The Wall Street Law Journal

THE SCAM: HOW WALL STREET TURNED SUBPRIME JUNK INTO INVESTMENT GRADE MORTGAGE-BACKED-SECURITIES

THE SHERMAN LAW FIRM

 

Each mortgage backed security (MBS) included different tiers, called “tranches”, which permitted investors to select from a series of different risk-return profiles within the MBS.  

 

The top tier of a MBS, called the senior tranche, was the safest investment in a mortgage-backed-security and carried the lowest yield.  By giving up yield, investors in senior tranches of mortgage-backed-securities had the first claims on the cash-flows generated by monthly payments on underlying mortgages.  Even though the senior tranche of a MBS often held only subprime mortgages, S&P, Moody’s and Fitch almost always rated the senior tranche as “investment grade.”  

 

Investment banks turned low quality mortgages into investment grade securities by over-collateralizing the senior tranches of MBS's.  In other words, Wall Street stuffed senior tranches full of enough extra subprime mortgages to allegedly give investors a sufficient cushion of extra cash-flow to protect investors against the possibility that some subprime borrowers might default.  That explanation - along with the high fees Bear Stearns, Merrill Lynch, Lehman and others paid to S&P, Moody’s and Fitch for rating the securities – was nearly always sufficient to secure the all-important investment grade credit rating.  

 

Because investors had almost no way to tell what was in a MBS, or a CDO filled with many mortgage-backed-securities, the word of the ratings agencies was gold.  This is how Wall Street used a little double-talk, and a lot of cash, to get their subprime junk an investment grade rating.

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By Brett D. Sherman, Esq. 

Info@Shermanlawyers.net 

Subprime's Trillion Dollar Questions...

Some answers seem so obvious that we wonder if anyone ever bothered to ask the right questions.

Q:  Aren't decisions to predicate the success or failure of trillion dollar securities and home loan markets  on the reliability (or unreliability) of timely mortgage payments from bad-credit, subprime borrowers with established track records of already failing to pay bills and/or meet other financial obligations pretty similar (in terms of stupidity) to hiring a diamond thief to guard a jewelry store?  

A.  Yes.  True.  At least it sure seems that way to us.

In the two scenarios, the following outcomes seem very likely.  In no particular order, we would predict: 1) The jewelry store will soon be missing some valuable inventory, and 2) many individuals with poor credit eventually start missing mortgage payments. 

Q:  If subprime borrowers began to default on their mortgages - whether it was 2006, 2007 or 2010, investors would lose billions - maybe even trillions of dollars, wouldn't they?

A:  Ummm, yup.  

Q:  And, historically speaking (we will put common sense aside for a moment), there was no chance that that interest rates would permanently stay unfathomably low, or that home equity would continue to grow at the mind-boggling pace that made the subprime securities industry viable in the first place.  

A:  Historically speaking, it was highly unlikely that the subprime securities market would work in the long run.  That's true.  But it sure paid well for a while...

The Sherman Law Firm

SUBPRIME FRAUD: Bear Stearns and Cioffi concealed that the subprime machine would fail in the long run.

INTRODUCTION

In order to function, the subprime securities market required (1) lenders - funded or owned by Wall Street investment banks - to find and make home loans to an endless stream of borrowers with bad-credit, and (2) subprime borrowers to keep current on home mortgage payments that many of them could barely afford.

In other words, the entire subprime mortgage-backed securities industry rested on the ability and desire of millions of people with an established history of not paying their bills suddenly flipping a switch and making regular mortgage payments on a consistent basis for long periods of time.  

Sound like an idea destined to work, or an idea destined to fail?   

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The Subprime Story - How it all worked (the short version)

In 2002-2003, Bear Stearns subprime guru Ralph Cioffi understood that securities backed by the value of subprime or near subprime mortgages (terms with which most Americans were then unfamiliar), would be hugely successful in the then-prevailing climate of low interest rates and rising home prices.   Cioffi  also knew, however, that subprime mortgages could never form the backbone of a securities market capable of performing reliably over the long run. That so many others apparently failed to grasp this fact is largely attributable to the fact that the power players in the subprime markets - aware that there was an Achilles heel inherent in their products - went to great lengths to cloak their jobs in mystery. 

