Confidence Men Part 3

"Thanks, d.i.c.k," Carmine said, taking it as a kind of congratulations.

There was more truth in Fuld's remark than the future CEO himself probably even realized. Certain differences between Carmine and his fellow managing partners would emerge only later. For one, Carmine couldn't embrace the idea that he was worth what he was getting paid. Looking over a bonus check in 1993 with his wife, Kathleen, he wondered aloud, "What more do we need?"

Like everyone in New York, he pa.s.sed his share of homeless people on the street. Their ranks had grown over the years, he noticed. New York had become a city of startling disparities. If you really believed that compensation was a dollar vote on your intrinsic and indisputable value, you might have looked past them. After all, there must be some reason they were on the street and you were wearing a Zegna suit.

But Carmine couldn't manage it, couldn't in good faith agree with the market's decisions about how vastly different some lives were valued compared with others. So he and Kathleen rented a U-Haul truck, drove it to one of those giant supermarkets in suburban New Jersey, and loaded it up with food. Then they began driving the streets of New York pa.s.sing out food to the hungry. Night after night, year after year, Carmine drove the streets in his trucks-first a van, then a panel truck, then a big one, with a cab and a trailer. At times he would stick around for a bit, after handing out the food.

"I like to watch them eat," he said to Kathleen one night. "That's my weakness, I guess. I need to touch something that's real, and there's nothing as real as hungry people having something to eat."

With a night-school degree from Pace University, Carmine made partner through a tireless career-long search for value-for something he could touch and convince others to invest in, something, or someone, that could pa.s.s his father's brutal crucible.

That was how he met Sonny. Sonny was Carmine's best client, one of Lehman's best, and for a time the largest converter of rental apartments into condominiums in the country. Sonny's story was cla.s.sically American in its basic lesson about success: anyone can achieve it. Coming to the United States from Israel at eighteen, with no education beyond high school and no money to speak of, Sonny proceeded to give Horatio Alger a run for his money. For years Carmine told Sonny's story-a kind of nutritiously humbling fare-to younger colleagues, who he felt tended to draw untested self-confidence from their bonuses and prestigious degrees.

Sonny, on other hand, was a guy even Carmine's father would have loved. He and his brother started out leasing an apartment together in LA, driving cabs to make rent. It was the 1970s, and the concept of apartments "going condo" was just taking hold. Pooling cab fares, Sonny and his brother eventually took out a loan to buy their first condo-a single unit. They worked out the math of the transaction, bought another condo, and flipped it. In time they had moved on to purchasing a small building. In this way they gradually built up their a.s.sets. Then they had an idea: a plan to convert apartments in cities that hadn't yet caught the condo fever.

Their stratagem was ingenious. The brothers would go to a town such as Milwaukee, look at rental prices, and, from these, calculate how much a mortgage might cost. Then they would set an imaginary price-"Two-Bedroom Condos Starting at $195,000"-which is exactly what a quarter-page ad in the Milwaukee Journal would say the next day. The local number listed in the ad would go to an answering machine in some hotel room they'd booked for a few weeks. Sonny and his brother would be long gone, back to LA, and a local Wisconsinite they'd hired would check the machine after a week or two. If there were five messages, that was the end of it; seventy messages, however, meant they'd head back to Milwaukee looking for an apartment building to buy. This was how, city by city, Sonny spread across the country.

He had a rule that Carmine liked to quote: "Buy low. Sell low-and a little." It meant don't get greedy. You don't want to hold on to inventory; you want to move it. No one, after all, can predict the future.

By 2004, Carmine estimates, Sonny was worth a billion dollars. Carmine himself, at that point, was managing Lehman's $50 billion real estate portfolio. The portfolio had been built up over years and was not part of the more recent mortgage derivative free-for-all. No, these were properties Lehman owned or financed for select investors. There tended to be an owner of record, so to speak, that was either the bank or one of its customers.

As New York real estate had been steadily appreciating, Sonny had been buying it-until suddenly he wasn't. Carmine talked it over with his old pal, noting that the price for residential properties, $110 per square foot, still had some upside and might go as high as $140. Sonny agreed with him but said he'd had enough of all that. He told Carmine that he'd "done fine in New York and it was foolish to stay until the bitter end, looking for the very tiptop and then trying to get out before everyone else."

Carmine had always thought of Sonny as a brother, but as they rose together, a key distinction between their work lives emerged. Carmine, who had treated Sonny's money as though it were his own, was now investing huge sums for people he could only know so well-and many not at all.

"He pulled out, plain and simple, because it was his money," Carmine would later say. It meant the lenses through which Sonny and Carmine saw risk were wholly distinct. The two of them looked at the same numbers and saw them differently. Such was the power of incentive and-with one's own money on the line-disincentive. These divergent perspectives were by no means unique to Sonny and Carmine, but in this case the latter's up-the-hard-way sensibility could help him grasp the wisdom bound up in Sonny's viewpoint, and he was big enough to thank his friend for a lesson learned.

