All The Devils Are Here: Unmasking the Men Who Bankrupted the World (6 page)

The battle was joined in the spring of 1987, when five investment banks—Salomon Brothers, First Boston, Merrill Lynch, Goldman Sachs, and Shearson Lehman—banded together “in an effort to persuade the government to bar [Fannie] from the newest and one of the most lucrative mortgage underwriting markets,” as the
New York Times
put it. The way Maxwell and Ranieri had dealt with the issue of whether Fannie should be allowed to issue REMIC securities prior to the passage of the law was by kicking the can: Fannie and Freddie were granted the ability to issue REMIC securities—but only temporarily. HUD was charged with the task of granting (or denying) Fannie Mae permanent approval, while the Federal Home Loan Bank Board had to make the same decision for Freddie Mac. The investment banks filed a hundred-page brief with HUD secretary Samuel Pierce, arguing that if HUD gave Fannie REMIC authority, they would “use their ability to borrow at lower costs to undercut the private sector,” as Tom Vartanian, the lawyer hired by the investment banks to press their cause, told the
New York Times
.

It was a bitter fight. The big S&Ls, which also feared Fannie’s market power, sided with Wall Street. The head of research at the United States
League of Savings Institutions, the lobbying organization for the S&Ls, told the
Times
that it cost Salomon two and a half times what it cost Fannie to issue a REMIC. Allowing Fannie to issue these securities, they complained, would force the private market out.

Fannie, in what would become its response whenever it was challenged, wrapped itself in the mantle of homeownership. It argued that its low costs also lowered mortgage rates for consumers, and that forcing it out of the market would make homes more expensive. In a March 1987 speech to the Mortgage Bankers Association, Maxwell said that the attack on Fannie Mae was part of a campaign by Wall Street and the big thrifts to “restore inefficiency to the housing finance system in order to increase their profits through higher home mortgage rates.” He added, “They don’t seem to care if this would close the door on homeownership for thousands upon thousands of American families.”

In the end, Pierce ruled that Fannie could issue up to $15 billion in REMICs over the following fifteen months. Vartanian’s clients trumpeted it as a victory, because the number wasn’t unlimited, but as he says today, “it was a short-term victory. We lived to fight another day, and we lived to lose another day.” Sure enough, by late 1988, Fannie had been granted “permanent and unlimited authority” to issue REMICs.

How did Fannie Mae persuade Pierce to rule in its favor? Not by sweet-talking, that’s for sure; Maxwell had an iron fist inside that velvet glove of his. “We essentially gutted some of HUD’s control over us in a bill that passed the House housing subcommittee,” Maloni says today. In that bill HUD’s ability to approve new programs was revoked. HUD went to Fannie, and essentially pleaded for mercy. “In return for us asking the Congress to drop the provision, HUD approved Fannie as issuers,” says Maloni.

Maloni also called Lou Nevins and told him that if Salomon didn’t back off, Fannie wouldn’t do business with the bank anymore. (Maxwell denies knowing about the call.) For all their conflicts, Salomon Brothers had been Fannie Mae’s banker, bringing its mortgage-backed deals to market and underwriting its debt offerings, making millions in fees as a result. This was a major threat. “It’s like the post office saying we won’t deliver your mail!” Nevins says. He remembers thinking to himself, “If they get away with this, there won’t be a private company in the world that will stand up to them.”

With the benefit of hindsight, it’s hard to argue that REMIC authority was the cataclysmic event that either party feared it was at the time. While Fannie
issued its own securities, Wall Street made immense amounts of money marketing and selling them—Fannie never had the ability to find the Japanese bank or the Midwest insurance company that might want a specific tranche. And Fannie was always going to play an important role in the mortgage-backed market because of its guarantees, which were prized by investors. Essentially, it got to decide which mortgages were worthy of securitization and which were not, and mortgage lenders had to offer mortgages that conformed to the GSEs’ strict standards. Indeed, after all the hype over REMICs, a series of big losses at several Wall Street firms—trader talk had it that Merrill Lynch lost over $300 million, which at the time was a big sum—caused the market to cool on carving up cash flows in such extraordinarily complex ways. At least for a time, the Street returned to old-fashioned pass-through securities, the ones that didn’t tranche the bonds, but simply sent the cash flow along to investors. The hedge fund manager David Askin, who lost hundreds of millions of investors’ money buying mortgage-backed securities that were supposed to have very low risk, told
Institutional Investor
that “not all this stuff is for kids in the studio audience to try and do at home.”

On the other hand, the future of the mortgage market might have been very different if Fannie Mae had lost control of it at that critical juncture. And the battle between Fannie and Wall Street did have consequences that would linger for a very long time. The threats that Fannie had faced—not just from a Wall Street that wanted to clip its wings, but from a White House that wanted to take away its built-in advantages—deeply affected Fannie’s corporate mind-set. Its attitude became one of outsized aggression toward even the most insignificant of threats. “You punch my brother, I’ll burn your house down” was the saying around the company. The idea that Fannie should be stripped of its government advantages became, in Maloni’s words, “the vampire issue”: it never completely went away. Fannie always felt that its opponents, whether competitors or critics in the government, were out to kill it. In this, it was absolutely right.

In addition, the REMIC fight established Fannie and Freddie as forces not just in Washington but on Wall Street. The two companies completely dominated the market for so-called conforming mortgages—that is, thirty-year fixed mortgages under a certain size made to buyers with good credit histories. “It was the end of the game,” says Nevins. By the end of the 1980s, there was more than $611 billion worth of outstanding GSE-guaranteed mortgage-backed securities, according to a study by economic consulting
firm Empiris LLC. The outstanding volume of private mortgage-backed securities—the ones without GSE guarantees—was just $55 billion, less than one-tenth that amount. Fannie, meanwhile, went from losing a million dollars a day to making more than $1 billion a year. Its market value exploded from $550 million to $10.5 billion.

