David Dayen | Chain of Title: How Three Ordinary Americans Uncovered Wall Street’s Great Foreclosure Fraud | The New Press | May 2016 | 26 minutes (7,150 words)
Below is an excerpt from Chain of Title, by David Dayen, the true story of how a group of ordinary Americans took on the nation’s banks at the height of the housing crisis, calling into question fraudulent foreclosure practices. This story is recommended by Longreads contributing editor Dana Snitzky.
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How could you not know who I am if you’re suing me?
Lisa Epstein drove down Highway A1A, along the Intracoastal Waterway, back to her old apartment in Palm Beach. At her side was her daughter Jenna, in a car seat; atop the dashboard was an envelope containing the monthly payment on her unsold co-op. Though her house was in foreclosure, Lisa always paid the mortgage on the apartment, her fallback in case of eviction.
Lisa gazed at the water out the window. She never wanted to miss mortgage payments; Chase told her to do it and promised assistance afterward, but then put her into foreclosure. The delinquency triggered late fees, penalties, and notifications to national credit bureaus. A damaged credit score affected a mortgage company’s decision to grant loan relief, which hinged on the ability to pay. Even if Lisa managed to finally sell the apartment, even if she could satisfy the debt on the house, the injury from this “advice” would stick with her for years. Chase Home Finance never mentioned the additional consequences, emphasizing only the possibility of aid. The advice was at best faulty, at worst a deliberate effort to seize the home. Lisa spent a lifetime living within her means, guarding against financial catastrophe. Now Chase Home Finance obliterated this carefully constructed reputation. She felt tricked.
America has a name for people who miss their mortgage payments: deadbeats. Responsible taxpayers who repay their debts shouldn’t have to “subsidize the losers’ mortgages,” CNBC host Rick Santelli shouted from the floor of the Chicago Board of Trade on February 19, 2009, two days after Lisa got her foreclosure papers. “This is America! How many of you people want to pay for your neighbor’s mortgage, that has an extra bathroom and can’t pay their bills, raise your hand!” The floor traders in Chicago, between buying and selling commodity futures, hooted. This rant would later be credited as the founding moment of the Tea Party. And it signified a certain posture toward delinquent homeowners, a cultural bias that equated missing the mortgage payment with failing the duties of citizenship. The indignation didn’t account for mortgage companies driving customers into default. However, lenders welcomed anything that humiliated deadbeats into blaming themselves. In most cases it worked: in the twenty-three states that required judicial sign-off for foreclosures, around 95 percent of the cases went uncontested.
But Lisa had an inquisitive mind. Before she would acquiesce, she wanted to understand the circumstances that led to this lawsuit from U.S. Bank, an entity she had never encountered before seeing it listed as the plaintiff. She had three questions: who was this bank, why did it have a relationship with her, and why was it trying to take her house?
As it happens, U.S. Bank is real. It’s the fifth-largest bank in the country, with more than three thousand branches, mainly in the Midwest and the Pacific Coast, not in Florida. Lisa learned all this through a cursory Google search. U.S. Bank also had a toll-free customer service number. But just like Wells Fargo, U.S. Bank’s reps had no record of a Lisa Epstein. “Look, you’re suing me. How could you not know who I am if you’re suing me?” Lisa implored. She gave U.S. Bank her Social Security number, her address, all her mortgage information. Nothing turned up.
Lisa kept every document from the closing in an old canvas bag from a nursing conference. She read the mortgage documents line by line, the way she had while eight months pregnant and sitting in the offices of DHI Mortgage. There was no mention of U.S. Bank, Wells Fargo, or even Chase, where she sent mortgage payments for a couple of years. Lisa made the deal with DHI Mortgage. How did these other banks get into the picture?
Lisa had a bit more luck when she Googled “U.S. Bank NA as trustee for JPMorgan Mortgage Trust 2007-S2,” the name of the plaintiff on her foreclosure documents. This sent her to the website of the Securities and Exchange Commission, specifically an investor report (known as an 8-K form) for the JPMorgan Mortgage Trust. One paragraph included every party she had become familiar with over the past several months:
J. P. Morgan Acceptance Corporation I (the “Company”) entered into a Pooling and Servicing Agreement dated as of May 1, 2007 (the “Pooling and Servicing Agreement”), by and among the Company, as depositor, Wells Fargo Bank, N.A., as master servicer (in such capacity, the “Master Servicer”) and securities administrator (in such capacity, the “Securities Administrator”) and U.S. Bank National Association, as trustee (the “Trustee”), providing for the issuance of J. P. Morgan Mortgage Trust 2007-S2 Mortgage Pass-Through Certificates.
