Confessions of a Subprime Lender

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Confessions of a Subprime Lender Page 12

by Richard Bitner


  In some ways, the investment firm-rating agency relationship mirrors the dysfunctional nature of the broker-lender relationship. If the broker is having trouble getting a deal approved, his account executive will tell him how to structure the loan. When an investment bank has a security filled with garbage loans, the agencies advise them how to structure the deals in order to maximize profit. A former analyst, who asked not to be identified, said, “the agencies understand the kind of pressure they’re under to meet the expectations of Wall Street. If they didn’t advise them, particularly on some of the tougher deals, the investment banks would struggle to hit their numbers.”

  The agencies defend themselves by issuing hundred-page disclaimers to go with the ratings. They emphasize that users of the information shouldn’t rely on any credit rating or opinion within the analysis for making investment decisions.

  Since the investment world depends on the agencies to provide impartial and objective evaluations, the disclaimers only serve to undermine the ratings. What good are they if investors can’t rely on them? It’s equivalent to building a car and sticking a label on the inside of a door that reads, “We want you to know we can’t stand behind anyone who had anything to do with the assembly of this vehicle. If the steering wheel falls off, motor falls out, or any bodily injury comes to you as a result of driving this car, just remember, we told you so.”

  The Power of the Agencies

  To understand just how powerful the rating agencies have become, consider this quote from New York Times columnist Thomas Friedman:

  There are two superpowers in the world today in my opinion. There’s the United States and there’s Moody’s Bond Rating Service. The United States can destroy you by dropping bombs, and Moody’s can destroy you by downgrading your bonds. And believe me, it’s not clear sometimes who’s more powerful.

  The power a company wields is best seen when its livelihood is threatened. The rating agencies proved their dominance in 2002 when Georgia passed a highly restrictive predatory lending law. The agencies determined that investors who purchased securities that contained certain types of loans could be held liable. To avoid this exposure, the agencies refused to rate any securities that contained these mortgages. Without an agency rating, investment banks couldn’t securitize the loans, which meant lenders had no secondary market to buy them. The agencies effectively shut down the Georgia mortgage market, forcing legislators to amend the law. Strangely enough, for all the negative press targeted at subprime lenders, the rating agencies did more to inhibit predatory lending legislation than any other group.

  The agencies believed the original Georgia law was in direct conflict with the Holder in Due Course doctrine. This principle protects the secondary market investors who purchase mortgage notes by immunizing them from liability. For example, a person who’s been victimized by a fraudulent broker has no recourse against the person or entity that buys the security. Since each loan is spliced and becomes a part of many different securities, thousands of investors could be liable for the actions of a single broker if not for this doctrine.

  Shortly after the Georgia fiasco, New Jersey went through a comparable experience. When the state passed a law that created similar liabilities for the secondary market, the agencies used the same tactic. This time the state dug in for a fight, and for a while it looked like the law would stick. But eventually the state gave in, realizing the fight couldn’t be won.

  The agencies sent a powerful message in Georgia and New Jersey: Any predatory lending legislation that addressed secondary market liability would face strong resistance. Since then more than 20 states have passed predatory lending laws and none of them had confrontations with the agencies because they bypassed the issue of liability altogether.

  Although the agencies executed their playbook under the guise of protecting the secondary market, they had other motives. Had either the Georgia or New Jersey law gone into effect, fewer loans would have been securitized. This would have meant less revenue for the agencies. Understanding that the laws would impact their bottom line, the agencies simultaneously protected investors and their own financial interests by mounting a fight.

  I don’t advocate overturning the Holder in Due Course doctrine. Any legislation that creates liability for the secondary market will negatively impact the securitization market and hurt the consumer. The most effective ways to solve this problem are discussed in Chapter 7. Nonetheless, Friedman’s comment on the agencies was dead-on. Any group that can shut down a state’s mortgage market is a powerful force.

  Who’s Running the Show?

  Collectively, the rating agencies and investment firms dictated how the subprime market operated. As Wall Street determined the type of loans that could be financed, the agencies rated the securities so investors would purchase the bonds. While many states passed laws to regulate nondepository lenders, most neglected to address underwriting standards and product guidelines.

  With little government oversight, Wall Street and the agencies became the de facto regulators of the industry. The implications of this are enormous. Both parties, driven by profit and shielded from liability, dictated how the market would function. Not only was the fox guarding the hen house, he hired a contractor and built a separate wing so he could feast at his convenience.

  Lenders wrote mortgages based on what the investment banks could securitize and the agencies would rate. If the secondary market dictated what loans it would buy and some of the most powerful companies in the world rated them as investment grade, how is a lender negligent for writing them? This is how lenders try to claim deniability.

  That isn’t a tactic to absolve lenders from potential wrongdoing. On the contrary, there’s plenty of blame that needs to be distributed and lenders deserve a share. But any solution to this crisis will only be effective if it addresses the deficiencies of Wall Street and the rating agencies.

  Rating New Products

  In some ways, the rating agencies present a contradiction. On one hand, they consistently rated securities with riskier mortgage products as investment grade. On the other hand, they claimed the newer loan products had no track record of performance, which gave them an excuse if their assessments were wrong. To say there’s no basis to compare performance, however, is not true.

