mortgage backed

THE GRIFT IN America always starts out with a little hum on the airwaves, some kind of dryly impersonal appeal broadcast over the skies from a high tower, an offer to sell something—help, advice, a new way of life, a friend at a time of need, the girl of your dreams. This is the way the ordinary American participates in this democracy: he buys. Most of us don’t vote more than once every four years, but we buy stuff every day. And every one of those choices registers somewhere, high up above, in the brain of the American Leviathan.
Back in early 2005 a burly six-foot seven-inch black sheriff’s deputy named Eljon Williams was listening to the radio on the way home from his nightmare job wrestling with Boston-area criminals at the city’s notorious South Bay House of Correction. The station was WILD, Boston’s black talk-radio station, which at the time featured broadcasts by Al Sharpton and the Two Live Stews sports radio show. While driving Williams heard an interview with a man named Solomon Edwards,* a self-described mortgage expert, who came on the air to educate the listening public about a variety of scams that had been used of late to target minority homebuyers.
Williams listened closely. He had some questions about the mortgage he held on his own three-decker home in Dorchester, a tough section of Boston. Williams rented out the first and third floors of his house and lived in the middle with his wife and his son, but he was thinking of moving out and buying a new home. He wondered if he should maybe get some advice before he made the move. He listened to the end of the broadcast, jotted down Edwards’s number, and later gave him a call.
He made an appointment with Edwards and went to meet him. “Nice young black man, classy, well-dressed,” Williams recalls now. “He was the kind of guy I would have hung out with, could have been friends with.”
In fact, they did become friends. Edwards, Williams recalled, took a look at the mortgage on the three-decker and did indeed find some irregularities. He told Williams about RESPA, the Real Estate Settlement Procedures Act, designed to prevent scam artists from burying hidden commissions in the closing costs for urban and low-income homebuyers in particular. And Edwards found some hidden costs in Eljon’s mortgage and helped him get some of that money back. “He saved me money,” Williams recalls now. “I really trusted him.”
Edwards ended up getting so close to Williams that he came over to his house from time to time, even stopping by for his son Eljon Jr.’s birthday party. (“Even brought a present,” Williams recalls.) In their time together Edwards sold Williams on the idea that he was an advocate for the underprivileged. “He would talk to me about how a rich man doesn’t notice when a biscuit is stolen from his cupboard, but a poor man does,” he says now. “He had the whole rap.”
Fast-forward a year. Williams and his wife decide to make their move. They find a small two-bedroom home in Randolph, a quiet middle-class town a little farther outside Boston. Williams had a little money saved up, plus the proceeds from the sale of his three-decker, but he still needed a pair of loans to buy the house, an 80/20 split, with the 80 percent loan issued by a company called New Century, and the 20 issued by a company called Ocwen.
Edwards helped him get both loans, and everything seemed kosher. “I was an experienced homeowner,” Williams recalls. “I knew the difference between a fixed-rate mortgage and an adjustable-rate mortgage. And I specifically asked him, I made sure, that these were fixed-rate mortgages.”
Or so he thought. The Williamses moved in to their new home and immediately fell into difficulty. In late 2006, Eljon’s wife, Clara Bernardino, was diagnosed with ovarian cancer. She was pregnant at the time. Urgent surgery was needed to save her life and her baby’s life, and the couple was for a time left with only Eljon’s income to live on. Money became very, very tight—and then the big hammer dropped.
In mid-2007 the family got a notice from ASC (America’s Servicing Company), to whom New Century had sold their 80 percent loan. New Century by then was in the process of going out of business, its lenders pulling their support and its executives under federal investigation for improper accounting practices, among other things—but that’s another story. For now, the important thing was that Eljon and Clara woke up one morning in June 2007 to find the following note from ASC in their mailbox:
This notice is to inform you of changes to your adjustable rate mortgage loan interest rate and payment …
The principal and interest due on your loan will be adjusted from $2,123.11 to $2,436.32…
Effective with your August 01, 2007 payment your interest rate will be adjusted from 7.225% to 8.725% …
Eljon, not yet completely flipping out, figured a mistake had been made. He called up Edwards, who was “weird” on the phone at first, mumbling and not making sense. When Eljon insisted that it was not possible that their mortgage was adjustable, since Edwards himself had told them it was fixed, Edwards demurred, saying he, Eljon, was wrong, that it was adjustable and he’d been told that.
Soon after that, Edwards stopped answering his phone. And soon after that, Edwards disappeared entirely. He was no longer at his office, he was no longer anywhere on earth. And the Williamses were left facing cancer, a newborn baby, and foreclosure. They subsequently found out that Edwards had taken more than $12,000 in commissions through their house deal—among other things by rigging the appraisal. Edwards, it turned out, was the appraiser. This long-conning grifter had taken a perfectly decent, law-abiding, hardworking person and turned him and his mortgage into a time bomb—a financial hot potato that he’d managed to pass off before the heat even hit his fingers.
Realizing that he’d been scammed, Eljon now went into bunker mode. He called everyone under the sun for help, from the state attorney general to credit counselors to hotlines like 995-HOPE. At one point he called ASC and, in an attempt to convince them to modify their loan, simply begged, telling them about his wife’s bout with cancer, the dishonest loan, their situation in general. “I offered to bring them documentation from the doctors, proof that we were in this spot because of a medical emergency, that what they were doing would put us into a life-and-death situation,” he says. “And they were like, ‘Whatever.’ They just didn’t care, you know.”
The family missed several payments and were, technically, in default. Williams dug in and prepared for an Alamo-like confrontation. “I would have barricaded myself in the house,” he says. “I was not leaving. Not for anything.”
In the end … but let’s leave the end for later. Because that’s where the story gets really ugly.
Every country has scam artists like Solomon Edwards, but only in a dying country, only at the low end of the most distressed third world societies, are people like that part of the power structure. That’s what makes the housing bubble that burst all over Eljon Williams so extraordinary. If you follow the scam far enough, it will literally go all the way to the top. Solomon Edwards, it turns out, is not an aberration, not even a criminal really, but a kind of agent of the highest powers in the land, on whose behalf the state was eventually forced to intercede, in the fall of 2008, on a gigantic scale—in something like a quiet coup d’état.
At the lower levels anyway, the subprime market works almost exactly like a Mafia protection racket.
Anyone who’s seen Goodfellas knows how it works. A mobster homes in on a legit restaurant owner and maxes out on his credit, buying truckloads of liquor and food and other supplies against his name and then selling the same stuff at half price out the back door, turning two hundred dollars in credit into one hundred dollars in cash. The game holds for two or three months, until the credit well runs dry and the trucks stop coming—at which point you burn the place to the ground and collect on the insurance.
Would running the restaurant like a legit business make more money in the long run? Sure. But that’s only if you give a fuck. If you don’t give a fuck, the whole equation becomes a lot simpler. Then every restaurant is just a big pile of cash, sitting there waiting to be seized and blown on booze, cars, and coke. And the marks in this game are not the restaurant’s customers but the clueless, bottomless-pocketed societal institutions: the credit companies, the insurance companies, the commercial suppliers extending tabs to the mobster’s restaurant.
In the housing game the scam was just the same, only here the victims were a little different. It was an ingenious, almost impossibly complex sort of confidence game. At the bottom end of the predator chain were the brokers and mortgage lenders, raking in the homeowners, who to the brokers were just unwitting lists of credit scores attached to a little bit of dumb fat and muscle. To the brokers and lenders, every buyer was like a restaurant to a mobster—just a big pile of cash waiting to be seized and liquidated.
The homeowner scam was all about fees and depended upon complex relationships that involved the whole financial services industry. At the very lowest level, at the mortgage-broker level, the game was about getting the target homeowner to buy as much house as he could at the highest possible interest rates. The higher the rates, the bigger the fees for the broker. They greased the homeowners by offering nearly unlimited sums of cash.
Prior to 2002, when so-called subprime loans were rare (“subprime” just refers to anyone with a low credit score, in particular anyone with a score below 660; before 2002 fewer than $100 billion worth of mortgages a year were to subprime borrowers), you almost never had people without jobs or a lengthy income history buying big houses. But that all changed in the early part of this decade. By 2005, the year Eljon bought his house, fully $600 billion worth of subprime mortgage money was being lent out every year. The practice of giving away big houses to people with no money became so common that the industry even coined a name for it, NINJA loans, meaning “no income, job, or assets.”
A class-action lawsuit against Washington Mutual offered a classic example. A Mexican immigrant named Soledad Aviles with no English skills, who was making nine dollars an hour as a glass cutter, was sold a $615,000 house, the monthly payments for which represented 96 percent of his take-home income. How did that loan go through? Easy: the lender simply falsified the documentation, giving Aviles credit for $13,000 a month in income.
The falsification mania went in all directions, as Eljon and Clara found out. On one hand, their broker Edwards doctored the loan application to give Clara credit for $7,000 in monthly income, far beyond her actual income; on the other hand, Edwards falsified the couple’s credit scores downward, putting them in line for a subprime loan when they actually qualified for a real, stable, fixed bank loan. Eljon and his wife actually got a worse loan than they deserved: they were prime borrowers pushed down into the subprime hell because subprime made the bigger commission.
It was all about the commissions, and the commissions were biggest when the mortgage was adjustable, with the so-called option ARM being particularly profitable. Buyers with option-ARM mortgages would purchase their houses with low or market loan rates, then wake up a few months later to find an adjustment upward—and then perhaps a few years after that find another adjustment. The jump might be a few hundred dollars a month, as in the case of the Williams family, or it might be a few thousand, or the payment might even quadruple. The premium for the brokers was in locking in a large volume of buyers as quickly as possible.
Both the lender and the broker were in the business of generating commissions. The houses being bought and sold and the human borrowers moving in and out of them were completely incidental, a tool for harvesting the financial crop. But how is it possible to actually make money by turning on a fire hose and blasting cash by the millions of dollars into a street full of people with low credit scores?
This is where the investment banks came in. The banks and the mortgage lenders had a tight symbiotic relationship. The mortgage guys had a job in this relationship, which was to create a vast volume of loans. In the past those great masses of loans would have been a problem, because nobody would have wanted to sit on millions’ worth of loans lent out to immigrant glass cutters making nine dollars an hour.
