The Sellout is an amazing story of our time

Michael Raffety

Feb. 26, 2010

“You can call this a “sellout” or say that Wall Street sold out its principles in the 1980s and later to make a buck. I would tell you as someone who knows these guys, they never had principles to sell out in the first place.”

— Teddy Forstmann

“…more than $13 trillion in household wealth was destroyed by the end of 2008.”

The subtitle of The Sellout by Charlie Gasparino summarizes the book: How Three Decades of Wall Street Greed and Government Mismanagement Destroyed the Global Financial System. The 499-page book is a quick read and guide to the inner workings of Wall Street that is fascinating and hard to put down.

The seeds for the recent financial collapse were sown in the 1980s when the big Wall Street firms converted from private partnerships to public companies.

‘…they were no longer gambling with their own money but with that of public shareholders, and literally overnight the bets got bigger and the use of borrowed funds, known as leverage, grew and grew,” Gasparino wrote.

The financial mechanism that eventually led to a worldwide financial debacle started in the 1980s also. It was the securitization of mortgages. Banks exchanged their mortgages for cash and Wall Street packaged pools of these mortgages into mortgage-backed securities. This reduced the risk of default or early payment. The first such mortgage bond was sold in 1970 by the Government National Mortgage Association, Ginnie Mae.

Then in 1983 First Boston bond underwriter Larry Fink created the Collateralized Mortgage Obligation. A CMO is divided into classes, or tranches, that represent different cash flows and prepayment risks. Freddie Mac, the Federal National Mortgage Association, liked it so much that it bought $1 billion worth, which tied IBM for the biggest bond issue at that time. It didn’t take long for the CMOs to get more complex, including a derivative called a Z tranche which receives interest and principal only when the other tranches are paid off.

Between 1985 and 1988 mortgage bond deals reached $1 trillion. What had been a financial backwater at trading firms became the big cash cow. As Gasparino noted, “By the mid-1980s, debt traders controlled the senior positions at nearly every major firm, except Merrill Lynch, the old-line brokerage firm, which was now desperately trying to expand into the bond market.”

While this mortgage bond business was building up another financial craze became more noticeable to the public in the 1980s — junk bonds, with Michael Milken as the king of junk, or bonds rated below investment grade. Teddy Forstmann, who had a small takeover firm, started warning about the perils of selling junk bonds to the uniformed. It was likely from a Forstmann quote that Gasparino took the name of his book: “‘People forget this was stuff you had to pay back,’ Forstman said recently. ‘And Wall Street would never tell the buyers how difficult it was to pay it all back. You can call this a ‘sellout’ or say that Wall Street sold out its principles in the 1980s and later to make a buck. I would tell you as someone who knows these guys, they never had principles to sell out in the first place.'”

After Federal Reserve Chairman Alan Greenspan raised interest rates to pop a speculative bubble in the bond market, the mortgage bond market crashed in 1994, causing Orange County in California to file for bankruptcy after using pension funds to buy a large position in fixed-income derivatives. The treasurer, who didn’t have a college degree, quit and his assistant went to jail. A Certified Public Accountant who had run against him and criticized the derivative investments, was appointed treasurer and is now on the Orange County Board of Supervisors.

Another trend that began in the 1990s was Fannie Mae and Freddie Mac, government supported enterprises, began issuing billions of dollars of debt annually and Wall Street firms like Bear Stearns were making fortunes doing the underwriting for them.

These GSEs, government supported enterprises, are at the root of the housing bubble that burst in 2007-2008.

“The GSEs’ contribution to the housing bubble may well be traced back to a meeting in Arkansas in early December 1992 between President-elect Bill Clinton and Henry Cisneros, the man who would later run the Department of Housing and Urban Affairs.’

According to Gasparino, “…eradicating poverty through home ownership would take big government, working with the banking business and mandating laws to force banks to lend to those most in need and with the least ability to pay. Clinton agreed.”

Cisneros had Fannie and Freddie set aside 42 percent of their mortgage guarantees for low- to moderate-income borrowers. Andrew Cuomo followed Cisneros in 1997 and bumped it up to 50 percent, adding in the “very low income.” Cuomo had the GSEs drinking up subprime loans like Big Gulps from 7-Eleven. Cuomo is now New York attorney general, where he is trying to prosecute Bank of America essentially for troubles that he started.

