Colossal Failure Of Common Sense Part 6

Reeling from the humiliation, embarra.s.sed beyond belief, I moved back into action. I'd always heard there were guys like Gatward on the big Wall Street trading floors, overseers whose creed was to keep everyone on their toes. I'd never been in any doubt that I wanted to be in the thick of the action, up there at the sharpest end of the business, where the bullets fly and you can get hit during your personal charge to glory.

But this Gatward was something else. He could have landed a job on a Viking s.h.i.+p. He'd just threatened to make me walk the plank, and I'd only just gotten there. But the venom he had unleashed on a staff member who had mistakenly endangered the firm's capital was something to behold. I never spoke about it, but the essence of his words was branded on my mind. These were words he never uttered, not literally, but the message had been hammered home: McDonald, we only hire the very best people here. And the best don't f.u.c.k it up. You want to be one of us, don't f.u.c.k it up again. Ever. Hear me? McDonald, we only hire the very best people here. And the best don't f.u.c.k it up. You want to be one of us, don't f.u.c.k it up again. Ever. Hear me?

It worked too. I never did. Bottom line: I knew he was right. He just wanted to get the very best out of all of his traders. And in case that public roasting ever preyed upon my mind, I kept in my desk a small framed copy of a very famous quotation from America's twenty-sixth president, Teddy Roosevelt: "Credit to the man who is actually in the arena, whose face is marred by dust and sweat ... who strives valiantly ... his place shall never be with those timid souls who knew neither victory nor defeat." Just to remind me that I had strived to be right there. It was demanding, it was all h.e.l.l about six times a day, and it was hard. Real hard. And it was the hard that made it great.

5.

A Miracle on the Waterway It pioneered the early development of the NINJA mortgage-that's no income, no job, no a.s.sets. It was a paradise on earth for the sun-bronzed mortgage salesmen who worked hand in glove with the home builders.

I USED TO USED TO think occasionally that our colleagues on the fourth floor, the mortgage and property guys, arrived at certain meetings a few minutes after everyone else in order to make a grand entrance. You know the style, like long-ago film stars trying to maximize the applause: the flurried grandeur of Fontaine and Crawford, the sa.s.sy tardiness of Monroe and Liz Taylor. think occasionally that our colleagues on the fourth floor, the mortgage and property guys, arrived at certain meetings a few minutes after everyone else in order to make a grand entrance. You know the style, like long-ago film stars trying to maximize the applause: the flurried grandeur of Fontaine and Crawford, the sa.s.sy tardiness of Monroe and Liz Taylor.

Later, having given the matter due reflection, I adjusted this opinion, and put the lateness of the mortgage guys down to their suspected love of long walks on the lake in Central Park.

In that bright fall of 2004, we were in the presence of G.o.ds, the new Masters of the Universe, a breed of financial daredevils who conjured Lehman's billion-dollar profits out of one of the most complex markets ever to show its head above Wall Street's ramparts.

This was the Age of the Derivative-the Wall Street neutron that provided atomic power to one of the most reckless housing booms in all of history. Derivative number one was the fabled CDO, the collateralized debt obligation. This new "technology" was created and perfected in Wall Street's investment banks, including Lehman but especially at Merrill Lynch.*

Like most sensational ideas, this one was simple, and in a sense solidly based. The process began in the offices of large U.S. mortgage brokers, particularly in California, Florida, and Nevada, where the prospect of a fast buck has never antagonized the natives. This was the start of a lending twilight zone, the advance of the shadow banks, places with no depositors, no customers filing in and handing over their paychecks to carefully run commercial banking organizations. The shadow banks would lend, finance, and provide capital for house purchases, but they had to borrow the money in the first place from proper banks, mainly because they didn't have the money themselves. Presto! We have a lender who's not really a lender, a lender who has to borrow borrow the money in order to make the loan. Huh? the money in order to make the loan. Huh?

They began to spring up all over the place, operating under the most creative banners in the history of marketing, naming themselves with comfort t.i.tles, ever friendly, ever ready to help-Right-Away Mortgage, No Red Tape Mortgage, LowerMyPayment.com, Deep-Green Financial, LoanCity OwnIt Mortgage, Sea Breeze Financial Services, Mortgage Warehouse. All shadow banks, just like the giants New Century, Aurora, BNC, and Countrywide.

It quickly occurred to these mortgage houses that if they could provide financing in the very short term, they could then sell the mortgage to one of the Wall Street banks. What they did was package together a thousand mortgages-that's one thousand homeowners who had borrowed around $300,000 each to purchase property. The money had been loaned to these borrowers at an initial annual rate of around 1 or 2 percent, which would be adjusted upward within one to three years. It's called an adjustable rate mortgage, known in the trade as an option ARM. The mortgage house then telephoned Lehman and explained that this package of one thousand mortgages represented a debt of $300 million. It was fully collateralized by the property deeds, and in this boom housing market, when everyone paid up monthly on the wave of soaring prices, it carried zero risk. On a $300,000 mortgage at 2 percent, no down payment, the monthly payment would be $500 a month. Multiply that by 1,000 and you get $500,000. Every month. No bulls.h.i.+t. All Lehman had to do was buy the loans for the $300 million and create a bond by securitizing the debt, just like one of the normal bonds I mentioned earlier. It could then be sold to investors, who could sit back and collect a share of the ma.s.sive monthly repayments from the homeowners.

