Lots of questions regarding the subprime mortgage market

I put it in GQ because I’m sure there are (mostly) factual answers regarding my questions.

OK, let’s start at the begining. A couple comes in wanting a loan and can’t afford one. The mortgage industry creates an ARM or Adjustable Rate Mortgage which has a low interest rate for the first maybe five years and then jacks up the interest rate to help earn extra money for the lender. They did it under the theory (or claimed theory) that borrowers would be earning more money in five years time and thus able to afford what they currently couldn’t. This much I get.

Here’s where it starts to break down for me. Now, either the lenders knew these loans were a time bomb waiting to go off or they thought they were sound lending strategies. Let’s ignore the latter for a second. Assume they were the former. Assume they were known to be a time bomb.

  1. How is it ethical or legal to sell in the first place?

The lenders packaged all this debt-ARMs and regular loans- bundled it together, and sold it to larger banks, reinvestment firms, or others. Before doing that, these bundles were independently rated and given an A-OK as a sound investment.

So let’s ask some more questions
2) Who were these people who rated the bundles?
3) Why were these people not allowed to unbundle the bundles and determine exactly what debt and offers and contracts were included?
4) How can one accurately rate something which one can’t actually analyse?
5) Why is it no one who analysed this caught the fact that these bundles were time bombs?

But regardless they were given a clean bill of health and resold to others. Who in turn occassionally rebundled and resold it to others. And onward and onward.

  1. Did the people that bought these bundles truly have no idea what they were buying? Why would they do that? Isn’t this like going to an auction and bidding on a trunk found in an attic that’s never been opened? It could contain anything from war bonds and gold jewelery to grandma’s doileys! Only one way to find out!
  2. Latching onto #6, why would these people trust the analysation skills of the independent raters who ALSO couldn’t unbundle the packages and see what was in there?
  3. How is it that many who bought this debt STILL doesn’t know what they bought?

But let’s back up and change the scenario. The people who originally sold the ARMs didn’t think they were time bombs. The opposite, in fact. They were sound investments all the way. The banks thought so. The mortgage industry thought so. The independent raters thought so. The people who bought the bundles thought so. Everyone all the way up trained in business and lending and economics who bought and sold and bought and sold these thought so.

One question remains:
9) Given all that, how in the world are we blaiming the people who took the banks up on the ARMs because THEY should have known better?

I really hope there are some factual answers to these questions. Thanks in advance.

I can answer some of your questions. I suspect others will push this into GD territory, though.

  1. Credit rating agencies- Moody’s, S&P and Fitch, among others; this is all they do - provide risk assessment services for investors.

  2. They were allowed to unbundle the bundles. Nobody bothered because unbundling would have been really, really complicated. Once a package of debts is securitized, a credit rating is assigned for the whole package. In order to analyze the actual risk of a specific bundle, you’d need to pull the paperwork on every single loan in it- hundreds, or even thousands of individual mortgages.

  3. One can’t. The credit rating agencies, the original lenders, and the security-buyers all failed to exercise due diligence. They figured that the risks would be minimal since there were so many little debts involved; since the debt would still be worth something if a lender defaulted (since house prices were going up anyway), they’d make money no matter what.

They failed to consider that if lots of people started defaulting, house prices would no longer be going up.

  1. See #3.

  2. If you’re standing at the edge of a cliff, and you can’t see what’s below- a ledge, or a 60-foot drop onto rocks- you can argue that you don’t know what will happen if you step off.

It doesn’t make it any less dumb.

ETA: Warren Buffet saw this coming, among others. Guess who’s going to make a killing picking at the choicest bits of the crippled financials now?

It’s not only the prospect of future income of the borrowers which made banks lend money to couples like the one in your example - another, and possible more important, aspect is the expected development in the real estate market. As long as prices keep rising, the mortgage is a pretty safe investment for the bank because the debt is backed by the value of the house. If they can’t afford paying the rates, the bank initiates foreclosure and thus gets its money. It can also be an attractive thing for the couple - they get mortgage now to buy a house they couldn’t afford on their current income, and a few years later they sell it and use the money the get to pay off the debts and to keep a profit for themselves. For some years, this scheme used to work quite well. I don’t see any ethical problems with that.

It’s not so much the ARMs (mortgage rates haven’t risen that much since these were written) as it is the minimal documentation loans–don’t really have to prove income, so borrowers can lie–plus marked lowering of standards such as the notion that future home value increases will make the loan-to-value more solid, so you don’t need a downpayment Right Now… (the increased value becomes your “downpayment”). This opens up mortgages to people with minimal cash down payment, more dishonesty and crummier personal financial decisions–by definition a more risky set.

But not the paper writer’s time bomb. Someone else’s. “I am just writing mortgages to help the underserved get homes.”