It was crucial for Ralph Cioffi and men like him to give subprime-backed securities and all credit derivative products reputations as exotic and complex instruments.  They wanted the public, and the press too, to give collective shoulder shrug and leave things to the experts.  Cioffi and company were successful in this regard because there legitimately were mysterious and highly complicated elements to what they did. The securitization process, for example, and the way the securities traded without any actual exchange.

When subprime experts at the various Wall Street firms spoke publicly or gave interviews they generally stuck to what theyin terms of making the credit markets work on Wall Street.  What they didn'ttalk about was the equally necessary activity that was happening at the beginning of the assembly line.  The market could only sustain itself with the ongoing generation of massive numbers of subprime mortgages, the majority of which required borrowers who could and would make their monthly payments. Moreover, Wall Street itself was the driving force behind the explosive growth of subprime mortgages. Firms like Bear Stearns funded huge quantities of subprime loans with giant warehouse loans to subprime lenders who often acted as Bear's private mortgage broker. Bear Stearns also owned several mortgage brokers of its own, including EMC Mortgage.

Subprime mortgages, of course, are home loans extended to individuals with poor credit. People with credit problems usually have a history of late payments and/or defaults on obligations to creditors. One of the most common reasons that people don't pay their bills on time is insufficient income.  In other words, people with bad credit frequently got that way because they couldn't afford to pay bills.  These were the people - the ones that couldn't pay their bills in the past - that Bear Stearns, Lehman Brothers, Citigroup, and others needed to be placed in adjustable rate subprime home mortgages in a never-ending supply. To call this concept unethical and ridiculous does not come close to providing an adequate description.  Anyone unable to see that the subprime machine had to fail, resulting in both a securities crisis and a housing crisis, any extended sampling of time should immediately cease thinking.  This tragedy was more than reasonably foreseeable (a legal standard), it was a stone cold guarantee (not a legal term).

Returning to 2002-03, Ralph Cioffi knew that the historically low interest rates and rising home prices then prevailing were ideal environment in which to make a lot of money in the subprime market.  In this environment, millions of subprime borrowers would be able to afford the low teaser rates on adjustable rate subprime mortgages. The vast majority of borrowers could - for a time - afford their home loans.  However, there was an intrinsically understood shelf life for how long many low credit homeowners would be able to keep current.  The length of that shelf life depended on whether and how much interest rates might increase before the loan payment amount adjusted and, critically, whether home prices continued their skyward march.  The pace of price appreciation was the ultimate key to the whole subprime scam, since the borrower acquired what amounted to free equity as the home value appreciated, that extra equity was theoretically a supplement for what might otherwise be unaffordable payments after a loan adjusted.  So, for the foreseeable future at least, Cioffi could see that the combination of low interest rates and rising home prices were a 'perfect storm' of sorts that should allow him and Bear Stearns to make many, many millions of dollars in the credit derivative markets.  Still, Cioffi was making a deal with the devil and he absolutely had to know it.

With Bonds built by bundling subprime or near subprime mortgages, usually received high credit ratings from agencies like Moody's and SP&P (each of the major credit rating agrencies has been investigated, and continues to come under scrutiny). The high ratings served a very important purpose,  making the securities seemmuch less risky then they were and permitted the investments to pass the rigorous standards required by institutional investors like pension funds. uninsurable. Cioffi knew that those big institutional investors - including investment banks themselves - would love mortgage-backed securities.  

As long as interest rates remained low, CDOs were preferable investments to other fixed income products with similar credit ratings that could not produce the same income stream. institutions.  CDO's also were attractice because institutions were reluctant to invest quite as heavily in stocks as they had before the stock market crash, then only a few years earlier.  All of these factors made subprime-based CDO's and similar asset-backed securities great investments for a brief period market cycle, just as Cioffi had anticipated.  The subprime securities market went through the roof. Profits, profits, and more profits - for Bear Stearns and for Ralph Cioffi. There are hardly ever any tough questions from supervisors or regulators when the money rains down.  Perhaps those are the times when scrutiny should be most intense.