At this same moment in 2004, a nearly identical conversation was taking place inside the New York Federal Reserve, with Tim Geithner, its youthful chairman, at the head of the table. In October 2003, at the age of forty-two, Geithner was placed at the helm of the most powerful of the inst.i.tution's twelve branches, insofar as it oversees a collection of the most powerful financial inst.i.tutions in the world. The chairman traditionally convenes an advisory board made up of representatives from big financial firms and top thinkers in various relevant fields. For the past fourteen years, an anchor of the board was Robert Shiller, one of the era's standout economists and someone in line, many would agree, for a n.o.bel Prize. If Stockholm gives Shiller the nod, it would almost certainly be for his pioneering work in behavioral economics, which helped the economist craft several books articulating how the succession of ever-growing bubbles, since the 1980s, would end disastrously. But Shiller was also a key developer of one of the practical tools most widely used by investors: the Case-Shiller Index. Aside from having made Shiller wealthy enough to do without the Swedish prize money, Case-Shiller charts and projects changes in real estate values.

At his first advisory board meeting with Geithner presiding, in 2004, Shiller described his data suggesting that home values, after having risen steadily for nearly three decades, were inflated by 30 to 50 percent. He focused specific attention on data he and his staff had unearthed showing how, over the past century, rents had tracked with mortgage payments in determining sale prices. In the early 1980s, as home values began their precipitous rise, these two lines began to diverge. Shiller, a densely educated Yale professor, and Sonny, the high-school-educated Israeli emigre, turned out to be brethren in teasing out and trusting a commonsense measure, the cost of shelter, to use as a yardstick to a.s.sess what was real, or unreal, in the buying and selling of property.

Around the table, the representatives from big financial inst.i.tutions, and many academics who'd grown wealthy advising those inst.i.tutions, looked on skeptically, figuring they had the mortgage planet properly mapped and a.s.sessed. Yes, it was true that by 2004 the FBI had issued a warning on the rampant fraud in mortgage underwriting. AIG was already telling Goldman-which had many of its former, and future, employees working at the Fed-that it was not going to underwrite any more credit default swaps, the soon-to-be-famous "insurance without reserves" that Wall Street firms and banks were selling to one another. Goldman figured that would be fine. AIG was already on the hook for billions if the mortgage-backed securities went bad. Goldman would just get other clients to write the CDSs, and it had already started hedging and swapping against the CDOs it was packaging and advertising as "safe as cash" to the investing public.

Shiller was saying to one and all that the entire financial edifice, and the U.S. mortgage market, the bedrock of the country's economic safety and soundness, was resting on the mother of all bubbles. Sonny, had he been present, would have agreed.

Shiller recently recalled the meeting, how he "talked about the bubble and housing prices," something the professor talked about at all the meetings. But, after a few minutes that day, running through his thoughts, data, and expertise on the matter of real estate, "I had this feeling, the same feeling anyone has when they are kind of violating groupthink. Here I am, talking about the bubble in the advisory committee and after a few minutes starting to feel uncomfortable about it. I'm thinking, maybe I'm sounding flaky. 'Bubble' was not even in the textbooks then. There is a certain image we project of scientific objectivity in the economics profession and 'bubble' sounded like a newspaper term." Bubble, incidentally, is now a term economists use. And Shiller can hardly be faulted for wondering if the problem was what he was saying, or how he was saying it.

Geithner ignored Shiller's warning and summarily removed him from the board.

To be fair, Carmine did not dramatically change course after his 2004 conversation with Sonny, either. He had a business to run, and it was a matter of incentives. His were different from Sonny's.

For his part, Sonny stuck by the inner rigors that had brought him such success. He called Carmine in 2006 to tell his friend, "I'm done. I'm out. I have no more inventory."

Carmine was startled. "How's that possible?" he asked.

Sonny explained to him that all the buildings he had bought in the past few years had been converted into condos and that he had just returned from his thirtieth apartment building auction in the past six months.

"I got outbid thirty times in a row," Sonny said. "I'm not going to pay whatever it takes to buy a building. Based on the rents in an area, I know what a building is worth. I know this business, and it's stupid to pay more than something's worth, even if you know there's a greater fool who will buy it from you."

So Sonny took his ball, his billion dollars, and went home. Carmine had lost his biggest client, though he continued to consider what he called "Sonny's rules." By early 2007 he was seeing more and more clearly that they were rules to live by.

It was around this time that Carmine found himself on the sh.o.r.eline when the real estate hurricane hit. In this case, it was the south Florida coast, where Lehman and its investors owned condominiums built during the construction boom of the past decade.

People had suddenly stopped showing up at their closings. Carmine noticed this, but it took him a few days to realize the full implications. Say someone, in March, signed a purchase and sale agreement for $900,000 for a South Beach condo, putting down 10 percent of the total price-in this case $90,000. When the closing date arrived in May, just sixty days later, and the lawyers and t.i.tle company convened to complete the deal, the buyer simply wouldn't show. The reason was that the price of the condo had dropped so fast in the meantime that it now made more financial sense to lose the $90,000 than to own the d.a.m.n thing. By the summer of 2007 more than half of the buyers in soft parts of the Florida market were no-shows at their closings.

