Subprime and Alt-A Mortgages: How the House of Cards Was Built
Book: Structured Finance and Collateralized Debt Obligations | Author: Janet M. Tavakoli | Publisher: John Wiley & Sons (2008) | ISBN: 978-0-470-44344-6
The CFS case from Chapter 7 was supposed to be a warning. It wasn’t.
Chapter 8 is where Tavakoli documents how the same mistakes, same ignoring of red flags, same reliance on untested models, and same willful blindness to obvious problems played out again in the subprime mortgage market - but bigger. Much bigger.
Subprime: Who Was Borrowing
Subprime borrowers had FICO scores below 650. Fair Isaac Corporation developed these scores to measure credit capacity, accounting for payment history, amount owed, length of credit history, types of credit used, and new credit. About 27 percent of borrowers had scores below 650, but only 12 to 20 percent might actually qualify for subprime loans because of other hurdles.
These borrowers were often approved even with debt-to-income ratios of 40 percent or more, loan-to-value ratios above 80 percent, recent bankruptcies, recent foreclosures, or histories of mortgage delinquency.
Fannie Mae and Freddie Mac had strict guidelines for conforming loans: verified income, housing costs under 28 percent of gross income, total debt under 36 percent, two years of job stability, actual down payment funds, and a two-month cash cushion after all expenses. Even with all those requirements, they were nervous about the class.
By April 2007, Freddie Mac’s CEO said the company would no longer buy NINA loans (no income, no asset verification), loans not underwritten at the fully amortized rate, or loans that didn’t account for insurance and property taxes.
That these were explicit new policy choices tells you something about what had been happening before.
Truthiness in Lending
Tavakoli borrows Stephen Colbert’s concept of “truthiness” - what you want the facts to be, as opposed to what the facts are.
The subprime market ran on it.
First Alliance Mortgage Company (FAMCO) charged origination fees of 10 to 25 percent of the loan value but misrepresented them as part of the interest rate. Teaser rates were described as constant unless market rates rose, when actually they could increase by a point every six months regardless of market conditions. Borrowers weren’t given required Truth in Lending Act booklets explaining how adjustable rates worked.
Then came the servicing abuses: promised improvements that never happened, unjustified fees added to collection amounts, inflated ARM payment calculations.
To prevent class action lawsuits, subprime documentation included mandatory arbitration clauses.
The product menu was designed for failure. Hybrid ARMs had fixed teaser rates for 2 years (2/28 ARMs) or 3 years (3/27) or 5 years (5/25), then reset to adjustable rates for the remaining term. The reset amounts were often unclear. Option ARMs allowed payments so low they didn’t cover interest costs - the unpaid interest was added to the loan balance. Negative amortization. Some areas saw home prices fall while mortgage balances were climbing.
Forty-year and 45-year ARMs were sold to people who would build essentially no equity in the early years.
Piggyback loans funded down payments so that 100 percent of the home value was financed. No-income-verification loans - “liar loans” - let borrowers state their own income with no documentation. Brokers had incentives to push refinancings and generate prepayment charges, a practice called rent seeking.
Alt-A mortgages had their own version of this: borrowers purchasing multiple properties with little or no money down, using option ARMs in markets where housing prices were flat or falling. Almost guaranteed upside-down mortgages.
The Predators Fall
Predatory lending thrived outside mainstream banking channels because Fannie and Freddie wouldn’t buy these loans and many banks wouldn’t extend credit without documentation.
Mortgage brokers originated 70 percent of subprime loans. Most did not adhere to prudent underwriting guidelines.
Investment banks stepped in. They extended credit lines to mortgage lenders so they could originate outside traditional channels. Some investment banks bought subprime lenders outright. Morgan Stanley bought Saxon Capital for $706 million. Merrill Lynch bought National City’s First Franklin unit for $1.3 billion. Merrill also had a stake in Ownit Mortgage Solutions and was a creditor of New Century when it filed for Chapter 11 in April 2007.
After mortgage lenders originated loans using bank credit lines, investment banks warehoused the mortgages, repackaged them into securitizations, and sold the tranched risk to investors - insurance companies, foreign central banks, REITs, mutual funds, pension funds, hedge funds.
Circular credit logic then fell apart. Investment banks told mortgage lenders to buy back bad loans. But those same investment banks had provided the credit lines those mortgage lenders depended on. When the credit lines dried up, the lenders couldn’t repurchase anything.
By March 2007, of the top 25 subprime lenders, 5 had been shut down, 3 no longer operated independently, 7 had announced large write-downs, and 1 was for sale. From late 2006 to July 2007, Aaron Krowne’s Implode-o-Meter tracked 100 major US mortgage lenders going kaput. An unprecedented failure rate.
Classic Ponzi Scheme
Tavakoli is direct: the lending relationship between investment banks and failing mortgage lenders had devolved into the largest Ponzi scheme in the history of capital markets.
The definition of a classic Ponzi scheme: using money from new investors to pay obligations to existing investors.
When mortgage lenders needed credit lines funded by new securitization revenues to buy back loans that didn’t meet requirements from old deals with old investors, the structure had crossed that line.
Investment banks had helped mortgage lenders issue IPOs, made equity investments, extended credit lines, and accumulated risky loans in warehouses awaiting securitization. The loans became collateral for CDOs and CDO-squared products. Each layer of securitization compounded errors in the underlying collateral. If the original loan quality was overestimated, the errors magnified with each repackaging.