Enter the banks, which devised a way out for everybody. A lot of this by now is ancient history to anyone who follows the financial story, but it’s important to quickly recap in light of what would happen later on, in the summer of 2008. The banks perfected a technique called securitization, which had been invented back in the 1970s. Instead of banks making home loans and sitting on them until maturity, securitization allowed banks to put mortgages into giant pools, where they would then be diced up into bits and sold off to secondary investors as securities.
The securitization innovation allowed lenders to trade their long-term income streams for short-term cash. Say you make a hundred thirty-year loans to a hundred different homeowners, for $50 million worth of houses. Prior to securitization, you couldn’t turn those hundred mortgages into instant money; your only access to the funds was to collect one hundred different meager payments every month for thirty years. But now the banks could take all one hundred of those loans, toss them into a pool, and sell the future revenue streams to another party for a big lump sum—instead of making $3 million over thirty years, maybe you make $1.8 million up front, today. And just like that, a traditionally long-term business is turned into a hunt for short-term cash.
But even with securitization, lenders had a limiting factor, which was that even in securitized pools, no one wanted to buy mortgages unless, you know, they were actually good loans, made to people unlikely to default.
To fix that problem banks came up with the next innovation—derivatives. The big breakthrough here was the CDO, or collateralized debt obligation (or instruments like it, like the collateralized mortgage obligation). With these collateralized instruments, banks took these big batches of mortgages, threw them into securitized pools, and then created a multitiered payment structure.
Imagine a box with one hundred home loans in it. Every month, those one hundred homeowners make payments into that box. Let’s say the total amount of money that’s supposed to come in every month is $320,000. What banks did is split the box up into three levels and sell shares in those levels, or “tranches,” to outside investors.
All those investors were doing was buying access to the payments the homeowners would make every month. The top level is always called senior, or AAA rated, and investors who bought the AAA-level piece of the box were always first in line to get paid. The bank might say, for instance, that the first $200,000 that flowed into the box every month would go to the AAA investors.
If more than $200,000 came in every month, in other words if most of the homeowners did not default and made their payments, then you could send the next payments to the B or “mezzanine”-level investors—say, all the money between $200,000 and $260,000 that comes into the box. These investors made a higher rate of return than the AAA investors, but they also had more risk of not getting paid at all.
The last investors were the so-called “equity” investors, whose tranche was commonly known as toxic waste. These investors only got their money if everyone paid their bills on time. They were more likely to get nothing, but if they did get paid, they’d make a very high rate of return.
These derivative instruments allowed lenders to get around the loan-quality problem by hiding the crappiness of their loans behind the peculiar alchemy of the collateralized structure. Now the relative appeal of a mortgage-based investment was not based on the individual borrower’s ability to pay over the long term; instead, it was based on computations like “What is the likelihood that more than ninety-three out of one hundred homeowners with credit scores of at least 660 will default on their loans next month?”
These computations were highly subjective and, like lie-detector tests, could be made to say almost anything the ratings agencies wanted them to say. And the ratings agencies, which were almost wholly financially dependent upon the same big investment banks that were asking them to rate their packages of mortgages, found it convenient to dole out high ratings to almost any package of mortgages that crossed their desks.
Most shameful of all was the liberal allotment of investment-grade ratings given to combinations of subprime mortgages. In a notorious example, Goldman Sachs put together a package of 8,274 mortgages in 2006 called GSAMP Trust 2006-S3. The average loan-to-value in the mortgages in this package was an astonishing 99.21 percent. That meant that these homeowners were putting less than 1 percent in cash for a down payment—there was virtually no equity in these houses at all. Worse, a full 58 percent of the loans were “no-doc” or “low-doc” loans, meaning there was little or no documentation, no proof that the owners were occupying the homes, were employed, or had access to any money at all.
This package of mortgages, in other words, was almost pure crap, and yet a full 68 percent of the package was given an AAA rating, which technically means “credit risk almost zero.” This was the result of the interdependent relationship between banks and the ratings agencies; not only were the ratings agencies almost totally dependent financially on the very banks that were cranking out these instruments that needed rating, they also colluded with the banks by giving them a road map to game the system.
“The banks were explicitly told by ratings agencies what their models required of the banks to obtain a triple-A rating,” says Timothy Power, a London-based trader who worked with derivatives. “That’s fine if you’re telling a corporation that they need to start making a profit or you’ll downgrade them. But when we’re in the world of models and dodgy statistics and a huge incentive to beat the system, you just invite disaster.”
The ratings agencies were shameless in their explanations for the seemingly inexplicable decision to call time-bomb mortgages risk free for years on end. Moody’s, one of the two agencies that control the vast majority of the market, went public with one of the all-time “the dog ate my homework” moments in financial history on May 21, 2008, when it announced, with a straight face, that a “computer error” had led to a misclassification of untold billions (not millions, billions) of junk instruments. “We are conducting a thorough review of the matter,” the agency said.
It turns out the company was aware of the “error” as early as February 2007 and yet continued overrating the crap instruments (specifically, they were a beast called constant proportion debt obligations) with the AAA label through January 2008, during which time senior management pocketed millions in fees.
Why didn’t it fix the grade on the misrated instruments? “It would be inconsistent with Moody’s analytical standards and company policies to change methodologies in an effort to mask errors,” the company said. Which translates as: “We were going to keep this hidden forever, except that we got outed by the Financial Times.”
In this world, everybody kept up the con practically until they were in cuffs. It made financial sense to do so: the money was so big that it was cost-efficient (from a personal standpoint) for executives to chase massive short-term gains, no matter how ill-gotten, even knowing that the game would eventually be up. Because you got to keep the money either way, why not?
There is an old Slavic saying: one thief sits on top of another thief and uses a third thief for a whip. The mortgage world was a lot like that. At every level of this business there was some sort of pseudo-criminal scam, a transaction that either bordered on fraud or actually was fraud. To sort through all of it is an almost insanely dull exercise to anyone who does not come from this world, but the very dullness and complexity of that journey is part of what made this cannibalistic scam so confoundingly dependable.
The process starts out with a small-time operator like Solomon Edwards, who snares you, the schmuck homeowner, and slaps your name on a loan that gets sent up the line. In league with Edwards is the mortgage lender, the originator of the loan, who like Edwards is just in it for the fees. He lends you the money and immediately looks for a way to sell that little stake in you off to a big national or international investment bank—whose job it is to take that loan of yours and toss it into a big securitized pool, where it can then be chopped up and sold as securities to the next player in the sequence.
This was a crucial stage in the process. It was here that the great financial powers of this country paused and placed their bets on the various classes of new homeowner they’d created with this orgy of new lending. Amazingly, these bigger players, who ostensibly belonged to the ruling classes and were fighting over millions, were even more dishonest and underhanded and petty than the low-rent, just-above-street-level grifters who bought cheap birthday presents for the kids of the Eljon Williamses of the world in pursuit of a few thousand bucks here and there.
A trader we’ll call Andy B., who worked at one of those big investment banks and managed one of these mortgage deals, describes the process. In the waning months of the boom, in the early part of 2007, Andy was put in charge of a monster deal, selling off a billion-dollar pool of securitized mortgages. Now retired from not only that bank but from banking altogether, he can talk about this deal, which at the time was one of the great successes in his career.
A big, garrulous family man with a wicked sense of humor, Andy B. had, for most of his career, been involved in fairly run-of-the-mill work, trading in CMOs, or collateralized mortgage obligations—“that’s like noncredit stuff, just trading around on interest-rate risk,” he says, “the blocking-the-tackle work of Wall Street.” But in the years leading up to the financial crisis he took a new job at a big bank and suddenly found himself in charge of a giant deal involving option-ARM mortgages, something he had almost no experience with.
“Option ARMs used to be a wealthy person’s product,” he explains now. “It was for people who had chunky cash flows. For instance, on Wall Street you get paid a bonus at the end of the year,” he said, describing one of the option ARM’s traditional customer profiles, “so I’ll pay a little now, but at the end of the year I’ll pay down the principal, true everything up—a wealthy person’s product. Then it became the ultimate affordability product.”
The option ARM evolved into an arrangement where the homebuyer could put virtually nothing down and then have a monthly payment that wasn’t just interest only, but, in some cases, less than interest only. Say the market interest rate was 5 percent; you could buy a house with no money down and just make a 1 percent payment every month, for years on end. In the meantime, those four points per month you’re not paying just get added to the total amount of debt. “The difference between that 5 percent and the 1 percent just gets tacked on later on in the form of a negative amortization,” Andy explains.
Here’s how that scenario looks: You buy a $500,000 house, with no money down, which means you take out a mortgage for the full $500,000. Then instead of paying the 5 percent monthly interest payment, which would be $2,500 a month, you pay just $500 a month, and that $2,000 a month you’re not paying just gets added to your mortgage debt. Within a couple of years, you don’t owe $500,000 anymore; now you owe $548,000 plus deferred interest. “If you’re making the minimum payment, you could let your mortgage go up to 110 percent, 125 percent of the loan value,” says Andy. “Sometimes it went as high as 135 percent or 140 percent. It was crazy.”
In other words, in the early years of this kind of mortgage, you the homeowner are not actually paying off anything—you’re really borrowing more. It was this perverse reality that, weirdly enough, made Andy’s collection of mortgages more attractive to other buyers.
Again, in the kind of tiered deal that was used to pool these mortgages, Andy had to find buyers for three different levels of the pool—the “senior” or AAA stuff at the top, the B or “mezzanine” stuff in the middle, and the unrated “equity” or “toxic waste” portion at the bottom. (In reality each of these levels might in turn have been broken down into three or more sublevels, but the basic structure was threefold: senior, mezzanine, equity.)
Selling the AAA stuff was never a problem, because there was no shortage of institutional investors and banks that needed large percentages of AAA-rated investments in their portfolios in order to satisfy regulatory requirements. And since the AAA-rated slices of these mortgage deals paid a much higher rate of return than traditional AAA investments like Treasury bills, it was not at all hard to find homes for that section of the deal.
Selling the mezzanine level or “tranche” of the deal was another story, one outrageous enough in itself—but let’s just say for now that it wasn’t a problem, that a trader like Andy B. would always be able to find a home for that stuff.
