How Mortgages Were Pumped Up
In the 1920s the Bronx was building as if there were no tomorrow. Apartment blocks went up a whole neighbourhood at a time, and around every building site a chain of contractors fed. We already know one cartel from those days—the plasterers of Gagliano and Monforte, with their “information bureau”. When Monforte was tried, Critchley writes, a telling episode came out. A contractor reckoned he’d do nicely if he took the job on for ninety thousand dollars. Monforte told him to bid a hundred and twenty-five. The contractor got the contract and an extra thirty-five thousand. He didn’t complain.
Who paid that thirty-five thousand? The developer. The developer was paid by the bank that lent money against the future building. And the bank was paid by the future tenants, who took out mortgages. As long as houses were going up in price, nobody counted. Why bother? Everybody in the chain added his bit: the buyer would pay anyway.
And then the boom ended. In 1935 Tommaso Gagliano, who headed one of the New York families, filed for bankruptcy. Debts of three hundred and fifty-two thousand dollars, assets of seventy-nine. He owed four and a half times what he had. Critchley doesn’t tie the bankruptcy directly to the end of the building boom, and I won’t claim the link is proven. But the picture is familiar. A man made money on a boom and lived as though the boom would last for ever.
When There’s More Money Than Business
Why does a property market get pumped up? Always for the same reason: there’s more money than good ideas to put it into. Spare money looks for something to turn into, and the easiest thing is concrete. The banker understands it, the client understands it, and it always “goes up”.
In seventies Sicily, Dickie writes, heroin money flowed in from America and turned into gold-plated toilets in peasant cottages, into apartment blocks and seaside villas, while the local private and co-operative banks doubled their share of the market in a decade. And Saviano describes how in Campania cement trusts became the Casalesi clan’s main weapon. Every building firm in the area bought its cement through them, and the clan made money at every stage of construction.
Extremes, of course. But before 2008 the whole world behaved the same way. Only the money was more honest. Asian countries and oil exporters had piled up huge savings and put them into safe American securities. Interest rates fell. There was an enormous amount of money looking for somewhere to earn. And it found American houses.
The Unspoken Guarantee
Everything in this story revolved around two organisations with funny names—Fannie Mae and Freddie Mac. The first, as we remember, was set up by the state back in 1938, the second in 1970. Over time both became private companies, and their shares traded on the stock exchange. They bought mortgage loans from the banks, packaged them into securities and promised the buyers of those securities that the money would come even if the borrower didn’t pay.
The trick sat in a single word. Everyone believed the state stood behind them, even though the documents said in so many words that these were not government obligations. The market didn’t believe the documents and believed common sense instead. Companies that big don’t fall. So they borrowed more cheaply than their own ratings allowed. And they grew unbelievably. In 1981 they guaranteed twenty billion dollars’ worth of mortgage securities; in 2007, more than three trillion. And they kept about one per cent of their own capital against the risk they had taken on.
One per cent. If borrowers failed to repay one hundredth of their debts, there would be no capital left. Not one mutual insurance fund on Don Vincenzo’s street would have dared to live with a cushion like that.
The Hard Sell
And below Fannie and Freddie, a machine we already know was turning. Many banks made loans, sold them on straight away and thought only about how to make the next one. Checking the borrower stopped paying: there’s no money in checking, there’s money in lending. Then came loans with no proof of income. Loans with a tiny down payment. Loans whose payments jumped sharply after two years. The reckoning was simple: the house will go up in price, the borrower will refinance.
The house didn’t go up. From the middle of 2006 American house prices began to creep down, and by early 2012 they had fallen by more than a third from the peak. Anyone who now owed more than his house was worth stopped paying. And the securities built out of loans like that were suddenly of no use to anyone.
On 6 September 2008 the state put Fannie and Freddie into conservatorship. In the end the Treasury put more than a hundred and eighty billion dollars into them. The unspoken guarantee turned out to be spelled out after all. Only it was the taxpayers who paid on it. Nine days later Lehman Brothers went bankrupt with assets of more than six hundred billion dollars, and the boiler I told you about at the start of the book blew in the world’s financial machine.
Where Do We Come In
Why am I going into so much detail? Because everything we’ve talked about in this part comes together here. Honest protection that keeps no reserves. A company with the king supposedly standing behind it. Managers who handle other people’s money and get a bonus for volume. A bank that takes as collateral the very thing it is pumping up in price. And a market where the advertised price has nothing to do with the one you can actually sell at.
None of these inventions was evil. Mortgages helped people buy houses. Guarantees made credit cheaper. When loans were packaged into securities, the risk was shared among many. The trouble is that all these machines were running at once, with no pressure gauges and no inspectors. And each one drove the next one faster.
The Don in the Boom Years
Our town had its own building boom too, a smaller one. Hotels were opening, restaurants were taking out loans for new dining rooms, and everyone wanted more laundry and more oil, and on credit. Back then I suggested to the Don that we give the clients longer to pay: everyone’s growing, everyone will pay up.
The Don said no. Every restaurant kept the same terms as before—a week. New hotels got a month at most, and only after their first year. Some took offence and went off to more obliging suppliers. Three years later the boom was over. Two new hotels and four restaurants closed and were left owing other people’s suppliers. Nobody owed us a thing.
I asked the Don back then how he’d known the boom would end. He said he hadn’t. “I don’t know when the party will end,” he said. “All I know is that every party ends. So I don’t sell on credit to people who are dancing.”
The Bottom Line
An unspoken guarantee gets spelled out at the worst possible moment, and the one who pays on it isn’t the one who gave it. And if a bank makes more from handing out a loan than from checking it, the checking will be done any old how.