Hark, Securitization of Sub Prime Mortgages Begins

Meanwhile, in 1994 the market for securitized subprime mortgages began to grow rapidly. The basic argument used was that if borrowers with poor credit history were offered credit, the price they would pay would outweigh the possibly greater risk of default, similar to the argument made regarding the return on high yield bonds. Additionally, difficulty gaining credit was thought likely to inhibit borrower prepayment. Loans were small and if bundled together offered the benefits of diversification.

Demand was strong, and origination swelled. The subprime market had historically been a fairly local one, and the originators mostly local companies operating in a niche business, knowing a good deal about their borrowers and selling their product as whole mortgage loans to banks with careful underwriting criteria. Securitization, however, gave such companies an attractively low cost of funds, and the opportunity to originate larger volumes, selling to the Street to securitize. This appeared to be a compelling opportunity for growth.

Independent loan originator operations have typically been cash flow negative, though this was often disguised by their recognizing as a gain on sale, required under accounting rules, the expected residual or equity value associated with the loans sold. The value of these future cash flows was dependent on a number of assumptions rarely supported by historical experience and was in turn discounted to present value.

Earnings as Defined by Generally Accepted Accounting Principles May Not Create Cash

Many board members of issuers as well as Wall Street underwriters and investors were confused by this as the Street rushed to take these companies, with their demonstrated growth in declared earnings (the “earnings” declared as a result of the gain on sale described above), public. Oops, those earnings and the resulting assets were not cash, and not easily salable. While acting as restructuring advisor to a subprime originator in 2007, we managed what we believed to be the first sale of a securitized residual interest.

As more subprime originators got involved, borrower prepayments escalated well beyond expected levels. Subprime borrowers could now refinance without difficulty. In 1997, the first massive write downs on residual values occurred. The originators, many of them now public, shuddered and were scrutinized. The assumptions made on the data used to establish ratings for securitizations, data that was not based on subprime payment histories but was instead based on assumed variations from the prime borrower data described above, were adjusted and the market moved on to its next and near fatal test.

Sub Prime Industry Almost Died in 1998

The events of 1998 almost stopped the subprime sector in its tracks, as in the wake of the international debt crisis and the collapse of Long Term Capital Management, liquidity dried up overnight. Absent liquidity, these companies cannot function. They typically have no borrowing power of their own as their balance sheets have few assets other than mortgage loans, which are financed by other lenders in advance of the next securitization.

Suddenly unable to borrow as the securitization market closed, many originators had no choice but to liquidate overnight. The quality of their loans was discovered to be much lower than expected. Whole loan buyers, for example, would not buy much of the product that had been originated for securitization, because as described above they evaluated every loan on its merits, whereas securitizations were based on aggregate loan pool parameters with little to no reunderwriting of individual loan files.

Many companies had gotten stuck on a vicious treadmill: they had to originate in ever greater volumes to keep their perceived earnings momentum high, and for the same reason they were aggressive in valuing residuals held on their books. Their underwriting standards became more and more generous as competition increased, and borrowers, knowing they could easily find alternative financing, ignored collection efforts. And then the music stopped.

While serving as emergency CEO of the oldest and strongest of these subprime originator and servicer companies, I knew that efforts had been made to sell the company before my arrival. Only one commercial bank had expressed any interest at all, as commercial banks then were worried about reputation risk and most did not want to be associated with the taint of lending to lower credit quality buyers.

I took the company apart and sold it in pieces, only to discover that in securitizing $6 billion in almost forty transactions, the issuer had never had their own issuer’s securitization counsel, instead relying entirely on underwriter’s counsel. I also found myself signing papers to pay for the removal of hundreds of pounds of canine fecal matter from houses, some with only three walls. On balance I was not displeased that subprime originators were disappearing.

Public Policy Starts the Subprime Cycle Again

And then, in 1999, the cycle started again. Under Secretary Andrew Cuomo, the Department of Housing and Urban Development (HUD) directed the mortgage agencies FNMA and FHLMC to increase their purchase of mortgages made to low-and moderate-income borrowers from 42% to 50%. HUD also raised two other Congressionally mandated goals: a special affordable housing goal for families with very low incomes jumped from 14% to 20%, a 43 percent increase, and raised a geographically targeted goal for underserved areas (central cities, rural areas, and underserved communities based on income and minority concentration) from 24% to 31%, a 29% increase. A huge influx of new money flooded into the subprime market, and banks were required to originate under various community reinvestment mandates.

