Sub Prime Fiasco
Posted in Newsroom on August 26, 2007 – 5:47 pm
by Bill Koenig
Rob Cyran and Edward Chancellor in their Wall Street article, “Thanks Greenspan,” stated:
Alan Greenspan was an ideal central banker — at least, as far as investment banks were concerned. Whenever their profitability was threatened, the former Federal Reserve chairman rode to the rescue.
Mr. Greenspan assisted investment banks in many ways. His general opposition to financial regulation made life easier for hedge funds, which became a major source of profits. When investment banks got into hot water after the tech bubble burst, the Fed chief had little to say about their abuse of conflicts of interest.
Even more important for the banks’ profits was Mr. Greenspan’s policy of boosting the economy by keeping short-term rates well below long-term yields. This “carry trade” became a license to print money for the investment banks’ proprietary trading desks and fixed-income departments.
Wall Street may fondly remember Mr. Greenspan. But did he really serve its long-term interests? The markets are being shaken by subprime defaults, and overly indebted hedge funds are unwinding their positions. Yet the housing bubble, unregulated hedge funds and opaque financial markets are part of Mr. Greenspan’s legacy.
John Mauldin of Dallas wrote:
To say the credit markets are frozen is an understatement. Talking to any number of people who have been in the markets for decades, this is the worst in their memory. Ironically, it is the 100-year anniversary of the Panic of 1907, when one banker (J. P. Morgan) stepped in and provided liquidity to the markets. The central banks of the world are providing liquidity; but as we will see, it is not mere liquidity that is needed.
You cannot explain the problems with just one or two items. A perfect storm of this sort takes a number of factors all coming together to work its mischief. Bad mortgage underwriting practices, bad rating agency practices, a destruction of confidence, excessive leverage and then the withdrawal of that leverage, the need for yield, greed, and complacency becomes paralyzing fear — all play their part.
Residential Mortgage Backed Security (RMBS)
A Residential Mortgage-Backed Security (RMBS) is a securitized interest in a pool of residential mortgages. It is structured as a bond. Instead of paying investors fixed coupon rate and principal, it pays out of the cash flows from the mortgage pool. The simplest form of mortgage-backed security is a mortgage pass-through. With this structure, all principal and interest payments (less a servicing fee) from the mortgage pool are passed to the investors each month.
The Participants in the Subprime Chaos
The subprime mortgage boom has had many players. Many have profited, but there are also many who are now feeling the consequences of ill-advised lending — not to mention the up to 2 million loans that may be at risk in the United States.
Here are the participants and their roles:
Major U.S. Banks: They close residential loans and make money on fees and points. They sell their loans to Wall Street firms who pool the mortgages together (securitize them) in bonds. Next, a major rating service rates the risk, and the bonds are then placed with investors/hedge funds.
Mortgage Companies: They close residential loans and make money on fees and points. They sell their loans to Wall Street firms who pool the mortgages together (securitize them) in bonds. Next, a major rating service rates the risk, and the bonds are then placed with investors/hedge funds.
Mortgage Brokers: Mortgage brokers originate about half of the loans made to borrowers with good credit. Their presence is even greater in other segments of the mortgage market where defaults are increasing. Brokers originate about three-quarters of subprime mortgages made to borrowers with bad credit, according to Wholesale Access. They also originate 70 percent of so-called Alt-A mortgages, a gray area that falls between prime and subprime.
Wall Street Investment Banks: Wall Street firms pool the residential loans (securitize them) into a bond. They place them with investors/hedge funds and international hedge funds for a fee and management fee.
Rating Firms (Moody’s, Standard & Poor’s and Fitch ratings): Ratings firms rate the securitized mortgage pools, which impacts the purchases of the loans based on their investment risk. They underwrite the loans with arm-length consultation with Wall Street firms.
SEC Oversight: Oversees the rating firms’ compliance.
Hedge Funds: Want safe assets that return gains — many with higher risk.
Asian and European Banks: Asian and European banks were the most aggressive buyers of mortgage-backed securities and other structured portfolios.
Real Estate Agents: Pitch the investment potential and the appreciation upside of a new home. Many times, they also refer the buyer to a mortgage broker.
Borrowers: It is estimated by the IRS that 60 percent of the subprime borrowers misstated their income in loan applications, which wasn’t checked in low-document loans.
First-Time Borrowers: Many borrowers were misled by realtors who pitched rapid appreciation potential and were led into risky loans by mortgage brokers.
IRS: They will come into the loop if there is debt forgiven by lenders at time of foreclosure. Debt forgiveness is treated as ordinary income in the year of the foreclosure, which will lead to tax due.
Law Firms: Some major law firms are preparing to file suit against the well-funded rating services on the basis that their ratings mislead investors, which influenced their investment decisions.
Congress: The Senate is preparing for fall hearings with an emphasis on rating services responsibility.
Anatomy of the Subprime Disaster: Many Original Traps
Trap: A family had little money for a down payment and chose a loan that would hold their monthly payments down for the first two years, after which the loan was supposed to be “reset” to a higher level.
Trap: Loans were made based on a person’s ability to pay the mortgage (which had reduced interest rates) on the first two years of the loan, not on the next 28 years. These were called 2/28 loans.
Trap: Realtor pitched the appreciation potential of a new home purchase to the prospective borrower — and in many cases found a mortgage broker to fund the purchase.
Trap: Mortgage broker many times attempted to assure the home buyer they would be able to refinance in a couple of years to keep their payments affordable, and that they might even be able to refinance — pulling money out of the house due to home appreciation.
Trap: The refinancing option for many subprime borrowers now looks impossible since loan balances may exceed the value of their home due to home value depreciation.
Trap: When the mortgage money dries up, housing values fall even further.
Trap: The lenders who were offering risky loan offers are now enforcing much stricter standards, putting the borrower into a deeper trap and the risk of foreclosure.
Trap: If the homeowner can find a buyer for their home at a reduced price, they have to go to the closing with money to make up the difference between the original purchase price/loan amount and the deflated sales price. (Equity isn’t likely, since most of these borrowers didn’t have equity to put into their homes originally.)
Trap: Without new financing or money to pay at closing (in the event the home can be sold), the home will be foreclosed with an increased likelihood of bankruptcy, leading to the family’s personal and financial life being totally disrupted for many years to come.
Trap: Debt canceled upon foreclosure is subject to federal income taxes.
