All The Devils Are Here: Unmasking the Men Who Bankrupted the World (8 page)

A native of France, Arnall was born in Paris in 1939, on the eve of World War II. His mother was a nurse; his father, a tailor by trade, was in the army. Not long before Paris fell to the Germans, Arnall’s father returned to Paris and warned his extended family they should leave as quickly as possible. Most of them refused. But Arnall’s father took his wife and young son to the south of France, where they waited out the war using false papers that hid the fact that they were Jews. Arnall himself discovered that he was Jewish only after the war, a fact that stunned him. With the war ended, the family moved first to Montreal, where Arnall attended Sir George Williams College, and then, in 1950, to California, where Arnall sold flowers on street corners to make money for his family. “I know firsthand the precious gift of freedom,” he once said.

Arnall exerted a powerful effect on those who came into his orbit. “He was scarily smart and charismatic,” says Jon Daurio, who worked for Arnall from 1992, when Arnall recruited him to be the corporate counsel of Long Beach, until 1997. (Daurio would go on to found several other subprime lenders.) Daurio and his wife had dinner with Arnall when he was trying to convince Daurio to join Long Beach. “My wife is a lawyer, and smart,” says Daurio. “She said, ‘I don’t understand 90 percent of what you talked about, but you’re an idiot if you don’t go work for him.’ ”

Even more than Mozilo, Arnall was known for running his companies with an iron fist. “He was very demanding, and not very tolerant,” recalls a
former executive. He had a penchant for enticing people to work for him, extracting what he wanted from them, and then losing all interest in them. “When he got what he wanted out of you, you were done,” this person added.

Unlike Mozilo, Arnall was extremely secretive. He never gave press interviews. The documents his companies filed with the SEC divulged only the bare minimum required under the law. Arnall did not attend industry conferences, and his name was never on the door of his companies. He hated even having to talk to securities analysts. “I met with him once,” recalls a former banking analyst. “We all had to sign forms agreeing not to disclose anything before we were allowed into the conference room. That never happened any other time in my twenty-plus-year career.”

Yet he was never, ever rude to people the way Mozilo sometimes could be; that wasn’t his style. On the contrary, he was gracious and polite to everyone, from janitors to community activists. He had old-world manners, was an avid reader and an intellectual. He was the sort who liked to remind people that if they had their health and their family, they had everything. And he gave away millions to charity. “He was quite concerned with society as a whole,” says Robert Gnaizda, the former general counsel of the Greenlining Institute, a public policy and advocacy group, who spent a great deal of time dealing with Arnall’s companies and came to know him well. “Except,” Gnaizda added, “for this little niche, where he wasn’t.”

That little niche, of course, was subprime lending.

The way hard-money lenders had always made their money was simple: knowing that the default rate among their borrowers was likely to be high, they imposed onerous terms on their customers, who had no choice but to agree to them. They claimed collateral on anything they could haul away—cars, household goods, you name it. They extracted high fees just for making the loan. And they charged as much interest as they could get away with. They were also extremely tough-minded about collecting what was owed them, which meant they usually got paid back. And the high fees meant that those who paid up more than made up for those who defaulted.

The biggest hard-money lenders, finance companies like the Associates, Beneficial, and Household Finance, also made second-lien mortgages, which allowed strapped consumers to borrow against their homes to raise cash. But hard-money lenders had never offered first-lien mortgages, because the economics of a thirty-year fixed mortgage with a sizable down payment simply made no sense in that sector of the market.

What changed was the law. Specifically, a series of laws passed in the early 1980s, intended to help the S&Ls get back on their feet, wound up having profound unintended consequences. (They also backfired spectacularly and helped create a second S&L crisis within a decade.) The first law, passed in 1980, was the Depository Institutions Deregulation and Monetary Control Act; among other things, it abolished state usury caps, which had long limited how much financial firms could charge on first-lien mortgages. It also erased the distinction between loans made to buy a house and loans, like home equity loans, that were
secured
by a house, which would prove critical to the subprime industry.

