By Brett Sherman; THE SHERMAN LAW FIRM
Prologue: The Subprime Crisis in 30 Seconds or Less (really)
LOW INTEREST RATES, A HOUSING MARKET FLOODED WITH MONEY, SUBPRIME LOANS BEGET BUNDLED SUBPRIME DERIVATIVES, PROFITS AND MORE PROFITS, A CREDIT / HOUSING BUBBLE, GREED, LIES, UNACCEPTABLE RISK MANAGEMENT, RATES RISE, MORTGAGES ADJUST, BUBBLE POPS, SUBPRIME DEFAULTS, FORECLOSURES, CONTAGION, WORTHLESS SECURITIES
I. Introduction: Countrywide and Bear are Responsible for Their Respective Fates.
Sometimes you can see a storm coming simply by looking at the sky. Unfortunately - even well after the looming subprime mortgage crisis had darkened the economic horizon – the people that mattered at Countrywide and Bear Stearns refused to acknowledge (publicly at least) the very obvious approaching disaster in the credit markets. Despite protests to the contrary from Countrywide and Bear Stearns, it is quite clear that only two things are possible: Either these companies intentionally ignored incredibly obvious signs that the subprime gravy train was about to crash, or management at both companies consisted of people who had no business operating a cash register at McDonald’s let alone billion-dollar financial institutions.
To the delight of the men and women at the top of these companies – led by CEO Angelo Mozillo at Countrywide and CEO Jimmy Cayne at Bear Stearns - it had been raining tons of subprime and near-subprime money for a long time. Countrywide made the loans. Bear Stearns bundled those loans into securities (CDOs being the best known), issued the securities, traded the securities, and managed in giant hedge funds. No matter what disaster might be looming in the mortgage industry, Mozillo, Cayne and their respective minions were determined keep their vision trained only on the very-near term. By putting on blinders, Countrywide and Bear Stearns could rake in mortgage-driven profits for as long as possible. It was classic high finance behavior - Take bucket after bucket of cash out of the well for as long as it lasts. Figure out what to do next only after the well is bone dry.
Unfortunately for pretty much the world, and for the futures of Countrywide and Bear Stearns, by 2005-06, the approaching storm was directly overhead. Interest rates were rising and home prices were falling. This combination, as had been widely predicted, was an atomic bomb to the subprime mortgage industry. Nevertheless, Countrywide kept lending and Bear Stearns kept bundling mortgages into what Bear represented would be safe, stable bonds that carried a very attractive yield.
Sporting a happy face for the public, Bear Stearns chose to outwardly ignore what a smart ten year old can figure out in math class:
If a hundred defaulted mortgages have a total value of zero, then a bond created with those one hundred defaulted mortgages is worthless.
The result, of course, was disaster.
The men and women in charge of Countrywide and Bear Stearns, and those executives responsible for managing risk at the respective companies wore blinders because they were corrupted by greed. That kind of inexcusable greed ultimately destroyed Countrywide (at least Angelo Mozilo's Countrywide) and Bear Stearns, and seriously damaged the financial lives of investors, employees, borrowers and others.
II. A Thumbnail Sketch of The Short Reign of Subprime Mania, using Countrywide and Bear Stearns as Case-studies.
Following the "tech-wreck" (the bursting of the dot.com and technology-driven stock market bubble) at the beginning of this decade, the Fed lowered interest rates to historic lows. Money was cheap to borrow for banks, and that meant that there was more money available for lending and lower interest rates at which all of that money could be loaned.
Lenders like Countrywide realized early on in this process that rates were so low that they could now make home loans to people with bad credit, or with little or no income, or with no money to use as a down payment. In short, Countrywide and other lenders practically threw cash at Americans who had no business having access to large sums of money. The interest only loan, or skip a payment loan, and other similar products became the focal point of a large segment of the residential mortgage business.
Because the borrowers had bad credit, they felt lucky to be approved and were more than happy when Countrywide and other mortgage lenders asked them to pay higher closing fees and a slightly higher interest rate than the rate offered to borrowers with excellent credit. Almost all subprime mortgages had an adjustable interest rate feature, which means that the rate can move up or down with a stated index like LIBOR.
It stretches credibility beyond the breaking point for Countrywide, once the largest home lender in America, to deny a full and thorough understanding of the basic principle that a rise in interest rates would have an almost immediate negative impact on the ability of many subprime borrowers to meet their loan payment obligations (history proves that interest rates do not stay very low for very long). Of course, Bear Stearns - then an investment bank that analyzed the real estate markets as part of its everyday business - also understood this principle. Similarly, Countrywide and Bear Stearns each knew (and really must have known from the start of the subprime boom) that they would eventually face a doomsday scenario if the housing market became stagnant or fell at a time when interest rates were going up.
