The Financial Crisis of 2008: An Analysis Based Upon Evidence Obtained From All The Devils Are Here — The Hidden History of the Financial Crisis By Bethany McLean and Joe Nocera — From a Bureaupathology Perspective

Section A — Introduction and General Description:

“Greed is Good” — until it goes bad. The mortgage crisis of 2007 involved several organizations, from mortgage brokers who provided the means of homeownership by making loans to homebuyers to the investment banks that constantly provided sources of funding using the force of Wall Street. Other companies that played key roles to enable mortgage lending were quasi-public/private organizations, such as the Federal National Mortgage Association, colloquially known as “Fannie Mae,” and the Federal Home Loan Mortgage Corporation, known as “Freddie Mac.” These companies were government-sponsored enterprises (“GSEs”) intended to federally guarantee mortgages to minimize risk. This minimized risk instilled confidence in the market. There were credit rating agencies that graded investments, such as Moody’s and Standards and Poor’s, who later compromised their integrity by selling ratings to mortgage-backed securities for profit. In addition, government oversight bodies such as the Office of Thrift Supervision and the Office of the Comptroller of the Currency oversaw banks depending on their classification, the Securities and Exchange Commission (“SEC”) regulated the investment banks and of course, the politicians working on Capitol Hill, who were supposed to keep the industry honest, allowed politics to dictate their actions. Additionally, large insurance firms such as American International Group (“AIG”) played an integral part in the process by insuring securities while at the same time sacrificing their neutrality by trading in those securities. Moreover, Alan Greenspan, the chairman of the Federal Reserve, who ignored all signs pointing to the looming burst of the housing bubble. Each entity played a crucial role, creating a toxic primordial soup consisting of avarice, envy, favoritism, politics, institutionalization, structural and oversight failure that culminated in the meltdown of the mortgage market and a major worldwide financial and home foreclosure crisis.

This crisis, however, actually began with a benevolent goal. By increasing sources of mortgage funding, the American dream of homeownership was broadened, especially for minority customers in poor communities. Prior to the 1980s, mortgages originated mostly through banks, particularly “Savings and Loan” banks (“S&Ls”), which used capital from bank account deposits to provide home loans. As such, mortgage funding was constrained by onerous restrictions as banks needed to keep large amounts of capital on hand, making less money available for lending. Successful lobbying led to political changes favorable to homeownership which resulted in the rise of lending companies. Investment banks on Wall Street increased the complexity of “securitization” in mortgage funding at the behest of big investment bank firms such as Goldman Sachs, Bear Stearns, and Lehman Brothers by creating investment products — both tangible and intangible — that were originally intended to sell the mortgage to investors by freeing up more money to fund future mortgages. The process, however, became perverse as cash flow realization led to corrupt practices and continual quantification of risk, leading to the creation of synthetic investments which were not available to the public nor traded on an open market and with no true way of valuation. Ultimately, all players involved were blinded by greed — both personal and corporate — in a seemingly never-ending battle of market share, arrogance, and narcissism. These players were motivated by market share, realizing organizational profits generated through investments, and the ability to charge exorbitant fees to mortgagees who were classified as “subprime” (those who had bad credit). Lenders knowingly underwrote, sometimes fraudulently, and funded mortgages they knew would default, often driven by the motivation of profiting handsomely by charging exorbitant fees on borrowers. Large investment banks who marginalized resident experts skeptical of these strategies often favored the young and aggressive. The older, institutionalized senior executives turned a blind eye or remained aloof and out of touch with the inner workings of the organization. Moreover, bad practices were enabled by the lack of government oversight from Congress to the President, which trickled down to regulatory agencies. All of the above entities and circumstances set the crisis in motion — a crisis that would affect the markets for years to come and led to landmark legislation aimed at reforming the financial industry in a manner not seen since The Great Depression.

Section B — The Failure:

