Sept/Oct/Nov 2009

Money for Nothing

How the Fed, the investment elite, and mortgage scammers brought down the US economy.

Seth Hettena


ALCHEMISTS IN THE MIDDLE AGES sought in vain to unlock the secret that would turn lead into gold, but their modern counterparts have introduced some important modifications— chiefly by turning gold into paper. The Federal Reserve, the gatekeeper of the American financial system, keeps tons of gold bullion in its subterranean vaults, and it creates dollars out of thin air to control the flow of money through the world's biggest economy. Under Ben Bernanke, the Fed has evolved into what David Wessel calls the fourth branch of government. And in recent months its powers have expanded dramatically, in order to combat the most severe financial crisis since the Great Depression. Wessel's In Fed We Trust is the best book yet written on the present crisis, and a measured and thoughtful look at the massive experiment the Fed has undertaken, the consequences of which may not be understood for years.

Among the many revelations in Wessel's book, the most disturbing is just how poorly those in charge of the financial system understood it. Under Alan Greenspan, the Fed had kept the monetary floodgates open for so long that the system was practically drowning in the stuff. If you were a banker, money was all but free for a time, and you lent until there were no borrowers left, all that extra money encouraging foolish risks. Yet the Fed couldn't see the trouble beneath the surface; it was better prepared for a terrorist attack or an outbreak of avian flu than anything close to the Great Panic of 2008. A crisis on such a scale "simply wasn't considered a plausible scenario," writes Wessel, the Wall Street Journal 's economics editor. "It was, as much as anything, a failure of the imagination, similar to the failure to anticipate terrorists hijacking big airlines and steering them into the World Trade Center." Not until the financial pipes were clogged did the Fed come to comprehend how the system worked. This realization is especially troubling as Congress considers a set of regulatory overhauls that would designate the Fed as the guardian against systemic threats to American finance.

Bernanke was an unlikely figure to be cast as the system's savior. The son of a drugstore owner from Dillon, South Carolina, he had served as chairman of Princeton's economics department and once described himself as an "academic lifer." Installed as Fed chairman in 2006, he was determined to be the "un-Greenspan." Bernanke's prior experience in politics involved two terms on a local school board, but he understood the consequences of Fed inaction better than most. He had devoted his academic career to the Great Depression, and like Nobel laureate Milton Friedman, he came to believe that after the financial collapse of 1929, the Fed had made things much worse. Bank after bank capsized in the 1930s, in no small measure because they could not borrow from the Fed, and by the time it acted, it was too late. As Bernanke told Friedman in 2002, "Regarding the Great Depression. You're right, we did it. We're very sorry. But thanks to you, we won't do it again."

Despite the pledge, he and his lieutenants very nearly did. Bernanke badly misread the economy in 2007, and his initial response to the Great Panic was timid. He pronounced the banking system healthy and declared that the subprime-mortgage problem had likely been "contained." But when the Treasury couldn't come up with the money to save Bear Stearns in March 2008, the Fed violated its sacrosanct principle of lending only to commercial banks and gave the Wall Street investment house enough money to make it through the weekend. It did so again for AIG, providing an eighty-five-billion-dollar loan to the troubled insurance giant. Bernanke pushed the Fed to cut interest rates to zero and stimulate frozen markets for mortgages, auto loans, and credit-card loans. Still, Wessel sees Bear Stearns as a missed opportunity. After Bear's near-death experience, Treasury officials drafted a "Break the Glass" contingency plan to ask Congress for five hundred billion dollars, but the plan went nowhere because things didn't look bad enough yet. "Bernanke and [Treasury secretary Henry] Paulson agreed that there was no point in offering Congress a plan so far-reaching unless the crisis was so severe that Congress would see no other option," Wessel writes.

They would have to wait for the biggest bankruptcy in American history, the September 2008 failure of Lehman Brothers, which nearly brought the entire financial system down with it. The government knew Lehman was in trouble—the company's chairman and chief executive, Richard S. Fuld Jr., had been calling Paulson and New York Federal Reserve president Timothy Geithner for months. Fuld was looking for government help, but both Paulson and Geithner told him to find a buyer—which in prevailing market conditions meant to twist in the wind. After rescuing Bear Stearns as well as Fannie Mae and Freddie Mac, the two government-sponsored mortgage giants, Paulson had reached a breaking point. "I'm being called Mr. Bailout," Wessel quotes him as saying. "I can't do it again."

