Who's to Blame for the Mortgage Mess

You know who the victims are. We name some of the villains in a credit crunch built on irresponsible subprime lending in the United States.

By Michael Brush

It’s not over, folks. There’s plenty of pain left to come for homeowners and investors already battered and bruised by the subprime-mortgage meltdown. Consider that analyst Mike Mayo of Deutsche Bank predicted Monday that worldwide losses from bad subprime-mortgage loans will reach as much as $400 billion. To date, reported losses are less than a quarter of that total. And market strategist Ed Yardeni on Monday doubled the odds of recession in 2008, to 30%.

But even if we don’t know when it will end, we’re getting a much better idea of whom to blame. It’s a collection of regulators, Wall Street titans and too-smart number crunchers who were supposed to be providing adult supervision. Instead, they chose either to enrich themselves or to look away as others did. Below is a rundown of the worst offenders.

No. 1: Alan Greenspan

In his best-selling book, Alan Greenspan describes how well he managed the economy during an “age of turbulence.” Unfortunately, he’s largely responsible for the current dose of it.

As chairman of the Fed, Greenspan took the federal funds rate down to 1% in 2003 and left it there for a year. Even as the Fed began raising rates, Greenspan’s exceptionally low interest rates “planted the seeds for the housing bubble,” says Robert Rodriguez, a money manager at First Pacific Advisors who saw the emerging subprime mess early on and has managed to dodge most of it so far.

Greenspan’s role in the current mess doesn’t stop there. He encouraged the use of adjustable-rate mortgages in a 2004 speech, which was “an insane, idiotic recommendation,” says Rodriguez. The following year he endorsed subprime loans to help marginal borrowers get into houses. And true to his somewhat naive brand of Ayn Rand libertarianism, Greenspan dismissed calls for more oversight of the mortgage business. This gave free rein to our next culprits: greedy mortgage brokers who had no problem pushing inappropriate loans on borrowers so that they could reap lucrative fees.

No. 2: Countrywide CEO Angelo Mozilo

None of this would have been possible without the help of mortgage lenders willing to go along with the charade. There are many of them, but I’d cite Countrywide Financial (CFC, news, msgs) CEO Angelo Mozilo as one of the most egregious.



Mozilo acknowledged potential risks in the subprime market early on, but he continued to compete to maintain market share, even though the only way to do this was to water down loan underwriting standards like everyone else. “If the market was offering something, they wanted to offer it too,” says Erin Swanson, a Morningstar (MORN, news, msgs) analyst who covers the stock.

Even though Mozilo made more than $20 million a year in salary and bonuses in 2004 and 2005, he wanted to book more profits, mainly by selling stock options, as Countrywide was riding high on the bubble. We know this because he took advantage of a special rule to set up an automatic selling program in his company’s stock. Company documents show he realized $310 million in the three fiscal years ending in June 2007. If his agenda was to cash out personally, he had a good motive to play along with the subprime charade.

Countrywide declined to comment, but a company spokesman has told other media outlets that no one, including Mozilo, could have foreseen the events that led to the current problems with subprime-mortgage debt and that all of Mozilo stock sales complied with regulatory rules.

No. 3: Christopher Ricciardi

Mozilo and the rest of the subprime lenders couldn’t have underwritten all those dodgy home mortgages without having a way to sell them and get them off their books. In this effort, they got a hand from our next culprits: the crafty bankers who created a Wall Street debt machine that repackaged subprime loans so they could be sold to investors.

An investment banker named Christopher Ricciardi helped turn Merrill Lynch (MER, news, msgs) into the “Wal-Mart of the CDO industry” between 2003 and 2006, according to The Wall Street Journal. Ricciardi “lobbied both credit-rating firms and investors, talking up the safety and juicy returns of CDOs,” the Journal says. Ricciardi has since left Merrill, which on Oct. 24 reported a $7.9 billion write-down related to its collateralized debt obligations.

Even if then-Merrill Chief Executive Stan O’Neal missed the subprime losses because they were too far down in the chain of command, he obviously knew about the First Franklin acquisition last January. First Franklin specialized in offering subprime mortgages to borrowers with poor credit histories. Merrill purchased the operation to get more exposure to subprime lending — just before the business was about to turn sour. So he shares the blame for Merrill’s role in the subprime debacle. He admitted this in a 20-minute video message to employees before leaving the bank.

No. 4: Ralph Cioffi and Jim Kelsoe

The masters of the CDO universe on Wall Street couldn’t have gotten very far without willing investors who stood ready to buy the repackaged subprime debt. There was no shortage of buyers because these instruments offered a tempting higher yield.

