“evil and greed,” as many ordinary Americans believed, or was there a basis of value that supported finance—a system of credit and debt that creates prosperity for hundreds of millions of people, or so Wall Street believed?
A senior executive at Bear Stearns said: “Making loans to creditworthy borrowers was one of the easiest ways to make money on Wall Street. The securitization machine became like an assembly line that produced massive amounts of bonds, which in turn produced massive profits for the industry. As long as there were borrowers who wanted loans, there was money to be made. As the market for prime mortgage loans became saturated, guys in the industry started looking for new ways to make money. The subprime markets presented that opportunity. Even though subprime loans were riskier than prime loans, the banks and Wall Street firms would not have to keep them on their books for long. This meant that they would not have to worry about the risk. Lending money to anyone who would take it regardless of their ability to service the debt became the norm.”
Risk is something that Americans understand well. It is part of our DNA. We have a love-hate relationship with it more than any other developed nation. You cannot be more of a risk taker than our founders were when they decided to overthrow the greatest military and economic power in the world. They took a risk that not only could they win a war against imperial England, but also that they could survive without the hand that fed them. (Great Britain was the main source of credit for the emerging nation before and after the Revolution.) Many of the comments in the aftermath of the financial crisis revolved around the “reckless risk taking of Wall Street.” Pundits, politicians, bloggers, journalists, and ordinary citizens fumed about the casino-like state of the mortgage markets. The battle of risk and reward dates back two centuries to Hamilton and Jefferson. The first credit crisis in America occurred in 1792 in the wake of a government bond scandal. Jefferson remarked, “The credit and fate of the nation seem to hang on the desperate throws and plunges of gambling scoundrels.”1 Some two hundred and eighteen-years later, in the spring of 2010, one senator echoed Jefferson’s words when discussing the CDO markets: “It’s gambling, pure and simple, raw gambling.”2
Nearly one hundred years ago in 1908, the Economist wrote: “The financial crisis in America is really a moral crisis, caused by the series of proofs which the American public has received that the leading financiers who control banks, trust companies and industrial corporations are often imprudent, and not seldom dishonest. They have mismanaged trust funds and used them freely for speculative purposes. Hence, the alarm of depositors, and a general collapse of credit.”3; A century later we found ourselves in the middle of yet another collapse of credit and moral dilemma. This financial crisis was no different than those before it. Profits had become more important than people once again. The industry forgot their foundation of service in the quest for profit. Who benefited from their product beyond a small group of financiers? What value did these financial instruments provide to society? Ordinary folks got wrapped up in the Street’s euphoria and took advantage of the easy money. They were the first ones to take the fall. Americans are risk takers by nature. Pioneers drove wagon trains through unknown lands facing enormous danger as they settled the West; speculators risked it all to cross the Rockies to pan for gold; immigrants, by the millions, came to our shores with nothing in their pockets to create fortunes except a wish and a prayer. The belief that you cannot have reward without risk is an inherent part of the American psyche. So where had that gone wrong? In the risk that our forefathers and mothers took, there was an element of sacrifice in it. They experienced hardship for gain. The end result was not always clear, but hard work, resilience and resourcefulness were part of the plan.
In the later subprime mortgage products, no effort went into creating these loans or securities. One loan underwriter at a big commercial bank said: “We were under pressure by top management to produce more products and post bigger profits. After a while, prime borrower demand for loans diminished, and we lowered standards for subprime borrowers. When the original subprime loan demands decreased, the industry reduced standards again. In the end, there were few standards remaining.” As I interviewed dozens of unemployed and worried professionals, a picture of market chaos appeared. Producers and management ran a race to the finish but had not realized the prize at the end was not worth the price. Wall Street was set up for profit, not philosophy. Yet the human connection was precisely the missing ingredient. Profits had obscured people. From Main Street to Wall Street, the human aspect of money had been neglected; more to the point, it had been completely ignored. Somehow the nature of the financial industry, or business itself, had written into the code that none of it was personal. The mortgage industry forgot that human beings were tied to the end of the loans. It was a simple fact ignored by too many. I sat and discussed this omission with industry pros, some of whom I had known and respected for years. While there were and are self-serving and ruthless people in finance, there are good guys too. Some are devoted fathers; others are great philanthropists. Many, as hard as it may be to believe for those outside the industry, are truly honorable people who simply never added two plus two to get four. They missed the obvious, thinking only of the bottom line and the push for profit. The profit margins had not represented people or family homes; they were simply numbers on a screen. When the dust cleared, the good guys in the industry were as shocked and horrified as everyone else.
A clear picture of Wall Street as both a perpetrator and victim of a fundamentally flawed model emerged. The financial industry had not seen itself as a public service directly tied to Main Street. Yet the industry functioned on service—to clients, customers, investors and consumers. If it forgot that human connection, its purpose was obscured. And therein lay the inherent misunderstanding, the false principle that finance is based solely on bottom line profits. Where were people in this bottom line? That was the financial model’s greatest flaw - its neglect of the direct connection to society. In a real sense it was a moral crisis, one that few in America and fewer still in the industry had recognized.
The Twenty-Eight Dollar Tomato
“Gerry” was a mathematical genius. In his Docker slacks and tasseled loafers, he sported a “preppy” collegiate look with a Poindexter IQ. Built like a teenage boy, the 38-year-old calculus whiz looked 15 years younger than his age. Frail and thin, he spoke with a deliberate seriousness that belied his childlike frame. As he explained the mortgage models he had created, it became obvious he spent large portions of his days building algorithms. Yet for all his brilliance, he was humble and warm with a sharp engaging wit. A quant (PhD in complex mathematics) educated at Berkeley and MIT, Gerry explained how the industry forgot the fundamental rules of risk and reward. When the Street began to securitize NINJA loans (no income, no job, no assets), some analysts like Gerry voiced their objection. The research quant’s job was to analyze products and reveal market strengths and weaknesses. Gerry discovered early in the subprime era that many of the lesser quality securities were “too risky” and not worth their stated value. Upper management was virtually high on profit, refusing to acknowledge any flaws in the system. Every time Gerry expressed his concerns about questionable securities, he was told to, “Sit the fuck down and shut up, you negative dude.” Top managers believed he was looking at the glass as half empty, not half full. When the market tanked, the firm was left with tens of billions of dollars of defaulting assets on their books. Management called Gerry and his group in to analyze their assets to see if they had any remaining value. Gerry remarked that the head of fixed income “looked like a puppy who had just pooped in the corner and asked, Can you help us?” Gerry said to me, “It is a sad day when you find out your company behaves like that. Every time you dupe someone, you lose future business.” I asked Gerry the Genius what went wrong with management and their business model. He believed it was “a failure in leadership.” Top management forgot about cost and value. Gerry compared the mortgage-backed securities market to selling tomatoes. The MIT trained quant explained: “I sell you a tomato for twenty-three dollars. You sell it to someone else for twenty-five dollars, who then sells it to someone else for twenty-eight dollars. Yet in reality that tomato is only worth twenty-three cents. That is what went on in the mortgage markets.” The financial industry was left with billions of rotting tomatoes on its books after the crisis. Like tomatoes, defaulting loans
