Seeing Through The Housing Bust ... by gimleteye

The mainstream media post-mortem on the housing bust is gathering steam. Click on "read more" for the first two days of the front page series by The Washington Post. It is good, as far as it goes. But like other mainstream media reports on the housing bust, it is written as a financial story, or, a story of "subprime" borrowers.

What is missing from mainstream accounts is the meeting of money and politics behind the boom and bust: how Wall Street and local homebuilders pressured local and federal elected officials and policy makers to lower regulatory barriers and environmental rules and regulatory oversight to allow the biggest financial bubble in US economic history to inflate and collapse, threatening our national economic security in the process and putting taxpayers at severe risk.

Although these stories have not been assembled in a single frame, the other side-- of the massive destruction to environmental resources--has been reported and reported very well. The St. Pete Times 2006 series, "Vanishing Wetlands", documents "despite a presidential policy of "no net loss", Florida has lost at least 84,000 acres of wetlands in the past 15 years. ... between 1999 and 2003, the US Army Corps of Engineers approved more than 12,000 wetland permits and rejected one."

In Miami during the boom, citizens and environmental groups objecting to the plowing of platted subdivisions into wetlands, Everglades buffer areas, and farmland, were called radical extremists and worse.

For instance, in public forums, then Mayor of Homestead, Florida, Steve Shiver got welcome encouragement from local bankers like Bill Losner and Bob Eppling and Chamber of Commerce zealots when he called objectors to development, "terrorists".

In Miami-Dade County during the boom, tens of thousands of acres in agriculture, presumably an industry of local importance, were replaced by concrete pads, feeder routes and cul de sacs during the building boom-- threatening the viability of food production in a region that may increasingly need to provide its own land and resources to feed millions of Floridians.

Former Mayor Shiver, today, is an operator of an amusement park in Maggie Valley, North Carolina-- presumably with a bank account sufficient to see him through.

The condo farms and suburban sprawl of South Miami-Dade were built in the final phase of the housing bubble: its foundations were liar loans and mortgage fraud, accruing largely to the benefit of land aggregators, speculators and local housing developers represented by trade associations like the Latin Builders Association and some of the nation's largest publicly traded homebuilders, like Lennar based in Miami.

Members of the Latin Builders and South Florida Builders Association control local legislatures through political campaign contributions; a formula that created incumbent fiefdoms. In the case of Hispanic politics--and Hialeah, Miami-Dade's largest municipality, in particular--they also funded Spanish language "political" commentaries that serve the purpose both of enforcing political orthodoxy in Miami and the radio-based campaigns that set US policy to Cuba in concrete for decades.

But the building boom triggered by historic low interest rates beginning in 2001 represented an exponential advancement of political forces as a result of Wall Street financial "innovations" that imploded in the mid-2007 into a world-wide credit crisis.

These innovations flowed through the securitization of mortgages-- combining pools in platted subdivisions in South Dade with those in suburban Arizona, all based on demographic averages and assumptions of low default rates--leveraging a dollar of debt into twenty or thirty dollars, from which fees were generated up the entire ladder of economic interests.

By mixing the work of rating agencies and insurance, Wall Street mathematical wizards buried doubt in calculations made right by virtue of complexity, creating a Wall of Money that rained down on builders through local bankers and mortgage brokers.

In South Florida, the Wall of Money triggered such a frenzy that lobbyists at County Hall abandoned the mundane business of shepherding contracts through compliant county commissioners in order to become developers themselves. No one wanted to be paid on an hourly rate or "success fee" or even a percentage of the deal when they could be part of the leverage game itself.

Lobbyists who ran County Hall in the 1990's like Rodney Baretto (prominent Republican campaign fund raiser, land owner outside Miami's Urban Development Boundary and Chairman of the Florida Fish and Wildlife Conservation Commission, appointed by Governor Charlie Crist), Brian May (former chief of staff to County Mayor Alex Penelas, now of Adrian Homes), and Chris Korge (prominent Democratic campaign fund raiser) transformed themselves to builders, having already mastered the barriers to entry: building permits and zoning changes. A whole second tier of lobbyists emerged as prospective developers, feeding at the bottom of the barrel; leveraging funding intended for low income housing into personal wealth. (It is wealth creation based on the storied formula in Hialeah: public officials and private developers manipulating federally subsidized, low income housing.)

