A lender’s ability to function depends on the existence of a secondary market. While banks and large financial institutions have sufficient capital to fund and hold mortgages in portfolio, most lenders don’t have that capability. A secondary market provides an outlet for lenders to sell mortgages, pay off their warehouse lines of credit, make a profit, and start the process over again. Without it, only the most highly capitalized companies could operate as mortgage lenders.
Our examination of the mortgage securitization process, the investment firms, and the rating agencies will lead to some troubling conclusions.• The relationship between the investment firms and rating agencies was fundamentally flawed, which compromised the rating process.
• Investors who purchased these mortgage-backed securities believed they were investment grade, when in fact the risk was much greater.
• Since the secondary market dictated the products lenders could offer, investment firms and rating agencies became the unofficial regulators of the subprime industry.
• The securitization market transformed the U.S. mortgage market, in some ways to the detriment of the consumer.
The Impact of Securitization
Securitization could be the single greatest innovation in mortgage lending. Before loans were securitized, a consumer relied on a bank to supply the money to fund a mortgage. The entire process, from origination to servicing, stayed with the same institution. Since banks owned every aspect of the loan and were heavily regulated, they were motivated to manage risk and treat borrowers fairly. If a consumer got into financial trouble because of something like lay-offs at a local factory, the local bank often knew about it before it became an issue. Owning the entire process gave banks the latitude to restructure the loan. You’ll see later in this chapter how securitization negatively impacts a borrower’s ability to modify his mortgage.
In addition to creating a renewable source of capital, mortgage securitization helped fragment the industry. A broker originated a loan while a mortgage lender funded it. The lender either sold the loan to another financial institution that held it in portfolio or used an investment bank to package it into a mortgage-backed security. A myriad of investors, ranging from banks to hedge funds, bought the investments for their portfolio. A servicing company collected payments, and when a loan defaulted, foreclosed on the property. The entire process originally performed by one entity was divided into five separate components.
This fragmentation gave each player a claim of plausible deniability. Mortgage brokers maintained that they only originated the loan, so any concerns about the loan’s quality were the lender’s responsibility. The lender underwrote the deal using the guidelines provided by the investment firms, so they merely delivered the final product investors wanted to buy. The Wall Street firms who packaged the securities and the investors who purchased them claimed to be “Holders in Due Course,” which protected them from any liability when lenders and brokers acted illegally. The entire food chain contributed to the current problems, but fragmentation allowed each player to point an accusatory finger at someone else.
While there is plenty of blame to go around, one conclusion is difficult to refute. The problems in today’s housing market exist because the investment banks packaged high-risk loans into securities and the rating agencies assessed them as investment quality. If the investors who purchased the securities understood what they were buying, the outcome would likely have been different.
Understanding Mortgage-Backed Securities
In Chapter 2 securitization was described as a process where thousands of mortgages are bundled together into financial products called mortgage-backed securities (MBS). The investors, usually banks or hedge funds, who purchase the bonds receive the principal and interest payments made by borrowers.
To show how it works, let’s assume a Wall Street firm like Merrill Lynch has a $1 billion pool of subprime mortgages. To package these loans into a security requires the services of a rating agency. Companies like Moody’s conduct an extensive analysis, determining the quality and performance characteristics for the entire pool of mortgages. The ratings they provide help the potential purchaser understand the risks associated with buying them.
The graphic in Figure 5.1 explains the basics of mortgage securitization. The security has levels or tranches (tranche is a French word for slice or section). In the financial sense of the word, each tranche is a piece of the deal’s risk. As you move from the highest rated slices of the security (AAA) to the lowest (Equity), the risk goes up, but so does the potential return.
Figure 5.1 The Basics of Mortgage Securitization
Moody’s reviews the pool of loans and determines that for 80 percent of a potential security to receive an AAA rating (making it investment grade), the other 20 percent has to be rated between AA and Equity. This format is commonly referred to as a senior-subordinate structure, meaning the lowest or subordinate tranches will sustain losses before the senior pieces. It also means the AAA investors get paid first, followed by AA, and so on. Purchasing the AAA portion of this security means that 20 percent of the entire pool must experience a loss before the AAA section is negatively impacted. The same way the pawns protect the king in chess, the lower tranches protect the higher tranches by taking the initial loss.
Here is where it gets more complicated. The security gets spliced and diced into a hodgepodge of separate investment vehicles—CMOs (collateralized mortgage obligations), CDOs (collateralized debt obligations), and CLOs (collateralized loan obligations), all of which represent different ways to distribute credit risk. The security gets diluted even further as some CDOs are backed by other CDOs, which can then invest again in other CDOs. We revisit CDOs toward the end of this chapter.
Since the original mortgages are no longer recognizable, judging the quality of the assets is next to impossible. Think of it this way: Imagine taking 10 different vegetables and pureeing them in a food processor until you have something close to soup. Ask someone to identify the ingredients but don’t let him taste it—make him rely strictly on his sense of sight. Your concoction is sure to make him wonder what’s inside.