Note that, according to the press release announcing these new targets, America’s homeownership rate hit a record high in 1998, with 66.3 percent of all households owning their own homes. Secretary Cuomo was quoted as saying that these higher affordable housing goals would disproportionately benefit minorities and city residents, helping to close the homeownership gap. Regrettably, the subprime lending market was alive again, and FNMA and FHLMC needed to buy hundreds of millions of products or face stiff daily fines for every day they missed their quota.

And We Pushed Ourselves into the Abyss

Following the terror attacks on September 11, 2001, fear of further attacks roiled an already-struggling economy, one that was just beginning to come out of the recession that followed the bursting of the tech bubble of the late 1990s. In response, the Federal Reserve began cutting rates dramatically to encourage borrowing, and related spending and investing. From the White House down to the local parent-teacher association, efforts were made to encourage the public to see spending as a form of patriotism.

As lower interest rates worked their way into the economy, the real estate market reacted. Both the number of homes sold and the prices they sold for increased dramatically beginning in 2002. The interest rate on a 30-year fixed-rate mortgage was at the lowest levels seen in nearly 40 years. Record low interest rates combined with ever-loosening lending standards to push real estate prices to record highs across most of the United States.

Low Interest Rates Fuel Frenzies in Multiple Arenas

Existing homeowners were refinancing in record numbers, tapping into recently earned equity that could be had with a few hundred dollars spent on a home appraisal. In the huge volume that ensued, even basic requirements like proof of income were being overlooked by mortgage lenders; 125% loan-to-value mortgages were being originated again, based on the faulty logic that rising real estate prices would translate to a 125% LTV mortgage being below the value of the house in two years or less.

A market literally as close to home as real estate becomes impossible to ignore when in the space of five years, home prices in many areas had doubled. Many of those who hadn’t purchased a home or refinanced considered themselves behind in the race to make money in that market. Mortgage lenders knew this and pushed ever more aggressively. New homes couldn’t be built fast enough, and homebuilders’ stocks soared.

Collateralized Debt Obligations Explode, In More Ways Than One

In 2002, originators introduced asset backed securities, including mortgage related securities, to CDOs as they were regarded as being less risky, better diversified, and more liquid than the corporate debt used theretofore. The CDO market, then estimated at about half a trillion dollars in size, mushroomed to an estimated size of over $2 trillion by the end of 2006. The CDO had become what some skeptics call an investment landfill, much like the subprime securitizations of the mid-1990s. While initially intended for corporate debt obligations, the structures were also useful for commercial real estate loans, for residential mortgage related product, and even for hedge fund collateral.

By 2006, according to a Deutsche Bank research report by Anthony Thompson et al., over half of the CDOs issued were based on structured finance collateral, and the great majority of that is estimated to be subprime collateral. It appears that many more difficult to place, lower rated tranches went into CDOs, making it much easier to place the senior tranches and keep originating more new deals, again with ever weaker collateral. Unfunded, synthetic CDOs were introduced, with derivative contracts used to replicate the cash flows expected by various pools of collateral. CDOs were introduced that invested in other CDOs: CDOs squared.

The Abyss Itself

With Wall Street, Main Street and everyone in between at least appearing to profit from the activity, who was going to put on the brakes? By the middle of 2006, however, cracks began to appear. New home sales stalled, and median sale prices halted their climb. Interest rates, while still low historically, were on the rise, with inflation fears threatening to raise them higher. Default rates began to rise sharply. Suddenly, the CDO didn’t look so attractive to investors in search of yield. Many of the CDOs had been re-packaged so many times that it was difficult to tell how much subprime exposure was actually in them.

Scores of mortgage lenders, with no more eager secondary markets or investment banks to sell their loans into, were cut off from what had become a main funding source. Late in 2006, dozens of mortgage lenders began to seek bankruptcy protection. The real estate markets plummeted after years of record highs. Foreclosure rates doubled in twelve months, by the end of 2007.

