Based on public information like this, the SEC should have taken immediate action and asked Merrill and other investment banks why they did not write down losses on mortgage loans and their securitization businesses. If the SEC was not alarmed by the newspapers, they should have been alarmed by an article that I wrote for risk professionals in first quarter 2007. There I emphatically stated that investment bank risk managers involved in securitizing subprime mortgages should get out and short the product, because the predators’ fall was in full swing. It was career suicide to be in a position of supposedly overseeing risk if one did not have the authority to stop the insanity. If, however, one did have the authority to do something about it, the time for action was past due. The SEC may not care about my views, but it ignored many voices from the business media and from investment professionals.
Tom Hudson and Beejal Patel of First Business Morning News (FBMN) broadcasting out of Chicago documented the troubles of subprime mortgage lenders. They were ahead of the pack in predicting massive write-downs at investment banks.With a shoestring budget and a half-hour broadcast, they presented the best overall coverage of the role of the Fed, mortgage lending, investment banks, and lax sophisticated investors. In fact, they presented great overall coverage on all aspects of finance. The show airs at 5:00 A.M. Chicago, and many Chicago traders—the largest volume of exchange traded derivatives in the world changes hand in Chicago—get up to watch FBMN ’s financial coverage.
In March 2007, Tom Hudson noted that “banks, brokers and auto companies” were writing down exposures to subprime lenders. In Chicago, Corus Bankshares, Inc. took a write-down on its shares of Freemont General, a large subprime lender. New Century was being sued in several states to stop it from giving new loans. Hudson noted that the Fed regulates banks and could have pushed to stop inflating the subprime market by allowing them to offer “teaser rates that weren’t explained to the borrowers.” I agreed, “The Fed seemed complacent about the risk.” I added that U.S. pension funds and mutual funds owned some of these risky products.“I don’t know anyone I hate enough to want to have a negative amortizing ARM (also called a pay option ARM). It is just a bad product.”Your loan amount increases and then the interest rate shoots up,“it is like the levies breaking.”15
Yet, investment banks and sophisticated investors did not take huge write-downs on their inventory backed by dodgy loans in first quarter 2007. Dodgy mortgage loans (and securities backed by dodgy mortgage loans) were priced using a mark-to-model. Investment banks with an incentive to use rosy assumptions controlled the models, and the result reminded me of Warren’s comment about the value of derivatives often being a mark-to-myth.
The SEC as regulator of the investment banks had the power, but it did nothing to halt securitization activity. Instead, investment banks accelerated securitization activity in the first part of 2007.
A typical residential mortgage-backed security, backed by a pool of subprime and other mortgage loans, has several levels of risk known as tranches. The risk of the first few loans to default in the portfolio is borne by the equity investor sometimes called the preference share investor, and so on up the line. In a typical deal, the lowest-rated BB tranche is protected by the equity investor, who absorbs the first 3.25 percent of the losses in the portfolio, if any.This is also known as 3.25 percent subordination. An investment-grade tranche rated BBB is protected by investors taking the first 5.5 percent of the loans to default, if any. In other words, it is protected by the combined losses absorbed by the first loss investor and the BB investor. An investor in the A rated tranche is protected by other investors taking the risk of the first 10 percent of the loans to default, and an investor in the AA rated tranche is protected by other investors taking the first 16 percent to default. The lowest AAA tranche is protected by 24 percent subordination, and the highest AAA rated tranche is protected by 70 percent subordination.
Investors might have felt safe with that much “protection” under the AAA rated tranche, but by December 2007, loans that were 60 days or more late in payments or in foreclosure had climbed to 22 percent (according to LoanPerformance) and recovery rates for subprime loans were very low and varied from pennies on the dollar to 50 percent or so for a first mortgage. Second mortgage loans were often worthless. Collateral rapidly vaporized. Deals made up of piggyback (second lien) loans had principal losses eating through tranches rated “AAA.” Investors with deals backed by first lien loans found that losses ate corrosively right through AA tranches, the higher tranches required massive and multilevel downgrades, and that was for deals that did not include a high concentration of loans from mortgage lenders with allegations of fraud. Based on past experience with unsound lending practices like in the manufactured housing market, these problems were foreseeable, and many professionals, including Whitney Tilson (of T2 Partners LLC and the Tilson Funds) and William Ackman (of Pershing Capital) sounded the alarm.
