I transcribed John Paulson’s (CEO of Paulson and Co.) entire testimony before the The Financial Crisis Inquiry Commission. Paulson was one of the first people to forsee the financial crisis, shorted, and made billions. One of his funds was up 589% in 2008 according to MarketFolly. To read the full story on John Paulson’s famous short, I highly recommend reading the best-seller The Greatest Trade Ever, which details how Paulson saw the crisis coming and the various methods he used to profit from it. Paulson is one of the only people who can actually claim to have foreseen the crisis and make money from it. According to Business Insider, John Paulson now runs the world’s third largest hedge fund in the world, with $32 billion AUM.
CS: Ok, um, it is October 8th 2010. We are interviewing Mr. John Paulson. Mr. Paulson my name is Chris Seifert. I’m with the financial crisis inquiry commission. We were established by a statute last year; the fraud enforcement and recovery act of 2009. It tells us to figure out the cause of the financial crisis by the end of this year and deliver a report (um) documenting what we found to be the cause of the financial crisis. It tells us to look at many things, including the role of sub-prime lending, nontraditional mortgage loan securitization, etc. So we, of course, thought it would make a lot of sense to talk to you, given your success in investing in the real estate markets over the last several years. So with that, why don’t we jump right into it? And if you could maybe first tell us what did you see in the real estate market in the 2000’s that made you decide to go short? What specifically were you looking at, what kind of signals did you see, and when did you in fact start going short?
Yeah. Well the first thing that I noticed just by being a normal active person in the market that the real estate market appeared very frothy and that values had risen very rapidly from where they were several years ago. So, that led me to believe that the real estate markets were overvalued. I’ve been around; I’m 54 years old so I’ve lived in New York all my life and New York periodically goes through a real estate crisis. We went through one in ’74, we went through one in the early 80’s and then again in the early 90’s. So, I didn’t subscribe to the school that real estate only goes up. I’ve been through cyclical periods before where there were lots of foreclosures, defaults and (you know) sharp drops in value. And, I felt that I had bought both my houses in foreclosure in the early 90’s. So, I thought that relative to what my houses were worth today, I mean in 2005/2006 what I had paid for them; they are up four or five times in value. I thought that we could be in a bubble. At the same time, it appeared that the credit markets were also extremely frothy. That there was generally very little attention paid to risk and any type of borrowers sell debt securities, regardless of the financial condition. And that spreads when the premium for risk were very low. So, we generally thought that the credit markets were overvalued, the real estate markets were overvalued, and we thought if that theory is correct it could present opportunities on the short side. When we looked … since the mortgage markets are the largest credit markets in the world, even bigger than the treasury market, they’re very large liquid markets, so we initially, we looked at the mortgage markets and then divided it into prime (I guess) or mid-prime and sub-prime. And to try and find mispriced securities we immediately focused on the sub-prime sector. And when we looked at that sector, what we were initially amazed at, first was the extraordinarily low quality, low credit characteristics of the loans that the average FICO score of the borrower was very low, around 630. Around half, over half of the mortgages were cash out refinancing (so based on appraisals not based on sale values). The loan to value was very high, exceeding 80%, and in some cases 100%… in many cases 100%. The concentration of sub-prime was in California where home prices had risen, even though the nationwide home price was falling. The reason that California had risen the most. And then some shocking ratios that close to half of the mortgages were stated income, no-doc loans. And of those that reported income, the debt to income ratio was stated 40% before considering taxes and insurance. And most shocking of all was that over 80% of the loans were adjustable rate mortgages. Where typically two twenty eights where the first two year was a teaser rate of around 7%, but then they reset at (unadible) 600 which at that time would indicate a 12% rate. So, none of this made any sense, it’s completely different than anything I have been involved in before. When I purchased my home, it was very strict underwriting standards; I had to provide two pay stubs, two years of tax returns, three months of bank statements, all sorts of credit card information. And, you know I got three mortgages in my life, so it never changed. And all of a sudden I saw the lowest quality margins with basically no underwriting standards at all. Most importantly there were two twenty eights which means if the average borrower was now spending over 40% of their gross income on debt service based on the teaser rate, that meant once the loan reset and the cost of the loan would go up by 50%, that they would either default, refinance the loan, or sell. But, if they couldn’t refinance or sell, they would have to default. It would be impossible for them to spend 60% of their income on debt service. So we thought that these were extraordinarily low quality mortgages that were very correlated to home price appreciation. And then if we were in a bubble and home prices would have fallen, these mortgages would likely default. And then after doing that analysis of the mortgages, and we did further analysis of the trends in the underwriting, the percent that were under percent, the combined loan to value ratio, and basically there would have been a steady deterioration in the credit quality. And then we looked at the structure of the mortgages. I should say we did one key piece of research which correlates, I mean based on the structure, you know I can say that these things need home prices to go up or they default. But then we did some research based on historical performance of the subprime mortgage securities and I think we analyzed a hundred MSAs and the performance of subprime loans based on growth rates in those MSAs, you’ll find a very strong correlation that when growth was very high default rates were very low but when growth slowed, default rates rose. And that … We didn’t find any periods that had negative growth from 2000 to 2005 but we found some at 0% growth. And at 0% growth, the data showed losses of around 7% in these pools.
