Book Review: The Fed And Lehman Brothers by Laurence Ball


In a new book just out to this month, The Fed And Lehman Brothers, economist Laurence M. Ball re-examines the evidence of the choices facing the managers of the 2008 financial crisis. In particular he looks at a crucial choice – to let the storied Wall Street firm Lehman Brothers fail in bankruptcy rather than offer taxpayer support for a bailout.

His conclusion: the Federal Reserve, US Treasury, and New York Fed made a grave unforced error in allowing Lehman Brothers to declare a messy bankruptcy – still the largest US corporate bankruptcy of all time – in the process adding destructive force to the financial tsunami already enveloping the economy and financial markets in September 2008. And they disingenuously described the reasons for their decision.

The main managers of the 2008 financial crisis, Treasury Secretary Hank Paulson, New York Federal Reserve Bank President Tim Geithner, and Federal Reserve Chairman Ben Bernanke all claimed in official testimony and their subsequent memoirs that Lehman Brothers was “insolvent” at the time of the bankruptcy. One of the conditions of Fed lending is that it cannot lend money to insolvent institutions, or banks with insufficient collateral to pledge for a new loan.

It is undeniable that Lehman faced a liquidity crisis in September 2008 – the inability to pay back everyone it owed money to, if everyone wanted their money back right away. That’s a classic problem facing any bank in which depositors demand immediate return of their deposits. The dispute Ball addresses is whether Lehman had enough assets in the medium-to-long run that would have covered what it owed so that a fresh loan from the Fed could have averted bankruptcy.

In household terms, we can imagine a well-off person with a valuable house and car worth a million dollars, $25,000 cash in the bank, and who owes $750,000 in a combination of a personal loan, mortgage and car loan. If a lender suddenly demands a $100,000 personal loan be paid back immediately, we would say that person has a liquidity problem but is not insolvent. Given enough time, the person could likely solve the problem, through a sale of the car and house. Even easier than a fire sale of the car and house, a fresh loan against the home equity would ease the situation. Bankruptcy is far from inevitable.

In the case of Lehman, Ball argues, the Federal Reserve had created a program earlier in 2008 that could have provided that fresh loan.

Through reviewing pre-bankruptcy financial disclosures, reports of the bankruptcy managers, and independent analyses of firms that considered purchasing Lehman but declined, Ball details the amount of assets Lehman had the week before it declared bankruptcy.

Hank_PaulsonHe conservatively estimates the assets available to pledge as collateral for a new loan from the Fed totaled $118 billion. Lehman’s ultimate need for funds, again conservatively estimated, probably reached $84 billion. In that difference, in the amount of available assets above Lehman’s borrowing needs, Ball makes the case that this was a liquidity problem, not an insolvency problem.

$84 billion, of course, is quite a bit of money. But considering that the Fed committed $123 billion to AIG and $107 billion to Morgan Stanley that same month, it wasn’t out of the range of what the Fed was otherwise and ultimately willing to commit to dampen the financial tsunami.

The managers of the crisis have claimed, to this day, the opposite. They argue that Lehman was insolvent, and any new loan from the Fed would put taxpayer money at risk of loss.

This may all seem like ancient history, but it’s still relevant today. The Fed raised rates a few weeks ago and plans a few more rate hikes the year, unwinding policies in place since the crisis. Meanwhile, we’re still trying to figure out what the right lessons are from 2008. We still do not have an agreement on the correct solution to Too Big To Fail financial institutions when they get in trouble and face a loss of confidence, essentially a “run on the bank.”

ben_bernankeDo we essentially nationalize them, as we did to mortgage giants Fannie Mae and Freddie Mac? Do we take an 80 percent government ownership, then slowly sell the pieces back to the public markets as they recover, as we did with insurance giant AIG? Do we guaranty portions of their bad debt portfolios and force a shotgun marriage among investment banks, as we did when JP Morgan Chase bought Bear Stearns and Bank of America bought Merrill Lynch? Or do we convert them to commercial banks from one day the next, and inject $20 billion of capital to signal public support, as we did with Goldman Sachs and Morgan Stanley?
The managers of the crisis did all these different things, with wildly differing outcomes for firms, employees, executives, shareholders, bondholders, and taxpayers.

The managers tried everything. The messiest, least controlled, and most destructive was the Lehman bankruptcy. Ball’s big question – did it have to happen? – is a counterfactual exercise that informs future choices. He further concludes, despite all the testimony of the crisis managers, that Treasury Secretary Paulson essentially made the call to let Lehman fail.
Paulson’s concern was to avoid the label “Mr. Bailout” in 2008, so he wanted to signal with the bankruptcy that sometimes firms did fail and that the government wouldn’t always be there. Ironically the bankruptcy was so disruptive that Paulson and the rest had to double-down, triple-down, and then quadruple-down on further bailouts. Clearly they did not anticipate the depth of the mess of Lehman’s bankruptcy filing.