Two years later came the Alternative Mortgage Transaction Parity Act, which made it legal for lenders to offer more creative mortgages, such as adjustable-rate mortgages or those with balloon payments, rather than plain vanilla thirty-year fixed-rate instruments. It also preempted state laws designed to prevent both these new kinds of mortgages and prepayment penalties. The rationale, needless to say, was promoting homeownership. “Alternative mortgage transactions are essential … to meet the demand expected during the 1980s,” read the bill.

As the rules changed, the “Big Three” hard-money lenders—the Associates, Beneficial, and Household—began to expand into first-lien mortgages, which made economic sense for the first time. S&Ls, of course, had also gained new freedoms from the series of laws designed to get them back on their feet. The new breed of thrift operators started lending to consumers who would have never previously qualified for a mortgage. Thus was the subprime mortgage industry born.

One of the first to take advantage of the new opportunities was a thrift called Guardian Savings & Loan, run by a flashy, aggressive couple named Russell and Rebecca Jedinak. As federal thrift examiner Thomas Constantine would later write, “It started at Guardian. Ground zero, baby.”

The Jedinaks moved into an aggressive form of hard-money lending. They offered loans—mostly refinancings—to people with bad credit, as long as those people had some equity in their house. “If they have a house, if the owner has a pulse, we’ll give them a loan,” Russell Jedinak told the
Orange County Register
. Kay Gustafson, a lawyer who briefly worked at Guardian, would later say that the Jedinaks didn’t really care if the borrower couldn’t pay the loan back because they always assumed they could take over the property and sell it. “They were banking on a model of an ever-rising housing market,” she told the
Register
. In June 1988, Guardian sold the first subprime
mortgage-backed securities. Over the next three years, the Jedinaks sold a total of $2.7 billion in securities backed by mortgages made to less-than-creditworthy borrowers, according to the
Register
. Fannie and Freddie were most decidedly not involved.

By early 1991, federal regulators had forced the Jedinaks out. The Resolution Trust Corporation, which had been established to clean up the second S&L mess, took over the thrift. Standard & Poor’s noted that Guardian’s securities were “plagued by staggering delinquencies.” In 1995, the government fined the Jedinaks $8.5 million, accusing them of using Guardian’s money to fund their lifestyles. They didn’t admit to or deny the charges, and anyway, they’d already started another lender, Quality Mortgage. After the Jedinaks were barred from the business, they sold Quality Mortgage to a company called Amresco, which itself became a fixture of the 1990s subprime lending scene.

Roland Arnall was right behind the Jedinaks. Unlike them, he built businesses that would last—at least, for a while. Arnall got a thrift license in 1979, just as the rules were changing, and he named his thrift Long Beach Savings & Loan. Initially, he built multifamily housing and other real estate developments, but he soon spotted a much better opportunity. Taking note of the exorbitant fees charged by the hard-money guys, he realized he could cut those fees in half and still make plenty of money. In 1988, Long Beach began to use independent brokers, just like Mozilo, to make mortgages to people with impaired credit. By the early 1990s, Long Beach was also selling mortgage-backed securities—which Wall Street was eagerly buying. The company grew exponentially; between 1994 and 1998, Long Beach would almost quintuple the volume of mortgages it originated, to $2.6 billion.

In 1994, Long Beach chucked its thrift charter. The charter had outlived its usefulness. Now that a mortgage originator could sell the loans to Wall Street, there was no particular need to be a deposit-taking institution.

But how could it be that Wall Street was willing to buy and securitize mortgages that Fannie and Freddie wouldn’t touch—mortgages made to people with a far higher chance of defaulting than traditional middle-class homeowners? This was something the founding fathers of mortgage-backed securities had never imagined was possible. Once, when Larry Fink was testifying before Congress in the 1980s, he was asked whether Wall Street might try to securitize risky mortgages. He dismissed the idea out of hand. “I can’t even fathom what kind of quality of mortgage that is, by the way, but if there is such an animal, the marketplace … may just price that security out.” By
that, he meant that investors would require such a high yield to take on the risk as to make the deal untenable. And yet, less than a decade later, that is exactly what was happening.