About this time in the late 1990s Wall Street invented a new bond, called a collateralized debt obligation. CDOs theoretically reduced risk by packaging not just mortgages, but credit card debts, high yield securities and car loans.

After the stock market crash, followed by 9/11, Greenspan did his part to create a housing bubble by lowering interest rates from 3.5 percent to 1 percent within a few months.

In 2001 Chase Mortgage started working with credit bureaus to find subprime borrowers. “We don’t service these loans, we just sell them to Wall Street,” Gasparino quoted one marketing manager at Chase.

This kind of lending activity had people “borrowing more than the value of their homes to pay for closing costs and other expenses, jacking up the size of their mortgage to as high as 120 percent of the value of their home.”

By 2005 Wall Street had come up with the CDO squared, which was not an actual collateralized debt obligation but “interest in a pool of CDOs.”

“These guys have no idea what they’re doing,” said Bill Dallas, owner of a subprime lending company that Merrill Lynch had bought a stake in. Dallas, according to Gasparino, warned his wholesalers to cut back on Alt-A loans, “which involved mortgages sold to people with intermediate credit scores and the riskiest of all, suprime mortgages.” Merrill Lynch wanted more of those subprime mortgages to pack into its mortgage bonds and CDOs to boost the return for investors.

The CDOs started piling up on Wall Street firms after the Securities and Exchange Commission allowed them to self-regulate for risk and then allowed them to hold the same amount of triple-A rated mortgage bonds as government Treasuries as reserves. The banks started counting these triple-A mortgage bonds in their capital reserves. Of course, the rating agencies stopped using Depression-era scenarios to apply to mortgage bond risk and, “By 2005 triple-A ratings were being handed out like candy; underwriters could demand the rating they wanted and did,” Gasparino wrote.

Moody’s, a rating agency, quadrupled its profits between 2000 and 2007 and, according to Gasparino, had the highest profit margin of any company on the S&P 500.

Things started seizing up when New York District Attorney Eliot Spitzer forced out Hank Greenberg as leader of the company he founded, AIG Insurance. His replacement as CEO got the insurance giant involved in insuring CDOs through credit default swaps. Credit Default Swaps are derivative contracts based on the underlying value of the debt instrument. They “gain or lose value depending on the likelihood of default.” If there is a default, the owner of the credit default swap gets paid back by the seller. AIG stopped selling CDSs in 2005 when it began worrying about a real estate downturn. But it had $80 billion in credit default swaps out on the market.

The downturn did come and the Wall Street firms and some banks, such as Citi Bank, were caught with billions of collateralized debt obligations and now with credit default swaps that were essentially worthless. And while Merrill Lynch was holding $40 billion-$50 billion in CDOs it couldn’t sell, new chief executive officer John Thain exuded optimism and spent $1.2 million remodeling and redecorating his office.

The implosion was the bankruptcy of Lehman Brothers, the sale of Merrill Lynch to Bank of America, the sale of Bear Stearns to JP Morgan Chase, $80 billion to prop up AIG, at least $25 billion for Citi Bank and Goldman Sachs becoming a regulated bank. “…more than $13 trillion in household wealth was destroyed by the end of 2008, according to the most recent statistics issued by the Fed. Globally, some estimates place the decline at close to $50 trillion.”

“Even with the billions in bailout money spent since Lehman’s demise to prevent an even bigger panic, bank lending and the economy remained anemic through 2009 (as this book goes to press, banks are still saddled with as much as $7 trillion in possibly problematic loans, bonds and trades on their books).

The Sellout is not just about billions and trillions and CDOs, CDSs and CMOs. It’s a dramatic story of the people and colorful characters of Wall Street, from a surprising number of incompetent CEOs to bond traders who would fly the whole bond desk to Las Vegas to continue gambling in a different venue, to the Wall Street CEO who kept marijuana in his desk. It is an incredible story told by an on-air editor for CNBC and columnist for the New York Post. A former writer for the Wall Street Journal, this is Gasparino’s third business book.


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