The_Fed_And_Lehman_brothersHaving said that, it doesn’t mean I think that Paulson, Geithner and Bernanke blew it in the management of the 2008 crisis. My overwhelming thought, ten years later, is how well they responded to unprecedented and unpredictable events. We are incredibly fortunate those particularly competent people held those positions at that particularly crucial time. They made one big mistake with Lehman, and they kind of fudged their reasons for it, but overall managed throughout the fog-of-war of the 2008 crisis admirably.


A version of this post ran in the San Antonio Express News and Houston Chronicle.

Please see related posts:

Book Review: Too Big To Fail by Andrew Ross Sorkin

Book Review: Diary Of A Very Bad Year by Anonymous Hedge Fund Manager



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SIGTARP is Back! Be Mad Again. And Happy

My favorite government watchdog of all time, SIGTARP[1], The Norse God of Financial Accountability, recently published another great critique of Treasury’s handling of TARP rules, this one about executive compensation within bailed out firms.

SIGTARP is a favorite of mine because they point out mistakes and errors with the TARP program. At its best, SIGTARP represents to me a hopeful sign that our federal government can learn from its mistakes.

In a time of deep cynicism about how “Washington is broken,” the Special Inspector General[2] role fills me with optimism. If our federal government is strong enough to weather pointed and non-partisan critiques from within, then we’ve got a pretty robust system.[3]

Which makes me happy. Ok, now back to the latest report.


Pay Czar blew it

SIGTARP reports that the Treasury department – and in particular the “Pay Czar”[4] put in place to limit executive compensation at bailed out firms – pretty much blew it.

Here’s what happened in simplest terms:

In 2009, Obama and then Treasury Secretary Geithner announced that firms that took TARP bailout money would be subject to rules about how much they could pay their top 25 executives.

This made and makes sense because

  1. When you take public money to save your firm, it’s a bit nasty to then turn around and send that public money out the door for private compensation in the form of salaries and bonuses. Which is EXACTLY what happened in 2008 with bailed out Wall Street firms, all of whom took TARP money, and then paid bonuses to their employees.
  2. At a time of deepening economic malaise, the ‘optics’ of bailed out executives taking big bonuses while Main Street folks lost their jobs and homes after earning 1/300th of the compensation seemed a bit, well, unfortunate.
  3. Geithner claimed that excessive executive compensation actually contributed to pre-crisis risk-taking. I don’t know if really buy this, but anyway, it was a theory of his that became part of the justification for limiting compensation.
  4. Restricting executive compensation should incentivize top executives to pay back their TARP money early, in order to return to the good old days of unrestricted compensation awards for themselves. Thus aligning taxpayer public interests with top executives’ private interests, as seems to have happened, according to Citigroup and Bank of America executives later interviewed by SIGTARP.


The Pay Czar rules said:

  1. The top 25 highest-paid executives at each firm should not receive cash compensation above $500K without special permission from the Pay Czar. Which permission, it turned out in retrospect, was not hard to get, as we read in the SIGTARP report.
  2. Compensation above $500K would have to come in the form of long-term restricted stock in the bailed company. Which is frankly not that onerous a rule, and probably ironically served to further enrich some executives who received huge stock awards at depressed 2009-2011 share prices. There’s a long and distinguished tradition of excessively compensating executes through share awards, as I’ve written about before.
  3. Compensation for the next 75 most highly-compensated employees had to be made in reference to average payments for comparable employees in similar jobs in the market. They couldn’t, or shouldn’t, be paid more than the average in the market without special permission. Which, again, makes sense because why are you being paid more than average when your freaking firm just got its ass bailed out with taxpayer money?
  4. These restrictions would stay in place until firms repaid their TARP bailout money.


My favorite GM bailout poster

My view on these rules, and what happened

When you look at these rules in aggregate, they do not seem to me restrictive at all. This is not written by some “Socialist Gubmint that wants to attack Capitalism and END OUR FREEDOMS.”

On the contrary, the only reasonable view of these rules, in my opinion, is that these rules were practically written by the bailed out firms themselves. Which, if you believe in at least the cognitive capture of the leaders of our regulatory system[5], you could plausibly argue they did write the rules.

Despite that, as SIGTARP reports, the Pay Czar totally failed to enforce even these executive-friendly rules, especially with some of the final TARP bailout companies, GM and Ally Financial.


