By Alec Klein and Zachary A. Goldfarb
The Washington Post
Sunday, June 15, 2008
Part I · Boom
The black-tie party at Washington's swank Mayflower Hotel seemed a fitting celebration of the biggest American housing boom since the 1950s: filet mignon and lobster, a champagne room and hundreds of mortgage brokers, real estate agents and their customers gyrating to a Latin band.
On that winter night in 2005, the company hosting the gala honored itself with an ice sculpture of its logo. Pinnacle Financial had grown from a single office to a national behemoth generating $6.5 billion in mortgages that year. The $100,000-plus party celebrated the booming division that made loans largely to Hispanic immigrants with little savings. The company even booked rooms for those who imbibed too much.
Kevin Connelly, a loan officer who attended the affair, now marvels at those gilded times. At his Pinnacle office in Virginia, colleagues were filling the parking lot with BMWs and at least one Lotus sports car. In its hiring frenzy, the mortgage company turned a busboy into a loan officer whose income zoomed to six figures in a matter of months.
"It was the peak. It was the embodiment of business success," Connelly said. "We underestimated the bubble, even though deep down, we knew it couldn't last forever."
Indeed, Pinnacle's party would soon end, along with the nation's housing euphoria. The company has all but disappeared, along with dozens of other mortgage firms, tens of thousands of jobs on Wall Street and the dreams of about 1 million proud new homeowners who lost their houses.
The aftershocks of the housing market's collapse still rumble through the economy, with unemployment rising, companies struggling to obtain financing and the stock market more than 10 percent below its peak last fall. The Federal Reserve has taken unprecedented action to stave off a recession, slashing interest rates and intervening to save a storied Wall Street investment bank. Congress and federal agencies have launched investigations into what happened: wrongdoing by mortgage brokers, lax lending standards by banks, failures by watchdogs.
Seen in the best possible light, the housing bubble that began inflating in the mid-1990s was "a great national experiment," as one prominent economist put it -- a way to harness the inventiveness of the capitalist system to give low-income families, minorities and immigrants a chance to own their homes. But it also is a classic story of boom, excess and bust, of homeowners, speculators and Wall Street dealmakers happy to ride the wave of easy money even though many knew a crash was inevitable.
'A Lot of Potential'
For David E. Zimmer, the story of the bubble began in 1986 in a high-rise office overlooking Lake Erie.
An aggressive, clean-cut 25-year-old, armed with an MBA from the University of Notre Dame, Zimmer spent his hours attached to a phone at his small desk, one of a handful of young salesmen in the Cleveland office of the First Boston investment bank.
No one took lunch -- lunch was for the weak, and the weak didn't survive. Zimmer gabbed all day with his clients, mostly mid-size banks in the Midwest, persuading them to buy a new kind of financial product. Every once in a while, he'd hop a small plane or drive his Oldsmobile Omega out for a visit, armed with charts and reports. The products, investments based on bundles of residential mortgages, were so new he had to explain them carefully to the bankers.
"There was a lot of education going on," Zimmer said. "I realized, as a lot of people did, this was a brand new segment of the market that had a lot of potential, but I had no idea how big this would get."
Zimmer joined the business as enormous changes were taking hold in the mortgage industry. Since World War II, community banks, also called thrifts or savings and loans, had profited by taking savings deposits, paying their customers interest and then lending the money at a slightly higher rate for 30 years to people who wanted to buy homes. The system had increased homeownership from less than 45 percent of all U.S. households in 1940 to nearly 65 percent by the mid-'60s, helped by government programs such as G.I. loans.
In 1970, when demand for mortgage money threatened to outstrip supply, the government hit on a new idea for getting more money to borrowers: Buy the 30-year, fixed-rate mortgages from the thrifts, guarantee them against defaults, and pool thousands of the mortgages to be sold as a bond to investors, who would get a stream of payments from the homeowners. In turn, the thrifts would get immediate cash to lend to more home buyers.
Wall Street, which would broker the deals and collect fees, saw the pools of mortgages as a new opportunity for profit. But the business did not get big until the 1980s. That was when the mortgage finance chief at the Salomon Brothers investment bank, Lewis Ranieri -- a Brooklyn-born college dropout who started in the company's mailroom -- and his competitor, Laurence Fink of First Boston, came up with a new idea with a mouthful of a name: the collateralized mortgage obligation, or CMO. The CMO sliced a pool of mortgages into sections, called "tranches," that would be sold separately to investors. Each tranche paid a different interest rate and had a different maturity date.
Investors flocked to the new, more flexible products. By the time Zimmer joined First Boston, $126 billion in CMOs and other mortgage-backed securities were being sold annually. "Growth is really poised to take off," Zimmer thought.