The Fed didn't anticipate how badly markets would react to its choice to let Lehman fail; it never occurred to the decision makers that the firm's collapse would trigger a run on money-market funds—the dollar-a-share mutual funds considered as safe as banks—and unleash chaos on Wall Street. Once the last potential federal protector, President Bush, declined to intervene on Lehman's behalf, "forces of evil" were unleashed on the global markets, writes Lawrence G. McDonald in A Colossal Failure of Common Sense.

McDonald, a former Lehman vice president and onetime junk-bond trader, is furious over what he views as an avoidable sacrifice. While Lehman was earning record profits in large part due to its risky bets on subprime mortgages, McDonald was growing uneasy over the firm's reliance on foolish borrowers and shady lenders. But Lehman remained fixated on the profits it was generating; if doom was beckoning, the firm's leaders couldn't or wouldn't believe it. As McDonald quotes Lehman managing director Mike Gelband, describing a conference with two of them:"They cannot understand. And they will never understand. When I beg either of them to listen to what I am saying, their eyes glaze over."

The firm began life as an Alabama trading and dry-goods concern in the mid-nineteenth century; when it bulked into a major regional cotton broker, it moved to Manhattan, the center of cotton trading after the Civil War. In time, Lehman became one of the country's biggest elite banking houses, financing Macy's, RCA, American Airlines, and Campbell Soup. It was, as McDonald recalls, a "select men's club, a paneled haven from the world's vulgarities."

In the main, however, A Colossal Failure of Common Sense leaves the story of Lehman's rise—and a balanced portrait of its demise—to others. McDonald is out to settle scores and assign blame. With the help of Patrick Robinson, a writer of military techno-thrillers, McDonald fulminates against Fuld, a man he has never met but nonetheless despises. "King Richard the Not-So-Great," as McDonald calls him, was an "oddball demigod" who ruled the investment house from his palatial, mahogany-paneled office on the thirty-first floor, moving unseen through the building like a "strange wraithlike presence." This pulpy demonization builds to climaxes that plainly owe more to Robinson's overheated tales than to McDonald's insider vantage: "After months of internecine warfare facing the light cavalry of Wall Street's analysts and researchers, Dick Fuld, his commanding officer, pulled him back from the front line to a more sheltered position."

And for all its purple-tinged accounts of corporate derring-do, A Colossal Failure of Common Sense is often a monumental study in authorial unself-awareness, as it depicts the firm's lead brokers having great fun placing million-dollar bets with other people's money. McDonald and his colleagues gleefully wait for corporations to fail so they can swoop in and scoop up profits. Indeed, Fuld's Lehman was consumed with profits, and McDonald was in this sense a model Lehman executive. He needed to make twenty million dollars for the firm to earn himself one million dollars in bonus money, and in his first two years trading the bonds of troubled companies, he made the firm just shy of fifty million. As he remembers pocketing seven-figure bonuses as though they were his due and recounts nights out at Manhattan's pricier restaurants, his attempts to blame Fuld for being too greedy ring hollow. "I could not help thinking how utterly disadvantaged the investing public was against this giant arsenal of research and talent at the immediate disposal of Wall Street's frontline traders," McDonald writes in one of his more trenchant asides. But that insight is quickly bypassed in favor of more pulse-pounding narration, leaving readers no clear sense of why the world isn't better off without Lehman Brothers in it.

Meanwhile, plenty of other passages make it all too plain that Lehman became an egregiously bad actor during the new millennium's mortgage boom. McDonald joined the firm in 2004, when Wall Street was in the midst of an unprecedented borrowing binge. Lehman had been the first major Wall Street firm to embrace all aspects of the mortgage business. Through a series of acquisitions, the company had acquired firms that issued and serviced billions of dollars' worth of mortgages. Many of these were of the now-infamous subprime and Alt-A varieties. Through the magic of financial engineering, however, Lehman had "securitized," or repackaged, these subprime and nearly subprime mortgages into triple-A bonds and resold them to unsuspecting investors. The problem was that Lehman was still holding on to many of these mortgages, some twenty-five billion dollars' worth, when the end came. The disastrous scale of Lehman's mistaken real estate bet dawned on McDonald when he traveled to Southern California and met his financial alter egos—the "cocky, relatively dumb bodybuilders" who worked for subprime-mortgage giant New Century Financial. "In that restaurant, crammed with self-satisfied know-nothings, we had gazed upon the amoral soul of this housing boom," he writes.

