The Great Deformation

by David Stockman

  Broker operations which inhabited the backwaters of home finance in 1981 thus became the monster of the Main Street midway. These fee-for-service mortgage contractors were now omnipresent in the neighborhoods of America, and had nearly eliminated old-fashioned at-risk “banking” from the home loan market. Not only did borrowers have progressively less skin in the game, but now the preponderant share of home loans was being originated by brokers who had no skin in the game at all.

  Moreover, the business evolved far beyond its mom-and-pop roots, such that by the end of the 1990s the nation’s largest single mortgage originator, with nearly $200 billion annually in new home loans, was a broker: Countrywide Financial. Most of its thousands of branches had no teller windows or vaults. Rather than intermediating bank deposits, it was a giant sales agency that kept new loan paper flowing to Freddie and Fannie in prodigious volume.

  Befitting its Southern California homeland, Countrywide’s irrepressible leader, Angelo Mozilo, had a perpetually deep tan which gave off an orange glow during his endless appearances on financial TV. His incessant message was that Countrywide could put every American family in their own home. Accordingly, he didn’t cotton much to any Washington official who had the temerity to interfere with the ceaseless flow of mortgages between his boiler rooms and the GSE balance sheets.

  During his stint as HUD secretary in the George H. W. Bush administration, for example, Jack Kemp had tried to revive the gospel of free markets by again proposing to curtail the GSEs. The Mozilo-dominated Mortgage Bankers Association floridly touted itself as a triumph of the free market, but when one of the true champions of free market economics actually proposed to apply those principles to the GSE financing machine, it was another matter.

  Since Countrywide’s entire business model depended upon its ability to rent Uncle Sam’s credit card for a razor thin spread, Mozilo quickly leapt to the offensive. Jack Kemp was “the worst person who could possibly have been put in that position,” fumed the kingpin of boiler-room home loans.

  Kemp’s jousting on behalf of free market capitalism proved to be futile, and disappeared without a trace into the curb drains of K Street, but two lessons from his failed challenge did endure. Most importantly, Countrywide Financial and its ilk were now the true face of home finance; for all practical purposes “at risk” bankers were obsolete.

  Secondly, once the Clinton home ownership strategy worked up a full head of steam, the idea that housing finance was too important to be left to the free market became inviolable. Now the only capitalism that counted was the crony kind, and at the heart of it stood the profoundly uneconomic business of home mortgage securitization.

  THE PHONY ECONOMICS OF MORTGAGE SECURITIZATION

  As has been shown, the Freddie and Fannie variety of mortgage securitization did not create societal value; it just extracted rents from the public credit. These windfalls, in turn, were largely captured by GSE executives and stock market speculators, including some large mutual fund managers.

  Bill Miller of Legg Mason, for example, even got himself nominated for the “next Warren Buffet” prize by loading up his mutual fund with Freddie and Fannie stock early, and then riding it all the way to the top (and eventually over the cliff). In this manner, the GSE scalpings from the nation’s 150 million taxpayers were capitalized and transferred to a few ten thousands of investors in Miller’s mutual fund and to those of his many momentum-stock imitators.

  The Wall Street–based private-label mortgage securitization business was also uneconomic. However, unlike GSEs, which were AAA-rated wards of the US Treasury and could therefore raise virtually unlimited amounts of funding with hardly a modicum of scrutiny by investors, the private-label underwriters faced a more significant challenge finding investors.

  Large institutional fixed-income investors such as corporate pension funds and life insurance companies were always looking for enhanced yield, but in those early days the Fed had not yet repressed interest rates low enough to kindle much interest in the intricacies and novelties of private-label mortgage-backed securities (MBSs). Indeed, since Wall Street could not compete with the GSEs for prime-quality mortgages, underwriters had to sell investors on a dual proposition.

