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

----

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

 

 

Another Brick in the Wall of Securities Fraud at Bear Stearns (updated)

*FRAUD BY SILENCE AND COVER-UP*     

By Brett Sherman

An individual's creditworthiness is highly correlated to mortgage default risk. In other words, the worse a borrower's credit history, the more likely it is that the borrower will default. 

A subprime borrower is more likely to default than an individual with strong credit background. Indeed, it cannot be disputed that subprime mortgages have always been riskier for lenders than conforming mortgages. It is specifically because subprime loans have relatively high default rates - and are therefore risky by definition - that subprime borrowers must pay higher interest rates than individuals who qualify for conforming mortgages. 

To prevent lenders from taking excessive risks, both prime and nonprime mortgage applicants historically have been subject to a rigorous underwriting process. In the later years of the housing bubble, lending standards simply disappeared for subprime mortgage applicants. 

Today, it is well known that subprime lenders (including Bear Stearns' own mortgage subsidiaries) progressively reduced subprime underwriting requirements during the housing bubble.  At the time, however, Bear Stearns failed to disclose (a) that lending standards were eroding, or (b) that the reason for lowering underwriting requirements was to preserve the immense profits from sales of mortgage securities. 

By 2004-2005, Bear Stearns knew that the supply of "qualified" subprime borrowers was dwindling. To keep the Company's mortgage inventories large enough to maintain and expand its incredibly profitable mortgage securitization and sales platforms, new mortgage origination rates had to stay high.  The only way lenders could assure a steady supply of new mortgages for the securitization machines of Bear Stearns and others was to increase the universe of the subprime borrowers. And the only way to increase the number of "qualified" borrowers was to relax, and eventually almost eliminate, subprime lending standards. 

Because mortgage default risk grows as credit quality and income shrink, Bear Stearns cannot credibly argue that the firm did not know that new batches of collateralized debt obligations were backed by far more risky loans than in prior years. 

Bear Stearns certainly knew that the MBS and CDOs the firm sold to investors in the later years of the bubble were loaded with junk mortgages.  Therefore, there is no doubt that Bear Stearns knew that the inevitable disruption of rising home prices could very well produce vast numbers of mortgage defaults by low credit homeowners. 

Despite all that it knew about the ever precarious quality of subprime loans, Bear Stearns continued to collude with credit rating agencies to obtain investment grade ratings. Worse, Bear Stearns still publicly insisted that its mortgage securities were extremely safe investments.

Sales of newer "vintage" collateralized debt obligations grew at an incredible rate through early 2007. At the time, Bear Stearns' decision to omit material and specific new risk disclosures (and/or to lie about the prospects of its MBS businesses) allowed the Company's stock price to artificially inflate. 

When defaults of low quality MBS and CDOs started to spike in late winter/early spring 2007, the high risk nature of the more recent crop of mortgages became apparent.  Soon thereafter, Bear Stearns' stock price began its long slide into oblivion. 

Failing to make plain English, honest, accurate and specific risk disclosures about the junk mortgages in the MBS and CDOs the firm created and sold is one way Bear Stearns committed securities fraud during the financial crisis. 

There were many others...