by Ron Suskind
Geithner ignored Shiller’s warning and summarily removed him from the board.
To be fair, Carmine did not dramatically change course after his 2004 conversation with Sonny, either. He had a business to run, and it was a matter of incentives. His were different from Sonny’s.
For his part, Sonny stuck by the inner rigors that had brought him such success. He called Carmine in 2006 to tell his friend, “I’m done. I’m out. I have no more inventory.”
Carmine was startled. “How’s that possible?” he asked.
Sonny explained to him that all the buildings he had bought in the past few years had been converted into condos and that he had just returned from his thirtieth apartment building auction in the past six months.
“I got outbid thirty times in a row,” Sonny said. “I’m not going to pay whatever it takes to buy a building. Based on the rents in an area, I know what a building is worth. I know this business, and it’s stupid to pay more than something’s worth, even if you know there’s a greater fool who will buy it from you.”
So Sonny took his ball, his billion dollars, and went home. Carmine had lost his biggest client, though he continued to consider what he called “Sonny’s rules.” By early 2007 he was seeing more and more clearly that they were rules to live by.
It was around this time that Carmine found himself on the shoreline when the real estate hurricane hit. In this case, it was the south Florida coast, where Lehman and its investors owned condominiums built during the construction boom of the past decade.
People had suddenly stopped showing up at their closings. Carmine noticed this, but it took him a few days to realize the full implications. Say someone, in March, signed a purchase and sale agreement for $900,000 for a South Beach condo, putting down 10 percent of the total price—in this case $90,000. When the closing date arrived in May, just sixty days later, and the lawyers and title company convened to complete the deal, the buyer simply wouldn’t show. The reason was that the price of the condo had dropped so fast in the meantime that it now made more financial sense to lose the $90,000 than to own the damn thing. By the summer of 2007 more than half of the buyers in soft parts of the Florida market were no-shows at their closings.
By the end of the year, Carmine was in round-the-clock discussions with the owner-investors of these complexes. Several suggested cutting prices. If values were dropping that fast, they should try to lure buyers to their closings by lowering the sale price on the condos. The problem was that prices were dropping so fast that, as Carmine said, “It would cause riots in the buildings. Someone would say, ‘I paid $900,000 two months ago for a unit that just got its price cut to $600,000. I’m gonna stop paying my mortgage. I’m gonna sue the developer.’ ”
Carmine sent along updates to his fellow managing directors and held the line. The other directors might have been shrewder in their methods of packaging and selling off debt, but it was not clear that they understood the dramatic fashion in which the mortgage values behind their CDOs were collapsing. They were relying on the safety of their tranches—the name for the way mortgages were bundled based on various flavors of perceived risk—and the credit default swaps the directors believed had insulated them from defaults. Carmine’s office, just down the hall, was a wormhole into an older world, one in which investment banks could assess their real estate holdings, if they ever cared to, by actually visiting the physical buildings.
In his grounded, intensely terrestrial life, Carmine was privy to other portents, too. The economy officially slipped into recession in December 2007. The following spring, Secretary Paulson would tell anyone listening that economic growth for the coming quarters looked steady, if not strong. But by today, in the late spring of 2008, Carmine noticed that there were more hungry people on the streets of New York than he had seen in many years—maybe ever. He had upped the number of runs with his truck.
Some people are graced with a more complete view of the complex world. It’s usually by happenstance; they cross invisible borders. Carmine, in his twisting path, was regularly visiting several disparate provinces in the wider country: on the Gold Coast of Florida, where those glittering condos stood empty along the endless beach; in his old Brooklyn neighborhood, where immigrants from Africa, South America, and the Caribbean were now trying to find footholds on the ever-slipperier shores of the American dream, by buying properties from his old Italian neighbors with “liar loans,” meaning no documentation needed; on the streets of New York City, where the homeless and hungry, leading indicators of the recession, lined up at his truck; and, of course, the sight from his twelfth-floor Lehman office, with its view across Midtown Manhattan, from lofty tower to lofty tower, high above the hard pavement.
What Carmine and Sonny and Bob Shiller all saw was the outcome of a thirty-year effort to find new ways to increase leverage without assuming heightened risk, a process rather breathlessly called “financial innovation.”
The experiment started in the late 1970s at Salomon Brothers, where Wolf and many other Wall Street titans had gotten their start. Salomon at the time was a bit like Florence in the early days of the Renaissance: they saw the world differently and then helped to make it so. The name of the Italian genius in this case was Lewis Ranieri, a rough-and-tumble trader at the mortgage bond desk, who saw debt, suddenly, with new eyes.
Governments and corporations had long been raising money by selling bonds, tradable on open, active markets. This had been going on and growing in sophistication for centuries. In the thirteenth century, governments first started floating bonds to raise money for wars. In the sixteenth century, in Italy, corporate bonds followed closely on the heels of the modern corporation. But as the successes of twentieth-century market economies brought with them higher standards of living and greatly expanded ownership, a third, vast new ocean of debt emerged: mortgages.