  First, the highest-rated tranches of private-label MBSs achieved AAA ratings as a result of structured finance, meaning that investors had to get comfortable with a whole new breed of bond indentures which sliced and diced the mortgage pool cash flows in favor of the more senior tranches. Second, investors could not help noting that the underlying mortgage pools, however they might be wacked up, consisted of high-risk loans with above-average default profiles from lower-end markets ranging from the exurbs of Orange County to inner-city Cleveland.

  Accordingly, only $11 billion of private-label subprime MBSs was issued by Wall Street in 1994, a mere 1.4 percent of the mortgage market during the year the Clinton home ownership crusade was launched. Two years later, private MBS issuance rose to $35 billion and by 1998, volume hit $85 billion. Yet that was still less than 6 percent of national mortgage originations, reflecting the fact that Wall Street had not yet thrown its balance sheet into the breach.

  The fact that Wall Street was still largely on the sidelines as of the late 1990s was the crucial restraining factor in delaying the arrival of the subprime plague. Most certainly, the mortgage broker industry was ready. By the mid-1990s, it was swarming with hucksters who would write loans to any applicant with a heartbeat.

  What was lacking, however, was sufficient warehouse credit lines and a deep private-label MBS market to package and distribute junk mortgages. For this reason, Countrywide hadn’t even bothered with subprime before 1997; its GSE business was booming and the private-label MBS market was not yet robust enough to move the needle on its massive scale of operations.

  AMERIQUEST: ROLAND ARNALL’S PREDATORY SALES MACHINE

  Nevertheless, the subprime industry was a financial cancer waiting to metastasize. The GSEs had now spawned a massive mortgage banker and broker industry. What was needed was for Greenspan to light the match, enabling Wall Street to get into the business of providing warehousing financing and a securitization takeout market for junk mortgages.

  In this environment, a crony capitalist operator named Roland Arnall had already spawned a far-flung web of operations. It included a holding company he controlled called Ameriquest Capital Corporation (ACC) and also a plethora of imitators such as New Century and Option One, which were run by former subordinates who had ventured out on their own. Together, these operations perfected the high-pressure selling machinery and the range of high-risk mortgage products which exploded onto the scene after the Fed’s panicked rate cutting in 2001–2003.

  Ameriquest Mortgage eventually grew to more than three hundred boiler rooms scattered around the nation and generated $80 billion annually in subprime mortgages. It was an ultra-high-pressure sales machine that was happy to hire ex–car salesmen when possible, but also enlisted ex–car wash employees if necessary. The point of Ameriquest’s recruiting policy was maximum possible ignorance about mortgage lending, so that brokers would be focused solely on moving product at daily quota rates which were equivalent to those of factory production lines.

  To keep the boiler rooms humming, Ameriquest invented many of the classic subprime products, including the stated income or “liar’s loan” and the 2/28 mortgage. The latter had a low teaser rate for two years and then converted to a much higher adjustable-rate mortgage for the next twenty-eight years, a trap that often caused hapless borrowers to “refinance” and end up in the same place two years later.

  What made these boiler-room operations so successful is also precisely what should have made the Arnall-style subprime mortgages extremely unappetizing to investors; namely, huge upfront points and fees. Indeed, the financial results for Arnall’s holding company over the period 2002–2004 are prima facie evidence that nothing about the nation’s leading subprime mortgage broker was on the level.

  During this thr
ee-year period, Ameriquest originated about $150 billion of subprime loans which it temporarily funded on warehouse lines and then sold en bloc to Wall Street underwriters. From this flow of new mortgages, which revolved through its warehouse borrowing line approximately every twenty days, it scalped almost $7.5 billion of revenue.

  This was a stunning haul for a pure brokerage operation and implied that the yield from fees and upfront points amounted to 5 percent of loan originations. Accordingly, Ameriquest’s boiler rooms were raking in margins at about six times the normal rate for prime-quality GSE loans.

  Not surprisingly, Arnall’s holding company extracted $2.7 billion of profits over the period from these generous revenue flows, meaning that its return on the pittance of capital it had invested in Ameriquest was so high as to be immeasurable. But the more damning aspect had to do with what was left from its revenue take after profits had been carted away.