  John Mauldin, author of the August 11, 2007, article, “Back to the 1998 Crisis, Subprime to Impact for a Long Time,” pulled a listing of all subprime Residential Mortgage-Backed Securities in Bloomberg. He sorted those with the most loans over 60 days past due to see what they showed. While the two worst performers were from 2006, many of the 20 worst performing securities were from 2000, 2001, and 2003, long before underwriting standards were loosened. Mauldin also noted that some of the mortgages from 2001 performed relatively well. His argument was that anyone who did their homework understood that performance was all over the board.

  The agencies have stated that their models relied on historical data and that there wasn’t enough information on popular items like stated income loans or piggyback loans (when first and second lien mortgages are closed simultaneously to avoid or minimize down payment requirements). Again, I find this logic to be faulty. Subprime piggyback mortgages were prevalent in the market as early as 2000. My company began offering 100 percent stated income loans through Countrywide with credit scores down to 620 in 2003. That’s four to six years worth of data on billions of dollars in subprime mortgages.

  This indicates the agencies’ models may be deficient in several ways. First, using Countrywide as an example, the guidelines for subprime stated income loans changed very little during the last four years. As time went by, however, a larger percentage of loans met this criterion. While the data existed to evaluate the performance of these loans, it’s possible the models didn’t account for the increased risk of having a higher percentage of riskier mortgages. Second, the models didn’t factor in market risk. When property values are rising, distressed borrowers can sell or refinance to get financial relie
f. As values stabilize or decline, borrowers have fewer options, which results in higher delinquencies.

  In a senior-subordinate structure, the lower tranches are designed to protect the top ones. By accurately predicting the bottom tier will only fail to a certain degree, the senior groups remain shielded from loss. When the assumptions are faulty and lower tiers start to fall, the upper tranches become vulnerable. Ultimately, the agencies rated too high a percentage of the securities as investment grade and not enough in the lower tranches. It’s like building a 12-foot-tall dam to hold back 20 feet of water.

  Slow to Respond

  The agencies have stated they’re not responsible for policing the performance of mortgage-backed securities. While they do review performance, they’re notoriously slow to change the ratings, believing a loan pool should show a sustainable pattern of loss before a downgrade should be considered. This strategy also shields them from scrutiny when a rating is horribly inaccurate.

  If the agencies downgrade a security shortly after it’s issued, credibility suffers. Imagine that a new pool of subprime loans experienced a higher rate of default than expected and kept getting worse each month. How would it look if AAA-rated mortgage-backed securities were downgraded just months after being issued? It would shake the entire investment community to its core and prove the agencies are either incompetent or compromised. Responding slowly allows the agencies to mask the extent of their mistakes.

  The strategy worked well until late 2006, when investors noticed how poorly the 2005 and 2006 subprime securities were performing. Not only didn’t the agencies sound the alarm, the worst performing securities weren’t downgraded until several months after most subprime lenders had gone out of business. On July 9, 2007, Moody’s announced that it would place 184 tranches of 91 CDOs on review for possible downgrade. The next day they issued an unprecedented 451 downgrades for first and second lien residential mortgage-backed securities. Since then the agencies have issued a massive number of downgrades, long after the poor performance of the securities became known. It’s clear that somebody was asleep at the wheel.

  How Securitization Impacts the Borrower

  The present record homeownership levels are a direct result of securitization. The aggressive mortgage offerings that helped higher-risk borrowers to finance a home existed because the loan could be sold on the secondary market and packaged into a security. For all the good securitization has done, the long-term fallout we’re about to experience may outweigh the short-term gain.

  Securitization not only allowed unqualified borrowers to secure financing, it imposed restrictions on distressed borrowers who needed relief. In the days when borrowers dealt directly with a local bank for every aspect of the mortgage, the relationship was flexible. Local banks could sit face-to-face with a distressed borrower to hammer out a solution. Since the relationship was localized, the bank had other reasons to act responsibly. When institutions develop a strong local brand, it only takes one disgruntled consumer to create a firestorm of bad publicity.

  Today, distressed borrowers have few options. If a defaulting homeowner is treated poorly, who is he going to mount his publicity campaign against? The broker has no liability for the loan. The subprime lender is probably out of business. The mortgage has been spliced into a hundred pieces so the borrower doesn’t know who owns it. Even if he did, the Holder in Due Course doctrine makes it difficult to pursue legal action. There may be a separate servicing company but, depending on the borrower’s circumstances, a loan modification may be difficult. Since defaults have recently soared, it has become apparent that most servicing companies aren’t properly staffed to handle the influx of distressed borrowers.

  While servicers would prefer to keep borrowers in the house making payments, providing them with relief has to make sense. A loan modification is most effective when it assists borrowers who’ve had a temporary setback, such as being out of work for a few months. If a borrower can resume making timely payments, the servicer is more inclined to work with him. But when a borrower just can’t afford the payment, there’s no reason to modify the mortgage.