Most homeowners had as much chance of decoding this as they did of learning Mandarin Chinese. Lisa had no background in real estate, economics, or high finance. The only time she dealt with anything Wall Street–related was when she chose funds for her 401(k) upon starting a new job. It took years of study to master nursing; nobody offered her a class in pooling and servicing agreements, or mortgage pass-through certificates. However, every thing that transformed the mortgage market, every thing that layered risk and drove the housing bubble, every thing that made buying a home in 2007 infinitely more dangerous than it should ever be, was contained in that innocuous-sounding paragraph.
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Franklin Roosevelt. . . created the most successful housing finance system in the world.
One thousand families. That’s how many Americans lost their homes each day at the height of the Great Depression. Franklin Roosevelt’s response to this relentless destruction created the most successful housing finance system in the world, a key to America’s political stability and emergence as an economic power house.
To stop foreclosures, the Home Owner’s Loan Corporation (HOLC) bought defaulted mortgages from financial institutions at a discount and sold them back to homeowners. Beginning in 1933, HOLC acquired one million mortgages—one out of five in the country at that time. Eighty percent of HOLC clients saved their homes when they otherwise might have lost them. And once every mortgage was paid off and the program closed, HOLC even turned a small profit.
HOLC gave borrowers a twenty-year mortgage with a fixed interest rate, allowing them to gradually pay off the principal over the life of the loan, a process known as amortization. At the time very few Americans had long-term mortgages. The most common product lasted two to five years; borrowers would pay interest each month and then either make a “bullet” payment of principal at the end or roll over into a new loan. When bullet payments came due during the Depression, there was no way for out-of-work homeowners to find the cash. And mortgage holders, saddled with their own funding problems, refused to renegotiate contracts and seized the homes. This only accelerated the housing collapse, putting more homes on the market when nobody could afford to buy. The HOLC solution was intended to attenuate this downward cycle. But it also eliminated the volatility of the bullet payment, which magnified periods of economic hardship. HOLC generated confidence in the long-term, fully amortized mortgage, which previously was seen as a scam unscrupulous door-to-door salesmen used to rob lower-class laborers of down payments.
The government did not want to hold HOLC mortgages, and investors feared buying them, since the families making payments had previously defaulted. So in 1934 Roosevelt established the Federal Housing Administration to provide mortgage insurance on HOLC loans. Borrowers paid a small FHA premium, and investors would be guaranteed their share of principal and interest payments. The FHA would eventually offer protection to loans made by private lenders as long as they issued mortgages with a 20 percent down payment and terms of at least twenty years. In 1938 the Federal National Mortgage Administration, commonly known as Fannie Mae, enabled this by purchasing government-insured mortgages, injecting additional capital into the lending industry.
More than anything, the system delivered security. Families could make one affordable monthly payment for two or three decades, and glory in the dignity of homeownership. Builders supported the desire by constructing developments of detached single-family homes outside of metropolitan centers. The interstate highway system connected suburbs to the cities. Subdivisions sprang up everywhere, and millions of Americans sought long-term fixed-rate loans to secure their spot in them. The FHA loosened standards and granted insurance on thirty-year loans with as little as 5 percent down for new construction. The GI Bill for returning World War II servicemembers further guaranteed low-rate loans through the Veterans Administration. In 1940, 15 million families owned their own homes; by 1960 that number jumped to 33 million. Buying a place in the suburbs became part of growing up, like college graduation or a wedding, the epitome of the promise of the middle class from the country that claimed to have invented it. It was a utopia of white picket fences, modern kitchens, and freshly cut grass.
Private lenders filled the demand for these loans, particularly the savings and loan industry, which had been around since the 1830s (known back then as the building and loan). The biggest problem for companies lending long is the funding: there’s money to be made, but lenders need large amounts of cheap up-front capital. Savings and loans found the formula by funding home mortgages with customer deposits. Government-supplied deposit insurance made ordinary Americans confident that they could put money into a bank and have it protected. The S&Ls benefited further when Congress granted them an interest rate advantage over commercial banks. This nudged depositors into S&Ls, increasing the funding available for mortgage finance.
S&Ls typically paid a healthy 3 to 4 percent rate of interest on accounts and charged between 5 and 6 percent on mortgages. That small float on hundreds of billions of dollars in loans added up. The system was mutually beneficial, and every one had a stake in a successful outcome. State laws initially restricted savings and loans to issuing residential mortgages within fifty to a hundred miles of their headquarters. So the S&Ls needed communities to prosper to increase deposits and subsequently increase loans. S&L presidents became local leaders, sponsoring local golf tournaments or Little League baseball teams.