With the ease of converting farmland to housing tracts, the lower level lobbyists turned poverty money from public agencies into private wealth; documented in the Pulitzer winning series by The Miami Herald: "The House of Lies.". What they did to others, they could do for themselves.

The bust in housing markets has wiped out all the gains garnered during the boom by publicly traded homebuilders across the nation. In other words, the only net benefit was to key executives who were able to cash out options, salaries, and immense compensation packages.

The New York Times reports, "Only a year ago, Wall Street reveled in an era of superlatives; record deals, record profit, record pay. But a mere 12 months later, nearly half of the profits that major banks reaped during the age of riches have vanished." (After a Rough Year, Nearly Half of Wall Street Bank Profits Are Gone, June 16, 2008)

In other words, seeing through the housing bust is to understand that the boom materially wrecked neighborhoods, communities, and environmentally sensitive lands to initiate an immense distribution of wealth. It was money created from nothing, pure confection used to generate billions in fees, commissions, and compensation by a small group of entrepreneurs.

With every passing month, as the billions in losses mount at banks and financial institutions, it is clear that the taxpayer will indeed by the lender of last resort for the terrible sequence of decisions that caused the asset bubble in the first place.

It would be revealing, indeed, if the candidates to be the next US president would offer their honest assessment of where our politics went wrong.

But, mostly, our politics is looking in the rearview mirror. The Florida Legislature, for instance, is comprised of officials who became so conditioned to the fruits of the housing boom, they simply can't accept the fact that it is over; and not just over, but collapsing in a way that is forcing government budgets to inflict ever greater tranches of pain on the public and taxpayers.

Miami lawmakers like former House Speaker Marco Rubio (Republican) have set a course to neuter the Florida Department of Community Affairs--the state agency charged with "growth management", as though regulations were the problem and not boundless greed. In Washington, the true nature of the crisis is still bottled up in Congressional committees and shadowy meetings of the Federal Reserve, as though a full reckoning of the fraud unleashed on the US economy by the housing boom is conversation only fit for solutions.

It is time for the mainstream media to become tougher, much tougher, in recounting how this bust happened, who benefited, and how much it will cost the US taxpayer.





The Bubble
How homeowners, speculators and Wall Street dealmakers rode a wave of easy money with crippling consequences.
By Alec Klein and Zachary A. Goldfarb
The Washington Post
Sunday, June 15, 2008; A01

Part I · Boom

The black-tie party at Washington's swank Mayflower Hotel seemed a fitting celebration of the biggest American housing boom since the 1950s: filet mignon and lobster, a champagne room and hundreds of mortgage brokers, real estate agents and their customers gyrating to a Latin band.

On that winter night in 2005, the company hosting the gala honored itself with an ice sculpture of its logo. Pinnacle Financial had grown from a single office to a national behemoth generating $6.5 billion in mortgages that year. The $100,000-plus party celebrated the booming division that made loans largely to Hispanic immigrants with little savings. The company even booked rooms for those who imbibed too much.

Kevin Connelly, a loan officer who attended the affair, now marvels at those gilded times. At his Pinnacle office in Virginia, colleagues were filling the parking lot with BMWs and at least one Lotus sports car. In its hiring frenzy, the mortgage company turned a busboy into a loan officer whose income zoomed to six figures in a matter of months.

"It was the peak. It was the embodiment of business success," Connelly said. "We underestimated the bubble, even though deep down, we knew it couldn't last forever."

Indeed, Pinnacle's party would soon end, along with the nation's housing euphoria. The company has all but disappeared, along with dozens of other mortgage firms, tens of thousands of jobs on Wall Street and the dreams of about 1 million proud new homeowners who lost their houses.

