So Why Did So Many People Buy Crappy Mortgages? Not Answered By Financial Crisis Inquiry Commission.Monday, January 31st, 2011
Yves Smith’s blog Naked Capitalism, in an article co-authored by Smith and attorney Tom Adams, really hits the sweet spot regarding the mortgage market collapse of 2008 by asking an obvious question the FCIC ignored: Why did people buy all those crappy mortgages?
“In common with other accounts of the financial crisis, the Financial Crisis Inquiry Commission report notes that mortgage underwriting standards were abandoned, allowing many more loans to be made. It blames the regulators for not standing pat while this occurred. However, the report fails to ask, let alone answer, why standards were abandoned.
In our view, blaming the regulators is a weak argument….
By blaming regulators (and the rating agencies), the report makes it seem as if it was just about what the lenders could get away with. But that same argument could be applied to any credit market, yet the US mortgage market was rife with remarkably crappy loans. And lenders still would suffer negative consequences for selling a bad product, even if they could get away with it for a while, such as loss of reputation due to inferior deal performance, losses on retained interests, and poor pricing for the drecky mortgages.
Along a similar line, the report notes that bonuses skyrocketed for the industry during the bubble years. Where did this money come from? Why had the mortgage industry never before generated such high compensation?
The obvious answer is that good loans did not generate hugely excessive bonuses, but bad loans did.
What happened is that the benefits for originating bad loans exceeded the cost of these negative consequences – someone was paying enough more for bad loans to overwhelm the normal economic incentives to resist such bad underwriting.
The best example of this is John Paulson, who earned nearly $20 billion for his fund shorting subprime. This amount of money was not ever possible or conceivable in the mortgage business prior to that point. The only way it could occur was through the creation of a tremendous number of bad loans, followed by a bet against them. Betting on good loans could never generate this much gain.
Given the massive amount of money earned by betting on bad loans, the logical next step is to ask, how did such incentives affect and distort the market?
Remarkably, the report never asks such a question. Yet the FCIC learned from Gregg Lippman of Deutsche Bank, who was arguably the single most important individual in developing the market for credit default swaps on asset backed securities (which allowed short bets to be placed on specific tranches of mortgage bonds) and related “innovations”, such as the synthetic CDO (a collateralized debt obligation consisting solely of CDS, nearly all of which were on mortgage bonds) that he helped over 50-100 hedge funds bet against bad mortgages. Didn’t it seem obvious to anyone at the commission that this information meant that a tremendous amount of money was invested in the market failing? What was the impact of this pile of money?
The report also fails to connect the dots about how Lippman and these funds accomplished their investment objective. Doing so would have allowed the report to draw conclusions about how the next crisis could be avoided.
The introduction of a standardized contract on credit default swaps in the mortgage related market (which took place in June 2005….notice the timing relative to when the really bad mortgage issuance took off?) allowed interested parties to bet against the mortgage market in a remarkably efficient manner – through the use of CDOs. CDOs allowed investors to bet on the weakest mortgage bonds, the BBB tranches, which were a teeny but critical portion of the original deal (note it was cheaper to place these bets via CDOs than the ABX index, although some of the short sellers did that also). If the dealers couldn’t place these dodgy pieces, the entire mortgage bond factory would have ground to a halt. The last thing the dealers would want to be stuck with is the least desirable portion of a bond offering.”
Beezer here. The answer is leverage. Incredible leverage that sent commissions and bonuses for the dreck loans into the stratosphere, overwhelming any normal caution that would have otherwise not allowed this entire house of cards to constructed.
“Dozens of warning signs, at every step of the process, should have created negative feedback. Instead, the financial incentives for bad lending and bad securitizing were so great that they overwhelmed normal caution. Lenders were being paid more for bad loans than good, securitizers were paid to generate deals as fast as possible even though normal controls were breaking down, CDO managers were paid huge fees despite have little skill or expertise, rating agencies were paid multiples of their normal MBS fees to create CDOs, and bond insurers were paid large amounts of money to insure deals that “had no risk” and virtually no capital requirements. All of this was created by ridiculously small investments by hedge funds shorting MBS mezzanine bonds through CDO structures.”
Beezer again. With the structures used $50 million down could ‘reference’ $84 billion in mortgage loans! Now that’s how you turn a run of the mill housing slowdown in to a global phenomenon that tanked the economies of North Atlantic countries and sucked trillions of taxpayer dollars into suddenly insolvent bank balance sheets.
“Now even though that ratio is eye-popping, a $50 million investment versus $84 billion of mortgage loans ultimately referenced, it is hard at this level to ascertain the impact in any tidy way. The BBB tranche was hardest to sell and only 3% of the total value of the RMBS. It had served to constrain demand. But the dynamic flipped. In tail wag the dog manner, the pipeline started demanding crappy loans to get that BBB slice. There was a chronic perceived shortage of AAA paper, so the bulk of the subprime could be sold, and the other less prized parts could be dumped into other CDOs, which were also big fee earners to the banks.
But we can assess the market impact for a particular CDO shorting strategy, the one used by the hedge fund Magnetar, which used heavily synthetic CDOs, with roughly 20% actual BBB bonds, the rest credit default swaps.
A back of the envelope calculation, which leaves out the complicating and intensifying factor of the inclusion of lower CDO tranches in supposed first gen CDOs (put more simply, regular “mezzanine” or CDOs composed largely of BBB rated subprime bonds could be and were often 10% CDO squared; the so-called high grade CDOs, made mainly of A and AA bond tranches, could be as much as 30% CDO squared) shows that every dollar of equity in “mezz” (largely BBB) asset backed securities CDOs that funded cash bond purchases generated $533 of subprime bond demand [(1/3% BBB tranche in original RMBS x 5% equity tranche in the CDO) x 80% BBB bonds in the CDO].
You then gross that up for how many dollars of actual loans that represented, since it took roughly $100 of loans to make $95 of bonds, so the impact on the loan market was $560. The Magnetar structure was roughly 20% cash bonds, 80% synthetics, so $560 x 20% is $112. In other words, the impact on the loan market of the Magnetar structure was over $100 for every dollar they invested.And looking across its entire program, we’ve estimated, when making allowance for the effect of lower tranche CDOs in their deals, that their program alone drove the demand for at least 35% of subprime bond issuance in 2006. Industry sources have argued the total impact was considerably greater, both due to the effects of the synthetic component and the fact the structure was imitated by other hedge funds and dealers.”
Beezer again. The FCIC report basically consists of the usual talking points about the crisis, but according to the authors the report falls far short of getting to the core problem. Why did people buy all these crappy mortgages?
“It is remarkable that the FCIC, with its access to industry figures and its subpoena powers, was unable to refine this sort of analysis together to give a clear picture of what was happening in the CDO market. The public deserves to know why Goldman, Paulson, Magnetar, Phil Falcone, Kyle Bass, George Soros, Deutsche Bank and 50 or more others were so eager to make these investments, why they wanted to keep the bad lending machine going, why they wanted to keep their strategies secret (even now), and how they made so much money so quickly. After all, it’s the rest of us who wound up holding the bag.”
Final Beezer. Exactly. Yves Smith is a pseudonym for a well known Wall Street trader who knows what she’s talking about. Adams worked for a monoline insurer so he intimately knows the mortgage insurance business. The article uses a nice chart that shows the structures used, including synthetics, to lever a mortgage pool beyond belief, never-mind reason. The FCIC conclusions can be found here.