When families encountered trouble—unemployment, medical bills, untimely death—and could no longer pay the mortgage, lenders worked with them to prevent foreclosure, because it was in their financial interest. They made more money keeping the borrower in the home, even with a reduced payment, than having to sell at a discount in foreclosure. This incentive maintained stability and kept home values rising. The annual foreclosure rate from 1950 to 1997 never rose above 1 percent of all loans and was often far lower.
By 1980 there was more money sloshing around the mortgage market—about $1.5 trillion—than in the stock market. And Wall Street investment banks looked at all that cash the way Wile E. Coyote looked at the Road Runner. They wanted a piece of the action.
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I wasn’t out to invent the biggest floating craps game of all time, but that’s what happened.
Lew Ranieri took over the mortgage trading desk for Salomon Brothers in 1978. He was fat, unkempt, and owned four suits, all of them polyester. In the Wall Street memoir Liar’s Poker, Michael Lewis describes Ranieri as “the wild and woolly genius, the Salomon legend who began in the mailroom, worked his way onto the trading floor, and created a market in America for mortgage bonds.” But he didn’t issue the first mortgage-backed securities; the federal government did.
Faced with a budget deficit during the Vietnam War, in 1968 Lyndon Johnson split up Fannie Mae to push its liabilities off the books. A redesigned Government National Mortgage Company (Ginnie Mae) continued to buy government-insured mortgages. But the new Fannie Mae and its counterpart, the Federal Home Loan Mortgage Corporation (Freddie Mac), became quasi-private, quasi-public companies (officially government-sponsored entities, or GSEs), which could purchase conventional mortgages not insured by the government, provided they met certain guidelines—usually thirty-year fixed-rate mortgages carefully underwritten to ensure that the borrower would pay them back. The GSEs would pool hundreds of these loans together and create bonds; they called it securitization. Revenue streams were created from the monthly mortgage payments, with each investor entitled to a proportional piece. For a small fee, GSEs guaranteed payments to investors, and because investors believed the government would never let the GSEs default, they happily bought the bonds. Investor cash built additional capital for mortgage financing, allowing more people to purchase a home.
Investment banks assisted Freddie Mac with the initial securitizations in 1971 but were only paid a small retainer. Salomon Brothers and Bank of America (BofA) attempted to bypass Fannie and Freddie with a private-label securitization in 1977, packaging BofA-originated loans into a bond. But government regulations prohibited the largest investors, like pension funds, from buying the securities. Others were too spooked by the uncertainty of whether the under lying loans would fail. And thirty-five states blocked mortgages from being sold into a private market. Despite this, Robert Dall, the Salomon trader who brokered the Bank of America deal, believed investment banks would profit from trading U.S. home mortgages, the biggest market in the world. They just needed creativity and some regulatory relief.
Ranieri took over at Salomon just as the savings and loans grew desperate, battered by the twin diseases of high inflation and Federal Reserve chairman Paul Volcker’s remedy, high interest rates. This hurt S&Ls on every level. Nobody wanted to borrow money at 20 percent to buy a home, nobody wanted to save when prices could soar next week or next month, and nobody wanted to keep money in a rate-capped S&L when they could get better returns from a money market fund or Treasury bill.
In 1981 Congress gave the S&Ls a huge tax break that allowed them to hide losses, helping to keep them afloat. But to take advantage of the tax relief, they needed to move assets off their books. Ranieri stepped into this void, buying mortgages from one S&L and selling them to another, profiting from the markup. It revealed the possibilities of Wall Street involvement in the mortgage market, and Salomon made a killing. Ranieri then got Freddie Mac to help with a bond deal that packaged older loans from a D.C.-area S&L called Perpetual Savings. Freddie’s involvement eliminated regulatory restrictions that prevented nationwide sales of mortgage-backed securities. But to attract institutional investors with the most cash, Ranieri redesigned the bond.
Big investors didn’t like the uncertainty in mortgages: you never knew when homeowners would pay them off , so you never knew the length of the loan and the projected profit on interest. So in 1983 Ranieri and his counterpart at First Boston, Larry Fink, created the collateralized mortgage obligation (CMO), the basic securitization structure used during the housing bubble.
Instead of investors buying bonds backed by mortgages and getting a proportional share of monthly payments, CMOs created different classes for investors with different risk profiles. Typically there were three tranches: the senior tranche, the mezzanine, and the equity tranche. When mortgage payments came in, the senior tranche would get paid first. What ever was left over went first to the mezzanine and then to the equity tranche. Lower tranches received higher interest payments on the bond to accommodate their higher risk. Investors buying senior tranches had confidence they would get paid off within a short time frame, usually five years. They didn’t have to worry whether each individual borrower could afford the payments; by selling a pool of thousands of mortgages, the odd default here or there wouldn’t matter. The higher-risk tranches had longer terms, from twelve to thirty years, and stronger payoffs. These more complex securitizations converted the mortgage, a hyperlocal, idiosyncratic, individual instrument, into a bond, a defined security that investors could buy and sell with confidence.