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(Unknown Female Voice): Excuse me, Mr. Paulson, when did you do that research?
JP: Let’s say in 2005 and in early 2006.
(Female): Thank you.
JP: And then we looked at the structure of the subprime loans and again were made to see that these were basically originated and then sold as securities and the securities were structured where the securities were tranched into an average 18 separate tranches ranging from various tranches of AAA, AA, to BBB, to BB. And at the … there was tremendous demand for the BBB as the lowest rated investment rate security. But that security only had 5.6% subordination. Which meant that if losses were greater than 5.6% this tranche would be impaired. On average these tranches were about 1.5% thick, so losses of 7%, these tranches would be extinguished. And then, we also had shown that at 0% growth losses in the data we analyzed could reach 7%. So, we basically felt if home prices declined to 0% of less, that losses in these pools would exceed 7%; wiping out the BBB. And, even though … then we started to look at home pricing and sure enough, home prices began peaking in ’05. The year over year change continued to decline, and by June ’06 home prices were no longer rising. That was the first point that home prices did not rise or decline by 1%. Which would imply that the securities issued in that environment of home prices stayed below 0% that the BBB could default. Yet the demand of the BBB was so great on the part of institutional investors that spreads continued to tighten in between June ’06 and December ’06 had tightened to on average 100 basis points. So I could buy protection on a BBB subprime security for about 100 basis points. And yet, if the losses in the pools exceeded 7%, these things could potentially go to zero. So, that was the… at that point that’s when we became very involved in these securities, and bought protection on the BBB and various subprime securities for our base funds and then set up a separate credit fund that focused initially and exclusively on this particular trade.
CS: And when were those funds set up? You noticed that home prices stopped going up in about June ’06, was it shortly after that time?
JP: Chris, in exactly June ’06 was when we started the credit fund because that was the point that… our indicator that losses at 0% or less growth could exceed the 7% level which would eventually extinguish the BBB.
CS: Let me ask you, I mean Kim had asked you…
JP: I would say that it wasn’t so simple; the average loss in subprime mortgage securities in June ’06 was 0.6%. So it was 60 basis points. So people were saying to us, “We don’t know what you’re talking about. Home prices are not growing, they’re at 0%, and the losses in our pool are only at 60 basis points. They will never get to 5.6%, a level that would impair the BBB, and we can’t say they’ll never get to 7%, that would wipe out the BBB.” And in fact, up until that point, according to the mortgage people, there had never been a default of an investment grade mortgage security.
CS: So on that … two questions on that. One, you know, who are the people telling you, “Hey there is only 6% losses and we don’t expect to see worse.” And I suspect that, or let me ask you, did you point out to them, “Well that’s true but over the last two years, there are a lot of two twenty eight loans being made with high LTV ratios and high DTI ratios and they haven’t reset yet. And the fact that home prices aren’t going up anymore” …is going to create the issue that you discussed a little earlier.
JP: First of all the loss data that we get of all performance which is a database of private mortgage backed securities, so we can just pull out that data from the historical performance of subprime mortgage securities. And you know, most of the dealers had relatively sophisticated research departments that we all had access to similar data. I agree with you that the quality of mortgages being underwritten in ’06 was inferior to the mortgages underwritten in the earlier periods and that the performance of the new securities may be different in a declining home price environment than they were in a rising price home environment. But, what they said was that, “Look, we’ve never had, since as far back as data goes, (which I think went back to pre-war around World War 2) there hadn’t been a nationwide where home prices declined.” You had to go back to the great depression to find a period where home prices declined nationally. So, they just didn’t… they were not factoring in that scenario to their analysis. And if the actual prices reached zero, that was likely a temporary aberration, and their impression was that the growth would soon return. And a point of fact that did surround that zero percent level for around the next twelve months.
