I feel I know a fair amount a MBSs as my girlfriend rates them for a living for one of the rating agencies.
There isn’t anything fundamentally wrong with the concept of MBSs any more that there is anything wrong with the concept of stocks. The problem is that in order to work as they are supposed to (spread out risk), a couple of things need to happen:
Lenders need to accurately assess the risk of each mortgage they lend out.
Those mortgages need to be bundled into “tranches” of mortgages of equivalent risk.
The compensation structure for the lenders, funds, rating agencies and so on need to be structured in a way that discourages conflicts of interest.
There needs to be some sort of transparancy in the process.
Pretty much none of that happened.
IOW, you can’t bundle a bunch of high risk mortgages together and call them AAA because there’s a lot of them.
Well, that’s not quite true. In the '90s, I worked for a due diligence company. We’d go in and look at every loan file (granted, some had missing documentation, but I don’t think that’s what you meant).
Now, that’s not to say that all buyers had due diligence performed, much less done properly. It is to say that it’s not impossible.
I wasn’t saying that it is impossible to do due diligence - the company mentioned above did exactly that - but that it was impossible for all buyers to do it for all securities in their portfolios. I suspect you charged a good deal to do it. If a company spent that much (and I bet you did it more efficiently than the average buyer would) they’d spend all or most of their expected return on due diligence. So, not logically impossible but financially impossible.
Does anyone know if lenders did assess the risk of their mortgages, and hid the data, or if they didn’t bother to assess the risk? I suspect the latter, since if they did the former they might be open to charges of fraud, and provide the law with a smoking gun.
I think there isn’t much doubt that there was fraud on the loan origination level. There was too much money to be made to turn people away. I tend to doubt it was particularly organized in the sense of it being orchestrated by each bank on a company wide basis. I think it probably began and ended with the people who were actually writing and approving the loans. But that’s not to say there wasn’t complicity on the part of bank management. You can’t issue thousands of mortgages with virtually no underwriting and have that escape notice. It was so bad that the term Ninja loans was coined for some of the subprime crap - no income, no job or assets.
“Where once more-marginal applicants would simply have been denied credit, lenders are now able to quite efficiently judge the risk posed by individual applicants and to price that risk appropriately. These improvements have led to rapid growth in subprime mortgage lending.”
Alan Greenspan
Chairman of the Federal Reserve Bank,
April 2005
“Mr. Howard made it clear to the mortgage broker that he could not read or write, but his loan application erroneously claimed he had had 16 years of education.”
Center for Responsible Lending report
“IndyMac: What Went Wrong?”
June 30, 2008
“I would reject a loan and the insanity would begin,”
one former underwriter
told CRL. “It would go to upper management and the next
thing you know it’s going to closing… I’m like, ‘What the Sam Hill?
There’s nothing in there to
support this loan.’”
Center for Responsible Lending report
“IndyMac:
What Went Wrong?”
June 30, 2008
“That was your homework—to watch Boiler Room.”—Lisa Taylor, Ameriquest loan agent, quoted in the Los Angeles Times, February 4, 2005
What is that movie? Boiler Room? That’s what it’s like. I mean,
it’s the [coolest] thing ever. Cubicle, cubicle, cubicle for 150,000
square feet. The ceilings were probably 25 or 30 feet high. The
elevator had a big graffiti painting. Big open space. And it was
awesome. We lived mortgage. That’s all we did. This deal, that deal.
How we gonna get it funded? What’s the problem with this one? That’s all everyone’s talking about . . .
We looked at loans. These people didn’t have a pot to piss in. They can barely make car payments and we’re giving them a 300, 400 thousand dollar house…
Then the next one came along, and it was no income, verified assets. So you don’t have to tell the people what you do for a living. You don’t have to tell the people what you do for work. All you have to do is state you have a certain amount of money in your bank account. And then, the next one, is just no income, no asset. You don’t have to state anything. Just have to have a credit score and a pulse.
[reporter] Alex Blumberg: Actually, that pulse thing. Also optional. Like the case in Ohio where twenty-three dead people were approved for mortgages…
Match the allegation with the institution.
**Allegation **
Handed out copies of the movie Boiler Room as a training tape
Partnered to sell its “PayOption Arms†with a brokerage owned by a five-time felon, whose convictions included gun-related charges
Forbade loan officers to check borrower income on certain loans
Ran an "art department" in its Tampa office, where documents were altered
Settled allegations of institutionalized marketing deception that covered two million customers
Developed “FastQual,†a program designed to approve borrowers in twelve seconds
Incentivized brokers and loan officers through “yield spread premiums†and other compensation schemes to put borrowers into more expensive loans
Case in point: this instant message exchange between two unidentified Standard & Poor’s officials about a mortgage-backed security deal on 4/5/2007:Official #1: Btw (by the way) that deal is ridiculous.
