Inside The Collapse, Part 1
March 14, 2010 12:04 PM
Michael Lewis writes about a handful of Wall Street outsiders who realized the subprime mortgage business was a house of cards and found a way to bet against it. Steve Kroft reports.
Wall Street: Inside The Collapse
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See all 29 CommentsA lot of people are now saying that CDS's were invented in 2000 but according to CBS they were made illegal in 1906 after being faulted for causing a depression at that time. So people on Wall St. and in the government, with a very little research should have known that they were not a healthy financial instrument. Add to that the fact that CDS's were re-introduced by a law passed on the last day of the lame duck Congress in 1999 and this whole thing stinks to high heaven.
1.) Any issue can be rated AAA, as it is simply of a function of the level of subordination (the first loss piece or "waterfall" for defaulted loans). In other words relative to the risk profile on a given issuance, by example say 30% of the issue is deemed by the rating agency to be subordinate, meaning that an investor in said AAA bond would have protection equal to 30% of the collateral having to default before they would experience a loss. Said 30% in this example would be referred to as the "first loss piece" or "residual interest." The "residual interest" would either be kept on the books of the issuer or more frequently sold as a separate security.
2.) Speaking to sub prime loans, the large originators ($1b+ per month in volume, most of which were centered in or around Orange County, CA - referred to as the "sub prime ghetto" by those in the business) had no incentive to either underwrite the loans or even fight aggressively to get them purchased in the secondary market. No, you did not read the last part of my statement incorrectly, as Wall Street whole loan buyers of sub prime were generally given what amounted to a free put (the ability to reject loan from a given trade without cause) on 3%-5% of the aggregate balance. Why, simply because they could sell the fall out from a given trade at a price that was still higher than par (AKA 100 cents on the dollar)
3.) Between 2002-mid 2006 there were literally NO LOSSES on defaulted loans. Borrowers in default were able to simply refinance the loan out of a default or the real estate had appreciated to a level that in the rare cases of liquidation everyone was made whole. I attended trade conferences were sellers of whole loans told me they sold xxx$millions (fill in the number) worth of loans to our competitors and never had a single claim for repurchase or an early payment default (EPD). We all knew of course that is would have been a statistically anomaly on the grounds of the "big bang theory" where even 1-loan (even in a superior credit pool) had not gone into default or had resulted in a claim. What was happening here is that any defaults were either cured by a refinance or it was more profitable for the servicer of the loans (working on behalf of either the Wall St. acquirer or the bond holders depending where in the process the loan defaulted) to work it out internally versus issuing a put back for a claim.
4.) The Wall St. compensation model was in fact skewed towards short term P&L results. While there were in fact hold backs on annual compensation and some firms paid a percentage of compensation in stock, large annual cash bonus payments were the norm and many senior traders that moved from firm to firm had massive multi year guarantees.
So what really went wrong? In mid 2006 I was called into a darkened conference room and informed that one of my "right hands", a VP that worked primarily on bulk transactions was being let go and that I had essentially "maxed out" from a compensatory perspective and should "strongly consider" the offered position in Residential Conduit Sales. I was even offered a relo package to Los Angeles. The underlying issue at hand was that I (or we in Residential Credit), despite being well respected within both the company and the industry in general, were too conservative relative to where our firm placed on the competitive risk matrix. I relay my personal experience only as cogent background color to the onset of the downward spiral.
What happened next?
1.) The real estate market started to "cool down"
2.) The "scratch and dent" bid price (the price paid for assets that were kicked out of trades) fell to a level below par (when this happened and the large sellers decided that it was time to start underwriting their loans and to fight harder to keep loans in trades, I was actually contacted to gage my interest for a head of credit position at a large sub prime originator)
3.) The concept of recourse back to the originator was a virtual fallacy. Even the larger originators could not with stand even a relatively small number of repurchase requests where the smaller originators were often doing volume of $20m or more per month with a tangible net worth of $1m or less!
