The Unraveling of Banks

In Chapter ç, I documented the rise of four of the most important banks that had become vertically integrated: Countrywide Financial, Bear Stearns, Washington Mutual, and Citigroup.

Bear Stearns

In 2006, Bear Stearns produced $9 billion in revenue, earned $2 billion in profits, and employed over thirteen thousand employees worldwide with stock market capitalization of $20 billion. By March 2008, the company was nearly bankrupt and was sold off to JPMorgan Chase for $1.2 billion. Its demise, beginning in the spring of 2007, is thought to be the beginning of the financial crisis.

The cause of Bear Stearns's demise was based in its strategy to make, buy, and hold CDOs. It had totally embraced the vertical integration business model and had aggressively entered all parts of the nonconventional mortgage market.

Unfortunately, as house prices decreased and the mortgages that underlay the CDOs experienced nonpayment and foreclosure, this caused sharp decreas­es in the market values of these types of bonds. In April 2007, bond dealers told the managers of two Bear Stearns hedge funds that they should write down the value of the assets in these funds. The funds, High-Grade Structured-Credit Strategies Fund and Enhanced Leverage Fund, owned $20 billion for the pur­chase of CDOs based on mortgage-backed securities (Burrough, 2008). The funds started losing value in September 2006 when housing prices began fall­ing that year. In May 2007, the Enhanced Leverage Fund announced that its assets had lost 6.75 percent. Two weeks later it revised that to an 18 percent loss. Investors began pulling out their money. Then the fund's bankers called in their loans. Parent company Bear Stearns scrambled to provide cash for the hedge fund, selling $3.6 billion in its assets. One of its creditors, Merrill Lynch, wasn't reassured. It required the fund to give it the CDOs as collateral for its loan. In the end, Bear Stearns agreed to buy the securities from Merrill and other lend­ers for $3.2 billion. It bailed out the failed hedge fund to protect an even larger run on the bank.

As a result of continuing pressure on their CDO holdings, on December 20, 2007, Bear Stearns announced its first loss in eighty years.

By March 13, Bear Stearns was nearly out of cash to meet its borrowing obli­gations. Bear Stearns had relied on short-term loans from the repo and ABCP markets to fund its securities, just as other banks were doing. As the agree­ments in these markets ended, the banks who had lent the money wanted their funds back. Bear Stearns hemorrhaged cash when the other banks called in their loans and refused to lend more. No one wanted to get stuck with Bear's junk securities. Bear Stearns didn't have enough cash to open for business the next morning.

It asked its main bank, JPMorgan Chase, for a $25 billion overnight loan. Chase CEO Jamie Dimon told them he needed more time to research Bear Stea­rns's real value before making a commitment. He asked the New York Feder­al Reserve Bank to guarantee the loan so Bear Stearns could open on Friday. Yet Bear's stock price plummeted when the markets opened the next day. That weekend, JPMorgan Chase realized Bear Stearns was worth only $236 million. That was just one-fifth the value of its headquarters building. To solve the prob­lem, the Federal Reserve held its first emergency weekend meeting in thirty years.

On March 16, 2008, JPMorgan Chase announced that it would acquire Bear Stearns in a stock-for-stock exchange that valued the bank at $2 per share. The Federal Reserve Bank lent $30 billion to JPMorgan Chase to purchase Bear Stea­rns.

Countrywide Financial

Between 2000 and 2003, Countrywide Financial tripled its workforce to more than thirty-four thousand as its mortgage origination business exploded. In 2001, the company changed its name from Countrywide Credit Industries to Country­wide Financial Corporation, a proclamation that it was no longer a mere mort­gage company. A full-fledged diversified financial-services company, it owned a bank, sold title insurance, created MBSs and CDOs, traded these securities, and held these securities on its own account. It, of course, used borrowed money to fund its activities. Like Bear Stearns, it was ultimately the combination of higher rates of delinquencies and foreclosures and their impact on MBSs and CDOs that brought Countrywide down. But while Bear Stearns's problems were cen­tered on its borrowing to hold on to MBSs / CDOs, because Countrywide was more centered on the origination and holding of mortgages, its troubles were even more directly tied to the housing market.

