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FCIC Report Misses Central Issue: Why Was There Demand for Bad Mortgage Loans?

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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.

A much more sensible explanation can be found by asking: what were the financial incentives for such poorly underwritten loans? Why would "the market" want bad loans?

All the report offers as explanation is that the "machine" drove it or "investors" wanted these loans. This is lazy and fails to illuminate anything, particularly when there are other red flags in the report, such as numerous mortgage market participants pointing to growing problems starting as early as 2003. Signs of recklessness were more visible in 2004 and 2005, to the point were Sabeth Siddique of the Federal Reserve Board, who conducted a survey of mortgage loan quality in late 2005, found the results to be "very alarming".

So why, with the trouble obvious in the 2005 time frame, did the market create even worse loans in late 2005 through the beginning of the meltdown, in mid 2007, even as demand for better mortgage loans was waning? It's critical to recognize that this is an unheard of pattern. Normally, when interest rates rise (and the Fed had begun tightening), appetite for the weakest loans falls first; the highest quality credits continue to be sought by lenders, albeit on somewhat less favorable terms to the borrowers than before.

In other words: who wanted bad loans?

The dissents' explanation is that the GSEs drove demand for affordable housing, which was what weakened underwriting standards. This might explain why the GSEs bought bad loans (which, oddly did default at lower rates than private market crappy mortgages, and thus didn't contribute significantly to the GSE losses), but it fails utterly to explain why "the market" outside of the GSEs BOUGHT bad loans.

In the market for private loans, who wanted bad loans?

Had the FCIC report bothered to connect the dots raised by this simple question, it could have actually contributed something.

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.

But conversely, this normally hard to place portion, precisely because it was the worst rated piece, suddenly became prized. Speculators could put a very small amount of money down and, if right, reap previously unheard of returns. For just a small investment in a CDO or CDS, an investor could create huge incentives for mortgage lenders to seek out unqualified borrowers and lend them far too much money (for reasons explained at greater length in ECONNED as well as in older posts on this blog, heavily synthetic CDOs pioneered by the hedge fund Magnetar were a particularly destructive way to execute this strategy. Those deals stoked the mortgage market directly, by using some actual BBB bonds, and indirectly, though their impact on spreads and the fact that pipeline players and other longs used some of the CDS not taken down by the shorts to lay off their risk, which encouraged them to stay in the game longer).

The report notes that many people saw the weakened standards and thought it was insanity and a serious problem. In fact, contrary to popular perceptions, many people in the securitization market thought the same thing. Some believed the problem would eventually cure itself, others thought there needed to be tighter controls. Virtually no one understood why the loans continued to be created, even after alarms were sounded. Almost no one recognized that there was a tremendous financial incentive for bad, rather than good, loans and that the alarms just made such bad loans more valuable. In fact, the alarms created a frenzy of more CDO creation as more hedge funds became aware of the opportunity to short the deals, which created demand for more bad loans.

The normal expectation was that warnings and threats about bad lending would have some impact on curtailing the bad loans, but it had the opposite effect: it led to more CDOs and demand for more "product" to short.

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.

Let us step through some simple math. If a hedge fund invested $50 million in shorting MBS via an equity investment in a CDO, it would lead to the creation of a $1 billion mezzanine ABS CDO (note this 5% assumption is conservative). In 2006, 80% of that CDO would consist of BBB or BBB-tranches of subprime bonds; remarkably, as much as 10% of that CDO could (and often did) consist of the lower-rated tranches of OTHER unsold CDOs, which would make the picture even worse, so for simplicity's sake, let's stick with the 80% figure.

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So of that $1 billion deal, $800 million is composed of BBB rated bonds. $800 million also happens to be a not-bad number for the size of a typical residential mortgage backed security, meaning from the AAA tranches down to the so called equity layer of that first generation securitization. The CDO, the second generation, would be composed of about 100 BBB MBS bonds created out of these securitizations, and the deals in aggregate would reference about $84 billion worth of mortgages (note that in this example, the $1 billion CDO would take down or if it was synthetic, "reference" $800 million of BBB bonds out of total RMBS issuance of $80 billion. The reason the total amount of bonds issued was $80 billion while the mortgage amount was $84 billion was that the bonds were "overcollateralized" as a form of protection to investors. But as we have seen, this "overcollateralization" fell vastly short of actual losses).

Now even though that ratio is eyepopping, 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.

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 wound up holding the bag.