CS: Do you know if, even though there, in response to that, do you know whether or not you’ve seen the level of home price appreciation since the depression, that you saw in the first half of the decade of the 2000’s.
JP: We absolutely haven’t. And that’s what we’ve focused on, but the differential point there was almost everyone looked at nominal growth. So, nominal is very misleading because it includes inflation. So when you look at the nominal growth of house prices, we had very high nominal growth in the 70’s when we had double digit inflation, but real growth was low so most people just looked at nominal. When we converted the nominal price into real price and then took that back over twenty five years, we found just what you had articulated Chris, that home prices (at least in our recorded history) had never appreciated that fast as they did in that 2000 to 2005 period, and would likely correct in the future. And that was all perspective. Our opinion was they were overvalued and they were going to correct and that the quality of mortgages was very poor, and the losses would likely be substantial.
CS: Did you have discussions with these folks too, on the issue of look in addition to the real rate of appreciation in home prices as opposed to nominal, one. And, two, the fact that, again, in the period following the great depression up until the, I think 2000’s, you didn’t have these new kinds of mortgage products.
CS: The low dock, no dock, high LTV, high DTI… umm exploding interest rates after one or two years.
JP: Chris, that’s logical to say today, but let me say one thing, I was not after convincing the research department that they’re wrong, I’m right. I was trying to do our own analysis and conclusions to make investment decisions for our firm, and try and understand why other people had contrary viewpoints. My goal was not to try and convince them that I’m right, they’re wrong; it’s just to understand what they’re doing, how we thought things differently and what the rationale for that was. Most of them, when we did express our viewpoints, thought we were inexperienced, had … were of novices in the mortgage market, and we were very very much in the minority. If I said a thousand to one, we were the one would be the scenario. Even friends of ours thought we were so wrong, they felt sorry for us.
CS: And I understand you weren’t trying to convince folks. I’m really just trying to understand what you were hearing from them, about why they thought you were so wrong and as you said feeling sorry for you.
JP: Yeah, I would say because there had never been a default of an investment grade mortgage security. And I’ll qualify that, except for, what do you call, (inaudible) manufactured housing in the early 90’s in California. You know, those mobile homes … prefab homes.
JP: And aside from that small data point, there had never been a default on investment grade mortgages. And house prices had never declined nationally. So, they just didn’t see … and that the actual loss rates at the time period were so far below the level that would impair mortgage security, they just didn’t see, you know, any problem at all at the second.
CS: Understanding that home prices nationally hadn’t decline very much, when you folks were doing your research were you, and I think you mentioned this earlier, were you looking at the geographic concentrations of the loans and the securitizations, and were you finding that, well, you know, national home price appreciation may not make a whole lot of difference if X% of the securitization is in California, Nevada, Arizona, Florida and the other states that have historically been bubble states?
JP: Yeah well, what Moody’s did was, you could not buy protection on securities in any particular state. So one of the reasons that Moody’s insisted upon in order to mitigate risk was to ensure pools were very well diversified, essentially it corresponded to the level of home sales in each state and that’s what composed these securities. So you essentially buy a nationalize buy protection or selling protection on a national pool. Without that, and there wasn’t that much variability, between the securities. I mean, California typically was the state with the highest concentration, but California is also the state with the highest … it’s the largest state with the highest value of homes relative to the rest of the country so there was nothing particularly disproportional about that.
CS: And I know you had, in response to Kim’s question, you said to the specific research you were looking in … at that in 2005 and 2006, but overall, generally, when did you and your company start looking at the markets and doing the kind of research that led you to take the short positions that you eventually took?
JP: Well I’ve been active in the credit markets since … I would say mid-2000. So initially I was a manager; a corporate finance banker at Bear Stearns. At that time I did many financings in the high yield market and the senior market to finance companies and acquisitions so, I had been through the default cycle in 1990 when Drexel Burnham Lambert imploded, and many of these high yield securities default with it. And then there was a period of relative prosperity between the early 90’s and until 2002 when we went through another credit cycle. We had high default rates of companies like Enron and WorldCom, and there were many defaults again. And we went through a relative period of prosperity again, from 2002 until the credit markets peaked probably in June 2007. Um, but again, in going through cycles and being slightly older, I subscribed to the views that the credit markets and the housing markets were cyclical. And that, uh, both housing and credit appeared to be at a peak in terms of, you know both quality and price and could be ready for a fall.
CS: In addition to looking at, you know, the various types of loans and home price appreciation, etc. were you looking at what the actual originators were and did you draw any views or conclusions on quality of loans based on who was originating the loans?