At the epicenter of the mortgage crisis was unmitigated envy, hubris, and avarice. Multiple parties competed for money and “market share,” fueled by a lack of foresight, internal and external oversight, and numerous other failures spanning several organizations. The prospect of incurring huge financial gains for all parties was so great that people and organizations became nearsighted as they made a staggering profit. Everyone wanted more, whether it was commissions, fees, or market domination. They were willing to do whatever it took without concern for the consequences. Whether it was the mortgage makers (originators) or “Wall Street” (financial firms), there were great incentives to lend money to borrowers who were unqualified for conventional mortgages backed by the GSEs, usually due to a poor credit score. These mortgages were considered “subprime.” Both the lender and the borrower were aware of the lender’s standing, but a mortgage could be underwritten for the right price, usually resulting in exorbitant fees paid by the borrower. One of the several methods employed by subprime mortgage makers in “making a mortgage” to subprime borrowers was a “no documentation” loan facilitated by fraudulent paperwork, such as forged W-2s, false employment verification documents, or misleading applications with forged signatures. These loans, often referred to as “liar loans,” were made possible by submitting incomplete paperwork and providing the borrower with the option of a low or no down payment (McLean & Nocera, 2010, pg. 211). Underwriting standards had eroded to the point of non-existence (pg. 130). Borrowers were set up to fail with such home loan products such as “adjustable-rate mortgages” or “2/28 loans” which made up for almost 69 percent of subprime loans in 2006 (McLean & Nocera, 2010, pg. 211). Borrowers of these products would often be lured by loan officers under the guise that these loans would be interest-free for the first two years, only for the interest rate to become practically usurious in year three (McLean & Nocera, 2010). The borrower was under intense pressure to re-finance by year three because payments were applied to interest instead of principal, increasing the amount owed, and borrowers unable to refinance as planned would be stuck in the terms of the underlying loan (McLean & Nocera, 2010). Subprime mortgages, however, consisted of mostly refinanced mortgages, usually “second lien” mortgages, in which the homeowner borrowed money against the equity of their homes. This was possible because home values were on the rise, but that value was quite often not accurate due to inflated appraisals (McLean & Nocera, 2010). Funds obtained from refinancing referred to a “cash-out refinancing” where homeowners refinanced their homes and liquidated cash value based upon the equity of the home, often using the funds for spending (McLean & Nocera, 2010). Another huge subprime lender by the name of New Century specialized in refinancing to the point where two-thirds of their loans were refinancings by February of 2004 (McLean & Nocera, 2010). Ameriquest, a key subprime lender, and other mortgage originators, often hired young, inexperienced, and ambitious people to sell mortgages, luring them into the work with a flashy lifestyle including high-end luxury cars, lavish parties, and most of all, making a great deal of money. Of those recruited, some had the requisite personalities, “the gift of gab,” and were kids just out of high school or college (McLean & Nocera, 2010). “These young people became loan officers, some of them earning a paycheck of $30,000 or $40,000 per month” (McLean & Nocera, 2010, pg.125). Some were plied with illicit drugs to increase productivity and, therefore, positive incoming cash flow (McLean & Nocera, 2010).

In the early 1980s, a series of state laws throughout the country were passed that “abolished state usury caps, which had long limited how many financial firms could charge on first-lien mortgages” (McLean & Nocera, 2010, pg. 29). It also separated the definition of loans made to buy a house and loans secured by a house such as home equity loans (McLean & Nocera, 2010, pg. 29). In the two years that followed, a law was passed to allow lenders to be more creative in the home loan products that were offered, such as adjustable-rate mortgages and those with balloon payments, as an alternative to conventional thirty-year fixed rate instruments (McLean & Nocera, 2010). These laws allowed the mortgage market to be funded permitting alternatives to bank-funded mortgages, giving rise to the subprime market as new lending companies began lending to lenders who were previously unqualified for a mortgage (McLean & Nocera, 2010).

Investment banks and organizations eventually found a way to fund mortgages through securitization. It involved a process of freeing up capital by lenders selling mortgages to Wall Street, who would make instruments that were bought by institutional or personal investors. These securities, known as “mortgage-backed securities” could take many forms, from tangible to intangible. Some securities used in this crisis were known as credit default swaps or collateralized debt obligations (“CDOs”). These securities, known as derivatives, were derived from another security and were a different approach to funding mortgages (McLean & Nocera, 2010). The original securitization of mortgages meant “investors in mortgage-backed securities owned pieces of actual mortgages” (McLean & Nocera, 2010, pg. 78). Before securitization, mortgage funding was usually “the province of the banks and S&Ls, which relied on savings and checking accounts to fund the loans” (McLean & Nocera, 2010, pg. 20). Eventually, a different approach to obtaining mortgage funding found itself by harnessing the power of Wall Street where investment firms were able to bundle mortgages and sell them to investors as securities. These securities were initially extremely attractive to lenders and financial firms due to spreading risk out to other concerned parties (McLean & Nocera, 2010). Securitization took the loan off the books of the originator, and lenders would no longer take the hit in the case of default (McLean & Nocera, 2010). The approach to securitization started to evolve into increasingly complex investment products, starting with “credit default swaps” that enabled speculators to bet on or against default and merely referenced a tangible item such as an MBS. Eventually intangible items such as “CDO Squared” were used to bet against CDOs. (McLean & Nocera, 2010, pg. 123). This initially assisted banks and investment firms to assess and mitigate risk. As such, investors did not own corporate loans, but rather, they owned the associated risk. Hence, with a synthetic investment there was always a winner and loser that would allow firms to assess their risk by measuring who was betting on what (McLean & Nocera, 2010). As there was a success in this methodology, “Wall Street” began to create other similar but increasingly complex synthetic investment products that firms would trade amongst each other, often mixing derivatives or MBSs of higher quality with those of lower quality. Of the top five investment firms, Goldman Sachs, which had no other no customers outside of other institutions and sophisticated investors, wallowed more in hubris because of their reputation. The firm would eventually become their own best customer upon going public in 1999. The CEO at the time, Hank Paulson, began putting the firm’s own best interests in mind ahead of clients by actively trading their portfolios and, at times, treating their clients as adversaries or “counterparties”. He felt that the concept of investment banking, the raising of capital for other companies, would no longer be the mainstay of the company (McLean & Nocera, 2010). The investment bank went on to acquire a huge portfolio of synthetic securities and trade derivatives. When the securities started to plummet in price, the firm attempted to sell the investments off to their unsuspecting customers by creating other products bearing their brand (McLean & Nocera, 2010). Immediately prior to the burst in the housing bubble, as synthetic investments and indexes were plummeting, Goldman would seemingly harangue AIG over CDOs they both played a part in launching, with collateral calls in the billions of claims often based upon contested interpretation of market conditions (McLean & Nocera, 2010). This ultimately caused AIG to initially lose approximately $5.5 billion and to need a bailout by the federal government.