  Ameriquest’s financial results implied that it had incurred $5 billion of expenses in generating these loans. Yet it had no permanent capital to service and operated from low-cost rented offices with virtually no overheads except data processing. Even after allowing for several billions to pay interest on warehouse credit lines and provide wholesale discounts to Wall Street underwriters, the surplus available for salesman compensation was extraordinary. Literally billions of dollars were paid in commissions, bonuses, and perks to a few thousand salesmen who carried the title of “loan officer.”

  Needless to say, the incentive for predatory selling and outright fraud was overwhelming, a proposition well amplified by the legends which swirled around the company’s run-amok sales culture. As one former manager later wrote: “My managers and handlers taught me the ins and outs of mortgage fraud, drugs, sex, and money, money and more money … At any given moment inside the restrooms, cocaine and meth were being snorted by … more than a third of the staff, and more than half of the staff was manipulating documents to get loans to fund, and more than 75 percent just made completely false statements … a typical welcome aboard gift [to new employees] was a pair of scissors, tape and whiteout.”

  CHURN AND BURN, SUBPRIME STYLE

  Meanwhile, the signs were blindingly evident that Ameriquest and its subprime brethren were not on the level financially. The most egregious of these was towering levels of profitability that defied economic common sense. Arnall thus showed up on the Forbes list in 2004 as being worth $2 billion, a figure which grew to $3 billion shortly after he completed his public service stint as co-chair of the January 2005 Bush inauguration.

  Given the thin margins normally available for simply brokering loans, it was impossible that Ameriquest was worth even a fraction of the Forbes figure. Any diligent buyer of product from Ameriquest’s mortgage origination machine, therefore, might have smelled a rat.

  In fact, the huge revenue margins, massive compensation pools, and outsized profits obtained by Ameriquest were not possible on the free market. No rational investor would have paid anything close to par for mortgages that were so recklessly underwritten, serially refinanced, ill documented, and dependent upon such onerous reset mechanisms as the Ameriquest mortgages.

  Stated differently, based on Ameriquest’s observable modus operandi, diligent investors would have demanded a deep discount on these hair-ridden loans. Yet had Ameriquest been forced to sell its loans at even 95 percent of par to compensate investors for the virtually unknowable risk inherent in its business model, its revenues would have been wiped out entirely, thereby vaporizing its fabulous profits and lunatic compensation pools.

  At the end of the day, Ameriquest and its subprime imitators operated an incredibly destructive feedback loop. Based on stupidly high Wall Street prices for their junk mortgages, they paid salesmen wholly uneconomic levels of compensation, which fueled their predatory sales machines; the huge volumes flowing through this machinery, in turn, generated even larger compensation pools which catalyzed even greater volumes of junk mortgages.

  So the whole subprime industry depended upon an egregiously over-priced market for junk mortgages, and there is no secret as to why it existed, especially after 2001. Wall Street created it and grew it to stupendous size. As detailed in chapter 20, the $100 billion market in high-risk mortgages that had built up by the year 2000 suddenly morphed into a trillion-dollar monster within just six years.

  THE FED’S PERFECT STORM: HOW 1 PERCENT INTEREST RATES FUELED THE BONFIRES OF SUBPRIME

  The truly insidious aspect of the subprime assault on America’s neighborhoods was not that operators like Roland Arnall and a handful of imitators got preposterously rich running a few thousand boiler rooms populated with predatory salesmen. America is riddled with dial-for-dollars operations, some of them just as seedy.

  The difference is that Arnall wasn’t selling aluminum siding or cosmetics, but $500,000 mortgages that could never have been funded in the absence of the Fed’s prosperity management model. As has been seen, the latter was based on the primitive notion that any amount of money printing was permissible, so long as it did not put undue upward pressure on commodity and product prices.

  Yet that was no constraint at all. In a world of massive US current account deficits and the “China price,” the American economy was, in effect, importing gale-force wage and product deflation. And it would continue to do so until China’s rice paddies were drained of excess labor and the People’s Printing Press stopped pegging its exchange rate.