SIGTARP: Norse God of Financial Accountability

The main points of the SIGTARP report, summarized for your reading pleasure (and to make your head explode with anger if you think about it too hard)


  • General Motors (the pension-payments company that also happens to make cars that people don’t buy) and Ally Financial (formerly GM Acceptance Corp, the auto-finance branch of General Motors) were the last of a special group of extraordinary bailout firms[6] to pay back TARP money.
  • Both firms’ executives made the case to the Pay Czar that restrictions on their executive compensation were counterproductive, because they were trying to be “competitive in the market” in order to pay back TARP money. The Pay Czar, according to SIGTARP, found this entirely self-serving argument persuasive when bending the compensation rules for GM and Ally.
  • This happened, despite the fact that other TARP firms rushed to pay back TARP money, in order to loosen up their pay restrictions. In other words, the restrictions on executive compensation effectively accelerated repayment as intended for most bailed companies, but the Pay Czar later forgot this and felt like the rules should be bent in order to accelerate the repayment to taxpayers. The Pay Czar got this backwards.
  • GM and Ally Financial in particular cost taxpayers quite a bit of money in the final accounting. Instead of collecting the repaid TARP money, the federal government sold its stakes in the companies to public markets at a loss – $11.159 B for GM, $1.763 for Ally. That didn’t stop the firms from getting the compensation rules bent repeatedly for them prior to these final accounting of losses.
  • Both companies – as detailed in the SIGTARP report – managed to get pay raises, exceptions to the $500K limit, exceptions to long-term stock restrictions, and ignored policies and procedures put in place by Treasury regarding payment restrictions.
  • Restrictions on executive compensation actually got looser and looser in the 2009 to 2014 period, even as expected losses at GM and Ally Financial became clearer and more likely.
  • Treasury approved at least $1 million in pay for every top 25 employee at GM and Ally in 2013, despite the supposed rules in place to guide the Pay Czar, and prior to the ‘repayment’ of TARP through the government sale of shares to public markets.


In Conclusion

The 2008 crisis and aftermath makes different people mad for different reasons.

For me, the most egregious part of the whole episode has been the enjoyment of private profits with the benefit of public bailout funds before, during, and after 2008.

I love SIGTARP for making available the details on this egregiousness.

I’m mad, but I’m happy we have a paper trail to help me know exactly what I’m mad about.



Please see related posts:

Book Review of Neil Barofsky’s Bailout: The Inside Account of How Washington Abandoned Main Street While Rescuing Wall Street

In Praise of SIGTARP – Norse God of Financial Accountability

SIGTARP I – Truth in Government

SIGTARP II – Biggest Banks Still Too Big To Fail

SIGTARP III – The Citigroup Bailout

SIGTARP IV – What Small Banks Are Going Under Next?

SIGTARP V – My Front Row Seat to the AIG Debacle

[1] SIGTARP stands for the Special Inspector General for the Troubled Asset Relief Program. Created by Congress, the SIGTARP periodically publishes reports on how TARP money was spent and misspent, investigations into criminal activity around TARP, and makes policy recommendations to Treasury about ways to do things better, or what it did wrong. I <3 SIGTARP.

[2] There are several Special Inspector Generals for a variety of important policy morasses in the federal government, including for “Iraq Reconstruction” and “Afghanistan Reconstruction. A big part of their role is to tell us exactly what got screwed up, how the money got wasted,  And that’s a good thing.

[3] I mean, we can all get ‘mad at Washington.’ But the fact is that Russia and China are not robust enough systems to handle an internal critique like a Special Inspector General. They are too fragile and they know it. We are anti-fragile.

[4] The Pay Czar is actually technically known as the Office of the Special Master for TARP Executive Compensation, shortened to OSM in the SIGTARP report. I like the phrase Pay Czar better, however, so I’m going to stick with it for the rest of this post. The first Pay Czar was Kenneth Feinberg, previously in charge of the 9/11 Victims Compensation Fund, and later the BP Oil Spill Fund, and Boston Marathon Bomb Victims Fund. Feinberg was later succeeded by Patricia Geoghegan, about whom I know nothing.

[5] ‘Cognitive capture’ is shorthand for my favorite theory I learned from from Chrystia Freeland’s Plutocrats, which I reviewed earlier.

[6] The Treasury Department especially tracked the ‘exceptional’ TARP bailout money given to AIG, Citigroup, Bank of America, Chrysler, Chrysler Financial, GM, Ally Financial (formerly GMAC), because these seven firms were especially FUBAR in 2008, meaning the amounts were really high and the risk of taxpayer losses were also exceptionally high.

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Book Review: Diary Of A Very Bad Year

I’ll admit to two large biases before praising Diary of a Very Bad Year: Confessions of an Anonymous Hedge Fund Manager.

First, I prefer a personal account by a financial practitioner, rather than a financial journalist’s perspective, nearly every time. This preference, after all, underpins my idea with the Bankers Anonymous site itself.

The acronymic jargon of an ordinary financial practitioner’s presentation, however, typically overshadows his story for the lay reader. Who, except the specialist, can unpack the Re-Remics from the Reverse Repos, the positive carry from the negative basis trades, or FX forwards from a commodity curve in backwardation? Only the rare financier knows his craft so well that he can explain complexity while using language we can all understand.