The initial CMOs needed Freddie Mac: it was still the only way to get them sold nationwide. But once the securitization structure was in place, Ranieri went to work legalizing it. As a trader told Michael Lewis about Ranieri, “If Lewie didn’t like a law, he’d just have it changed.” In 1984 Congress passed the Secondary Mortgage Market Enhancement Act (SMMEA), which eliminated the ban on private banks selling mortgage-backed securities without a government guarantee. SMMEA also preempted state restrictions on privately issued mortgage-backed securities; no longer did investment banks have to register with each state to sell them.
The most important part of SMMEA involved the rating agencies, companies that assessed the risk of various bonds. Under SMMEA, institutional investors who previously were barred from making dangerous investments could purchase mortgage-backed securities as long as they had a high rating from a nationally recognized statistical rating organization. Investors could outsource their due diligence to the rating agencies; they didn’t have to examine the salary of some home buyer in Albuquerque in order to buy an interest in his loan. President Reagan signed SMMEA in October; Ranieri showed up for the ceremony.
Next Ranieri secured a tax exemption for pools of mortgages held in a special investment vehicle known as a real estate mortgage investment conduit (REMIC). The REMIC operated like a trust, able to acquire mortgages and pass income to investors without paying taxes. Investors would pay taxes only on the bond gains, not on the purchase of the mortgages. The Tax Reform Act of 1986 legalized the REMIC structure and made mortgage bonds more desirable.
The mortgage-backed securities market reached $150 billion in 1986. It probably accelerated the demise of the S&L industry, which finally imploded in the late 1980s. The money used for making mortgage loans, instead of coming from depositors, now came from investors all over the world. Ranieri and his allies insisted the goal was to free up more funding for mortgages. He was a dream salesman who just wanted to give every American a piece of something better, a nice house for their families. But homeownership rates rose nearly twenty points from the 1940s to the 1960s under the old system. From 1970 to 1990, during the handover of mortgage finance to Wall Street, rates only went up two points.
While Wall Street did well with securitization, it could not dislodge the GSEs from their market dominance. The GSEs still had that implicit backstop of a government rescue. Investors valued that and bought most of their mortgage bonds from Fannie and Freddie. As long as banks tried to compete on a level playing field, packaging carefully underwritten thirty-year fixed-rate loans, they couldn’t win.
Salomon Brothers fired Lew Ranieri in 1987. He was a victim of his own success. When the mortgage business standardized, Wall Street investment banks staffed up with Ranieri’s old traders. Another generation would crack the code and beat Fannie and Freddie, finding a new set of mortgage products to slice and dice. Ranieri, who started his own firm, never saw that coming. As he would later tell Fortune magazine, “I wasn’t out to invent the biggest floating craps game of all time, but that’s what happened.”
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Ace never could find out who owned his mortgage.
Once she understood the securitization structure, Lisa Epstein could identify all the component companies and their involvement in her mortgage. DHI Mortgage was the originator that sold Lisa her loan. DHI immediately flipped it to JPMorgan Chase, which became the “depositor,” in industry parlance. JPMorgan acquired thousands of loans like Lisa’s, pooling them into a mortgage-backed security to sell to investors. To securitize the loans, JPMorgan placed them into a trust (JPMorgan Mortgage Trust 2007-S2), which qualified for REMIC status and its significant tax advantages. The REMIC forced JPMorgan to add an additional link in the securitization chain—in this case, U.S. Bank, trustee for all the assets in the trust. U.S. Bank hired a servicer, Chase Home Finance, to collect monthly payments, handle day-to-day contact with borrowers, and funnel payments to investors through the trust. So Chase had one link in the chain as a depositor and a separate link as a servicer, basically a glorified accounts receivable department.
Investors in the trust get their portion of the monthly mortgage payments, but under the law they’re merely creditors, holders of JPMorgan Mortgage Trust 2007-S2 pass-through certificates; the trustee, the entity passing payments through to investors, owns the loan. That’s why U.S. Bank, not JPMorgan Chase, sued Lisa. JPMorgan Chase gets its proceeds from the sale of the mortgage bonds and walks away. U.S. Bank earns a fee for administering the trust. For performing day-to-day operations on the loans, the servicer, Chase Home Finance, gets a small percentage of the unpaid principal balance, along with any fees generated from servicing. This securitization added an additional wrinkle: the inclusion of Wells Fargo as the securities administrator, with the function of calculating interest and principal payments to the investors. As this involved scrutinizing cash fl ow from the servicer, it also made Wells Fargo the “master servicer” on the loan. When Chase Home Finance informed Lisa that Wells Fargo was blocking mortgage modifications, it probably had to do with this master servicer role.