In spite of its diversification and vertical integration, mortgage origination was the core of its business. In 2001, Countrywide Financial was the third-largest home loan provider in America, after Wells Fargo and Washington Mutual. Its CEO, Angelo Mozilo, wanted Countrywide Financial to be number one. It held that position briefly, in the early 1990s, before being overtaken by the competi­tion. In 2001, Mozilo announced he wanted to achieve a huge market share in mortgage originations—30 to 40 percent—that was far greater than anyone in the financial services industry had ever attained.

During the housing boom from 2001 to 2003, Countrywide thrived. In 2004, the company edged out Wells Fargo to become the largest home-mortgage pro­vider.

2005 revenue, $2.4 billion in profits, and a mortgage-origination engine that had generated a staggering $490 billion in loans.

Countrywide Financial kept the riskiest piece of a securitization, the tranches it could not sell because they had the lowest ratings, on its own balance sheet. This was a common practice for originators who issued securities that made their financial positions more transparent. Starting in 2005, Countrywide began to keep both interest-only ARMs and a chunk of home equity loans, both the loans themselves and the lowest-rated tranches from home equity loan securiti­zations, on its balance sheet as well. By the end of 2006, Countrywide had $2.8 billion worth of low-rated tranches on its balance sheet, representing about 15 percent of its equity. The rationale was that while there would be some delin­quencies on the mortgages in the securities, the income stream from these loans would provide stability during tougher times. By the end of 2006, Countrywide had $32.7 billion worth of interest-only ARMs on its balance sheet, up from just $4.7 billion at the end of 2004. Much of these holdings were being supported by money borrowed in the ABCP market.

In 2006 and early 2007, as house prices were starting to fall and originations were getting more difficult, Countrywide Financial ramped up its business of buying mortgage loans from banks that were faltering in order to stay at the top of the rankings for originations and provide raw materials for their securitiza­tion business. In the second quarter of 2007, the company announced that de­linquency rates on Countrywide's subprime mortgages had more than doubled, to 23.7 percent from less than 10 percent at the end of March.

As 2007 progressed, subprime defaults continued to escalate, and Country­wide's creditors started to stop rolling over loans made in the ABCP market. By August, it was difficult for Countrywide Financial to obtain any short-term funding, a move that constricted its ability to operate. Within days, Countrywide drew down its entire $11.5 billion line of credit, an obvious sign of desperation. It tried to get the Federal Reserve to use its emergency lending authority to loan it money to stay solvent, but the Federal Reserve refused. On August 23, 2007, Countrywide Financial announced that Bank of America would invest $2 bil­lion, giving the market the confidence that Countrywide had access to the deep pockets it needed to keep running.

But throughout the fall of 2007, Countrywide experienced continued pressure on its MBS-CDO portfolio and continued to have difficulty raising money in the ABCP market. As a result, its stock continued to fall. By the end of the year, Mozilo began to look for someone to buy the company. In July 2008, Bank of America acquired Countrywide for $4 billion. Less than a year earlier, its market capitalization had been more than six times that amount, at nearly $25 billion.

Washington Mutual

In the 1990s, Washington Mutual (WaMu) had been a conservative savings and loan bank. At the end of 2007, WaMu had more than forty-three thousand em­ployees, twenty-two hundred branch offices in fifteen states, and $188.3 billion in deposits. In 2008, it became the largest failed bank in US history. This was the result of WaMus aggressive entry into the nonconventional mortgage origina­tion market throughout the 2001-2007 period. Chairman and CEO Kerry Kill- inger's goal in this period was to build WaMu into the “Wal-Mart of Banking” by catering to lower- and middle-class consumers to whom other banks deemed too risky to lend. They offered many forms of nonconventional mortgages that had terms that made it easy for the least creditworthy borrowers to get financing. They expanded into big cities, including Chicago, New York, and Los Angeles.

