By Zachary A. Goldfarb and Alec Klein
The Washington Post
Monday, June 16, 2008
The mortgage executives who gathered in a blond-wood conference room in Southern California studied their internal reports with growing alarm.
More and more borrowers were falling behind on their monthly payments almost as soon as they moved into their new homes, indicating that some of them never really had the money to begin with. "Nobody had models for that," said David E. Zimmer, then one of the executives at People's Choice, a subprime lender based in Irvine. "Nobody had predicted people going into default in their first three mortgage payments."
The housing boom had powered the U.S. economy for five years. Now, in early 2006, signs of weakness within the subprime industry were harder to ignore. People with less-than-stellar credit who had bought homes with adjustable-rate mortgages saw sharp spikes in their monthly payments as their low initial teaser rates expired. As a result, more lost their homes; data showed that 70 percent more people faced foreclosure in 2005 than the year before. Housing developers who had raced to build with subprime borrowers in mind now had fewer takers, leaving tens of thousands of homes unsold.
People's Choice was feeling the slowdown, too. It had been generating about $500 million in loans each month, but profit fell by half in the first quarter of 2006, according to documents filed for an initial public offering that was later abandoned.
Zimmer saw the mounting problems as head of the department that worked with Wall Street to package mortgage loans into securities to be sold to investors. Such securities had fueled the housing boom by pumping trillions of dollars into the mortgage market.
Two decades earlier, Zimmer had been among the young salesmen pitching early versions of mortgage-backed securities. He had stayed in the field, becoming a top salesman at Prudential Securities before moving on to help run a big investment fund that specialized in those exotic products.
Now he was trying to make sure People's Choice could continue to raise money by pooling subprime loans. Zimmer and some other executives urged the company to tighten its lending standards. That could lower the rate of defaults. And the better the quality of the loans, the more investors would want them, he figured.
But "there was always push back" from sales executives when he advocated more conservative lending, Zimmer said. Like most big lenders, well over half of the loans made by People's Choice came not from its own employees but from independent mortgage brokers. If the company stopped taking the brokers' riskier loans, the brokers might take both those and their higher-quality loans elsewhere. What's more, People's Choice's own loan sales force -- at about 1,000 employees, the bulk of the company -- worked largely on commissions from loans they made.
"There were times when voices would get raised," Zimmer said. A colleague would pound the table, asking: Why don't you see this?"I was not," he said, "a popular person."
As his team analyzed the individual loan files, Zimmer said he was struck by evidence of fraud, such as doctored bank statements. "Fraudulent loans were a big part of the subprime mess," he said. Mortgage brokers forged borrowers' signatures and pumped up their income, he said. People seeking to buy and sell a home for a quick profit lied that they were going to live in the home -- qualifying for a lower interest rate. But People's Choice calculated that it would have been too complicated and expensive to go after fraud, Zimmer said.
Even as People's Choice sought to preserve its business, the housing climate continued to deteriorate. Many borrowers were defaulting so quickly that the company did not have time to pool those mortgages and sell them off as securities.C hapter VI What Else Is at Risk?
Feb. 7, 2007 . A few hours separate startling announcements. HSBC, a 142-year-old London-based bank that was one of the largest subprime lenders, says it must set aside $10.6 bi llion to cover expected losses. Then another industry giant, New Century Financial, says it will have to redo almost a year of accounting to reflect the depth of its losses.
In subsequent weeks, the stock values of many subprime lenders plunged, and others filed for bankruptcy protection. Construction of new homes hit its lowest point in nearly a decade. On Feb. 27, the Dow Jones industrial average fell 416.02 points, the seventh-largest point loss ever.
At the Federal Reserve, officials remained unruffled. They privately calculated that even if subprime losses were severe, the dollars involved would be no more than a blip in the overall economy. As late as June, Fed Chairman Ben S. Bernanke spoke via satellite to a conference of international economic officials in South Africa, predicting, "the troubles in the subprime sector seem unlikely to seriously spill over to the broader economy or the financial system."
But in financial circles, word circulated about trouble inside one big New York investment bank. Bear Stearns had two hedge funds that invested heavily in securities backed by subprime mortgages. Hedge funds, which handle the money of wealthy investors, are lightly regulated and don't have to report much about their operations to investors. So it was a surprise to Wall Street when the funds appeared on the brink of collapse, forcing Bear Stearns to lend one of them billions of dollars to keep it afloat.
The question in many boardrooms became: What else is at risk?Chapter VII 'This is a Tidal Wave'
Debate among People's Choice executives gave way to questions about the subprime lender's own survival. The investment banks that had bought subprime mortgages to pool them were now demanding that lenders like People's Choice take back the mortgage loans that had gone into default, arguing that misrepresentations had been made about the borrowers. And lenders had to take them; they couldn't risk further damaging their relationship with the banks.
"Now the whole industry is starting to choke on the volume of loans put back to them," Zimmer said.
People's Choice turned around and tried to sell off the bad loans but took "a huge hit," he said. The company had been scrambling to further tighten its lending standards, getting rid of mortgages with no down payment and requiring borrowers to have stronger credit histories. But "by then, it was too late," Zimmer said. "This is a tidal wave."
Finally, banks that had been lending cash to keep People's Choice in business cut off the company. "When that happens, you're done," Zimmer said. "It's the kiss of death."
People's Choice filed for bankruptcy protection in March 2007. By June, Zimmer was laid off.
