(9 am. – promoted by ek hornbeck)
In researching my Sunday diary I ran across some interesting facts and figures I thought I would share with you. Grab a pencil and paper, your finance calculator and pop some pop corn because this is going to be entertaining in a sick and disgusting sort of way. Follow me below the fold for a trip to the house of cards where our dreams live, located at the intersection of greed and larceny with a little betrayal along for the ride.
between 2001 and 2006, the number of terminated subprime purchase-money loans – those used to purchase rather than refinance a house – outweighed the estimated number of first-time-homebuyers with subprime mortgages. According to the analysis, many subprime borrowers may have intended to make a quick exit from subprime loans – using the loans as “bridge financing” to speculate on house prices and then sell for a profit after values increased.
The study also found that subprime lending did not increase homeownership, as subprime activists believed it could. The number of defaults in a sample of subprime purchase-money mortgages within two years of origination is almost equal to the estimated number of first-time homebuyers who held subprime mortgages, the analysis found.
The report goes on to say the big defaults in 2006 and 2007 weren’t caused because the quality of the loans, since the quality of loans had been declining for the previous 6 years and as the housing market slowed defaults over took prepayment exits. Of the loans originated between 2001 and 2006 after 3 years 80% were no longer in effect either thru prepayment or default. Sub prime loans have always been very risky, easy money and booming housing market created a perfect storm.
This would have been bad enough but for Credit Default Swaps which made it exponentially worse. CDS were invented in 1997 by a team working for JPMorgan Chase. They were designed to shift the risk of default to a third-party, and were therefore less punitive in terms of regulatory capital. CDS swamped the global economy and sunk ours almost completely bit not without significant help and enablers.
In February of 2005 the “group of five”, the most powerful and influential Wall Street bankers met to rewrite the rules of Wall Street that led to the housing collapse and with it the global economy. The new standardized contracts they allowed banks to protect themselves from all the risks of sub prime loans and created the hottest capital markets in the world.
The banks wanted more mortgage-backed securities to sell to clients. Creating a standardized “synthetic” instrument, or derivative, would leverage small numbers of subprime mortgages into bigger securities. In that way, the firms could produce enough to meet global demand.
What Does Synthetic Mean?
A financial instrument that is created artificially by simulating another instrument with the combined features of a collection of other assets. For example, you can create a synthetic stock by purchasing a call option and simultaneously selling a put option on the same stock. The synthetic stock would have the same capital-gain potential as the underlying security.
Synthetic Collateralized Debt Obligation
What Does Synthetic Collateralized Debt Obligation Mean?
A form of collateralized debt obligation (CDO) that invests in credit default swaps (CDSs) or other non-cash assets to gain exposure to a portfolio of fixed income assets. Synthetic CDOs are typically divided into credit tranches based on the level of credit risk assumed. Initial investments into the CDO are made by the lower tranches, while the senior tranches may not have to make an initial investment.
Synthetic CDOs are a modern advance in structured finance that can offer extremely high yields to investors. However, investors can be on the hook for much more than their initial investments if several credit events occur in the reference portfolio.
The issuer of the CDO, typically an investment bank, earns a commission at time of issue and earns management fees during the life of the CDO. The ability to earn substantial fees from originating and securitizing loans, coupled with the absence of any residual liability, skews the incentives of originators in favor of loan volume rather than loan quality. This is a structural flaw in the debt-securitization market that was directly responsible for both the credit bubble of the mid-2000s as well as the credit crisis, and the concomitant banking crisis, of 2008.
Creating CDOs from other CDOs creates enormous problems for accounting, allowing large financial institutions to move debt off their books by pooling their debt with other financial institutions and then bringing these debts back on to their books calling it a Synthetic CDO asset. This not only has allowed financial institutions to hide their losses, but has allowed them to inflate their earnings. This has the unfortunate effect of doubling potential losses book-wise.
As the five-year real estate boom approached its peak in 2005, Wall Street marketed a new type of security backed by high-interest subprime mortgages issued to the least credit-worthy home buyers. Blessed by the biggest credit rating companies as safe investments, these instruments offered higher returns than government bonds with the same ratings.
Investment banks, including Bear Stearns Cos., Deutsche Bank AG and Lehman Brothers Holdings Inc., sold $1.2 trillion of these securities in 2005 and 2006, said Brian Bethune, director of financial economics for Global Insight Inc. in Waltham, Mass.
None of this could have happened without the participation of Wall Street’s three biggest arbiters of credit — Moody’s Investors Service, S&P and Fitch Ratings. About 80 percent of the securities carried AAA ratings, the same designation given to U.S. Treasury bonds.
The companies’ ratings underpinned Wall Street’s expansion of the global market for securities based on high-risk subprime loans.
Issuers got guidance from rating companies on how to shape their subprime securities to win the ratings, says Joshua Rosner, managing director of the New York-based research firm Graham Fisher & Co. Investment banks used software distributed by the ratings companies to show them how to meet the requirements, then paid the companies to have the securities rated, he says.