After his bad experience with the Oakwood investment, Warren had warned that securitization distanced the supplier of funds (the investment banks) from the lending transaction (mortgage lenders using mortgage brokers) and “the industry’s conduct went from bad to worse.”16 Human nature has not changed.
As for Merrill, it continued its securitization activity in 2007, despite red flags from failing mortgage lenders, including Ownit. For example, in early 2007, it created a package of loans including piggyback loans issued by Ownit.17 Around 70 percent of the borrowers had not provided full documentation of either their income or assets. Most of the loans were for the full appraised value (no down payment), and home prices were already showing weakness if not outright falling. In the deal documents, Merrill mentioned that Ownit went bankrupt, but did not mention it was Ownit’s largest creditor. Can Merrill say it did an “arms-length” transaction with Ownit when a Merrill officer sat on Ownit’s board? In early 2008, both Moody’s and Standard and Poor’s downgraded the AAA rated tranche (an investment they had rated as “super safe” with almost no possibility of loss) to B (junk status meaning you are likely to lose your shirt). Moody’s forecast that 60 percent of the original portfolio value could eventually be lost.18
MAD is the military term for mutually assured destruction, and unsound mortgage lending practices guaranteed that the housing market would be damaged along with the balance sheets of investors that participated by ignoring the risk or by being suckered into unknowingly taking excessive risk. By turning a blind eye to the massive rape of the mortgage loan market, investment bankers assured damage to the U.S. housing market and to their own balance sheet when they were stuck with enormous exposure to their own mischief.
Most of the “early post-signing” defaults in loans, originated through the early months of 2007, had been on “stated income loans,” (also known as liar loans) especially with loan-to-value ratios approaching 100 percent, whether they were subprime or not. This suggested stated income was overstated. Future defaults would kick in as resets on coupons occurred in a soft housing market.
Throughout most of 2007, the Federal Reserve seemed to be in denial, using reverse moral suasion by minimizing estimates of potential damage. On August 3, 2007, I told CNBC’s Joe Kernen: “The market is nervous because everyone feels like they are being lied to. Chairman Ben Bernanke seems to have been doing his homework on Wall Street.” Earlier Bernanke reported subprime loss estimates of only $50 to $100 billion. Credit Suisse First Boston had been projecting $50 billion and Citigroup projected $100 billion for subprime losses. I felt every one underestimated ultimate default rates and equally important “they are grossly overestimating recovery rates in subprime. . . .Wall Street really screwed Main Street.” I had projected $270 billion to $340 billion in subprime losses and around $450 billion to $560 billion for all risky mortgage loan products including Alt-A and prime mortgages.19 My estimates represented only principal losses, and predatory securitization of predatory loans would amplify these losses.
The day the segment aired, a client
asked,“Are you saying Bernanke is incompetent, or are you saying he’s a lying coward?”
“Can’t you think of any other possibilities?” I asked in reply.
“What else could there be?”
“He may be brave in support of the wrong cause.”
My client later reminded me of those words when Associate Justice of the Supreme Court, Antonin Scalia, told 60 Minutes that torture (such as waterboarding) is not “punishment,”20 implying that the constitutional prohibition against cruel and unusual punishment wouldn’t apply to torture. My client joked that investment banks would like to waterboard me to prevent me from talking.
My loss projections were higher than anything coming out of the U.S. government or Wall Street. It turns out I was predicting the greatest losses, and I was too optimistic. Housing speculators and overreaching homeowners took risk, seemingly with “eyes wide shut.” Many others were lured with the promise of homeownership. Predatory lenders targeted minorities and lower-income people who were intellectually and financially mugged, then dumped on the side of the road. The motto of predatory lenders is “every minority left behind.”