By the late 1970s, home mortgages in the United States totaled in the trillions of dollars, kicking off an explosive growth in interest payments. These payments flowed mostly into traditional commercial banks, savings and loans, and credit unions, institutions that since the Depression had been federally insured under the Glass-Steagall Act, which also kept them legally separate from investment houses and brokerages. In return for this security, these institutions accepted strict limits on how they could invest their assets. Their basic function was to assess creditworthiness and lend out money accordingly. Mortgages were thus one of the pillars of their business model. The so-called 3-6-3 rule governed a banker’s work life: pay depositors 3 percent interest (short-term liability), lend their money out at 6 percent, and be on the golf course by 3:00 p.m. Banking was boring, prudent, and reliable, and because of this it could serve as a sturdy backbone for the U.S. economy.
But investors were less enthusiastic about the arrangement. If they hoped to invest in mortgages, they could do so only secondhand, by investing in the thousands of sleepy institutions that held all those American mortgages on their books. The genius of Ranieri and his colleagues—and a future Wall Street leader named Larry Fink, then at First Boston—was in developing a new way to invest in this untapped pool of mortgage debt. By breaking home mortgages down into different categories, based on characteristics such as loan terms (30-year fixed, 15-year adjustable, etc.) and borrowers’ credit scores, they found they could assess the risk of default and the chance of a loan being repaid early. Once the risk was established, it could be priced into a security, and so the mortgage-backed security was born.
Even if someone had come up with the idea in, say, the early 1960s, it would have been impossible to implement any earlier than it was. As much as Ranieri’s insight, it was the great leap forward in computing power, those famous supercomputers of the seventies, that made the MBS possible by allowing financial firms to aggregate and process the huge amounts of data that went into pricing risk. If the “profiling equations” that established a security’s riskiness could be made sound, the prize was tremendous: a smorgasbord of investment oppor
tunities, of virtually any risk profile of debt (and corresponding return), for every investor’s taste. Ranieri believed that the market efficiencies gained through this process, of bringing together new communities of debt buyers and sellers, could reduce mortgage rates by as much as 2 percent. And the same securitization model could be easily extended to monthly payments made on cars, credit cards, insurance policies—on anything, really. Credit would be extended to an undiscovered country of borrowers, and the underwriters of the original loans would not even have to hold the debt on their books. They could sell it to the vast new world of creditors, and thereby free up more cash to lend. If this new lend-and-send idea caught on, it would make the stock market look small by comparison.
By 2008 it had. Those old-line activities of the financial industry—the challenging work of, say, identifying underappreciated value in public companies, made famous in the 1980s by value investors such as Warren Buffett and Fidelity’s Peter Lynch—were by that point overwhelmed four to one by the new line of debt investments in “securities” backed by contractually mandated payments of all sorts of debt “assets”: mortgages, credit cards, and car loans.
This shift, of course, didn’t occur in a vacuum. In the early 1980s, just as the rating agencies first began to stamp mortgage-backed securities as sound investments, the wider economy began tipping away from its mid-twentieth-century equilibrium, and the demand for debt inside the United States steadily rose.
It was a perfect storm of trends: global outsourcing of jobs, with profits flowing back to senior managers, stockholders, and investors; increasing automation in the workplace; full-time jobs increasingly becoming temporary or contract labor; the steady decline of unions and resulting wage and benefit concessions; and the 1990s arrival of the Internet and software advances, allowing the fewer remaining workers to be that much more productive. All this created overall economic growth. The U.S. GDP, at roughly $14 trillion in 2007, was twice as large as it was in 1980. But that wealth flowed dramatically to the top, as real median wages stayed flat for nearly three decades. In 1980 the richest 1 percent of Americans received about 9 percent of overall income, roughly the same level it had been since World War II. By 2007 it was 23 percent—an income disparity not seen in the United States since 1928, a time of Robber Baron wealth, stock manipulation schemes, and vast poverty, where more than half of America still lived on farms and survived, with little security, off the land.
But now, in the new century, there was a financial relationship between the widening strata of American life. Despite Shakespeare’s catchphrase “neither a borrower, nor a lender be,” the vast majority of Americans who’d seen their incomes flatten were loaded up on cheap debt to fill the gap between earnings and rising expenses and to fuel consumptive desires. Rich folks were borrowing, too. The lenders were, in essence, those who’d caught the decades-long updrafts of the economy and had built up large investment portfolios, now heavily—and disastrously—invested in the miracle of debt securities, creating an enormous bubble.
Most bubbles, historically speaking, last between only a few months and a few years. When they pop, those caught within them feel the bite and amend their ways, regrounding themselves in a hard-eyed clarity on how to apply their limited means on items of greatest discernible value. Burning off wild-eyed overconfidence, or making one resistant to its purveyors, is the whole point of such retrenchment. It acts as a counterweight to what behavioral economists, such as Daniel Kahneman, have mathematically mapped since the early 1970s: a host of subtle human biases that make the upside look more likely than a downside of equal or even greater probability. While confidence has outdistanced pessimism over the past several centuries, accounting for an embrace of risk as an engine of human progress, the corrections are crucial.
