Inside Job (15 page)

But
why
was the firm so dangerously exposed? Knowing the risks, knowing that a huge bubble would inevitably end, why had the firm continued to buy and hold so much junk, and why was it so
reliant on such huge amounts of short-term funding? Well, the working-level people directly exploiting and profiting from the bubble didn’t have much incentive to end it, or warn anyone. As
long as they could sell junk, they made money. When it started to go bad, many of them even made money by betting against it—by betting against specific securities, against indexes of
mortgage-backed securities, and against firms likely to fail in the crash. And while they shared in the gains, all of the losses were someone else’s problem.

But that logic mainly applies to those who were most directly profiting from annual cash bonuses and could move to other firms. What about senior management and boards of
directors, not just of Bear Stearns but of the others that collapsed—Lehman, Merrill Lynch, AIG, Citigroup, and even the lenders (WaMu, Wachovia, Countrywide, etc.)? In the event of failure,
the CEOs and boards of these firms would unquestionably lose jobs and wealth not easily replaced. The answer to this question reveals a great deal, and we will consider it shortly. For now, let us
continue our tour of Wall Street conduct.

We know more about Bear Stearns than we do about most other banks, due to the lack of government investigation and because the civil suits are being delayed. But sufficient material is available
on other lenders to confirm the generality of bad behaviour. Some examples follow.

GOLDMAN SACHS IS
the other major bank for which there is a substantial internal record, thanks to documents obtained by the Senate Permanent
Subcommittee on Investigations. The most interesting parts of Goldman’s behaviour are considered in the next chapter, because they pertain to what happened after the bubble ended. For now, I
will simply provide one example to make the point that Goldman created junk like everyone else.

In the 15 October 2007 issue of
Fortune
magazine, Allan Sloan published his superb article “House of Junk”, which focused on a series of securities, the GSAMP Trust 2006-S-3,
totalling $494 million out of the $44.5 billion in mortgage-backed securities that Goldman Sachs sold in 2006. The GSAMPs were issued in April 2006 (during Hank Paulson’s final months as CEO
before becoming Treasury secretary), having been assembled from second mortgages sourced from among the worst subprime lenders, including Fremont and Long Beach. Since they were all second
mortgages, the lender could not foreclose in the event of default. The average loan-to-value ratio of the pool was 99.29 percent,
meaning that borrowers had essentially zero
equity in the homes, and 58 percent of the loans had little or no documentation. Despite this, 93 percent of the securities were rated investment grade, and 68 percent were rated AAA, the highest
possible rating, by both Moody’s and Standard & Poor’s, the two largest rating agencies. Yet by October 2007, 18 percent of the loans had already defaulted, and all of the
securities had been severely downgraded.
²⁰

So it was junk. But did they
know
it was junk? They most certainly did; they started betting against it in late 2006, and by late 2007 they were already making net profits on their bets
against mortgage securities. We’ll return to Goldman Sachs later in discussing how the financial sector handled the end of the bubble, the crisis, and the post-crisis environment. It’s
interesting, and hasn’t been sufficiently publicized.

MORGAN STANLEY WAS
one of the leading global securitizers. In the first quarter of 2007 alone, MS created $44 billion of structured securities backed by
mortgages and other assets. One modest deal sold to an unsophisticated institutional investor, the pension fund for Virgin Islands government employees, is a good illustration of banking ethics in
the twenty-first century.
²¹

The security in question was a particularly toxic thing called a synthetic CDO. A synthetic CDO is a kind of virtual, imitation CDO, not backed by actual loans or debts, but essentially a
collection of side bets on other securities, constructed to track their performance. As with any bet, it takes two parties—someone betting that the securities will work, and someone else
betting that they will fail.

The synthetic CDO in question here, Libertas, referenced, or made side bets on, some $1.2 billion of mostly mortgage-backed securities, a large share of them sourced from New Century, WMC, and
Option One, all of them notoriously bad subprime lenders. The Virgin Islands pension fund bought $82 million worth of AAA-rated notes forming
part of Libertas. The deal closed
in late March 2007, and before the year was out, the securities were nearly worthless. But it gets better.