Second, the Anonymous Hedge Fund Manager (HFM) featured in the book was a client of mine for a short while when I sold bonds on the emerging markets desk for Goldman. His clear language and thinking made a strong impression at that time.

Which explains why, when I read a review of this book a few years ago, I immediately thought of my ex-client. Was he the unidentified HFM? An email query and reply a few hours later confirmed it, yes.

Through a series of interviews with a journalist, HFM gives a wide-ranging but personal perspective on his experience between September 2007 and August 2009, covering the periods of the deepest dive and steepest financial recovery. His interests, while inescapably specific and technical, frequently veer to the philosophical and big picture.

In the free-fall period of late 2008 – when even the most plugged-in hedge fund manager was overwhelmed with unexpectedly bad developments – we experience a real existential question for financial markets: If all private banks were at risk of implosion without the backing of the US Government, what happens when the US Government defaults? Who is insuring it and how do you hedge that risk? Martians were not offering credit default swaps to earthlings.

Diary of a Very Bad Year will not tell you everything you need to know about the Credit Crisis of 2008. It will tell you what a large hedge fund manager experienced, in real time, in a way no journalist on the outside could ever tell you.

It’s the best book I’ve ever read on the Crisis.

I read this a few years ago but was reminded of it because my wife just read Diary of a Very Bad Year this past week. She found it somewhat technical for the non-finance expert – as terms like leverage, credit default swaps, FX crosses, and even ‘hedge fund,’ get thrown around without explanation or definition. But she also appreciated the brilliance and humor of HFM in describing those two awful years, in real time.

The final chapter reveals HFM’s plan to quit New York City and move to Austin, TX with his fiancé.

He’s burned out on the stress of the Crisis and the responsibility of managing a large team and complex portfolio at his New York hedge fund. He dreams of eliminating his management responsibilities, simplifying his life, and shifting his balance, away from working, and more toward living.

When I checked in with him for lunch in Austin a few years ago, he had followed his plan exactly.

diary of a very bad year


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Book Review: I.O.U. by John Lanchester

In reading and reviewing John Lanchester’s I.O.U. – Why Everyone Owes Everyone and No One Can Pay I continue my quest for the best contemporary histories of the 2008 Crisis.

One reason to study and understand a crisis like 2008 is to avoid repeating it.  George Santayana’s pithy justification for historical review – “those who do not learn from history are doomed to repeat it,” – is apt, and not just because my father-in-law is a Santayana scholar.[1]

Another reason to study the 2008 crisis is to respond appropriately with a public narrative, and ultimately with financial policy, based on what we learned.  I frequently shake my head at both the public narrative about what happened, and I also grit my teeth about financial policy.  So I keep looking for the best accounts of the crisis.

Lanchester’s I.O.U. is one of the best.  He’s a stunningly clear writer who usefully adopts colloquial language to explain financial concepts.  Most non-finance readers need analogies and narratives to grasp a synthetic credit default-swap CDO, and Lanchester wields these beautifully.

Lanchester was researching contemporary City of London[2] life for his excellent Capital – which I reviewed here – when he realized that the financial innovations of The City were:

  1. Fascinating in and of themselves
  2. Completely opaque to non-financial people
  3. Suddenly wreaking havoc around the world


The result is a clear, entertaining, and informative analysis of the causes of the crisis.  Lanchester’s review is more comprehensive about the global financial system, for example, than Michael Lewis’ more narrowly-cast The Big Short, which relied on a few closely-drawn characters and their profitable trade against the sub-prime mortgage market.

Unlike the US-oriented histories of the 2008 crisis, Lanchester writes from the UK perspective, rounding out what we may already know from Andrew Ross Sorkin’s Wall Street-oriented Too Big To Fail, for example.

Lanchester reviews the proximate causes of the crisis

a)    Extraordinary, hidden leverage in the world’s largest banks (Chapter 1)

b)   Financial innovation in securitization models but with limited actual historical data behind the models (Chapter 2)

c)    An over-reliance on home ownership as an investment, both in the UK as well as in the USA (Chapter 3)

d)   A system of mortgage underwriting and securitization that removed consequences from the originators (Chapter 4)

e)    An intellectual failure to consider our tendencies to misunderstand risk (Chapter 5)[3] and

f)     A blindness of regulators to the hints of future disaster (Chapter 6).

Lanchester does not risk readers’ ire by shifting some portion of responsibility for the crisis from lenders to borrowers – something I actually appreciated about Edward Conard’s Unintended Consequences – but he’s got a satisfactorily complete narrative of the causes of the crisis.

Have you read a book yet on the 2008 Crisis that is funny, clear, accurate, and in plain English?

I owe you a recommendation.

Try I.O.U.

Now you owe me.