  So the Fed’s panicked money-printing campaign after December 2000 was a pact with the devil in economic terms: it permitted the US economy to live high on the hog in the short run, while it offshored the nation’s traceable goods industries and buried its balance sheet in external debt in the longer run. One of these obligations, ironically, was mortgage debt in the form of GSE paper.

  Foreign central banks led by the People’s Printing Press of China owned less than $100 billion of GSE paper before the Fed ignited the mortgage boom in 2001. Through continuous absorption of excess dollars remitted by their exporters, however, they had accumulated upward of $1 trillion of Freddie and Fannie paper by July 2008. Sequestering unwanted dollar claims, the mercantilist central banks of Asia thereby ensured there would be no flare-up of CPI inflation and no sell-off in the bond market.

  With the bond vigilantes incarcerated in a red vault in Beijing, as it were, 1 percent money market rates revived Wall Street’s speculative juices and ignited the carry trade like never before. Indeed, it is difficult to imagine a better setup to induce Wall Street to feed the marauding bands of subprime mortgage bankers with warehouse credit, and to carry hundreds of billions of junk mortgage inventory until it could be sliced and diced into private-label MBSs.

  As the great housing carry trade gathered momentum on Wall Street in 2002–2003, however, the folly of the Fed’s bubble finance was palpable. In a credit-saturated economy, the price that matters above all else is the price of credit; that is, the interest rate on short-term borrowings and the yield curve across the spectrum of longer-dated debt securities.

  Yet the Fed’s prosperity management model completely ignored the need for honest and accurate pricing of liquid credits and debt capital. In fact, by completely disabling free market interest rates, it fueled both the final binge of household mortgage borrowing and also fostered Wall Street’s capacity to fund and securitize the junk mortgage loans being generated by the brokers’ boiler rooms.

  At the end of the day, the great housing fiasco did not represent a failure of the free market. It happened because the free market had been supplanted by two great financial deformations of the state: the GSEs which gave birth to the predatory mortgage boiler rooms and the central bank which favored them with a rogue funding machine parked at each and every notable Wall Street address.

  CHAPTER 20

  HOW THE FED BROUGHT

  THE GAMBLING MANIA TO

  AMERICA’S NEIGHBORHOODS

  THE EFFECT OF THE FED’S 2001 MONEY-PRINTING PANIC WAS THAT “ca
p rates” on long-lived assets like real estate were driven sharply lower, thereby causing prices to soar. Soon the increased collateral value of properties, both homes and shopping malls, begat even more lending and even higher prices.

  Furthermore, Main Street was now populated by a small army of former dot-com speculators who were bitterly disappointed, but also eagerly looking for the next asset class that could generate instant riches. Accordingly, they quickly caught on to the homeowners’ leveraged buyout (LBO) gambit: repeatedly refinancing and flipping properties as valuations rocketed.

  The figures for mortgages crystallize the massive debt loop which emerged in the domestic real estate markets. In the case of the residential sector, home mortgages outstanding rose by $750 billion, or 13.2 percent, in 2002. This was a robust figure under any circumstances, but extraordinary in light of the fact that the US economy was just emerging from its post-dot-com slump.

  During the course of 2002, there had been zero net job creation and wage and salary incomes had grown by less than 1 percent. From day one of the home mortgage boom, therefore, the driving force was rising housing asset prices, not burgeoning household incomes and capacity to borrow.

  As the housing bubble inflated, the level of outstanding home mortgages just kept growing at faster and faster rates. During 2003 mortgage debt outstanding increased by 15 percent and then grew by another 15 percent in 2004. The latter gain represented an annual increase of $1 trillion and was no aberration: annual home mortgage debt growth remained in the trillion-dollar-per-annum league until the housing bubble finally started cooling off in the second half of 2007.

  By any historic standard, these were outlandish gains. Annual home mortgage growth, for example, had averaged only $170 billion per year during the five years after the 1990 recession and had peaked at just $425 billion in 1999.