I could go on, however, the 3-stated events likely contributed more to the downward spiral and what was soon to be called toxic debt than any other factors. One could of course get granular and make the argument that borrower who took a loan that they knew they couldn't afford is just as culpable as anyone else, though they seem to be getting a pass these days.
When lenders ran out of truely qualified buyers, they sold to unqualified buyers out of greed knowing there would be a lag time between when they sold the mortgages to Wall Street and when the defaults started. When the defaults started, Wall Street knew that the mortgages which it had been purchasing were defective (more greed)and they knew which lenders were making the defective loans.
Hello all these executives had a fiduciary responsibility and FAILED, all the money they made should be taken for restitution to all that lost money and their JOBs and HOMES. These people are criminals - they need to be brought to justice and should never be able to work in any field in finance ever again! Where are the AG in each state - why are they not going after all these guys!
It was a congress controlled by the banking lobby and banking controlled by greed that got us here. The repeal of Glass Segal and the Banking Modernization Act of 1999 lead us down this road. We have now had the largest transfer of wealth in the history of the country and no one has been held accountable except the taxpayers.
Here is an easier to understand explanation:
1) While every administration since Jimmy Carter ( The Community Reinvestment Act) has wanted everyone in a home of their own it was congress who removed all the stops in 1999 and allowed financial institutions to combine banking and gambling.
2) Unregulated Mortgage "Brokers" and smaller banks start writing up mortgages regardless of qualification with the support of and pressure from the government.
3) Mortgages are bought by banks, big banks.
4) The Banks start to package the mortgages into investments called Collateralized Debt Obligations (CDO) , this is a derivative.
5) Rating agencies, beholding to the banks for their business, rate the CDO's as "AAA" Investments. They did this knowing full well many were bad investments. This was fraud.
6) The CDO's were then sold around the world to other banks, and investors including municpalities.
7) A smart guy feels the investments aren't good and will fail. He invents insurance that can be sold to the banks to protect them. The insurance is called a Credit Default Swap, another derivative.
8) AIG (an Insurance Company) issues a ton of Credit Default Swap policies without the funds to back them up.
9) The mortages fail and the entire mess comes crashing down taking AIG, the banks and us along with it.
10) Congress then puts the "Trouble Asset Relief Program" (TARP) in place and transfers the wealth of the nation for generations to come to the very people who subverted the worlds economy.
When the defaults started, Wall Street knew that the mortgages which it had been purchasing were defective and they knew which lenders were making the defective loans. Rather than not buying mortgages from Countrywide, IndyMac Bank, etc., Wall Street bought more or them. Why? Because the execs realized that they had a guaranteed way to make billions of dollars. Split apart the mortgages and then rebundle them and sell them but also sell dirt cheap insurance that the bundles would meet expectations. To evade insurance laws and the requirements to keep reserves, they called the insurance credit default swaps.
Because they knew the bundles would tank, Wall Street got congress to change the law so that anyone could buy a cds on any mortgage bundle. It was like an arsonist selling fire insurance to all his friends on homes which he had already set on fire. The execs knew that the entire market would eventually crash, but not before they had personally pocketed hundreds of millions of dollars and in some cases billions of dollars by collecting on the cds's on the defective mortgage bundles.
That is the reason Geithner, while had of the NY Fed and then as sec of treasury, refused to insurance the individual home mortgages. If every home mortgage had been insured, then none of the Bundled Mortgages would have tanked and all the cds which the Wall Street execs had bought would have been worthless. Instead Geithner made certain that the US government would give AIG, Goldman Sachs, etc enough cash to pay off the cds's they had sold to their execs.
Geithner belongs in prison along with a lot of other uber wealthy, but 60 Minutes along with the Obama administration is pretending they Geithn er. and his ilk were innocent bystanders. That's like saying Al Capone was an innocent bystander.
Those regulators and who are the real creators for this financial AAA-bomb are still acting and fully in charge, as if nothing has happened and ignored by the media. I refer here to the Basel Committee and their public relation agency the Financial Stability Board. bit.ly/csOfCQ
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