Investors who buy these securities face the same challenge. Many believe the confusing nature of the investments means the fund managers who purchased them had no clue what they were buying. For this reason, the rating agencies are vital to the process. Without their objective analysis, investors wouldn’t be able to recognize the risk associated with purchasing the securities.
Why is something as simple as a mortgage payment dissected into a myriad of investment options? In the 1980s, companies like Salomon Brothers and Drexel Burnham Lambert determined that mortgages were more valuable when spliced into pieces. It’s similar to corporate raiders who buy companies on the cheap, break them up, and sell off the pieces. The sum of the parts is greater than the whole.
Wall Street Enters the Mix
Subprime was still in its infancy in the mid-1990s when Lehman Brothers became the first Wall Street investment bank to aggressively enter the business. Its earliest efforts to align with a subprime lender, however, proved disastrous.
In 1995, when they provided financing for First Alliance Mortgage Co. and underwrote the securities, Lehman’s own internal memos questioned whether some borrowers had the capacity for repayment. As other investment banks backed away from First Alliance, federal and state regulators started to investigate their practices. Throughout the turmoil, Lehman continued to support First Alliance, keeping the operation in business. Even though Lehman internally acknowledged the potential for bad publicity as a result of their involvement, they stayed the course, believing the potential fee income outweighed the risks.
In 2003 a California jury awarded over $50 million in damages against First Alliance and attributed 10 percent of the responsibility to Lehman’s involvement. It was eventually discovered that many of the sales tactics used by loan officers at First Alliance confused and misled borrowers. Viewing the experience with
First Alliance as an aberration, Lehman was already pursuing other investment opportunities. One year before First Alliance closed its doors in 2000, Lehman, in a joint venture with then-ailing Amresco, Inc., became the first major Wall Street firm to operate a subprime lending unit, Finance America. The next year they acquired BNC Mortgage and eventually merged the two companies together.
In 2000, other Wall Street firms started to enter the subprime business. While some acquired servicing operations, others followed Lehman’s example and purchased mortgage companies. Within a few years, major Wall Street firms like Merrill Lynch and Bear Stearns began acquiring subprime mortgages through multiple channels (wholesale and retail) to feed their securitization machines.
While lending firms made excellent profits, the big Wall Street firms made a killing. If you recall the profitability discussion from Chapter 2, imagine bypassing the middleman—companies like Kellner Mortgage who were getting paid 400 to 500 basis points—and taking mortgages from the consumer and broker levels and putting them directly into a security. The record earnings on Wall Street were driven, in part, by the mortgage securitization business. The high margin and the explosive housing market only fueled the desire for even more of this product.
Although Wall Street is skilled at making money, risk management has never been an area of expertise. This point can’t be stressed enough: The current mortgage debacle is a direct result of Wall Street’s inability to manage risk. In fact, companies like Merrill Lynch had no effective risk management processes in place until shortly before the subprime implosion. Since the focus was on feeding the securitization machine and driving profits, no one was paying attention to the basic fundamental principles of risk management.
The Rating Agencies
Until the 1970s, rating agencies operated under a business model different from the one they use today. An investor who wanted ratings bought a subscription to the agency’s service. When the Securities and Exchange Commission (SEC) decided that the ratings serve a greater public interest, the SEC changed the business model. Instead of buying a subscription, companies would have to pay the agencies for rating their debt. In hindsight this may have been the single greatest mistake in the history of the SEC.
Except for those loans backed by the U.S. government, most mortgages are rated by one of three credit rating agencies: Moody’s, Standard and Poor’s (S&P), and Fitch. These companies evaluate the loss potential for a pool of mortgages. They examine everything from the expected frequency and severity of defaults to the characteristics of the loans within the security. Instead of examining every loan, they only use a sample, relying on the representations provided by the issuers.
Given the huge discrepancy between the performances of subprime mortgage-backed securities and the ratings they received, one or more of the following assertions seem plausible. First, the relationship between the investment firms and the agencies was compromised. Second, the investment firms provided the agencies with insufficient information to grade the securities accurately. This supports the agencies’ belief that their ratings are only as good as the information given to them. Third, the statistical models the agencies used to evaluate the mortgage pools were defective. Each of these claims will be considered as the agency-Wall Street relationship is examined.
A Lucrative Business Model
Rating mortgage-backed securities is a highly profitable business. During the last five years, Moody’s has been one of the most profitable companies in the S&P 500 stock index. Standard and Poor’s and Fitch have generated phenomenal returns as well. As the real estate market soared, so did their income. When the Hearst Corporation purchased a 20 percent stake in Fitch in 2006, they viewed the income opportunities from rating CDOs as a highly attractive feature of the sale.