In order to buy the loans, Lehman would borrow the $300 million in the short-term commercial paper market. Because the debt was secured by the mortgages, it could be turned into a mortgage-backed security (MBS). Now it was essentially a $300 million CDO bond, which the Lehman traders would slice up into, say, three hundred bonds at $1 million each and take to market as an investment vehicle that would pay as much as a 7 or 8 percent coupon, straight out of the gate. These would be sold in various numbers to major hedge funds, banks all around the world, and major investors, all jumping in for a cut of that interest payment, which might rise to 9 or even 10 percent in two years. (We're simplifying here. Lehman and other investment banks used a technique called a.s.sets swaps to, in effect, provide immediate returns to investors, even though some of the mortgages started paying just the teaser rate of 2 percent for the first couple of years).

Now, it did not take long for the original mortgage salesmen to realize that to earn their commission, all they needed was a signature. The head office did not care one way or another whether the loans were sound or not, because the mortgage house would sell them on to Lehman or Merrill Lynch within a month. Lehman didn't much care either, because once the bonds were sold the problem was no longer theirs, and in the rampant housing market that was an extremely fast process, with the bonds being distributed all over the world to banks such as HSBC, Iceland's Kaupthing Bank, or j.a.pan's Mitsubis.h.i.+.

The final holder of the bond, the distant bank or fund, also held the deeds to the original houses. Which meant that a homeowner in sunlit California could be sitting in a house that was owned by a couple of Eskimos out on the ice floes chasing polar bears, six thousand miles away. Has the world gone stark raving mad? Has the world gone stark raving mad? I asked myself-or, more correctly, I asked myself-or, more correctly, should should have asked myself. But of course I didn't in 2004. I accepted the words of Lehman's fourth-floor G.o.ds that everything was, as the British say, tickety-boo. have asked myself. But of course I didn't in 2004. I accepted the words of Lehman's fourth-floor G.o.ds that everything was, as the British say, tickety-boo.

One of the great glories of the process was the vast distance it placed between the ultimate lender-say, some hedge fund in Hong Kong-and the person who had taken out the mortgage in the first place, because this had the effect of diluting any complaints there might be. In essence, no one needed to worry whether it all ran smoothly or not. Hence the new G.o.ds of Lehman, the mortgage men, were able to take their daily walks on the lake in Central Park, unapproachable by mere mortals like ourselves. They were a study in fine-tuned hubris.

As if their arrogance was not sufficient, Lehman had recruited another battalion to provide the mortgage division with credence beyond even their dreams: all three leading credit-rating companies, Fitch Ratings, Moody's, and Standard & Poor's. These three did much more than just rate the CDOs for risk; they played an integral role in putting the CDOs together. The agencies offered guidance and expertise to the biggest investment banks on Wall Street. For Lehman they investigated the quality of each mortgage and then supervised the packaging of the bond. The agencies instructed the CDO a.s.semblers how to squeeze the most profit from the mortgage-backed securities. Each CDO contained a fair share of good-quality homeowners who were expected to pay on time every month. There were also swaths of borrowers who might be a bit suspect financially, and these mortgages were spread evenly among the CDOs, which lessened the risk of selling any really poor product. Thus Fitch, Moody's, and S&P were complicit in the entire program, not merely because of their skill in advising on both good and vulnerable mortgages but also because they gave the banks credence, allowing them to issue CDOs with triple-A ratings, signed and certified by the three biggest names in the business.

By the time I reached Lehman Brothers, those CDOs were the bedrock of a new Wall Street bonanza. Corporations such as Lehman Brothers were making fortunes in fees. And so, of course, were the ratings agencies.

All three of them had been handed overwhelming responsibilities by the financial regulators, who had in effect outsourced the monitoring of CDOs. Never had the agencies been on the right end of such an enormous cash cow. CDOs were exploding as thousands of people were given mortgages, and the agencies quickly decided to charge three times as much as normal to rate them. Even early on, there were those who wondered if the three agencies' princ.i.p.al motive for providing the investment houses with favorable CDO ratings might have been money. A couple of years later Moody's reported annual profits of $1.52 billion-almost half of it from the structured financing boom. S&P was not far behind, charging as much as $600,000 to rate a $500 million CDO.

In any event, it was one heck of a plus for Lehman's salesmen to go out with a bond which they could prove was investment-grade rated, because investors needed little encouragement to go for AAA-rated CDOs* that offered the same yield as investment-grade corporate bonds. At least they would, within twenty-four months, when the interest rate on the adjustable-rate mortgages ripped upward to 9 or 10 percent. The bond was solid, guaranteed by the burgeoning housing market, in which prices were rising 10 percent per annum. That's the way it worked-the U.S. housing market had never dropped more than 5 percent in any year since the Great Depression. Plus the bonds were highly rated by either Fitch, Moody's, or S&P, all of which most people believed were some kind of quasi-governmental organizations, and which had spent decades rating stodgy, traditional stocks and bonds. that offered the same yield as investment-grade corporate bonds. At least they would, within twenty-four months, when the interest rate on the adjustable-rate mortgages ripped upward to 9 or 10 percent. The bond was solid, guaranteed by the burgeoning housing market, in which prices were rising 10 percent per annum. That's the way it worked-the U.S. housing market had never dropped more than 5 percent in any year since the Great Depression. Plus the bonds were highly rated by either Fitch, Moody's, or S&P, all of which most people believed were some kind of quasi-governmental organizations, and which had spent decades rating stodgy, traditional stocks and bonds.

All of this was being pulled by the ferocious undercurrent of rock-bottom interest rates. Bank rates were hovering near zero, bank interest wasn't worth having, and government bonds were paying so little that most people would have been just as happy burying their cash in their backyards. The ten-year Treasury yield in 2004 was only 4.05 percent. This was the beginning of a vicious cycle known on Wall Street as the "positive feedback loop." So long as China kept churning out under-priced goods and purchasing U.S. Treasury bonds by the s.h.i.+pload, nothing much seemed likely to change. Investors flooded into those mortgage-backed securities to get a higher yield on their money.