Even AIG, as a top insurance company, would become heavily involved in dealing with synthetic securities by acquiring a portfolio in these securities, spinning off a subdivision to be able to trade financial products. This subdivision, known as AIG-FP (Financial Products Division), circumvented legal constraints prohibiting insurance companies from trading securities and having certain capital requirements, enabling the company to acquire market share and enormous profits. During the formative events of this crisis and up until a few years before the meltdown, AIG was run by a CEO who was antiquated in his approach to running the company for a variety of reasons, including his concerns about secrecy and profitability. The CEO at the time, Hank Greenberg, refused to pay for anything that did not turn a profit (McLean & Nocera, 2010). He also created a siloed corporate structure by walling off parts of the company in a manner where crucial communication only came to him. At one point, Greenberg had thirty employees reporting directly to him (McLean & Nocera, 2010). Under Greenberg’s tenure, there was always pressure to take risk because they were a large company with a Triple-A rating from the credit rating agencies (McLean & Nocera, 2010). There was even more pressure to consistently show a 15% profit each year. After the company faced scrutiny the following year, several intentional and faulty accounting practices would come to light (McLean & Nocera, 2010). Furthermore, their ongoing fiduciary relationship with Goldman Sachs enabled AIG to increase their market share by being able to guarantee subprime loans. AIG-FP was able to “lend” securities to other entities to facilitate the short sale of stock and even had a mortgage originator making subprime loans (McLean & Nocera, 2010, pg. 193). As such, the company heavily invested in the subprime market and when the market started to deteriorate due to default, so did AIG. Eventually what brought down Hank Greenberg was his arrogance towards regulators, such as the SEC and the New York Attorney General. He stonewalled requests for documents and remained cavalier instead of acknowledging wrongdoing despite evidence to the contrary, which incurred the ire of his board of directors as well (McLean & Nocera, 2010). His arrogance towards both regulators and his board led to the uncovering of accounting irregularities by AIG’s accounting firm after they audited the books of AIG and several of its subsidiaries (McLean & Nocera, 2010).

As time went on, companies who rated securities, such as Moody’s, Standard’s & Poor’s, and Fitch, compromised their rating systems’ integrity by selling their illustrious top “AAA” ratings to subscribers (investment firms) instead of analyzing the security, thereby enabling the financial firms involved to claim that their issued security was rated AAA (McLean & Nocera, 2010). By selling their AAA ratings, which only a few companies legitimately enjoyed, it opened up the market to certain institutions who were, by law, only allowed to buy these AAA rated securities (McLean & Nocera, 2010). Individual and institutional investors depended on the credit rating agencies’ opinions in choosing what investments to make. As synthetic investments became increasingly complex, they were bundled with securities based on the subprime market. In time, subprime mortgages would default as borrowers were unable to meet their obligations. Ultimately the securities became worthless, leading to losses in the billions to firms and other invested parties such as pension funds and municipalities.