Please see related post: Book Review of Capital by John Lanchester

And related post: Michael Lewis on John Lanchester’s Capital

and please also see All Bankers Anonymous Book Reviews in one place


[1] Can I interest you in Santayana’s most accessible work, the 1935 novel The Last Pilgrim?  This edition is edited by my father-in-law, and overall, good stuff.  Among other things, The Last Pilgrim offers an interesting view of turn-of-the-last-century Boston Brahmin life.  Boston Brahmins were, and are, some impressively thrifty folks.

[2] “The City of London,” or “The City” for non-financial folks does not mean the whole municipal entity including Buckingham Palace and Parliament and all the rest, but rather is shorthand for the capital city’s financial sector.  In the UK when people say “The City of London” they mean the equivalent of saying “Wall Street” in the U.S.

[3] Lanchester acknowledges an intellectual debt to Nassim Taleb in this chapter, from his excellent books Fooled by Randomness and Black Swan.

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Book Review: Capital by John Lanchester

I’ve been searching in the past few years for the best book to explain the 2008 Crisis, but I have yet to find it.

John Lanchester’s novel Capital presents the 2007 and 2008 pre-conditions for the crisis in London – soaring real estate values, extraordinary inequality, random good and bad fortune, injustice, and fundamental cultural misunderstandings.

Lanchester’s diverse London characters occupy the same space – a single, gentrifying block in London – but arrive from entirely different worlds. 

We meet the stand-in for pre-crisis London, the successful but clueless and doomed banker Roger, who finds his lifestyle nearly unaffordable at 1 million pounds per year. 

A Banksy-style performance artist, his mother, and his dying grandmother show a temporal cross-section of England, unable to communicate across generations.

Lanchester has a gift for cultural nuance in portraying four distinct immigrant stories: The Zimbabwean meter maid working and living illegally, the Polish contractor riding the home renovations wave to save money before returning home, the Pakistani shopkeeper and his extended family, and the gifted 17 year-old footballer from Senegal signed to an extraordinary professional contract.

With few exceptions[1] Lanchester has empathy for all of his characters as they each suffer an existential crisis concurrent with the financial crisis.

Lanchester employs a unifying plot hook – a semi-mysterious harassment campaign affecting all of the homeowners of the single London block – that doesn’t quite matter to the novel.  Neither the vague sense of dread the campaign engenders – nor the resolution of the harassment campaign – justify its prominence in most chapters.  Nevermind, though, because the novel does not need it. 

His sympathetic characters and gentle satire show us the way we live now, together in time and space but apart in everything else.

Capital does not explain the 2008 crisis, but it seems like an accurate time capsule of the “same street/different universe” world we occupy now – both before the crisis and since then.

Please see related post: Michael Lewis reviews Capital by John Lanchester.

Please also see related post: All Bankers Anonymous Book Reviews in one place.



[1] Roger’s wife Arabella notably displays no redeemable features – just neglect, cluelessness, self-absorption, and conspicuous consumption.

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Interview: Mortgage Originator Explains the Crisis

Please click above to listen to full interview.

Mike sat down with David, a former mortgage originator during the boom times.  They discuss the move into Subprime lending, the causes of the crisis, and shockingly, whether it was all worth it.

David:  Hi my name is David and I used to be a mortgage underwriter and originator.

Mike: David, thanks very much for joining me.  Can you give me a little bit of background to what is a mortgage underwriter and originator doing. What does that mean?

David: I started out originating.  I was the one making phone calls.  My initial contact was with the customer directly.

Mike:  So, the customer comes in, and I think you said you started in the year 2000?

David:  Yeah it was in 2000 and it was right before, or right I guess right at the start of the whole refinance boom.  My territory was Northern and Middle California. So that’s kind of where everything starts.

As the Great Mortgage Crisis of 2008 slips into history, a consensus builds that the biggest breakdown of the system occurred because the different links in the mortgage production chain knew what they knew, and acted in their own self interest, but nobody knew enough of what the others knew.

I thought of this recently as I sat down with David.  He worked as a mortgage originator precisely the same time I worked as a mortgage bond salesman.  During that time, I never talked to a mortgage originator.  Nobody I ever worked with on Wall Street ever sat down with the guys originating mortgages to compare notes.  It never occurred to us.  An economist might call this breakdown in communication ‘informational friction.’  You might call it ‘stupid.’

Cogs during the Mortgage Boom Times

Mike: So [from] 2000 to 2001, I’m interested in part because it parallels where I was.  I joined the mortgage bond department in the end of 2001, which it sounds like you’d been at the job for a year. And what we were experiencing on the Wall Street side of things was an extraordinary boom in origination just the mortgage pipeline had never been bigger.  Everybody essentially who owned a home already would benefit from refinancing.  So everybody was refinancing at a breakneck pace.  I’m assuming from where you were sitting that your business was booming, and you have something to offer that everybody wants, right?