JP: We did. Generally, I would say that the best quality originators were banks with a history of credit underwriting and a good reputation such as a Wells Fargo or a JP Morgan. And the worst underwriters were the, you know, I don’t know how to describe them but sort of “fly by night” mortgage brokers which were really just in it to maximize the short term fees.
CS: But could you, in terms of shorting securitizations, you mentioned you can’t really short states because Moody’s has requirements on diversification in that regard, can you target originators… and did you?
JP: I think you could pull out data on the performance of originators. You can for instance in ’06, and pull out all of the subprime loans issued in ’04, and then rank them by originator and you would start to see patterns. That the worst originators generally dealt in … the worst performance pools generally dealt in the subprime segment. I mean they’re in the wholesale broker channel and the best ones were the better known banks and references.
CS: The reason that I ask, as you can probably imagine, is that many originators have just said, “Look, our underwriting standards are no different from anybody’s underwriting standards, we’re all just underwriting to the secondary mortgage market and that’s just what can be sold.” So in that …
JP: That’s not true, that’s not true. For instance … Lehman Brother’s didn’t have a … origination network, so they … versus a bank like Wells Fargo has thousands of branches around the country and trained credit teams. So when Wells Fargo did a securitization, they basically were from internally generated loans through their branch network. And they maintained very high credit underwriting standards. The brokers, not only there but … not only there but Lehman, Morgan Stanley … they don’t have these retail networks. So they would go into the market and find bulk loans from unaffiliated mortgage brokers. And generally, the quality of those loans and the underwriting standards were much … were inferior quality to the ones originated by the banks of industry …you know with proper credit underwriting standards.
CS: So did you form any opinions about certain originators versus others? Other than the generalized opinion that you just voiced, those that didn’t have the sense of branch networks and relied and unaffiliated loan brokers had lower loan quality.
JP: Yeah, I would say that … you know we did pull out the data and ranked them by performance and they sort of fell into that pattern. Where, surprisingly, the investment banks that securitized loans had the worst experience, and then you have these, kind of a … I forget their names… pure play subprime originators, anywhere from Ameriquest to New Century, Saxon, I can’t remember all of the names that were sort of in the … let’s say the top or the worst part would probably be the banks and a couple of these let’s say independents. And then in the middle 50% would be the Auckland’s and all these other independent subprime originators who have all subsequently gone bankrupt. And then the top quartile would be the JP Morgan, the Wells Fargo, and other banks that were involved.
CS: What about Countrywide? In ’04 to ’07 they were the number one originator in the U.S. and at least the top 2 or 3 when it came to the nontraditional mortgage project, whether it was pay an option arm or whether it’s subprime or the all day or the low dock no dock. Can you form any opinions about them, and did it change over time?
JP: You know, I …they were active and big but they were not …the credit quality I would say was better than the worse ones. They would be in the better half, certainly the better half if not the better quartile. I mean, they were … they may have been involved in a segment that is clearly not viewed as an attractive segment but they were relatively disciplined in systems and underwriting standards, you know, and had to abide by the rules and things like that. The other guys … the New Centuries were drifting further from any type of control and then the mom and pop brokers that may have had 5 or 10 offices, maybe 1 office, they had absolutely no control.
CS: Any opinions on why that was?
JP: What do you mean?
CS: On why you had this … on why the mom and pops and the pure play originators (the New Centuries, the Ameriquests of the world) simply didn’t have controls and underwriting standards were so much looser than others?
JP: Well see, these were essentially sales organizations. They’re not very sophisticated, their goals were to increase volumes and increase fees. And, you know, at the top of the company you’re going to have more responsibility but a top salesman and you were on your own, then you shut up and all you cared about was volume. And you compensated the salesmen based upon production, and you know, you basically sold the same two twenty eights, but you may have cut corners at other places… and you know all that they cared about was volume origination. And then you got some very unsavory players, like I put Ameriquests in that category. I put them in because they settled with … they paid over $300 million in fines to the state attorney general, I think in February ’06 or in the early part of ’06 for one falsifying appraisals, and two, lying about borrower income. So they knew that they had to meet certain underwriting standards, but they would lie about the appraisal, so they could do a cash out refinancing for the borrower and they would lie about the income so that the borrower would pretend to have enough income. Now, Wells Fargo would (in my opinion) NEVER, EVER do that! And, Country Wide would have systems in place, either they’d tell you or as a stated income loan, and they’re not gonna check and you’d buy it with that caveat. But if they said they’d check, they’d be doing the credit checks. When you get to a non… a private guy who doesn’t care, he may just fill it in, stated income appraisal, and say, “Yes we checked,” when they really didn’t, and that’s when you got the really bad quality stuff.