Before meeting Warren, I wrote about industry problems, but only in a general way. Warren’s subtle encouragement helped me find my voice. Now I specifically challenged the Federal Reserve Bank and major investment banks on national television.
I told CNBC’s Joe Kernen that I advocated a temporary moratorium on subprime foreclosures, followed by mortgage restructurings.That meant first reappraising to lower values reflecting the devastation caused by predatory lending and then restructuring mortgages to an affordable fixed rate. In some areas, the reappraised values will be drastically lower and the mortgage terms radically different.This protects misled homeowners. Borrowers complicit in fraud, or who willfully overleveraged, should not be given the same protection but could unintentionally benefit. Helping fraudsters is not anyone’s idea of a solution but having a few of them slip through the cracks was preferable to the ruination of entire neighborhoods.The devastation was already well underway and needed to be halted.
In some parts of the Midwest every third home is vacant in minority neighborhoods. Housing prices have plummeted. Fixing the problem for innocent homeowners will mean losses must be born by lenders, including subprime mortgage bankers, investment banks that provided financing to the mortgage bankers, and the investors in subprime mortgages and securitizations backed with subprime mortgages. There is no reason for U.S. taxpayers to bail out the sophisticated financiers.
It is counterintuitive, but limiting losses by reappraising and rewriting mortgages would result in a higher recovery rate that would be good for everyone and limit overall losses.
Servicers collect and record loan payments and credit loan accounts. In the summer of 2007, a major Midwest-based servicer of mortgage loans told me the rating agencies’ subprime recovery rates were much too optimistic.The servicer said modifying a mortgage was highly preferable to recovering zero or negative value after foreclosure fees and depressed asset prices took their toll on recovery of relatively low loan balances. These were geographically diverse U.S. subprime loans, but they were alike in risk characteristics.The servicer’s staff worked frantic 13-hour days to salvage value. The servicer underreported delinquencies, overdue payments, which were usually reported one month behind prime mortgages already. The day a homeowner missed a payment, the servicer got on the phone trying to work out a new deal. The servicer allowed skipped payments and did not report them as delinquencies. The servicer discovered that if homeowners missed two payments, the loan was virtually doomed to default because most homeowners gave up after that. It aggressively “re-aged” mortgages—ignoring missed payments urging borrowers to make even one payment so the loan could appear alive. If this practice was typical, the scope of the subprime problem was underreported.The servicer restructured loans doomed to fail in the future. It sold loans for pennies (3 cents to 6 cents) on the dollar. Some of the loans had negative equity (the homeowner owed more than the home was worth) at the time of delinquency. The servicer avoided foreclosure, because legal costs relative to low loan balances and long delays ate up more money than it recovered. Assets included trailers, mobile homes, and homes in areas with depressed prices.
If this sounds odd, consider that in 2008 a plethora of banks started reclassifying loans on their balance sheets (Astoria Financial,Wells Fargo & Co., and others) or began using more optimistic data (Wachovia Corp. and Washington Mutual). If you don’t like the numbers, just change the definition. In July 2008,Wells Fargo stock price jumped 33 percent when its losses were less than expected, but it announced that, as of April 2008, it would wait an additional two months before writing off a loan (180 days instead of 120 days) saying it did not affect its earnings announcement. At the time Wells Fargo’s portfolio of home equity loans was $83.6 billion and it was showing signs of stress.2122
JPMorgan Chase’s CEO Jamie Dimon is a master at balancing the short game of earnings announcements with the long game of running a bank. He steered away from most of the mortgage madness, but announced that “jumbo” mortgages (large balance mortgages to good credits) showed increasing losses. Dimon announced that these prime mortgages to the bank’s best customers had losses of 0.95 percent (up from 0.05 percent the prior year), and the losses could triple. For example in California, housing prices had collapsed leading to higher loan losses even for prime (good credit) borrowers. He said JPMorgan may have waded back into the mortgage market early: “We were wrong.We obviously wish we hadn’t done it.”23
The Federal Reserve kept interest rates low for years seemingly complacent in light of consumer lending problems in the late 1990s and the early part of the twenty-first century. In April 2005, then Fed Chairman Alan Greenspan said mortgage lenders efficiently judged the risk.24 Instead, Greenspan should have raised the alarm about foolish mortgage lending. The Fed compounded its errors when it bailed out Countrywide, the second largest subprime lender in the United States, which is regulated by the Office of Thrift Supervision. Countrywide is also a primary dealer, authorized to trade U.S. government and other select securities with the Federal Reserve System.The Fed should have revoked Countrywide’s primary dealer status and let it fend for itself.