At no time was it made clear to Lisa that when she sent in her mortgage payment to Chase Home Finance, somebody at Wells Fargo crunched the numbers on it and told a colleague at Chase to send the money through U.S. Bank to investors, whether a Norwegian sovereign wealth fund or an Indiana public employee retirement plan. Heck, nobody told Lisa that DHI Mortgage would grant her a loan and immediately sell it off to a different division of JPMorgan Chase from the one she’d been paying all these years. This idea of banks trading mortgage payments like they would baseball cards didn’t sit well. And it made it all the more galling to Lisa that Chase Home Finance would tell her to stop paying: according to the securitization chain, they didn’t even own the mortgage. Maybe they profited so much off late fees, they wanted to push people into foreclosure.
But while this was all critical information for Lisa to know, it only raised more questions. She had to understand why securitization translated into suffering for so many homeowners, especially in her backyard. By 2009, one out of every four Floridians with a mortgage was either behind on payments or in foreclosure. How was that even possible? It wasn’t like someone detonated a bomb in Miami and Orlando to wipe out businesses. No plague triggered all the state’s crops to rot in the fields. Depressions like this—and Florida was experiencing a depression, in Lisa’s eyes—didn’t happen spontaneously. Who put this in motion? Who prospered from the pain?
A week after receiving her foreclosure notice, Lisa stumbled across a blog called Living Lies. Neil Garfield was a former trial attorney in Fort Lauderdale, and in his biography he also claimed to be an economist, accountant, securitization expert, and former “Wall Street insider.” He had striking features, big eyebrows, and a perfectly cropped, jet-black beard. He looked like a character actor in a 1970s cop movie. Garfield started Living Lies in October 2007. The site featured day-to-day commentary on the mortgage crisis, a large volume of legal resources, and a mission statement: “I believe that the mortgage crisis has produced manifest evil and injustice in our society. . . . Living Lies is the vehicle for a collaborative movement to provide homeowners with sufficient resources to combat bloated banks who are flooding the political market with money.”
It didn’t take much digging to see that Garfield was running a business. He sold manuals on how lawyers and laypeople could defend themselves from foreclosure. He conducted paid seminars across the country. He had an ad for something called “securitization audits.” Many people presenting themselves as lawyers descended on homeowners at this time, making optimistic yet vague promises that they held the secret to saving homes from foreclosure. State and federal authorities warned homeowners to proceed cautiously with “foreclosure rescue” specialists, especially in Florida, where white-collar scams were a local specialty, even an economic growth engine.
But Garfield had attracted a following. He told NBC News in early 2009 that the site had jumped from 1,000 hits per month a year earlier to 67,000 per month. And he did pull together the loose threads Lisa craved to comprehend: how securitization drove people into foreclosure, who profited from the outcome, and whether their financial machinations violated the law. More important, Garfield maintained an open comment section, so every one in the then-small community of people willing to talk about their foreclosures online could share stories and swap information. It was like two parallel websites existing in the same space: Garfield on top, and the rabble of dispossessed homeowners under neath.
They included Andrew Delany, known online as Ace, a licensed carpenter from Ashburnham, Massachusetts, who lost his income due to a spinal disorder. Alina Virani (Alina), a paralegal from Orlando, her lender told her she couldn’t refinance, and when she called to complain, she discovered they went out of business. James Chambers (Jim C), of Clearwater, saw his business devastated by the downturn, and faced bankruptcy. These stories were familiar to Lisa: personal misery combined with underhanded behavior. James Chambers said Chase sued him but Washington Mutual owned his loan. Alina Virani got some help from an attorney in Ohio, who found that her lender violated federal consumer protection laws. Ace never could find out who owned his mortgage.
There was no support group for foreclosure victims; nobody wanted to even talk about it. It reminded Lisa of when every one called cancer “the big C,” not daring to utter the word. But the commenters at Living Lies represented the stirrings of a community, all focused on solving the same problem, like a distributed network. Lisa bookmarked the site and returned to it daily. There was a spirit there, the opposite of the shame and humiliation every one assumed foreclosure victims should feel. These people were ready to fight. And as Lisa read on, the schemes they related sounded less like the sober processes of modern finance and more like a crime spree.
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It was redlining in reverse.
Michael Winston, a new executive at Countrywide Financial Corporation, pulled into the company parking lot one day in 2006 and read the vanity license plate on the next car over: “FUND-EM.” Winston asked the man getting out of the car what that meant.
“That’s [CEO Angelo] Mozilo’s growth strategy. We fund all loans.”
“What if the borrower has no job?” Winston asked.
“What if they have no assets?”
“If they can fog a mirror, we’ll give them a loan.”