I’ve been pretty hard on the investors, but honestly with the bond rating companies giving what is essentially junk bonds the same rating as Treasury Bonds but with significantly higher rates of return, they are telling investors these bonds are solid can’t fail instruments.
Even as the market continued to tank and the hand writing was on the wall, even more exotic instruments came into being, betting on the fall. Mortgage brokers were now selling the bet on a borrowers ability to refinance their existing loan rather than their ability to repay.
Home prices had been on a five-year tear, rising more than 10 percent annually. Bass conceived a hedge fund that bet on a crash for residential real estate by trading securities based on subprime mortgages to the least credit-worthy borrowers. The investment bank, which Bass declines to identify, owned billions of dollars in mortgage-backed securities.
Within six months, Bass was right. Delinquencies of home loans made to people with poor credit reached record levels, and prices for the securities backed by these subprime mortgages plunged. The world’s biggest financial institutions would write off more than $80 billion in subprime losses, while Bass, his allies and a handful of Wall Street proprietary trading desks racked up billions in profits.
The risks were amplified by the derivatives, contracts whose values are derived from packages of home loans and are used to hedge risk or for speculation. The vehicles allowed investors to bet against particular pools of mortgages.
The magnified losses caused by derivatives made it possible for a small number of defaulting subprime borrowers to freeze world credit markets.
That’s what happened in July after payments in the first quarter stopped on 13.8 percent of subprime mortgages representing 4.8 percent of total U.S. borrowers.
At the time this happened there were approximately 44 million mortgages in the US, of those 4 million were considered at risk. 2,112,000 million mortgages of those 291,456 were in default and started the downward spiral. 291,456 homes out of 44 million or barely .005 percent of all mortgages. Of course when one is leveraging not 3 or 4 to 1 but 40 to 1, 50 to 1, even 70 to 1 eventually …..
The defaults caused demand for subprime securities to dry up. Uncertainty over the value of the financial products spread to investment funds globally. Corporate lending stopped because no one knew what the collateral was worth. By Aug. 10, the Federal Reserve and the European Central Bank were forced to inject a combined $275 billion into the banking system to keep money flowing.
Everybody pimping, making obscene amounts of money and completely ignoring any warning signs or urgings from the Federal Reserve to tighten their credit standards. If this isn’t enough there are still mega banks wanting to do the same thing to Alt-A loans, betting when they will default. Its Vegas baby!
These financial instruments are so tangled it is unlikely they will ever be figured out. But I find it interesting 1.2 trillion dollars in these securities were sold between 2005 and 2006, isn’t 1.2 trillion the amount Geitner wants to buy toxic paper?
Certainly, not all of the bad mortgages sold in 2005 and 2006 are still in the toxic catagory if you are to believe the Federal Reserve. Since 2004 7 million homes have already been lost to foreclosure. In 2003 there were $332 billion outstanding in sub prime loans, in 2007 the figure was $1.3 trillion. Proportion of completed foreclosures attributable to adjustable rate loans out of all loans made in 2006 and bundled in subprime mortgage backed securities a whopping 93%. Those foreclosed homes helped trigger the run on AIG. It is estimated it costs the lender about $50,000 per home to foreclose, but foreclosure triggers the insurance pay off, leaving absolutely no incentive to “work” with home owners.
The lenders made the bad loans (up to 50% with no income documentation) bundled them in investment securities and sold them, getting their money back. They then issue CDS to protect against the defaults they knew were coming, to recover their non existent losses because they bundled and sold these bad loans. Next come the CDO to take one more crack at whatever is left of the market. The big lenders are also writing off billions in these loans. Didn’t they receive billions in TARP funds to help cover these write downs? Now we are pouring billions into AIG, billions going to banks here and abroad, which for me begs the question why do we need 1.2 Trillion to buy toxic paper. Homes foreclosed in 2007 and the first three quarters of 2008 are long gone. At the very least the lenders now own the home and aren’t intitled to any additional compensation. If they lost money, oh well, the cost of doing unsound business.
They fucked investors, they fucked other banks, they fucked each other, they fucked borrowers and they fucked us. A giant fuck fest orchestrated and led by a bunch of criminal opportunists who were too clever by half. So clever they ultimately fucked themselves right out of business.
When you look at how it all came to be it isn’t even a house of cards, it is a house of tissue, nothing air, investments existing largely in the imaginations of the profoundly greedy. It is fraud. Pouring trillions into these banks via AIG only rewards them. There has to be a better more effective way to spend those dollars, seize the banks, protect the depositors, perhaps the share holders and investors after excess assets have been sold. Save the healthy parts, sell them or spin them off and let the rest die. Along with strict regulations to keep this from ever happening again there must be prosecutions of bank management, the Wall Street “group of 5” and the bond rating companies. Since Bernanke seems to still not get it and Geitner hasn’t said enough to inspire confidence, team Obama will probably not be the first source of redress. I would expect the law suits from the investors to start long before anything meaningful comes out of Washington. In any event no more money should be given to AIG or any bank until the government has seized, audited and directs exactly where the money goes.