By the end of the year, Carmine was in round-the-clock discussions with the owner-investors of these complexes. Several suggested cutting prices. If values were dropping that fast, they should try to lure buyers to their closings by lowering the sale price on the condos. The problem was that prices were dropping so fast that, as Carmine said, "It would cause riots in the buildings. Someone would say, 'I paid $900,000 two months ago for a unit that just got its price cut to $600,000. I'm gonna stop paying my mortgage. I'm gonna sue the developer.' "

Carmine sent along updates to his fellow managing directors and held the line. The other directors might have been shrewder in their methods of packaging and selling off debt, but it was not clear that they understood the dramatic fashion in which the mortgage values behind their CDOs were collapsing. They were relying on the safety of their tranches-the name for the way mortgages were bundled based on various flavors of perceived risk-and the credit default swaps the directors believed had insulated them from defaults. Carmine's office, just down the hall, was a wormhole into an older world, one in which investment banks could a.s.sess their real estate holdings, if they ever cared to, by actually visiting the physical buildings.

In his grounded, intensely terrestrial life, Carmine was privy to other portents, too. The economy officially slipped into recession in December 2007. The following spring, Secretary Paulson would tell anyone listening that economic growth for the coming quarters looked steady, if not strong. But by today, in the late spring of 2008, Carmine noticed that there were more hungry people on the streets of New York than he had seen in many years-maybe ever. He had upped the number of runs with his truck.

Some people are graced with a more complete view of the complex world. It's usually by happenstance; they cross invisible borders. Carmine, in his twisting path, was regularly visiting several disparate provinces in the wider country: on the Gold Coast of Florida, where those glittering condos stood empty along the endless beach; in his old Brooklyn neighborhood, where immigrants from Africa, South America, and the Caribbean were now trying to find footholds on the ever-slipperier sh.o.r.es of the American dream, by buying properties from his old Italian neighbors with "liar loans," meaning no doc.u.mentation needed; on the streets of New York City, where the homeless and hungry, leading indicators of the recession, lined up at his truck; and, of course, the sight from his twelfth-floor Lehman office, with its view across Midtown Manhattan, from lofty tower to lofty tower, high above the hard pavement.

What Carmine and Sonny and Bob Shiller all saw was the outcome of a thirty-year effort to find new ways to increase leverage without a.s.suming heightened risk, a process rather breathlessly called "financial innovation."

The experiment started in the late 1970s at Salomon Brothers, where Wolf and many other Wall Street t.i.tans had gotten their start. Salomon at the time was a bit like Florence in the early days of the Renaissance: they saw the world differently and then helped to make it so. The name of the Italian genius in this case was Lewis Ranieri, a rough-and-tumble trader at the mortgage bond desk, who saw debt, suddenly, with new eyes.

Governments and corporations had long been raising money by selling bonds, tradable on open, active markets. This had been going on and growing in sophistication for centuries. In the thirteenth century, governments first started floating bonds to raise money for wars. In the sixteenth century, in Italy, corporate bonds followed closely on the heels of the modern corporation. But as the successes of twentieth-century market economies brought with them higher standards of living and greatly expanded ownership, a third, vast new ocean of debt emerged: mortgages.

By the late 1970s, home mortgages in the United States totaled in the trillions of dollars, kicking off an explosive growth in interest payments. These payments flowed mostly into traditional commercial banks, savings and loans, and credit unions, inst.i.tutions that since the Depression had been federally insured under the Gla.s.s-Steagall Act, which also kept them legally separate from investment houses and brokerages. In return for this security, these inst.i.tutions accepted strict limits on how they could invest their a.s.sets. Their basic function was to a.s.sess creditworthiness and lend out money accordingly. Mortgages were thus one of the pillars of their business model. The so-called 3-6-3 rule governed a banker's work life: pay depositors 3 percent interest (short-term liability), lend their money out at 6 percent, and be on the golf course by 3:00 p.m. Banking was boring, prudent, and reliable, and because of this it could serve as a st.u.r.dy backbone for the U.S. economy.

But investors were less enthusiastic about the arrangement. If they hoped to invest in mortgages, they could do so only secondhand, by investing in the thousands of sleepy inst.i.tutions that held all those American mortgages on their books. The genius of Ranieri and his colleagues-and a future Wall Street leader named Larry Fink, then at First Boston-was in developing a new way to invest in this untapped pool of mortgage debt. By breaking home mortgages down into different categories, based on characteristics such as loan terms (30-year fixed, 15-year adjustable, etc.) and borrowers' credit scores, they found they could a.s.sess the risk of default and the chance of a loan being repaid early. Once the risk was established, it could be priced into a security, and so the mortgage-backed security was born.

Even if someone had come up with the idea in, say, the early 1960s, it would have been impossible to implement any earlier than it was. As much as Ranieri's insight, it was the great leap forward in computing power, those famous supercomputers of the seventies, that made the MBS possible by allowing financial firms to aggregate and process the huge amounts of data that went into pricing risk. If the "profiling equations" that established a security's riskiness could be made sound, the prize was tremendous: a smorgasbord of investment opportunities, of virtually any risk profile of debt (and corresponding return), for every investor's taste. Ranieri believed that the market efficiencies gained through this process, of bringing together new communities of debt buyers and sellers, could reduce mortgage rates by as much as 2 percent. And the same securitization model could be easily extended to monthly payments made on cars, credit cards, insurance policies-on anything, really. Credit would be extended to an undiscovered country of borrowers, and the underwriters of the original loans would not even have to hold the debt on their books. They could sell it to the vast new world of creditors, and thereby free up more cash to lend. If this new lend-and-send idea caught on, it would make the stock market look small by comparison.