Before 2001, the agencies generated most of their income by rating corporate bonds. As the real estate market soared, income from rating mortgage-backed securities greatly exceeded their core business. According to figures provided by S&P spokesman Chris Atkins in an August 12, 2007, Seattle Times article, they charge nearly three times as much (12 basis points) to value a CDO as they do to rate a corporate bond (4.25 basis points). A $1 billion CDO generates $1.2 million in income. Moody’s doesn’t disclose its pricing schedule, but Fitch does. The gap between their fees charged for rating corporate bonds (3 to 7 basis points) and rating CDOs (7 to 8 basis points) is not as great as Standard and Poor’s, but it’s still significant.
Since $1 to $2 trillion in new residential mortgage-backed securities have been issued every year since 2002, the agencies had a strong motive to pursue this business. When you add up the figures, the numbers are staggering. Using a 10 basis-point average fee, $1 trillion in new securities issued equals $1 billion in revenue.
Unlike the lenders and investment firms, the rating agencies possess two advantages. First, since they’re paid a percentage based on the size of the security, their income only changes relative to volume. In other words, while lenders and investment firms have at least some financial interest in the performance of a product, the agencies always get their cut. Second, even if they drastically misrepresent how a security should perform, they face no liability. If a baseball umpire consistently makes poor calls, the league replaces him. When an agency makes a bad call, an investment firm has no reason to use someone else. In fact, the opposite is true. Since agencies face no liability for inaccurate assessments, there is no advantage to being cautious. A liberal approach to rating securities means more profit for their Wall Street customers.
A Hand in the Process
As the official umpires in the world of big league finance, the agencies exist to provide the investment world with objective analyses. To understand the importance of their work, consider that many regulated financial institutions—insurance companies and banks—can only purchase investment-quality (AAA) debt. This means they can only put money into conservative, safe investments. Without the agencies, the financial institutions wouldn’t know what qualifies as investment grade. Of course, all types of investors rely on the agencies’ opinions, not just regulated industries.
The recent turmoil indicates, however, that rating agencies aren’t objective. Josh Rosner, managing director of the research firm Graham Fisher, noted in an op-ed piece in the New York Times that raters play a significant role in assisting the issuers. He put it this way:
The rating agencies are far from passive arbitrators in the markets. In structured finance, the rating agency can be an active part of the construction of the deal. In fact, the original models used to rate collateralized debt obligations were created in close cooperation with the investment banks that designed the securities.
The rating agencies liken themselves to information providers, claiming they have structures in place to prevent conflicts of interest. This is the corporate mantra but evidence suggests otherwise. Two colleagues, who asked not to be identified, have attended sales presentations given by the agencies. Both confirmed the agencies help clients structure complicated mortgage securities before they ever get rated. Using the agencies to guide them, investment firms package the securities to get a higher percentage of the MBSs rated as AAA. It’s the equivalent of having a teacher write a student’s term paper for him.
Why do investment firms want a higher percentage of the security rated AAA? The answer, like everything else in the mortgage industry, comes back to profit. Because of the reduced risk, the AAA tranche can be sold at a higher price than the lower tranches. Since the subordinated pieces carry more risk, they’re sold at a discount. To maximize revenue, investment firms need the largest possible percentage of the security to receive an AAA rating.
As Rosner notes in the same op-ed piece, the system has problems:
Only slightly more than a handful of American non-financial corporations get the highest AAA rating, but almost 90% of collateralized debt obligations (CDOs) that receive a rating are bestowed such a title. Are we willing to believe that these securities are a
s safe as those of our most honored corporations?
To understand the significance of his statement requires a basic knowledge of CDOs. A CDO is nothing more than a redistribution of credit risk. It takes the lowest rated tranches from different securities and packages them together into a separate structure. Agencies rate a CDO the same way they do a mortgage-backed security, slicing it into AAA, AA, and so on.
If subprime lenders made chicken salad out of chicken shit, rating agencies turned it into filet mignon. To claim a subprime CDO carries the same risk as bonds issued by the most financially sound corporations is not only mind-boggling, it’s negligent. With CDO losses reaching the billions, investors have retreated from buying all but the very safest of mortgage-backed securities.
A Conflicted Relationship
The entire rating process appears to be fundamentally flawed. By now, the inherent contradictions in the system should be clear on several levels. First, since the investment banks compensate the agencies, the relationship, in Rosner’s words, is “hopelessly conflicted.” Second, as active participants in the deals they structure, the agencies are not objective. Third, having no liability coupled with exorbitant revenues is a toxic combination.
There’s another aspect to the relationship that merits discussion. If an investment bank issuing a security believes 80 percent of it should be rated AAA and the agency can validate only 75 percent, the issuer can threaten to move the business to another agency, but it doesn’t usually come to that. Since the agencies understand the threat is real, they perform an advisory function to help their clients achieve the desired results.
Confessions of a Subprime Lender Page 11