As for the larger dangers of mortgage-backed securities—the ones that would emerge in the years before the financial crisis—they were largely overlooked as Wall Street and the GSEs raced to establish a market for their new miracle product. Largely, but not entirely. At one congressional hearing, Leon Kendall, then chairman of the Mortgage Guaranty Insurance Corporation, a private insurer of mortgages, offered up a prophetic warning: “With all our concern in enhancing the secondary mortgage market, we should continue to have appropriate and equivalent concern relative to keeping people in houses.” Historically, he noted, less than 2 percent of people lost their homes to foreclosure, because “what was good for the lending institution was also good for the borrower.” But the new securitization market threatened to change that, because once a lender sold a mortgage, it no longer had a stake in whether the borrower could make his or her payments. He concluded, “The linkage, which I support fully, between the mortgage originator and the secondary market must be built carefully and appropriately…. Unless we have sound loans … we are going to find that the basic product we are trying to enhance and multiply will turn out soiled.”

While securitization appeared to be alchemy, it wasn’t, in the end, a magic trick. All the risks inherent in mortgages hadn’t disappeared. They were still there somewhere, hidden, lurking in a dark corner. Dick Pratt, who had left the Federal Home Loan Bank Board to become the first president of Merrill Lynch Mortgage Capital, used to put it this way: “The mortgage is the neutron bomb of financial products.”

There was one final consequence. After the REMIC battle, Wall Street realized it was never going to dislodge Fannie and Freddie from their dominant position as the securitizers of traditional mortgages. If it hoped to circumvent the GSEs and keep all the profits to itself, Wall Street would have to find some other mortgage product to securitize, products that Fannie and Freddie couldn’t—or wouldn’t—touch. As Maxwell later put it, “Their effort became one to find products they could profit from where they didn’t have to compete with Fannie.”

He added, “That’s ultimately what happened.”

T
he birth of mortgage-backed securities didn’t just change Wall Street and the GSEs. It changed the mortgage business on Main Street, too. Mortgage origination—that is, the act of making a loan to someone who wants to buy a home—had always been the province of the banks and the S&Ls, which relied on savings and checking accounts to fund the loans. Securitization mooted that business model.

Instead, securitization itself became the essential form of funding. Which meant, in turn, that all kinds of new mortgage companies could be formed—companies that competed with banks and S&Ls for mortgage customers, yet operated outside the banking system and were therefore largely unregulated. Not surprisingly, these new companies were run by men who were worlds apart from the local businessmen who ran the nation’s S&Ls and banks. They were hard-charging, entrepreneurial, and intensely ambitious—natural salesmen who found in the changing mortgage market a way to make their mark in American business. Some of them may have genuinely cared about putting people in homes. All of them cared about getting rich. None of them remotely resembled George Bailey.

These new mortgage originators were of two distinct breeds—at least at first. One set of companies originated fairly standard loans to people with good credit, which they sold to Fannie and Freddie; Countrywide Financial was a good example of that kind of company. The second group had very different roots. They grew out of what was known as hard-money lending—lending made to poor people, primarily. (“Hard money” refers to the large down payments its customers had to make, even for a basic item such as a refrigerator.) These new companies moved hard-money lending into the mortgage market, making loans that would eventually become known as
subprime. They couldn’t sell to the GSEs, because, for a long time, the GSEs wouldn’t buy such risky mortgages. On the other hand, this influx of new lenders created exactly what Wall Street had been searching for: mortgage products it could securitize without Fannie and Freddie.

There is much irony in the fact that Countrywide Financial began life in that first group of companies, since it would later become the mortgage originator most closely associated with the excesses of the subprime business. But it’s true. Its founder and CEO, a smart, aggressive bulldog of a man named Angelo Mozilo, believed strongly in the importance of underwriting standards—that is, in making loans to people who had the means to pay them back. In the early 1990s, a big competitor, Citicorp Mortgage, was forced to take huge losses, the result of making shoddy loans in a drive to increase market share. Mozilo’s reaction was pitiless. “They tried to take a shortcut and went the way of every institution that has ever tried to defy the basics of sound underwriting principles,” he told
National Mortgage News
in 1991.

There may have been another reason for Mozilo’s withering dismissal of mighty Citigroup. Citi represented the establishment. Mozilo, Bronx born and Fordham educated, spent his life both wanting to beat the establishment and harboring a burning resentment toward it. “I run into these guys on Wall Street all the time who think they’re something special because they went to Ivy League schools,” he once told a
New York Times
reporter. “We’re always underestimated…. I must say, it bothered me when I was younger—their snobbery and their looking down on us.” When he was starting out, the business was “lily white,” Mozilo’s former partner Howard Levine recalls. Mozilo was an extremely dark-skinned Italian-American, and very sensitive about that heritage. He once told a colleague about returning from his honeymoon with his new wife, Phyllis, and stopping in Virginia Beach on the way home. They went into a restaurant to have dinner. “We don’t serve colored,” the waiter said. “I’m Italian,” Mozilo replied. “That’s what they all say,” said the waiter.

Born in 1938, Mozilo was the son of a butcher who had emigrated from Italy as a young man. The Mozilos lived in a rental flat. “I saw my dad struggle all his life,” Mozilo later explained. “He lived to be fifty-six and died of a heart attack.” Mozilo’s uncle, who worked for an insurance company, had the only white-collar job in the family. Young Angelo worked for his
father until he was old enough to ask his uncle to help him find a job. At fourteen, he became a messenger for a small Manhattan mortgage company.