I must confess that I have stayed away from this controversy, in which various unnamed hedge funds are grousing about investment banks, Bear Stearns in particular, somehow mucking with the assets underlying certain mortgage-related instruments, modifying them so as to help stressed borrowers. The hedgies are upset because they allege that the investment banks are engaged in this activity, not to try to assist borrowers or to keep Congress and the press off their backs, but to cheat them on their puts (bets that the instruments would decline in price).
This argument has mainly (and correctly) been met with “pigs get slaughtered” reaction. It was predictable that if things got really bad, there would be regulatory and public pressure to do something; the fact that the hedge funds didn’t anticipate this is their problem.
But I have been confused as to what precisely the hedge funds were complaining about (in terms of exactly what sort of intervention the investment banks were making) and it turns out I am not wrong to be a bit at sea. Tanta at Calculated Risk, who has been following this closely, is also not clear on exactly what is happening, but in a colorful and useful post, she dissects what has been made public:
So what has given rise to today’s latest installment of WSDS (Wall Street Derangement Syndrome)? In this post of the other day we were attempting to wade through the undistinguished reporting on this current hullabaloo subject of hedge funds accusing investment banks generally and Bear Stearns specifically of “market manipulation.” I observed at the time that, among other things, I couldn’t figure out what sort of mortgage-security-related transactions Bear was alleged to have engaged in: modifications? Repurchases? Purchases of mortgages? Purchase of bonds? Lots of people are focused on what motive Bear might have to do something or other with a subprime RMBS/ABS, the idea being that some action could be taken to prevent write-downs on a security or set of them, such that Bear would avoid making a payout to hedge funds who purchased credit protection from Bear on these “reference” securities. What has been making me crazier than usual is that I can’t get a clear fix on what this “action” is that Bear has been alleged to have taken.
Here’s a new piece of reporting on this, which I have not (yet) found on the web. The source is Dow Jones Newswire, “Artful Hedge Trimming On Wall Street,” by Steven D. Jones (thank you, Brian):
Hedge funds, which insure mortgage-backed securities by purchasing credit default swaps, have complained that some techniques used to restructure loans reduces the value of their swaps. That’s because in renegotiating loan terms lenders may pull loans out of the underlying loan pool in a security and reduce the likelihood of default. . . .
But what may appear to be a tempest in a teapot goes to the heart of the swap business. Renegotiating loan terms is one thing, but removing troubled loans from portfolios specifically to avoid paying losses on credit default swaps may erode the value in the swap market that is essential to subprime lending.
“What is objectionable are non-economic transactions in order to avoid making payments to holders of derivative positions,” says Harvey Pitt, a former Securities and Exchange Commissioner and advisor to hedge funds in the matter.
When Wall Street firms buy worthless loans out of a portfolio they eliminate the risk of paying off the credit protection the firms sold to hedge funds. Renegotiating loans with homeowners doesn’t affect swap investors and benefits lenders and homeowners. But just buying and removing defaulted mortgages from loan pools to avoid paying derivative holders weakens the system, says Pitt.
“My concern is that this type of manipulative conduct will undermine the credibility of the subprime mortgage market,” he says.
I confess that there’s something about Harvey Pitt (who last I knew is a former SEC Chairman as well as a former Commissioner, but whatever) making claims about the credibility of the subprime mortgage market that sends my personal irony tolerance well into the danger zone, so let’s not get into consideration of the source here. I first want, however, to highlight the utter absurdity of the claim that, after all the fraud, criminally loose underwriting, and perfectly disgusting capital resource misallocation that has collectively been known as the “subprime mortgage market” in the last few years, it can be asserted with a straight face that there’s any credibility left there to blow.
Ditto goes for the unironic claim that “the swap market . . . is essential to subprime lending.” Well, sure. Flame-retardant suits are essential to surviving the process of driving a motorcycle up a steep ramp at 150 mph and shooting over a series of raging bonfires, but there’s also the idea that you could just not drive a motorcycle up a steep ramp at 150 mph and shoot over a series of raging bonfires and then you wouldn’t really need that fireproof get-up. The “credibility” Pitt is talking about is the “credibility” of stupid subprime lending, a party that’s been and done and over now that the “swap market” has decided it’s no longer a great “risk-free” trade. You want someone to shed tears over that, you’re on the wrong blog.
That nonsense aside, notice once again how difficult it is to really get a handle on what the alleged behavior here is. The implication is that modifying or “restructuring” a troubled loan is OK, but buying a loan out of a pool in order to restructure it is not OK. On the face of it that makes zero sense, and so what is necessary is the further claim that the latter—buying a loan out of a pool in order to modify it—represents a dishonest act by the mortgage servicer because it is a “non-economic” transaction for the servicer. That is, what is assumed is the servicer will lose money doing it that way, and if the servicer is volunteering to lose money, there must be a reason, and the reason must be to avoid paying out on the swaps, which would involve a much bigger loss than the loss on the restructured loans.
Here’s where we need to get all unsloppy with our language and UberNerdly with our concepts, members of the press. I have yet to see anyone in any published source make any reference to an actual shelf or issue in which this practice is alleged to have occurred, so I can’t go to EDGAR, find the deal documents, and tell you exactly what rights and obligations that specific deal gives to a specific servicer in regards to modifications. Until such time as certain folks quit making nonspecific allegations in the press that the rest of us can’t verify because we can’t see what deal you’re talking about—sure, a cynical person might see this as an attempt at market manipulation by the hedgies, designed to drive investors out of those “manipulated” tranches and therefore drive their prices down to increase the swap payout to the hedgies, but of course that would be, like, so totally unfair and mean and unsympathetic besides like totally lacking in actual evidence OMG so I’m not going to do any such thing—we are stuck trying to measure the “credibility” of the manipulation argument by looking at how subprime RMBS/ABS deals usually work. So please take the following with that in mind: there may be deals out there that give a servicer rights or obligations I am not aware of. In what follows I am merely working with what I do know about all the deals I’ve ever seen. I have not seen them all; subprime securitizations have never been a specialty of mine, God help me…..
The post continues with a very long (and if you are into this sort of thing, enormously informative) discussion of the nitty gritty of these deals usually are modified. For those who are less geeky, she give an example of why Bear Stearns et al might be proceeding as they are:
You therefore ask: so why the hell would a servicer ever want to do such a stupid thing as buy a seriously delinquent loan out of the pool, when it has the right to leave it there and make the security eat the loss? There are certainly situations in which everyone involved gains by this practice. Imagine that the loan in question is an ARM, the pool is an ARM-only pool, and the only way to fix up the loan and avoid foreclosure is to modify it to a fixed rate. The deal does not want a fixed rate loan in it; that messes up the net yield and cash-flow and may even violate the prospectus (if the prospectus says there are only ARMs in the pool).