Ironically, it was the government itself that had helped make Wall Street skilled at securitizing riskier mortgages—specifically the Resolution Trust Corporation. In cleaning up failed thrifts, the RTC wound up with hundreds of billions of dollars worth of assets—everything from high-rise office buildings to vacant plots of land—that it took from the S&Ls it was closing down. Eventually, the RTC decided that the best way to get rid of those assets was to securitize them and sell them to investors. Much of the RTC’s raw material, though, qualified as risky and thus couldn’t be backed by Fannie Mae or Freddie Mac.

Ah, but if the securities could get a double-A or triple-A credit rating, investors like pension funds would be able to buy them, even without the GSEs’ seal of approval. It was the high rating, after all, that was required for them to hold the securities, not Fannie and Freddie’s guarantee. Even before the RTC, Wall Street had been experimenting with ways to make risky securities less risky by issuing, for instance, a letter of credit promising investors payment in the event the cash flow from the assets wasn’t enough. But the RTC allowed Wall Street to work on such techniques—“credit enhancement,” they were called—on a far broader scale. Over time, people came up with all sorts of ways to do credit enhancements. You could get insurance from a third party—a bond insurer, say. You could “overcollateralize” the structure, meaning you put in more mortgages than were needed to pay the investors, so that there was extra in case something went wrong. Or (and this would come later) you could do a so-called senior/subordinated structure, where the cash flows from the underlying mortgages were redirected so that the “senior” bonds got the money first, thereby minimizing the risk for the investors who owned those bonds. Credit enhancements helped convince the rating agencies to rate some of the tranches triple-A, which in turn helped convince investors to buy them. “The innovative techniques that the RTC developed are now in the process of being used by private sector issuers,” was the way Michael Jungman, the RTC’s director of asset sales, put it in a 1994 lecture. Indeed.

Larry Fink, obviously, had never envisioned credit enhancements. But as a 1999 paper by economists at the conservative American Enterprise Institute noted, “The attraction of this segmentation of risk is that the senior (collateralized) debts appeal to investors with limited taste for risk or limited ability to understand the risks of the underlying loans.” At last, Wall Street had
a securitization business it could do on a large scale—and it didn’t have to share a penny with the GSEs.

There was a final key to the rise of the subprime business. The federal government was behind it. Not in so many words, of course—and, to be fair, it is highly unlikely that many people in government truly understood what they were unleashing. But by the 1990s, government’s long-running encouragement of homeownership had morphed into a push for
increased
homeownership. Thanks to the second S&L crisis, the percentage of Americans who owned their own home had actually dropped, from a historic high of 65.6 percent in 1980 to 64.1 percent in 1991. In a country where homeownership was so highly valued, this was untenable.

Thus it was that, early in his second term as president, Bill Clinton announced his National Homeownership Strategy. It had an explicit goal of raising the number of homeowners by 8 million families over the next six years. “We have a serious, serious unmet obligation to try to reverse these trends,” said Clinton, referring to the drop in the homeownership rate. To get there, the administration advocated “financing strategies fueled by creativity to help home buyers who lacked the cash to buy a home or the income to make the down payments.” Creatively putting people who lacked cash into homes was precisely what the new subprime companies purported to do.

Which also explains why the government had such a hard time cracking down on the subprime companies, even as it became apparent that there was widespread wrongdoing. Roland Arnall’s company, Long Beach Mortgage, offered a case in point. In 1993, the Office of Thrift Supervision, a new agency created by Congress to regulate the S&Ls, alleged that Long Beach was discriminating against minorities by charging them more for their loans than they charged whites. Long Beach ducked this investigation when it gave up its thrift charter, leaving the OTS with no authority over the company.