Inside Job (12 page)

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.

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

W
E 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 cretinously 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.