CS: So let me ask you something on a different topic. And, on the one hand you’ll be happy that I don’t want to go into it on too much detail but, of course, the whole Abacus CEO got a lot of press. And the only thing I want to ask you about that in general, is: We’ve also seen reports for example, that, you know, other folks and other investment banks didn’t want to do those kinds of investment deals. They didn’t want to structure CDO’s that were initiated at the behest of somebody that wanted to take the short side of the deal. When you went out, or when folks approached you, I mean, were there folks out there that were saying, “Look, we don’t want to put together a deal like that,”?
JP: Well, let me just say a couple of things. Number one, every CDO has a buyer and a seller of pretention. So for anyone to say that they didn’t want to structure a CDO, because someone was buying pretention on that CDO, then you wouldn’t do any CDO’s.
CS: Well they’re not saying that, they’re…
JP: By definition …
CS: Right but what they’re saying is that they didn’t wanna structure a CDO where the short investor had a role in selecting the collateral.
JP: Well, there had … who … how did they find the short investor?
CS: I’m not following you.
JP: Well, how do they find the investor to buy the protection and the CDO?
CS: Well that’s different than selecting the collateral for the CDO…
JP: I would say that, generally, these banks, in order to do a CDO, you had to match a buyer and a seller or the CDO never got done, so … if you had a seller that only wanted a group of names and you couldn’t find a buyer, then that CDO would never get done. And CDOs on average were very well diversified pools. You know, I think that pretty much you had to have a hundred different subprime securities. So, it was a very diversified … when you have to get a hundred, there weren’t like that many issues. I mean there may have been four hundred issues over the course of a year, and if you’re doing a CDO of one of recent vintages where the last 90 days, you basically took all of the securities that were issues and that went into the CDO. But, I would say that … part of the initial structuring was to get a pool that both the buyer and the seller could initially agree upon. And then once you got that pool, then you went through the structuring and the rating process.
CS: So let me ask …
JP: Well ultimately, whatever the pool was it was then rated by the rating agencies, and if they didn’t like the collateral in the pool, they would … the security wouldn’t get rated or they would ask for a substitution of higher quality collateral in order to be able to … or they would adjust the ratings for what portion was AAA vs. AA and the like.
CS: Right, well I understand, believe me, that regardless of who’s selecting the collateral and how it’s selected, the disclosure on what the collateral is, and people can make their own decisions. Um… let me ask you a question on another topic that I mentioned in the beginning when I got started; and that is on prime broker accounts. We’ve talked to both some of the investment banks; you know folks that worked at the investment banks, like Bear and Lehman, and then various hedge funds that had prime broker accounts. And we’ve heard from them that because (and let me preface this by saying that I’m certainly no expert or knowledgeable about ways of the street for prime broker accounts so bear with me). But they’ve told us that I guess you can hypothecate securities and lever up the accounts of your prime brokerage customers so that if an when they wanna withdraw their funds or securities from those accounts, that can create a real problem for the investment banks. Can you provide any insight on that, and say for example whether you were reducing your prime broking accounts at any of the investment banks, whether that would, whether or not you knew that was creating any problems for them?
JP: Not really sure I understand the question.
CS: Well good thing then that I prefaced it with my lack of knowledge. But that’s probably why; I was not very articulate. Let me try again. Generally what folks have told us is that it’s similar to just a basic run, right? And so, when customers wanna pull their money out of the financial institution then you’ve gotta replace it, so that’s one. But apparently there was another layer for prime brokerage accounts because the prime brokerage firm itself could lever up that account by either re-hypothecating the securities out, or otherwise, so that it would create another layer of problem for them if they had to close that account out and replace the securities and the cash. Does that help?
JP: Yeah somewhat. So I think what you’re saying is: could clients ask for money from their prime broker account which could cause a funding problem for the prime broker?
CS: Right, but in a way that prepped not just the same as withdrawing cash out of a regular account because the securities or cash has been lent out to another party by the broker.
JP: I wouldn’t really know… only because I’m not really a … I see it from my side and I’ve never really looked at it from the bank’s side: what they do with the money or how they finance it.
CS: Well, I mean did you you… Let me just ask directly. I don’t know if you did reduce any of your accounts at the prime broker banks in ’07 or ’08, but did you? And did any of them call you and say, “Hey, you know, we’d really prefer you not to do this. It’s creating problems.”