Countrywide, which came out of nowhere to become the nation’s largest mortgage originator, was part of a new system of mortgage financing that realized Lew Ranieri’s master plan for Wall Street domination of the residential housing market. Congress shepherded the industry down this path, eliminating roadblocks so lenders could issue mortgages to people with bad credit.
The Depository Institutions Deregulation and Monetary Control Act (DIDMCA) of 1980 preempted state anti-usury caps, which limited the interest rate lenders could charge borrowers. Two years later, the Garn–St. Germain Depository Institutions Act eliminated mortgage down payment requirements for federally chartered banks. Embedded in Garn– St. Germain was the Alternative Mortgage Transaction Parity Act. This also tossed out state restrictions on mortgages, allowing all lenders, federal or state, to offer adjustable-rate mortgages with steep resets, where the interest rate went up sharply after the initial “teaser” rate. It also permitted interest only or even “negative amortization” loans, where principal increased in successive payments.
Congress was trying to save the savings and loan industry by making mortgages more profitable, effectively legalizing consumer abuse to aid a class of financial institutions. That didn’t work: S&Ls blew up by the end of the 1980s. But without the elimination of these anti-predatory lending laws, argued Jennifer Taub of Vermont Law School in her book Other People’s Houses, “subprime lending could not have flourished.”
Wall Street figured out how to outflank Fannie Mae and Freddie Mac by securitizing alternative loans, which didn’t conform to GSE standards. Investment banks made the securities attractive with “credit enhancements,” guarantees to investors in the form of insurance or letters of credit. With these enhancements, even packages of the worst mortgages could achieve super-safe credit ratings. Riskier mortgages were more lucrative for Wall Street, because these “subprime” loans reeled in higher interest rates over the thirty-year terms. In other words, subprime loans were prized precisely because they gouged the borrower more. And as long as investors received assurances of risk-free profits, they would buy the bonds.
Investment banks began to offer lightly regulated nonbank mortgage originators, who specialized in marketing to poor borrowers, warehouse lines of credit, or defined funding for their mortgages. In exchange, the banks would purchase all the originator’s loans and package them into private-label securities (PLS), separate from Fannie and Freddie’s mortgage-backed securities on conforming loans. The originators knew what the big banks wanted: subprime mortgages, and lots of them. Brokers were given “yield spread premiums,” bonus payments for every high-rate mortgage they sold.
Lenders perversely described exotic loans as “affordability products.” After a teaser period of one to two years, monthly payments would increase by thousands of dollars. If borrowers ever showed concern about this (and typically they didn’t, as disclosures were written in such byzantine legalese that virtually no one could decipher it), brokers told them not to worry: they could always refinance again. Every refinance away from the payment shock added closing costs—profit for the lender—and built up unpaid balance on the loan. It was not uncommon for homeowners to refinance five or six times in a few years, taking on more debt each time.
Another industry creation was the cash-out refinance, giving borrowers with equity in their homes a new loan with a lower starting payment, along with some cash to cover other expenses. This was an attractive option for newly targeted low-income families of color. Since the 1930s African Americans and Hispanics were locked out of the housing market, with government maps “redlining” designated tracts of land (indicating them as off-limits to nonwhite buyers) and banks shunning their business. Now old women in inner-city Detroit or Cleveland got knocks on their door from pitchmen promising to make their financial hardships disappear. It was redlining in reverse. For decades the problem had been that black people couldn’t get loans; now the problem was that they could.
Nonbank lenders Option One, New Century, and First Alliance started in the mid-1990s, joining Countrywide and Long Beach Mortgage, which would eventually become Ameriquest. Federal Reserve statistics show that subprime lending increased fourfold from 1994 to 2000, to 13.4 percent of all mortgages. Brokers were under significant strain to pump out subprime loans with high interest rates or else lose their warehouse lines of credit. So lending standards flew out the window. Practically no applicants were rejected.
That these loans were harmful concerned nobody. The Clinton administration wanted to increase homeownership rates, which had fallen amid the S&L collapse. It wasn’t likely to crack down on irresponsible lending practices if they served that goal. Anyway, the Federal Reserve held responsibility over consumer protection for mortgages, and Alan Greenspan viewed regulations the way an exterminator viewed termites.
Investment banks also got more sophisticated about the securities. Mathematicians fresh out of college—quantitative analysts, or “quants”—spent their working hours converting risky subprime loans into something that could secure a coveted AAA rating, guaranteeing sale into the capital markets. For example, banks had no problem selling high-rated tranches of their mortgage-backed securities, but the lower-rated mezzanine and equity tranches were more of a puzzle. To solve this problem, they built something called a collateralized debt obligation (CDO), using the same tranching mechanism, squeezing AAA ratings out of low-rated junk. Then they would make CDOs out of the unsold portions of CDOs, creating what was known as a “CDO-squared,” and so on. Investors knew they were buying securities backed by mortgages; they didn’t know they were getting repackaged left overs of the worst bits, julienned through financial alchemy into something “safe.”