The aftershocks of the housing market's collapse still rumble through the economy, with unemployment rising, companies struggling to obtain financing and the stock market more than 10 percent below its peak last fall. The Federal Reserve has taken unprecedented action to stave off a recession, slashing interest rates and intervening to save a storied Wall Street investment bank. Congress and federal agencies have launched investigations into what happened: wrongdoing by mortgage brokers, lax lending standards by banks, failures by watchdogs.

Seen in the best possible light, the housing bubble that began inflating in the mid-1990s was "a great national experiment," as one prominent economist put it -- a way to harness the inventiveness of the capitalist system to give low-income families, minorities and immigrants a chance to own their homes. But it also is a classic story of boom, excess and bust, of homeowners, speculators and Wall Street dealmakers happy to ride the wave of easy money even though many knew a crash was inevitable.

Chapter I

'A Lot of Potential'

For David E. Zimmer, the story of the bubble began in 1986 in a high-rise office overlooking Lake Erie.

An aggressive, clean-cut 25-year-old, armed with an MBA from the University of Notre Dame, Zimmer spent his hours attached to a phone at his small desk, one of a handful of young salesmen in the Cleveland office of the First Boston investment bank.

No one took lunch -- lunch was for the weak, and the weak didn't survive. Zimmer gabbed all day with his clients, mostly mid-size banks in the Midwest, persuading them to buy a new kind of financial product. Every once in a while, he'd hop a small plane or drive his Oldsmobile Omega out for a visit, armed with charts and reports. The products, investments based on bundles of residential mortgages, were so new he had to explain them carefully to the bankers.

"There was a lot of education going on," Zimmer said. "I realized, as a lot of people did, this was a brand new segment of the market that had a lot of potential, but I had no idea how big this would get."

Zimmer joined the business as enormous changes were taking hold in the mortgage industry. Since World War II, community banks, also called thrifts or savings and loans, had profited by taking savings deposits, paying their customers interest and then lending the money at a slightly higher rate for 30 years to people who wanted to buy homes. The system had increased homeownership from less than 45 percent of all U.S. households in 1940 to nearly 65 percent by the mid-'60s, helped by government programs such as G.I. loans.

In 1970, when demand for mortgage money threatened to outstrip supply, the government hit on a new idea for getting more money to borrowers: Buy the 30-year, fixed-rate mortgages from the thrifts, guarantee them against defaults, and pool thousands of the mortgages to be sold as a bond to investors, who would get a stream of payments from the homeowners. In turn, the thrifts would get immediate cash to lend to more home buyers.

Wall Street, which would broker the deals and collect fees, saw the pools of mortgages as a new opportunity for profit. But the business did not get big until the 1980s. That was when the mortgage finance chief at the Salomon Brothers investment bank, Lewis Ranieri -- a Brooklyn-born college dropout who started in the company's mailroom -- and his competitor, Laurence Fink of First Boston, came up with a new idea with a mouthful of a name: the collateralized mortgage obligation, or CMO. The CMO sliced a pool of mortgages into sections, called "tranches," that would be sold separately to investors. Each tranche paid a different interest rate and had a different maturity date.

Investors flocked to the new, more flexible products. By the time Zimmer joined First Boston, $126 billion in CMOs and other mortgage-backed securities were being sold annually. "Growth is really poised to take off," Zimmer thought.

After a few years at First Boston, Zimmer eventually ended up at Prudential Securities on the tip of Manhattan near the World Trade Center, selling increasingly exotic securities based not only on mortgages but also credit card payments and automobile loans.

As Wall Street's securities grew more complex and lucrative, so did the mathematics behind them. Zimmer would walk over to Prudential's huge "deal room." The room was filled with quantitative researchers -- "quants" -- a motley crew of math wonks, computer scientists, PhDs and electrical engineers, many of them immigrants from China, Russia and India. The quants built new mathematical models to price the securities, determining, for example, what borrowers would do if interest rates moved a certain way.

The industry, which came to be known as structured finance, grew steadily. Zimmer grew with it. He got married, raised two kids and climbed to the level of senior vice president, a top salesman at Prudential.

