House of Cards (61 page)

As for the renovations the house needed, Kellie and Villareal discussed the costs associated with them after the closing. Villareal agreed to pay for all the renovations, according to a tape of their conversation. The renovations were never completed. Within three months, Kellie could no longer afford the mortgage payments on the house. After five months of nonpayment, Wells Fargo sold Kellie's mortgage to EMC Mortgage, a subsidiary of Bear Stearns that originated and serviced mortgage loans of all kinds and sold them to investors. Soon thereafter, the home was put back on the market, again through Long and Foster, at a price of $225,000—some $75,000 below the outstanding mortgage balance of about $300,000. The sale was subject to an agreement by EMC to permit what was known as a “short sale,” for an amount less than the mortgage. Kellie also informed EMC that she would not be able to pay the $75,000 balance, assuming the sale happened. “Kellie keeps a journal of her seizures,” according to a document detailing her ordeal, “which reported that she experienced an increase in seizures throughout the mortgage process. She has also experienced feelings of betrayal, fear, stress, humiliation, and frustration. Kellie and Gregory have experienced a serious strain on their relationship throughout this process. Gregory has upgraded his asthma medication due to increasing frequency and severity of asthma attacks, which he attributes to stress.”

Although it may be only part of the story, Russell Roberts, the George Mason University economist, sees this kind of deceitful behavior as the natural outgrowth of the government mandates. “It's not that much of a tragedy,” he said. “People talk about it for political gain. But many of the people who've lost their homes never had them in the first place. A lot of our people bought the homes with no money down. In fact, you can find Countrywide press releases where they brag about their special 103 percent loan: ‘We don't just cover your mortgage, we'll lend you your closing costs, too.' And [the borrower] walks into a house and six months later they're having trouble making the payments. Then they, quote, lose their home, unquote, but they lose no equity; they were renters before. Now, they're really renters. I don't want to diminish [foreclosure]. It's embarrassing. It's humiliating. There's probably shame and despair and you maybe thought you were going to own the house but you don't. But it's not like they were thrown out on the street after they lost their equity. They didn't have any equity in these houses to start with. It's a very strange situation.”

Henry Cisneros, the former mayor of San Antonio, Texas, was Clinton's Secretary of Housing and Urban Development from 1993 to 1997. In the midst of the financial crisis, in October 2008, the
New York Times
caught up with Cisneros to ask him about his role in encouraging home ownership among a group of people who would have been better off financially if they had remained renters. He said, “I have been waiting for someone to put all the blame on my doorstep.” He appeared not to be joking. In the
Times
Cisneros argued that it was “impossible to know in the beginning that the federal push to increase homeownership would end so badly” and that once the housing boom started, the regulators did not have the tools to stop it. “You think you have a finely tuned instrument,” he said, “that you can use to say: ‘Stop! We're at 69 percent home-ownership. We should not go further. These are people who should remain renters.' But you really are just given a sledgehammer and an ax. They are blunt tools.” He said that people “who should not have been homeowners” had been lured by “unscrupulous participants—bankers, brokers, secondary market people…. The country is paying for that, and families are hurt because we as a society did not draw a line.”

This lowering of credit standards as a way of increasing home ownership had begun to come home to roost by the time Whitney wrote her research report in October 2005. “Since 1996,” she wrote, “sub-prime lending has grown 489%”—from $90 billion to $530 billion—“largely through the extension of credit to first-time borrowers. We believe that at least 5% of the mortgage market is at risk due to very low equity positions in homes. Greenspan's recent statements concur with this estimate based upon what he believes to be the portion of the population which has dangerously low equity positions in their houses.” Whitney described how underwriting standards had deteriorated scandalously during this bubble by allowing people with lower credit scores to get mortgages, by allowing them to finance a large percentage of the purchase price, by creating new mortgage products that delay paying off the principal, and by requiring less documentation of income and assets. The introduction of adjustable-rate mortgages merely exacerbated this disastrous trend by allowing borrowers to choose from a smorgasbord of repayment options, including an option that allowed for a small monthly payment whereby the deferred interest and principal payment were merely added to the back end of the loan balance, increasing it beyond all recognition. “When interest rates rise, the borrower's total loan balances as well as monthly payments increase even more so, thus increasing the borrower's overall financial burden and likelihood of default,” she observed.

She concluded with a bombshell. “We believe low equity positions in their homes, high revolving debt balances, and high commodity prices make for the ingredients of a credit implosion, particularly at this point in the consumer cycle,” she wrote. “As a result, we believe those lenders with exposure to this segment (largely subprime lenders) will experience loss levels of great enough enormity to not only substantially erode profitability but which could also impale capital positions. However, most important, we believe restricted liquidity caused by regulatory guidelines for greater capital ratios could begin a domino effect of corporate insolvencies similar to those witnessed post-1998.” Whitney's insightful report— which in retrospect revealed only a small part of the problem—was like the proverbial tree falling in the forest with no one around to hear whether it made a sound. There was simply too much money to be made as the housing bubble continued to inflate for any of the participants—not only at Bear Stearns but also across Wall Street—to stop and take notice.

The FDIC, the government agency responsible for supervising the banking system and insuring deposits, did take notice of Whitney's report. “I was the only one who caught the attention of the FDIC with such a report,” she said, “and I never saw any report that mapped out the potential hazards the way my report did.” Richard A. Brown, a senior economist at the FDIC, said Whitney's report “really made an impression upon the staff here at the FDIC” and he invited her to speak about her findings at a forum held at the FDIC on January 19, 2006. She reviewed for the FDIC her report and made a new and interesting observation about Wall Street banks. “The banks need to originate some product,” she said. “One of the biggest problems for the banking industry today is tremendous deposit growth and very little asset growth. So you have institutions that are liability-rich and asset-poor, and they're going to put anything on the balance sheet they can. For the past five years or so, mortgages have provided the best vehicle for asset growth.”