All the while, investment firms such as Merrill Lynch, marginalized the concept of risk management. The experienced traders who were well versed in risk management, for instance, John Breit, a tenured risk manager and former physicist, was considered to be overly conservative for the firm’s appetite, were marginalized in favor of the young and aggressive who were extremely motivated to realize an ever-increasing profit. After sidelining risk management across the top five investment firms and as various synthetic securities would eventually crumble, some senior executives, such as Stan O’Neal, CEO of Merrill Lynch, remained aloof or lacked a crucial understanding or micro-managed creating silos. These CEOs were either in denial or panicking trying to keep their companies viable.

The federal government not only turned a blind eye but curtailed investigations and laws enacted on a state level to curb predatory lending. Although states filed various lawsuits against certain subprime lenders, including Ameriquest who paid $325 million to settle charges of predatory lending brought by the various state Attorney Generals, it failed to spur any federal action (McLean & Nocera, 2010). The companies were charged with misleading and deceptive lending practices, acting in concert with appraisers who would artificially inflate the value of the collateral house, charging upfront fees “points” with the false promise of lower interest rates, and misrepresenting the existence of other fees such as the existence of prepayment penalties (State of CT, 2006).

Then there was Alan Greenspan, who, at the time, was Chairman of the Federal Reserve. Mr. Greenspan was a believer in market discipline and “an outlier in his libertarian opposition to most regulation” (pg. 85). Under the tutelage of Ayn Rand and, at the time, a conservative economist, he evolved to become even more of a true believer in the free market (pg. 85). As such, his view was that the market would correct itself in the normal course of business. There were several mechanisms in place to curb predatory lending at the disposal of the Fed — including a law called the “Home Ownership and Equity Protection Act (“HOEPA”) which gave the Federal Reserve to power to flatly prohibit mortgage lending practices that it concluded were unfair or deceptive — or designed to evade HOEPA” (McLean & Nocera, 2010, pg. 86).

GSEs’ secondary mortgage markets were intended to buy mortgages from mortgage makers (“originators”) and give their stamp of approval to free up money for lenders to make more loans (McLean & Nocera, 2010). By doing so, the GSEs gave their stamp of approval to the mortgage being purchased which was considered just as good as a AAA rating given by the credit agencies and carried with it the full faith and credit of the United States Government (pg. 47). The GSEs wielded a lot of political power through friends on Capitol Hill (McLean & Nocera, 2010). Their downfall was that they developed an insatiable appetite for market share regarding mortgage-backed securities and derivatives (McLean & Nocera, 2010). This would later result in huge losses necessitating a government bailout and takeover to preserve what was left of the mortgage market (McLean & Nocera, 2010). Eventually, the GSEs were also consumed by not only a lust for power but also an unquenchable thirst for profit, and as such, lost sight of their underlying mission. “Fannie and Freddie raced to get into subprime mortgages because they feared being left behind by their non-government competitors” (McLean & Nocera, 2010, pg. 363).

In the end, as “subprime” borrowers started to default on their payments, housing prices fell, and the value of the derivatives, which were not traded on open markets, started to plummet. Investment firms sustained heavy losses and became indebted to other interested parties to the tune of billions of dollars. This resulted in not only the end of some financial firms, but also congressional hearings. Moreover, there were economic ripple effects spanning from widespread foreclosures to plummeting of various investment products, including retirement and pension funds.

Section C- Symptomatic Analysis:

An in-depth examination of the various organizations, specifically the mortgage originators and the financial firms that directly caused the financial crisis of 2008, reveal several symptoms. The first and most prominent was a self-serving corporate culture fueled by greed and hubris. For example, at AIG, Greenberg refused to keep up with the technology necessary for a modern financial firm trading in an electronically based market and used an outdated method to data-mine their earnings. “Hank ran the company unlike any other twentieth-century company” (McLean & Nocera, 2010, p. 192). “Even though it had gotten huge, there was no company infrastructure. The systems were completely antiquated. It still gathered its earning data every quarter by hand. And all decisions were made by him to a remarkable degree” (McLean & Nocera, 2010, p.192). Greenberg is a perfect example of a damaging performance by a chief executive of the corporation. As discussed, Greenberg “didn’t like to pay for anything that didn’t generate revenue” and, as such, “scrimped on computers and software that other companies bought as a matter of course, and refused to pay the salaries necessary to hire a first-rate operations staff” (McLean & Nocera, 2010, p.192). This explained how his internal controls were later found to be subpar, not only by Goldman Sachs investment bankers working on a joint venture with AIG but also by AIG’s accountants, PriceWaterhouseCoopers, and regulatory agencies such as the SEC and the New York State Attorney General’s Office (McLean & Nocera, 2010). This would eventually lead to various civil regulatory actions against Greenberg. Furthermore, lateral communication was also non-existent as other departments and subsidiaries were walled off and, as a result, had thirty executives reporting to him directly when most CEOs of similar companies only had six (McLean & Nocera, 2010). Greenberg only wanted either himself or his second in charge to have a “complete grasp of AIG’s convoluted business” (McLean & Nocera, 2010, p.192). Additionally, there was a constant push by Greenberg for 15% profit margins and increasing the amount of risk taken even though the company had a seemingly large and profitable cash flow. When faced with inevitable external scrutiny, Greenberg was often resistant, arrogant, and uncooperative despite a mountain of evidence of corporate improprieties. He incurred the wrath of not only the oversight bodies but his own board of directors which resulted in additional harsh punitive measures. In the end, since AIG had numerous international clients and several business deals, the U.S. government initially bailed out AIG for approximately $85 billion to contain the meltdown (McLean & Nocera, 2010).