The CDOs seemed safe, well recommended, highly rated in the hottest market around-a market with a fantastically low default rate. The real granite-hard backup for these securities was, of course, the house, which cost $300,000 and would swiftly go to $330,000, like every house in the country, up 10 percent per annum. That's the way it worked. The U.S. housing market had never dropped more than five percent in any year since the Great Depression.

And it was making fortunes for my new employers. Which was why the Lehman mortgage guys wore those smug expressions as they walked through the hallways, supremely confident of their judgment, sure of their market, thrilled by the lion's share of Lehman profits they alone engendered.

Unsurprisingly, they became the blue-eyed boys of the thirty-first floor, demiG.o.ds who rubbed shoulders with the mighty, who saw, and sometimes even spoke to, Fuld and Gregory. There could surely be no higher honor than that. Not at Lehman. Their words were not so much heard as acclaimed; their budgets were enormous, their bonuses magnificent, their freedoms enviable. And the risks they took were nothing short of awesome. In truth, they made the rest of us feel slightly second-cla.s.s as we toiled away, pitting our wits against the market, making good steady traditional profits, millions of dollars each week, every one of which paled by comparison with the zillions being coined on the fourth floor by the mortgage guys. From our standpoint it seemed everyone was admiring them and helping them. Whatever they needed-extra budget, permission for more risk, permission to invest colossal hunks of the firm's capital in their market-they got.

Their most important helpers, however, were unseen, unsung, hardworking toilers in the market, a bit like ourselves in many ways. I refer to the mortgage salesmen out in the golden West, that Shangri-la where the locals s.h.i.+ver, gripe, and moan when the temperature drops below 72 degrees in January. The place where sales reps look like bodybuilders, toned and bronzed, teeth like piano keyboards, surfboards in the back of their cars. California, where the living is easy, and mortgages are even easier. Somewhere out there, a vast army of these salesmen was writing mortgage deals for people who wanted, in many cases, a first home.

Of course, in times past, buying a home required sufficient personal capital to make a sizable down payment, usually 20 percent, sometimes a little more. It also required the person to sit right down in front of the banker or mortgage executive and prove beyond a shadow of reasonable doubt annual income, job, and prospects of remaining employed. In many cases people were asked what they proposed to do about the mortgage if for any reason they became unemployed. And honesty was a watchword, because the local banker was an integral part of the community, a familiar figure, who shared schools, sports, and friends.h.i.+ps with many of his clients. These were the standards of American banking, and they had stood the test of time, the pivotal issue being in every case the reliability of the customer and his ability to repay the money his home had cost.

But as the year 2004 drew to a close, there was a brand-new culture in real estate. The mortgage broker was no longer the lender, because he was about to unload the whole package, one thousand mortgages at a time, to Lehman Brothers or Merrill Lynch for the now-well-established parceling-out process, masterminded by the ratings agencies, Fitch, Moody's, and S&P. So the brokerage house did not care what happened after that, because they no longer had their own capital on the line. And those bodybuilder salesmen, those affable Californians, were free to run amok among lower-middle-income earners and sell them anything they darned pleased. There were no standards, no consequences, no responsibilities, and no recriminations. Because, and I stress this once more, n.o.body cared. There was no need. The brokerage firms could sell any and every mortgage they wrote, sell it on to Lehman Brothers or Merrill Lynch, or any other major U.S. bank, on faraway Wall Street.

No team of salesmen ever had a more liberal, freewheeling brief. Just sign up the prospect, write his mortgage, and collect your commission. Needless to say, this heaven-sent career path attracted literally thousands of a certain type of salesman. One of the biggest of the California brokerage houses, New Century, a corporation with many, many direct lines to our mortgage-backed securities trading floor, staffed 222 branch offices coast to coast and used a network of 47,000 mortgage brokers, many of whom worked in their "satellite offices"-that is, their apartments or cars. Those salesmen were applying deceptive, high-pressure tactics to people who never even realized they needed a mortgage, never mind a refinance, or a reverse mortgage, or a no-doc.u.mentation mortgage, or an adjustable-rate mortgage, or a balloon mortgage, or a cash-back mortgage, or an easy-money mortgage, as advertised by the more ruthless of the breed on local gospel radio stations. There was a whole new language evolving, creating selling strategies that had never been heard of before. What the h.e.l.l's a balloon mortgage? What do you mean, an easy-money mortgage? Don't ask, for Christ's sake-they'll try to sell you one.

For the record, an easy-money mortgage is a mortgage for $330,000 on a house that costs only $300,000. The salesman just hands over the change to the homeowner. Sir, I'm not just offering you a brand-new home; I'm about to write you a check for $30,000 for yourself. What could you possibly be doing with your wife and children in this little apartment when I'm right here to change your life? Just sign here. And don't worry about the repayments. We start off at 2 percent, go to Sir, I'm not just offering you a brand-new home; I'm about to write you a check for $30,000 for yourself. What could you possibly be doing with your wife and children in this little apartment when I'm right here to change your life? Just sign here. And don't worry about the repayments. We start off at 2 percent, go to maybe 10 percent, but not for another couple of years. By then your property will have increased in value. Don't worry about it maybe 10 percent, but not for another couple of years. By then your property will have increased in value. Don't worry about it.

Every day, there were around half a million mortgage salesmen working California alone, out there pitching, signing up more and more prospects, and to h.e.l.l with the consequences. More than 40 percent of all U.S. subprime mortgage lenders originated in California. It was easier to finance a new house than it was to finance a new car. In fact, it was cheaper to buy a house than rent an apartment. No wonder those mortgage brokers made more money than any salesmen ever made since records began. And all roads led, ultimately, to Wall Street, especially to Lehman Brothers, fourth floor, where the mortgages were being flipped into CDOs, sliced, diced, packaged, and s.h.i.+pped on to Reykjavik, London, Dublin, Frankfurt, Hong Kong, and Tokyo.