After 2004, when it became more difficult to find new mortgagors, WaMu aggressively entered the nonconventional loan market. It pressed sales agents to approve loans while placing less emphasis on borrowers' incomes and assets. WaMu set up a system that enabled real estate agents to collect fees of more than $10,000 for bringing in borrowers. Variable-rate loans, option adjustable-rate mortgages (option ARMs) in particular, were especially attractive, because they carried higher fees than other loans and allowed WaMu to book profits on inter­est payments that borrowers deferred.

Washington Mutual's ultimate failure was caused by its aggressive pursuit of nonconventional originations. But they were particularly vulnerable because of the way they went about doing this. For example, they did a lot of business in California. By December 2007, the national average home value was down 9.8 percent. In California, there was fifteen months' worth of unsold inventory, and prices had dropped more than the national average. By the end of 2007, because house prices in California had dropped so much, many of their outstanding loans were more than 100 percent of the home's value, making borrowers more likely to default on their loans.

Even as house prices were falling, WaMu continued to aggressively pursue nonconventional mortgages as the market for originations turned down. Be­cause they were more focused on the nonconventional mortgage market to begin with, they were more vulnerable as the customers who bought those loans began to default. After originating these mortgages, WaMu found it difficult to either sell the mortgages to others to securitize or sell the securities it was producing itself. This was particularly true after August 2007 when the market for mort­gage-backed securities dramatically declined. Like many other banks, WaMu could not resell these mortgages or the securities they had produced. As their problems became apparent, they also ran into the problem of finding it difficult to raise money in the ABCP market. In the fourth quarter of 2007, they were forced to write down $1.6 billion in defaulted mortgages. Bank regulators made them set aside cash to provide for future losses. As a result, WaMu reported a $2 billion net loss for the quarter. Its net loss for the year was $6.7 billion, which dwarfed its 2006 profit of $3.6 billion.

In December 2007, WaMu reorganized its home loan division, closing 160 of its 336 home loan offices and removing twenty-six hundred positions in its home loan staff (a 22 percent reduction). In April 2008, as a result of the ongoing fore­closures in subprime mortgages, the company announced that three thousand people companywide would lose their jobs, and the company stated its intent to close its 176 remaining standalone home loan offices, including 23 in Washington state and its loan-processing center in Bellevue, Washington. At the same time, as a result of the difficulty of selling MBS-CDOs, it stopped buying loans from outside mortgage brokers. To try to stem the outflow of its capital to support its portfolio of loans and MBS-CDOs, WaMu also announced a $7 billion infusion of new capital by new outside investors led by TPG Capital. TPG agreed to pump $2 billion into WaMu, while other investors agreed to buy an additional $5 bil­lion in newly issued stock.

But WaMu was so deeply leveraged and so involved in nonconventional mort­gages that ultimately all of these moves failed. Simply put, as delinquencies and foreclosures for nonconventional mortgages increased, WaMu could not raise enough capital to support what it had borrowed to obtain mortgages and buy securities. In June 2008, Kerry Killinger stepped down as the chairman, though remaining the chief executive officer. On September 8, 2008, under pressure from investors, the Washington Mutual holding company's board of directors dismissed Killinger as the CEO.

By late September 2008, WaMu's share price had closed as low as $2. It had been worth over $30 in September 2007 and had briefly traded as high as $45 in 2006. While WaMu publicly insisted it could stay independent, it had hired Goldman Sachs to identify potential bidders. However, several deadlines passed without anyone submitting a bid. When Lehman Brothers went bankrupt in September 2008, WaMu experienced a bank run on their deposits. Depositors withdrew $16.7 billion out of their savings and checking accounts in less than a month, representing 9 percent of WaMu's deposits.

By early October, the Federal Deposit Insurance Corporation (FDIC) said the bank had insufficient funds to conduct day-to-day business. This led the Federal Reserve and the Treasury Department to step up pressure for WaMu to find a buyer, as a takeover by the FDIC could have been a severe drain on the FDIC in­surance fund. The FDIC ultimately held a secret auction of Washington Mutual Bank. On the morning of Thursday, September 25, regulators informed officials at JPMorgan Chase that they were the winners. They paid $1.9 billion and agreed to assume the bank's secured debts and liabilities to depositors.

