Wall Street Law Blog

When is a prime mortgage not a prime mortgage? A different take on contagion... (update 1)

How high-risk borrowers contaminated securities backed by prime mortgages. A story about the financial crisis and contagion.

* * *

In the 1980s we had trickle-down economics. During the first half of the 2000s, we had trickle-up credit scoring.

Before you yawn (or stop reading), consider that credit score inflation was

(1) a real phenomenon, and

(2) helps explain why, when the crisis hit, the market for bonds backed by supposedly high quality prime mortgages suffered from the same kinds of liquidity problems as subprime backed MBS.

Background: The Golden Age of Subprime and its impact on Credit Scores 

The performance of subprime mortgages during the first half of the first decade of the 21st century was strong enough to justify (rationalize) AAA credit ratings for senior tranches of structured bonds backed by those mortgages. However, the banks that jiggered and gerrymandered the structures of those bonds knew that their AAA-like performance was an illusion. The banks knew -- as we have addressed about in numerous prior Wall Street Law Blog posts -- that it was the unique economic climate of the early 2000s, plus the widespread abuse of ARMs with short-term below market "teaser" rates (and loans with similar "affordability" features), that kept subprime default rates down.
 
Because low subprime mortgage defaults concealed the poor quality (i.e., crappiness) of securities backed by subprime mortgages, Wall Street banks could to sell all the subprime-backed MBS that their securitization machines could produce.
 
Being big fans of math, we like to describe subprime's brief but memorable "golden age" with an equation:

(R x Li) + (R x HPA) = BCR

Translation: Record low interest rates plus record home price appreciation equals bogus credit ratings.

Ok. So far, nothing in this post should be news to any amateur crisisologist.

 

But did you know that the number of prime borrowers went way up during the golden age of subprime? It's true. Credit scores spiked in the first half of the 2000s. This period of credit score inflation meant lots of high-risk borrowers could qualify for prime mortgages.

Welcome to the World of  Credit Score Inflation

The fact that credit scores went up at the same time that subprime defaults were low is no coincidence. Indeed, if you think about it, the connection makes perfect sense.

Credit scores went up a for the same reasons that subprime defaults were low. Specifically, credit score inflation was a byproduct of record low interest rates and record home price appreciation.

Remember the equation-

(R x Li) + (R x HPA) = BCR

The equation works equally well if we substitute CSI (credit score inflation) for BCR (bogus credit ratings).

Thus-

(R x Li) + (R x HPA) = CSI

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NOTE

Equations are for illustrative purposes. We are NOT mathematicians (clearly) and our "equations" really have nothing whatsoever to do with math.

So, before quants and math teachers and algebra students taunt us, please understand that we do realize that BCR does NOT equal CSI.

However, it is still true (as far as we know) that E = MC Squared.

 

* * *

During the golden age of subprime, many credit-impaired homeowners used the theoretical wealth produced by record increases (on paper) in the values of their homes and borrowed a lot of real money by taking out new mortgages. These new mortgages were usually cash-out refinancings or home equity loans.
 
Thanks to securitization, of course, these loans were very easy to come by. In fact, for subprime borrowers, aggressive mortgage brokers practically begged homeowners to borrow against home equity.

Now, after buying a few Plasma TVs and a SubZero Fridge and maybe a Viking Range, a subprime borrower could use the rest of that "free money" (or, since home values kept going up, borrow even more money) and pay off all of their maxed-out high interest credit cards, overdue bills, and other debts that earned the individual subprime status in the first place.

The result of "cleaning up" all this debt? Very quickly, the borrower's credit score improved. Often, the credit score went up a lot. Suddenly, a habitual deadbeat could appear to be a good credit risk. Many beneficiaries of credit score inflation were actually able qualify for prime mortgages.

The Trouble with Credit Score Inflation

First, a quick recap: credit score inflation is a rapid rise in an individual's FICO score for reasons that have nothing to do with that individual's creditworthiness.

During the housing bubble, credit score inflation made a whole bunch of people with poor credit histories seem like good credit risks. Deadbeats suddenly had credit scores that qualified them for prime mortgages even though most were still deadbeats.

When these borrowers refinanced again (as they generally had to do before their mortgages reset to a much higher rate), their new mortgages could be classified as prime mortgages. Suddenly, because of credit score inflation, there was real dilution in the quality of prime mortgage pools.

When the bubble popped, home equity disappeared, returning to the ether from which it came. However, the crop of former subprime borrowers that qualified for prime mortgages through the magic of credit score inflation still had to repay the real money they had borrowed. Many couldn't.

Credit Score Reversion

Before long, the CSI-enabled prime borrowers were behind on bills or defaulting on mortgages. For these folks, this post-bubble period became the era of credit score reversion.
 