After a few years at First Boston, Zimmer eventually ended up at Prudential Securities on the tip of Manhattan near the World Trade Center, selling increasingly exotic securities based not only on mortgages but also credit card payments and automobile loans.
As Wall Street's securities grew more complex and lucrative, so did the mathematics behind them. Zimmer would walk over to Prudential's huge "deal room." The room was filled with quantitative researchers -- "quants" -- a motley crew of math wonks, computer scientists, PhDs and electrical engineers, many of them immigrants from China, Russia and India. The quants built new mathematical models to price the securities, determining, for example, what borrowers would do if interest rates moved a certain way.
The industry, which came to be known as structured finance, grew steadily. Zimmer grew with it. He got married, raised two kids and climbed to the level of senior vice president, a top salesman at Prudential.
Zimmer's clients through the 1990s were mutual funds, pension funds and other big investors who dealt in big numbers: sometimes hundreds of millions of dollars. He'd get up at 4:30 a.m., be out of the house by 5, catch the 5:30 train from Princeton, N.J., be locked to his desk for 10 hours, devouring carbs -- pizza, lasagna -- and consumed by stress, but thinking nonetheless, "It was so much fun."
April 14, 2000. A rough day on Wall Street. The technology-laden Nasdaq stock index, which had more than doubled from January 1999 to March 2000, falls 356 points. Within a few days, it will have dropped by a third.
Although the business of structured finance grew during the 1990s, Internet companies drew the sexiest action on the Street. When that bubble popped, average Americans who had invested in the high-flying stocks saw their savings evaporate. Consumer and business spending began to dry up.
Then came the 2001 terrorist attacks, which brought down the twin towers, shut down the stock market for four days and plunged the economy into recession.
The government's efforts to counter the pain of that bust soon pumped air into the next bubble: housing. The Bush administration pushed two big tax cuts, and the Federal Reserve, led by Alan Greenspan, slashed interest rates to spur lending and spending.
Low rates kicked the housing market into high gear. Construction of new homes jumped 6 percent in 2002, and prices climbed. By that November, Greenspan noted the trend, telling a private meeting of Fed officials that "our extraordinary housing boom . . . financed by very large increases in mortgage debt, cannot continue indefinitely into the future," according to a transcript.
The Fed nonetheless kept to its goal of encouraging lending and in June 2003 slashed its key rate to its lowest level ever -- 1 percent -- and let it sit there for a year. "Lower interest rates will stimulate demand for anything you want to borrow -- housing included," said Fed scholar John Taylor, an economics professor at Stanford University.
The average rate on a 30-year-fixed mortgage fell to 5.8 percent in 2003, the lowest since at least the 1960s. Greenspan boasted to Congress that "the Federal Reserve's commitment to foster sustainable growth" was helping to fuel the economy, and he noted that homeownership was growing.
There was something very new about this particular housing boom. Much of it was driven by loans made to a new category of borrowers -- those with little savings, modest income or checkered credit histories. Such people did not qualify for the best interest rates; the riskiest of these borrowers were known as "subprime." With interest rates falling nationwide, most subprime loans gave borrowers a low "teaser" rate for the first two or three years, with the monthly payments ballooning after that.
Because subprime borrowers were assumed to be higher credit risks, lenders charged them higher interest rates. That meant that investors who bought securities based on pools of subprime mortgages would enjoy higher returns.
Credit-rating companies, which investors relied on to gauge the risk of default, gave many of the securities high grades. So Wall Street had no shortage of customers for subprime products, including pension funds and investors in places such as Asia and the Middle East, where wealth had blossomed over the past decade. Government-chartered mortgage companies Fannie Mae and Freddie Mac, encouraged by the Bush administration to expand homeownership, also bought more pools of subprime loans.
One member of the Fed watched the developments with increasing trepidation: Edward Gramlich, a former University of Michigan economist who had been nominated to the central bank by President Bill Clinton. Gramlich would later call subprime lending "a great national experiment" in expanding homeownership.
In 2003, Gramlich invited a Chicago housing advocate for a private lunch in his Washington office. Bruce Gottschall, a 30-year industry veteran, took the opportunity to pull out a map of Chicago, showing the Fed governor which communities had been exposed to large numbers of subprime loans. Homes were going into foreclosure. Gottschall said the Fed governor already "seemed to know some of the underlying problems."
'Half-Truths' and Lies
The young woman who walked into Pinnacle's Vienna office in 2004 said her boyfriend wanted to buy a house near Annapolis. He hoped to get a special kind of loan for which he didn't have to report his income, assets or employment. Mortgage broker Connelly handed the woman a pile of paperwork.
On the day of the settlement, she arrived alone. Her boyfriend was on a business trip, she said, but she had his power of attorney. Informed that for this kind of loan he would have to sign in person, she broke into tears: Her boyfriend actually had been serving a jail term.