By 2008 it had. Those old-line activities of the financial industry-the challenging work of, say, identifying underappreciated value in public companies, made famous in the 1980s by value investors such as Warren Buffett and Fidelity's Peter Lynch-were by that point overwhelmed four to one by the new line of debt investments in "securities" backed by contractually mandated payments of all sorts of debt "a.s.sets": mortgages, credit cards, and car loans.

This shift, of course, didn't occur in a vacuum. In the early 1980s, just as the rating agencies first began to stamp mortgage-backed securities as sound investments, the wider economy began tipping away from its mid-twentieth-century equilibrium, and the demand for debt inside the United States steadily rose.

It was a perfect storm of trends: global outsourcing of jobs, with profits flowing back to senior managers, stockholders, and investors; increasing automation in the workplace; full-time jobs increasingly becoming temporary or contract labor; the steady decline of unions and resulting wage and benefit concessions; and the 1990s arrival of the Internet and software advances, allowing the fewer remaining workers to be that much more productive. All this created overall economic growth. The U.S. GDP, at roughly $14 trillion in 2007, was twice as large as it was in 1980. But that wealth flowed dramatically to the top, as real median wages stayed flat for nearly three decades. In 1980 the richest 1 percent of Americans received about 9 percent of overall income, roughly the same level it had been since World War II. By 2007 it was 23 percent-an income disparity not seen in the United States since 1928, a time of Robber Baron wealth, stock manipulation schemes, and vast poverty, where more than half of America still lived on farms and survived, with little security, off the land.

But now, in the new century, there was a financial relationship between the widening strata of American life. Despite Shakespeare's catchphrase "neither a borrower, nor a lender be," the vast majority of Americans who'd seen their incomes flatten were loaded up on cheap debt to fill the gap between earnings and rising expenses and to fuel consumptive desires. Rich folks were borrowing, too. The lenders were, in essence, those who'd caught the decades-long updrafts of the economy and had built up large investment portfolios, now heavily-and disastrously-invested in the miracle of debt securities, creating an enormous bubble.

Most bubbles, historically speaking, last between only a few months and a few years. When they pop, those caught within them feel the bite and amend their ways, regrounding themselves in a hard-eyed clarity on how to apply their limited means on items of greatest discernible value. Burning off wild-eyed overconfidence, or making one resistant to its purveyors, is the whole point of such retrenchment. It acts as a counterweight to what behavioral economists, such as Daniel Kahneman, have mathematically mapped since the early 1970s: a host of subtle human biases that make the upside look more likely than a downside of equal or even greater probability. While confidence has outdistanced pessimism over the past several centuries, accounting for an embrace of risk as an engine of human progress, the corrections are crucial.

But they are inconvenient, and hard to predict. That's where Greenspan, understanding this, established his greatest historical influence. He helped to ensure that, in each crisis, the rollover of debts-the "liquidity bridge" Wolf wrote of-would be supported by the federal government: a flood of liquidity that altered the ancient, commonsense physics between price and value, confidence and pessimism. The retrenchments, with all their cleansing effects, never really occurred. And the debt bubble, shifting its focus as needed, continued to grow. The practical effect of this by 2000 was a continued rise in borrowing, and corresponding debt, at the same time that the lowered Fed rates reduced the return on fixed-income investments, such as government bonds. It was, to reverse Churchill, the beginning of the end.

The era's victors-that 1 percent of the population hauling in 23 percent of overall income, and their kindred in other countries-had by 2001 started to hit a wall of their own. After the bursting of the Internet bubble, it was clear the stock market was an unattractive destination. Stocks were flat. Capital, lots of it, was suddenly very impatient. The great pools of money-investment funds, pension funds, government funds, corporate funds, amounting to $38 trillion of the world's acquired wealth by 2001-were searching for a safe, fixed-income yield. As Greenspan cut rates, and stressed that he planned to cut them further to continue to fuel America's debt-driven consumption-at that point accounting for 70 percent of GDP-that great river of money flowed more forcefully than ever into the U.S. market fueling that debt. American debt, in terms of MBSs and other mortgage-related derivatives, had become the preferred investment opportunity of the entire world.

The underlying truth was that these securities were less secure than their name or profiling equations suggested-far less secure, in fact. The idea that all mortgages couldn't drop at once was simply wrong. And many of the banks suspected it, even if, year by year, they weren't sure what to do about it. Clayton Capital, hired in 2004 by a host of large investment banks, noted that nearly 40 percent of all mortgages had significant underwriting "irregularities." The fundamental and ancient relationships that underlie credit, going back to pa.s.sages in Deuteronomy-that borrower and lender enter a relationship that carries obligations on both ends-were severed by the firms originating mortgages, taking front-end profit, and selling the mortgages off into investment pools, defined mostly by their yield, that were then sold far and wide by the great marketing and influencing machines of Wall Street. Prudence, even common sense, had been bled out of the equation.

But that's what always happens when everyone is focused on what something can be sold for while ignoring the many other factors that define worth. It just had never happened on such a sweeping scale.