That left the bottom tier. The key to any of these huge mortgage deals was finding a buyer for this “equity” tranche, the so-called toxic waste. If the investment banks could sell that, they could make huge up-front money on these deals. In the case of the $1 billion pool of mortgages Andy was selling, the toxic waste represented the homeowners in the pool who were the worst risks—precisely the people buying those insane negative amortization mortgage deals, making 1 percent payments against a steadily growing debt nut, borrowing against money they had already borrowed.
But Andy was fortunate: there were indeed clients out there who had some appetite for toxic waste. In fact, they were friends of his, at a hedge fund. “There were two companies that were buying tons of this stuff, Deutsche Bank and this hedge fund,” he says now. “These were smart guys. In fact, [the hedge fund guys] taught me about tiering this kind of risk—they were actually teaching my traders as we were buying these packages.”
The reason this hedge fund wanted to buy the crap at the bottom was that they’d figured that even a somewhat lousy credit risk could make a 1 percent monthly payment for a little while. Their strategy was simple: buy the waste, cash in on the large returns for a while (remember, the riskier the tranche, the higher rate of return it pays), and hope the homeowners in your part of the deal can keep making their pathetic 1 percent payments just long enough that the hedge fund can eventually unload their loans on someone else before they start defaulting. “It was a timing game,” Andy explains. “They figured that these guys at the bottom would be able to make their payments even later than some of the guys higher up in the deal.”
Before we even get to why these “smart guys” got it wrong, it’s worth pointing out how consistent the thinking is all along this chain. Everybody involved is thinking short-term: Andy’s hedge fund clients, Andy himself and his bank, certainly the originator-lender, and in many cases even the homeowner—none of them actually believed that this or that subprime loan was going to make it to maturity, or even past 2008 or 2009. Everybody involved was, one way or another, making a bet not on whether or not the loan would default, but when (and specifically when in the near future) it would default. In the transaction between Andy and his hedge fund clients, Andy was betting short and his clients were betting long, “long” in this case being a few months or maybe a year. And even that proved to be too long in that market.
Meanwhile a lot of the homeowners taking out these loans were buying purely as a way of speculating on housing prices: their scheme was to keep up those 1 percent payments for a period of time, then flip the house for a profit before the ARM kicked in and the payments adjusted and grew real teeth. At the height of the boom this process in some places was pushed to the level of absurdity. A New Yorker article cited a broker in Fort Myers, Florida, who described the short resale history of a house that was built in 2005 and first sold on December 29, 2005, for $399,600. It sold the next day for $589,900. A month later it was in foreclosure and the real estate broker bought it all over again for $325,000. This clearly was a fraudulent transaction of some kind—the buyers on those back-to-back transactions were probably dummy buyers, with the application and appraisal process rigged somehow (probably with the aid of a Solomon Edwards type) to bilk the lenders, which in any case probably didn’t mind at all and simply sold off the loans immediately, pocketing the fees—but this is the kind of thing that went on. The whole industry was infested with scam artists.
Neither Andy nor his clients were even aware of the degree of that infestation, which was their crucial mistake. In this new world they should’ve realized they could no longer trust anything, not even the most seemingly solid pillars of the traditional lending infrastructure.
For example, part of the reason Andy’s hedge fund clients had such faith in these homeowners in the toxic-waste tranche is that their credit scores weren’t so bad. As most people know, the scores used in the mortgage industry are called FICO scores and are based on a formula invented back in the late fifties by an engineer named Bill Fair and a mathematician named Earl Isaac. The Fair Isaac Corporation, as their company was eventually called, created an algorithm that was intended to predict a home loan applicant’s likelihood of default. The scores range from 300 to 850, with the median score being 723 at this writing. Scores between 620 and 660 are considered subprime, and above 720 is prime; anything in between is considered “Alt-A,” a category that used to be a catchall term for solid borrowers with nontraditional jobs, but which morphed into something more ominous during the boom.
Wall Street believed in FICO scores and over the years had put a lot of faith in them. And if you just looked at the FICO scores, the homeowners in Andy’s deal didn’t look so bad.
“Let’s say the average FICO in the whole deal, in the billion dollars of mortgages, was 710,” Andy says. “The hedge fund guys were getting the worst of the worst in the deal, and they were getting, on average, 675, 685 FICO. That’s not terrible.”
Or so they thought. Andy’s bank assembled the whole billion-dollar deal in February 2007; Andy ended up selling the bottom end of the pool to these hedge fund clients for $30 million in May. That turned out to be just in the nick of time, because almost immediately afterward, the loans started blowing up. This was doubly bad for Andy’s clients, because they’d borrowed half of the money to buy this crap … from Andy’s bank.
“Yeah, we financed fifteen million dollars of it to them at a pretty attractive rate,” he recalls. Which for Andy’s clients wasn’t even enough, apparently, compared to other similar deals they’d done. “We’re lending fifty percent, and they’re getting better rates from other guys. Like they’re bitching about us only giving fifty percent.”
But now all that borrowing would come back to kill them. “So now they’ve got all this leverage, and the loans start coming on line,” Andy says. “And we’re noticing there are guys going delinquent. And we’re thinking, why are they going delinquent? They only have to make a one-percent payment!”
It turns out that the FICO scores themselves were a scam. A lot of the borrowers were gaming the system. Companies like TradeLine Solutions, Inc., were offering, for a $1,399 fee, an unusual service: they would attach your name to a credit account belonging to some stranger with a perfect credit history, just as the account was about to close. Once this account with its perfect payment history was closed, it could add up to 45 points to your score. TradeLine CEO Ted Stearns bragged on the company’s website: “There is one secret the credit scoring granddaddy and the credit bureaus do not want you to know: Good credit scores can be bought!”
In an alternative method, an applicant would take out five new credit cards with $5,000 limits and only run a $100 balance. “So FICO goes, oh, this guy’s got $25,000 of available credit, and he’s only drawing down $500,” Andy explains. “He’s very liquid.”
What was happening, it turned out, was that many of these people with their souped-up credit scores had bought their houses purely as speculative gambles—and once they saw home prices start to go down, they abandoned ship rather than pay even the meager 1 percent payment. Andy’s hedge fund clients were toast, and within a few months they were selling huge chunks of their portfolio to raise cash to cover their losses in the deal. “I’m looking at [the list of the holdings up for sale], and I’m thinking, they’re done,” recalls Andy.
Even crazier was how Andy sold off the middle tranche of the pool. The AAA portion was never really a problem to sell, as the institutional investors like pension funds back then had a nearly unlimited appetite for the less-risky part of these deals. And the bottom of the deal, the toxic stuff, he’d sold off to his hedge fund guys. “I’m kind of stuck with the middle pieces,” says Andy.
Which theoretically was a problem, because who wanted the middle portion of a billion-dollar package of option-ARM mortgages? After all, the market for this portion—the mezzanine—was kind of limited. “The AAA guy can’t buy them, because they’re only triple-B, and the hedge funds, there’s not enough juice in them to buy that stuff,” says Andy.
So what did they do with the BBB part? That’s easy: they re-rated it as AAA paper!
How? “They would take these BBBs, and then take the BBBs from the last five deals or so,” says Andy, “and put it into a CDO squared.”
What’s a CDO squared? All it is is a CDO full of … other CDOs!
It’s really an awesome piece of financial chicanery. Say you have the BBB tranche from that first deal Andy did. You lump it in with the BBB tranches from five, six, seven other deals. Then you just repeat the same tiering process that you started with, and you say, “Well, the first hundred thousand dollars of the revenue from all these BBB tiers that goes into the box every month, that goes to the AAA investors in this new CDO.”
“And now the ratings agencies would say, okay, let’s do a first, second, and third loss,” referring to the same three-part structure of the overall pool, “and now let’s call seventy percent of these AAA,” says Andy.
This sounds complicated, but all you have to do is remember the ultimate result here. This technique allowed Andy’s bank to take all the unsalable BBB-rated extras from these giant mortgage deals, jiggle them around a little using some mathematical formulae, and—presto! All of a sudden 70 percent of your unsalable BBB-rated pseudo-crap (“which in reality is more like B-minus-rated stuff, since the FICO scores aren’t accurate,” reminds Andy) is now very salable AAA-rated prime paper, suitable for selling to would-be risk-avoidant pension funds and insurance companies. It’s the same homeowners and the same loans, but the wrapping on the box is different.
“You couldn’t make this stuff up if you tried, in your most diabolical imagination,” says Andy now.
But it wasn’t the toxic waste or the mezzanine deals that blew up the financial universe. It was the AAA-rated tiers of the mortgage-backed deals that crushed America’s financial hull, thanks to an even more sophisticated and diabolical scam perpetrated by some of the wealthiest, most powerful people in the world.
At around the same time Andy was doing his billion-dollar deal, another trader at a relatively small European bank—let’s call him Miklos—stumbled on to what he thought, at first, was the find of a lifetime.
“So I’m buying bonds,” he says. “They’re triple-A, supersenior tranche bonds. And they’re paying, like, LIBOR plus fifty.”
Jargon break:
LIBOR, or the London Interbank Offered Rate, is a common reference tool used by bankers to determine the price of borrowing. LIBOR refers to the interest rate banks in London charge one another to borrow unsecured debt. The “plus” in the expression “LIBOR plus,” meanwhile, refers to the amount over and above LIBOR that bankers charge one another for transactions, with the number after “plus” referring to hundredths of a percentage point. These hundredths of a point are called basis points.
So when Miklos says, “LIBOR plus fifty,” he means the rate London banks charge to borrow money from one another, plus 0.50 percent more. If the LIBOR rate is 0.50 percent that day, then LIBOR plus fifty means, basically, 1 percent interest.
So Miklos was buying the AAA portions of deals like Andy’s at LIBOR plus fifty, and all you really need to know about that price is that it is slightly higher than what he would have been paying back then for a Treasury bill. The whole bubble game in the years leading up to the financial meltdown was driven by this small difference in the yield between Treasuries, which are more or less absolutely safe, and the AAA-rated slices of these collateralized securities.
Why? Because what few regulations there are remaining are based upon calculations involving AAA-rated paper. Both banks and insurance companies are required by regulators to keep a certain amount of real capital on hand, to protect their depositors. Of course, these institutions do not simply hold their reserves in cash; instead, they hold interest-bearing investments, so that they can make money at the same time they are fulfilling their reserve obligations.