Of course, it was always inevitable that things would turn.  From late 2005 on, subprime problems were all over the place. Cioffi and Bear Stearns (and other Wall Street firms) demanded more and more mortgages from subprime lenders. Since Wall Street was funding the loans, the lenders (some of which were owned by Wall Street firms) lowered lending standards to the point where they were practically giving mortgages to anyone with a pulse. These sub-sub prime borrowers (usually barely vetted by underwriters) were very unlikely to meet their mortgage payment obligations.   And that made the loans as waste of time.  They were worthless to Wall Street. 

Interest rates steadily climbed, so did the default rate on subprime loans.  More and more defaults followed, partly because more loans were adjusting upward in response to the higher rates. Suddenly, disaster.  Housing prices stopped climbing.  There was excess inventory in the real estate market.  Home equity - subprime's temporary safety net - completely evaporated. 

The housing bubble went pop and home foreclosures reached into the millions.  Securities backed by subprime loans plummeted in value.  And then, almost immediately, they were totally illiquid, worth nothing at all.  Investors lost billions.  Bear Stearns own accounts, filled with CDOs, Credit Default Swaps, and similar securities (or as Wall Street was now calling these securities -"toxic waste").   Bear's eulogy at that point was only a formality.

Ralph Cioffi always knew that basic economics would one day cause the speeding locomotive he was riding to crash.  No doubt, had hoped for a softer impact.  But he had to know the end wouldn't be pretty.  Cioffi understood that you can't build a successful product with staying power if it depends on the  performance of people who cannot be counted on to perform. For subprime loans and subprime backed securities, unusual economic conditions helped deceive investors by masking Cioffi's inherent and unavoidable problem for a few profitable years.  But the problem with masks is that eventually somebody notices you are wearing one.  

The Subprime Con Game - a brief history of audacious greed.

Subprime's fate was sealed from the start.

By Brett D. Sherman; The Sherman Law Firm

Subprime Lending Was A House of Cards that worked as long as interest rates stayed low and housing prices continued to rise.  Trouble is, we live in a dynamic economy. 

In a dynamic economy, stock values rise and fall,  inflation rises and falls, interest rates rise and fall.  And the housing market is famously cyclical.  In other words, the odds of interest rates remaining at or near historic lows and housing continuing to boom for more than a few years at the most were pretty close to zero.  If you think your local lender or investment bank didn't grasp this very basic idea, think again.

When interest rates rose - as they eventually had to do - adjustable rate mortgages held by so many subprime borrowers adjusted right on up with them.  This was a major problem for those who could just barely afford their mortgage payments at the original payment level.  The potential saving grace was the home equity (which provided an additional source of cash) that homeowners enjoyed as a result of skyrocketing house prices.  Of course, many subprime borrowers - often encouraged or cajoled by subprime lenders - had already borrowed against this equity to do things like put in swimming pools, remodel the master bath, and install home theaters. These folks didn't have very much equity, if any, to draw upon when interest rates started to spike.  

Then, the predictable endgame.  As interest rates kept right on rising, the pace of the booming housing market began to slow.  Then home prices flattened out.  Then, in most parts of the country, prices started to dip.  Goodbye equity.  Hello subprime defaults.  And more defaults, and even more.  So long to the value of mortgage-backed securities, especially those backed by subprime mortgages. 

The death of subprime (at least in the form it existed from 2003-2007) wasn't just predictable, it was a sure thing. So why didn't the public - or even sophisticated hedge fund managers get it?  Because the whole enterprise was a scam, a con, and the people running the con - from lenders to investment bankers - had a vested interest in keeping the process as mysterious as possible.  At that, they unfortunately were quite successful

By Brett D. Sherman; The Sherman Law Firm

Subprime Lending Was A House of Cards that worked as long as interest rates stayed low and housing prices continued to rise.  Trouble is, we live in a dynamic economy. 

In a dynamic economy, stock values rise and fall,  inflation rises and falls, interest rates rise and fall.  And the housing market is famously cyclical.  In other words, the odds of interest rates remaining at or near historic lows and housing continuing to boom for more than a few years at the most were pretty close to zero.  If you think your local lender or investment bank didn't grasp this very basic idea, think again.