Morgan Stanley owned the short side of the entire deal—in other words, the people who created and sold these securities were betting that they would fail. So they did very well indeed when
the pension fund’s notes defaulted, as they did within months. Since Morgan Stanley owned the short side, they kept the entire $82 million principal of the Virgin Islands pension investment.
Nice work. You sell a deal, collect your sales commission, then you get to keep the customer’s entire investment when the securities fail.

That much is not in dispute. But, stunningly enough, it is not per se illegal to create and sell a security with the intention of profiting from its failure—a state of affairs that the
investment banking industry is in no rush to publicize, much less change. So the question in the Virgin Islands lawsuit is whether Morgan Stanley knowingly misrepresented the quality of the
securities. Here is the pension fund’s side of the story.

Morgan Stanley had long been New Century’s largest “warehouse” lender—supplying funds for New Century to assemble loans for securitization. As such, it carefully
monitored conditions at the lender. We saw in the previous chapter that as the bubble ended and accounting problems surfaced, New Century rapidly declined into bankruptcy.

Morgan Stanley disclosed in the Libertas prospectus that New Century had been accused of trading and accounting violations, but did
not
mention the mounting claims for breaches of
warranties. They also mentioned that “several published reports also speculated that [New Century] would seek bankruptcy protection or be liquidated.” Still, like all securitizers, they
claimed they had vetted the loans and that they met standard quality guidelines.
²²

But Morgan Stanley knew a great deal more than it had disclosed. It had participated in a 6 March conference call with New Century and its creditors. After the call, Citigroup decided to invoke
its default rights against New Century. About a week after the Libertas deal closed, Morgan Stanley seized $2.5 billion in New Century assets; New Century declared bankruptcy soon thereafter. The
bankruptcy examiner later
wrote: “[The] increasingly risky nature of New Century’s loan originations created a ticking time bomb that detonated in
2007.”
²³

The question in the lawsuit is whether Morgan Stanley deliberately withheld material information. But that was habitual for them. Like those of all the other securitizers, Morgan Stanley’s
loans had been examined by Clayton Holdings, which, as usual, found that many of them violated even Morgan Stanley’s internal guidelines, and that many defective loans were securitized
anyway.

In June 2010 Morgan Stanley agreed to pay $102 million to settle a lawsuit brought by the attorney general of Massachusetts. While not admitting wrongdoing, Morgan Stanley executed an
“Assurance of Discontinuance” specifying a long list of improper acts and referencing a long list of past bad practices.

According to the settlement, when Morgan Stanley had been faced with a choice of maintaining its credit standards or continuing to source New Century loans, it chose to jettison standards.
Morgan Stanley began to accept loans that didn’t comply with the Massachusetts “best interest” law, and progressively discarded its remaining internal quality rules. Even after
Morgan Stanley declared New Century to be in default, it continued to provide funding for its mortgages—as long as the money was wired deal by deal to settlement accounts with availability
only upon mortgage execution.
²⁴

And what about Option One? They were the H&R Block subsidiary, one of the “Worst of the Worst” subprime lenders. By the first part of 2007, delinquency rates on the loans from
Option One that were used for Libertas were more than double the company’s earlier default rates even before the deal was closed. It does not appear that Morgan Stanley shared that
information with the investors.
²⁵

During the bubble, Morgan Stanley had record profits, like everyone. As for the crisis, well, they survived, despite coming close to collapse in 2008. But Morgan Stanley would have done much
better had it not been for one man, Howie Hubler, a senior trader whose erroneous bets on the mortgage market cost Morgan Stanley $9 billion.

But the
nature
of Mr Hubler’s bets is far more revealing than the size of the loss, particularly when compared to the rest of Morgan Stanley’s
behaviour. Mr Hubler didn’t lose money because he innocently thought that mortgage securities were good things. Quite the contrary.

Like the people at Bear Stearns, Mr Hubler was anything but an obscure rogue trader. He ran a fifty-person group, and his decisions were reviewed by senior management. Mr Hubler realized by late
2004 that the housing market was a huge bubble, that it would burst, and that when that happened, thousands of mortgage-backed securities based on awful subprime loans would fail. Mr Hubler talked
to his management about this, and they agreed with him.