Official #2: I know right…model def (definitely) does not capture half the risk.
Official #1: We should not be rating it.
Official #2: We rate every deal. It could be structured by cows and we would rate it.
"The big saying was ‘A skinny file is a good file,’ " said Nancy Erken, a WaMu loan consultant in Seattle. She recalled helping credit-challenged borrowers collect canceled checks, explanatory letters and other documentation that they could afford their loans.
"I’d take the files over to the processing center in Bellevue and they’d tell me ‘Nancy, why do you have all this stuff in here? We’re just going to take this stuff and throw it out,’ " she said…
In an internal newsletter dated Oct. 31, 2005, and obtained by The Seattle Times, risk managers were told they needed to “shift (their) ways of thinking” away from acting as a “regulatory burden” on the company’s lending operations and toward being a “customer service” that supported WaMu’s five-year growth plan.
Risk managers were to rely less on examining borrowers’ documentation individually and more on automated processes, Melissa Martinez, WaMu’s chief compliance and risk oversight officer, wrote in the memo.
Soon after, WaMu’s risk managers were called to an “all-hands” meeting at the company’s posh new conference center near Seattle-Tacoma International Airport. Dale George, a former senior credit-risk officer in Irvine, Calif., recalled that Martinez emphasized “the softer side of risk management” at the meeting.
"The whole tone it set was that ‘Maybe the next file I review I should pull back, hold off on downgrading (a loan), not take a sharp pencil to what production was doing,’ " he said.
“They weren’t going to have risk management get in the way of what they wanted to do, which was basically lend the customers more money.”…
**
“Someone in Florida had made a second-mortgage loan to O.J. Simpson, and I just about blew my top, because there was this huge judgment against him from his wife’s parents,” she recalled. Simpson had been acquitted of killing his wife Nicole and her friend but was later found liable for their deaths in a civil lawsuit; that judgment took precedence over other debts, such as if Simpson defaulted on his WaMu loan.
"When I asked how we could possibly foreclose on it, they said there was a letter in the file from O.J. Simpson saying ‘the judgment is no good, because I didn’t do it.’ "**
No cite, but many of these lenders had wholly inadequate loan loss reserves, mainly because they weren’t expecting to hold onto the loans they had originated. So if they were assessing the risk, they weren’t listening to their own analysts.
You have a few misconceptions. Your basic premise is correct but you don’t bundle mortgages into a tranche, you bundle them into a pool and you carve them up into tranches. There are many ways to slice the cake but typically the top tranche would get seniority and get all payments of interest and principal first, then the next tranche and so forth and so on.
Even for subprime mortgage pools it would not be unreasonable to rate the top tranche as tripleAAA but what people would do is take some of the crappier tranches and bundle THOSE together into a pool and take the top tranche of THAT pool and call it tripleAAA and so forth and so on.
And this is where the CRA comes in. We now had default history on subprime borrowers that ran decades long with several intervening recessions. We thought we had a handle on the sort of risk we were dealing with. Then people started to run with it.
They took the data from a black folks with bad credit who had the income and debt equity ratios for a conventional loan and interpolated that data into what would happen with a zero down payment, zero income verification, with shitty credit (AND we didn’t really check the appraisal very well) and came up with how THAT borrower would act and priced mortgages based on that basis.
But ALL of that would probably STILL have been OK if we didn’t have actors like IndyMac (Countrywide), Ameriquest and New Century actively pursuing bad mortgages to package and sell.
They didn’t really care about the CRA, credit scores or anything else. There was a huge quantity of money floating round looking for a AAA-rated safe investment that would yield more than bonds. A handful of guys on Wall Street realised they could make a huge amount of money selling dodgy MBS to these investors/sovereign funds so they did. The big WS firms owned outright or big chunks of most of the worst mortgage originator offenders, got the mortgage/ratings agencies regulations scrapped via the politicians they owned, etc. It was a top-down operation.
At the time, AFAIK, the company was the best at what we did. So, no, not cheap. And man, did the clients have money to spend – a common phrase around the office to describe it was that they “hemorrhaged money”.
So I understand that you were talking financially, and not logically – and I’m still saying that it’s entirely possible to do due diligence on every loan. It can (should, actually) be viewed as just a cost of doing business – and relative to the amount spent on purchasing any one MBS, the cost of doing the due diligence is a pittance.