JP: Um… not us. I mean we didn’t create problems; we had two prime broker relationships. One was with Bear Sterns and the other was with Goldman Sachs. The Bear Sterns had a unique structure from the other banks in that they had a separate subsidiary where they only kept prime broker accounts. They didn’t mingle that with the rest of the firm, so there was no rehypothecation of securities from the securities court to the brokerage firm. Most of the other banks or all of the other banks handled their prime brokerage accounts where their brokerage subsidiaries so the funds are mixed up. And we liked that structure that Bear Sterns put together a long time ago because we thought it added an incremental layer of protection where that even if Bear Sterns as the operating Co. was to fail, it would not affect the safety of the prime broker assets which were ring fenced into a separate subsidiary. And that, I think, is eventually what happened where even if Bear Sterns had failed prior to sale of JP Morgan, they were not going to file for the securities court for the prime broker assets for it. That being said, supposedly part of the liquidity crisis was the prime broker clients withdrawing money from Bear Sterns. So I guess if these big banks withdraw a lot of money very quickly, it has the potential to create sometimes a funding problem.
CS: Were you guys pulling your money out of Bear?
JP: No, we didn’t pull our money back, because we had pretty much experts in financials. And we had not only analyzed the mortgage department and mortgage industry, but analyzed the banks and the individual banks and what their exposures to the various securities were. And like we thought these subprime securities were doomed to fail, we thought that many of the banks also had put themselves into a position where they were doomed to fail. So, we had done a lot of work and we were very concerned about our own money, and what could happen if one of these banks failed. We started to look at that as a possibility and felt pretty good that Bear Sterns securities court (I’m not talking about the parent) was pretty safe to keep our money. And that even if they failed, our assets would have been safe. Now that’s not to say I wasn’t terrified that weekend where Bearn Sterns was either going to be sold to JP Morgan or fail, and that was um… But in talking with them, if they didn’t sell to JP Morgan, the parent would have filed on Monday, but they were not going to file for the prime broker subsidiary so I think I made the right decision. However, because of our concern about the prime brokers, when the Bear Sterns hedge funds failed in June ’07, which was about 9 months before Bear Sterns failed, that to us was a canary in a coal mine. So after that failure, we no longer kept our cash balances in any prime broker account, either at Bear or at Goldman. And we set up a contour account at Bank of New York I believe where we took all our cash out and completely removed it from the financial system and only invested in treasuries. And as the market got dicier and dicier we reduced more and more of our positions where (just looking here) we were almost, by the end of it, by the time Lehman failed, we were almost all cash; all treasuries. We had taken our money out of the prime brokerage and kept them in treasuries.
CS: So let me ask you given that you’ve been talking mostly about your views on real estate and various securitizations behind it and the firms that were holding it and I think you now had said just a couple of minutes ago had said that certain financial institutions had given their holdings might not be in that great a position. You know obviously you guys took positions that made you and your clients a lot of money while the executives of those financial institutions and other companies and the various regulators of the US didn’t notice it as well and it cost a lot of folks in the country a lot of money. And any opinions on the statute tells us in terms of looking at causes of financial crisis to of course look at the institutions that got into trouble and to look at the role of regulation. Any opinions on management of those institutions of the role of regulation of the banks or the investment banks in the U.S.?
