All The Devils Are Here: Unmasking the Men Who Bankrupted the World (4 page)

Almost since the phrase “The American Dream” was coined in the early 1930s, it has been synonymous with homeownership. In a way that isn’t true in most other countries, homeownership is something that the vast majority of Americans aspire to. It suggests upward mobility, opportunity, a stake in something that matters. Historically, owning a home hasn’t just been about taking possession of an appreciating asset, or even having a roof over one’s head. It has also been a statement about values.

Not surprisingly, government policy has long encouraged homeownership. The home mortgage interest deduction is a classic example. So is the thirty-year fixed mortgage, which is standard in only one other country (Denmark) and is designed to allow middle-class families to afford monthly mortgage payments. For decades, federal law gave the S&L industry a small interest rate advantage over the banking industry—the housing differential, this advantage was called. All of these policies had unswerving bipartisan support. Criticizing them was political heresy.

Fannie Mae and Freddie Mac were also important agents of government homeownership policy. They, too, were insulated from criticism. Fannie Mae, the older of the two, was born during the Great Depression. Its original role was to buy up mortgages that the Veterans Administration and the Federal Housing Administration were guaranteeing, thus freeing up capital to allow for more government-insured loans to be made.

In 1968, Fannie was split into two companies. One, nicknamed Ginnie Mae, continued buying up government-insured loans and remained firmly a part of the government. Fannie, however, was allowed to do several new things: it was allowed to buy conventional mortgages (ones that had not been insured by the government), and it was allowed to issue securities backed by mortgages it had guaranteed. In the process, Fannie became a very odd creature. Half government enterprise, it had a vaguely defined social mandate from Congress to make housing more available to low- and middle-income Americans. Half private enterprise, it had shareholders, a board of directors, and the structure of a typical corporation.

At about the same time, Congress created Freddie Mac to buy up mortgages from the thrift industry. Again, the idea was that these purchases would free up capital, allowing the S&Ls to make more mortgages. Until 1989, when Freddie Mac joined Fannie Mae as a publicly traded company, Freddie was actually owned by the thrift industry and was overseen by the Federal Home Loan Bank Board, which regulated the S&Ls. People in Washington called Fannie and Freddie the GSEs, which stood for government-sponsored enterprises.

Here’s a surprising fact: it was the government, not Wall Street, that first securitized modern mortgages. Ginnie Mae came first, selling securities beginning in 1970 that consisted of FHA and VA loans, and guaranteeing the payment of principal and interest. A year later, Freddie Mac issued the first mortgage-backed securities using conventional mortgages, also with principal and interest guaranteed. In doing so, it was taking on the risk that the borrower might default, while transferring the interest rate risk from the S&Ls to a third party: investors. Soon, Freddie was using Wall Street to market its securities. Volume grew slowly. It was not a huge success.

Though a thirty-year fixed mortgage may seem simple to a borrower, mortgages come full of complex risks for investors. Thirty years, after all, is a long time. In the space of three decades, not only is it likely that interest rates will change, but—who knows?—the borrowers might fall on hard times and default. In addition, mortgages come with something called prepayment risk. Because borrowers have the right to prepay their mortgages, investors can’t be sure that the cash flow from the mortgage will stay at the level they were expecting. The prepayment risk diminishes the value of the bond. Ginnie and Freddie’s securities removed the default risk, but did nothing about any of these other risks. They simply distributed the cash flows from the pool
of mortgages on a pro rata basis. Whatever happened after that, well, that was the investors’ problem.

When Wall Street got into the act, it focused on devising securities that would appeal to a much broader group of investors and create far more demand than a Ginnie or Freddie bond. Part of the answer came from tranching, carving up the bond according to different kinds of risks. Investors found this appealing because different tranches could be jiggered to meet the particular needs of different investors. For instance, you could create what came to be known as stripped securities. One strip paid only interest; another only principal. If interest rates declined and everyone refinanced, the interest-only strips could be worthless. But if rates rose, investors would make a nice profit.

Sure enough, parceling out risk in this fashion gave mortgage-backed securities enormous appeal to a wide variety of investors. From a standing start in the late 1970s, bonds created from mortgages on single-family homes grew to more than $350 billion by 1981, according to a report by the Securities and Exchange Commission. (By the end of 2001, that number had risen to $3.3 trillion.)

Tranching was also good for Wall Street, because the firms underwriting the mortgage-backed bonds could sell the various pieces for more money than the sum of the whole. And bankers could extract rich fees. Plus, of course, Wall Street could make money from trading the new securities. By 1983, according to
BusinessWeek
, Ranieri’s mortgage finance group at Salomon Brothers accounted for close to half of Salomon’s $415 million in profits. Along with junk bonds, mortgage-backed bonds became a defining feature of the 1980s financial markets.