Zimmer's clients through the 1990s were mutual funds, pension funds and other big investors who dealt in big numbers: sometimes hundreds of millions of dollars. He'd get up at 4:30 a.m., be out of the house by 5, catch the 5:30 train from Princeton, N.J., be locked to his desk for 10 hours, devouring carbs -- pizza, lasagna -- and consumed by stress, but thinking nonetheless, "It was so much fun."

Chapter II

'Extraordinary' Boom

April 14, 2000. A rough day on Wall Street. The technology-laden Nasdaq stock index, which had more than doubled from January 1999 to March 2000, falls 356 points. Within a few days, it will have dropped by a third.

Although the business of structured finance grew during the 1990s, Internet companies drew the sexiest action on the Street. When that bubble popped, average Americans who had invested in the high-flying stocks saw their savings evaporate. Consumer and business spending began to dry up.

Then came the 2001 terrorist attacks, which brought down the twin towers, shut down the stock market for four days and plunged the economy into recession.

The government's efforts to counter the pain of that bust soon pumped air into the next bubble: housing. The Bush administration pushed two big tax cuts, and the Federal Reserve, led byAlan Greenspan, slashed interest rates to spur lending and spending.

Low rates kicked the housing market into high gear. Construction of new homes jumped 6 percent in 2002, and prices climbed. By that November, Greenspan noted the trend, telling a private meeting of Fed officials that "our extraordinary housing boom . . . financed by very large increases in mortgage debt, cannot continue indefinitely into the future," according to a transcript.

The Fed nonetheless kept to its goal of encouraging lending and in June 2003 slashed its key rate to its lowest level ever -- 1 percent -- and let it sit there for a year. "Lower interest rates will stimulate demand for anything you want to borrow -- housing included," said Fed scholar John Taylor, an economics professor at Stanford University.

The average rate on a 30-year-fixed mortgage fell to 5.8 percent in 2003, the lowest since at least the 1960s. Greenspan boasted to Congress that "the Federal Reserve's commitment to foster sustainable growth" was helping to fuel the economy, and he noted that homeownership was growing.

There was something very new about this particular housing boom. Much of it was driven by loans made to a new category of borrowers -- those with little savings, modest income or checkered credit histories. Such people did not qualify for the best interest rates; the riskiest of these borrowers were known as "subprime." With interest rates falling nationwide, most subprime loans gave borrowers a low "teaser" rate for the first two or three years, with the monthly payments ballooning after that.

Because subprime borrowers were assumed to be higher credit risks, lenders charged them higher interest rates. That meant that investors who bought securities based on pools of subprime mortgages would enjoy higher returns.

Credit-rating companies, which investors relied on to gauge the risk of default, gave many of the securities high grades. So Wall Street had no shortage of customers for subprime products, including pension funds and investors in places such as Asia and the Middle East, where wealth had blossomed over the past decade. Government-chartered mortgage companies Fannie Mae and Freddie Mac, encouraged by the Bush administration to expand homeownership, also bought more pools of subprime loans.

One member of the Fed watched the developments with increasing trepidation: Edward Gramlich, a former University of Michigan economist who had been nominated to the central bank by President Bill Clinton. Gramlich would later call subprime lending "a great national experiment" in expanding homeownership.

In 2003, Gramlich invited a Chicago housing advocate for a private lunch in his Washington office. Bruce Gottschall, a 30-year industry veteran, took the opportunity to pull out a map of Chicago, showing the Fed governor which communities had been exposed to large numbers of subprime loans. Homes were going into foreclosure. Gottschall said the Fed governor already "seemed to know some of the underlying problems."

Chapter III

'Half-Truths' and Lies

The young woman who walked into Pinnacle's Vienna office in 2004 said her boyfriend wanted to buy a house near Annapolis. He hoped to get a special kind of loan for which he didn't have to report his income, assets or employment. Mortgage broker Connelly handed the woman a pile of paperwork.