JP: Yeah, I mean I’ll say several things that you know, they’re not very complicated and if they were in place, I think could have largely if not completely avoided the financial crisis; as far as regarding the mortgage market. And you know, there were standards by the way, they just weren’t enforced. That absolutely need mortgage standards that you have to have a fully underwritten mortgage loan. It makes NO sense to lend someone money without doing ANY credit check on the borrower! I mean it’s absurd. And until 2000, I don’t think it was ever done. The no doc loans before required 50% down. There was a very timely segment before that 1% of the mortgage market that essentially was to borrowers that worked in private cash businesses and made cash and didn’t show tax returns. They could get a mortgage from their local bank if they put 50% of the purchase price down in equity, and they would get a 50% mortgage. And those loans did not require income verification; but because they down payment was so high. But that was extrapolated and exploited and ultimately became no doc loans for everyone with no down payment to bad credit history so… I think if you have mortgage underwriting standards that require (even if it’s a subprime loan), that it’s a lower (which just means it’s of a lower credit quality), that it just means that you provide a full documentation. Income verification, asset verification, verification that it’s an owner occupied home, and that would have (and required some down payment) and that would have, I think, 40% of the mortgages, and all the ones that were troubled didn’t have those characteristics. And that’s relatively simple and prior to this crisis was standard. Secondly, what caused both Bear and Lehman to fail, were two things that baffled (agreed) address. That was they were way over… there was way too much leverage. Bear was somewhere on average of about 35 to 1 leverage. And the leverage ratio I’m using is just total assets to tangible common equity. Forget about this risk weighing stuff and including preferred or goodwill as a form of equity. Just look at total assets to equity; these firms were ridiculously levered. To me it’s impossible that you can even think you can run something at 33 to 1 leverage, all you need is a 3% dip on your assets and your equity is wiped out. So, there clearly needs to be higher capital standards for banks, and I think that’s been fairly well addressed. Secondly, you can’t own (even with 12 to 1 leverage if you bring the capital ratio to 8%) you still can’t own risky assets in that 12 … as part of that 12 to 1 ratio. So both Lehman and Bear and the other banks were holding private equity positions. They were holding real estate directly owned, or the equity portions of real estate deals. They owned the subprime mortgage securities. They owned other all day mortgage securities. They owned commercial mortgage securities, lower tranches. They owned equity tranches of these securitizations. They owned so much crap (I don’t mean crap but it’s not the type of investment … if you could have any leverage you can … you can’t do a leveraged buyout with … buy something with 10% equity and 90% debt and take that 10% equity piece and then lever it up 12 to 1 or 30 to 1. That thing, if the company goes bankrupt, you are going to lose 100% of that investment. Those types of risky assets really shouldn’t have any leverage associated with them. Or, if you own bankrupt securities, maybe 2 to 1, but not 12 to 1 or 30 to 1. So, if you had higher capital standards and instead of 30 to 1 if bear was 12 to 1, and to the extent that they had risky assets need to post even more equity, they wouldn’t have held those risky assets or would have been held at 6 to 1 or 8 to 1. And then under those scenarios I don’t think that these two banks would have defaulted. The other troubled institution was AIG, and they got into trouble from their derivative products group. And what was absurd about the derivatives market which was exemplified at AIG, was that you can sell protection with no collateral. So AIG the financial products group had about $500 billion protection they sold and that entity was capitalized with about $5 billion in equity. So they were about 100 to 1 levered. And, you know, NO COLLATEROL REQUIREMENT. You can sell as MUCH protection as you want. And even that company that bought that Abacus, that ACA, which was the collateral agent and also bought the AAA tranche, they were like 120 to 1 levered. They had like $50 billion of protection on $600 million of equity. It shouldn’t have … it’s absolute absurdity. So, what needed in that case is you have to hold collateral. There has to be margin requirements for both buying and selling protection. You know, you can’t buy a stock, not the derivative itself was the requirement but the margin was the requirement. If you buy a stock and open an account, the maximum leverage you can get on a regular account is 2 to 1. So if you put in $100, then you can buy $200 worth of stocks. And they’ll lend you $100. And the moment it goes down you either have to post more collateral, or they’ll sell it and because of that there has never been… rarely ever losses in the retail margin business. But it’s like in this case, with the derivative and AIG; they could buy $100 worth of stocks with only $1 worth of equity. Well obviously, these stocks don’t have to fall very far and that equity is gone. And that’s what AIG did, so I think legitimate margin requirements on derivatives would have prevented that problem from happening. And, I think those simple four things: Number 1. Mortgage underwriting standards that are simple a logical to follow, 2. Higher capital ratios for banks, 3. Higher capital against risk assets for banks and 4. Margin requirements on derivatives … that would have prevented the crisis from happening.
CS: Understanding those are your four main points, any other thoughts on your contributing points to the financial crisis?
JP: Hmm… Well, those are pretty significant.
CS: No, they are!
JP: I mean AIG … you know the rating agencies come up… I think Stu mentioned that the compensation for the rating agencies is wrong, where the borrower essentially pays the rating agency. And that creates perverse incentives for the rating agencies to issue the ratings in order to get paid, and if they didn’t issue the proper ratings, they didn’t get paid. And they became (Moody’s sort of became) a growth company, and sort of got stuck in this mode of producing 20% plus earnings and growing the derivatives product business. To meet expectations and trading at extraordinarily high PEs with very high growth, and they got trapped I think in a perverse economic incentive that may have led to their laxness in rating securities.