America, with its huge economy, found itself in the later stages of a vast pyramid scheme. By late 2006 it was clear that the U.S. mortgage market, as large as it was, could not absorb another drop of capital. The sluggishness of productivity gains and real economic growth in the United States had finally caught up with the eternal dream of home buying. Even with the government's public-private mortgage banks, Fannie Mae and Freddie Mac, guaranteeing roughly 80 percent of all mortgages, and for years encouraging the extension of debt to unsteady borrowers as part of a national bipartisan push to spread the "virtues" of home ownership, the mortgage market could not grow any further. Wall Street's remedy to this, since the saturation's start in 2004, was to create "synthetics," products that allowed investors to make naked bets without any tangible connection to the underlying a.s.set. A thousand bettors could wager with one another on the fortunes of a single mortgage. Investors could buy CDOs that were simply bets on the fortunes of other CDOs. Then they began to use credit default swaps-something created, without guaranteed reserves, to lower the price (and risk) of sleepy corporate bonds in the 1990s-as faux insurance for CDOs. Of course, there was nothing sleepy about a CDO, with its towers of descending risk profiles and equations of how each level was expected to respond to shifting economic forces. Nothing sleepy about a synthetic CDO, based on bets over how those equations would perform. This new strain of CDS was more like a collateral standoff between so-called counterparties, a bit like those casinos that allow bettors to sign their houses over as collateral in exchange for more chips. The more collateral-and CDSs often used CDOs as their collateral-the more leverage was permissible as an added illusion of a "we're in this together" security. All that made the debt flow even more freely.

All this business created enormous fees. It was very profitable for investment banks and rating agencies. And virtually all of it happened in the shadows-a vast dark pool for financial derivatives that had virtually no transparent clarity for either buyer or seller. The middlemen, the investment banks, knew what they were dealing with.

But like it or not, they all still lived inside the wider U.S. economy, which had not been inventing and investing, saving and hustling, in its storied, robustly profitable way for many years. Those things are hard, and ever harder in the new global economy. They take time and grit and, sometimes, luck. And they actually fit with the ancient and immutable physics of investing: high risk, high reward; low risk, low reward. The country's native engines of innovation had been obsessed instead with a shortcut: the repackaging and expansion of credit into a vote of confidence in a better tomorrow. "Debt," a word broken down morphologically into underlying terms such as "denial" and "hope," had become potent currency in the world of politics, just as in its financial counterpart.

Civilizations rise and fall on confidence. America had figured out a way to borrow money to manufacture it.

4.

Inside the Bubble.

With his nomination secure by early June, Barack Obama-now the putative leader of the Democratic Party-was faced with the most important decision since the declaration of his candidacy: choosing a running mate.

The guiding principle for the selection of a "number two" has long been a hard-eyed a.s.sessment of need-finding a person who will fill some perceived deficits in the politician topping the ticket. Geography, of course, usually carries the day. The denizen of a part of the country that looks with suspicion on the nominee: He's not from here, he's not one of us, but he's chosen someone who is. It was decided, not surprisingly, that Obama's greatest vulnerability was his lack of experience, especially in facing John McCain, who'd spent three decades on the national political stage. Obama, until so recently a midwestern state legislator, needed a partner who could claim long affinity with a part of America that was still largely foreign to him: the tiny nation-state of Washington, D.C.

To head up the search committee, Obama announced on June 4 that he had turned to someone who had long, intimate relations with Washington's most experienced players: Jim Johnson, the former head of Fannie Mae.

Johnson's gravity and profile were testimony to a host of hard truths-ones not found in high school civics texts-about the way the nation's capital has actually operated, at least for the past few decades.

Back in 1977, Johnson was executive a.s.sistant to Vice President Walter Mondale and went on to be Mondale's campaign chairman in his failed run against Reagan in 1984. Reagan's landslide was fueled in no small measure by the enthusiastic support he received from American business. Johnson-having to raise money for Mondale against Reagan's overwhelming advantage-acutely felt the change Reagan had brought to Washington: an official end to the adversarial relationship between government and business engendered by FDR during the Depression. That stance-of government acting as the no-nonsense traffic cop, enforcing the "rules of the road" for the great pursuit of economic advancement and profit-had been slowly buckling since 1971. That year, Richard Nixon imposed a 10 percent tariff on all imported goods as a response to the way economics had increasingly become a kind of "war by other means," as Clausewitz would put it, in the burgeoning, increasingly borderless global economy. It was a war that every American soon felt buffeted by with the oil embargo, gas rationing, and resultant "stagflation" of the 1970s, as Ford and then, more dramatically, Carter, increasingly saw government's role as nourishing the profits and protecting the franchise of America's signature industries. It wasn't until Reagan, though, that the laws guiding the conduct of business were themselves seen as the problem, and that government needed to "get out of the way," in Reagan's parlance, in every way possible, to unleash America's native, "can-do" spirit. Profits and patriotism were starting to become gently enmeshed.

Jim Johnson followed Mondale's crushing defeat with a trip north, to a managing director's post at Lehman Brothers. In 1991, suffused with exciting insights about risk management from Wall Street's first modern era of "financial engineering," he returned to Washington with some innovative ideas about how to breathe life into that slow-footed half-man/half-beast called Fannie Mae.