Not a problem. Almost anyone could borrow hundreds of thousands of dollars for a house in those wild days. Connelly agreed to send the paperwork to the courthouse where the boyfriend had a hearing. As it happened, he was freed that day. Still, Connelly said, "that was one of mine that goes down in the annals of the strange."
Strange was becoming increasingly common: loans that required no documentation of a borrower's income. No proof of employment. No money down. "I was truly amazed that we were able to place these loans," Connelly said.
It was a world removed from his start in the business, in 1979, when the University of Maryland graduate joined the Springfield office of a savings and loan. For most of his 25 years in the industry, home buyers provided reams of paperwork documenting their employment, savings and income. He'd fill out the forms and send away carbon copies for approval, which could take 60 days.
Connelly was now brokering loans for Orlando-based Pinnacle or for subprime specialists such as New Century Financial that went to borrowers with poor credit history or other financial limitations. Connelly said he secured many loans for restaurant workers, including one for $500,000 for a McDonald's employee who earned about $35,000 a year.
Lenders saw subprime loans as a safe bet. Home prices were soaring. Borrowers didn't have to worry about their payments ballooning -- they could sell their homes at any time, often at a hefty profit. Jeffrey Vratanina, one of Pinnacle's co-founders, said Wall Street wanted to buy more and more of the mortgages, regardless of their risk, to pool them and then sell them to investors. "Quite candidly, it all boils down to one word: greed," he said.
In the Washington area, the housing boom coincided with a surge in the immigrant population, especially Latinos in places such as Prince William County. For many of them, subprime and other unconventional loans were the only way to attain the American dream of owning a home. Pinnacle's customers included construction workers, house cleaners and World Bank employees, who "saw an opportunity to get into a house without putting much money on the table -- to save money to buy furniture to decorate the house," said Mariano Claudio, who in his late 20s was helping run Pinnacle's emerging-markets division, which was dedicated to immigrants.
Pinnacle ran ads on Spanish-language television and radio, set up booths at festivals and sponsored soccer matches at George Mason University. Brokers would hold raffles for gift cards or digital music players to collect names, addresses and phone numbers. It was "a great way to assemble a database of potential clients," Connelly said.
He said his commission and fees depended on how much work he did on the loan, a common industry practice that often led to higher charges for subprime borrowers. Connelly said he carefully reviewed fees with his customers. "The way it's justified morally and ethically is [that] the deal requires more work for a first-time home buyer or one with inferior financial history," Connelly said. "It's a balancing act of morals and ethics -- and the need to make a living."
Some brokers ignored the balance. Connelly began to hear about loan officers who charged low-income borrowers fees of as much as 5 percent of the loan or got a kickback by tacking extra percentage points to the interest rate on a mortgage. "Many borrowers are overwhelmed by the sheer volume of paperwork, disclosures, etc., and they're just not equipped to fully understand," he said. "There were half-truths and downright lies and severe omissions."
A mortgage lender could hire practically anybody. "It's not rocket science," Connelly would tell new hires, such as the busboy who quickly traded in his Toyota Tercel (value: $1,000) for a Mazda Miata sports car (value: $25,000). Pinnacle was running out of office space, forcing some loan officers to work on window ledges or out of their cars.
Then came the party at the Mayflower at the end of 2005, a celebration hosted by the emerging-markets division. In June 2003, the division had originated $500,000 in loans. By the end of 2005, it was doing $500 million with hundreds of brokers across the country.
"It built to a head," Connelly said of the times. "You could point to the Christmas party as the pinnacle."
Jan. 31, 2006. Greenspan, widely celebrated for steering the economy through multiple shocks for more than 18 years, steps down from his post as Fed chairman.
Greenspan puzzled over one piece of data a Fed employee showed him in his final weeks. A trade publication reported that subprime mortgages had ballooned to 20 percent of all loans, triple the level of a few years earlier.
"I looked at the numbers . . . and said, 'Where did they get these numbers from?' " Greenspan recalled in a recent interview. He was skeptical that such loans had grown in a short period "to such gargantuan proportions."
Greenspan said he did not recall whether he mentioned the dramatic growth in subprime loans to his successor, Ben S. Bernanke.
Bernanke, a reserved Princeton University economist unaccustomed to the national spotlight, came in to the job wanting to reduce the role of the Fed chairman as an outsized personality the way Greenspan had been. Two weeks into the job, Bernanke testified before Congress that it was a "positive" that the nation's homeownership rate had reached nearly 70 percent, in part because of subprime loans.
"If the housing market does slow down," Bernanke said, "we'll want to see how strong the subprime mortgage market is and whether or not we'll see any problems in that market."
Staff writers David Cho and Neil Irwin and staff researchers Richard Drezen and Rena Kirsch contributed to this report.