When interest rates rose - as they eventually had to do - adjustable rate mortgages held by so many subprime borrowers adjusted right on up with them.  This was a major problem for those who could just barely afford their mortgage payments at the original payment level.  The potential saving grace was the home equity (which provided an additional source of cash) that homeowners enjoyed as a result of skyrocketing house prices.  Of course, many subprime borrowers - often encouraged or cajoled by subprime lenders - had already borrowed against this equity to do things like put in swimming pools, remodel the master bath, and install home theaters. These folks didn't have very much equity, if any, to draw upon when interest rates started to spike.  

Then, the predictable endgame.  As interest rates kept right on rising, the pace of the booming housing market began to slow.  Then home prices flattened out.  Then, in most parts of the country, prices started to dip.  Goodbye equity.  Hello subprime defaults.  And more defaults, and even more.  So long to the value of mortgage-backed securities, especially those backed by subprime mortgages. 

The death of subprime (at least in the form it existed from 2003-2007) wasn't just predictable, it was a sure thing. So why didn't the public - or even sophisticated hedge fund managers get it?  Because the whole enterprise was a scam, a con, and the people running the con - from lenders to investment bankers - had a vested interest in keeping the process as mysterious as possible.  At that, they unfortunately were quite successful

Subprime's fate was sealed from the start.

By Brett D. Sherman; The Sherman Law Firm

Subprime Lending Was A House of Cards that worked as long as interest rates stayed low and housing prices continued to rise.  Trouble is, we live in a dynamic economy. 

In a dynamic economy, stock values rise and fall,  inflation rises and falls, interest rates rise and fall.  And the housing market is famously cyclical.  In other words, the odds of interest rates remaining at or near historic lows and housing continuing to boom for more than a few years at the most were pretty close to zero.  If you think your local lender or investment bank didn't grasp this very basic idea, think again.

When interest rates rose - as they eventually had to do - adjustable rate mortgages held by so many subprime borrowers adjusted right on up with them.  This was a major problem for those who could just barely afford their mortgage payments at the original payment level.  The potential saving grace was the home equity (which provided an additional source of cash) that homeowners enjoyed as a result of skyrocketing house prices.  Of course, many subprime borrowers - often encouraged or cajoled by subprime lenders - had already borrowed against this equity to do things like put in swimming pools, remodel the master bath, and install home theaters. These folks didn't have very much equity, if any, to draw upon when interest rates started to spike.  

Then, the predictable endgame.  As interest rates kept right on rising, the pace of the booming housing market began to slow.  Then home prices flattened out.  Then, in most parts of the country, prices started to dip.  Goodbye equity.  Hello subprime defaults.  And more defaults, and even more.  So long to the value of mortgage-backed securities, especially those backed by subprime mortgages. 

The death of subprime (at least in the form it existed from 2003-2007) wasn't just predictable, it was a sure thing. So why didn't the public - or even sophisticated hedge fund managers get it?  Because the whole enterprise was a scam, a con, and the people running the con - from lenders to investment bankers - had a vested interest in keeping the process as mysterious as possible.  At that, they unfortunately were quite successful

BEAR STEARNS, COUNTRYWIDE AND THE SUBPRIME CRISIS; How two successful financial institutions failed Economics 101 and Basic Risk Management, losing billions of dollars in the process.

 

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 HOUSING BUBBLE, GREED, UNACCEPTABLE RISK MANAGEMENT, RATES RISE, MORTGAGES ADJUST, BUBBLE POPS, SUBPRIME DEFAULTS, FORECLOSURES, WORTHLESS SECURITIES - COUNTRYWIDE AND BEAR STEARNS SUFFER CONSEQUENCES

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 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 Mozillo's Countrywide) and Bear Stearns, and serious 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

The Subprime Meltdown in Plain English, Part One: Underlying concepts

THE SHERMAN LAW FIRM

HIGH RISK / HIGH RETURN INVESTMENTS AND A WORKING DEFINITION FOR CODENAME SUBPRIME.

(This post is part one of a step by step walk through the world of the subprime mess at banks like Bear Stearns, Lehman, UBS, and others.  Some of our more sophisticated readers may find Part One quite basic.  Nevertheless, we decided to start in what felt to us like the basement of a very tall building.  We will, we promise, start climbing stairs soon).

Part One:  The underlying issue, Subprime equals Junk.

Institutions and individuals have suffered huge investment losses due to the subprime meltdown.  Subprime lawsuits are all over the news. Why?  The cause is the same for all financial scandals - Greed.  Bear Stearns and many other once respected Wall Street banks allowed themselves to get carried away because the money was flowing in.  Voices of warning or dissent were shouted down. 