We were watching an almost unprecedented bonanza. And from where I stood on the Lehman trading floor, it was a bonanza that had to be respected. The fourth-floor guys were making this banking corporation enormous profits, and no one could deny that. Their status was beyond question, and no one had come to any harm yet. Their performance was not far short of miraculous. I didn't think we'd need to buy wine for the Christmas party, since the mortgage guys could probably produce chateau-bottled vintages from tap water, a technique hitherto regarded as a dying art.

There's one thing I definitely know about miracles: they hardly ever happen. But I was watching one, the mystical transformation of debt, some of it highly shaky, into one of the biggest profit booms seen on Wall Street for years. Thousands and thousands of people, from faraway places, all contributing to our balance sheet on the anvil of the fourth-floor number crunchers. Everything I had ever been taught, everything I had ever learned, suggested that such seemingly miraculous events rarely last, and occasionally end in catastrophe.

And yet, and yet ... There seemed to be no end to the irresistible force of the United States housing market as it rolled straight ahead, crus.h.i.+ng all objections, problems, and hesitations. That market lumbered its way forward, muttering its omnipotent creed: The U.S. housing market has never dropped more than 5 percent in any year since the Great Depression The U.S. housing market has never dropped more than 5 percent in any year since the Great Depression.

My personal instincts were plainly out of sync with the Lehman philosophy. h.e.l.l, we were the leaders in this property rampage; we'd helped invent the CDOs, and no one could sell these gold-edged derivatives better than us. I didn't dare mention even a semblance of doubt, not to anyone. That would have been tantamount to high treason, as if the president of the United States had invited Osama bin Laden to Camp David for the weekend.

Still, without one iota of reason, evidence, or fact, I wondered. Deep in the night I wondered. Sometimes I went to sleep trying to make sense of the billion-dollar mortgage debts against our breathtaking profits. And then, four days before Christmas something happened. Something that was a puzzle more than a truth, and it did not occur to anyone else. At least I don't think it did. No one ever said anything. It occurred perhaps only to a guy like myself, a natural worrier, who had been lying awake at night, wondering.

Four days before Christmas, December 21, 2004, the news flashed onto my screen. Franklin Delano Raines-named for the thirty-second president of the United States-had suddenly quit his exalted post as chairman and chief executive officer of the colossus of the Federal National Mortgage a.s.sociation, Fannie Mae to the rest of us. The first black man in history to head a Fortune 500 company was now history himself. He accepted what was being called an early retirement, but in truth, he was trying to duck out from under shocking allegations of accounting irregularities-cooking the books to increase his multimillion-dollar bonus.

Franklin Raines, a graduate of Harvard Law School and a Rhodes scholar at Magdalen College, Oxford, served in both the Carter and Clinton administrations. His departure from Fannie Mae was not a surprise because of the serious investigations being conducted by the Office of Federal Housing Enterprise Oversight (OFHEO), the body that regulates the largest American financer and guarantor of home mortgages.

But what did surprise me was another related item that suddenly zipped onto my in-house screen within hours of Raines's controversial departure. Fannie Mae was issuing, through Lehman Brothers, a ma.s.sive $5 billion deal-$2.5 billion convertible preferred and $2.5 billion straight preferred stock. It totaled one of the biggest convertible deals I'd ever seen. And they wanted it done fast. Real fast. By December 30.

I sat at my desk for a few minutes and mentally digested that. And then I thought, Here we are in the biggest, can't-get-beat housing explosion for half a century, and the government-backed mortgage house Here we are in the biggest, can't-get-beat housing explosion for half a century, and the government-backed mortgage house, the biggest in the country, suddenly needs urgent cash, emergency cash, in a big hurry, right out of the Last Chance Saloon, in the middle of the friggin Christmas vacation. Now the biggest in the country, suddenly needs urgent cash, emergency cash, in a big hurry, right out of the Last Chance Saloon, in the middle of the friggin Christmas vacation. Now that that I don't understand I don't understand. Was there a connection between that and the removal of Franklin Raines from power? Could this sweet-talking son of a Seattle janitor have taken so much of Fannie Mae's money for himself he'd wiped them out? Plainly not. Not to the tune of $5 billion. But he'd obviously done something pretty spectacular, since he'd managed to pay himself $90 million in bonuses, and OFHEO wanted it back.

Raines had been behind a strongly promoted policy at Fannie Mae to issue bank loans to people with low to moderate incomes and to ease their credit requirements. By the time of his "early retirement," Fannie Mae was already buying up subprime loans and loading up on mortgages from all kinds of shadow banks.

Now, in the s.p.a.ce of a few hours, Raines was out, and Fannie Mae was acting as if they were on the breadline, being asked by a government agency to restate its earnings, marking them down from $9 billion to $6.3 billion.

Something's wrong here, I thought. But I had to get back to the task at hand: the $5 billion in preferred stock had to be sold overnight, and my group was in charge of the operation. It was a sensational piece of business, selling what was virtually a government bond for a 2.5 percent commission, adding up to a $125 million fee for Lehman. Rich Gatward and our convertible securities sales team stayed up all night to complete the deal, because the bond market never closes. When it's 8:00 P.M. P.M. in New York, it's 10:00 in New York, it's 10:00 A.M. A.M. in Tokyo, 9:00 in Tokyo, 9:00 A.M. A.M. in Beijing, Shanghai, and Hong Kong. At 11:00 in Beijing, Shanghai, and Hong Kong. At 11:00 P.M. P.M. in New York they're trading in Bombay. At 3:00 in New York they're trading in Bombay. At 3:00 A.M. A.M. in New York they're open in Munich and Rome. At 5:00 in New York they're open in Munich and Rome. At 5:00 A.M. A.M. on Wall Street they're trading Brent crude oil in London. on Wall Street they're trading Brent crude oil in London.