On the day of the settlement, she arrived alone. Her boyfriend was on a business trip, she said, but she had his power of attorney. Informed that for this kind of loan he would have to sign in person, she broke into tears: Her boyfriend actually had been serving a jail term.

Not a problem. Almost anyone could borrow hundreds of thousands of dollars for a house in those wild days. Connelly agreed to send the paperwork to the courthouse where the boyfriend had a hearing. As it happened, he was freed that day. Still, Connelly said, "that was one of mine that goes down in the annals of the strange."

Strange was becoming increasingly common: loans that required no documentation of a borrower's income. No proof of employment. No money down. "I was truly amazed that we were able to place these loans," Connelly said.

It was a world removed from his start in the business, in 1979, when the University of Maryland graduate joined the Springfield office of a savings and loan. For most of his 25 years in the industry, home buyers provided reams of paperwork documenting their employment, savings and income. He'd fill out the forms and send away carbon copies for approval, which could take 60 days.

Connelly was now brokering loans for Orlando-based Pinnacle or for subprime specialists such as New Century Financial that went to borrowers with poor credit history or other financial limitations. Connelly said he secured many loans for restaurant workers, including one for $500,000 for a McDonald's employee who earned about $35,000 a year.

Lenders saw subprime loans as a safe bet. Home prices were soaring. Borrowers didn't have to worry about their payments ballooning -- they could sell their homes at any time, often at a hefty profit. Jeffrey Vratanina, one of Pinnacle's co-founders, said Wall Street wanted to buy more and more of the mortgages, regardless of their risk, to pool them and then sell them to investors. "Quite candidly, it all boils down to one word: greed," he said.

In the Washington area, the housing boom coincided with a surge in the immigrant population, especially Latinos in places such as Prince William County. For many of them, subprime and other unconventional loans were the only way to attain the American dream of owning a home. Pinnacle's customers included construction workers, house cleaners and World Bankemployees, who "saw an opportunity to get into a house without putting much money on the table -- to save money to buy furniture to decorate the house," said Mariano Claudio, who in his late 20s was helping run Pinnacle's emerging-markets division, which was dedicated to immigrants.

Pinnacle ran ads on Spanish-language television and radio, set up booths at festivals and sponsored soccer matches at George Mason University. Brokers would hold raffles for gift cards or digital music players to collect names, addresses and phone numbers. It was "a great way to assemble a database of potential clients," Connelly said.

He said his commission and fees depended on how much work he did on the loan, a common industry practice that often led to higher charges for subprime borrowers. Connelly said he carefully reviewed fees with his customers. "The way it's justified morally and ethically is [that] the deal requires more work for a first-time home buyer or one with inferior financial history," Connelly said. "It's a balancing act of morals and ethics -- and the need to make a living."

Some brokers ignored the balance. Connelly began to hear about loan officers who charged low-income borrowers fees of as much as 5 percent of the loan or got a kickback by tacking extra percentage points to the interest rate on a mortgage. "Many borrowers are overwhelmed by the sheer volume of paperwork, disclosures, etc., and they're just not equipped to fully understand," he said. "There were half-truths and downright lies and severe omissions."

A mortgage lender could hire practically anybody. "It's not rocket science," Connelly would tell new hires, such as the busboy who quickly traded in his Toyota Tercel (value: $1,000) for aMazda Miata sports car (value: $25,000). Pinnacle was running out of office space, forcing some loan officers to work on window ledges or out of their cars.

Then came the party at the Mayflower at the end of 2005, a celebration hosted by the emerging-markets division. In June 2003, the division had originated $500,000 in loans. By the end of 2005, it was doing $500 million with hundreds of brokers across the country.

"It built to a head," Connelly said of the times. "You could point to the Christmas party as the pinnacle."

Chapter IV

Warning Sign

Jan. 31, 2006. Greenspan, widely celebrated for steering the economy through multiple shocks for more than 18 years, steps down from his post as Fed chairman.

Greenspan puzzled over one piece of data a Fed employee showed him in his final weeks. A trade publication reported that subprime mortgages had ballooned to 20 percent of all loans, triple the level of a few years earlier.