Did Morgan Stanley then warn its customers? No. Did it stop selling tens of billions of dollars of crappy subprime mortgage-backed securities? No. Did it tighten its loan standards?
No—indeed, as we have just seen, it lowered them. Did it warn the regulators? No. Did it stop financing the worst subprime lenders? No.

What Morgan Stanley
did
do, however, was give Howie Hubler permission to begin betting
against
subprime mortgage-backed securities, massively. Using credit default
swaps—we’ll get to them—he placed enormous bets that very low-quality, but nonetheless highly rated, mortgage securities would fail.
²⁶

But there was a problem. The bubble lasted longer than anyone at Morgan Stanley predicted that it could. And as 2004 became 2005 and then 2006, maintaining Mr Hubler’s bets became
expensive. But Mr Hubler was absolutely certain that the bubble would eventually burst, and he wanted above all to maintain his bets against those really awful subprime mortgage securities.

And so, with Morgan Stanley’s knowledge and approval, Howie made a huge mistake. In order to pay for his bets
against
the lowest-quality mortgage securities, he started writing
insurance for other, supposedly higher-quality mortgage securities—securities that Mr Hubler thought would not default until much later than the really awful ones. But insurance on these
higher-quality securities was much cheaper, so
in order to sell enough insurance (to obtain enough premium income) to fund his bets against the obviously crappy securities,
he needed to write insurance on a
lot
of them.

For a short time it worked, and in the first quarter of 2007 Morgan Stanley made $1 billion from Hubler’s strategy. But when the shit hit the fan, the supposedly higher-quality securities
failed rapidly, too. Just as Morgan Stanley had underestimated the size and duration of the bubble, so too it had underestimated the severity of the collapse. Internal politics and/or sexism
probably also interfered; an article published in
New York
magazine in April 2008 described power struggles and institutional sexism involving Hubler, other traders, John Mack (the CEO), and
Zoe Cruz, Morgan Stanley’s highest-ranking female executive. Cruz was not a saint; she too endorsed the idea of secretly shorting the subprime market. But Cruz, to whom Hubler reported,
apparently became alarmed about the potential risks of Hubler’s strategy.

But Hubler apparently ignored her. And so Howie lost $9 billion for Morgan Stanley. Of course, he kept his previous bonuses—tens of millions of dollars. He was forced to resign but was not
officially fired, so he also collected his deferred compensation.

With wonderful irony, during its crisis in 2008, Morgan Stanley’s CEO campaigned publicly and angrily against one group that, he said, represented a danger to financial stability and a
menace to society. After a tough public fight, Morgan Stanley persuaded the SEC to restrict the actions of this group. Who were these evil people, and what was this dangerous activity that needed
emergency regulation?

Short sellers, of course—people betting against Morgan Stanley stock, who therefore had an incentive for the company to fail. In late 2008 Laura Tyson, a member of Morgan Stanley’s
board of directors whom I have known for twenty-five years, told me with an utterly straight face, in what was probably my final conversation with my former friend, that hedge funds were conspiring
against Morgan Stanley, shorting its stock while spreading malicious rumours and withdrawing their money in order to weaken the firm. Laura also told me that she and Stephen Roach, Morgan
Stanley’s chief economist during the
bubble, had both warned senior management that the bubble would burst. When I asked her whether the bonus system had contributed to
the crisis, she said no, and told me that those who had caused Morgan Stanley’s own losses had themselves suffered greatly. “Those people were
crushed,
” she said.
“They have lost
everything
.”

Laura did
not
tell me that her firm had been constructing and selling securities with the intent of profiting from their failure, nor that Morgan Stanley’s losses in 2008 were
caused principally by a tactical error in implementing a massive bet against the bubble that it had helped create—a strategy that had provided a huge incentive not to warn its customers, the
regulators, or the public of the impending crisis. Did she know about it? I don’t know, although during the bubble she had been in frequent contact with Zoe Cruz and Morgan Stanley’s
senior management.