All The Devils Are Here: Unmasking the Men Who Bankrupted the World by Joe Nocera, Bethany McLean Page A
Authors: Joe Nocera, Bethany McLean
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wouldn’t count toward Fannie and Freddie’s affordable housing goals. There is no data to prove that the GSEs avoided those loans, although neither company ever guaranteed large quantities of loans that they considered subprime.
In the end, though, it didn’t really matter whether Fannie and Freddie moved into riskier mortgages quickly or slowly, reluctantly or gleefully. What mattered was that they entered this new market at all. In so doing, they gave their imprimatur to what had previously been an entirely separate universe. A line that had once been absolute was now blurring. “The whole definition of subprime was ‘the stuff that Fannie and Freddie wouldn’t touch,’ ” a former executive explains. No longer.
Much later, Maxwell would concede, with great sadness, that Fannie Mae had forgotten a simple question: Why are we here? If Fannie Mae had kept that question paramount, the company would have remembered that it didn’t exist solely to generate ever-increasing profits or to keep pace with the private market, but to supply liquidity when the housing market needed it. If Fannie had remembered that, the company might have found its moral compass when it needed it most—and maybe left a different legacy.
4
Risky Business
T he most cutting-edge firm on Wall Street in the early 1990s was not Drexel Burnham Lambert, which had dominated the 1980s with its junk bonds, or Goldman Sachs, whose sheer moneymaking prowess would first dazzle and then repulse the country during this last decade. No, the firm that everyone on Wall Street wanted to emulate was a one-hundred-year-old commercial bank: J.P. Morgan. During the same era that the subprime mortgage industry was rising from the primordial ooze and Fannie Mae was consolidating its power over the mortgage securitization market, J.P. Morgan was making an important series of innovations around the concept of risk.
Risk was the bank’s obsession. It wanted to measure risk, model risk, and manage risk better than any institution had ever done before. It wanted to embrace certain risks that no bank had ever taken on, while shedding other risks that banks had always accepted as an unavoidable part of banking. To this end, J.P. Morgan (along with other firms, too) hired mathematicians and physicists—actual rocket scientists!—to create complex risk models and products. They were called “quants” because they tried to make money not by examining the fundamentals of stock and bonds, but by using more quantitative methods. They devised complex equations rooted in modern portfolio theory, which held as its core principle that diversification reduced risk. They searched for securities that seemed to move in tandem, and then used computers to take advantage of tiny discrepancies in their price movements. Their risk models were statistical marvels, based on probability theory. The new securities they invented, designed to shift risk from one firm’s books to another’s, were practically metaphysical. After the transaction was completed, the original security remained on the first firm’s books, but the
risk
it represented had moved. These new products were called derivatives, becausethey were “derived” from another security. J.P. Morgan’s chief contribution in this area was something called the credit default swap. Its breakthrough risk model was called Value at Risk, or VaR. Both products quickly became tools that everyone on Wall Street relied on.
What did these innovations have to do with subprime mortgages? Nothing, at first. J.P. Morgan and Ameriquest could have been operating on different planets, so little did they have to do with each other. But in time, Wall Street realized that the same principles that underlay J.P. Morgan’s risk model could be adapted to bestow coveted triple-A ratings on large chunks of complex new products created out of subprime mortgages. Firms could use VaR to persuade regulators—and themselves—that they were taking
In the end, though, it didn’t really matter whether Fannie and Freddie moved into riskier mortgages quickly or slowly, reluctantly or gleefully. What mattered was that they entered this new market at all. In so doing, they gave their imprimatur to what had previously been an entirely separate universe. A line that had once been absolute was now blurring. “The whole definition of subprime was ‘the stuff that Fannie and Freddie wouldn’t touch,’ ” a former executive explains. No longer.
Much later, Maxwell would concede, with great sadness, that Fannie Mae had forgotten a simple question: Why are we here? If Fannie Mae had kept that question paramount, the company would have remembered that it didn’t exist solely to generate ever-increasing profits or to keep pace with the private market, but to supply liquidity when the housing market needed it. If Fannie had remembered that, the company might have found its moral compass when it needed it most—and maybe left a different legacy.
4
Risky Business
T he most cutting-edge firm on Wall Street in the early 1990s was not Drexel Burnham Lambert, which had dominated the 1980s with its junk bonds, or Goldman Sachs, whose sheer moneymaking prowess would first dazzle and then repulse the country during this last decade. No, the firm that everyone on Wall Street wanted to emulate was a one-hundred-year-old commercial bank: J.P. Morgan. During the same era that the subprime mortgage industry was rising from the primordial ooze and Fannie Mae was consolidating its power over the mortgage securitization market, J.P. Morgan was making an important series of innovations around the concept of risk.
Risk was the bank’s obsession. It wanted to measure risk, model risk, and manage risk better than any institution had ever done before. It wanted to embrace certain risks that no bank had ever taken on, while shedding other risks that banks had always accepted as an unavoidable part of banking. To this end, J.P. Morgan (along with other firms, too) hired mathematicians and physicists—actual rocket scientists!—to create complex risk models and products. They were called “quants” because they tried to make money not by examining the fundamentals of stock and bonds, but by using more quantitative methods. They devised complex equations rooted in modern portfolio theory, which held as its core principle that diversification reduced risk. They searched for securities that seemed to move in tandem, and then used computers to take advantage of tiny discrepancies in their price movements. Their risk models were statistical marvels, based on probability theory. The new securities they invented, designed to shift risk from one firm’s books to another’s, were practically metaphysical. After the transaction was completed, the original security remained on the first firm’s books, but the
risk
it represented had moved. These new products were called derivatives, becausethey were “derived” from another security. J.P. Morgan’s chief contribution in this area was something called the credit default swap. Its breakthrough risk model was called Value at Risk, or VaR. Both products quickly became tools that everyone on Wall Street relied on.
What did these innovations have to do with subprime mortgages? Nothing, at first. J.P. Morgan and Ameriquest could have been operating on different planets, so little did they have to do with each other. But in time, Wall Street realized that the same principles that underlay J.P. Morgan’s risk model could be adapted to bestow coveted triple-A ratings on large chunks of complex new products created out of subprime mortgages. Firms could use VaR to persuade regulators—and themselves—that they were taking
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