When Ranieri finishes, an audience member asks a simple question: “What do you see as the less than rosy scenario when the mortgage market goes into the toilet?”
“I don’t understand what the ripple effects would be,” he replies. “All sorts of people are holding risks that would be hard to track down. And in some cases they wouldn’t even know they are holding the risk.”
Scene 4: Same place, same morning. “Finally,” Josh Rosner thinks to himself as he listens to Ranieri. “Someone is calling it as it is.”
Rosner is the skeptical analyst who back in 2001 wrote the prescient paper “A Home without Equity Is Just a Rental with Debt.” In mid-2005, his sources at the Fed start telling him that rates are going to rise significantly, in no small part to “cure” the excess speculation in housing. He is soon warning clients that the housing market has peaked.
In recent years, Rosner has continued to dig into the numbers underlying the housing boom. It is apparent, he says, that “we’ve bumped up against the law of large numbers in homeownership.” At the end of 2000, the official homeownership figure stood at 67.4 percent. Four years later, with the subprime bubble well under way, the homeownership rate hits 69 percent. That is as high as it will ever go. All of that craziness—not just the bad loans themselves, but the devastated neighborhoods, the people thrown out of their homes, the huge buildup of debt on both Main Street and Wall Street—for a gain of 1.6 percent? Is it really worth it?
To Rosner, the answer is clear: no. His data shows that most of the frenzy hasn’t even been about purchasing a place to live. Rosner’s eureka moment comes when he sees data showing that about 35 percent of the mortgages used to purchase homes in 2004 and 2005 are not for primary residences, but for second homes and investment properties. And as he has been saying for years, the number of people borrowing to buy an actual home is dwarfed by the number of people borrowing to refinance. The refis, in turn, are made possible by rising home values—which may not even be real, given all the inflated appraisals. (In fact, Alan Greenspan himself noted in a study he co-authored in 2007 that about four-fifths of the rise in mortgage debt from 1990 to 2006 was due to the “discretionary extraction of home equity.”)
Like Ranieri, Rosner has become worried about the CDO market. Around the same time as Ranieri’s speech, Rosner approaches a finance professor at Drexel University, Joseph Mason, to co-author a paper with him. They deliver it in February 2007 at the Hudson Institute. The title is a mouthful: “How Resilient Are Mortgage Backed Securities to Collateralized Debt Obligation Market Disruptions?” Their conclusions, however, are straightforward. The issuance of CDOs, which have mushroomed to more than $500 billion in 2006, is propping up the housing market by buying almost all of the riskier tranches of mortgage-backed securities. Investors—real investors, who are not part of the daisy chain—no longer want them. Even investment-grade CDOs will lose money if home prices begin to fall substantially, Rosner and Mason write. If that happens, it could set off a contagion of fear, as investors rush to unload their CDO positions. A vicious circle would then start that would have terrible ramifications, not just for the housing market but for the economy.
Rosner and Mason have also pondered some larger questions. If housing is such an important component of U.S. social policy, and the funding mechanism for housing has become this shaky pyramid of debt, does it really make sense to have the housing market at the mercy of this hugely unstable funding? And inasmuch as investors around the world have sunk their money into U.S. mortgage-backed securities, what are the implications if that market starts to crack? “Perhaps of greater concern is the reputational risk posed to the U.S. capital markets,” they write.
Scene 5: February 7, 2007. New Century files what’s called an 8-K, a document that conveys important news that can’t wait until the next quarter’s results. The headline is stark: “New Century Financial Corporation to Restate Financial Statements for the Quarters Ended March 31, June 30 and September 30, 2006.” Part of the reason for the restatement, the company says, is to “correct errors” in the way it has accounted for its many repurchase requests. The stock, which had hit its high of $51.22 just a few months earlier, plunges 36 percent in one day. By March, the company admits that it is unable to file any financial reports. By then, its repurchase claims have risen to a staggering $8.4 billion. The stock falls to about a dollar. By April, New Century is bankrupt. Never once, during the entire housing bubble, did the company report a quarterly loss before filing for bankruptcy.
By the end of 2006, anyone could have found his or her own data points to know that the subprime market was in trouble. The clues were everywhere. The staggering rise in home appreciation, which in some parts of the country had averaged 10 to 15 percent a year, was slowing down. In places like Arizona, California, Florida—the states where the housing bubble had been most pronounced—housing prices were already declining. Subprime borrowers with option ARMs, the ones who were counting on an increase in their home equity to refinance, were suddenly out of luck. With their homes no longer increasing in value, they had no way to refinance. Foreclosures were nearly double what they had been three years earlier. Delinquencies: up. Stated-income loan defaults: up. And of course those early payment defaults—the ones that signaled just how reckless the subprime originators had become—were way up. Subprime originators had created the conditions for “the perfect storm,” said John Taylor at that OTS housing symposium.