But they are inconvenient, and hard to predict. That’s where Greenspan, understanding this, established his greatest historical influence. He helped to ensure that, in each crisis, the rollover of debts—the “liquidity bridge” Wolf wrote of—would be supported by the federal government: a flood of liquidity that altered the ancient, commonsense physics between price and value, confidence and pessimism. The retrenchments, with all their cleansing effects, never really occurred. And the debt bubble, shifting its focus as needed, continued to grow. The practical effect of this by 2000 was a continued rise in borrowing, and corresponding debt, at the same time that the lowered Fed rates reduced the return on fixed-income investments, such as government bonds. It was, to reverse Churchill, the beginning of the end.
The era’s victors—that 1 percent of the population hauling in 23 percent of overall income, and their kindred in other countries—had by 2001 started to hit a wall of their own. After the bursting of the Internet bubble, it was clear the stock market was an unattractive destination. Stocks were flat. Capital, lots of it, was suddenly very impatient. The great pools of money—investment funds, pension funds, government funds, corporate funds, amounting to $38 trillion of the world’s acquired wealth by 2001—were searching for a safe, fixed-income yield. As Greenspan cut rates, and stressed that he planned to cut them further to continue to fuel America’s debt-driven consumption—at that point accounting for 70 percent of GDP—that great river of money flowed more forcefully than ever into the U.S. market fueling that debt. American debt, in terms of MBSs and other mortgage-related derivatives, had become the preferred investment opportunity of the entire world.
The underlying truth was that these securities were less secure than their name or profiling equations suggested—far less secure, in fact. The idea that all mortgages couldn’t drop at once was simply wrong. And many of the banks suspected it, even if, year by year, they weren’t sure what to do about it. Clayton Capital, hired in 2004 by a host of large investment banks, noted that nearly 40 percent of all mortgages had significant underwriting “irregularities.” The fundamental and ancient relationships that underlie credit, going back to passages in Deuteronomy—that borrower and lender enter a relationship that carries obligations on both ends—were severed by the firms originating mortgages, taking front-end profit, and selling the mortgages off into investment pools, defined mostly by their yield, that were then sold far and wide by the great marketing and influencing machines of Wall Street. Prudence, even common sense, had been bled out of the equation.
But that’s what always happens when everyone is focused on what something can be sold for while ignoring the many other factors that define worth. It just had never happened on such a sweeping scale.
America, with its huge economy, found itself in the later stages of a vast pyramid scheme. By late 2006 it was clear that the U.S. mortgage market, as large as it was, could not absorb another drop of capital. The sluggishness of productivity gains and real economic growth in the United States had finally caught up with the eternal dream of home buying. Even with the government’s public-private mortgage banks, Fannie Mae and Freddie Mac, guaranteeing roughly 80 percent of all mortgages, and for years encouraging the extension of debt to unsteady borrowers as part of a national bipartisan push to spread the “virtues” of home ownership, the mortgage market could not grow any further. Wall Street’s remedy to this, since the saturation’s start in 2004, was to create “synthetics,” products that allowed investors to make naked bets without any tangible connection to the underlying asset. A thousand bettors could wager with one another on the fortunes of a single mortgage. Investors could buy CDOs that were simply bets on the fortunes of other CDOs. Then they began to use credit default swaps—something created, without guaranteed reserves, to lower the price (and risk) of sleepy corporate bonds in the 1990s—as faux insurance for CDOs. Of course, there was nothing sleepy about a CDO, with its towers of descending risk profiles and equations of how each level was expected to respond to shifting economic forces. Nothing sleepy about a synthetic CDO, based on bets over how those equations would perform. This new strain of CDS was more like a collateral standoff between so-called counterparties, a bit like those ca
sinos that allow bettors to sign their houses over as collateral in exchange for more chips. The more collateral—and CDSs often used CDOs as their collateral—the more leverage was permissible as an added illusion of a “we’re in this together” security. All that made the debt flow even more freely.
All this business created enormous fees. It was very profitable for investment banks and rating agencies. And virtually all of it happened in the shadows—a vast dark pool for financial derivatives that had virtually no transparent clarity for either buyer or seller. The middlemen, the investment banks, knew what they were dealing with.
But like it or not, they all still lived inside the wider U.S. economy, which had not been inventing and investing, saving and hustling, in its storied, robustly profitable way for many years. Those things are hard, and ever harder in the new global economy. They take time and grit and, sometimes, luck. And they actually fit with the ancient and immutable physics of investing: high risk, high reward; low risk, low reward. The country’s native engines of innovation had been obsessed instead with a shortcut: the repackaging and expansion of credit into a vote of confidence in a better tomorrow. “Debt,” a word broken down morphologically into underlying terms such as “denial” and “hope,” had become potent currency in the world of politics, just as in its financial counterpart.
Civilizations rise and fall on confidence. America had figured out a way to borrow money to manufacture it.
4
Inside the Bubble