David: That’s exactly what it was, and that’s part of the reason that I got the job of there, was I didn’t have any financial experience previous to that, I was a salesman as I had done for years and years before that. And a friend of mine that worked in the personnel department at the bank knew that, and knew that they were coming up on this huge boom of refinancing.

Since we were mainly dealing with A and A+ paper, the most qualified borrowers, there was never a situation where we had to sell things that they didn’t need.  We just had an influx of people calling and an influx of business, and they needed people who could handle that.  The department that I worked for grew exponentially over the two years that was there.

The phones were literally ringing off the hook, in the end of 2001, to refinance homes or to take home equity out because the rates were so good.

But back in those days, at least in the beginning, business was booming and everybody made money.

David: There was no risk involved at the time.  If you got a borrower in from Northern California, from Carmel, who – say he made, you know, $3 million per year, and he’s got an 820 FICO, what do I care?  He’s going to put 20% down, even if, for some reason, he falls off the face of the earth and he goes 6 months and he defaults, we get the house back into our portfolio because we paid for it, it’s our money.  We sell the house again through our real estate side. Or through a realtor that we know, we make money on that, and we’ve got this 20% down, his $250,000 initially.  There was absolutely no risk involved in lending to those types of borrowers.

Mike: There was just so much volume going through the system and everybody qualified essentially and everybody had home equity.

David: Yeah it was a flood.  And our big territory was California, and that was like the beginning of like the tech boom.  All the software guys were out there.  And Google hadn’t even started yet, it was Yahoo and Microsoft and these guys were just collecting money and their bank accounts were huge and they really couldn’t account for all of it because they didn’t get normal paychecks or they got bonuses, or this and that, but they had perfect credit and they had a lot of money and we sold them houses.

Mike: So we know now, in the macro picture, 9/11 happens, the Fed lowers interest rates, there’s extraordinary amounts of money looking for some return, all the models say that mortgage are a great place to get a return, so on the investor side everybody wants mortgages, and on the retail side, everybody wants to refinance their house, which has gone up in value, so its just this awesome machine, and I was also a cog in the machine, in doing my bit.  When you’re a cog in the machine it’s not always, it’s not obvious to us what this is all going to lead to.

The Move to Subprime and Alt-A Lending

And then two great new types of mortgage origination came along.  Alt-A, which meant you could provide much less information than on a traditional mortgage application, and Subprime, which meant you could get a mortgage even though you did not have a history of actually paying your bills.  We started to dive into that where I worked, and David’s two employers during that time period also entered the exciting new world of people with marginal credit and minimal screening of their applications.   Again, so much money was being made.

I joined the Goldman mortgage desk in the end of 2001, beginning of 2002.  and at that time Goldman had, pretty much that month, there was a guy named Kevin Gasvoda, he’s a Vice President and he’s got this mandate to get Goldman into this business because we’d realized that Bear Stearns and Lehman Brothers were taking/stealing our market share in the mortgage department and we didn’t have a subprime or Alt-A program.  And Goldman had basically not gotten into that business because of reputation risk, and we didn’t quite trust that these people would pay the money back, but suddenly in 2002 we were going to invest in that, and the models say that looking back over the last five years everybody does pay their subprime mortgages back. And Alt-A is a perfectly safe product if you structure it correctly, and by the way Lehman and Bear are making tons of money doing this, they are just printing money.

I distinctly remember this kind of back and forth from, internally at Goldman of ‘Should we be in this market?’

In the ‘90s they’d decided not to be, but by 2002, kind of just as I was joining, they were saying ‘We cannot NOT be in this market, we have to be there.  We’ve not trusted it in the past but we’ve got to be there and it/s growing so fast.  That’s my side of the subprime thing, so what’s going on, on your side, while that’s happening?

David: That’s pretty much, actually that’s exactly, almost exactly parallel to what was happening at my bank.    It went from a kind of normal application process, so a normal application form, we’d call their bank for verification, they’d submit income, assets, they’d submit pay stubs that kind of thing, like you would nowadays if you went to get any mortgage, anybody.

Six or seven months into my stay there, so middle of 2001, we didn’t care anymore.  I was literally getting applications with a social security number, a name, a job description, and a bank account statement, and that was it, and we’d write them a check for a million dollars.  And that was happening all day long because it didn’t matter.

Six or seven months into my stay there, so middle of 2001, we didn’t care anymore.  I was literally getting applications with a social security number, a name, a job description, and a bank account statement, and that was it, and we’d write them a check for a million dollars.  And that was happening all day long because it didn’t matter.

Mike: The process of just social security number, job, that was for A-Paper, that’s high quality borrowers, that’s 2001

David: Those would be our no income, no asset borrowers,

In other words, Alt-A paper

David: they come in, we run their credit, and they’ve got an 820 FICO

Mike: Perfect credit, we’ll cut you the check

David: Yeah, we’ll give you what, it’s not a big deal.

