The Great Deformation (78 page)

The Reagan-era “fix” of accounting gimmicks and deregulation thus resulted in a rogue's army of born-again thrifts. They were permitted to grow like Topsy based on phony “regulatory capital,” and to load their balance sheets with commercial real estate and junk bond risks they did not understand.

Furthermore, they often funded themselves by raising taxpayer-insured liabilities in the deregulated market for brokered deposits. Needless to say,
this jerry-built calamity was an offense to every principle of sound banking. It is not surprising, therefore, that it hit the wall and splattered into the $150 billion S&L disaster by the end of the 1980s.

In the long run, however, the huge cost of the Washington-conducted S&L cleanup was only a small part of the price tag. During the years before these mutant thrift institutions met their final demise, they retrenched dramatically from home mortgage lending, the very area where their core competence had historically resided. Between 1980 and 1986, for example, home mortgages dropped from 80 percent of S&L assets to 55 percent, and continued to fall for the balance of the decade.

In short, the Fed's Great Inflation and the Reagan administration's misdirected treatment of banking institutions as agents of the free market, when they are inherently wards of the state, resulted in the demise of the nation's competent base of mortgage-lending institutions. In 1970, home mortgage lending had been a healthy, vibrant industry financing the rise of the American middle class. Twenty years after Camp David, the home lending business was fatally impaired, just as Washington launched its misbegotten crusade for increased home ownership.

WHEN JACK KEMP GOT ROLLED BY THE ORANGE MAN

The double whammy of a busted savings and loan industry and a booming GSE takeout channel for mortgage loans catalyzed the parabolic rise of an entirely new (and distinctly inferior) channel of home finance: the mortgage broker industry. Thus, in 1987 there were 7,000 mortgage brokers nationwide, but this figure grew to 16,000 by 1992 and then surged to 36,000 by 1998 and more than 53,000 as of 2004.

In terms of dollar volume, mortgage brokers accounted for only $110 billion of housing loans in 1987 but this figure had soared to $1 trillion by 1998. And that was just the beginning. During the epic refinancing boom in 2003, mortgage brokers originated more than $2.6 trillion of home loans, meaning that mortgage broker volume grew by a factor of twenty-six times in only a decade and a half.

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

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

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

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

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

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

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

THE PHONY ECONOMICS OF MORTGAGE SECURITIZATION

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

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

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

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

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

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

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

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

AMERIQUEST: ROLAND ARNALL'S PREDATORY SALES MACHINE

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

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

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

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

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

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

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

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

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

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

CHURN AND BURN, SUBPRIME STYLE

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

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