Washblog

According to an analysis of $2.5 trillion worth of subprime loans performed for the Wall Street Journal, most of those who obtained subprime loans would have qualified for better terms. For example, in 2005, 55% and in 2006 61% of subprime borrowers had credit scores high enough to obtain conventional loans. Because brokers were rewarded for persuading borrowers to take on higher interest rates than those they qualified for, there was strong pressure to avoid conventional loans with lower rates.

That from a working paper (PDF) from the Levy Economics Institute of Bard College.

So clearly the majority of subprime borrowers in 2005 were not only qualified, they were getting ripped off on their rate. But what about their documentation?

From the same footnote:

For example, at New Century Financial Corporation, "brokers could earn a `yield spread premium' equal to 2% of the loan amount--or $8,000 on a $400,000 loan--if a borrower's interest rate was an extra 1.25 percentage points higher" (Brooks and Simon 2007). According to New Century's rate sheet, spreads for similar borrowers with similar loans depended on documentation, with "full docs" typically paying interest rates 60 to well over 100 basis points less than "stated docs"--even with the same high credit scores. (Rate sheet available at(http://online.wsj.com/public/resources/documents/tretro_SubPrime1107.html, accessed 12/3/2007). This may also explain why brokers accepted little documentation from borrowers.

At the mortgage broker level (anyone remember the "Big Kahuna" who was always on TV with "millions and millions to lend"?) there is always an incentive to make bigger loans - the bigger the loan, the more the profit and commission. And in this environment there was an incentive to jack rates AND an incentive to receive as little documentation as possible.

And think of what really was the typical situation: a naive borower making a huge commitment, intimidated by finance and filled with the desire to fulfill that American Dream. So much paper work. Can I qualify? The mortgage broker says that there's an easier way. It will cost more, but it's less confusing and he just implies that maybe this is the only way to qualify. So the borrower goes for it.

From 2001 to 2006 the percentage of subprime loans that were low- or no-doc almost doubled until it was over 50% of those loans. And low- or no-doc loans were reported to be at least 16% of all new home loans originated in 2006. God knows what the number finally hit when you combine all types of loans.

But wait a second, how could that be? Surely the banks to whom these brokers sold the loans didn't want foreclosures around their ears. They would naturally prefer more documentation, right?

Oh really? Maybe not.

This article about Washington Mutual may seem a little technical, but just click on the little chart in the middle. Now look at the line right below line 8 - you see where it says "Full Document."? This is a securitization by Washington Mutual of about half a billion dollars in Alt-A mortgages. That's right, only about 11% of those mortgages were written with full documentation.

Why would an otherwise reputable bank fill one of its offerings with low- and no-doc loans? Well, more than 90% of that offering was rated AAA. In general, a AAA rating that means that the default risk for people who buy that portion of the mortgage bond should be about half a percent. And yet about 18% of those mortgages have defaulted completely in less than a year. So how do you get away with that without being jailed for fraud?

I asked my friend who is a finance/m+a director at a large American technology corporation. He was impatient with me:

"Look, Moody's rated the financial model, not the loans".

"But how is that possible?" I protested.

"They had insurance. Mutual funds bought the security. They didn't do their homework. They're idiots. What do you want from me? Screw 'em."

I thanked him and he went back to work doing due diligence, analysis and writing tight agreements the way I thought good business people always did.  Apparently I was naive. Wait, or was I?

"...They rated the financial model, not the loans."

I thought about that statement. Why did it seem familiar?

When my Dad first graduated from law school, one of the first cases he got involved in came from the aftermath of something called "The Great Salad Oil Swindle". In the early 60's a  "colorful" man from New Jersey called Tino De Angelis conned large Wall Street institutions into lending him $150 million 1963 dollars.

What he did was fake a huge inventory of soybean oil - so large an inventory that he would have cornered the market had it been real. With ingenious techniques worthy of a stage magician he  carefully tricked inspectors into believing that huge tanks, rail cars and ships full of water were actually full of soybean oil. Banks ultimately lent him money thinking it was secured by this enormous amount of a valuable commodity. The story was made into a book of the same name and parts of it were very funny as the criminal De Angelis worked his massive illusion.

Being among the many young lawyers and accountants who were tasked with untangling the Tino De Angelis web of deceit and its aftermath, what my father learned and taught me is that all financial scams - from that one, to Enron, to LTCM to the present crisis - are based on failures to document inventory. No matter how complicated a scam seems, at its core a scam always relies on fooling people about the underlying inventory. But to do that in a way that is profitable is tricky. Enough information has to be given to the suckers so that they will give the scammer money, but other information has to be kept away from the sucker so that they don't catch on.

What the scammer does, ultimately, is create a financial model in the sucker's head where the sucker gets paid and doesn't see the real risk.  Scams often rely on fooling outside "observers" into "confirming" what the scammer is selling. That's even more tricky. Scammers need an outside observer who has the best reputation for honesty possible and then they must get that upstanding person or institution to confirm the story but not the real facts. They have to keep professionals from asking inconvenient questions.

This is done by separating the sucker and the observer from the real data in whatever way possible. The scammer then makes things complex, mysterious, substitutes meaningless facts for meaningful ones - anything to obfuscate the situation.

And now we come to the "no doc" loan. There is no better way to hide the facts than to make sure you yourself do not have them. Ideally, nobody has them. That's the best situation of all. If all you have is the story and you sell that story, you are not even committing fraud. The sucker is defrauding himself.

Because if Washington Mutual and Moody's were telling investors that these piles of crap mortgages really would pay like AAA-rated securities, they might be liable for fraud and people would go to jail. But if they were just selling a financial model with no real, underlying data...well...buyer beware. Mortgage broker makes money. Bank makes money. Investment bank makes money. Rating agency makes money. Buyers of the mortgage securities get screwed. Borrower loses his house and pays fees and interest for nothing. Everybody else keeps their fees and walks away clean.

Welcome to the jungle. See no evil.