Knowing this, the banking industry regulators—in particular a set of bylaws called the Basel Accords, which all major banking nations adhere to—created rules to make sure that those holdings these institutions kept were solid. These rules charged institutions for keeping their holdings in investments that were not at least AAA rated. In order to avoid these capital charges, institutions needed to have lots of “safe” AAA-rated paper. And if you could find AAA-rated paper that earns LIBOR plus fifty, instead of buying the absolutely safe U.S. Treasury notes that might earn LIBOR plus twenty, well, then, you jumped on that chance—because that was 0.30 more percentage points you were making. In banks and insurance companies with holdings in the billions, that subtle discrepancy meant massive increases in revenue.
It was this math that drove all the reckless mortgage lending. Thanks to the invention of these tiered, mortgage-backed, CDO-like derivative deals, banks could now replace all the defiantly unsexy T-bills and municipal bonds they were holding to fulfill their capital requirements with much higher earning mortgage-backed securities. And what happens when most of the world’s major financial institutions suddenly start replacing big chunks of their “safe” reserve holdings with mortgage-backed securities?
To simplify this even more: The rules say that banks have to have a certain amount of cash on hand. And if not cash, something as valuable as cash. But the system allowed banks to use home loans as their reserve capital, instead of cash, Banks were therefore meeting their savings requirements by … lending. Instead of the banking system being buttressed by real reserve capital, it was buttressed by the promised mortgage payments of a generation of questionable homebuyers.
Everyone and his brother starts getting offered mortgages. At its heart, the housing/credit bubble was the rational outcome of a nutty loophole in the regulatory game. The reason Vegas cocktail waitresses and meth addicts in Ventura were suddenly getting offered million-dollar homes had everything to do with Citigroup and Bank of America and AIG jettisoning their once-safe AAA reserves, their T-bills and municipal bonds, and exchanging them for these mortgage-backed “AAA”-rated securities—which, as we’ve already seen, were sometimes really BBB-rated securities turned into AAA-rated paper through the magic of the CDO squared. And which in turn perhaps should originally have been B-minus-rated securities, because the underlying FICO scores of the homeowners in deals like Andy’s might have been fakes.
Getting back to the story: So Miklos is buying AAA bonds. These bonds are paying his bank LIBOR plus fifty, which isn’t bad. But it becomes spectacular when he finds a now-infamous third party, AIG, to make the deal absolutely bulletproof.
“So I’m getting LIBOR plus fifty for these bonds,” he says. “Then I turn around and I call up AIG and I’m like, ‘Hey, where would you credit default swap this bond?’ And they’re like, ‘Oh, we’ll do that for LIBOR plus ten.’ ”
Miklos pauses and laughs, recalling the pregnant pause on his end of the phone line as he heard this offer from AIG. He couldn’t believe what he’d just heard: it was either a mistake, or they had just handed him a mountain of money, free of charge.
“I hear this,” he says, “and I’m like, ‘Uh … okay. Sure, guys.’ ”
Here we need another digression. The credit default swap was a kind of insurance policy originally designed to get around those same regulatory capital charges. Ironically, Miklos had once been part of a famed team at JPMorgan that helped design the modern credit default swap, although the bank envisioned a much different use for them back then.
A credit default swap is just a bet on an outcome. It works like this: Two bankers get together and decide to bet on whether or not a homeowner is going to default on his $300,000 home loan. Banker A, betting against the homeowner, offers to pay Banker B $1,000 a month for five years, on one condition: if the homeowner defaults, Banker B has to pay Banker A the full value of the home loan, in this case $300,000.
So Banker B has basically taken 5–1 odds that the homeowner will not default. If he does not default, Banker B gets $60,000 over five years from Banker A. If he does default, Banker B owes Banker A $300,000.
This is gambling, pure and simple, but it wasn’t invented with this purpose. Originally it was invented so that banks could get around lending restrictions. It used to be that, in line with the Basel Accords, banks had to have at least one dollar in reserve for every eight they lent; the CDS was a way around that.
Say Bank A is holding $10 million in A-minus-rated IBM bonds. It goes to Bank B and makes a deal: we’ll pay you $50,000 a year for five years and in exchange, you agree to pay us $10 million if IBM defaults sometime in the next five years—which of course it won’t, since IBM never defaults.
If Bank B agrees, Bank A can then go to the Basel regulators and say, “Hey, we’re insured if something goes wrong with our IBM holdings. So don’t count that as money we have at risk. Let us lend a higher percentage of our capital, now that we’re insured.” It’s a win-win. Bank B makes, basically, a free $250,000. Bank A, meanwhile, gets to lend out another few million more dollars, since its $10 million in IBM bonds is no longer counted as at-risk capital.
That was the way it was supposed to work. But two developments helped turn the CDS from a semisensible way for banks to insure themselves against risk into an explosive tool for turbo leverage across the planet.
One is that no regulations were created to make sure that at least one of the two parties in the CDS had some kind of stake in the underlying bond. The so-called naked default swap allowed Bank A to take out insurance with Bank B not only on its own IBM holdings, but on, say, the soon-to-be-worthless America Online stock Bank X has in its portfolio. This is sort of like allowing people to buy life insurance on total strangers with late-stage lung cancer—total insanity.
The other factor was that there were no regulations that dictated that Bank B had to have any money at all before it offered to sell this CDS insurance. In other words, Bank A could take out insurance on its IBM holdings with Bank B and get an exemption from lending restrictions from regulators, even if Bank B never actually posted any money or proved that it could cover that bet. Wall Street is frequently compared by detractors to a casino, but in the case of the CDS, it was far worse than a casino—a casino, at least, does not allow people to place bets they can’t cover.
These two loopholes would play a major role in the madness Miklos was now part of. Remember, Miklos was buying the AAA-rated slices of tiered bonds like the ones Andy was selling, and those bonds were paying LIBOR plus fifty. And then he was turning around and buying default swap insurance on those same bonds for LIBOR plus ten.
To translate that into human terms, Miklos was paying one-tenth of a percentage point to fully insure a bond that was paying five-tenths of a percentage point. Now, the only reason a bond earns interest at all is because the person buying it faces the risk that it might default, but the bonds Miklos was buying were now 100 percent risk free. The four-tenths of a percentage point he was now earning on the difference between the bond and the default swap was pure, risk-free profit. This was the goose that laid the golden egg, the deal of the decade. Once he bought the AIG default swap protection on his bonds, Miklos couldn’t lose. The only thing to compare it to would be a racetrack whose oddsmakers got stoned and did their math wrong—imagine if you could put a dollar on all twenty horses in the Kentucky Derby and be guaranteed to make at least $25 no matter who wins the race. That’s what it’s like to buy bonds at LIBOR plus fifty that you can credit-default-swap at LIBOR plus ten.
“So I’ve basically got forty basis points in my pocket,” Miklos recalls, giggling even now. “It’s free money. I mean, I’m getting those forty basis points running, for the life of the bond.”
Making matters even more absurd, the bonds Miklos was buying were already insured; they had, built in to the bonds themselves, something called monoline insurance. Monoline insurance refers to the insurance provided by companies like Ambac and MBIA. These companies, for a fee, will guarantee that the buyer of the bond will receive all his interest and principal on time. Miklos’s bonds contained MBIA/Ambac insurance; in the event of a default, they were supposed to cover the bond.
So Miklos’s bond deal was, in a sense, almost triple insured. It was AAA rated to begin with. Then it had the monoline insurance built in to the bond itself. Then it had credit default swap insurance from AIG. And yet there was that four-basis-point spread, just sitting there. It was bizarre, almost like Wall Street had reached into Miklos’s office and started handing him money, almost without his even asking. Perhaps not coincidentally, it was very much like the situation for ordinary homeowners, who around the same time found themselves suddenly and inexplicably offered lots of seemingly free money. It sounded too good to be true—was it?
Miklos’s bank thought so. “It was so unreal, my bosses wouldn’t let me book this stuff as profit,” he recalls now. “They just didn’t believe it could be true. I explained it to them over and over, but they wouldn’t mark it as profit.”
That didn’t mean, however, that they didn’t want him to do more of those trades. But no sooner had Miklos tried to buy more of the bonds than he found that another, much bigger party had discovered his little secret. “Suddenly someone is buying like five hundred million dollars of this stuff and getting the same swap deal from AIG,” he says. “I’m getting blown out of the water.”
Miklos starts hearing that the other party is one of the top five investment banks on Wall Street. And the rumor is that the money behind the deals is “partner money”—that the higher-ups in the Wall Street colossus had caught on to this amazing deal and were buying it all up for themselves, with their personal money, via the firm’s proprietary trading desk. “They started tagging AIG with all of this stuff,” he recalls. “And we got squeezed out.”
So here’s the question: why would AIG do this? Andy, though not involved with that deal, has a theory.
“The question is, were they stupid—or were they just never intending to pay?” he asks.
Before we get to the final part of the story—the part that involves a meeting of the very highest officials in government and heads of the most powerful financial companies in the world colluding on one final, unprecedented, grand-scale heist—we have to back up just a little and talk about another continent of Wall Street scams. Because what happened with AIG, what brought the financial crisis to a head, was really an extraordinary merger of the two different schools of cutting-edge Wall Street scammery, taking place under the one roof of AIG.
One school was the part we’ve already seen, the credit default scam that Miklos tapped into. This was the monster created by a pinhead American financier named Joe Cassano, who was running a tiny unit within AIG called AIG Financial Products, or AIGFP (FP for short). Cassano, a beetle-browed, balding type in glasses, worked for years under Mike Milken at the notorious Drexel Burnham Lambert investment bank, the poster child for the 1980s era of insider manipulations. He moved to AIG in 1987 and helped set up AIGFP.
The unit originally dealt in the little-known world of interest rate swaps (which would later become notorious for their role in the collapse of countries like Greece and localities like Jefferson County, Alabama). But in the early part of this decade it moved into the credit default swap world, selling protection to the Mikloses and Goldman Sachses of the world, mainly for supersenior AAA-rated tranches of the tiered, structured deals of the type Andy put together.
How you view Cassano’s business plan largely depends on whether you think he was hugely amoral or just really stupid. Again, thanks largely to the fact that credit default swaps existed in a totally unregulated area of the financial universe—this was the result of that 2000 law, the Commodity Futures Modernization Act, sponsored by then-senator Phil Gramm and supported by then–Treasury chief Larry Summers and his predecessor Bob Rubin—Cassano could sell as much credit protection as he wanted without having to post any real money at all. So he sold hundreds of billions of dollars’ worth of protection to all the big players on Wall Street, despite the fact that he didn’t have any money to cover those bets.