Investors who had to mark portfolios to market saw losses rapidly. Subordination and other credit protections came under pressure, causing spreads to widen and prices to drop even before rating agencies had a chance to act. BBB- tranches could only absorb cumulative losses of 9 to 11 percent before losing principal. With subprime foreclosures heading toward 30 percent and recovery rates falling to unprecedented lows in distressed zip codes, principal losses on BBB- tranches were not just possible - they were probable. Some CDO-squared products that unwound recovered as little as 25 cents on the dollar.
Portfolio Risk and Voluntary Due Diligence Failures
Not all CDOs were in trouble. Pre-2006 vintage deals with solid collateral and proper structure were more robust.
But investors in private placements (144A deals) were responsible for doing their own due diligence. Many didn’t. They competed for product and jumped in without scrutinizing the documentation.
One deal’s documentation showed that underwriting criteria were unavailable for 79 percent of the loans. If you owned that deal, the means of knowing you were at risk had been provided to you. Any collateral acquired through mortgage brokers with no information about underwriting guidelines was risky collateral.
Tavakoli’s judgment: investors who engaged in voluntary due diligence failures would find little sympathy. But if material information was not disclosed, that was a separate issue with potential remedies.
The Risk Manager’s Dilemma
The problem with risk management in subprime wasn’t mathematical. It was structural.
Risk managers don’t have power. Their job is to identify risk. Stopping it requires authority they typically don’t have.
Ben Bernanke appeared on national television telling lenders to apply tighter standards. The Fed regulated investment banking arms of commercial banks but not independent investment banks like Merrill Lynch or Lehman Brothers.
At Merrill Lynch, Mike Blum, head of global asset-backed finance, sat on the board of Ownit Mortgage Solutions. Ownit made second-lien mortgages, issued 45-year ARMs, and originated no-income-verification loans. When Ownit imploded, Blum faxed in his resignation.
Ownit’s founder said it plainly: “The market is paying me to do a no-income-verification loan more than it is paying me to do the full documentation loans.”
Raising a concern about limiting credit lines to mortgage brokers would have been career suicide for a risk manager. The bank’s securitization group was earning high fees. Questioning the wisdom of the relationship would have been career-cratering.
Other major players in subprime aggregation included Lehman Brothers, Bear Stearns, UBS, Credit Suisse First Boston, Morgan Stanley, RBS Greenwich Capital, and Deutsche Bank. None of them were alone in continuing to securitize risky loans.
How to Create a Securitization Disaster
By the end of 2006, more than 10 thinly capitalized mortgage brokers were in serious financial difficulty. Between late 2006 and early July 2007, the number reached 92 in bankruptcy or serious trouble.
The mechanism was simple. Brokers pumped mortgages into the system. More mortgages meant more origination fees. Brokers worked with unregulated loan officers whose commissions depended on volume. This created incentives to let underwriting standards slip, let documentation standards slip, and to push products with low initial payments that ramped up later.
Investment banks and commercial banks provided warehouse credit lines. Multiple banks often had simultaneous exposure to the same mortgage lender. The warehouse was a special purpose entity that accumulated loans until there were enough to back a CDO. If loans violated representations and warranties or stopped payment within 90 days, the warehouse could ask the lender to repurchase. But mortgage lenders had used their fee income to pay officers and expenses. They had no reserves.
The classic Ponzi formula: no income source other than the business that got you into trouble in the first place, so you borrow from one lender to meet obligations to another.
MILA is a representative example. A 300-employee company that funded at least $4.5 billion in mortgages in 2005, making it a top-30 US subprime lender. It had a “proprietary model” to determine loan risk. When MILA declared bankruptcy in summer 2007, it listed less than $8 million in assets against $174.7 million in liabilities, with Bear Stearns ($21 million), GMAC ($10.5 million), and Goldman Sachs Mortgage ($6.8 million) among its unsecured creditors demanding repurchases of substandard loans. MILA had nothing to repurchase with.
Models vs Common Sense
In April 2005, Fed Chairman Alan Greenspan spoke at the Federal Reserve’s Community Affairs Research Conference and praised credit-scoring models for enabling lenders to efficiently extend credit to a broader spectrum of consumers. He described the rapid growth in subprime lending as a benefit of these improvements.
Tavakoli’s assessment: unreasonably complacent given the consumer lending problems of the late 1990s and early 2000s.
The motivations of thinly capitalized mortgage lenders were not challenged. The slippage in underwriting standards was not challenged. The emergence of loan products unprecedented in their risk went unchallenged.
Rating agencies once again relied on untested models without validating the assumptions. The CFS problem with charged-off credit card receivables was replayed with subprime mortgages. Same missing data. Same proxy substitutions. Same failure to require independent verification.
The rating agencies were broken. Garbage in, garbage out. Investors in some cases voluntarily failed to do due diligence. In other cases they were misled.
When Moody’s managing director Claire Robinson was asked at a June 2007 conference why there hadn’t been more downgrades, she said: “What they don’t understand about the rating process is that we don’t change our ratings on speculation about what’s going to happen.”
This was a failure of permanent destruction of underlying value being treated as a speculation problem.
Lack of Due Diligence: What Should Have Been Done
Appropriate due diligence on the underlying loans would have included:
- Statistical sampling of loan portfolios
- Verification of home price appraisals in the sample
- Verification that mortgages were not missold to homeowners
- Verification of borrowers’ total debt loads
- Income verification of stated-income loans in the sample
- Verification that homeowners could cope with coupon resets
None of this was done at scale. Rating agencies charged first-rate prices for third-rate work. Savvy investors in mortgage-backed securities knew the products needed to be marked down because the assumptions underlying the ratings were wrong. Investment banks arranging these deals knew. Many hedge funds knew. They all kept playing until they couldn’t.
The next post picks up with what those hedge funds did about it - and what happened when Bear Stearns found itself on the wrong side.
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