The Federal National Mortgage a.s.sociation, known colloquially as Fannie Mae, was established by Roosevelt in 1938 to spread home ownership and more affordable housing to a still-beleaguered nation. The idea was for Fannie Mae to act as the builder and guarantor of a liquid, second-mortgage market that would disenc.u.mber the balance sheets of banks so they could make more housing loans. The government had been holding bids and creating short-lived specialty markets since the days of Alexander Hamilton, but creating a permanent ent.i.ty that, in essence, held a monopoly over an industry-in this case second mortgages-was a new, somewhat uncomfortable role. So, in 1954, a federal statute turned Fannie Mae into something novel, a "mixed-ownership corporation," in which the federal government held controlling preferred stock while private investors could purchase common stock. In 1968 it officially became a publicly held corporation, to remove its debt and related activities from the federal balance sheet. But the federal guarantor's role remained. Fannie, and, in 1970, a sister ent.i.ty called Freddie Mac-built to compete with Fannie in the second-mortgage market in order to create some marketplace discipline-both carried the "full faith and credit" backing of the United States, a security blanket that merited continued government oversight of their activities while allowing them to borrow money more cheaply than any potential compet.i.tor could.

Which is what they both did through the 1970s and 1980s, as the two government-sponsored enterprises, or GSEs, bought and sold mortgages, and then mortgage-backed securities. By "backstopping" loans that conformed to certain standards of sound underwriting, they lowered the cost of those loans as a way to, in essence, reward prudence.

It wasn't until the early 1990s, under Johnson, that Fannie Mae began to rethink the earnings potential of this arrangement. Wall Street was working furiously, as it had been for a decade, to free its net income from the consequences of risk. It was, after all, the core of their business model to package, parcel, and sell off debt, getting transactional fees and a taste of the debt service, while transferring burden of "default risk"-that cold shower of propitious clarity for lenders since ancient times-to any locale other than their own balance sheets.

But someone had to "hold the risk" and, through the 1990s, Jim Johnson volunteered. Year by year, Fannie's and Freddie's balance sheets became engorged with underpriced risk as the guarantor of nearly 80 percent of the U.S. mortgage market. Along the way, though, the GSEs-and by a.s.sociation the U.S. government-were the guarantors of Wall Street's business model and its vast profits.

There were, of course, a few people who noticed the perils of this financial arrangement and waved their arms in distress, but they were washed downstream on a fresh and frothy river of cash that was soon surging though Washington. Johnson, who helped dig the ca.n.a.l, made sure that water flowed wherever it was needed. Political action committees and campaign coffers of both parties, and all manner of causes, some quite worthy, were recipients of Fannie's largess. Johnson became chairman of both the Kennedy Center for the Arts and the Brookings Inst.i.tution, while Fannie and Freddie became the destination of choice for former elected officials, a.s.sorted senior regulators, and anyone of consequence in D.C. with that patriotic can-do spirit and bills to pay. Meanwhile, Johnson and his deputy, Franklin Raines, were among a handful of people in Washington who were graced with Wall Streetlevel compensation. And they did it the Wall Street way: justifying handsome compensation by moving expenses off Fannie's balance sheet, an action that a government oversight agency later deemed improper, and underreporting Johnson's pay at $6.2 million. In fact, it was $21 million. Ultimately, Johnson's haul from seven years running Fannie-he handed it off to Raines in 1998-was over $100 million.

The issue of compensation, though, was even more broadly applicable. Elected officials of both parties, watching the two-decade rise of the professional, managerial, and financial cla.s.ses in America while most Americans saw their incomes freeze or decline, could compensate for those shifts by directing Fannie's might. From the mid-1990s forward, Fannie, by widening the types of mortgages it would guarantee, was the agent of the "American dream of home ownership"-a dream trumpeted by both Clinton and Bush-by extending mortgages to those who were, increasingly, on the wrong side of economic tides Washington felt it could do so little to reverse.

The price for those best intentions was to "bid out" the government's precious role as guarantor. While Wall Street created the models to separate risk from reward, the government's role as backstop-final recipient of the risk being pa.s.sed to and fro between investors in debt-was crucial to the equation. By 2003, concern that the GSEs, at that point carrying $1.5 trillion in debts, could be capsized by a shift in the markets prompted the Bush administration to propose they be overseen by a division of Treasury that could set capital requirements for the giants based on market conditions. The subtext, of course-to curb the GSEs' lending standards-soon became a political struggle with populist overtones. Fannie's supporters rose up: policing Fannie in this way would mean less affordable homes for middle- and low-income Americans.

As is often the case, the debate was shaped by the distinctive voice of Representative Barney Frank, the Ma.s.sachusetts Democrat and a member of the powerful House Financial Services Committee.

"Fannie Mae and Freddie Mac are not in crisis," he said at a hearing. "The more people, in my judgment, exaggerate a threat of safety and soundness, the more people conjure up the possibility of serious losses to the Treasury, which I do not see, I think we see ent.i.ties that are fundamentally sound financially, and withstand disaster scenarios, and even if there were a problem the Federal government doesn't bail them out, but the more pressure there is there, then the less I think we see in terms of affordable housing." Did it matter that Barney's partner, Herb Moses, had worked at Fannie, a job Barney helped him get, or that his mother, the sainted Mrs. Frank, had received a $75,000 grant from Fannie for a foundation she ran that helped the elderly?