Cassano’s business was rooted in the way these structured deals were set up. When investment banks assembled their pools of mortgages, they would almost always sell the high-yield toxic waste portions at the bottom of the deals as quickly as possible—few banks wanted to hold on to that stuff (although some did, to disastrous effect). But they would often keep the AAA-rated portions of the pools because they were useful in satisfying capital requirements. Instead of keeping low-yield Treasuries or municipal bonds to satisfy regulators that they had enough reserves on hand, banks could keep the AAA tranches of these mortgage deals and get a much higher rate of return.
Another thing that happened is that sometime around the end of 2005 and 2006, the banks started finding it harder to dump their excess AAA tranches on the institutional clients. So the banks ended up holding on to this stuff temporarily, in a practice known as warehousing. Theoretically, investment banks didn’t mind warehousing, because they earned money on these investments as they held them. But since they represented a somewhat larger risk of default than normal AAA investments (although, of course, this was not publicly conceded), the banks often went out and bought credit protection from the likes of Cassano to hedge their risk.
Banks like Goldman Sachs and Deutsche Bank were holding literally billions of dollars’ worth of these AAA-rated mortgage deals, and they all went to Cassano for insurance, offering to pay him premiums in exchange for a promise of compensation in the event of a default. The money poured in. In 1999, AIGFP only had $737 million in revenue. By 2005, that number jumped to $3.26 billion. Compensation at the tiny unit (which had fewer than five hundred employees total) was more than $1 million per person.
Cassano was thinking one of two things. Either he thought that these instruments would never default, or else he just didn’t care and never really planned to pay out in the event that they did. It’s probably the latter, for things worked out just fine for Cassano; he made $280 million in personal compensation over eight years and is still living in high style in a three-floor town house in Knightsbridge in London, while beyond his drawing room windows, out in the world, the flames keep kicking higher. Moreover, reports have also surfaced indicating that the Justice Department will not prosecute him.
That’s what Andy means when he asks if, in offering guys like Miklos their crazy insurance deals, AIG was being stupid, or whether they were just collecting premiums without ever intending to pay. It would fit perfectly with the narrative of the grifter era if it turned out to be the latter.
That was one scam AIG had running, and it was a big one. But even as Cassano was laying nearly $500 billion in bets with the biggest behemoths on Wall Street, there was another big hole opening on the other side of the AIG hull. This was in AIG’s Asset Management department, headed by yet another egomaniacal buffoon, this one by the name of Win Neuger.
Semi-notorious in insurance circles for his used-car-salesman/motivational-speaker rhetorical style, Neuger is a sixty-year-old executive who came up in AIG in the mid-1990s and, much like Cassano, spearheaded a major new profit-seeking initiative within the traditionally staid and boring insurance business. Via the magic of an internal memo system he whimsically called “Neuger Notes,” the executive set out a target for his two-thousand-plus employees: they were to make “one thousand million” dollars in annual profit, a nice round number Neuger liked to refer to as “ten cubed.”
In quest of that magical “ten cubed” number, Neuger wasn’t going to brook any dissent. In his Neuger Notes back in December 2005, Neuger wrote, “There are still some people who do not believe in our mission … If you do not want to be on this bus it is time to get off … Your colleagues are tired of carrying you along.”
How was he going to make that money? Again, just like Cassano, he was going to take a business that should have and could have been easy, almost risk-free money and turn it into a raging drunken casino.
Neuger’s unit was involved in securities lending. In order to understand how this business makes money, one first needs to understand some basic Wall Street practices, in particular short selling—the practice of betting against a stock.
Here’s how shorting works. Say you’re a hedge fund and you think the stock of a certain company—let’s call it International Pimple—is going to decline in value. How do you make money off that knowledge?
First, you call up a securities lender, someone like, say, Win Neuger, and ask if he has any stock in International Pimple. He says he does, as much as you want. You then borrow a thousand shares of International Pimple from Neuger, which let’s say is trading at 10 that day. So that’s $10,000 worth of stock.
Now, in order to “borrow” those shares from Neuger, you have to give him collateral for those shares in the form of cash. For his trouble, you have to pay him a slight markup, usually 1–2 percent of the real value. So perhaps instead of sending $10,000 to Neuger, you send him $10,200.
Now you take those thousand shares of International Pimple, you go out onto the market, and you sell them. Now you’ve got $10,000 in cash again. Then, you wait for the stock to decline in value. So let’s say a month later, International Pimple is now trading not at 10 but at 7½. You then go out and buy a thousand shares in the company for $7,500. Then you go back to Win Neuger and return his borrowed shares to him; he returns your $10,000 and takes the stock back. You’ve now made $2,500 on the decline in value of International Pimple, less the $200 fee that Neuger keeps. That’s how short selling works, although there are endless nuances. It’s a pretty simple business model from the short seller’s end. You identify securities you think will fall in value, you borrow big chunks of those securities and sell them, then you buy the same stock back after the value has plummeted.
But how does a securities lender like Neuger make money? Theoretically, with tremendous ease. The first step to being a successful securities lender is having lots and lots of securities. AIG had mountains of the stuff, through its subsidiary insurance companies, annuities, and retirement plans. An insurance company, after all, is just a firm that takes money from a policyholder and invests it in long-term securities. It then takes those mountains of securities and holds on to them as they appreciate over periods of years and years. The insurer makes money when the securities it buys with the policyholder’s money appreciate to the point that the company has something left over when it comes time to pay out policyholders’ claims.
It’s a good, solid business, but AIG wanted to make more money with those securities. So they formed a company that took those securities and lent them, en masse, to short sellers. From the point of view of the securities lender, the process is supposed to be simple and completely risk free. If you’re the lender, borrowers come to you for shares; you make money first of all because they pay you that 1–2 percent markup (called the general collateral, or GC, rate). You lend out a thousand shares, but the borrowers give you 102 percent of what those shares cost as collateral—that extra 2 percent is the GC rate, which you get really for nothing, just for having lots of securities to lend.
So now you’ve got all this cash, and you don’t know when you’re going to have to take back those securities you lent out, but the understanding is that it could be anytime and will usually be in the near future. So say Borrower A takes a thousand shares of International Pimple from you and gives you that $10,000 as collateral—you have to be prepared to take those thousand shares back and give him his money back at any time. Because of this, you normally don’t want to invest in anything risky at all, anything that requires a long commitment. After all, why bother? You can take that money, buy U.S. Treasury notes with it, twiddle your thumbs, and make nice money basically for free—without any risk at all.
“The collateral shouldn’t be subject to market volatility,” says David Matias of Vodia Capital, who notes that more conservative sec lenders basically only put their collateral into short-term, ironclad safe investments like U.S. Treasuries, because there’s no reason not to. “Say you can make a fifty bps spread [i.e., one-half of 1 percent]. That’s enormous in this business. If you’ve got $100 billion in collateral and you can make a fifty bps on an annualized basis … that’s like a half-a-billion-dollar business right there.”
That’s the way it’s supposed to work. If Win Neuger and AIG had just taken the mountain of securities their subsidiary life insurance companies held, lent it out on the market, taken that collateral and invested it in the usual boring stuff—Treasuries, for instance—they would have made a small fortune without any risk at all. But that isn’t what Win Neuger did, because Win Neuger is a moron.
What Neuger did, instead, is take that collateral and invest it in residential-mortgage-backed securities! In other words, he took cash and plunged it into the very risky, not-really-AAA AAA-rated securities that bankers like Andy were cranking out by the metric ton, thanks to the insane explosion of mortgage lending.
This was par for the course during an era when you could never really be entirely sure where your money was or how safe it was. The high yields that these structured deals were offering to investors proved a monster temptation to people up and down the financial services industry. Larry Tabb of the TABB Group, a financial advisory company, gives an example.
“So take me,” he says. “I own a bank account. The money for my payroll, it either stays in my account or earns no interest … So what my banker says is, why don’t we, every night, we’ll roll that into an interest-bearing account. And then the next morning you’ll get it back, and we’ll give you interest overnight on it. And I’m like, ‘Okay, that sounds wonderful.’
“So along comes the credit crisis,” he says, “and, being in the industry, I say, okay, well, what are these guys putting my money into? So I called up my bank and I say, what are you guys putting my overnight money into? And the answer is like, agency and agency-backed securities.* And I’m like, oh, how much interest are they getting me? Oh, about one percent a year. So these are toxic securities that you’re putting me into, and you’re giving me one percent interest.”
“Great. And how much were they making?” I ask.
“Exactly,” Tabb says, explaining that in the end he was left with two options—go without any additional interest, or put all his money at risk while getting ripped off by other bankers.
Neuger’s scheme was a variation on the same business model. They were taking cash collateral in the billions from all the major investment banks on earth—Deutsche, Goldman, Société Générale—and plunging it into the riskiest instruments imaginable. What’s especially crazy about what he did is that the nature of his business dictated that he should have stayed away from all but the very shortest-term investments, because the people he was lending his securities to might at any time have decided they wanted their collateral back.
But Neuger did just the opposite. He borrowed short, taking collateral that technically he had to be prepared to give back overnight, and invested long, in instruments that take ten, fifteen, thirty years to mature. This was a business model that only worked if new business was continually coming in—and we all know what that’s called.
“It’s kind of a Ponzi scheme, actually,” says Matias of Vodia Capital. “If your business is growing, that point at which you have to pay it back is postponed into the future. As long as your business is growing, you have more collateral, not less. But as soon as your business contracts, your collateral starts to decrease and you actually have to make good on that collateral payback. They were betting the money as if they had years to ride through the market. But they didn’t.”
So within AIG in the period leading up to the total collapse of the housing bubble, you had two major operations running that depended entirely on the continued insane inflation of that bubble. On one hand, Joe Cassano was selling billions of dollars in credit default swap protection to banks like Goldman and Deutsche Bank without having any money to cover those obligations. On the other hand, Win Neuger was lending out billions of dollars of securities to more or less the same customers, then taking the collateral he was getting in return and investing it in illiquid, residential-mortgage-backed, toxic securities.