Many people argued that this was not only ethical, but noble–a way of opening up home ownership to the underserved. It should also be noted that it’s common for various mortgage brokers to be separate from “the lenders” depending on how you use the terms.
Finally, if it’s not illegal, it’s not illegal. That’s part of the regulation part of this whole discussion. Unfortunately some people think “regulation” at the entry point for loans is code for “discrimination against the poor” or “discrimination against a particular class.” In normal political speak when you hear “regulation” they are talking about “Wall Street” since it’s political suicide to regulate the Polloi.

So now you have a really toxic start. Mr Bleeding Heart wants to lend to the poor and Mr Greedy Bastard gets a commission off making sure the paper is written. Mr Wall Street wants to make money By Any Means Possible. Nice start to destroying what has always been very solid paper: the standard mortgage with an Actual Down Payment and Actual Responsible Mortgagees with their Own Money (the downpayment) at risk.

And of course what starts out as a well-intentioned outreach to the underserved by Mr Bleeding Heart rapidly expands to writing paper for Mr Greedy Getrich Quick who takes advantage of the climate to take out loans on purely speculative personal investments.

Not enough time for me to answer all of these questions. I might point you to the article by Sloan and Serwer in the Time Mag 29 September issue.
http://www.time.com/time/business/article/0,8599,1842123,00.html
Pretty balanced on what happened after the nice toxic start that made a pretense of crappy paper being OK and OK to bundle in with traditional mortgages as if they were both acceptable components of collateralized debt obligations.
Plus some interesting sidebars on nutty ways to make it seem like your firm’s bad paper is “insured” against loss (insured by other bad paper…).

The main lesson should be that smart people will always be around to subvert well-intentioned dumber people. I am not sure it matters how hard you try to regulate and what your overall political structure is. The poor you have with you always and the smart seem to find a way to get rich and powerful in every culture. Some cultures–capitalist ones in my opinion :slight_smile: --seem to also produce actual wealth as a byproduct of human interactions. And the very best cultures allow people who are smart and altruistic to make just enough workable regulation to not choke wealth production.

But I’m saving that for my book: The Capitalist Manifesto.

Damn. Title has already been taken.

Statistics. You have a model that shows that historically 1 of 100 good credit borrowers have defaulted, that 5 of 100 pretty good credit borrowers have defaulted, that 10 of 100 marginal credit borrowers have defaulted and that 30 of 100 lousy credit borrowers have defaulted. When you put together enough loans, it should not matter what any one particular loan looks, the number of defaults should follow this pattern.

Problem: the historic model was true for a long period when real estate prices were rising, at first steadily and then a whole lot. During this latter period, default rates went down because stressed buyers could sell or refinance, and this recent experience got averaged into the statisics with the rest.

Problem: mortgage brokers and non-traditional lenders enter the picutre–they do not care about making good loans because they do not keep the mortgages. The evidence supporting creditworthiness may not have been checked or may have been falsified, creating conditions different from those reflected in the statistics.

Problem: people with lousy credit find out the institutions are looking the other way (prior problem) and the numbr of false applications goes up (either because people really wanted an house and thought they could swing it if current conditions continued (assumption) or because they wanted to participate in the bubble appreciation of houses). Again, conditions different than those the statistics were based on.

Solution? Well, someone in the chain should have been checking up on the policies and practices of the biggest originators (Countryside) re credit checks/evidence/appraisals and the clear change in incentives brought about by mortgatge brokers who have no “skin in the game” should have been factored in. “Someone” is probably a bundler of mortgages or a investment bank doing diligence while structuring the bundle or a rating ageny before it rates. (Does not remove culpability from anyone actually making false statement in connection with the origination–the borrower, the appraiser or anyone complicit with them.) It is a hard thing to say that a statistical model that has worked for a long time should be overhauled before anything bad has actually happened, but that is what these types were paid to do (in part).

It is more complicated than this.

First, the people who bought the various flavors of hybridized securities and CDOs did know what was in them. These securities contained a variety of assets and derivatives, including solid mortgages from reliable borrowers. It is important to note that these CDOs are continuing to pay interest and the overwhelming majority are not in default.

The securities are typically divided into tranches, each offering a different admixture of risks and returns over a given period of time. The risks and returns were based on modeling of past foreclosure behavior. A precise combination of mortgages and derivatives were selected to achieve a given risk rating.

There were small deviations across the board in the foreclosure rate that caused a wide swath of securities to be downgraded. This ultimately drove the liquidity crisis: increase in capital requirements by everyone combined with a decrease in the value of their assets due to mark-to-market rules ended up with a total money lockdown and margin calls all over the damn place.

It is not so much that the banks don’t know what is in the bonds. It is that they do not know exactly how to model the future behavior of some of the riskier tranches given the deviation from past behavior. There is a lot more research that needs to be done.

It bears repeating that the majority of these bonds are still paying interest and are still investment grade. Their value has collapsed because the market for them has collapsed. It does not mean that all of the bond payments have dried up.