In Northern Virginia, things were also unraveling. Kevin Connelly, a mortgage broker at Pinnacle Financial's Vienna office, fielded calls from desperate homeowners. Some had been counting on disappearing sources of income -- family, renters -- to pay for mortgages. Many had been employed in the home-building industry, which was shedding workers in droves. Still others owed more on their mortgage than the home was now worth.
"There was a gross underestimation of the true cost of homeownership," Connelly said.
For most of these callers, he had nothing to offer. "What happened was the values had dropped, the credit scores had dropped, and the loan programs had gone away," Connelly said. "I would hang up the phone and be frustrated that I didn't have a solution."
Connelly's colleagues were fleeing even faster than they'd come on board in the boom years. At staff meetings, the gallows humor -- only half funny -- was, "We're having a sales contest, and the winner gets to keep his job," Connelly said.
By last summer, the atmosphere was motionless in his office. Each morning, Connelly visited a Web site called "the Mortgage Lender Implode-O-Meter," which chronicled lenders that were going under. His day "went from talking to 10 people and doing eight transactions to talking to 10 people and doing one transaction," he recalled.
By summer's end, he said, "I was working alone in that office."Chapter VIII Secret War Room
July 19, 2007 . Fed Chairman Bernanke tells Congress: "Rising delinquencies and foreclosures are creating personal, economic, and social distress for many homeowners and communities -- problems that likely will get worse before they get better."
Bernanke and others at the Fed still did not see how severely the troubles would cascade through the economy.
The chairman did warn Congress of "significant financial losses" in the subprime industry, saying there were "implications of this for financial markets." He was right. Within days, Countrywide Financial, the nation's largest mortgage lender, announced that its profit had fallen by a third as more homeowners defaulted. The Bear Stearns hedge funds that had invested heavily in the subprime market went under. The largest bank in France, BNP Paribas, suspended three funds that held mortgage-backed securities.
Then the credit raters -- Moody's, Standard & Poor's and Fitch, which over time had become high priestesses of the global capital markets -- astonished investors by abruptly downgrading many subprime-backed securities that they had previously blessed. The rating companies, which assign letter grades to all kinds of debt issued by companies, municipalities and countries, came under criticism from investors who questioned whether they had issued rosy assessments because they had been paid by the banks whose securities they rated. The credit raters responded that they have procedures in place to prevent conflicts of interest.
Banks and investors also questioned whether there were hidden weaknesses in the broader market for mortgage-backed securities and other complex investments, such as collateralized debt obligations, or CDOs, which combined various kinds of debt.
As a result, banks, anticipating their own losses, began to hoard cash and refused to lend. The fallout: A major part of the machinery of U.S. capitalism -- the $28 trillion credit market that ensures big companies can pay their employees and buy equipment by taking out loans -- nearly shut down. In August, the credit crunch sent the stock market into its most volatile period since the Enron days.
The Fed pumped money directly into the markets, loaning to banks and accepting as collateral the mortgage-backed securities that few investors wanted anymore.
At the Treasury Department, Robert Steel, undersecretary for domestic finance, called Wall Street executives, housing agencies and the Fed for counsel but particularly sought out two men who had shown keen insight before the collapse.
One was Edward Gramlich, who had been warning for years that subprime borrowers were vulnerable to overextending themselves. He had since retired from the Fed and had just published a book, "Subprime Mortgages: America's Latest Boom and Bust." Gramlich told Steel that borrowers went beyond their means and that lenders encouraged it -- and now homeowners needed counselors to avert foreclosures.
Steel also telephoned Lewis Ranieri, a pioneer in mortgage-backed securities. Ranieri told the Treasury official that many of the securities were actually in good shape but banks couldn't unload them because of the perception that they had no value.
Fed officials, in a state of growing alarm by late August, maintained an outward calm at their annual symposium at Jackson Hole, Wyo. But secretly, Bernanke and other top Fed officials met several times a day in a makeshift war room where they had installed secure telephone lines.
Bernanke, a former Princeton University professor, employed the Socratic style, going around the table, asking his Fed team how the central bank should respond to the crisis, according to some of those present. How aggressive should the Fed be in using its influence on interest rates -- a broad sword that affects the entire economy? What risk did the credit problems pose to average Americans?
After one long discussion, the Fed officials went downstairs to the public conference, where one economist, John Taylor of Stanford University, was criticizing the Alan Greenspan regime for having kept interest rates so low for too long.
Gramlich, too sick to attend the conference after being diagnosed with leukemia, had his speech read by a colleague: "The subprime market, for all its warts, is a promising development, permitting low-income and minority borrowers to participate in credit markets." But, he added, "a majority of loans are made with very little supervision."
In the coming weeks, the Fed began aggressively cutting interest rates to encourage banks to lend. In October, the Bush administration announced a Gramlich-style idea, Hope Now, an alliance of counselors, lenders and other industry participants who would work to help borrowers avoid foreclosure by renegotiating mortgage terms. But it was clear that the trouble was not over when some of the nation's biggest banks began reporting unexpectedly large losses: Morgan Stanley, $3.7 billion. Merrill Lynch, $8.5 billion. Citigroup, $11 billion.
In his final weeks, Gramlich followed the unfolding financial crisis from his home near Dupont Circle, sitting in a white easy chair at a window overlooking Connecticut Avenue. He was resigned to the fact that he couldn't play a larger role. Five days after his speech was read in Jackson Hole, he died.
Staff writers David Cho and Neil Irwin and staff researchers Richard Drezen and Rena Kirsch contributed to this report.