All the Devils Are Here

Bethany McLean and Joe Nocera trace the roots of the 2008 financial crisis across three decades, arguing that the catastrophe resulted from interlocking failures by Wall Street, government regulators, mortgage lenders, credit rating agencies, and political leaders on both sides of the aisle.

The story begins in the late 1970s, when three figures created the mortgage-backed security, a product that bundles home loans into bonds sold to investors. Lewis Ranieri of Salomon Brothers named the process "securitization." Larry Fink of First Boston developed "tranching," carving bonds into slices of varying risk. David Maxwell, CEO of Fannie Mae, a government-backed mortgage company, fought to keep his company central to the new market. Legislation in 1984 and 1986 removed legal barriers and cemented the role of credit rating agencies, whose ratings allowed investors to buy complex securities without analyzing underlying loans. An early warning emerged: Securitization severed the link between borrowers and lenders, meaning originators no longer had a stake in whether loans were repaid.

Unable to compete with Fannie Mae and its sibling Freddie Mac in traditional mortgages, Wall Street turned to subprime loans, mortgages made to borrowers with poor credit or insufficient income. Early 1980s laws abolished state interest-rate caps and legalized adjustable-rate mortgages. Roland Arnall pioneered subprime lending through Long Beach Savings & Loan, undercutting high-fee private lenders who served borrowers shut out of normal bank credit. Angelo Mozilo co-founded Countrywide Financial, building it into the largest mortgage originator. Early in his second term, President Clinton announced his National Homeownership Strategy, encouraging creative financing and making it politically difficult to police subprime abuses. A first subprime bubble burst around 1998, but the industry recovered.

Under CEO Jim Johnson in the 1990s, Fannie Mae built an enormous lobbying operation and ruthlessly attacked critics. Congress created a dedicated regulator for the government-sponsored enterprises (GSEs), as Fannie and Freddie were known, in 1992, but Fannie's lobbyists ensured weak oversight and minimal capital requirements.

At J.P. Morgan, CEO Sir Dennis Weatherstone commissioned Value at Risk (VaR), a model expressing a firm's maximum expected daily loss as a single figure under normal conditions, though it said nothing about rare catastrophic events. Saleswoman Blythe Masters structured the first credit default swap in 1994, transferring default risk between parties while the original loan remained in place. A 1994 General Accounting Office report warned that derivatives—financial contracts that transfer or transform risk—were dangerously concentrated and posed systemic risk, but Federal Reserve chairman Alan Greenspan and other regulators refused to act.

AIG, the world's largest insurance company under CEO Hank Greenberg, entered derivatives through its subsidiary AIG Financial Products (AIG-FP). J.P. Morgan created the collateralized debt obligation (CDO) in 1997, bundling credit default swaps into a structure whose "super-senior" tranche, the highest-priority slice, was expected to absorb losses only after all others were wiped out. AIG-FP insured these tranches, and regulators ruled that banks buying such protection could cut capital requirements by 80 percent, generating enormous demand.

The last serious attempt to regulate derivatives failed in 1998 when Brooksley Born, chair of the Commodity Futures Trading Commission (CFTC), asked whether derivatives should face reporting or capital requirements. Treasury Secretary Robert Rubin and Deputy Secretary Larry Summers attacked her at the President's Working Group, a body coordinating top financial regulators, and Greenspan joined them. When the hedge fund Long-Term Capital Management collapsed months later, Born pleaded with Congress to act. Instead, the Commodities Futures Modernization Act of 2000 explicitly exempted derivatives from regulation.

The rating agencies, particularly Moody's, became corrupted by structured finance, the practice of packaging loans and other assets into complex securities. Moody's executive Brian Clarkson pressured analysts to protect market share, and agencies handed out triple-A ratings using models with fatally flawed assumptions about housing prices. CDOs exploited the system through ratings arbitrage, repackaging risky bonds into structures rated mostly triple-A. By 2006, CDO sales reached approximately $500 billion.

A second subprime bubble emerged after Greenspan pushed interest rates to historic lows. Arnall built Ameriquest into the largest subprime lender by 2004 through a brutal sales culture where employees forged documents and inflated appraisals. Wall Street firms demanded the riskiest mortgages for the highest yields. At Countrywide, sales chief David Sambol pushed to match every competitor's product while CEO Mozilo privately emailed that the company was "flying blind." Wall Street amplified the danger with synthetic CDOs, which referenced existing bonds rather than containing real collateral, allowing the same risky tranches to be cloned repeatedly.

Goldman Sachs, which went public in 1999, practiced rigorous mark-to-market accounting, valuing positions at current prices rather than historical cost. When its mortgage desk suffered losses in late 2006, executives ordered risk reduction using synthetic CDOs, sometimes at clients' expense. The Securities and Exchange Commission (SEC) later charged Goldman with fraud over one such deal; the firm settled for $550 million. Merrill Lynch CEO Stan O'Neal pushed his firm to take similar risks without similar discipline. In 2006, O'Neal promoted bond salesman Osman Semerci and fired veteran traders who understood mortgage risk. Over the next year, Semerci and deputy Dale Lattanzio added roughly $45 billion in subprime CDO exposure while assuring O'Neal the risk was minimal.

After accounting scandals forced CEO Franklin Raines to resign, successor Daniel Mudd inherited a Fannie Mae losing market share to private subprime securitization. Under pressure from investors and tougher housing goals, Fannie and Freddie began purchasing subprime securities and guaranteeing Alt-A mortgages, loans between prime and subprime that often involved limited documentation. By late 2007, Fannie had $350 billion in Alt-A exposure. At AIG, Greenberg was forced out in 2005 over accounting scandals. His replacement, Martin Sullivan, lacked the knowledge or force to control AIG-FP, where Joe Cassano had amassed $60 billion in credit default swaps on subprime-heavy CDOs.

The crisis erupted in stages. In summer 2007, two Bear Stearns hedge funds collapsed after short-term lenders demanded repayment and Merrill Lynch seized $850 million in assets no one would buy near face value. Rating agencies began mass downgrades, effectively ending the CDO business. Countrywide drew down its $11.5 billion credit facility and was acquired by Bank of America for $4 billion. At Merrill, exiled risk manager John Breit discovered $55 billion in hidden subprime exposure; O'Neal was forced to resign after a $7.9 billion write-down. At AIG, Cassano insisted losses were impossible as Goldman Sachs and other counterparties demanded collateral. AIG's auditors declared a material weakness, a serious internal-control failure in financial reporting, triggering cascading demands. Despite raising $20 billion, AIG required an $85 billion government rescue by September 2008.

On September 5, 2008, Treasury Secretary Hank Paulson placed Fannie and Freddie in conservatorship, a federal takeover, committing $200 billion in support. Ten days later, Lehman Brothers filed for bankruptcy after CEO Dick Fuld resisted urgent advice to find a buyer. Merrill was sold to Bank of America the same weekend. The collapses demonstrated that the nation's largest institutions had operated with massive leverage and tight interconnections through derivatives, assuming the government would rescue them.

Congress passed the Dodd-Frank Wall Street Reform and Consumer Protection Act in 2010, creating a Consumer Financial Protection Bureau and requiring derivatives transparency, but the law left critical details to regulators facing fierce industry resistance. The most glaring omission was any reform of Fannie and Freddie, which by 2010 backed more than 95 percent of all mortgages. The homeownership rate fell to 66.9 percent, erasing the bubble's entire increase. The Center for Responsible Lending estimated that more borrowers lost homes to foreclosure than purchased through subprime loans, meaning subprime lending was a net drain on homeownership.