While Bear Stearns's fixed-income revenue for the year ended November 30, 2005, declined 12 percent, to $2.3 billion, from $2.6 billion in 2004, the business was still humming along quite profitably. The firm's SEC filing stated that “mortgage-backed securities origination revenues declined from the robust levels of fiscal 2004 due to a flattening yield curve, shifting market conditions and changes in product mix. A decline in agency CMO volumes was offset by an increase in non-agency mortgage originations.” Regardless of the stumble in fixed income, the firm posted a record profit of $1.5 billion in fiscal 2005, up 9 percent from the $1.3 billion of net income the year before. Since the start of 2006, Bear's
stock had risen nearly 25 percent, closing at $143.50 on April 17. Cayne's compensation for 2005 was $25.1 million, and his nearly 6.8 million shares of Bear Stearns stock were worth $972 million at that moment.

A
S
P
AUL
F
RIEDMAN
knew well, Ralph Cioffi was a highly regarded salesman but short on managerial skills. In a pattern that Friedman had witnessed firsthand from Cioffi's time as a manager in the fixed-income department, in 2006 Cioffi's awkwardly named High-Grade Structured Credit Strategies Fund started getting very sloppy in its paperwork regarding trades (securities bought and sold) between the hedge fund and Bear Stearns's investment bank and broker-dealer. In its offering memoranda regarding the establishment of the hedge fund, BSAM assured its High-Grade Fund investors that when Cioffi traded with Bear Stearns, the “Fund's operating procedure required disclosure, consent, and approval before the deal could be settled,” according to an administrative complaint filed by the Commonwealth of Massachusetts against BSAM. “Unbeknownst to investors, the very controls and procedures established to safeguard their interests did not survive the daily ordeals of trading and managing and leveraging. Investors who sought to take advantage of the inimitable risk management reputation of Bear Stearns found themselves in a highly complex hedge fund investment program that relied on overworked junior personnel to manage a conflict reporting process required by federal law.” The problem was that Cioffi had failed to get the approval of the fund's independent, unaffiliated directors before it bought securities from its Bear Stearns affiliate. In 2003, 18 percent of Cioffi's transactions failed to be properly approved. By 2006, 79 percent of his transactions with affiliates had not received approval—a technicality, to be sure, but a violation that was against federal law and that went to the heart of proper disclosure to investors.

“There was a watershed moment during the summer of 2006,” Friedman said, “when the compliance people said to Ralph, ‘You're not getting the trades approved correctly.' There were two parts to it. One is ‘You're not getting the preapprovals on trades with Bear Stearns,' and two, ‘By the way, you shouldn't be trading with Bear Stearns anyway,' and again, what a shock. Ralph had done hundreds of trades with Bear Stearns and he forgot this little thing called getting his paperwork done. It's classic Ralph. Details were just not his best trick, and equally startling was that BSAM didn't have a process to pick up on it, because it really shouldn't have been Ralph's responsibility to oversee himself. How did BSAM miss it for a year? It was hundreds of trades. How did they miss it? I've never understood.”

The problem was that Cioffi made the task of disclosing these transactions and seeking approval for them “a low-priority task for junior assistants,” according to the Massachusetts complaint. From the official start of Cioffi's fund, in October 2003, Joanmarie Pusateri, who had been at Bear Stearns since June 1986, was responsible for administrative and operational tasks, including obtaining written approval for trades with affiliates that were rife with potential for conflict of interest. Pusateri knew that she had to get the approvals on a timely basis but did not know that failure to do so was a violation of federal law. Neither Cioffi nor Tannin had informed her of the section of the Investment Advisers Act of 1940 that explained that it would be unlawful to make a trade with a client “without disclosing to such client in writing before the completion of such transaction the capacity in which he is acting and obtaining the consent of the client to such transaction.”

She also did not know why obtaining such approvals from the fund's independent directors was essential for trades between Cioffi's hedge fund and Bear Stearns. At one point during 2004, Pusateri met with a BSAM compliance officer who informed her that she had failed to get the requisite approval for between ten and twenty affiliated trades, and she took steps to obtain the missing consents. The fact that she didn't fully understand the reasons for obtaining these approvals “caused confusion among her delegates,” one of whom was Jessica Borenkind, a sales assistant to whom Pusateri assigned the task of getting approvals. But Borenkind was no better at getting the necessary approvals than was Pusateri. Once a month BSAM compliance would send Borenkind a spreadsheet showing where she had failed to get the required approvals. Of course, by then, all the trades listed had cleared and settled, so each of her clerical failures represented a violation of the law. Borenkind left Bear Stearns by “mutual agreement” on November 20, 2006. In the fall of 2005, Cioffi hired Richard Bierbaum as a trading assistant and gave him the task of getting the trading approvals, although he had never been responsible for such a job before. As Bierbaum explained, “In sort of the daily triage of the work dynamic, at first I didn't believe it to be very important.” At the end of 2005, Bierbaum was placed on “a two-month probation” because he was “overworked” and unable to get his work done on a timely basis. He left Bear Stearns voluntarily three days before his colleague Borenkind.

In early 2006, before they left Bear Stearns, Borenkind and Bierbaum met with Marisol Farley, from BSAM compliance, who informed them that the Investment Advisers Act required them to get the necessary approvals before the trades settled. During the summer of 2006, in
a “scare meeting,” BSAM compliance put more pressure on Cioffi's team to comply, and it was then that Borenkind learned that even one missing approval “could have serious legal repercussions.” Of the 2,300 trades the hedge fund had done between the start of the fund and 2006 that required prior approvals, 47 percent were not properly approved in advance.