Tranching, however, was not the only necessary ingredient. A second important factor was the involvement of the credit rating agencies: Moody’s, Standard & Poor’s, and, later, Fitch Ratings. Ranieri pushed hard to get the rating agencies involved, because he realized that investors were never going to be comfortable with—or, to be blunt, willing to work hard enough to understand—the intricacies of the hundreds or thousands of mortgages inside each security. “People didn’t even know what the average length of a mortgage was,” Ranieri would later recall. “You needed to impose structures that were relatively simple for investors to understand, so that they didn’t have to become mortgage experts.” Investors understood what ratings meant, and Congress and the regulators placed such trust in the rating agencies that they had designated them as Nationally Recognized Statistical Ratings Organizations, or NRSROs. Among other things, the law allowed investors who
weren’t supposed to take much risk—like pension funds—to invest in certain securities if they had a high enough rating.

Up until then, the rating agencies had built their business entirely around corporate bonds, rating them on a scale from triple-A (the safest of the safe) to triple-B (the bottom rung of what was so-called investment grade) and all the way to D (default). At first, they resisted rating these new bonds, but they eventually came around, as they realized that rating mortgage-backed securities could be a good secondary business, especially as the volume grew. Very quickly, they became an integral part of the process, and so-called structured finance became a key source of profits for the rating agencies.

And the third thing Ranieri and Fink needed in order to make mortgage-backed securities appealing to investors? They needed Fannie Mae and Freddie Mac.

At around the same time Ranieri and Fink were trying to figure out how to make mortgage-backed securities work, Fannie Mae was going broke. It was losing a million dollars a day and “rushing toward a collapse that could have been one of the most disastrous in modern history,” as the
Washington Post
later put it. As interest rates skyrocketed, Fannie found itself in the same kind of dire trouble as many of the thrifts, and for the same reason. Unlike Freddie Mac, which had off-loaded its interest rate risk to investors, Fannie Mae had kept the thirty-year fixed-rate mortgages it bought on its books. Now it was choking on those mortgages. Things got so bad that it had a “months to go” chart measuring how long it could survive if interest rates didn’t decline. It had even devised a plan to call on the Federal Reserve to save it if the banks stopped lending it money.

Two things saved Fannie Mae. First, the banks never did stop lending it money. Why? Because their working assumption was that Fannie Mae’s status as a government-sponsored enterprise, with its central role in making thirty-year mortgages possible for middle-class Americans, meant that the federal government would always be there to bail it out if it ever got into serious trouble. Although there was nothing in the statute privatizing Fannie Mae that stated this explicitly—and Fannie executives would spend decades coyly denying that they had an unspoken government safety net—that’s what everyone believed. Over time, Fannie Mae’s implicit government guarantee, as it came to be called, became a critical source of its power and success.

The second thing that saved Fannie Mae was the arrival, in 1981, of David Maxwell as its new chief executive. Maxwell’s predecessor, a former California Republican congressman named Allan Oakley Hunter, was not particularly astute about business, nor were the people around him. During the Carter administration, when he should have been focusing on the effects of rising interest rates on Fannie’s portfolio, he had instead spent his time feuding with Patricia Harris, Carter’s secretary of Housing and Urban Development.

Like Hunter, Maxwell had once been a Republican. A Philadelphia native, he graduated from Yale, where he was a champion tennis player, and then Harvard, where he studied law, before joining the Nixon administration as general counsel of HUD. When he was approached to run Fannie, he was living in California, running a mortgage insurance company called Ticor Mortgage, and he’d converted to the Democratic Party because he felt that in California that was the only way to have any influence. “I was a businessman,” Maxwell says now. A businessman was exactly what Fannie Mae needed. Jim Johnson, the Democratic power broker who succeeded Maxwell as Fannie’s CEO in the 1990s, would later say that he “stabilized the company as a long-term force in housing finance.” Judy Kennedy, an affordable housing advocate who worked for Freddie Mac as a lobbyist in the late 1980s, puts it more grandly. She calls Maxwell a “transformative figure.”

Maxwell was gracious and charming—the sort of man who sent handwritten notes, opened his office door to all his employees, and took boxes of books with him to read on vacation—but he was also incredibly tough, with blue eyes that could turn steely cold. He did not tolerate mediocrity. He couldn’t afford to. “He was fighting for the survival of the company, and anyone, no matter what level, who was not up to the task left or was asked to leave,” says William “Bill” Maloni, who spent two decades as Fannie’s chief lobbyist. During Maxwell’s ten-year reign, Fannie had four presidents and burned through lower-level executives. When Maxwell retired, the company’s head of communications made a video that showed corporate cars moving in and out of Fannie’s offices with body bags in the trunks.

Maxwell immediately began running Fannie in a more businesslike fashion. He tightened the standards for the loans that Fannie bought. He put in new management systems. Under Hunter, Fannie used to buy mortgages as much as a year in advance. That meant that lenders had time to see where interest rates were going, then shove off only unprofitable loans on Fannie. Maxwell changed that, too.

What he couldn’t change was the combination of resentment and envy that Washington felt toward Fannie Mae. There was, Maxwell says, “tremendous disdain” for Fannie. “All over Washington, there were people doing stressful, important jobs for not a lot of money, and here was this place on Wisconsin Avenue where people did work that wasn’t any more challenging—and yet, by Washington standards, they made huge amounts.” He remembers taking his wife to a dinner party shortly after he arrived in town. “By the time we left, she was in tears, and I was close!” he later recalled.