CDO sales increased exponentially after market deregulation through the Commodity Futures Modernization Act in December 2000, in one of President Clinton’s last official acts. You didn’t even have to own the mortgages to wager on whether they would go up or down. “Synthetic” CDOs just tracked the price of certain mortgage securities, with investors taking up either side of the bet. This multiplied the amount of money on the line well beyond the value of the mortgages and turned the whole thing into gambling.
The securitization machine resembled the children’s game of hot potato. Every one stopped caring whether the borrower could pay back the loan, because every one passed the default risk up the chain. The lenders didn’t care because they sold the loans to Wall Street banks; the banks didn’t care because they passed them on to investors; and the investors didn’t care because Wall Street’s financial wizards lied to them. Investors were assured that the loans were of high quality; furthermore, they were told that even if a few failed, slicing and dicing thousands of loans from all over the country into bonds would make up for the delinquencies and eliminate the risk. The geographic diversity of the bonds would insulate investors from a regional market collapse, and every one knew that mortgage markets were regional; you never saw a broad-based price decline. The credit rating agencies, paid by banks to rate the securitizations, blessed the whole scheme, either out of ignorance or to make sure they grew their businesses.
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The entire industry was assembled on a mountain of fraud.
In the late 1990s, amid the Asian financial crisis, Wall Street pulled back on warehouse funding for nonbank lenders. Subprime lending momentarily stopped, and some lenders went out of business. But this was only a blip. Though consumer lawsuits exploded during this period, complaining of predatory practices, the Federal Reserve and other regulators showed no interest. When the smoke cleared, the remaining subprime lenders and their Wall Street funders started up the machines again. The second wave of subprime mortgages dwarfed the first wave.
The entire industry was assembled on a mountain of fraud, starting from the first contact with a prospective home buyer. Many brokers over-inflated home appraisals to increase the loan balance. Some pushed borrowers into “no income, no asset, no job” (NINJA) loans by telling them they would get better deals if they falsely inflated their income. These were also called “liar’s loans.” If loan officers demanded income verification, brokers would sometimes even use Wite-Out and replace the numbers on W-2 forms, or construct fake tax returns with a photocopier, to get them through underwriting. In his book The Monster, Michael W. Hudson describes one loan sent to underwriting that claimed a man coordinating dances at a Mexican restaurant made well over $100,000 a year. The dance coordinator got the loan.
The typical borrower too easily fell prey to this routinized deceit. Some lenders took borrowers eligible for prime-rate loans—people with perfect credit, like Lisa Epstein—and gave them subprime ones. Others forged borrowers’ signatures on disclosure forms that would have actually explained how much in interest and fees they were paying. Some brokers used light-boards or even a bright Coke vending machine to trace signatures and enable the forgery. Others presented borrowers with a loan at closing whose first few pages looked like a fixed-rate loan, masking the toxic mortgage under neath. When the borrower signed all the papers, the broker ripped those first pages off.
The fraud continued up the chain as well. The Financial Crisis Inquiry Commission found that a third-party firm called Clayton Holdings, brought in to reunderwrite samples of loans backing subprime mortgage securities for twenty major banks, consistently found defects in half the loans in the samples. Clayton relayed its findings to the banks, who promptly used them to negotiate after-the-fact discounts on the full loan pools from originators. Those discounts never got passed on to bond investors, who remained ignorant about the defects. In such cases, the securitizers knowingly sold defective products to investors without disclosure, and took extra profits based on how defective they were. It was clear securities fraud.
Many investment banks knew about, and indeed drove, the poor quality of the loans. Internal documents later uncovered in a lawsuit against Morgan Stanley, the largest buyer of mortgages from subprime lender New Century, showed the bank demanding that 85 percent of the loans they purchase consist of adjustable-rate mortgages. When a low-ranking due diligence official told his supervisor about the litany of problems associated with New Century loans, she responded, “Good find on the fraud :). Unfortunately, I don’t think we will be able to utilize you or any other third party individual in the valuation department any longer.” In other words, finding the fraud got people fired.
