.9
At the same time, Verschleiser was pushing hard for more volume. One of the conduit managers e-mailed her staff:
I refuse to receive any more e-mails from [Verschleiser] . . . questioning why we’re not funding more loans each day. I’m holding each of you responsible for making sure we fund at least 500 each and every day. . . . If we have 500+ loans in this office we MUST find a way to underwrite them and to buy them. . . . I was not happy when I saw the funding numbers and I knew that NY would NOT BE HAPPY.
Later that year, the same executive e-mailed her staff: “I don’t understand that with weekend overtime why we didn’t purchase more loans. . . . Our funding needs to be $2 billion this month. . . . I expect to see ALL employees working overtime this week to make sure we hit the target number.”10
An early warning of declining quality was a 2005 spike in EPDs, which Bear Stearns defined as a missed payment in the first ninety days. Bear Stearns’s policy had previously been to hold purchased loans in inventory for ninety days before securitizing them, in order to ensure their quality. But in 2005 the team decided to shorten the holding period, so loans could be pushed into securities before an EPD occurred. Verschleiser told the unit that he wanted all “the subprime loans closed in December” to be in securitizations by January—in effect, within a month of purchase. He confirmed that policy in mid-2006, reminding staff “to be certain we securitize the loans with 1 month epd before the epd period expires.” Later, he demanded to know why specific loans that experienced early delinquencies “were dropped from deals and not securitized before their epd period expired.”11
The predictable consequence was a flood of EPDs in securitized loans. Bear assured its investors that they would diligently police EPDs, because these usually indicated a seriously defective loan. In their presentations to Ambac, Bear Stearns had touted their aggressive followup to assert claims on behalf of investors if a securitized loan went bad soon after the close of a securitization deal. The usual protocol was to buy back the bad loan from the investor and force the originator either to replace it with a good equivalent or to return the cash.
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