"I looked at the numbers . . . and said, 'Where did they get these numbers from?' " Greenspan recalled in a recent interview. He was skeptical that such loans had grown in a short period "to such gargantuan proportions."

Greenspan said he did not recall whether he mentioned the dramatic growth in subprime loans to his successor, Ben S. Bernanke.

Bernanke, a reserved Princeton University economist unaccustomed to the national spotlight, came in to the job wanting to reduce the role of the Fed chairman as an outsized personality the way Greenspan had been. Two weeks into the job, Bernanke testified before Congress that it was a "positive" that the nation's homeownership rate had reached nearly 70 percent, in part because of subprime loans.

"If the housing market does slow down," Bernanke said, "we'll want to see how strong the subprime mortgage market is and whether or not we'll see any problems in that market."

Staff writers David Cho and Neil Irwin and staff researchers Richard Drezen and Rena Kirsch contributed to this report.



PART 2
The Bubble
How homeowners' missed mortgage payments set off widespread problems and woke up the Fed.
By Zachary A. Goldfarb and Alec Klein
The Washington Post
Monday, June 16, 2008; A01

The mortgage executives who gathered in a blond-wood conference room in Southern California studied their internal reports with growing alarm.

More and more borrowers were falling behind on their monthly payments almost as soon as they moved into their new homes, indicating that some of them never really had the money to begin with. "Nobody had models for that," said David E. Zimmer, then one of the executives at People's Choice, a subprime lender based in Irvine. "Nobody had predicted people going into default in their first three mortgage payments."

The housing boom had powered the U.S. economy for five years. Now, in early 2006, signs of weakness within the subprime industry were harder to ignore. People with less-than-stellar credit who had bought homes with adjustable-rate mortgages saw sharp spikes in their monthly payments as their low initial teaser rates expired. As a result, more lost their homes; data showed that 70 percent more people faced foreclosure in 2005 than the year before. Housing developers who had raced to build with subprime borrowers in mind now had fewer takers, leaving tens of thousands of homes unsold.

People's Choice was feeling the slowdown, too. It had been generating about $500 million in loans each month, but profit fell by half in the first quarter of 2006, according to documents filed for an initial public offering that was later abandoned.

Zimmer saw the mounting problems as head of the department that worked with Wall Street to package mortgage loans into securities to be sold to investors. Such securities had fueled the housing boom by pumping trillions of dollars into the mortgage market.

Two decades earlier, Zimmer had been among the young salesmen pitching early versions of mortgage-backed securities. He had stayed in the field, becoming a top salesman at Prudential Securities before moving on to help run a big investment fund that specialized in those exotic products.

Now he was trying to make sure People's Choice could continue to raise money by pooling subprime loans. Zimmer and some other executives urged the company to tighten its lending standards. That could lower the rate of defaults. And the better the quality of the loans, the more investors would want them, he figured.

But "there was always push back" from sales executives when he advocated more conservative lending, Zimmer said. Like most big lenders, well over half of the loans made by People's Choice came not from its own employees but from independent mortgage brokers. If the company stopped taking the brokers' riskier loans, the brokers might take both those and their higher-quality loans elsewhere. What's more, People's Choice's own loan sales force -- at about 1,000 employees, the bulk of the company -- worked largely on commissions from loans they made.

"There were times when voices would get raised," Zimmer said. A colleague would pound the table, asking: Why don't you see this?"I was not," he said, "a popular person."

As his team analyzed the individual loan files, Zimmer said he was struck by evidence of fraud, such as doctored bank statements. "Fraudulent loans were a big part of the subprime mess," he said. Mortgage brokers forged borrowers' signatures and pumped up their income, he said. People seeking to buy and sell a home for a quick profit lied that they were going to live in the home -- qualifying for a lower interest rate. But People's Choice calculated that it would have been too complicated and expensive to go after fraud, Zimmer said.

Even as People's Choice sought to preserve its business, the housing climate continued to deteriorate. Many borrowers were defaulting so quickly that the company did not have time to pool those mortgages and sell them off as securities.