That’s the information I was looking for. So, it is safe to say that the investment bankers were not really interested in knowing the risk, since that would force them to back off buying the high return securities.
There was also an article in the Times magazine a year or so back about how the bankers gamed the risk models of their companies. These approved deals with a small amount (1% perhaps) of risk; they structured all their deals to have exactly this. And of course some of the models didn’t include the possibility of the housing market going down.
Dick Dastardly, thanks for the quiz. I was thinking more about people on the investment banking side. We all know that the mortgage brokers were weasels.
And, in assigning blame, you are right about Carter, but you need to add all those nearly illiterate borrowers who had the nerve to not read and analyze 30 page mortgage documents and who were stupid enough to believe the brokers.
Not that I disagree with your general point but which regulations got scrapped? As far as i can tell, the rating agencies were never very well regulated 9because the market regulaates itself you know).
Ratings agencies used to make their money by being paid by the buyers of the bonds/securities they were rating, so they had an interest in accurately rating whatever it was. This eventually changed round to the seller paying for the rating, regulation gradually being relaxed or not enforced and eventually in 2002 they were allowed to self-regulate. Banks and securities firms, the mortgage industry etc. have been lobbying away the New Deal-era regulations for decades. Regulations were scrapped outright ( eg. Glass-Steagal) or just not enforced. In 2005 securities firms led by Goldman successfully lobbied the SEC to allow them to lever up their debt:assets ratio from 10:1 to 30 and more :1. Bush actually put banking lobbyists, the people trying to get banking regulations scrapped, in charge of the regulators. One of those guys is the guy taking the chainsaw to the stack of banking regulations in the picture I’ve posted before. The Bush administration also used the regulators to block attempts by the states to stop the predatory lending that exploded from 2002 onwards.
When were the ratings agencies regulated in a way that would have prevented this fiasco?
Sure their business model cahnged a LOOOOONG time ago but they’ve been paid by issuers for a long long time now without any problem. The problem was identified and ignored by the Bush administration but I don’t remember anyone repealing anything.
Glass steagall was repealed by Clinton because it was anachronistic. The worse problem was when we allowed banks to got from 10% marginal reserves to 3% marginal reserves. This made any sort of uptick on defaults an unmitigated disaster.
By Clinton? He signed the Gramm-Leach-Biley Act into law. It’s a hell of a stretch to say he was responsible for it, though. It was Republican legislation, only supported by Democrats once the Pubs agreed to a quid pro quo on some other bills.
It’s not that existing legislation was repealed. Glass-Steagal wasn’t repealed overnight, by the time Clinton scrapped it the banking lobbyists had already gutted most of it and there wasn’t much left of the original act left to repeal. The SEC didn’t repeal their regulations on debt:asset ratios, there was no congessional legislation, they jkust did it quietly after a few meetings with the top securities firms who convinced them that because they had all this rock solid AAA-rated MBS and similar securities that hedged their risk down to almost nothing so they should be allowed to massively lever up their debt. Regulation wasn’t really repealed, it was just quietly relaxed or not enforced, and it was something that had been happening since 1980 although it really started to get silly over the last ten years.
In its early stages one of the key risk factors in the MBS tranche offered to the market was the weighted credit score of the individual mortgage holder. It was assumed at the time that usual mortgage qualifiers, such as income to mortgage payment ratio or mortgage to equity ratio (downpayment vs. mortgage) were in accordance with unwritten rules of mortgage issuance and verified and confirmed by the originating bank. That assumption was based on trust, a trust in due diligence and trust in sound business practices of the MBS originating bank. Once the trust was broken by almost any player in the market that’s when credit market froze.
The compounding (no pun intended) of the problem happened when AIG started insuring Goldman’s and others’ MBS investments via credit derivatives.
What s interesting to me is that the essence of the problem was the pure and simple fraud for which, it appears, all originators of the MBS are guilty of. What’s more startling is the guys who were on the hook for all of this never asked for reasonable evidence how healthy underlying instruments of the MBS are.
They even had so called “announced” MBS tranches where documentation completion for the purpose of risk rating was 3 months away yet investors sucked them up dry as soon as they were announced.
So, the guy that pushed for sale of a higher mortgage was in fact increasing overall appeal of the future mortgage pool and he was surely paid on the basis of metrics that increase mortgage pools returns. The guy who wanted to sell it to you probably was not even aware of the end result as he was probably given different expectations on his sales performance. What you as a buyer then faced was a shift in mortgagee business as 20 years ago mortgage salesman would be more conservative than this.
Yes, but they needed models to show why they thought their pricing was good. I believe the history of CRA loan performance was used as the basis for a lot of the modeling.