In September 2004 the FBI’s Criminal Division formally warned of a mortgage fraud “epidemic,” with more than twelve thousand cases of suspicious activity. “If fraudulent practices become systemic within the mortgage industry,” said Chris Swecker, assistant director of the FBI unit, “it will ultimately place financial institutions at risk and have adverse effects on the stock market.” Despite this awareness, almost no effort was put into stamping out the fraud. In fact, when Georgia tried to protect borrowers with a strong anti-predatory lending law in 2002, every participant in the mortgage industry, public and private, bore down on them. Ameriquest pulled all business from the state. Two rating agencies, Moody’s and Standard and Poor’s, said they would not rate securities backed by loans from Georgia, cutting off the state from the primary mode of funding mortgages. And the Office of the Comptroller of the Currency, which regulated national banks, told the institutions that they were exempt from Georgia law. Georgia eventually backed down and replaced the regulations, rendered moot by an unholy alliance of the industry and the people who regulated them.
Banks issued $1 trillion in nonprime mortgage bonds every year during the bubble’s peak. Subprime mortgages made up nearly half of all loan originations in America in 2006. Total mortgage debt in America doubled from 1999 to 2007. There was so much money in mortgages that loan brokers right out of college made $400,000 a year. Traders on Wall Street made even more.
Home prices appreciated rather slowly for fifty years, but between 2002 and 2007 they shot up in a straight line. In several states, annual price in-creases hit 25 percent. Since this boosted property values, boosted the economy, and made the industry more profitable, few politicians or regulators raised alarms. Even Fannie Mae and Freddie Mac, locked into buying “conforming loans” for their securities, lowered their standards and bought subprime loans once they started to lose market share to the private sector. Everyone mimicked industry claims that the market transformation was good for homeowners, and for a little while it was: even amid rising prices, homeownership rates rose over this period to an all-time high of 69.2 percent. Nobody wanted to stop the merry-go-round while the song was still playing.
At the end of 2006 the song stopped, and homeowners used to refinancing out of trouble were stuck. Even before this point, you could see warning signs in skyrocketing early payment defaults—people missing their very first mortgage payment. Foreclosures started to occur in large enough numbers—they nearly doubled in 2007, and again in 2008—that mortgage-backed securities, even the senior tranches that were supposed to be infallible, took losses. Investors tried to dump the securities, and banks stopped issuing new ones. Brokers suddenly had no money to make new loans; by 2008, all of them were either out of business or, in the case of Countrywide, sold to Bank of America. The entire system, which soared along with home prices, crashed when those prices dropped. And because the system had been replicated multiple times, in CDOs and other credit derivatives, failures cascaded through Wall Street investments and led to a catastrophic financial crisis.
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The reality is that nearly all securitized mortgage loans are worthless and unenforceable.
Lisa read about all this and internalized it; after a couple of weeks of intense study, she could cite chapter and verse on previously unknown financial industry machinations. She started to daydream while working, her mind filled with theories about mortgage-backed securities and what caused the crash. At work or at home, it became hard for Lisa to concentrate on anything else.
Of all the websites she sought out, none deconstructed securitization and Wall Street malfeasance like Living Lies. Neil Garfield went much deeper than the surface layer of fraud in the subprime scam. He viewed the originators as straw lenders, because they immediately sold the loan and did not care about its quality. To Garfield, this violated modest federal mortgage laws such as the Truth in Lending Act. Garfield called such originators “pretender lenders” and thought the fact that they relinquished their interest in the loan by having investors pay it off in full could form the basis of a legal challenge.
More interesting to Lisa were Garfield’s contentions about promissory notes, mortgage assignments, and pooling and servicing agreements. “The reality is that nearly all securitized mortgage loans are worthless and unenforceable,” Garfield wrote in one post. “The ONLY parties seeking foreclosures . . . do not possess ANY financial interest in the loan nor any authority to foreclose, collect, modify or do anything else,” he wrote in another. He quoted a bankruptcy attorney in Missouri, who added, “Democracy is not supposed to be efficient—because in the tangle of inefficient rules lies the safety and security of popular rights. The judge is not there to clear the sand from the gears of the machine—the judge is the sand.” Lisa didn’t understand Garfield’s line of argument at first, but a lot of Living Lies commenters were agitated about it, talking about document fraud and broken chain of title. And the discussion refreshed Lisa’s memory about something in her court summons.
Count II in the complaint was entitled “Re-establishment of Lost Note.” Lisa needed more information about what that actually meant—what was the difference between the note and the mortgage?—but it surprised her that the plaintiff admitted that it lost a key document and was trying to reestablish it in some manner. Others at Living Lies had note problems; for example, Andrew “Ace” Delany’s lender could never supply the note, although he asked for it every week. What was with this epidemic of lost notes? Where did they go? And how did that impact foreclosure cases?
As the twenty-day deadline for responding to the summons loomed, Lisa wanted to find out.
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Copyright © 2016 by David Dayen. This excerpt originally appeared in Chain of Title: How Three Ordinary Americans Uncovered Wall Street’s Great Foreclosure Fraud, published by The New Press. Reprinted here with permission.