As daylight broke over Manhattan and the team wearily put the finis.h.i.+ng touches to the gigantic deal, everyone was pretty tired, and I was still wondering just why the biggest U.S. mortgage operators, backed by the federal government, in the most reliable property market for years, should suddenly require a huge and instant injection of capital, when they should have been opening their Christmas presents or decorating the tree.

Maybe some politician was sick of them asking for money. Maybe the antics of this Raines character had seriously p.i.s.sed someone off, and they'd temporarily slammed the door on Fannie's credit with the government. But something did not add up, and around here things were supposed to add up.

Despite that long night's work on the preferreds, the plight of Fannie Mae remained. All through that morning we were hearing the occasional bursts of good news from the fourth floor, and for me, this made the contrast even more p.r.o.nounced. By lunchtime, however, I'd cast my disquiet aside. Face the facts, Larry: those guys upstairs are in the driver's seat, Fannie Mae or not Face the facts, Larry: those guys upstairs are in the driver's seat, Fannie Mae or not.

Business was so sensationally good they'd decided to cut out some of the several middlemen involved in the process of creating the CDOs. Lehman had been permitted to purchase a couple of real bucket shops, mortgage outfits with thousands of salesmen out there pressuring old ladies into loans they didn't need and might not be able to pay back. We owned those teams of salesmen, and they gave us one h.e.l.l of a start on the opposition. But if anything ever did go wrong, Lehman Brothers would surely take their share of the blame. For the moment, though, there was no blame, just glory, profits, and other miracles.

The bucket shops I referred to were both out west. One was called BNC and was located in Irvine, California, a town southeast of Los Angeles and about five miles inland from Newport Beach. The second was Aurora Loan Services, out of Littleton, Colorado, a suburb of Denver, due south of the mile-high city. The temptation of the housing explosion in California had proved too much for Aurora, which had opened a large office in Lake Forest, ten miles down the coast from Irvine, in the shadow of the Santa Ana Mountains. I don't know what it was about that area, but New Century-a broker we did not own-was in Irvine too, headquartered in a huge black-gla.s.s palace, writing the mortgages and selling them right on to Wall Street, mostly to us.

Lehman had owned a stake in Aurora since 1997, which was well before most investment banks even dreamed of owning a mortgage broker. They had bought a piece of BNC in 2000. But by now, Christmas 2004, Lehman owned them both outright, which was a situation made in heaven for fleet-footed bankers, traders, and salesmen, because the mortgage brokers were not regulated by any government agency, unlike retail stockbrokers or real estate agents. The mortgage brokers could do anything they pleased.

And Lehman was an outstanding owner. They transformed Aurora from a small loan servicer into a nationwide lending powerhouse in the Alt-A market-that's one level above the subprime candidates, people with less risky credit scores who were able to swing at least a small down payment. However, the Alt-A loans required little or no proof of income-no formal doc.u.mentation. These were known in the business as no-doc loans.

Aurora also had offices in Sunrise, Florida, and Florham Park, New Jersey, and Scottsbluff, Nebraska. They had twenty-five hundred employees, with sales reps earning six-figure incomes and working eighty-hour weeks to meet the cascading demand for mortgages to buy homes that instantly increased in value.

BNC worked out of a rented 73,000-square-foot s.p.a.ce on several floors of an eight-story building out near John Wayne Airport. The rent cost them almost $200,000 a month, but business was sensational and they were writing billions of dollars' worth of mortgages and, like Aurora, feeding them back to Lehman. Thus there were armies of salesmen out there, with no greater complication in their lives than to get a prospect to agree to a mortgage and sign on the dotted line.

Much of the time the mortgage was out and on its way to Lehman before the ink was dry on the contract. Aurora and BNC could not get rid of them quickly enough. The Lehman mortgage group could not wait to get their hands on them, feeding them into the system, getting them packaged, rated by the agencies, and moved out into the world market as securities-CDOs, the best profit earners on earth. In 2004, BNC and Aurora originated $40 billion in subprime and Alt-A mortgages.

It seemed to me that everyone and his brother was trying to jump onto this bandwagon. Even General Motors, at the time the world's largest automaker, was in on the action. They owned General Motors Acceptance Corporation (GMAC), which operated ResCap, a wholly owned subsidiary that allowed the auto giant to get into the vast home mortgage market. Indeed, in the third quarter of 2004, GMAC, riding the explosion of the shadow banks, made a $656 million profit, perhaps a blessing in disguise, because it masked a $130 million loss by GM on its North American automotive operation.

I could not help thinking what a privilege it was to be working at the trading desk in Lehman Brothers. Because there were times when it seemed like this throbbing merchant bank was the hub of the entire business world. Take the General Motors situation. Because our mortgage guys were right on the front line, buying from the biggest brokerages, which owned mortgages by the thousands, they knew, and consequently we knew, the sheer scale of GM's ResCap operation, and its lifeblood importance to the guys who made Buicks, Chevrolets, Pontiacs, and Cadillacs. could not help thinking what a privilege it was to be working at the trading desk in Lehman Brothers. Because there were times when it seemed like this throbbing merchant bank was the hub of the entire business world. Take the General Motors situation. Because our mortgage guys were right on the front line, buying from the biggest brokerages, which owned mortgages by the thousands, they knew, and consequently we knew, the sheer scale of GM's ResCap operation, and its lifeblood importance to the guys who made Buicks, Chevrolets, Pontiacs, and Cadillacs.