A.  An oversimplified (but hopefully useful) framework for understanding high risk investments.

In theory (and often in practice), demand for an investment product is directly related to whether potential returns are high enough to justify the risk an investor assumes by parting with his money.   High risk investments require the potential for an investor to reap high returns.  For example, an investor in a low-rated bond (one with a higher chance of default) will demand a higher yield than an investor in a highly rated bond (one with very little chance of default).

We can think of an high risk investor as a high roller at a casino craps table.  As long as a gambler keeps winning, the casino keeps paying out his bets.  And, because craps is a risky game, the payouts tend to be high.  The odds say that the gambler will eventually crap out, losing whatever money the gambler has on the table at that particular moment in time. The dice player's hope is to win more than he loses, ultimately walking away with more money than he had when the night - or the weekend, or month, etc. - began.

A high risk investor is hoping that he will make a lot more money from a risky investment then the amount of money invested.  This, of course, is a very common goal for gamblers and investors  alike.  The craps player bets on how many rolls, and how many payoffs, before he craps out.  The investor in a high risk security is betting on how long his investment will pay a high yield and/or increase in value.  In the case of a high-yield bond, the investor hopes the investment will actually pay a high yield for the entire term of the investment. 

However, as the high roller understands the risks of casino gambling, the investor knows that (depending on just how risky an investment it is) there is a possibility that the ultimate risk of the investment (i.e., credit defaults) may eventually materialize, resulting in an investment that is essentially worthless.  Just as the casino gambler hopes the house pays on enough rolls for his night to be profitable, the high-risk investor is actually betting that the investment pays high returns at least long enough for the investment to be profitable. 

A key caveat here is that,  among "high risk investments", there are far different levels of risk.  An investment bank gets in trouble when it intentionally downplays the risk level, or fails to disclose the actual amount of risk, even to investors that understand they are invested in products that inherently carry a reasonably substantial degree of risk.  This is precisely the accusation levied against Bear Stearns subprime hedge fund managers Cioffi and Tannin with respect to funds that went under in June 2007.

B.  Some thoughts about the euphemism "Subprime." 

Subprime means high risk.  A subprime credit card is a credit card that has a high interest rate because the there is a high risk that the credit card holder will ultimately default on his or her payment obligation.  A subprime mortgage is a mortgage given to a person who's credit and/or income levels would not, under traditional lending standards, qualify that person for the mortgage.  Because the borrower's credit history or income level - or both - make the loan a risky proposition for any lender, the interest rates are marked up, often substantially.

Wall Street has a name for investment products that carry high interest payments and a high risk of default.  The term is JUNK.  As in the junk bonds that became so infamous, and worthless, during the 1980's.  Actually, the term was junk.  In the 2000's, the marketers ran with a new term -subprime. 

The thing about subprime investments is that they paid investors (like hedge funds and their investors) very high yields - and so a whole lot of money - until the credit train broke down.  Wall Street was practically printing money.  But the banks knew it couldn't last. The science of econimics virtually assures that markets backed by high-risk credit are virtually certain to break down at some point.  And when that breakdown begins, it creates an accelerated domino effect as banks race to protect their assets.   This is precisely what occured when Bear Stearns lost two subprime hedge funds in the summer of 2007. 

Having been through the disasterous summer of 2007, Bear Stearns clearly knew the subprime train would eventually crash so badly that the tracks would permanently be ruined.  And Bear Stearns knew what would happen when the crash came.  Despite Bear's protests to the contrary, it is pretty clear that there was no depression style 'run on the bank' situation at Bear Stearns in March 2008.  There was merely the accelerated domino effect that Bear knew would one day come. 

Why didn't Bear Stearns (or UBS, Merrill Lynch, Lehman, and others) take steps to prevent the subprime house of cards from growing too high before it fell? That same old word - GREED.   The returns on peddling and owning these investments were too high to slow down.  Bear's stock price shot right through the roof.  Risk management be damned. 

 

COMING IN PART 2 OF THIS SERIES:  THE CREDIT DEFAULT SWAP (CDS) EXPLAINED IN PLAIN ENGLISH!

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