Merrill Lynch became increasingly symptomatic under the tenure of Stan O’Neal, who was envious of Goldman Sachs and became increasingly obsessive in his crusade to not only compete with Goldman Sachs but to eventually surpass them, striving to dominate the investment end of the mortgage market. The primary symptom of dysfunctional organization exhibited by Merrill Lynch was the damaging behavior exhibited by the CEO, such as communication blocks, obstinacy, aloofness. All of this damaging behavior resulted in conflict within the executive ranks. Additionally, the company exhibited an inward-looking, self-serving, organizational culture. Furthermore, O’Neal also fostered a closed and siloed corporate environment where he “insisted that the company executives speak only to him about their business and not discuss the business with one another” (McLean & Nocera, 2010, p.162). O’Neal was elevated to CEO in 2002 and wanted to immediately change the culture of the company affectionately known as “Mother Merrill”, an idea of what the company was founded upon, because he saw it as meek and too risk-averse (McLean & Nocera, 2010). Much like Greenberg at AIG, O’Neal also took many risks, constantly pushing his executives and trading desks to take more risk. He was also in favor of hiring the young and aggressive while firing those who did not have the risk appetite he preferred (McLean & Nocera, 2010). Part of the increased risk-taking strongly favored by O’Neal was the ever-increasing underwriting of collateralized debt obligations (“CDOs”) that was partly derived from subprime mortgages (McLean & Nocera, 2010). The risk became intense as levelheaded and experienced key risk managers and traders were marginalized in favor of the young and aggressive traders. Some of the young traders were charismatic, had the ear of credit rating agencies, and had the ability to have securities he peddled rated as AAA (McLean & Nocera, 2010). Risk managers were often left scratching their heads, concerned with trader ethics and whether the investment being sold was suitable for the client (McLean & Nocera, 2010). At times, reason would prevail with some senior traders making sure that Merrill Lynch did not keep too many synthetic securities in inventory. Rather, these synthetic securities were “warehoused” and as such, were reflected on the firm’s balance sheet (McLean & Nocera, 2010). That approach was not risky or aggressive enough for Merrill Lynch. One senior executive, Dow Kim, would assure traders “that the firm would do whatever it takes to stay number one” (McLean & Nocera, 2010, p.166). Even competent and experienced risk managers such as John Breit, who felt that “Wall Street was quantitatively illiterate,” wasn’t opposed to derivatives but felt that they needed to be reined in and expertly managed (McLean & Nocera, 2010, p. 236). Merrill Lynch would become yet more aggressive, firing more experienced yet cautious traders in favor of more intensive managers who would drive trading deeper into the subprime market. One specific manager, Osman Semerci, had a reputation of being exceptionally driven, extremely aggressive and dangerously reckless. Semerci was not afraid of taking big risks for a big profit — exactly what O’Neal wanted on the trading desks (McLean & Nocera, 2010). Semerci also purged crucial risk management staff. As the end of the world as the firm knew it neared, Semerci had his exit strategy planned with $10,000 taped to the bottom of his desk and a Turkish passport that was not registered with the firm as required. (McLean & Nocera, 2010). In its ongoing quest for dominating Wall Street in subprime mortgages, Merrill Lynch acquired a subprime mortgage originator, much to O’Neal’s behest and delight. The firm intended to “securitize to its heart’s content” as a result (McLean & Nocera, 2010, p. 238). In the end, O’Neal, often remained detached, as “the intricacies of the firm’s trading positions held no interest for him, except to the extent they had shown profits or losses” (McLean & Nocera, 2010, p.235). It would be the beginning of the end for his tenure when he finally listened to John Breit, who informed him in September of 2007 that the firm was going to lose at least $6 billion (McLean & Nocera, 2010). Merrill Lynch would report an approximate loss of $10 billion in October of 2007. Merrill Lynch was subsequently sold to Bank of America at a substantial discount from the first offer. Amazingly, O’Neal walked away with $161 million in retirement benefits (McLean & Nocera, 2010). It was then he fully realized the error of his ways, trusting in the wrong people (McLean & Nocera, 2010). In a bit of poetic justice, the cautious and competent trader fired by Osman Semerci, Jeff Kronthal, was rehired by O’Neal’s successor to thunderous applause from the trading staff (McLean & Nocera, 2010).