And yet, down here on our floor, there was Jane Castle, poring over her charts, studying the financials of the corporations that made the parts that went into those automobiles. She could see with total clarity what was happening-sales were slowing, and the enormous U.S. factories were slowing with them. You want to know why? Ask Jane. The problem was a world commodity uprising, and she was already expert on the subject.

A couple of months previously she and I had sat in her office and gone over the charts for Tower Automotive. Tower was a global designer and producer of structural automotive components, used by virtually every major car factory-Ford, Chrysler, General Motors, Honda, Toyota, BMW, Fiat, and Renault. They had more than eight thousand employees in thirty-nine factories in thirteen different countries spread over North America, South America, Europe, and Asia. Their specialty was the frame of the car, the steel cha.s.sis and suspension systems. In Detroit, Tower was regarded as the endless heartbeat of the industry. But Jane thought they were going bust.

She was looking at the price of steel, which was going through the roof, currently standing at around $800 a ton, having more than doubled in the past several months from $380 a ton. The problem, it seemed, was China, struggling to complete its Olympic stadiums and buying steel from anywhere they could locate it. Their appet.i.te was ravenous, and from where we stood, it appeared half the world's steel production was heading for Shanghai on any given day. In addition, China kept announcing plans to industrialize the entire country. At one point the People's Republic threatened to build twenty cities the size of Chicago, complete with towering steel-girdered skysc.r.a.pers, which would have swallowed up just about every hunk of metal on earth, leaving the rest of us to live in friggin' wigwams.

Jane was really negative about the makers of the car cha.s.sis. Especially the bonds. She had it in her mind that the high cost of steel was causing the auto companies to cut back, and in her view that must have an impact on Tower Automotive, which she envisioned sitting in the shadow of a mountain of spare steel cha.s.sis the size of Tiger Stadium.

It was the new Tower convertible bond that concerned her. It was a senior unsecured convertible bond, which meant that in the event of a total collapse of the company, it ranked number two in terms of priority for repayment. However, the language of the covenants was imperfect. That's my term; Jane had already read the indentures from end to end and considered the language as somewhere between weak and downright diabolical. Should the corporation collapse, Jane thought, both the banks and the straight bondholders would move in, wiping out every single a.s.set, every last steel bar. I was trading the Tower convertible bonds and realized that such a chain of events would put our clients in considerable danger.

Jane felt the situation was so bad that she had already consulted our lawyers, and her view was simple: we should short the Tower bonds and the stock, big-time. In her view, their bank debt of $1 billion was too great; with a slowdown in cash flow, they would go bankrupt, and soon. I agreed with her entirely, and I went up to see Richard Gatward to make our case.

He was very cool about it. I mean that in the modern relaxed sense. "Okay, buddy," he said, "you want to short five million? Let's make it ten." Since the bonds were trading at 78 cents on the dollar, that meant to go in for ten times $780,000, borrow the bonds, get them sold, and wait for their value to decline.

So we went ahead, and waited. November went by, and in December, Tower Automotive bonds crashed by 15 percent, from 78 cents to 67 cents. In the coming weeks they fell much further, from 67 cents to 40 cents. That Jane. That brave, brave little bear had called it. And hardly had the smile faded from her face when Tower crashed again, all the way down to 10 cents on the dollar. They filed for Chapter 11 bankruptcy protection on February 2, 2005.

We unloaded half of our position at 40 cents all the way down to 10 cents, which gave me a trading profit for our department of $5 million. Joe Beggans was trading the straight debt and made $5 million, and Peter Sch.e.l.lbach was trading the bank debt and made $5 million.

The next day, Jane said the bonds had fallen too far and there was still a mountain of steel hanging around somewhere. Yes, it probably was the size of Tiger Stadium.

She told me, "We should get back in at 10 cents, Larry. They could go to 30. But we need to get a few clients together with us and buy all of them, get into a strong position, controlling the entire issue. That way the banks will almost certainly pay a high price to get rid of us, on the grounds of nuisance value. Get Lehman out of the picture, they can form the creditors' committee, sort out Tower, and reclaim their money without a lot of grief from us."

So we went back in, and Gatward and I bought just about every available Tower bond, mopping up the market at 10 cents on the dollar. We nearly traded the bond's initial size that day. That gave us a strong controlling group, and we went into the first meeting armed with lawyers. In fact, Jane went in person, accompanied by our legal counsel, Dan Kamensky Jane and Dan demanded that the bank respect the legal position of the convertible bondholders, and threatened to paralyze the bank's entire strategy for months if it did not.

The bankers hemmed and hawed, hedging their bets, uncertain whether to plunge in and buy us out. But the market found out, and the rumors drove up the price, with everyone waiting on the banks. When the bonds lifted above 25 cents on the dollar, we went in and sold, all the way to 32 cents, leaving the bankers standing there. Again.

It all made another $4 million profit for the firm, and const.i.tuted a very reasonable day's work. Not with the flash and flourish of the mortgage boys, but still, a nice profit, cleverly earned, at relatively low risk, given our seat at the bankruptcy committee, and bondholding in a corporation that owned a pile of steel the size of Tiger Stadium.

The U.S. housing market had essentially gone berserk, and all through the winter of 2005 we heard nothing but roars of triumph from the fourth floor as prices for homes, new and old, continued to climb. And the CDOs with their glorious high yields were selling faster than the properties.