Sheila Bair, who had been sworn in as the new chair of the FDIC that summer, was shocked to discover how far underwriting standards had fallen in the four years since she left the government. Back in 2002, when she had been assistant secretary of the Treasury for financial institutions, there had been problems with predatory lending, for sure, but nothing like this. Nothing even close. One of the first things Bair did upon taking office was order up a database that included every securitized subprime mortgage. It was immediately obvious when she looked at it that there was going to be a massive problem when the ARMs reset.
Meanwhile, a risk manager at one of the big Wall Street firms started noticing something unprecedented: people were walking away from their homes. “Historically,” this risk manager said, “people stopped paying their credit cards first, then their cars, and only then their homes. This time, people with $50,000 cars and $300,000 mortgages would get in their cars and drive away from their homes.”
The newspapers offered further evidence of the looming problems. All through the fall, the business press wrote article after article about the rise in foreclosures and the troubles suddenly hitting the subprime companies. “Payments on Adjustable Loans Hit Overstretched Borrowers,” declared the Wall Street Journal in August of 2006. “Foreclosure Figures Suggest Homeowners in for Rocky Ride,” the Journal said a month later. A month after that, Washington Mutual reported that its home loan unit had lost $33 million in the third quarter. HSBC, which had been a major buyer of second-lien mortgages, announced huge losses and shut down its purchases. And on and on.
On Main Street, the subprime bubble was grinding to a halt. There was going to be a great deal of pain, for both the borrowers and the subprime companies. But Wall Street had one more trick up its sleeve. This was a mechanism created by Wall Street to allow investors to short the housing market similar to the way investors can bet against stocks. It was a natural development—at least from Wall Street’s point of view—but it evolved into one of the most unnatural and destructive financial products that the world has ever seen: the synthetic CDO.
The key ingredient in a synthetic CDO was our old friend the credit default swap. For that matter, the key to shorting the mortgage market was the credit default swap. By 2005, credit default swaps on corporate bonds were ubiquitous, with a notional value of more than $25 trillion. (The notional value of credit default swaps peaked in 2007 at $62 trillion.) They were used by companies to protect against the possibility that another entity it did business with might default. They were used by banks to me
asure the riskiness of a loan portfolio, because their price reflected the market’s view of risk. And they were used in the mortgage-backed securities area by CDO underwriters to wrap the super-senior tranches. The AIG wrap, you’ll recall, was the key to allowing banks with triple-A tranches on their books to reduce their capital.
In the corporate bond market, traders were using credit default swaps not just as protection against the possibility that a bond they owned might default. They were also using them to make a bet—a bet that a company might default, even when the trader didn’t own the underlying bonds. These credit default swaps had become standardized, meaning that the conditions under which the buyers and sellers got paid were always the same. That’s the way markets tend to evolve: first comes hedging, and then comes speculation. To Wall Street, this is all good, because the more players in the market—whatever their reasons—the more trading there is.
In the mortgage-backed securities market, the credit default swaps that people were using to insure those super-seniors were a kind of short, since the buyer of the protection would be paid off if the super-senior tranches defaulted. But no one thought of them this way—they were focused on the regulatory capital advantages. And they were a customized agreement between two parties, which made them hard to trade, because any buyer would have to understand all the complex terms of the deal.
But why couldn’t you create a standardized credit default swap on mortgage-backed securities? That way, anyone could play. Instead of having to painstakingly scratch out terms with the party on the other side, you could trade these instruments the way people do stocks. That would dramatically expand the market—and all the more so if you also published an index of the prices of mortgage-backed securities. Wall Street likes to say that indices are good because they offer transparency—everyone can see what the prices are—and liquidity, meaning it’s easier to get in and out of trades that are based on a public index. That’s probably true. But it’s also true that indices reduce complexity to the simplicity of a published number, allow investors to think they understand a market when they really don’t, and create a frenzy of trading activity that mainly benefits Wall Street.
Developing a big market of tradable credit default swaps on mortgage-backed securities would have several consequences. It would encourage Wall Street firms that were nervous about having mortgage risk on their own books to stay in the business, because now they could hedge their exposure. It would encourage people who had no economic interest in the underlying mortgage-backed securities to simply place bets on whether or not they could decline, because now it was relatively easy to do so. And it would also mean that someone had to take the other side of those bets, because that is, by definition, the way a credit default swap works.
Three firms—Deutsche Bank, Goldman Sachs, and Bear Stearns—led the drive to turn credit default swaps on mortgage-backed securities into easily tradable, standardized instruments. The group, which included Deutsche Bank trader Greg Lippman, Goldman trader Rajiv Kamilla, and Bear trader Todd Kushman, began meeting in February 2005 to figure out what the holders of a short interest should receive, and when they should receive it. Should the protection buyer—as Wall Street called the counterparty on the short side—get his or her money when the mortgage defaulted? When it was ninety days delinquent? The traders decided that the protection buyer should get paid as the mortgage lost value—which would be determined by the Street firm that sold the instrument—in sums that made up for the lost value. They called their concept Pay As You Go, or PAUG. (The correct pronunciation rhymes with “hog,” says one person who was involved.) “To tell the truth, it’s not very glamorous,” Lippman later told Bloomberg reporter Mark Pittman.