So who was bingeing on subprime-backed debt and contributing to the creation of a thriving end market for these instruments? Some of the biggest casualties so far happened at Bear Stearns (BSC, news, msgs), where two hedge funds run by Ralph Cioffi blew up earlier this year, costing investors in those funds an estimated $1.6 billion. Bear Stearns declined to comment.

The biggest subprime-related disaster in the mutual fund world has played out at Regions Morgan Keegan Select High Income (MKHIX), according to Morningstar analyst Scott Berry. The fund, run by Jim Kelsoe, is down nearly 50% this year. Morgan Keegan declined to comment. But in a Nov. 7 note to shareholders, Kelsoe said that 14% of the Select High Income fund portfolio was linked to subprime mortgages. He said many debt instruments in his portfolio no longer trade. So their values are based on models projecting future cash flows, and “there are no optimistic projections at this time.”

The big tip-off that these CDOs might be trouble — according to money managers who avoided them — was their sheer complexity, which made them virtually impossible to understand. This is because the CDOs were made up of hundreds of individual mortgage-backed bonds. Each of them was backed by a thousand or more subprime loans. So it’s tough to get a handle on key factors like the average credit scores of the borrowers or the real-estate markets the loans were made in.

“We realized we couldn’t dig in and understand what was in those things,” says Connie Bavely, who runs the T. Rowe Price Summit GNMA Fund (PRSUX). “You don’t buy something if you don’t understand it.”

No. 5: The ratings agencies

Money managers may have been blinded to problems with debt instruments backed by subprime mortgages because of their hunger for higher yields. But in missing the cues, they also got a hand from the credit-ratings agencies, which get paid to evaluate debt products and make a call on the likelihood of default. The three big ones are Standard & Poor’s, Moody’s Investors Service and Fitch Ratings.

“The rating agencies missed something, to be gracious about it,” says Don Quigley, the co-portfolio manager of the Julius Baer Total Return Bond Fund (JBGIX). Part of the problem, says First Pacific Advisors’ Rodriguez, is that rating these debt instruments was big business, and the ratings agencies were often getting paid for the ratings by the same people who were creating the debt instruments. So they might have been tempted to let their guard down when it came to weighing the likelihood of negative scenarios.

“As far back as 2004-2005 we were aware of questionable underwriting, potential fraud and limited documentation” in the home-mortgage industry, says Rodriguez. “These did not appear to be appropriately considered in the rating process.” What’s more, risk models used by the ratings agencies assumed continued home price appreciation that would allow marginal home buyers to refinance their loans when their monthly mortgage payments went up.

“We suspect that with so much money to be earned by originating, securitizing and rating, there were too many conflicts to take a very critical view of the process,” says Rodriguez. The ratings agencies declined to comment.

No. 6: Mortgage brokers

Home buyers should have known better than to get into adjustable-rate loans they couldn’t afford when interest rates reset higher. But I’d single out another party in the industry for the most blame: the mortgage brokers.

For mortgage brokers — many of whom were independent operators in mom-and-pop shops — the real-estate bubble was a real bonanza, and their greed got the better of them.

“Quite frankly, there was a race to lower standards to generate more loans,” says a former mortgage broker with a major bank in the Chicago area. And for good reason: A merely “good” mortgage broker could easily take home $250,000 a year. But most of them were bringing in $500,000 to $750,000 as long as they cranked out enough loans — and damn the consequences, says the former mortgage broker. “It was like kids in a candy store. You had to be a complete screw-up not to make money. There were basically no guidelines, no restrictions and no oversight.”

Ultimately, to keep the money machine moving, the mortgage brokers stooped to offering so-called “ninja” loans, or loans that required no verification of income, job or assets. “It got to the point where the only thing you had to do was be able to breathe and have a credit score above their threshold,” says the former broker. Mortgage brokers couldn’t care less if the loans ultimately went bad — because they knew by that time the loans would be far away in the hands of unwitting investors.

The lawyers drawing up the mortgage-loan contracts deserve honorable mention as culprits. They could have done a far better job of telling home buyers what would happen when mortgage rates reset, believes Joe Stegmayer, the chief of Cavco Industries (CVCO, news, msgs), which sells manufactured homes.

“The lawyers were drafting contracts that were so complicated, they knew home buyers were not going to read them,” he says. “So why not have a summary sheet that says ‘You are signing an adjustable-rate mortgage, and the rate probably will go up by this amount.’”