Broke, USA

There were other culprits, of course, starting with all those mortgage brokers willing to accept fees for steering clients into the 2/28 teaser loans they couldn’t possibly afford in year three. “The brokers were the drivers, as far as I’m concerned,” said Chuck Roedersheimer, a bankruptcy attorney I met in Dayton who specializes in cases involving home foreclosure. They worked on commissions, Roedersheimer said, that could reach 3 or 4 percent of the loan’s value if it included a generous yield spread premium—the bonuses a lender gave brokers who steered borrowers into higher priced, more profitable loans. Early on, Option One was among those lenders refusing to pay a yield spread premium, essentially a bribe for putting people into higher-priced loans. “But then brokers stopped sending them business,” the Center for Responsible Lending’s Mike Calhoun said. “So they turned around and endorsed yield spread premiums because that’s what they needed to do to compete.” (A study commissioned by the Wall Street Journal found that more than half of the borrowers taking out a subprime loan between 2000 and 2006 had a credit score high enough to qualify them for a conventional rate loan.) Mortgage broker might once have been considered an honorable profession, but by the start of the 2000s it seemed nothing more than a quick way to become rich. “Literally you saw people going from used car dealer to mortgage broker,” Jim McCarthy said.

Yet the system worked after a fashion—as long as home prices continued to rise at a brisk rate. The broker was happy to put a homeowner holding an adjustable rate mortgage about to reset into a new mortgage if a $300,000 house was now worth $350,000, as was the lender. Everyone earned another fee, and the ultimate stakeholders would even hold collateral that was appreciating in value. There would only be a problem if home prices fell. Without the ability to refinance, people would be trapped in adjustable rate mortgages they couldn’t really afford and as more families were forced into foreclosure, prices would fall further, widening the gap between the amount owed on a property and the price it would fetch at a sheriff’s sale. Only then would it seem as if everyone had been living in a perversely rosy world.

“Losses were remarkably low given the crazy lending they were doing,” Mike Calhoun said, “but that was because they were doing even crazier stuff, putting off foreclosures by refinancing people into even less sustainable loans.” The most maddening part, Calhoun said, was that the more lenders loosened their terms, the more it reinforced a perception that there was nothing wrong. Home ownership was on the rise, the stock market was soaring, and politicians on both sides of the aisle were happily accepting campaign contributions from these rich new benefactors. “It was a hard time to say this giant storm is building but it’s beyond the horizon,” Calhoun said.

In places like Ohio that weren’t experiencing the same boom in home prices as other parts of the country, consumer advocates started talking about another problem: appraisal inflation. For Beth Deutscher, an early member of the Predatory Lending Solutions Project that Jim McCarthy helped put together, the case that alerted her to the problem involved two sisters in their sixties, both legally blind and living on a fixed income. The sisters were in a house in such poor shape that the dining room sloped downhill, Deutscher said, and cracks were visible in the foundation. Yet somehow they owed a lender $100,000 after a broker sweet-talked them into signing papers they couldn’t read for a loan they couldn’t afford. Initially Deutscher, who by this time was running an organization she helped found called the Home Ownership Center of Greater Dayton, read the appraiser’s report and wondered if the crazy real estate inflation taking place in other locales had hit Dayton. The house to her seemed worth less than half that $100,000. But the case of the sisters taught her that as bad as waves one and two of the subprime mortgage fiasco had been, there were still new shocks to be had in wave three. Select appraisers, it seemed, were happy to enrich themselves by fabricating a report when a lender needed the justification for an outsized loan.

“With that case it started to become clear that lenders are not afraid to loan more than a house was worth,” Deutscher said. “It became all about maximizing the up-front profit and then moving on to the next loan, with no conscience about how that was going to play out.”

The big rating agencies would play similarly destructive roles as well—and not out of ignorance, Kevin Byers told me when I visited him in Atlanta. To make his point he grabbed a stack of reports he keeps handy in a desk drawer. One is from Moody’s and is dated May 2005. It explores what its analysts called the “payment shock risk” associated with the 2/28s as lenders continued to lower the teaser rates to make loans seem more affordable. “The resulting differences in potential payment increase,” the analysts note, will have a “meaningful” impact on the financial soundness of these loans. Another, written by two Standard & Poor’s analysts in April 2005, explores what the pair describe as the “continuing quest to help keep the loan origination flowing.” Lenders are resorting to any number of new products to keep loan volume up, they wrote, including mortgages that mean people will own less of their home over time rather than more and the repurposing of interest-only loans for the subprime market, a product that really only made sense for a rich client who can afford the balloon payment on the other end. “There is growing concern around the increased usage of these mortgages,” they wrote.