In January 2006, an index based on subprime mortgages began trading for the first time. (“THE market event of 1H ’06,” proclaimed a Goldman analyst.) Just as an index like the S&P 500 has five hundred big company stocks, this new index, called the ABX, would list specific tranches of mortgage-backed securities. Once the ABX was up and running, investors could buy or sell contracts linked to the price of mortgage-backed securities, sorted by rating and by year. So, for instance, an investor could short the ABX 06-1 triple-A, meaning a triple-A slice that was originated in the first half of 2006. “Before that, no one ever thought about whether to be long or short mortgages, because everyone was always long and it always worked,” says one trader who was involved.
That wasn’t quite true. The ABX made shorting the mortgage market much easier than it had been before. But even before its creation, a handful of investors—skeptical hedge fund managers, primarily—had sought a way to make a bearish bet on the mortgage market. They had pushed Wall Street firms to sell them customized credit default swaps on specific tranches of mortgage-backed securities. The most famous of these hedge fund managers was John Paulson, who would wind up making $4 billion in 2007 betting against subprime mortgages. He was hardly the only one, though. Michael Burry, a hedge fund manager in California, had become convinced after digging through mountains of paper and actually looking at the underlying loans that the housing market was going to crack. As early as the spring of 2005, he began to enter into trades with Wall Street firms in which he took a short position.
Greg Lippman at Deutsche Bank was one of the few traders operating inside the CDO machine who openly turned against subprime mortgages; indeed, his growing negative view was part of his incentive for getting involved in creating tradable credit default swaps in the first place. Having been, he later said, “balls long in 2005,” he did an about-face when he saw a chart showing that people whose homes had appreciated only slightly were far more likely to default than those whose homes had risen by double digits. Everyone had always thought that unemployment caused mortgage defaults. Lippman realized that the world had changed—now all you’d need was a slowdown in the rate in home appreciation. Lippman would later say that it “takes a certain kind of person to acknowledge that what they spent a lifetime toiling away at doesn’t work anymore.” In the classic fashion of the convert, Lippman became Wall Street’s most enthusiastic salesman for shorting subprime mortgages, making presentations to anyone who would listen. An exuberant, crude man, he had T-shirts made up that read, “I’m short your house.”
Another skeptic was Andrew Redleaf, who ran a big hedge fund in Minneapolis called Whitebox Advisors. His hedge fund traded primarily in what he liked to call “stressed” bonds. (“If a distressed bond has an 80 to 90 percent chance of default, a stressed bond has a 50 percent chance of default,” he explained.) Shaky mortgage bonds were right in his wheelhouse.
A brilliant mathematics student at Yale, Redleaf became an options trader who searched for anomalies between the prices of two different but related securities. By taking advantage of those anomalies, he made money. From a standing start in 1999, Redleaf built Whitebox into a $4 billion hedge fund.
An advocate of the new field of behavioral economics, Redleaf believed that markets were not always rational, that models were not always right, and that Wall Street’s blind adherence to both gave him plenty of opportunity to make money. To him, the mortgage market was as good an example of Wall Street’s shortsightedness as anything you could possibly find. After the crisis, he wrote a book with a Whitebox colleague, Richard Vigilante, entitled Panic, in which he spelled out his philosophy:
This ideology of modern finance replaces the capitalist’s appreciation for free markets as a context for human creativity with the worship of efficient markets as substitutes for that creativity. The capitalist understands free markets as an arena for the contending judgments of free men. The ideologues of modern finance dreamed of efficient markets as a replacement for that judgment and almost as a replacement for the men. The most gloriously efficient of all, supposedly, were modern public securities markets in all their ethereal electronic glory. To these most perfect markets the priesthood of finance attributed powers of calculation and control far exceeding not only the abilities of any human part
icipant in them but the fondest dreams of any Communist commissar pecking away at the next Five Year Plan.
To Redleaf, the cause of the crisis was simple: Wall Street had “substituted elaborate, statistically based insurance schemes that, with the aid of efficient financial markets, were assumed to make old-fashioned credit analysis and human judgment irrelevant.”
Redleaf’s subprime epiphany had come years before, when he listened to a presentation by a New Century executive at an investment conference. He was struck by the fact that 85 percent of New Century’s mortgages were cash-out refinancings. He asked the New Century executive about the default rate for the refinancings as opposed to mortgages that were used to purchase a new home. The man said he didn’t know, but speculated that they probably weren’t any different. This didn’t ring true to Redleaf, whose experience with corporate bonds suggested that defaults were much higher when the debt went to pay off insiders than when it went for general corporate purposes. Cash-out refis struck him as the homeowner’s version of paying off insiders.
Redleaf had another insight. Even back then, he could see that the business model so long touted by the subprime originators made no sense. The companies were saying that they could grow market share, on the one hand, while still using underwriting standards that weeded out borrowers likely to default. “I’ve seen this movie before,” he said. “You can’t have tighter standards and grow share. You can’t even have different standards. In the end, you wind up lending money to people who can’t pay it back, and that isn’t a good business model for a public company.”
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