This was the backdrop for the still largely secret events that took place during the weekend of September 14, 2008, when the government stepped in to rescue AIG and changed the face of the American economy forever.
The CDS insurance Joe Cassano was selling started to show cracks as early as 2005. The reason Cassano could sell this insurance without putting up any money in the first place was that AIG, a massive financial behemoth as old as the earth itself, had a rock-solid credit rating and seemingly inexhaustible resources. When Cassano did deals with the likes of Goldman and Deutsche Bank (to say nothing of Miklos and his smaller Euro bank), all he needed in the way of collateral was AIG’s name.
But in March 2005, AIG’s name took a hit. The firm’s then-CEO, Maurice “Hank” Greenberg, was forced to step down when then–New York attorney general Eliot Spitzer charged Greenberg with a series of accounting irregularities. Those allegations, and Greenberg’s departure, led the major ratings agencies to downgrade AIG’s credit rating for the first time ever, dropping it from AAA to AA.
When that happened, it triggered clauses in the CDS deals Cassano was writing to all his counterparties, forcing the parent company to post collateral to prove its ability to repay—$1.16 billion, to be exact, in the wake of that first downgrade.
In 2007, as the housing market began to collapse, some of Cassano’s clients started to become nervous. They argued that the underlying assets in the deals had seriously declined in value and demanded that Cassano post still more collateral. Importantly, it was Goldman Sachs that freaked out first, demanding in August 2007 that AIG/Cassano fork over $1.5 billion in collateral.
AIG disputed that claim, the two sides argued, and ultimately AIG handed over $450 million. This was right around the time that Cassano was busy lying his ass off about the dangers of his portfolio. In the same month that he agreed to hand over $450 million to cover the depreciation in value of the assets underlying his CDS deals, Cassano told investors in a conference call that everything was hunky-dory. “It is hard for us, without being flippant, to even see a scenario within any kind of [rhyme] or reason that would see us losing one dollar in any of those transactions,” he said.
A month later, Cassano fired an accountant named Joseph W. St. Denis, who discovered irregularities in the way AIG valuated a target company’s hedge fund accounts; Cassano openly told St. Denis that he wanted to keep him away from his CDS portfolio. “I have deliberately excluded you from the valuation of the Super Seniors [CDSs] because I was concerned that you would pollute the process,” he says.
Then, in October 2007, Goldman Sachs came back demanding more money, this time asking for $3 billion. The two sides again argued and again settled on a compromise, as Cassano and AIG this time agreed to pony up $1.5 billion. This was a key development, because when AIG’s outside auditor (PricewaterhouseCoopers) heard about Goldman’s demands, it downgraded Cassano’s swaps portfolio, writing down some $352 million in value that quarter.
Despite this very concrete loss of value, Cassano and his superiors at AIG continued lying their asses off. In yet another conference call in early December 2007, Cassano repeated his earlier position: “It is very difficult to see how there can be any losses in these portfolios.”
But it was too late to stave off disaster. By the time Cassano made that December statement, two other major counterparties, Merrill Lynch and Société Générale SA, had come knocking, demanding collateral to cover their deals. By late December, four more banks piled on: UBS, Barclays, Crédit Agricole’s Calyon investment-banking unit, and Royal Bank of Scotland Group. Deutsche Bank and a pair of Canadian Banks, CIBC and the Bank of Montreal, would join in later.
AIGFP by that point was, for all intents and purposes, dead. In February 2008, PwC, the auditor, found a “material weakness” in AIG’s books, and that quarter AIG announced an extraordinary $5.3 billion loss for the fourth quarter of 2007. Cassano was finally axed that same month, although, amazingly, he was still being paid a $1 million monthly retainer. Then, in May, AIG posted yet another record quarterly loss, of $7.8 billion. The company’s then-CEO, Martin Sullivan, was forced to step down in June. The nightmare was officially beginning.
And the collateral calls kept coming. By July 31, 2008, AIG had handed over $16.5 billion in collateral to Cassano’s clients. But some of them, in particular Goldman Sachs, were not satisfied. Goldman still had about $20 billion in exposure to AIG and it wanted its money. The management of AIG, however, disputed the amount it owed Goldman as per Cassano’s agreements. This was normal, but the lengths to which Goldman went to fight its cause were extraordinary.
“Collateral calls are somewhat subjective because they are based on the caller’s [i.e., Goldman’s] valuation of the CDS,” says one government official who would later be involved in the AIG bailout negotiations. “There may be a degree of negotiation, and since the called [AIG] has the money and the caller [Goldman] wants it, the called has a certain amount of power in the negotiations … This is what happened between AIG and Goldman.”
As is well known by now, these collateral disputes were a big part of the reason the government was ultimately forced to step in and take action to prop up AIG on the weekend of September 13–14, 2008. One of the key precipitating incidents, in fact, was the decision by the various credit agencies to downgrade AIG a second time. When AIG learned that Moody’s and Standard and Poor’s intended to downgrade them again on September 15, AIG knew it was in serious trouble, as the downgrade would trigger still more collateral clauses in Cassano’s crazy-ass deals. Already in a desperate fight to stave off Goldman and other clients that were screaming for the collateral ostensibly owed thanks to the last downgrade, AIG was now going to be on the hook to those same people for tens of billions more. It was this impending ratings holocaust that got the Treasury and the Fed scrambling, beginning Friday, September 12, to figure a way out for everyone concerned.
That part of the story is well known by now. What is less well known is the role that the other AIG crisis—the one caused by Win Neuger—played in the same mess.
Just a few months before, in late June and early July 2008, at roughly the same time Sullivan was stepping down and AIG was announcing a massive $7.8 billion first-quarterly loss, Neuger was announcing problems in his own unit. It seems that by July 2007 Neuger had lent out about $78 billion worth of securities and invested nearly two-thirds of the collateral he received in mortgage-backed crap. By March 31, 2008, the value of his portfolio had dropped to $64.3 billion. In late June, AIG made it public: Neuger, rather than make his “ten cubed” in profits, had actually lost $13 billion in the course of a year.
What is interesting about this is how the world came to find out about it. Neuger, remember, made his money by pulling securities out of the holdings of AIG’s subsidiary life companies, lending them out to Wall Street, then taking the cash put up as collateral and investing it. Unlike Cassano’s CDS deals, the securities he was lending were actually quite solid, so the parties he was lending them to—in large part the same people who were Cassano’s counterparties, i.e., Goldman, Deutsche, Société Générale, etc.—were in theory not at risk of taking great losses. After all, they were still holding the securities, the ordinary stocks and bonds in the portfolios of the subsidiary life companies, and those things were still worth something.
But a funny thing began happening in late 2007 and early 2008. Suddenly Neuger’s customers started returning their securities to him en masse. Banks like Goldman Sachs started returning huge chunks of securities and demanding their collateral back. In what quickly struck some regulators as a somewhat too convenient coincidence, many of these banks that started returning Neuger’s sec-lending cash were also counterparties to Cassano’s Financial Products division.
“Many of the counterparties who were involved with the securities-lending business, they were knowledgeable as to what was going on with [Cassano’s] Financial Products division,” says Eric Dinallo, at the time the head of the New York State Insurance Department. “You had people who were counterparties to the credit default swap side who were also able to pull cash out of [Neuger’s] sec-lending business.”
Early in that summer of 2008, Dinallo would chair a multistate task force charged with helping AIG “wind down” its crippled securities-lending business in such a way that AIG’s subsidiary insurance companies (and by extension the holders of policies issued by those companies) would not be harmed by any potential bankruptcy. The threat that a run on Neuger’s sec-lending business would result in these insurance companies getting bankrupted or seized by state insurance commissioners was like a guillotine that hung over the entire American economy in the summer of 2008—and, in ways that to this day remain unknown to most Americans, that guillotine would become a crucial factor in the decision to bail out AIG and AIG’s counterparties amid the implosion of September 2008.
Neuger had been borrowing from AIG subsidiary companies like American General, SunAmerica, and United States Life, companies that insured tens of thousands, if not hundreds of thousands, of ordinary policyholders and retirees. If enough of Neuger’s securities-lending clients demanded their money back at once, suddenly there was a real threat that the parent company AIG would have to reach down and liquidate the assets of these mom-and-pop insurance companies, leaving those tens of thousands of people out in the wilderness. All in order to cover Neuger’s colossally stupid and unnecessary bets on the mortgage market.
Faced with this terrifying possibility, the regulators in numerous states—led by New York but also including Texas, which contained many thousands of ordinary people with American General policies—suddenly took notice. It was little noted at the time, but when AIG announced that $13 billion loss, Texas insurance officials said publicly that they were not aware of the liabilities involved with Neuger’s portfolio. “We were aware of this portfolio, but we didn’t have transparency on what was in it because it was off-balance-sheet” in the company’s statutory accounting reports, said Doug Slape, chief analyst at the Texas Department of Insurance.
It was around this time, in June and July, that Dinallo and insurance officials from the states scrambled to step in and make sure that AIG had enough funds to cover the messes in the securities-lending business. The states had a mandate to make sure that no one would be allowed to take value out of these mom-and-pop insurance companies; before they would ever let that happen, they would step in and take the companies over.
They had the power to do that, but in July the officials were trying everything they could to avoid taking that drastic step. The situation was so serious that the federal government also stepped in to help convince the states not to seize any of the AIG subsidiaries if they could avoid it. “Treasury was calling the governors of the states and getting the governors to get their insurance commissioners to stay on board,” says Dinallo. “I was in the middle of these eleven-state conference calls—eleven states being the number of states that had AIG subsidiary companies—and we were making sure that everybody was saying the same thing: that if we start seizing life or property insurers because they file for bankruptcy, it will be bad for everybody.”
In the end, the task force worked with AIG and got them to sign a “make-whole” agreement in which they pledged to put some money into the subsidiary pool and throw in another $5 billion or so to cover any potential future losses. The states thought this would be more than enough.
“As of June thirtieth, everything was still more or less fine,” says one state official involved in those negotiations. “It wasn’t the end of the world yet.”
But AIG and its subsidiary life companies were only “fine” up to a point. The garbage Neuger had invested in—and about a third of his portfolio was mortgage-based toxic crap—had plummeted in value, perhaps irreversibly. He couldn’t sell the stuff and he couldn’t really replace it in his portfolio with something safer. All he could do was hold on to his big folder full of worthless paper and hope it recovered its value. Meanwhile, he had to cross his fingers and hope his customers/counterparties wouldn’t start returning their securities and demanding their money back.
