Henry Paulson - On the Brink - Inside the Race to Stop the Collapse of the Global Financial System

Why were we so off? We missed the dreadful quality of the most recent mortgages, and we believed the problem was largely confined to subprime loans. Default rates on subprime adjustable-rate mortgage loans (ARMs) from 2005 to 2007 were far higher than ever; ARMs made up half of subprime loans, or about 6.5 percent of all mortgages, but they accounted for 50 percent of all foreclosures. Even worse, the problems were coming far more quickly. In some cases, borrowers were missing their very first payments.

Homeowner behavior had also changed. More borrowers chose to do the previously unthinkable: they simply stopped paying when they found themselves “underwater,” meaning the size of their loan exceeded the value of the home. This happened quickly in cases where there was little or no down payment and housing prices were falling sharply. These homebuyers had no skin in the game.

The housing decline would have been a problem in its own right. It might even have caused a recession—though I doubt one as deep or as long lasting as what we would experience later. But what we did not realize then, and later understood all too well, was how changes in the way mortgages were made and sold, combined with a reshaped financial system, had vastly amplified the potential damage to banks and nonbank financial companies. It placed these firms, the entire system, and ultimately all of us in grave danger.

These changes had taken place inside of a generation. Traditionally, U.S. savings and loan institutions and commercial banks had made mortgage loans and kept them on the books until they were paid off or matured. They closely monitored the credit risk of their portfolios, earning the spread between the income these loans produced and the cost of the generally short-term money used to fund them.

But this “originate to hold” approach began to change with the advent of securitization, a financing technique developed in 1970 by the U.S. Government National Mortgage Association that allowed lenders to combine individual mortgages into packages of loans and sell interests in the resulting securities. A new “originate to distribute” model allowed banks and specialized lenders to sell mortgage securities to a variety of different buyers, from other banks to institutional investors like pension funds.

Securitization took off in the 1980s, spreading to other assets, such as credit card receivables and auto loans. By the end of 2006, $6.6 trillion in residential and commercial mortgage-backed securities (MBS) were outstanding, up from $4.2 trillion at the end of 2002.

In theory, this was all to the good. Banks could make fees by packaging and selling their loans. If they still wanted mortgage exposure, they could hold on to their loans or buy the MBS of other originators and diversify their holdings geographically. Pension funds and other investors could buy securitized products tailored for the cash flow and risk characteristics they wanted. The distribution of the securities beyond U.S. banks to investors around the world acted as a buffer by spreading risks wider than the banking system.

But there was a dark side. The market became opaque as structured products grew increasingly complex and difficult to understand even for sophisticated investors. Collateralized debt obligations, or CDOs, were created to carve up mortgages and other debt instruments into increasingly exotic components, or tranches, with a wide variety of payment and risk characteristics. Before long, financial engineers were creating CDOs out of other CDOs—or CDOs-squared.

Lacking the ability of traditional lenders to examine the credit quality of the loans underlying these securities, investors relied on rating agencies—which employed statistical analyses rather than detailed studies of individual borrowers—to rate the structured products. Since investors typically wanted higher-rated securities, the structurers of CDOs sometimes turned to so-called monoline insurance companies, which would for a fee guarantee the creditworthiness of their products, many of which were loaded with subprime mortgages. Savvy investors seeking protection often bought credit default swaps on the CDOs and other mortgage-backed products they owned from deep-pocketed financial companies like American International Group (AIG).

As financial companies scrambled to feed the profit machine with mortgage-backed securities, lending standards deteriorated badly. The drive to make as many loans as possible, combined with the severing of the traditional prudential relationship between borrower and lender, would prove lethal. Questionable new loan products were peddled, from option adjustable-rate mortgages to no-income-no-job-no-assets (NINJA) loans. By the end of 2006, 20 percent of all new mortgages were subprime; by 2007, more than 50 percent of subprime loans were originated by mortgage brokers.

All of this was complicated by the rapidly growing levels of leverage in the financial system and by the efforts of many financial institutions to skirt regulatory capital constraints in their quest for profits. Excessive leverage was evident in nearly all quarters.

This leverage was hardly limited to mortgage-related securities. We were in the midst of a general credit bubble. Banks and investment banks were financing record-size leveraged buyouts on increasingly more lenient terms. “Covenant-lite” loans appeared, in which bankers eased restrictions in order to allow borrowers, like private-equity firms, increased flexibility on repayment.

Indeed, I recall a dinner at the New York Fed on June 26, 2007, that was attended by the heads of some of Wall Street’s biggest banks. All were concerned with excessive risk taking in the markets and appalled by the erosion of underwriting standards. The bankers complained about all the covenant-lite loans and bridge loans they felt compelled by competitive pressure to make.

I remember Jamie Dimon, the JPMorgan chairman and CEO, saying that such loans, made mostly to private-equity firms, did not make sense, and that his bank wouldn’t be making any more of them. Lloyd Blankfein said Goldman, too, would not enter into any such transactions. Steve Schwarzman, the CEO of Blackstone, a dominant private-equity firm, acknowledged he had been getting attractive terms and added that he wasn’t in the business of turning down attractive money.

Chuck Prince, the Citigroup CEO, asked whether, given the competitive pressures, there wasn’t a role for regulators to tamp down some of the riskier practices. Basically, he asked: “Isn’t there something you can do to order us not to take all of these risks?”

Not long after, I remember, Prince was quoted as saying, “As long as the music is playing, you’ve got to get up and dance.”

It was, in retrospect, the end of an era. The music soon stopped. Two of the CEOs at that dinner—Prince and Jimmy Cayne of Bear Stearns—would be gone shortly, their institutions reeling.

Leverage works just great when times are good, but when they turn bad it magnifies losses in a hurry. Among the first to suffer when housing prices fell were a pair of multibillion-dollar hedge funds set up by Bear Stearns that had made leveraged investments in mortgage-related securities that subsequently went bad. By late July both funds had effectively shut down.

Bad news came fast, from within and outside the United States. Spooked investors began to shun certain kinds of mortgage-related paper, causing liquidity to dry up and putting pressure on investment vehicles like the now-notorious structured investment vehicles, or SIVs. A number of banks administered SIVs to facilitate their origination of mortgages and other products while minimizing their capital requirements, since the SIV assets could be kept off the banks’ balance sheets.

These entities borrowed heavily in short-term markets to buy typically longer-dated, highly rated structured debt securities—CDOs and the like. To fund these purchases, these SIVs typically issued commercial paper, short-term notes sold to investors outside of the banking system. This paper was backed by the assets the SIVs held; although the SIVs were frequently set up as stand-alone entities and kept off banks’ balance sheets, some maintained contingent lines of credit with banks to reassure buyers of their so-called asset-backed commercial paper, or ABCP.