CS: So why do you think … I mean the points that you make are very well taken. But, I’m presuming that the managers of these institutions and the regulators of these institutions were well aware of the high leverage, the low margin requirements, etc. Umm… how … any opinions on that? What else did they miss? I mean, I think you mentioned the fact that they were too highly levered, and that they …
JP: Yeah! I mean, look…it’s amazing to me because in retrospect it all looks so obvious. But, at the time, they were very growth oriented, they wanted to see their stocks rise, they were competing against each other for earnings growth and return on equity and bonus pools and the like. And a way to increase their earnings was to grow their balance sheets, and add more leverage. And if they can add a spread then that increased their equity and their overall profits. So they became sort of … well once things go up in a strong up cycle, you don’t see any downside. So, at the top of the market, they just weren’t looking at the downside, they were looking at the upside, and became more and more aggressive until they blew up!
CS: Do you have any opinions about the Fed? I mean one of the things that we’ve seen obviously (and this is all public) is that you know there was a very low interest rate environment following the crash of the NASDAQ and the 9/11 attacks, and they gradually started to increase I think starting in 2004, one. And then two, there has certainly been some criticism about them not doing all they could under the HOPA regulations.
JP: What were the HOPA regulations?
CS: I’m sorry, the Home Owners Protection Act that under which arguably they could have cracked down on some of the underwriting standards.
JP: Yeah, I think that would have been … I think the Federal Reserve did have oversight for the mortgage area, and there was very little oversight getting to … in the mortgage area. I think that demanding or insisting that proper underwriting guidelines be followed, not allowing no income verification or no doc loans, requiring a down payment (even if it’s only 5%) would have gone a long way to dramatically (just those simple rules)…Look, you have to have simple rules, and I’m not saying you can’t make a loan to a bad credit; at least verify that they have the income and the assets that they say they do. And, those simple rules would have done … light years to preventing the market that it ultimately resulted in. And also, I think that we could have… we could eliminate negative AM loans, you can assist loans that have amortization built in and it’s really the fringe areas: the no doc loans, the stated income, the 100% financing, negative AM and interest only is where most of the problems develop. And I do think simply, that if you had margin requirements … look if you had margin requirements on stocks and the reason you have margin requirements on stocks is because during the great depression, there was no margin. You could buy stocks at 10% margin, and that caused everyone to buy lots of stock on margin, and then when the stock market fell more than 10%, they were all wiped out. That caused margin calls which fed the selling which led to the stock market crash. So the first thing that they came up with was you know you gotta have reg T rule I guess either in ’33 or ’34, which is you have to put down 50%. You can’t borrow more than 50% against a stock. And essentially, the same thing happened into the derivatives market. It burst onto the scene with no margin requirements. And because the credit markets were so stable, people became delusional in thinking that because it’s AAA it will never go down. We can leverage AAA securities 100 to 1 and that absurd leverage led to the collapse of AIG. But very simply if you had margin required against derivates, AIG could never have happened.
CS: Right. So I know we’re …I’m sorry go ahead.
JP: And also, if Bear Sterns had a whole 8% common equity against its assets, then Lehman, they would have never … and also if they held illiquid private equity investments, even higher, you know 100% equity, then they wouldn’t have all this risky stuff on their balance sheet. They would have had far less leverage, and they would have never defaulted. And, constructively, that’s what Basel III essentially says now; 8% equity to capital ratio, and higher risk weightings what they call for illiquid, risky type assets. And I think adoption of those rules will lead to a much safer financial system.
CS: So I see we’re close to the end, and probably at the end of the time, so I have one last question for you. One thing that I haven’t asked you about that’s in our statute that I’d like you to comment on if you can, and that is the role of Fanny and Freddy. I mean obviously they were “BIG” and financing about $5 trillion of the mortgages in the U.S. … do you have any opinions on their role as a possible contributing cause to the crisis?
JP: Well, I think that … you know … they provide (obviously) they provide such an essential part for the mortgage market today … we wouldn’t have a mortgage market I tell you without Freddy and Fanny and FHA; they’re something like 95% of all mortgages. But, I would say that they had two problems. They deviated from their underwriting standards. So, as a way to gain share they also lowered their credit underwriting. They wanna participating in all day and subprime securities; aside from the full doc high credit quality loans which … and you know that led to poorer quality and higher losses. And secondly, they were massively leveraged. They leveraged 80 to 120 to 1, if you include their on balance sheet assets and their guarantees. Which, again, is far in excess of what any financial institution should have.
CS: Ok. Mr. Paulson, I very much appreciate your time today. Thank you very much.
JP: Alright, thanks Chris. Thanks Kim. I look forward to reviewing the report!
CS (and Kim): Thank you.