Probably not, but appearances notwithstanding, nothing was done as Fannie and Freddie took on more of Wall Street's risk. To be sure, the GSEs never pressed for the underwriting of subprime loans-which were defined by the fact that they didn't conform to Fannie's and Freddie's underwriting standards. But mixing of conforming and nonconforming loans into CDOs and other mortgage-backed securities brought the contagion directly into the Roosevelt-era's edifice to affordable housing for a battered nation.

What was clear by the fall of 2007 was that those best intentions worked only in a landscape where government and business were separate and distinct in their definition of core interests-one of public purpose, the other private endeavor. Once the government business partnership was stuck, with profits as a shared goal, it was just a matter of when the "mixed ownership corporation" would explode and how costly it would be.

When Jim Johnson was first asked to join up with Caroline Kennedy and Eric Holder to start some preliminary inquiries for a VP search in April, the former Fannie Mae CEO was already displaying signs of toxicity. Some smart a.n.a.lysts on Wall Street and a few at Treasury had begun running the numbers on Fannie and Freddie: their liabilities in the current environment were daunting and taxpayers could be on the hook if the federal government were forced to make good on the GSEs' precious guarantee. But as soon as Johnson was officially introduced on June 4 to head the VP search committee, McCain's campaign went on the offensive. It took just five days for reporters to discover that Johnson had gotten loans for some of his properties directly from Angelo Mozilo-the CEO of Countrywide, the huge mortgage underwriter at the center of the subprime mess.

"I think it suggests a bit of a contradiction," McCain chided Obama on Fox News, "talking about how his campaign is not going to be a.s.sociated with people like that."

Two days later Johnson resigned his post, stressing it was unpaid and thereby voluntary-a statement showing his continued appreciation of the power of illusion. Tapping Johnson was a misstep for Obama, spurred on by his desire to pick a running mate who would ease his flight to a perch atop the nation's imperious and insular capital. McCain, of course, had spent many years in Washington as a boy-the son and grandson of famous admirals-and saw it change from the time he arrived as a freshman congressman from Arizona in 1983. In fact, he lived it, getting caught up in the signature scandal of the early 1990s savings-and-loan mess as one of the five senators accused of trading favors with failed S&L operator Charles Keating.

McCain could remember the postWorld War II period in Washington, when the town was filled with plenty of lifelong public servants who didn't pine for private sector rewards or think about the perfect time to leave for lobbying work. It was to that era-and that ethic-that he spoke about pa.s.sionately and publicly, expressing genuine shame and contrition about his dealing with Keating. It saved his political career, and he went on to be a crusader, certainly among Republicans, for campaign finance reforms. Obama and a campaign team heavy with Washington outsiders were showing a lack of acuity about the town they soon hoped to command, while McCain understood the ugly ways in which Washington had, from year to year, been debased. Yes, Jim Johnson knew everybody in Washington-and across decades he had helped fund the town's glorious, can-do lifestyle-but suddenly, no one could afford to know him.

The driver of the car pulled up to 32 Maple Hill Drive on June 9 and peered into the modest Tudor home for signs of life. The clock showed 7:00 a.m., and the air was already warm in antic.i.p.ation of a hot summer day.

These early-morning pickups more often involved gated estates, where the crunch of tires on gravel announced the car service's arrival. In the world of high finance, rare was the curbside pickup. But then, Tim Geithner had never been party to the affluence that typically came with a career in the industry. He was often mistaken for an investment banker. Something about the quick smile, withdrawn just as quickly. After being put in charge of the New York Fed, he and his wife bought this relatively modest house in Larchmont, New York, in front of which a car engine now softly idled.

Inside the house, Geithner was getting ready for a wildly busy day. The driver might make the Fed building in thirty minutes if FDR Drive was clear, but even so, he would be cutting things close. Geithner's first morning call, with Goldman CEO Lloyd Blankfein, was scheduled for 7:45. John Mack from Morgan Stanley was set for 8:15, and Jamie Dimon of JPMorgan for 9:30, and by then Geithner would probably be running late for his speech at the Economic Club of New York. It was an insane schedule. It had been since Bear's collapse.

As the subprime crisis began to unfold, Geithner had joined with Hank Paulson and Ben Bernanke to decide, in a sense, the fate of the economy. He was the least high profile of the three but had become, all the same, increasingly central to the group's decision-making process. Just three months earlier it had been Geithner in the lead, setting up the Bear Stearns deal with JPMorgan.

While Paulson was still holding the line that Wall Street would have to take care of itself without the help of taxpayer money, Geithner was tending to his downside risk: having to answer the "what did you know and when did you know it" question.

The New York Fed chair had first become aware of the gathering economic storm in an August 2007 phone call. To Geithner's disbelief, the mortgage giant Countrywide, and leader of the subprime bonanza, was not going to be able to refinance its repo book.

"Repo" was industry-speak for "repurchase agreement," a growing practice in the financial sector by which firms borrowed and lent each other huge sums of money on short-term bases-a few weeks, a few days, sometimes just overnight. Like any other loan, collateral has to be put up to secure the loan. Like lots of firms of all types-banks, financial firms, industrial companies-Countrywide was using mortgage derivatives, such as CDOs, as collateral. At this point, Geithner, like virtually every other regulator, had only a pa.s.sing familiarity with how repos were being used and how they'd grown since 2005. They were viewed as another kind of cheap, short-term lending, somewhere between commercial paper and a swap. And as with the credit default swaps, the partic.i.p.ants in this arrangement were called counterparties. No one, in 2007 or even 2008, knew how big the repo market was.