“It’s not like they didn’t know that all this was going on,” Byers said. “They just didn’t want to do anything about it because they had a vested interest.” The institutions putting together these packages loaded with toxic loans were the very ones paying the credit agencies to evaluate the creditworthiness of the loans, and so the agencies would liberally hand out top ratings while relegating their concerns to the occasional research report. “I think they saw their role as ending once they put the investor community on notice that there are structural issues that they need to watch out for,” Byers said. The attorney general of Ohio was among those suing the major credit rating agencies, claiming their stamping of a triple-A rating on high-risk and wobbly securities cost state retirement and pension funds more than $450 million in losses.

Alan Greenspan shares some of the blame—a lot of the blame, according to some. Congress had deputized the Federal Reserve to enforce a sense of fair play inside the subprime market but the Fed chair steadfastly maintained a hands-off approach even as subprime grew from 5 percent of the mortgage market in 2001 to a 29 percent share by 2006. Worse, Greenspan kept interest rates historically low through the first half of the decade—at 1 percent in 2003, the lowest rate in half a century. “I’m sitting there watching Greenspan continuing to lower interest rates,” Kathleen Keest said, “and I’m going, ‘I thought your job was to take the punch bowl away and you’re pouring more rum into it.’” Federal Reserve Governor Edward Gramlich would rebuke Greenspan for showing no interest in investigating the predatory behavior of the subprime lenders.

There were those who said Wall Street was primarily responsible. Their insatiable appetite for these loans— the New Yorker’s Connie Bruck called it Wall Street’s “addiction”—kept everyone motivated. But then one can also fault those wanting to buy small tranches of a mortgage-backed bond for keeping demand high. And to say “Wall Street” is to miss out on a broader range of culprits. In the mid-2000s, it seemed every major financial institution in the world had a hand in this dirty business. By 2006, Wells Fargo, through its Wells Fargo Home Mortgage unit, ranked as a top-ten subprime lender, as did Citigroup, which ranked fourth. Washington Mutual placed eleventh on that same list and Chase Home Financial, a division of JPMorgan Chase, seventeenth. HSBC, the London-based financial giant that had purchased Household Finance, was number one on the list in 2006 after its subsidiary, Household Finance, regained the top spot with $53 billion in subprime loans. A chastened Ameriquest, which paid a $325 million settlement earlier that year, fell to seventh.

And the big financial conglomerates were hardly the only major corporations to aggressively jump into the subprime mortgage business. The money H&R Block made offering refund anticipation loans had apparently given the tax preparation giant a taste for subprime profits because in 1997 it paid $190 million for Option One and in short order transformed it into a top-tier subprime lender. General Motors aggressively entered the subprime market through its GMAC unit, which bundled together nearly $26 billion in mortgage-backed securities in 2006, and General Electric owned WMC, a subprime lender that made $33 billion in mortgage loans in 2006, ranking it fifth on the Inside B&C Lending list.

Glen Pizzolorusso, a WMC sales manager, gave a sense of what life was like in the middle of the credit cyclone when he agreed to an interview in 2008 with the radio show This American Life. Pizzolorusso, in his mid-twenties, seemed to be living the life of a mini-celebrity. He bought $1,000 bottles of Cristal champagne at bottle clubs in Manhattan and rubbed shoulders with the likes of Christina Aguilera and Cuba Gooding, Jr. He bought a penthouse on Manhattan’s Upper East Side and a $1.5 million house in Connecticut and owned a Porsche and two Mercedes to get him back and forth. He was making between $75,000 and $100,000 per month and suspected something might be seriously wrong in his life when one month he was paid $25,000 and that wasn’t enough to cover his expenses. “I did what YOU do every day, try to be the best at my job,” he wrote on a blog he created to defend himself after his story appeared on the radio. He didn’t create the rules, he said, and the corporation he worked for had stayed within the law. His sole regret, he wrote, was that he had spent his money so foolishly.