The boom stretched into every part of the country, even the staid northeastern urban strip up the Atlantic coast from Philadelphia to Boston. They were not quite in the same league as the burgeoning markets in the Sun Belt-Florida, Arizona, California, and Nevada-but they were strong and profitable nevertheless, especially in millionaires' enclaves such as the Hamptons on Long Island and Newport, Rhode Island.

House prices were actually creating millionaires out of the most unlikely people. It seemed that every time someone put a residence on the market, it was worth more than it had been six months before. I said worth worth, although I probably meant cost cost. They are not, of course, the same. The phenomenon reached the point where it was a media event, and in newspapers and publications everywhere, there were constant stories and features about the boom, some of them incredulous, but all of them taking it seriously.

It was not until the early spring that we began to hear the first jokes about the housing market. Wall Street is always always the first place you hear jokes about any national event, political, financial, s.e.xual, or even catastrophic. And the jokes, tentative though they were, involved all those different kinds of mortgages, offered to buyers who didn't need to provide proof of income-you know, the $400,000-a-year bus driver and the $10,000-a-month janitor. Wall Street, which as a rule understands more, or at least should understand more, the first place you hear jokes about any national event, political, financial, s.e.xual, or even catastrophic. And the jokes, tentative though they were, involved all those different kinds of mortgages, offered to buyers who didn't need to provide proof of income-you know, the $400,000-a-year bus driver and the $10,000-a-month janitor. Wall Street, which as a rule understands more, or at least should understand more, always always finds the funny side. Well ... mostly. Because it didn't matter, did it? Even if the homeowner found it difficult or even impossible to make the payments, that $300,000 house would go up by $30,000 in a year, so everyone kept right on winning. finds the funny side. Well ... mostly. Because it didn't matter, did it? Even if the homeowner found it difficult or even impossible to make the payments, that $300,000 house would go up by $30,000 in a year, so everyone kept right on winning.

One name in particular kept popping up on the joke menu: a place called Stockton, the seat of San Joaquin County, east of San Francisco, and one of the largest agricultural areas in the United States, the asparagus capital of the world. Stockton sits on the south side of the wondrous California Delta, that sprawling complex of inland waterways where the mighty Sacramento River flows out of the north and meets the picturesque San Joaquin River was.h.i.+ng up from the south. The result is a geographic marvel, a lush and fertile area perhaps fifty miles long by forty miles wide, with spectacular lakes, islands, tributaries, creeks, backwaters, and wetlands, all set some 60 miles east of San Francisco, deep inland, in the California Central Valley, with a wide waterway navigable all the way to the Golden Gate Bridge.

Stockton was one of the locales that pioneered the early development of the NINJA mortgage-that's no income, no job, no a.s.sets. It was a paradise on earth for the bodybuilders, the sun-bronzed mortgage salesmen who worked hand in glove with the home builders. Together they were s.h.i.+pping in potential clients by the busload, hundreds of people fleeing east, away from the incredible house prices in the San Francis...o...b..y Area, and finding hope and shelter in Stockton, where a brand-new four-bedroom single-family home cost only $230,000.

And these slick-talking brokers actually paid you to buy. That NINJA loan was nothing short of a miracle for so many financially strapped families, because it was quite often 10 percent bigger than the amount required to buy the house. You just signed doc.u.ments that specified a 100 percent mortgage, put the change in your pocket, and moved in. The population of Stockton increased by five thousand every year between 2000 and 2005.

An added advantage for the salesman was that Stockton had the highest rate of illiteracy in the United States. Half their clients could not even read the mortgage contract, never mind comprehend it. One suspects that might apply particularly to the section of the contract pointing out that the artificially low 1 or 2 percent interest rate offered initially would probably increase fivefold or even tenfold in the not-too-distant future, rendering the mortgage unpayable. The bodybuilders, somewhat playfully, referred to this part as the "teaser," a phrase that was increasingly finding its way into the Wall Street joke lexicon that spring.

I should point out that the Stockton jokes were always surrept.i.tious and never-repeat, never-uttered during any meetings in the Lehman building when the mortgage guys swaggered in with their balance-sheet-busting results for the month. Because they had access to the perfect retort: We're making this much money because we know precisely what we're doing and because the U.S. housing market always goes up. That's We're making this much money because we know precisely what we're doing and because the U.S. housing market always goes up. That's always always, not sometimes, not usually. So get on with your own very modest activities and leave the big corporate profits to us.

The trouble was, no one really knew much about Stockton except that it had a population climbing toward 290,000 and consisted of rows and rows of brand-new houses. They were digging up the asparagus fields to build more, and according to one feature I read in one of the financial journals, there were several tons of glossy brochures crammed into mailboxes every day, scams offering people who might not be able to pay their mortgages the opportunity to take out a new mortgage, or a refinance, or a credit card with a million-dollar limit. According to the Wall Street Journal Wall Street Journal, when they called to activate the card, they were sold another loan to pay off the loans they already couldn't pay. The current joke on Wall Street was that Stockton was the only town in America where you had to send in an application in order not not to get a loan. This was subprime nirvana, attracting the kind of clientele that caused to get a loan. This was subprime nirvana, attracting the kind of clientele that caused Forbes Forbes to note that there were 6,750 crimes per 100,000 Stockton residents that year. to note that there were 6,750 crimes per 100,000 Stockton residents that year.

I remember reading the article and wondering how many of those particular felons had mortgages that had gone through Lehman and ended up on the books of a j.a.panese or Icelandic bank. There was not one shred of evidence that the mortgage bonanza would ever go wrong or that house prices would fall, but by golly, if they ever did, Stockton would surely be ground zero for financial crisis. I imagine there were other people sharing my own doubts and skepticism about all this, but it would have been grotesquely unfas.h.i.+onable to state them. Not to mention politically incorrect.