From a macro perspective, the problem was that tons of high-risk prime mortgages were marbled throughout the universe of RMBS and CDOs. Of course, like everything else in the derivatives world, it was virtually impossible to know which pools were infected by these faux-prime mortgages and which weren't.

The rest of the story is a familiar one.

By now, we all know that contagion kicks in during a crisis when (a) there are bad assets, and (b) the market for those assets lacks transparency.

Bottom line?

Contrary to Wall Street's standard narrative, the mortgage crisis did not simply spread from subprime to prime because of fear. Certainly fear was a factor, but the reason for the fear was that Wall Street cloaked mortgage bonds in so much complexity and disclosed so little information in order pull off the whole MBS/CDO scam that investors had no way to parse good bonds (assuming there were a few) from bad ones.

But the other, frequently overlooked point is this: There were enough bad mortgages that were not "subprime" - including the faux-prime mortgages described in this post - that the markets acted rationally (for once) by shunning all securities that depended on the performance of home mortgages, regardless of classification, in the United States.

By Brett Sherman
The Sherman Law Firm

 

 

Securities Fraud at Bear Stearns, Part 1 (encore)

Part 1:  Introduction -

Understanding securities fraud at Bear Stearns - Backstory of The Global Financial Crisis

Two and a half years later, why should anyone care whether Bear Stearns (through Senior Management) committed securities fraud? 

Because...

(a) To understand how securities fraud by top executives at Bear Stearns toppled what was the fifth largest Wall Street investment bank is to understand why all of Wall Street's major investment banks subsequently disappeared.

(b)  The fraud that caused the end of the era of the traditional Wall Street investment bank gave birth to a chain of events that evolved into the worst financial crisis since the Great Depression.  

-and-

(c) As a direct result of their own securities fraud and other illegal conduct, members of senior management at Bear Stearns collected enormous financial windfalls that they did not earn and do not deserve to keep.  Senior management's windfalls came at the expense of America's economy and the economies of other countries around the world (and, on a "closer to home" level, executive committee members enriched themselves at the expense of Bear's own employees and shareholders).  

There are two basic elements of the financial windfalls that, to date, Bear's executive committee members have managed to retain-

First, Bear Stearns paid its Executive Committee members enormous cash bonuses for "leading" the company to record revenues from 2002 through 2006 with the same unsustainable high-risk business model that (a) caused Bear's failure and (combined with the same, similar, and/or related misconduct at Merrill Lynch and Lehman Brothers and Citi,and Goldman Sachs and insurance giant AIG -- to name a few of the responsible companies) (b) ultimately produced the global financial crisis.  

The second (and far more lucrative) element of the financial windfalls reaped by senior management came from selling massive amounts of Bear Stearns stock at artificially high prices.  The record "success" Bear Stearns achieved because of its fraudulent and unsustainable business model temporarily produced record high share prices for Bear Stearns common stock.   Indeed, from January 2000 to January 2007, the share price for BSC stock quadrupled.  

During this period of stock price inflation, Bear's five top executives -- all of them members of the former investment bank's executive committee -- reportedly sold more than $1 billion dollars worth of stock-based compensation from prior years. 

Again, the story of unjust enrichment at Bear Stearns is a microcosm of unjust compensation practices all over Wall Street.

So far, securities fraud by Bear's former leaders has been a tremendous success.  The primary reason for this is, we believe, the sheer complexity of the fraud.   From the housing bubble to "affordability mortgages" to the different kinds of derivative securities that were part and parcel of the long running course of securities fraud at Bear Stearns (and on Wall Street generally), the misconduct at issue revolves around a lot of intimidating stuff. 

From easier (but not easy) to understand  concepts like subprime and Alt-a mortgages to harder (often headache inducing) "structured products" like mezzanine collateralized debt obligations, credit default swaps to fixed income terms like yield spreads, it is a daunting task to peel back the layers of fraud on Wall Street during the 2000s.   

"Fraud by complexity" is very dangerous.  Until Main Street has a far better understanding of what happened on Wall Street, then the corrupt rigged game that senior management for the old investment banks played so well for so long will resurface in slightly different form sooner rather than later.  

A deep examination of securities fraud at Bear Stearns is, we at Wall Street Law Blog believe, a great place to start parsing fact from fiction and isolating the complex -- but ultimately fascinating -- story of the genesis of a financial catastrophe.  

We do not profess to have all the answers.  But , in subsequent parts of this series, we intend to ask questions and frame issues in ways designed to eliminate as much complexity as possible.

Stay tuned for Part 2 (and the rest of our series).

The Wall Street Law Blog, a Publication of The Sherman Law Firm.