The release of the first batch of FCIC interview reveals interesting finger-pointing among some of the major players. We’ve argued (and in ECONNED, provided a considerable amount of supporting analysis) that the subprime shorts drove the demand for bad mortgages. There is no other explanation for the explosion of demand for “spready,” meaning bad, mortgages that started in the third quarter of 2005. As Tom Adams and I describe in a recent post:
Signs of recklessness were more visible in 2004 and 2005, to the point were Sabeth Siddique of the Federal Reserve Board, who conducted a survey of mortgage loan quality in late 2005, found the results to be “very alarming”.
So why, with the trouble obvious in the 2005 time frame, did the market create even worse loans in late 2005 through the beginning of the meltdown, in mid 2007, even as demand for better mortgage loans was waning? It’s critical to recognize that this is an unheard of pattern. Normally, when interest rates rise (and the Fed had begun tightening), appetite for the weakest loans falls first; the highest quality credits continue to be sought by lenders, albeit on somewhat less favorable terms to the borrowers than before.
In other words: who wanted bad loans?…
Had the FCIC report bothered to connect the dots raised by this simple question, it could have actually contributed something.
By blaming regulators (and the rating agencies), the report makes it seem as if it was just about what the lenders could get away with. But that same argument could be applied to any credit market, yet the US mortgage market was rife with remarkably crappy loans. And lenders still would suffer negative consequences for selling a bad product, even if they could get away with it for a while, such as loss of reputation due to inferior deal performance, losses on retained interests, and poor pricing for the drecky mortgages.
Along a similar line, the report notes that bonuses skyrocketed for the industry during the bubble years. Where did this money come from? Why had the mortgage industry never before generated such high compensation?
The obvious answer is that good loans did not generate hugely excessive bonuses, but bad loans did.
What happened is that the benefits for originating bad loans exceeded the cost of these negative consequences – someone was paying enough more for bad loans to overwhelm the normal economic incentives to resist such bad underwriting.
The best example of this is John Paulson, who earned nearly $20 billion for his fund shorting subprime. This amount of money was not ever possible or conceivable in the mortgage business prior to that point. The only way it could occur was through the creation of a tremendous number of bad loans, followed by a bet against them. Betting on good loans could never generate this much gain.
Given the massive amount of money earned by betting on bad loans, the logical next step is to ask, how did such incentives affect and distort the market?…..
You can read the explanation of the mechanisms here.
Yet the narrative of the subprime shorts as good guys still gets undue deference, particularly in the mainstream media. Bloomberg took note of the Paulson version of history in his interview with the FCIC but neglected to consider the account of Scott Eichel, who was head of credit trading at Bear in 2002 and co-head of the mortgage department in 2007.
First the Bloomberg report:
“The Federal Reserve did have oversight for the mortgage area, and there was very little oversight given in the mortgage area,” Paulson said in an October 2010 interview released today by the Financial Crisis Inquiry Commission on its website. “Demanding that proper underwriting guidelines be followed, not allowing ‘no doc’ loans, requiring a down payment, even if it’s just 5 percent,” would have gone a long way toward preventing the crisis…
Paulson said his firm researched the mortgage markets in 2005 and early 2006 and found subprime loans had “no underwriting standards at all.” Mortgages underwritten in 2006 were inferior to those from earlier periods, he said.
“None of this made any sense to us,” Paulson, 55, said, recounting his experience obtaining three mortgages before the housing boom. “When I purchased my home it was very strict underwriting standards. I had to provide two pay stubs, two years tax returns, three months of bank statements, all sorts of credit card information.”
Now consider the Eichel discussion. Bear was far from a paragon of virtue, yet the subprime short strategy did not pass its smell test.
The interview makes clear that when Eichel met with Paulson’s team, they wanted Bear’s help to select the worst possible deals or they would select the worst possible deals.
Eichel said he believed their business was built around the long side of the market: everybody hopes the deal does well. In this case, Paulson was a new type of counterparty that wanted to deal to do poorly.
Eichel rejected the Paulson deals out of hand after the second meeting.
He also discussed the fact that on any synthetic deal, there is a short side but there is also CDO manager who’s job it is to pick the best possible asset, so that’s why Bear was comfortable with such deals. Bear didn’t love synthetic CDOs and did not see them as part of their core business practice. It tended ended to stay with same managers and issuers.
Eichel turned down every short seller who wanted the Paulson type of deal including the Morgan Stanley prop desk and Magnetar.
Note that this ins’t news; the Greg Zuckerberg book, The Greatest Trade Ever, also reported that Bear turned down Paulson down because they had reservations about the propriety of his strategy.
Tom Adams also points out that analyses of this period typically fail to chronicle accurately the deterioration of underwriting standards. One particularly amusing study is by the St. Louis Fed, which argues that subprime lending standards tightened prior to the crisis. The error in its reasoning is in plain view. It notes:
An important feature of the subprime market during 2000-2006 was the significant growth in the proportion of originations with lower documentation and higher loan-to-value ratios (LTV). There is a clear trend of a decline in underwriting standards along these dimensions.
It nevertheless attempts to do a “multidimensional analysis” which evidently gives heavy weight to FICO (how “multidimensional” can an analysis be on a low doc/no doc loan?). As Tom Adams notes:
FICO is not a terribly accurate predictor of performance for a subprime mortgage – FICO scoring only became widespread after 1999 and there was very little analysis available for its long term predictive ability for much larger loan balances than autos or credit cards. However, despite lack of sufficient data, years of true underwriting standards, such as debt to income, LTV, months of reserve, payment stubs and tax returns, were abandoned in favor of using FICO as the underwriting tool. As a note – subprime auto lenders used detailed scorecards for their borrowers, but FICO was not the primary component of their scoring. Other factors were deemed more important. These transactions have held up much better than subprime mortgages and they were on depreciating assets (which is why, of course, lenders had to be more careful).
Also, the authors get the analysis of purchase vs. refinance wrong. With prime mortgages, purchase loans tend to perform better. However, subprime loans were traditionally refinance loans (usually cash out). In the early days, subprime lenders were fairly careful about who they lent to – their target market was people who had been in their homes for at least 5 years, had stable jobs and work history (and were able to document their income with tax returns etc, even if self employed), had equity and had encountered a financial difficulty – thus, the need for more cash. In the mid-2000s, the new target market became first time home buyers who had very little credit history (thus, making FICO score an even worse predictor, since it was based on “thin files”), had no money for down payments (thus, piggy back seconds) and a short job history. Basically, purchases were bad in subprime lending and had generally been avoided in the early days.
Moreover, many lenders gamed labels like subprime and alt A. We had to create our own definitions. Also, many lenders provided poor information regarding documentation – each lender had its own marketing names for their documentation programs,so there was no uniform standard of what “limited documentation” looked like. This also presented an opportunity for lenders to game the system (and lenders like Countrywide were the worst abusers). DTI was also very inconsistent.
This serves to illustrate that many conventional analyses even now tend to miss the dramatic deterioration in underwriting standards. The use of low and no doc loans rose rapidly from 2004 onward, and these pools were particularly favored by the subprime shorts. Moreover, we now know how some aspects of the underwriting were abused, for instance, by the use of inflated appraisals, so analyzing historical data will not provide a full measure of the fall in underwriting standards.
Yet digging into the comfortable narrative of the subprime shorts as heros, or at least harmless, would reveal yet another viper’s nest of bad practices and abuses. The officialdom seems determined to push onward with its “look forward, not back” stance, which means the perps will be able to engage in similar types of looting when the opportunity next presents itself.