The mortgage originators, specifically Countrywide Financial, employed management policies that certainly encouraged damaging employee behaviors. The CEO, Angelo Mozilo, founded the company in 1969 with noble intentions. He was a self-made business from humble beginnings who believed that every American should be able to own a home. “Mozilo, Bronx born and Fordham educated spent his life wanting to beat the establishment and harboring a burning resentment towards it” (McLean & Nocera, 2010, p.23). Mozilo started working for a mortgage company in a menial capacity at a young age, worked his way up there while in high school, and met his future business partner who, with Mozilo, started Countrywide Financial in 1969 (McLean & Nocera, 2010). After some initial struggles through the years, from obtaining mortgage funding through a bank, investors, or an investment bank, options were limited to loans that could be insured by the Federal Housing Administration or Veterans Affairs. Countrywide was able to start experiencing growth after the Savings and Loan crisis fueled lending by non-bank mortgage companies (McLean & Nocera, 2010, pg. 23). Fannie Mae was known to buy up mortgages shortly after they were made, freeing up more capital for mortgages (McLean & Nocera, 2010). As mortgage originators such as Countrywide became wildly popular in the home lending business, Mozilo would have a metamorphosis. He changed from a well-intentioned entrepreneur to a greedy CEO who became lost in his thirst for market share. (McLean & Nocera, 2010). As Countrywide was prospering, he became increasingly intense, driving his employees incredibly hard, consistently wanting more (McLean & Nocera, 2010). “For a long time he had a classic case of entrepreneurial paranoia — that gnawing fear that, someday, everything he had built would suddenly vanish” (McLean & Nocera, 2010, p. 25). A proud man who had to know absolutely everything about his business, he created a very competitive and fiercely loyal workplace culture where employees toiled and considered the company a difficult place to work (McLean & Nocera, 2010). These traits would eventually lead Countrywide over the brink. Initially, Mozilo was fundamentally opposed to subprime mortgages that he saw as predatory. Mozilo, however, would come to put his business over his ideals (McLean & Nocera, 2010). Once lending volume on loans aimed at lending conventional mortgages dropped at Countrywide, with borrowers going to subprime lenders, it got the attention of inquiring stock analysts (McLean & Nocera, 2010). “He got in because he felt he had no choice. If he stayed out of subprime, Countrywide would never be number one — and that was unacceptable” (McLean & Nocera, 2010, p.37). Mozilo would look at competitors, such as Ameriquest, with disdain, and “he did not want Countrywide viewed in the same light (McLean & Nocera, 2010, p.138). Market share remained his obsession (McLean & Nocera, 2010). Eventually, Mozilo and his Chief Operating Officer, Stan Kurland, would take Countrywide down a path similar to Merrill Lynch, with the acquisition of a bank in 2000. Before that, they formed a Real Estate Investment Trust (“REIT”) which did business as Countrywide Mortgage Investments. The REIT’s purpose was to “aggregate loans from other lenders and turn them into mortgage-backed securities” which also began originating its subprime mortgages (McLean & Nocera, 2010, p.192). Eventually, some at Countrywide would be taken aback about how money was starting to matter too much to Mozilo. For instance, “in 2000, he owned 2.8 million shares of Countrywide stock, including options, and would take home $6.6 million in compensation — a number that would rise to $10.1 million by 2001 and $23.6 million by 2003” (McLean & Nocera, 2010, p. 141). Also mirroring the modus operandi at Merrill Lynch, Countrywide had a taste for the aggressive at the expense of the cautious and experienced. Similar to Osman Semerci at Merrill Lynch, there was a salesman at Countrywide by the name of Dave Sambol “who cared about risk but wanted to win” and “only cared about building his kingdom” (McLean & Nocera, 2010, p.142). Eventually, as was the situation at Merrill Lynch, the cautious and experienced workers were marginalized in favor of the risk-takers. At one point, Countrywide, at Mozilo’s behest, delved even further into the subprime market by offering 180 different subprime mortgage products (McLean & Nocera, 2010). Among those were a “subprime loan known as 80/20 — the customer took out two loans to borrow 100 percent of the money needed to purchase a home” where the sales force was told by Mozilo to listen to Sambol and not Kurland (McLean & Nocera, 2010, p.144). As predatory lending would begin to surface in the national spotlight, Countrywide and Mozilo remained politically savvy and “spent $8.7 million between 2002 and 2006 on political donations, campaign contributions, and lobbying to defeat anti-predatory lending legislation” (McLean & Nocera, 2010, p.149). Mozilo, however, remained arrogant and was quoted as stating “no regulator is going to tell me what kind of products I can offer” (McLean & Nocera, 2010, p.149). Even as the market was well on its way to disaster in the summer of 2007, Countrywide was still obsessed with market share. “Countrywide ramped up its business of buying loans” (McLean & Nocera, 2010, p.300). They were no longer selling other loans on its books, thus bearing a tremendous amount of risk (McLean & Nocera, 2010). Eventually, securitization of mortgages stopped, home prices dropped, and mortgages, including prime mortgages, increasingly defaulted (McLean & Nocera, 2010). Eventually, Bank of America would invest $2 billion in Countrywide to keep market confidence. With the staggering amount of debt, Countrywide was about to realize, however, the crash wiped out Countrywide’s 2005 and 2006 reported earnings. Bank of America acquired them in January of 2008 for $4 billion, and that was the end of Countrywide.