Countrywide posted its expanded interest-only programs on its Web site in September 2003 (and appeared to remove it in 2007). Few borrowers are savvy enough for interest-only loans, since mortgage borrowers paid no principal on loans, just interest. Many hoped housing prices would rise so they could refinance or take a profit.The program included NINA (no documentation: no income verification, no asset verification), No Ratio (no income information, so no debt to income ratio is calculated allowing the borrower to assume a greater debt load than would be allowed with a traditional mortgage), and SISA (stated income, stated assets) loans. The FHA guaranteed some Countrywide loans, and presumably they conformed to FHA’s requirements. But FNMA and FHLMC were the chief buyers of Countrywide’s loans, and many of these loans were problematic.
On August 5, 2007, I told CBS’s Thalia Assuras that the mortgage lending relationship with investment banks is one of the largest “Ponzi schemes in financial history” and “risky mortgage products were made to people who couldn’t afford them.”25 I misspoke. I meant to say it is the largest Ponzi scheme in the history of the capital markets.
By the end of 2006, Countrywide’s loans showed signs of trouble. The week of August 6, 2007, rumors hit the market that Countrywide was looking for a “white knight,” a deep pocket investor to either take it over or to provide a liquidity injection, but it had no success. On August 7, 2007, the Federal Open Market Committee issued an economic outlook statement saying that inflation, not the mortgage market problems, were the chief concern, and it would not cut the federal funds rate (the borrowing rate) to inject more liquidity into the market. But just two days later, on August 9, the European Central Bank injected around $130 billion into the European banking system,
and the Federal Reserve pumped $24 billion into the U.S. banking system through the Federal Reserve’s Open Market Trading Desk.
On August 10, 2007,Warren and I spoke on a different topic, and—without naming names—he mentioned that two large companies had come to him hat in hand needing billions.There would be a couple of major blow-ups since they were running out of options. I independently guessed that Countrywide was one of the beggars.
One of the ways Countrywide got money was by issuing commercial paper (asset-backed commercial paper or ABCP) backed by its loans. The week of August 13, 2007, investors shunned Countrywide’s debt. Nervous investors demanded higher interest rates. Countrywide told its creditors (investment banks) it wanted to borrow money (by drawing on its credit card-like credit lines). Countrywide wanted to borrow $11.5 billion from a 40-bank syndicate. Countrywide was in a desperate situation. Market rumors were that the banks refused to lend the money, and asked the Fed for concessions.
On August 15, 2007, I wrote Warren that investors were nervous because Canadian money market funds found their investments (not necessarily related to Countrywide) were backed by risky leveraged subprime products. Prices plummeted as investors realized they would lose principal on AAA rated products.26
The banks got their concessions, and lent to Countrywide. On Thursday, August 16, 2007, the stock market (Dow) fell more than 340 points as Countrywide borrowed $11.5 billion. It seemed to me that on Thursday, one or more of the banks leaked the news ahead of the Fed’s announcement on Friday because, near the end of trading on Thursday, the market rebounded from the 340 point nosedive to finish down only 15 points. On Friday, August 17, 2007, the Fed announced its concessions—a cut of 50 basis points (bps) in the discount rate to 5.75 percent from 6.25 percent along with news of relaxed borrowing terms. The Fed agreed to accept investments backed with (Countrywide’s) mortgage loans as long as they had the now-suspect AAA rating. The Fed also extended the “overnight” discount window borrowings to 30 days. On Friday, August 17, 2007, the stock market marched upward.
Dear Mr. Buffett: What an Investor Learns 1,269 Miles From Wall Street Page 11