The amoral deal making that kept the housing bubble inflated is the main subject of And Then the Roof Caved In, a book by CNBC reporter David Faber based on the network's recent documentary House of Cards, a rare bout of soul-searching for the notoriously market-cheering cable network. At the center of the action in Faber's account is a clutch of clever hedge-fund managers who had the incredible prescience to recognize the bubble as the opportunity of a lifetime.

But one member of the elite, a Dallas-based fund manager named Kyle Bass, began assiduously tracking the dark side of the boom. He had uncovered frauds in the 1990s, and he followed a hunch to start digging into the mortgage bonanza. It took months of investigation for him to learn the boom's chilling secret—borrowers who shouldn't have borrowed from lenders who shouldn't have lent, to use Warren Buffett's phrase. Bass came to see his instincts were right during a meeting with a recent business school graduate who ran a loan-trading desk at one of Wall Street's biggest firms. The trader calmly admitted he wasn't concerned about the quality of the loans. "We just package 'em up and sell 'em as fast as we can," the trader told Bass.

Continuing his investigation, Bass found Daniel Sadek and Quick Loan Funding. Sadek, a Lebanese immigrant whose formal education ended in the third grade, was a Mercedes salesman in Orange County, California, who had discovered that many of his customers were loan officers at the region's growing mortgage lenders. For a $250 fee, he became licensed to sell mortgages, too, and in 2002 he started Quick Loan Funding. With its motto, "Don't wait, we won't let you," Quick Loan took on the nastiest subprime loans and hired former pizza deliverymen and kids who worked in electronics stores to sell them. Making five million dollars a month in 2004 and 2005, Sadek became a movie producer, using his firm's profits to finance Redline, a film about street racing, which starred his fiancée and his collection of pricey sports cars.

Bass warned about the subprime world, but as was the case with McDonald and other market Cassandras, his appeals fell on deaf ears. In August 2006, he told senior executives at Bear Stearns, which owned billions of dollars in subprime mortgages, about his research. "That's a very compelling presentation you've got there," Bear's chief risk officer whispered into his ear. "God, I hope you're wrong." An official at the Fed told Bass that he didn't see things the same way. And the housing economy continued to grow.

Like any savvy fund manager, however, Bass found his own way to profit from his belief that the market was headed for a major crash—via the insurance deals called credit-default swaps. The banks wanted him to buy these swaps because it meant more fees, as well as more income streams they could package and sell off to investors, and because they believed that their mortgages would never go bad. Bass formed a $110 million fund and started placing his bets. For very little risk, he could wager against securities that contained mortgages originated by Quick Loan Funding and other negligent lenders. "It was the greatest trade Bass had ever encountered," Faber writes. In February 2007, Bass excitedly called Faber after a sudden spike in mortgage delinquencies, which sent the value of Bass's credit-default swaps soaring. "He was about to become a very wealthy man," recalls Faber.

Of course, Bass's good fortune was taking shape amid far larger calamities on the world stage. Faber tracks the fallout all the way to the Arctic Circle, where the town of Narvik, Norway, becomes a symbol of Wall Street's relentless search for investors willing to buy its junk. He finds people like Arturo Trevilla, a Mexican immigrant with three children who with a $3,600-a-month salary managed to buy a $584,000 house in San Clemente, California, in 2005. Two years later, Trevilla's mortgages adjusted, and his monthly payments soared to more than $5,000. Trevilla lost his job, and then he had to hand his keys back to the bank. "I was just with my oldest kid and right after I give the keys and get in the car, I start crying," he told Faber. "Because I felt like part of our American dream was just on those keys." The moral for Faber, as for all retrospective chroniclers of the crisis, seems coldly obvious, now that some of the rubble has been cleared away: Someone— or rather a host of someones, from the Fed and the Lehman titans on down to the Quick Loan Funding telemarketers—should have let the Arturo Trevillas of the world wait.

Seth Hettena, a writer based in San Diego, is the author of Feasting on the Spoils: The Life and Times of Randy "Duke" Cunningham, History's Most Corrupt Congressman (St. Martin's Press, 2007).

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