Section D — Diagnosis:

Upon review of various organizations who played a part in the financial crisis of 2008, a crisis fueled by the mortgage market, three diagnostic categories apply — Institutionalization, Oversight Failure, and Structural Failure.

AIG’s failure to keep up with evolving modern technology led by an antiquated and self-serving management was consistent with structural failure. Although the company had become a behemoth of a corporation with several subsidiaries, the company’s information technology was woefully inadequate for a modern-day business. Employees railed against the infrastructure, especially when data mining to gather earnings information was conducted in a laborious and archaic manner. This resulted in extremely subpar internal controls, which came to the attention of other business partners and regulators. The company did not want to pay for anything that did not turn a profit. Hence, they did not invest in the requisite hardware and software necessary to function in the modern era, nor did they hire staff that would capably operate and such equipment in the form of an IT department.

AIG also suffered from institutionalization as its structural failure was self-serving the company. AIG was structured in an extremely convoluted manner with internal communication silos. The top executives, most of which ran the numerous AIG subsidiaries, were isolated and obstructed from communicating with counterparts. These executives were to report only to the CEO, Greenberg, who kept proprietary details to himself. Keeping the company as arcane as possible also impeded regulators. Additionally, Greenberg took an arrogant approach to external oversight, to the company’s disadvantage. As additional fines were levied on the company by regulators, the board of directors became exasperated. Furthermore, in Greenberg’s crusade to turn a 15% profit each year, he was obsessed with ever-increasing risk taking despite the profitability and wealth of the business. His antiquated and opaque manner of running a business would serve to keep employees sequestered and facilitate the corporate crusade for unreal profit margin expectation. This, in turn, would place AIG as a major contributor to the financial crisis resulting in losses to the company for billions of dollars — losses which were subsequently burdened by the U.S. taxpayer.

Merrill Lynch suffered from structural failure, institutionalization and internal oversight failure. Like AIG, the structure of the firm was constructed in a manner where internal executive communication was siloed to the detriment of the company. An intense competitive corporate vision and a desire to dominate the mortgage securities market changed the ethos of the corporation from making investments available to average investors to securitizing and trading for the firm’s portfolio. As such, the firm acquired a voracious appetite for what would become an overwhelming amount of risk, fostering “the young and the reckless” in both trading and management positions. Internal oversight, specifically the Risk Management Department, quickly became marginalized — segregated and moved from a front-office to back-office operation. Even in risk management’s minimal role, they recognized improprieties regarding trades and the methods employed by aggressive traders. With minimal resources and power, they were often left just to ponder due diligence. As oversight mechanisms were given a backseat to maximize profit, the firm’s overexposure to securities underwritten by the firm ultimately caused failure, resulting in the subsequent discounted and distressed sale to Bank of America. Furthermore, the firm failed to recognize that one of its favored aggressive managers, Osman Semerci, a foreign national, had an escape plan. Semerci had a UK passport which was registered with compliance, but he also possessed a Turkish passport, unbeknownst to the firm, which he had taped under his desk along with $10,000 dollars. On the day he was fired, as he was being escorted from the corporate headquarters, he asked his secretary to retrieve both. Further contributing to internal oversight failure was the aloof manner in which the CEO ran the investment bank in addition to his isolated and close-minded approach to leadership. This led to company short-sightedness. The company failed to realize the dire straits of the company’s position and put full faith in Machiavellian executives whose priority was for the organization to stay number one at all costs. This corporate culture fostered institutionalization as the company became consumed and blinded by its obsession with profits and cornering the market. At the end, the CEO, O’Neal, would lament that he placed his trust in the wrong people as he retired with a bruised ego but an exorbitant severance package.