Many institutional funds were faced with margin and collateral calls from nervous banks, which forced them to sell other assets, such as stocks and bonds, to raise cash. The increased selling pressure took hold of the stock markets, as major equity averages worldwide were hit with sharp declines in a matter of weeks, which effectively stalled the strong market that had taken the Dow Jones Industrial Average to all-time highs in July of 2007.

In 2008 the turmoil driven by developments in the subprime mortgage markets had ripple effects throughout the world. What made it more intense this time is a function of the policies described above that supported the movement of money out of the banking system and thus out of regulatory oversight, for over 30 years. Large financial institutions bought and sold credit default swaps on assets they didn’t own. By 2008, these derivative contracts had grown to an estimated $62 trillion from $900 billion in 2001. Warren Buffett called them “financial weapons of mass destruction.”

Multiple Financial Institutions Fail

Lehman Brothers Holdings, Inc., the fourth largest investment bank in the United States, also filed for bankruptcy protection in September 2008, the largest investment banking bankruptcy since the 1990 filing of Drexel Burnham Lambert Group, Inc. Bear Stearns, long a tough trading- oriented investment bank, ran out of money and was bought out by J.P. Morgan. The initial deal was $2 a share. Tense negotiations upped it to $10, valuing the company at less than the market price of the Bear’s Manhattan flagship office. Venerable Merrill Lynch, known for its large retail investor activities, failed and was taken over by Bank of America in that same month.

Government-sponsored enterprises (GSEs) Federal National Mortgage Association (Fannie Mae) and Federal Home Loan Mortgage Corporation (Freddie Mac) having struggled despite huge injections of government cash to support the housing market over the course of 2008, were placed into conservatorship by the U.S. Treasury in September 2008 to allow the government to continue to use them to provide emergency support to the housing market.

American International Group (AIG), that insurance company that started the joint venture in 1986 to create a swap business was pushed to the brink of insolvency when a credit rating downgrade triggered the rights of swap counterparties to demand collateral AIG didn’t have. Policymakers however, chose to rescue AIG with a September 16, 2008 agreement with the Federal Reserve Bank for a U.S. $85 billion secured loan facility, in exchange for warrants for 79.9% of the equity of AIG.

In the panic that followed the Lehman Brothers’ bankruptcy and the AIG bailout in September 2008, investors rushed to quality, moving funds from corporate investments to the safety of government securities. Safety at this point was far more important than yield.

Investors began selling money market funds on Friday, September 12th, ahead of Lehman Brothers’ bankruptcy on Monday, September 15 and continued to do so on Monday, September 15. On September 16, one money market fund, the Reserve Primary Fund, announced that it anticipated sufficient losses on its holdings of Lehman commercial paper that it might not be able to redeem all its shares at $1 per share. In mutual fund parlance, it “broke the buck,” a very rare occurrence.

This does not mean that its investors suffered substantial losses, but only that fund managers did not believe it could support its $1 constant share price. Reserve Primary Fund’s shareholders did not lose more than 1 or 2 percent of the value of their shares, far less than the 7 percent that stock market investors lost on a single day, September 29, 2008, during the financial crisis.

Nevertheless, the idea that there was some connection between the losses at the Reserve Primary Fund and the instability in the financial system that occurred after the Lehman bankruptcy and the AIG bailout took root. The withdrawal of funds from the Reserve Primary Fund was somewhat dramatically called a “run,” although in substantial part it was the result of a general investor move to the perceived safety of government money market funds. The fact that the RPF “broke the buck” added to the drama but was not of material significance in light of the fund’s eventual investor losses of less than 2 percent.

And WaMu, Too, Bites the Dust

In related developments, Washington Mutual Savings Bank (WaMu) became the largest failed bank in U.S. history. At year-end 2007, WaMu had more than 43,000 employees, offices in 15 states and $188.3 billion in deposits. Its net loss for the year was $67 billion (source: WaMu 2007 Annual Report). In the second half of September 2008, panicked WaMu depositors withdrew $16.7 billion, 9 percent of its deposits, out of their savings and checking accounts. The Federal Deposit Insurance Corporation said the bank had insufficient funds to conduct day-today business, seized control and started looking for buyers, ultimately striking a deal with JP Morgan.