This, incidentally, was not an unreasonable expectation. Under normal circumstances a sec-lending business like Neuger’s wouldn’t have to deal with a lot of customers returning their securities (also called closing out their accounts) all at once. Normally the lender would lend out his securities on short-term contracts—say, sixty to ninety days—and at the end of that time the client would either renew the deal or else the securities would be lent to someone else. In either case the securities would remain lent out. This is called rolling the deal. Since the securities Neuger had lent out were still valuable, and the parties holding them didn’t have that much real risk of a loss, it was reasonable to expect that his clients would keep rolling them into the future.
And as long as the deals kept rolling, Neuger’s losses would remain hidden, or at least intermittent and therefore manageable. At the very least, this is what the state insurance officials, examining things jointly in June, expected.
“We didn’t see any reason why the counterparties should worry,” says the state official. “The stuff was still valuable. There wasn’t much risk.”
But then something surprising happened. The counterparties did start closing out their accounts with Neuger. One in particular was extremely aggressive in returning securities to AIG: Goldman Sachs. Goldman had been leading the charge throughout the year in closing out its accounts with Neuger; now, in the summer of 2008, it stepped up the pace, hurling billions of dollars’ worth of Neuger’s securities back in his car-salesman face and demanding its money back.
Dinallo here interjects with what he calls a “powerful” piece of information—that during this period when Goldman and all the other counterparties suddenly started pulling cash out of AIG’s securities-lending business, no other sec-lending firm on Wall Street was having anything like the same problems. If Neuger’s counterparties were pulling their cash out en masse, it didn’t seem to be because they were worried about the value of the securities they were holding. Something else was going on.
“We analyzed every single other sec-lending business that was under our jurisdiction,” Dinallo says. “And not any one of them had problems. To this day they don’t have problems … You had Met Life, and AXA, and all these others—there were twenty-three others—and they had no issues. It was just AIG.”
So of all the billions of dollars’ worth of securities that had been lent out, it seemed the big Wall Street banks in the summer of 2008 suddenly found reason to worry only about those lent out by just one company—the same company that just so happened to owe these same banks billions via its unrelated credit-default-swap business.
“So what’s the coincidence of that?” asks Dinallo. “It was clearly a result of what was going on in the financial products division.”
Once the sec-lending counterparties started pulling out, the run on AIG was on. Already besieged with requests for cash to cover nutjob Joe Cassano’s bets, AIG now needed to come up with billions more to cover the losses of the firm’s other idiot stepchild, Win Neuger.
Lacking the funds to cover Neuger’s losses, AIG once again rang up the state insurance regulators along with the Federal Reserve, this time with a more urgent request. The parent company wanted permission from the regulators to reach down into its subsidiary companies and liquidate some of their holdings—imperiling the retirement accounts and insurance policies of thousands—in order to pay off the likes of Goldman and Deutsche Bank.
The states balked, however. In fact, the situation grew dire enough that by the first week of September, Texas—which was home to some of AIG’s biggest subsidiary insurance companies and would have been affected disproportionately if AIG tried to raid those companies’ holdings—had drawn up a draft letter outlining its plans to seize control of four AIG subsidiary companies, including American General.
“We got active in stepping in to protect those companies from being swallowed up in what was happening with the overall AIG picture,” says Doug Slape of the Texas Department of Insurance.
“Texas was definitely very aggressive,” says Dinallo.
The seizure of AIG subsidiaries would have been an extraordinary, unprecedented event. It was an extreme step, the nuclear option: had this occurred, the state would have simply stepped in, frozen the companies’ business, and then distributed the assets to the policyholders as equitably as possible. If the assets weren’t sufficient to cover those policies (and they almost certainly would have covered just a fraction of the company’s obligations), then the state also had public guaranty associations that would have kicked in to help rescue the policies. But without a doubt, had Texas stepped in to seize American General and other companies, policyholders and retirees who might already have paid premiums for a lifetime would have been left basically with pennies on the dollar.
“Thousands would have been affected,” says Slape.
It gets worse. Had Texas gone ahead and seized those subsidiaries, all the other states that had AIG subsidiaries headquartered within their borders would almost certainly have followed suit. A full-blown run on AIG’s subsidiary holdings would likely have gone into effect, creating a real-world financial catastrophe. “It would have been ugly,” says Dinallo. Thousands if not tens or hundreds of thousands of people would have seen their retirement and insurance nest eggs depleted to a fraction of their value, overnight.
The Texas letter was prepared and ready to go on the weekend of September 13–14. That was when an extraordinary collection of state officials and megapowerful Wall Street bankers had gathered in several locations in New York to try to figure out how best to handle the financial storm that had gathered around a number of huge companies—not only AIG, but Lehman Brothers, Merrill Lynch, and others.
The key gathering with regard to AIG took place at the offices of the New York Federal Reserve Bank. The government/state players included a group from the Fed, led by then–New York Fed official Timothy Geithner, as well as officials from the Treasury (then run by former Goldman Sachs chief Henry Paulson) and regulators from Dinallo’s office at the New York Insurance Department. The private players of course included AIG executives and teams of bankers from, primarily, three private companies: JPMorgan, Morgan Stanley, and Goldman Sachs. For most of the weekend, the AIG meetings took place in the Fed building, with Fed officials in one corner, Dinallo’s people in a conference room in the center, and bankers from the three banks in each of the remaining corners.
Now, JPMorgan had a good reason to be there: it had been hired as a banking consultant by AIG some weeks before to try to salvage its financial health. Morgan Stanley, meanwhile, had been (since the Bear Stearns rescue) hired to consult with the U.S. Treasury. Why Goldman was there is one of the key questions of the whole bailout era. Goldman did not represent anyone at this gathering but Goldman.
Ostensibly, Goldman was there because of its status as one of AIG’s largest creditors. But then Deutsche Bank and Société Générale were also similarly large creditors, and they weren’t there. “I don’t know why they were there and other large counterparties weren’t there,” says Dinallo. There was something special about Goldman’s status, and what that thing was was about to come out, in a big way.
On that Saturday, one state regulatory official present for these meetings—we’ll call him Kolchak—saw the prepared Texas letter for the first time and immediately realized its implications. In conference calls with other state officials Kolchak understood that the Texas letter was like a giant bomb waiting to be set off. If Texas moved on the companies, the other states would follow and a Main Street disaster would be under way. And that bomb was going to blow under one specific circumstance. Texas was waiting to see if AIG was determined to reach into those subsidiary companies, and AIG was only going to do that if Neuger’s counterparties insisted on a massive collateral call. But among those counterparties, most were willing to be cool and hold on to the securities. Only one was making noise like it was not going to be patient and was willing to pull the plug: Goldman Sachs.
That fact was made clear the next morning, on Sunday, when all the main parties met in the grand old conference room on the first floor of the Fed building. “It’s like this weird, medieval lobby,” says Kolchak. “No one ever goes in there, ever. That made it even weirder.” The sight of this seldom-used hall, packed with fifty or sixty of the most powerful financiers in the world, was surreal—as was the angry announcement made by Goldman CEO Lloyd Blankfein at the outset of the meeting. Kolchak reports that Blankfein was the dominant presence at the meeting; he stood up and threw down the gauntlet, demanding that AIG cough up the disputed collateral in the CDS/Cassano mess.
“Blankfein was basically like, ‘They [AIG] can start by giving us our money,’ ” Kolchak says. “He was really pissed. He just kept coming back to that, that he wanted his fucking money.”
After that meeting Kolchak suddenly grasped, he thought, the dynamic of the whole weekend. Goldman was really holding a gun not only to the head of AIG but to the thousands of policyholders who, somewhere outside the room and all across America, had no idea what was going on. Basically what was happening was that Blankfein and the other Goldman partners wanted the money AIGFP and Cassano owed them so badly that they were willing to blow up the other end of AIG, if needed, to make that happen. Even though they weren’t really in danger of losing any money by holding on to Neuger’s securities, they were returning them anyway, just to force AIG into a crisis.
With Texas ready at any moment to move in and seize the AIG subsidiaries, all Goldman had to do to create a national emergency was make that one last giant collateral call on Neuger’s business. If it did that, all the other banks would follow, the run on Neuger’s business would continue, and AIG would be forced to try to raid its subsidiaries. That in turn would force the states to step in and seize the subsidiary insurance companies.
Blankfein’s announcement that Sunday morning was a declaration that Goldman had no intention of relenting. It was going to pull the pin not only on AIG but on the financial universe if someone didn’t come up with the money it felt it was owed by AIG.
“That’s what the whole weekend was about,” says Kolchak. “We’re all basically there to try to figure out if Goldman is going to stand down. There’s literally a whole army of bankers there trying to figure out a way to get Goldman to call off the dogs.”
After that Sunday morning announcement, the scene became even more surreal. Literally hundreds of bankers from the three banks had already descended upon AIG’s headquarters at nearby 70 Pine Street (which has since been sold off for pennies on the dollar to Korean investors—but that’s another story, for later) and begun poring over AIG’s books in search of value. But there wasn’t much left.
“Honestly, pretty much everything that hadn’t been nailed down had already been liquidated and invested in RMBS [residential-mortgage-backed securities] and stuff like that,” says one source close to AIG who was there that weekend. The only stuff left was a lot of weird, eclectic crap. “We’re talking ski resorts in Vail, little private equity partnerships, nothing that you could sell off fast,” he says.
The bankers who were poring over this stuff were working feverishly to see if there was enough there that could be turned into ready money to fight off the collateral calls. “They’re working to see if there’s enough value, enough liquidity, to pay up,” says Kolchak. “And at the end of this, Goldman comes back and basically says no. There’s not enough there to satisfy them. They’re going to turn the jets up.”
AIG, meanwhile, was begging state officials to intercede on its behalf with Goldman with regard to the collateral demands on the Neuger business. “They’re like, ‘Can you get Goldman to lay off?’ ” says one state regulator who was there that weekend.