As for Countrywide Financial, their quest for dominance in the mortgage lending market led to organizational institutionalization. Facilitated by an arduous work culture set fostered by management which stressed fidelity, the company evolved from a company with an ethical philosophy of making suitable loans to becoming a predatory lender. Propelled by the unquenchable thirst for market domination and faced with the prospect of risk by potential downgrading of the company’s common stock due to competition, the company looked inward and opted for self-preservation instead of ethics. As such, Countrywide fully immersed itself into the subprime market and away from the sacred principles that it was founded upon, becoming antithetical to its former self. The company eventually made completely unsuitable loans fully cognizant of the strong likelihood of default, passing the debt instrument onto investors. As with Merrill Lynch, Countrywide also sidelined risk management — the aggressive were put on a pedestal while the more conservative and cautious were rendered insignificant. The cavalier culture of the company rallied around a doing whatever it takes slogan. This approach to its interpretation of both regulation and risk led to its “doubling down” of predatory lending practices, all under the arrogant assumption that protection could be bought through political contributions.

Section E — Summary and Current State of Affairs:

Upon examination of the several organizations that converged to create the financial crisis of 2008, the most prevalent underlying catalyst was greed — both personal and corporate. Whether it was the mortgage originators, the investment banks, the insurance companies, or rating agencies, materialism played a crucial role — both in a quest for profit and market share. This led to an institutional mindset, formulated and cultivated by a culture that was fostered by leaders. Political greed and agendas also had a role in the crisis advanced by political campaign contributions and pandering under the guise of setting unrealistic goals of fulfilling the American Dream. At times, this culminated in subsequent federal curtailment of state lawsuits alleging predatory lending.

Twelve years later, the companies involved look quite different or received substantial government bailouts. Countrywide Financial was sold to Bank of America. Ameriquest was absorbed by Citigroup who took over what was left of its portfolio of mortgages, valued at $45 billion (McLean & Nocera, 2010, pg. 208). AIG was ultimately bailed out by the federal government for a total of $182 billion to prevent exacerbating the meltdown due to AIG’s international deals (McLean & Nocera, 2010, pg. 358). Goldman Sachs was made whole by the Federal Reserve regarding their dealings with AIG which later led to some allegations that Goldman Sachs was favored and received more than lost (McLean & Nocera, 2010). Further, it was alleged that some of the bailout money went to pay bonuses, drawing the ire of many (McLean & Nocera, 2010). The firm was eventually called in front of the Senate to answer for its arrogance and was publicly lambasted for duping clients and thus exacerbating the crisis. (McLean & Nocera, 2010, pg. 361). Merrill Lynch now operates under the name of Merrill and continues as an investment firm as a subsidiary of Bank of America. Additionally, the federal government bought what was left of securitized subprime mortgages in an effort to get banks back up and running (McLean & Nocera, 2010, pg. 358).

Several reforms were enacted under the Wall Street Reform and Protection Act, signed into law in July 2010. Among some of the changes were broadening powers of the Federal Reserve in examining the financial system, the creation of a new consumer protection agency to prevent predatory lending, and most derivatives are now traded on an exchange, enabling transparency (McLean & Nocera, 2010, pg. 358). Some other reforms prohibited proprietary trading at financial institutions which accept deposits and allowed liquidation of failing companies as an alternative to bailouts (McLean & Nocera, 2010, pg. 358).

Regarding mortgage lending practices, Fannie Mae and Freddie Mac remain wards of the government, GSEs that still have the mandate to guarantee mortgages (McLean & Nocera, 2010). Mortgage lenders have tighter standards — such as continuing education and certification — and consumers must meet set standards such as credit scores, debt to income ratio, employment verification, and loan counseling, among other things, are required for borrowers.

Bibliography

McLean, B. & Nocera, J. (2010). All The Devils Are Here: The Hidden History of the Financial Crisis. New York: Portfolio/Penguin

State of Connecticut, Department of Banking (2006, January 23). Ameriquest to Pay $325 Million for Predatory Lending Practices that Bilked Consumers. Retrieved on 10/28/20 from https://portal.ct.gov/DOB/Newsroom/2006/Ameriquest-to-Pay-$325-Million-in- Nationwide-Settlement

WRITTEN BY

Brian Erbis is a retiring NYPD detective based in New York City. Financial crimes consultant and owner of Brian Erbis Consulting LLC. Freelance blogger.