David then moved over to USAA Bank, but did not enjoy the subprime market as much.

David: Um, I was there really briefy because I don’t, I didn’t think they were going in the direction that I wanted to go in, as far as that’s concerned…the jumped immediately into the, uh, mid-level and subprime lending because what’s they wanted to get into.

Mike: All the models said, sub-prime people actually paid back, if you looked the previous four years, they all refinanced and paid their money.

David: Absolutely all the math worked.  But the thing is if you look back four years on anything it’s going to work.  If you look eight years or ten years or sixteen years…you’d have to look as far back as the Great Depression – recently – to find where the curve was.  It’s so big it’s hard to see the whole thing especially when you’re focusing on making money like everybody else was.

The reason I didn’t like it so much was they were gearing more toward sub-prime people, and I could obviously see they were starting to lend to borrowers who were not going to be able to pay stuff back.

I’m not saying anything about about USAA bank, obviously everybody was starting to do it at the same time. Because you’re right everybody said “They’re going to pay us back” even though we knew if you give somebody with a 40% debt ratio and you mitigate that by a credit score they still don’t have enough money to pay the loan back, no matter what their credit says and that credit might say that now I mean six months from now and eight months from now it’s going to drop 100 points because they just defaulted on the mortgage you sold them that was, that was out of their means.  And that’s why I said I’m not gonna kind of do this anymore.

David moved back to a customer service job at a private mortgage broker, something he enjoyed immensely, in contrast to the previous work with Subprime and Alt-A borrowers.

The American Dream Business, Gone Bad

David: That was the opposite side of what I was doing before, where we were just handing out checks to people, you know, four or five years previous to that.  And didn’t care about anybody or anything, just making money, this was helping people get into houses.  And actually, like, making their dream come true. It’s not that trite a sentiment when you’re actually doing it.   When you actually are able to call somebody and say we’ve got your loan approved, you’re going to get this house.  It’s much more satisfying than just signing your name on a piece of paper that’s worth a million dollars.

Mike: So you, but you enjoyed that part of it?

David: Absolutely

Mike: It was satisfying to be originating and brokering mortgages for folks.

David: Yeah, and that’s kind of the, that was the fun part, was doing that, versus trying to sell products that probably weren’t suited for somebody to them, and thinking always in the back of your head, is this person going to lose their house, are we going to lose money, is everybody.  Like, this is starting to kind of not, not be agreeable anymore.


David: Yeah, and that’s kind of the, that was the fun part, was doing that, versus trying to sell products that probably weren’t suited for somebody to them, and thinking always in the back of your head, is this person going to lose their house, are we going to lose money, is everybody.  Like, this is starting to kind of not, not be agreeable anymore.

Small Mortgage Errors Compounded With Great Leverage

So, back to the economists, and the information frictions.  One of the things I really liked talking to David about was bridging that information gap.  What is it he knew, that Wall Street should have known.  Its too late of course, but still, what if mortgage originators, mortgage bond salesmen, and mortgage investors had actually spoken to each other in the run up years to 2008?

Mike:  With the benefit of hindsight lots of people have pointed out that all along the mortgage chain each person was doing their job more or less properly as they saw fit, and each person was acting in their own self interest and yet somehow there was information lost.  Somewhere between either the models don’t take into account enough past information on the investor or bank structuring side, homeowners aren’t taking into account the idea that real estate values don’t always go up, they also go flat and they also go down.  On the mortgage origination side lots and lots of banks went under because they sold wholesale packages to Wall Street, which then stopped taking them and putting them back and it just bankrupted the mortgage originators who couldn’t take back the, at that point, unsaleable mortgages.

So everybody got hurt, and yet it’s interesting because every one of us was trying to do the best we could.  In the back of our minds “Huh, something’s not quite going right.”  Do you have any anecdotes of having talked to homeowners about something being not quite right.

David: What I look back now and think about were all the times where we…we you stretch it a little bit.  And if I’m stretching this person’s income by $1,000, or if they’re telling me they make you know $3,500/month, versus $3,200/month and I see their pay statements and it kind of makes sense and I’m just cursorily looking over it and signing off on it, well, that $300 has to come from somewhere, theoretically.  That’s kind of what happened, and I’m that one person.  And there’s one hundred of me.  And there’s a thousand of my departments, and there’s a thousand of my banks.  If you take all those little stretches and flubs and oversights that don’t mean anything at the time because you’re either caught up in writing a loan or making a deadline or a quota

Mike: Keep your volume up, make your monthly number.

David: Or even at the best, helping somebody get a house.