"That was really interesting," Geithner later reflected, "because Countrywide had no idea what its exposure was, no understanding of what it had gotten into. And the fact that the market was unwilling to fund Treasuries if Countrywide was a counterparty was the best example of how fragile confidence was and how quickly it turned."

Translation: the market would not even lend Countrywide cash to buy Treasury bonds, the safest investment in the firmament. CDOs, MBSs, or similar types of mortgage-based collateral that Countrywide was using to roll over its repo loans were suddenly seen as impossible to value or sell in August 2007, meaning it was illiquid. The whole point of collateral is that it can be taken-the way the repo man repossesses your car after too many missed payments-and sold in liquid markets for cash. Collateral that is illiquid is no collateral at all. Countrywide's intended use for the borrowed funds-to go out, like Sal Naro, and buy Treasuries and sh.o.r.e up its balance sheet or to use them as collateral for emergency bank loans-was irrelevant. Its collateral was no good.

Geithner, at the time and looking back, saw this strictly in terms of confidence.

Confidence, in fact, was Geithner's currency. He viewed his role, then and later, as a.s.suring confidence in the financial markets, by any means necessary, at whatever cost. His view was that the financial markets would engage in myriad transactions, all but matching the diversity of flora and fauna in the natural world. Knowing how all those transactions worked was daunting and unnecessary. His job, and that of the Fed, was to preserve widespread faith in the system's overall soundness.

"People on Wall Street watch each other," he explained. "It's like watching people leave a theater. As soon as a few people leave, the tone of the theater shifts. All these huge inst.i.tutions start to pull back, and they watch each other pulling back and wonder, 'What's going on?' "

Whether there is actually a fire in this crowded theater, or just someone yelling "Fire!," the job of the regulator is to rush in with the hoses. Spray first; ask questions later. Over the weekend of March 1416, as Bear Stearns imploded, Geithner had taken extraordinary measures to prevent a ma.s.s exodus from the Wall Street theater. Bear Stearns died because it could not roll over its repo book. Why? It was using mortgage-backed securities and related derivatives, still sporting their triple-A ratings from Moody's, as collateral. In its final weeks, other firms, getting jittery about Bear, were shorting the repo durations, from months to weeks to days. In its last week, Bear had to raise $50 billion a night in repos to replace the expiration of its day-to-day obligations and to fund operations. This is called "rolling your book" of debts. This is how financial firms die in this era. It's not from losses, or declining revenues. It happens when they can't roll their debts-essentially replacing old credit cards with new ones, every day.

The $30 billion federal backstop that ultimately clinched the Bear Stearns deal had been Geithner's handiwork, though Bernanke got the credit. They presented the circ.u.mstances of the rescue at the time as a once-in-a-lifetime emergency that called for unorthodox action. But that was dead wrong. Saying this repeatedly only forced the actual players driving the financial markets to have to decide why Geithner and Bernanke were lying or whether they were stupid.

Around 11:00 a.m., Geithner arrived at the Grand Hyatt Hotel on Park Avenue, speech in hand and fresh off his call to Jamie Dimon. He had given his talk the particularly dry t.i.tle "Reducing Systemic Risk in a Dynamic Financial System." But dry was, on balance, a good thing in the world of high finance.

The Economic Club of New York had long been a prestigious audience for industry bigwigs and esteemed economists. Almost exactly two months earlier, on April 8, fresh off of orchestrating the Bear Stearns rescue, Geithner had sat front and center to hear Paul Volcker eviscerate the Fed's recent actions in that very deal.

The luncheon had been in honor of Volcker's eightieth birthday, whose actual date was back in September 2007. The former Fed chairman stood behind the lectern, hunched and mumbling, delivering his first address at the club in thirty years. As he worked his way into the speech, however, he grew more impa.s.sioned, finally railing against those regulators who had allowed "excesses of subprime mortgages to spread into the mother of crises." His voice rose to a thunderous pitch as he declared, "The financial system has failed the test of the marketplace!"

An audience member later asked him if he predicted a crisis of the dollar.

"You don't have to predict it," Volcker retorted. "You're in it."

By the summer of 2008, gloom and doom had become popular position for economists, but Volcker was in a category of his own. Geithner valued the man's a.n.a.lysis and insight-everyone did-yet now he found himself implicated in exactly what Volcker found so reckless.

"The Federal Reserve," Volcker had continued, enunciating clearly and slowly to underscore the importance of what he was about to say, "has judged it necessary to take actions that extend to the very edge of its lawful and implied power . . . and in the process transcended long-embedded central banking practices and principles."

Was the former chairman implying that the Bear Stearns deal had been legally dubious? It was a tough criticism, coming from the venerable Volcker. The term "moral hazard"-describing the dangerous precedent of federal actions supporting reckless business practice-had become part of the Washington lexicon by this point. But that was still mostly noise. Volcker, on the other hand, just a month after the Bear Stearns rescue, was the first major voice to say that Bear Stearns was an investment firm free to make money as it saw fit, and to fail without pity. If this meant that the rest of Wall Street was forced, by existential fears, to suffer huge losses on its debt casino and start racing toward prudence to survive, so be it.

To think this way, you'd have to be able to imagine a world without Goldman Sachs.