It seemed like an interesting idea. Federally chartered financial institutions such a Fannie Mae had been selling mortgage-backed securities to investors for decades. Those securities gave buyers higher yields than they could get on U.S. Treasuries but also proved to be relatively secure investments. Even if one or two homeowners defaulted on their mortgages they represented a small fraction of the total mortgages packaged in such securities. And with ever-rising real estate values the chances were good that the full value of a defaulted loan could be recovered.
So why wouldn’t it be a good idea to offer investors an even higher rate of return by packaging the mortgages of less creditworthy homebuyers who could not qualify for a standard mortgage but were willing to pay a higher interest rate to become homeowners? That was the question posed by some of the biggest financial institutions in the United States as they began to purchase, package, and sell “Structured Investment Vehicles” or SIVs.
There were in fact a number of reasons that such instruments were not a good idea. First, they were being offered at a time when real estate prices had gone through the roof and it was widely recognized that the country was at serious risk of a bubble bursting decline in home prices. Such instruments not only added to the “irrational exuberance” of seemingly ever-rising home valuations but also ensured that the stratospheric valuation of homes greatly increased the risk that such instruments could result in huge losses to investors.
Secondly, the revolution in the processing of mortgage applications which has occurred in this country in recent decades removed the word “diligence” from the concept of due diligence. Key determinations about the creditworthiness of would-be borrowers were in the hands of businesses known as “loan originators” who had little or no stake in whether applicants had the financial capacity to repay the mortgages for which they were applying. In fact, the more applications they approved the more money they were able to make.
Following Federal Reserve rate cuts in late 2001, millions of homeowners refinanced and millions more found that low rates permitted them to enter the housing market for the first time. There was a huge expansion in the mortgage origination business but by 2004 the flow of new applications began to subside. Mortgage originators needed to find new markets if they were to continue to collect the fees that kept them in business. The only real option was to expand the market by turning to the so-called subprime borrower—people whose financial history and current economic situation would have previously not permitted them to get a mortgage.
In an earlier period it might have been difficult for the mortgage originators to find lenders for this new universe of would-be homeowners. That is where Wall Street stepped in and how the SIV market was created. While it is generally understood that the mortgage originators had no incentive to insure the creditworthiness of the new borrowers, it is less well understood that at least some of the Wall Street firms that packaged the subprime loans and sold them to unwitting investors were in much the same position.
Allan Sloan, a Senior Editor at Fortune Magazine, dissected a purchase, packaging, and resale of a single group of subprime mortgages in a recent article published in Fortune. In the spring of 2006, Goldman, Sachs & Co. put together a package of “some 8,274 second-mortgage loans originated by Fremont Investment & Loan, Long Beach Mortgage Co., and assorted other players.” It was only one of 916 residential mortgage-backed issues sold that year and represented a little less than one percent of the total value of such securities sold in 2006. It was, however, clearly one of the worst.
The average equity held by the “homeowners” in this mortgage package was less than one percent. About 58 percent of the loans were no-documentation or low-documentation. No one knows whether these borrowers actually occupied the residences they were using as collateral, whether they were employed or whether they had any of the assets they told the loan originators they possessed.
Goldman Sachs purchased these mortgages and packaged them into something called Goldman Sachs Alternative Mortgage Product (GSAMP) Trust 2006-S3. They then divided the $496 million in mortgages into 13 separate securities; three containing the “best quality” but lowest yield loans; seven containing the intermediate loans and the three containing the lowest quality but highest yielding loans. They then sold at least 12 and perhaps all of the 13 securities, which Sloan refers to as “financial toxic waste.”
The default rate on these loans has been so high that all three of the lowest quality securities are totally worthless, four of the seven mid-level securities are worthless and one other is deteriorating rapidly. The ratings on the top-level securities have been reduced from AAA to BBB and as a result their value has declined markedly. To date, the losses to Goldman Sachs customers are probably in excess of $300 million.
But the real bombshell in Sloan’s story was not the shockingly poor quality of the products that were sold or the massive losses that were absorbed by hapless buyers. The real surprise is that Goldman Sachs not only absorbed none of the losses but in fact profited handsomely from the demise of the securities that they were telling clients to invest in. How? Because another part of Goldman Sachs was heavily shorting these securities in their own portfolio at the same time they were recommending them for the portfolios of other institutions.
A recent article by Kate Kelly in the Wall Street Journal dug deeper into the Goldman’s maneuver:
“The group’s big bet that securities backed by risky home loans would fall in value generated nearly $4 billion of profits during the year ended Nov. 30, according to people familiar with the firm’s finances. Those gains erased $1.5 billion to $2 billion of mortgage-related losses elsewhere in the firm. On Tuesday, despite a terrible November and some of the worst market conditions in decades, analysts expect Goldman to report record net annual income of more than $11 billion.”
Wall Street icon Henry Kaufman, who spent 26 years with Solomon Brothers where he served as the managing director and the last 20 years where he has been president of Henry Kaufman & Company, warned in the Wall Street Journal in October that the subprime is only part of a far larger problem in the way our credit markets function.
“Giant financial conglomerates contribute to the opaqueness in our financial markets. Their activities span across many sectors—from consumers to business, from trading to investing, from securities underwriting to lending and proprietary trading, from insurance underwriting to real-estate brokerage, from managing billions of dollars of other people’s money to consulting and advising. Their global presence has been growing briskly, with some now garnering more than half their profits from foreign operations. Their size, scope, and embeddedness in financial markets are impossible to decipher from their published balance sheets. Because their reach is so vast and deep, these financial behemoths are deemed too big to fail.”
Kaufman argues that the Federal Reserve and U.S. Treasury Department have failed to keep pace “with a series of fundamental structural changes that have transformed markets in recent decades” He further states, “Today’s regulatory system is largely a historical artifact left over from the era when financial markets and institutions were much more fragmented and insulated from one another.”
Kaufman urges the creation of a Financial Oversight Authority within the Federal Reserve to monitor and supervise the activities of the largest financial conglomerates. According to Kaufman, the 15 biggest U.S.-based financial conglomerates have combined assets in excess of $13 trillion. He warns that failure to take such steps will mean that “the shocks and reverberations from the subprime mortgage crisis will be a mere prelude to greater injury to our credit system.”
The course urged by Kaufman could not be more different than the one being pursued by Treasury Secretary Henry Paulson. In fashioning the Bush administration response to the subprime crisis, Paulson emphasized that his approach was entirely crafted by the private sector. Or as Alan Abelson observed in Barrons, Paulson “must have worn gloves during the negotiations since the president crowed that it was strictly a private-sector construct, unsullied by the government’s ugly fingerprints.”
So it is clear that another year will go by with little or no supervision of the major players in a stunningly complex yet poorly regulated global financial system. Whether the credit markets will muddle through or seize up and throw the global economy into a tailspin is something no one can predict. But in the meantime, we can expect senior Bush administration officials to sit on their hands, claiming that these large financial institutions know best and that more direct government supervision would be counterproductive.
After all, the enormous talent and public good will of these institutions is something our Treasury secretary should be very familiar with. He was, after all, the CEO of Goldman Sachs when the decision was made to market GSAMP Trust 2006-S3 to his firm’s institutional clients while also overseeing the Goldman traders who were simultaneously betting that these same kinds of financial products would decline sharply in value.
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