C hapter VI What Else Is at Risk?
Feb. 7, 2007 . A few hours separate startling announcements. HSBC, a 142-year-old London-based bank that was one of the largest subprime lenders, says it must set aside $10.6 bi llion to cover expected losses. Then another industry giant, New Century Financial, says it will have to redo almost a year of accounting to reflect the depth of its losses.

In subsequent weeks, the stock values of many subprime lenders plunged, and others filed for bankruptcy protection. Construction of new homes hit its lowest point in nearly a decade. On Feb. 27, the Dow Jones industrial average fell 416.02 points, the seventh-largest point loss ever.

At the Federal Reserve, officials remained unruffled. They privately calculated that even if subprime losses were severe, the dollars involved would be no more than a blip in the overall economy. As late as June, Fed Chairman Ben S. Bernanke spoke via satellite to a conference of international economic officials in South Africa, predicting, "the troubles in the subprime sector seem unlikely to seriously spill over to the broader economy or the financial system."

But in financial circles, word circulated about trouble inside one big New York investment bank. Bear Stearns had two hedge funds that invested heavily in securities backed by subprime mortgages. Hedge funds, which handle the money of wealthy investors, are lightly regulated and don't have to report much about their operations to investors. So it was a surprise to Wall Street when the funds appeared on the brink of collapse, forcing Bear Stearns to lend one of them billions of dollars to keep it afloat.

The question in many boardrooms became: What else is at risk?

Chapter VII 'This is a Tidal Wave'
Debate among People's Choice executives gave way to questions about the subprime lender's own survival. The investment banks that had bought subprime mortgages to pool them were now demanding that lenders like People's Choice take back the mortgage loans that had gone into default, arguing that misrepresentations had been made about the borrowers. And lenders had to take them; they couldn't risk further damaging their relationship with the banks.

"Now the whole industry is starting to choke on the volume of loans put back to them," Zimmer said.

People's Choice turned around and tried to sell off the bad loans but took "a huge hit," he said. The company had been scrambling to further tighten its lending standards, getting rid of mortgages with no down payment and requiring borrowers to have stronger credit histories. But "by then, it was too late," Zimmer said. "This is a tidal wave."

Finally, banks that had been lending cash to keep People's Choice in business cut off the company. "When that happens, you're done," Zimmer said. "It's the kiss of death."

People's Choice filed for bankruptcy protection in March 2007. By June, Zimmer was laid off.

In Northern Virginia, things were also unraveling. Kevin Connelly, a mortgage broker at Pinnacle Financial's Vienna office, fielded calls from desperate homeowners. Some had been counting on disappearing sources of income -- family, renters -- to pay for mortgages. Many had been employed in the home-building industry, which was shedding workers in droves. Still others owed more on their mortgage than the home was now worth.

"There was a gross underestimation of the true cost of homeownership," Connelly said.

For most of these callers, he had nothing to offer. "What happened was the values had dropped, the credit scores had dropped, and the loan programs had gone away," Connelly said. "I would hang up the phone and be frustrated that I didn't have a solution."

Connelly's colleagues were fleeing even faster than they'd come on board in the boom years. At staff meetings, the gallows humor -- only half funny -- was, "We're having a sales contest, and the winner gets to keep his job," Connelly said.

By last summer, the atmosphere was motionless in his office. Each morning, Connelly visited a Web site called "the Mortgage Lender Implode-O-Meter," which chronicled lenders that were going under. His day "went from talking to 10 people and doing eight transactions to talking to 10 people and doing one transaction," he recalled.

By summer's end, he said, "I was working alone in that office."

Chapter VIII Secret War Room
July 19, 2007 . Fed Chairman Bernanke tells Congress: "Rising delinquencies and foreclosures are creating personal, economic, and social distress for many homeowners and communities -- problems that likely will get worse before they get better."

Bernanke and others at the Fed still did not see how severely the troubles would cascade through the economy.