Anyway, my thoughts didn't matter, because the housing market simply would not slow down. For the twelve months through May 1, 2005, U.S. housing prices nationally had already beaten the previous year's record 11.2 percent increase. Right now the increase stood at a whopping 12.5 percent and rising. But the Sunbelt was checking in at around 30 percent. In Florida prices were up 33 percent, in Nevada 31.2 percent, and in California 27 percent-everywhere except Stockton, where the rise was 50 percent. The same $230,000 four-bedroom residence I mentioned earlier was now worth $325,000. And even with some of the interest-rate resets kicking in daily, it was still worthwhile to buy, albeit just, because the market was still still rising. rising.

When you work on one of Wall Street's major trading desks, there are a million graphs you need to check out, even study, on a daily basis, just so you don't get caught on the wrong side of a trend. One of the main market indicators is the credit spread. This is a measurement between the yield of U.S. Treasury bonds, which carry the smallest possible risk, and the yield of a publicly traded corporate bond. In a smooth market, the Treasury bond will probably yield a rock-solid 5 percent, and a corporate bond rated investment grade (AAA or AA) might yield half a percent more. The language for that on Wall Street is "50 basis points," or "50 bips." Thus when we talk about a credit spread-say, between Treasuries and AAA corporate bonds-we are discussing the difference between those two yields. Typically, we might say, "This bond is trading 50 bips wide of Treasuries." In the case of a junk bond, rated CCC and obviously loaded with risk, you'd expect a very high yield, anywhere from 500 up to 900 basis points, to compensate the bondholder for the fact that he might lose all his dough. Risk and reward: the oldest rule in finance. That's basically what the credit spread is measuring.

In the early spring of 2005 the spreads on junk bonds were becoming ever tighter. In the seven days leading up to May 21, they came down another 100 bips, to 400 basis points. A CCC junk bond was now paying a coupon of just under 9.00 percent, against ten-year Treasuries that were paying 4.30 percent, and a few months before in March, the yield on the Lehman Brothers High Yield Index was as low as 6.80 percent, a credit spread of just 250! By any standards that was a tight squeeze, but n.o.body cared. Everyone had become cavalier about risks in this raging bull credit market. Everyone was taking them, because of the near-insatiable desire to earn something on their money. With the banks paying only 2 or 3 percent and a truly staggeringly low default rate in the housing market, with billions of free dollars circulating in the fabulous credit boom, it seemed to make sense.

But in my deepest, never-tell-a-soul, cross-my-heart-and-hope-to-die, most secretive thoughts, I thought they were taking risks up on the fourth floor in the mortgage department. Sometimes I thought my facial expression might betray my unspoken fears about this property market. But I've always been a pretty good poker player, and I don't think it ever did. And while sometimes I looked around at the top bra.s.s in this corporation, at least the ones with whom I came into regular contact, and searched for a flicker of cynicism or annoyance on their faces, I never saw a flash of mild exasperation or even irritation at the men who plainly believed the unstoppable security of the property market was cast into American folklore as firmly as that other set of rules that came down on stone tablets from Mount Sinai.

There was, however, one exception to that, an exception about which I'm colossally uncertain, fearful that it might have been my imagination. But I twice thought I saw my ultimate boss, Alex Kirk, Lehman's global head of high-yield and leveraged-loan businesses, and a huge power in the land, look just a tad hard-faced at some of the more optimistic a.s.sumptions coming from the guys who walked on water. On anyone else I might not have noticed, but Alex was a terrific guy, of very even temperament, displaying nerves of steel in all of our trading sorties. He was six feet tall, had an extremely commanding presence, and was never p.r.o.ne to unnecessary displays of emotion.

My observation took place at one of our 7:00 A.M. A.M. meetings. The discussion was about the U.S. real estate market, and I thought I noticed something. It wasn't a lapse in concentration, because he was listening intently, no doubt about that. But for just a split second I thought he might say something, and I sensed it might be an unfavorable comment. But whatever it was, he reined himself in and said nothing. meetings. The discussion was about the U.S. real estate market, and I thought I noticed something. It wasn't a lapse in concentration, because he was listening intently, no doubt about that. But for just a split second I thought he might say something, and I sensed it might be an unfavorable comment. But whatever it was, he reined himself in and said nothing.

Just before we broke up, to return to the trading floor, I thought I noticed it again. And once more the subject was property. But once more our leader refrained from making a comment, and I never gave it another thought. At least not until we were outside the room. That was when Alex pulled Larry McCarthy and me aside and looked at us with a deadly serious expression.

"This housing market," he snapped, "it's all 'roided up." I quote him with pinpoint accuracy because it was the very first time in hundreds of hours of discussions, both formal and informal, in Lehman's headquarters that I ever heard anyone utter a single detrimental phrase against the mortgage and property guys.

I quote the precise words because he used sports jargon for athletes who have been taking steroids, building themselves up with an illegal drug, mostly for events that require explosive power, such as baseball hitting, track and field sprinting, bike racing, and the like. That's how they describe an opponent: all 'roided up. And Alex Kirk used the phrase to describe the state of the real estate market in various sections of the United States, the ones upon which a large chunk of our balance sheet was poised, and upon which we had truly awe-inspiring risk and exposure.

I actually could not quite believe he had said it, and I could see Larry McCarthy standing there, wide-eyed with amazement. If he'd used the phrase himself, no one would have batted an eye because such inflammatory remarks are expected from him. But Alex? Cool, calculating, select-your-words-with-care Alex? Wow, this was big. "The whole thing is f.u.c.king ridiculous," he confirmed, obviously not wanting to sugarcoat the issue completely. And then he added, just for good measure, "This market is on f.u.c.king steroids."