Citigroup

Citigroup began the twenty-first century as a large, diversified conglomerate bank. It had operations in every major financial market including retail, com­mercial, insurance, and investment banking. It had extensive credit card opera­tions and far-flung outposts around the world. It truly was a global bank. But, by all accounts, the company was large and poorly run. Its merger activities in the 1990s had created such a large collection of banks that its activities were never fully integrated. One of the main ways this became a problem was around the issue of taking on risks of various kinds.

For example, during the financial crisis, the Federal Reserve took the bank to task for poor oversight and risk controls in a report it sent to Citigroup. Lynn Turner, a former chief accountant with the Securities and Exchange Commis­sion, said the bank's balkanized culture and management made problems inev­itable: “If you're an entity of this size,” he said, “if you don't have controls, if you don't have the right culture and you don't have people accountable for the risks that they are taking, you're Citigroup” (New York Times, 2008c)

Citigroup's lack of integration meant that as the company rapidly expanded its mortgage origination and securitization activities from 2001 to 2008, manage­ment was unaware of the riskiness of the ventures and the exposure of the bank (Wilmarth, 2013). The principal architects of Citigroup's great expansion into CDOs were Charles Prince, CEO, and Robert Rubin, an influential director and senior adviser. Rubin had been cochairman of Goldman Sachs and later Trea­sury secretary during the Clinton administration. There he helped push for the repeal of the Glass-Steagall Act. This repeal had helped the creation of Citigroup possible by allowing banks to expand far beyond their traditional role as lenders and permitting them to profit from a variety of financial activities. During the same period, he also helped beat back tighter regulations over mortgage securi­ties products.

For some time after Sanford Weill, an architect of the merger that created Citigroup, the bank had been less focused on bond trading. But in late 2002, Prince, who had been Weill's longtime legal counsel, was put in charge of Citi­group's corporate and investment bank. As the housing market around the Unit­ed States took flight, the CDO market grew apace as more and more mortgages were pooled into securities. Prince and Rubin correctly saw that the expansion of the US mortgage market from 2000 to 2003 presented a huge opportunity for the bank. Prince saw that the production and creation of MBSs / CDOs would rap­idly increase Citigroup's earnings and have a positive impact on its share price.

From 2003 to 2005, Citigroup more than tripled its issuing of CDOs, to more than $20 billion from $6.28 billion, and this transformed Citigroup into one of the industry's biggest players. Firms issuing the CDOs generated fees of 0.4 percent to 2.5 percent of the amount sold, meaning Citigroup made up to $500 million in fees from the business in 2005 alone. In 2005 as prices in the hous­ing market peaked, Citigroup decided to double down on the MBS-CDO mar­ket. They moved even more aggressively, particularly into the nonconventional MBS-CDO market. They added to their trading operations and snagged crucial people from competitors. Bonuses doubled and tripled for CDO traders. In De­cember 2005, with Citigroup diving into CDOs, Prince assured analysts that all was well at his bank: “Anything based on human endeavor and certainly any business that involves risk-taking, you're going to have problems from time to time,” he said. “We will run our business in a way where our credibility and our reputation as an institution with the public and with our regulators will be an asset of the company and not a liability” (Wilmarth, 2013: 87).

But the bank never quite appreciated the riskiness of the MBS / CDO market. Starting in June 2006, Senior Vice President Richard M. Bowen III, the chief underwriter of Citigroup's Consumer Lending Group, began warning the board of directors about the extreme risks being taken on by the mortgage operation that could result in massive losses. The group bought and sold $90 billion of resi­dential mortgages annually. Bowen's responsibility was essentially to serve as the quality control supervisor ensuring the unit's creditworthiness. When Bowen first became a whistleblower in 2006, foreclosures were rising, and Citigroup was deeply involved in origination and securitization of the riskiest mortgages and mortgage products (Terris, 2007).