The chairman did warn Congress of "significant financial losses" in the subprime industry, saying there were "implications of this for financial markets." He was right. Within days, Countrywide Financial, the nation's largest mortgage lender, announced that its profit had fallen by a third as more homeowners defaulted. The Bear Stearns hedge funds that had invested heavily in the subprime market went under. The largest bank in France, BNP Paribas, suspended three funds that held mortgage-backed securities.

Then the credit raters -- Moody's, Standard & Poor's and Fitch, which over time had become high priestesses of the global capital markets -- astonished investors by abruptly downgrading many subprime-backed securities that they had previously blessed. The rating companies, which assign letter grades to all kinds of debt issued by companies, municipalities and countries, came under criticism from investors who questioned whether they had issued rosy assessments because they had been paid by the banks whose securities they rated. The credit raters responded that they have procedures in place to prevent conflicts of interest.

Banks and investors also questioned whether there were hidden weaknesses in the broader market for mortgage-backed securities and other complex investments, such as collateralized debt obligations, or CDOs, which combined various kinds of debt.

As a result, banks, anticipating their own losses, began to hoard cash and refused to lend. The fallout: A major part of the machinery of U.S. capitalism -- the $28 trillion credit market that ensures big companies can pay their employees and buy equipment by taking out loans -- nearly shut down. In August, the credit crunch sent the stock market into its most volatile period since the Enron days.

The Fed pumped money directly into the markets, loaning to banks and accepting as collateral the mortgage-backed securities that few investors wanted anymore.

At the Treasury Department, Robert Steel, undersecretary for domestic finance, called Wall Street executives, housing agencies and the Fed for counsel but particularly sought out two men who had shown keen insight before the collapse.

One was Edward Gramlich, who had been warning for years that subprime borrowers were vulnerable to overextending themselves. He had since retired from the Fed and had just published a book, "Subprime Mortgages: America's Latest Boom and Bust." Gramlich told Steel that borrowers went beyond their means and that lenders encouraged it -- and now homeowners needed counselors to avert foreclosures.

Steel also telephoned Lewis Ranieri, a pioneer in mortgage-backed securities. Ranieri told the Treasury official that many of the securities were actually in good shape but banks couldn't unload them because of the perception that they had no value.

Fed officials, in a state of growing alarm by late August, maintained an outward calm at their annual symposium at Jackson Hole, Wyo. But secretly, Bernanke and other top Fed officials met several times a day in a makeshift war room where they had installed secure telephone lines.

Bernanke, a former Princeton University professor, employed the Socratic style, going around the table, asking his Fed team how the central bank should respond to the crisis, according to some of those present. How aggressive should the Fed be in using its influence on interest rates -- a broad sword that affects the entire economy? What risk did the credit problems pose to average Americans?

After one long discussion, the Fed officials went downstairs to the public conference, where one economist, John Taylor of Stanford University, was criticizing the Alan Greenspan regime for having kept interest rates so low for too long.

Gramlich, too sick to attend the conference after being diagnosed with leukemia, had his speech read by a colleague: "The subprime market, for all its warts, is a promising development, permitting low-income and minority borrowers to participate in credit markets." But, he added, "a majority of loans are made with very little supervision."

In the coming weeks, the Fed began aggressively cutting interest rates to encourage banks to lend. In October, the Bush administration announced a Gramlich-style idea, Hope Now, an alliance of counselors, lenders and other industry participants who would work to help borrowers avoid foreclosure by renegotiating mortgage terms. But it was clear that the trouble was not over when some of the nation's biggest banks began reporting unexpectedly large losses: Morgan Stanley, $3.7 billion. Merrill Lynch, $8.5 billion. Citigroup, $11 billion.

In his final weeks, Gramlich followed the unfolding financial crisis from his home near Dupont Circle, sitting in a white easy chair at a window overlooking Connecticut Avenue. He was resigned to the fact that he couldn't play a larger role. Five days after his speech was read in Jackson Hole, he died.

Staff writers David Cho and Neil Irwin and staff researchers Richard Drezen and Rena Kirsch contributed to this report.