Mike: Right

David: All those things have to come from somewhere, that’s not just…they don’t just go away.  So if you approve this person, or don’t approve this person, or you approve too many of these people, or a hundred of your compatriots are doing the same thing at exactly the same time then the numbers start to skew from the model to actuality and it’s like gaining weight or getting fat, you don’t notice it

Mike: it’s only a half pound per month, but a year later…you’re a lot fatter

David: Exactly, you don’t notice it until you’re 50 pounds overweight a year later, and then you start thinking about all the times you had an extra serving of ice cream, or you didn’t stop at, you know, two pieces of cheese, or whatever it is.

Mike: You’re making me feel guilty

David: Yeah, me too.

Mike: I like your explanation that the income has to be $3,500 [per month] but it’s actually $3,200 and there’s this missing $300/month, that where it’s close enough so we’ll just pass it on

David: Yeah

Mike: And yet, $300/month, you know, it gets put on the credit card and then eventually you’re talking about…

David: And that’s what it is

Mike: …You’re $20,000 in the hole and your house is in foreclosure.

David: It doesn’t seem like a lot to me.  Because I’m thinking, “Yeah, no, this is fine.”  Its only $20/month on their payments to give them this versus this, but 20 times a year, times thirty years, your asking this person to repay back thirty thousand dollars more than they are currently able to.  And that’s assuming that their position is going to get better, instead of assuming their position is going to stay the same or get worse which is what actually happened.

Mike: It gets pretty geared up, pretty leveraged.

David: Yeah.

Mike: Small mistakes get amplified.  On the Wall Street structuring side, where we knew to the Nth degree how to exactly satisfy the letter of the law with respect to how the rating agencies needed bonds to be structured – not the spirit of it, not we’re going to make some safe AAA-rated bonds and some A-rated bonds then BBB-rated bonds, but precisely the letter and not a single iota of wiggle room is you take those $300/month off income and then you gear that to the Nth degree of what the rating agencys will let Wall Street get away with.

All of the mortgage business was entirely a, what we would call a rating agency arbitrage, where you’re just doing precisely the thing that will get you the rating you need to sell it to your investors, but with the no wiggle room, and then as the origination is happening that way, even if you have a slight hiccup it’s all going to come down.

Was It All Worth It?  David Says Yes

Towards the end of our conversation David and I were getting a little bit philosophical and then he surprised me, by saying the entire mortgage debacle might have been worth it.  I had never met anyone who would say that outloud.  But David did.

David: Yeah. That’s something I think about too.  If it wouldn’t have worked out so well for everybody – yeah it went to something bad but – if that money wouldn’t have been made would everything still have kept rolling or would have just been kind of steady or stagnant.  Let’s say you win the lottery, and you go out and you spend all your money in a year. Who’s to say that wasn’t the best year of your life?  And it wasn’t worth spending all of that money on?

Mike: Were the gains in the lead up from say, 2000 to 2007, bigger than the ultimate loss of a steady-state of just steady growth?

David: and that’s coming from someone who isn’t rich, who isn’t wealthy.  I didn’t make, you know, tremendous gains.  I was just a regular employee.  I made a good paycheck, a regular salary but it wasn’t, it wasn’t anything I could retire on.  It wasn’t anything or it wasn’t going to have to work the rest of the, the rest of my life. So, just to be clear about who is actually saying this. It’s not someone who has, who has profited from that big wave, and I’m sitting on a big pile of money giving, giving an interview saying how good it was. This is someone who will has to work a job everyday for the rest of my life because the industry now probably couldn’t support what it did back then.  And I still think that that might have been worth it to get where we are now to know what we know.

Mike: yeah it’s an interesting thing that most people are not saying, which is, the boom might’ve been worth the bust. Is that in a sense what you’re saying?

David: Yeah

Mike: both from a knowledge as well as from a wealth standpoint?

David: Yeah

Mike: That’s a really unusual statement.

David: It’s the position of someone who’s watched it from the inside and then the extreme outside. Someone who gas prices matter to, who knows what a gallon of milk costs.  And, it still seems to me that the experience and that the situation is okay now, it’s not as dire I don’t think as people are making – it was – in like 2007 and 2008 when we almost actually literally lost everything.

Mike: we were staring at the financial abyss, living in caves

David: Yeah it was really close.  It was a financial Holocaust. It was going to happen. Everybody was going to lose everything, at the same time. And banking was going to stop. But it didn’t.  The fact is it didn’t, because we took everything that we had learned from the previous seven or eight years and said “Okay, this isn’t going to work.  We’re seeing it not work.”

If that wouldn’t have happened, would we have even seen that.  Would the curve have been shallower and longer, and had more detrimental effect, if the spike wouldn’t have been so great when it was.

Mike: I think that’s really interesting.  Most people don’t have your philosophical approach to it. I don’t know either way.

David: As I said, it’s not to mitigate or to rationalize, you know, the millions of dollars that I made, because I haven’t.  And it’s not positive just to be positive about it, to kind of negate others things or to ignore it.  I’m by nature a very pragmatic person.  But even that.  You have to at least accept that the experience was worth it.


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