All of this pressure from the collateral calls on the Win Neuger/sec-lending side were matched by the extremely aggressive collateral calls Goldman in particular had been making all year on the Cassano/CDS side of the business. In fact, two years later, the question of whether or not Goldman had used those collateral calls to accelerate AIG’s demise would be a subject of open testimony at hearings of the Financial Crisis Inquiry Commission in Washington. I was at those hearings on June 30, 2010, sitting just a few seats away from the homuculoid Cassano, who was making his first public appearance since the crash. And one of the first things that Cassano was asked, by the commission’s chairman, Phil Angelides, was whether or not Goldman had been overaggressive in its collateral calls. The author apologizes on behalf of Angelides for the reckless mixing of metaphors here, but his question is all about whether AIG fell into crisis or was pushed by banks like Goldman:
ANGELIDES: The chronology … appears to indicate that there’s some pretty hard fighting with Goldman Sachs in particular through March of 2008, and then after. I used the analogy when I started here: was there a cheetah hunting down a weak member of the herd? … I am trying to get to this very issue of was a first domino pushed over? Or did someone light a fuse here?
Another FCIC commissioner put it to Cassano this way: “Was Goldman out to get you?”
Angelides during the testimony referred to Goldman’s aggressiveness in making collateral calls to AIG. At one point he quotes an AIGFP official who says that a July 30 margin call from Goldman “hit out of the blue, and a fucking number that’s well bigger than we ever planned for.” He called Goldman’s numbers “ridiculous.”
Cassano that day refused to point a finger at Goldman, and Goldman itself, through documents released to the FCIC later in the summer of 2010 and via comments by Chief Operating Officer Gary Cohn (“We are not pushing markets down through marks”), denied that it had intentionally hastened AIG’s demise by being overaggressive with its collateral demands.
Nonetheless, it’s pretty clear that the unwavering collateral demands by Goldman and by the other counterparties (but particularly Goldman) left the Fed and the Treasury with a bleak choice. Once the bankers came back and pronounced AIG not liquid enough to cover the collateral demands for either AIGFP or Neuger’s business, there was only one real option. Either the state would pour massive amounts of public money into the hole in the side of the ship, or the Goldman-led run on AIG’s sec-lending business would spill out into the real world. In essence, the partners of Goldman Sachs held the thousands of AIG policyholders hostage, all in order to recover a few billion bucks they’d bet on Joe Cassano’s plainly crooked sweetheart CDS deals.
Within a few days, the crisis had been averted, but at the cost of a paradigm-changing event in American history. Paulson and the Fed came through with an $80 billion bailout, which would later be expanded to more than $200 billion in public assistance. Once that money was earmarked to fill the hole, Texas stood down and withdrew its threat to seize AIG’s subsidiary life companies, since AIG would now have plenty of money from the Federal Reserve to pay off Neuger’s stupidities.
As is well known now, the counterparties to Joe Cassano’s CDS deals received $22.4 billion via the AIG bailout, with Goldman and Société Générale getting the biggest chunk of that money.
Less well known is that the counterparties to Neuger’s securities-lending operations would receive a staggering $43.7 billion in public money via the AIG bailout, with Goldman getting the second-biggest slice, at $4.8 billion (Deutsche Bank, with $7 billion, was number one).
How they accomplished that feat was somewhat complicated. First, the Fed put up the money to cover the collateral calls against Neuger from Goldman and other banks. Then the Fed set up a special bailout facility called Maiden Lane II (named after the tiny street in downtown Manhattan next to the New York Federal Reserve Bank), which it then used to systematically buy up all the horseshit RMBS assets Neuger and his moronic “ten cubed”–chasing employees had bought up with all their billions in collateral over the years.
The mechanism involved in these operations—whose real mission was to filter out the unredeemable crap from the merely temporarily distressed crap and stick the taxpayer with the former and Geithner’s buddies with the latter—would be enormously complex, a kind of labyrinthine financial sewage system designed to stick us all with the raw waste and pump clean water back to Wall Street.
The AIG bailout marked the end of a chain of mortgage-based scams that began, in a way, years before, when Solomon Edwards set up a long con to rip off an unsuspecting sheriff’s deputy named Eljon Williams. It was a game of hot potato in which money was invented out of thin air in the form of a transparently bogus credit scheme, converted through the magic of modern financial innovation into highly combustible, soon-to-explode securities, and then quickly passed up the chain with lightning speed—from the lender to the securitizer to the major investment banks to AIG, with each party passing it off as quickly as possible, knowing it was too hot to hold. In the end that potato would come to rest, sizzling away, in the hands of the Federal Reserve Bank.
Eljon Williams is still in his house. He scored an extraordinary reprieve when two things happened. One, the state of Massachusetts in the person of Attorney General Martha Coakley launched an investigation of some of the mortgage-lending companies in her state, including Litton Loans—a wholly owned subsidiary of Goldman Sachs that ended up owning the smaller of Eljon’s two mortgage loans. Coakley accused Goldman Sachs of facilitating the kind of fraud practiced by Solomon Edwards by providing a market for these bad loans through the securitization process, by failing to weed out bad or unfair loans, and by failing to make information about the bad loans available to potential investors on the other end. By the time Coakley settled negotiations with Goldman Sachs, the latter had already been the beneficiary of at least $13 billion in public assistance through the AIG bailout, with $10 billion more coming via the Troubled Asset Relief Program and upwards of $29 billion more in cheap money coming via FDIC backing for new debt under another Geithner bailout program, the Temporary Liquidity Guarantee Program.
Despite all that cash, Goldman drove a very hard bargain with Coakley. It ultimately only had to pay the state a $50 million fine, pennies compared to what the bank made every month trading in mortgage-backed deals. Moreover, it did not have to make a formal admission of wrongdoing. A month or so after Coakley and Goldman went public with the terms of their settlement, Goldman announced that it had earned a record $3.44 billion in second-quarter profits in 2009.
But there was one benefit to this mess, and that was this: Goldman, through Litton, forgave entirely the smaller of Eljon Williams’s two mortgage loans. Meanwhile his other lender, ASC, agreed under public pressure to a modification, allowing Eljon and his family to return to a relatively low fixed rate. A religious man, Williams talks of the events that led to his keeping his home as though they involved divine intervention. “I prayed on it, and prayed on it,” he says. “And it happened.”
What is most amazing about the mortgage-scam era is how consistent the thinking was all the way up the chain. At the very bottom, lowlifes like Solomon Edwards, the kind of shameless con man who preyed on families and kids and whom even other criminals would look down on, simply viewed each family as assets to be liquidated and converted into one-time, up-front fees. They were incentivized to behave that way by a kink in the American credit system that made it easier, and more profitable, to put a torch to a family’s credit rating and collect a big up-front fee than it was to do the job the right way.
And, amazingly, it was the same thing at the very top. When the CEO of Goldman Sachs stood up in the conference room of the New York Federal Reserve Bank and demanded his money, he did so knowing that it was more profitable to put AIG to the torch than it was to try to work things out. In the end, Blankfein and Goldman literally did a mob job on AIG, burning it to the ground for the “insurance” of a government bailout they knew they would get, if that army of five hundred bankers could not find the money to arrange a private solution. In their utter pessimism and complete disregard for the long term, they were absolutely no different from Solomon Edwards or the New Century lenders who trolled the ghettos and the middle-class suburbs for home-buying suckers to throw into the meat grinder, where they could be ground into fees and turned into Ford Explorers and flat-screen TVs or weekends in Reno or whatever else helps a back-bench mortgage scammer get his rocks off. The only difference with Goldman was one of scale.
Two other things are striking about the mortgage-scam era. One was that nobody in this vast rogues’ gallery of characters was really engaged in building anything. If Wall Street makes its profits by moving money around from place to place and taking a cut here and there, in a sense this whole mess was a kind of giant welfare program the financial services industry simply willed into being for itself. It invented a mountain of money in the form of a few trillion dollars’ worth of bogus mortgages and rolled it forward for a few years, until reality intervened—and suddenly it was announced that We the Taxpayer had to buy it from them, at what they called face value, for the good of the country.
In the meantime, and this is the second thing that’s so amazing, almost everyone who touched that mountain turned out to be a crook of some kind. The mortgage brokers systematically falsified information on loan applications in order to secure bigger loans and hawked explosive option-ARM mortgages to people who either didn’t understand them or, worse, did understand them and simply never intended to pay. The loan originators cranked out massive volumes of loans with plainly doctored applications, not giving a shit about whether or not the borrowers could pay, in a desperate search for short-term rebates and fees. The securitizers used harebrained math to turn crap mortgages into AAA-rated investments; the ratings agencies signed off on that harebrained math and handed out those AAA ratings in order to keep the fees coming in and the bonuses for their executives high. But even the ratings agencies were blindsided by scammers who advertised and sold, openly, help in rigging FICO scores to make broke and busted borrowers look like good credit risks. The corrupt ratings agencies were undone by ratings corrupters!
Meanwhile, investment banks tried to stick pensioners and insurance companies with their toxic investments, or else they held on to their toxic investments and tried to rip off idiots like Joe Cassano by sticking him with the liability of default. But they were undone by the fact that Joe Cassano probably never even intended to pay off, just like the thousands of homeowners who bought too-big houses with option-ARM mortgages and never intended to pay. And at the tail end of all this frantic lying, cheating, and scamming on all sides, during which time no good jobs were created and nothing except a few now-empty houses (good for nothing except depressing future home prices) got built, the final result is that we all ended up picking up the tab, subsidizing all this crime and dishonesty and pessimism as a matter of national policy.
We paid for this instead of a generation of health insurance, or an alternative energy grid, or a brand-new system of roads and highways. With the $13-plus trillion we are estimated to ultimately spend on the bailouts, we could not only have bought and paid off every single subprime mortgage in the country (that would only have cost $1.4 trillion), we could have paid off every remaining mortgage of any kind in this country—and still have had enough money left over to buy a new house for every American who does not already have one.
But we didn’t do that, and we didn’t spend the money on anything else useful, either. Why? For a very good reason. Because we’re no good anymore at building bridges and highways or coming up with brilliant innovations in energy or medicine. We’re shit now at finishing massive public works projects or launching brilliant fairy-tale public policy ventures like the moon landing.
What are we good at? Robbing what’s left. When it comes to that, we Americans have no peer. And when it came time to design the bailouts, a monster collective project spanning two presidential administrations that was every bit as vast and far-reaching (only not into the future, but the past) as Kennedy’s trip to the moon, we showed it.