  While trustees and servicers have some discretion to modify loans or create repayment plans, the process isn’t straightforward. Depending on how the rules are written within the securitization agreement, modification plans can lead to disputes between servicers and investors. Kurt Eggert, professor of law at Chapman University School of Law, refers to it as “tranche warfare.”

  In his April 17, 2007, testimony to the Committee on Senate Banking, Housing and Urban Affairs Subcommittee on Securities, Insurance and Investments, Eggert discussed how the securitization process works to the detriment of the distressed borrower.

  Restructuring the loan poses a substantial fiduciary dilemma to the trustee, because it would almost inevitably involve removing some part of a stream of income from one tranche and adding income to another tranche. This “tranche warfare” is a significant brake on the flexibility to restructure a loan . . . One tranche might hold the right to any principal repayments made during the first year, another to interest payments during that year, yet another to interest payments during the second year, and so on.

  In other words, stealing from one tranche to pay another creates legal challenges. Since mortgage-backed securities are broken down into complex payment streams, any effort to modify a loan would likely benefit one tranche at the expense of another. When trustees are faced with making such a choice, they open themselves to claims they breached their fiduciary duty. In the end, it’s often easier for servicers and trustees to avoid using any discretion as a way to sidestep these disputes. This helps to explain why, according to Moody’s Investors Service, servicers adjusted only 1 percent of subprime mortgages that had rates reset during the first six months of 2007.

  What the Future Holds

  There is little doubt that the housing and mortgage markets are in for a bumpy ride. Although Chapter 7 discusses potential solutions, there are no quick fixes or easy answers. I’m concerned that Congress will either pass ineffective legislation or the courts will take matters into their own hands. In some cases, it’s already starting to happen.

  In October 2007, a colleague shared with me his recent experience. He worked for a firm that securitized subprime and nonagency mortgages and he participated in a meeting to discuss a lawsuit against his firm. What’s interesting is how the Holder in Due Course Doctrine didn’t apply because of the special circumstances of this case. Here’s his story:

  The borrower originally took a five-year ARM back in 2002. Since the broker and lender were both out of business, she filed a lawsuit against my firm, the company that securitized her mortgage. She told the judge she didn’t understand what would happen to the interest rate when the loan adjusted. Her original interest rate was 4 percent and had gone to 7 percent a few months earlier. Her husband had cancer so the loan had become a hardship.

  I walk into the judge’s chambers with our attorney and the first thing the judge says is he understands both sides of the case. But he wants to know what we’re going do to help this woman. He expected us to fix the problem and keep it out of his courtroom.

  There are a couple of interesting things about the loan. To start, the borrowers both had great credit and income when they qualified. She was an A borrower who got a fair deal. She was also an intelligent, working professional who signed numerous disclosures, just like every other borrower, explaining what it meant to have an ARM. This wasn’t someone who got duped. She either didn’t read the documents or was just looking for a way out. In the five years she had the mortgage, she never missed a payment. When her husband contracted cancer and stopped working, she couldn’t pay her property taxes, which I think prompted her lawsuit.

  I didn’t think she had a legitimate case against anyone. But the judge felt sorry for her and wanted us to fix it to keep it out of his courtroom. We decided it wasn’t worth the bad press that would come from fighting a woman whose husband was battl
ing cancer. By the time we paid the court costs, her attorney’s fees, back taxes and permanently modified her loan to a fixed rate of 6.5%, we spent $100,000 to fix a loan that we never made and appeared to be in no way fraudulent or deceptive.

  Her whole argument amounted to “I didn’t understand.” When someone who wasn’t manipulated and that probably knew better got this kind of treatment, it opened my eyes. It made me wonder what someone with a legitimate grievance could get.

  CHAPTER 6

  Secondary Contributors: The Fed, Consumers, Retail Lenders, Homebuilders, and Realtors

  The preceding chapters show that the collapse of the mortgage market was a direct result of several groups acting in a deceptive or fraudulent manner. It took brokers manipulating loans, lenders financing unqualified borrowers, investment banks securitizing risky mortgages, and rating agencies validating these securities as investment grade to unleash the perfect storm. In all likelihood the full impact from this collective effort won’t be known for years to come.

  However, there are still some pieces of this story that need to be told. We’ll start by examining how the secondary participants—the Federal Reserve, borrowers, retail lenders, homebuilders, and realtors—contributed to the problem. We’ll then review the specific events and trends that led to the explosive growth and eventual demise of the subprime industry.

  Secondary Contributors: The Federal Reserve

  There’s a large contingent who believe that Alan Greenspan and the Federal Reserve were the primary contributors to the housing and mortgage debacle. For me, discussing the actions of the Fed is not unlike the conundrum Greenspan talked about in his now-famous 2005 speech. The monetary policy employed by the Fed is a main reason anyone involved with subprime mortgages, or any form of lending for that matter, prospered during the last six years. I discussed the subject with a colleague at an industry conference in 2005, and his comments still resonate with me. He said, “Greenspan’s decision to lower rates changed my life.” Since he made more money in the previous four years than during his entire business career, it’s easy to understand why. He wasn’t alone in his thinking. The Fed’s decision to lower the federal funds rate created a windfall the mortgage industry may never see again.

 

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