On November 3, 2007, Bowen emailed Citigroup chairman Robert Rubin and the bank's chief financial officer, head auditor, and chief risk management officer to again expose the risk and potential losses, claiming that the group's internal controls had broken down and requesting an outside investigation of his busi­ness unit. But the board chose to ignore him. Citigroup eventually stripped Bow­en of most of his responsibilities and informed him that his physical presence was no longer required at the bank (New York Times, 2008b).

As the crisis began to unfold, Citigroup announced on April 11, 2007, that it would eliminate seventeen thousand jobs, or about 5 percent of its workforce, in a broad restructuring designed to cut costs and bolster its long-underperform­ing stock. But top management at Citigroup continued to be in denial about the potential problems for the bank. After securities and brokerage firm Bear Stearns ran into serious trouble in summer 2007, Citigroup decided that the possibility of trouble with their CDOs was so tiny (less than 1 / 100 of 1 percent) that they excluded them from their risk analysis. But eventually, with the crisis worsening, Citigroup announced on January 7, 2008, that it was cutting another 5 percent to 10 percent of its 327,000-person workforce.

Heavy exposure to troubled mortgages in the form of CDOs, compounded by poor risk management, led Citigroup into trouble as the subprime mortgage crisis worsened in 2008. Citigroup not only had massive amounts of MBSs / CDOs on its books but also owed creditors money it had borrowed to produce and buy those securities. By November 2008, Citigroup was insolvent, despite its receipt of $25 billion in taxpayer-funded federal TARP funds. On November 17, 2008, Citigroup announced plans for about fifty-two thousand new job cuts, on top of twenty-three thousand cuts already made in 2008. The same day, its stock dropped, and the com­pany's market capitalization fell to $6 billion, down from $300 billion two years pri­or. Eventually, staff cuts totaled over one hundred thousand employees, and shares of Citigroup common stock traded below $1.00 on the New York Stock Exchange.

As a result, on November 23, 2008, Citigroup and federal regulators approved a plan to stabilize the company and forestall a further deterioration in the com­pany's value. The US government announced a massive bailout for Citigroup designed to rescue the company from bankruptcy while giving the government a major say in its operations. A joint statement by the US Treasury Department, the Federal Reserve, and the FDIC announced, “With these transactions, the U.S. government is taking the actions necessary to strengthen the financial sys­tem and protect U.S. taxpayers and the U.S. economy” (Federal Reserve, 2008).

The bailout called for the government to back about $306 billion in loans and securities and directly invest about $20 billion in the company. The Treasury provided $20 billion in TARP funds in addition to $25 billion given in October. The Treasury Department, the Federal Reserve, and the FDIC agreed to cov­er 90 percent of the losses on Citigroup's $335 billion portfolio after Citigroup absorbed the first $29 billion in losses. The Treasury would assume the first $5 billion in losses, the FDIC would absorb the next $10 billion, and the Federal Reserve would assume the rest of the risk.

In return, on February 27, 2009, Citigroup announced that the US govern­ment would take a 36 percent equity stake in the company by converting $25 billion in emergency aid into common stock with a United States Treasury credit line of $45 billion to prevent the bankruptcy of the company. The government guaranteed losses on more than $300 billion of troubled assets and injected $20 billion immediately into the company. The salary of the CEO was set at $1 per year, and the highest salary of employees was restricted to $500,000. The US government also gained control of half the seats in the board of directors, and the senior management was subject to removal by the US government if there were poor performance.

The bailout worked. By December 2009, the US government stake was re­duced from a 36 percent stake to a 27 percent stake, after Citigroup sold $21 billion of common shares and equity in the largest single share sale in US history. By December 2010, Citigroup repaid the emergency aid in full, and the US gov­ernment had made a $12 billion profit on its investment in the company. In 2010, Citigroup achieved its first profitable year since 2007. It reported $10.6 billion in net profit, compared with a $1.6 billion loss in 2009.