But, even as the winds of disaster began to blow, Countrywide's focus remained fixed on the huge profits that could be made in subprime mortgages and other mortgages that could not qualify as "A" Paper". Bear Stearns swimming in cash due to its mortgage-backed securities business. Bear (and other banks like Lehman and Merrill Lynch) took these same subprime mortgages and other low quality credit products, bundled them into bonds (the aforementioned CDO's and other credit derivative investment products), attached an attractive yield, and very successfully offered the mortgage-backed bonds to investors.
When the whole mortgage-backed securities mania was starting, the thinking on Wall Street was that bundling low credit mortgages would allow for bonds with good yields in what was a time when more traditional bonds were paying poor yields due to low interest-rates. The subprime business, both for home mortgage lenders and for Wall Street, became a runaway blockbuster. Countrywide and Bear Stearns quickly became two of the most significant (if not the most significant) players on the two sides of the subprime world (lender and investment bank).
Lenders and investment banks built billion dollar businesses on a less than solid foundation cobbled from loans to individuals with poor credit, no credit, and/or no income. There also were the liar loans in which an individual might get an Alt-A loan (near subprime) just by stating his or her income, no verification required. Isn’t a business built on such poor underpinnings by definition a house of cards? And don’t houses of cards always collapse?
So what happened next? Profits - lots and lots of profits. Home prices soared because there was more money to be borrowed and, therefore, more people competing for homes. On Main Street, John Doe toasted his good fortune. He had bad credit, sure, but he also had his dream home. These were the new good old days, right? John conveniently forgot that he lost most of his life savings at the end of the previous economic boom, when all of that money he had in can't miss dot-coms went up in smoke.
John Doe on Main Street can be forgiven for failing to understand market cycles and the concept of bubbles. Financial risk managers cannot be forgiven for this egregious sin. Low interest rates plus easy available money for people without credit put a whole lot of buyers in the housing market, many of whom simply should not be there. Understanding that housing prices must go up when so many more buyers enter the market is probably covered by the third lecture in college Economics 101 (the lesson about supply and demand). By lecture five, most Econ Professors have gotten to the concept of 'bubbles.' This is elementary stuff. The country was in a housing bubble. But, as Countrywide and Bear Stearns again know all too well, bubbles never last.
Under normal economic conditions (i.e., when money isn't flowing like water and credit applications aren't written in crayon), basic math dictated that millions of subprime borrowers simply would not be able to afford their mortgages. When interest rates did jump, all of those low interest adjustable subprime loans adjusted upward. Thus began the inevitable end game for the subprime loan market, and for the securities those mortgages backed. Next was the predicted flood of mortgage defaults and foreclosures. Home prices fell in 2006, reportedly for the first time since the Great Depression. The Housing Bubble had popped. The subprime house of cards was collapsing.
A prime function of Risk Management groups on Wall Street is to engage in analysis and dialog with colleagues and senior management on an ongoing basis to make sure that an investment bank's overall portfolio, and the individual parts of that portfolio, are not engaged in strategies that carry an imprudent level of risk. To do their jobs, risk managers rely on their own knowledge and monitoring (the human factor), as well as sophisticated computer programs.
The Risk Management teams (and many other senior managers) for both Countrywide and Bear Stearns certainly had to have seen the writing on the wall long before the subprime market blew up. After all, low interest rates can't last forever. And, it takes far less than a mediocre risk manager to "get it" regarding the concept that rising interest rates plus homeowners facing rising mortgage payments, with bad credit and often little cash, is a Molotov cocktail.
Bear Stearns Risk Managers were complicit in allowing Bear to rely far too heavily on credit derivatives on a firm-wide basis, and to do so for far too long. Maybe Bear's Risk Managers were pressured by senior management to look the other way. Maybe they were paid “special bonuses” or had some other motivation to ignore their responsibilities. Whatever the case, Risk Management at Bear Stearns was an abject and unacceptable failure.
Countrywide's Risk Team fared little better than the Risk Managers at Bear Stearns. At Countrywide, the immense commitment to subprime mortgages, held for far too long, proved to be the chief factor in the lender's undoing. At Bear Stearns, the immense commitment to subprime mortgage-backed securities had a similar impact on the investment bank.
Lenders like Countrywide and investment banks like Bear Stearns needed each other to make the subprime loan and securitization businesses work. Countywide and Bear Stearns both fell far from their high pedestals because each company was so blinded by greed that the decision was made, most likely at the highest levels, to essentially play out a good hand for as long as it lasted without serious regard for the future.
Countrywide is not, to my knowledge, claiming to be the victim of a conspiracy. Bear Stearns and JP Morgan, on the other hand, have blamed everyone from short-sellers to CNBC to Goldman Sachs to a vast right wind conspiracy (well, maybe not that). No conspiracy killed Bear Stearns. Bad management and fraud took care of that. Bear Stearns is culpable for its own demise.
The Sherman Law Firm
Recent Comments