Dennis
08-25-2007, 12:40 PM
Interesting article in the light of recent events:
Liars’ loans- BBC News
• Robert Peston
• 20 Aug 07, 08:00 AM
The underlying cause of the current global financial crisis is a system in which there’s little personal responsibility for lending decisions.
Here’s how it all works (or, as we now see, how it doesn’t work).
In the US, some half a million mortgage brokers have been incentivised to “sell” mortgages to potential homebuyers.
They don’t work for the providers of the loans. They are paid commissions for the volume of mortgages they arrange. So, of course, they try to arrange as many mortgages as they can, not minding the consequences.
If the customer wants to borrow more than he or she can really afford, then that’s no problem, thanks to a wonderful innovation called “stated income, stated assets” loans.
These allow US homebuyers to give a personal undertaking that their income is a certain level, even if they don’t provide any proof.
Such loans have been taken out by hundreds of thousands of US citizens who are pay-as-you-earn tax-payers and could therefore have easily provided proof of earnings, had they wanted to do so.
Surprise, surprise: studies have shown “discrepancies” between what such borrowers say they earn and what they actually earn, in 95 per cent of these loans.
These mortgages are now colloquially known as “liars’ loans”.
But liars’ loans are just the extreme manifestation of a US system for generating home loans which is predicated on turning a blind eye to economic reality.
When a borrower has difficulty making repayments on a loan, a mortgage broker would typically encourage them to pay off that loan by taking out a new one for an even greater amount! These are the infamous “rolling loans” which “gather no losses”.
When a loan is rolled over, no one need know that defaults loom – at least not for a while.
Wall Street’s sausage machine
What happens to all these hundreds of billions of dollars in home loans?
Well the paperwork and administration is usually done by specialist home loans companies, such as New Century Financial (which went into bankruptcy protection in the spring).
Then the debt itself goes into a giant mincing and mixing machine on Wall Street operated by the biggest US investment banks, led by Goldman Sachs, Morgan Stanley, Merrill Lynch and the like.
They take all this debt and they process it into asset-backed securities, or bonds.
Note that Goldman, Morgan et al have NO CONNECTION with the borrowers and NO IDEA whether an individual borrower is a good risk or a bad risk.
But they have historic data on default rates.
And this data allows them – or so they claim – to assess whether a bond is a good risk or a poor risk, and therefore to price it for consumption by international investors.
What’s more, verification of the riskiness of a bond is provided, for a fee, by the specialist credit-rating agencies, led by Moody’s and Standard & Poor’s (let’s for now ignore the obvious conflict-of-interest that as the market for these bonds expands, the rating agencies make bigger profits).
There’s a conspicuous problem here. An important part of the US home loans market, the sub-prime mortgages provided to those with poor credit histories, is a young market which has grown like topsy.
Or to put it another way, data gathered from past performance of loans in a small market may not be much of a guide to the future performance of a trillion dollar plus market.
But that hasn’t stopped the big investment banks citing this questionable data to convert sub-prime loans into bonds that they claim are risk-free and which have a so-called triple-A credit rating.
Here’s how they do the clever engineering.
For argument's sake, let’s say that they estimate that as many as one in two home loans will default and that on average there will be a 40 per cent loss on those defaulting loans. That, in turn, gives a maximum risk of 20 per cent losses on a portfolio of these loans.
Bad news? Not for creative investment bankers. Out of this portfolio of low-quality loans, they can create supposedly high quality bonds by putting in place covenants which stipulate that the first 20 per cent of losses would be attributed to one bunch of really poisonous bonds, usually called toxic waste, leaving the rest of the bonds almost as safe as US Treasury bonds (in theory).
Before we move on, it’s probably worth recapping the phony assumptions made by the investment banks as they create these bonds:
1) That historic data on default rates is useful even though the market has exploded in size
2) That data of any sort is useful even though the system for originating the loans, with mortgage brokers paid by the volume of loans they make, actually encourages fraud.
So far, so disturbing. But it gets worse.
Because the demand for toxic waste isn’t as huge as all that (some purchasers of this poison have suffered horrendous losses), investment banks have looked for ways to slice and dice the toxic waste, to create something almost edible.
They’ve mixed it up with other securities in collateralized debt obligations, which are bonds created out of other bonds – or sometimes they are bonds created out of bonds, that are in turn created out of other bonds (collateralized debt obligations squared, as if you wanted to know).
Even these bonds made of bonds rely to a worrying extent on all that dodgy historic data to determine their risk of default – the credit risk – or the risk that they’ll be vulnerable to interest-rate changes.
But notice too that once the original sub-prime loan is in a collateralized debt obligation, that loan could be one of perhaps a million different loans all mashed together to form this new bond.
What that means is that the eventual purchaser of the collateralized debt obligation has no more idea what’s in that bond than a sap eating a Turkey Twizzler knows what he or she is eating. Little wonder that when there’s a global scare about what may actually be in these bonds, no one wants to touch them.
That said, the investment banker will argue, on the basis of portfolio theory, if you put one load of toxic waste with another seemingly independent load of toxic waste, then the risk of holding them will fall. But for that to be true, each bunch of toxic waste would have to be uncorrelated to the other bunch – and that ain’t necessarily so.
Here’s the bottom line: for the past few years, Wall Street has operated a giant machine for turning mind-boggling amounts of US home loans – which are hugely vulnerable to losses from fraud and the inescapable cycles in interest rates and housing prices – into supposedly risk-free investments for risk-averse investors in Asia, the Middle East and (as it turns out) for Europe’s big banks.
Now if I worked for Goldman Sachs, Morgan Stanley, Merrill Lynch or the other big US investment banks, I might be considering my career options at the moment. It is inconceivable that they will escape unscathed from this debacle. Whatever the financial cost to these banks, which will not be trivial, there will also be significant damage to their reputations.
Liars’ loans- BBC News
• Robert Peston
• 20 Aug 07, 08:00 AM
The underlying cause of the current global financial crisis is a system in which there’s little personal responsibility for lending decisions.
Here’s how it all works (or, as we now see, how it doesn’t work).
In the US, some half a million mortgage brokers have been incentivised to “sell” mortgages to potential homebuyers.
They don’t work for the providers of the loans. They are paid commissions for the volume of mortgages they arrange. So, of course, they try to arrange as many mortgages as they can, not minding the consequences.
If the customer wants to borrow more than he or she can really afford, then that’s no problem, thanks to a wonderful innovation called “stated income, stated assets” loans.
These allow US homebuyers to give a personal undertaking that their income is a certain level, even if they don’t provide any proof.
Such loans have been taken out by hundreds of thousands of US citizens who are pay-as-you-earn tax-payers and could therefore have easily provided proof of earnings, had they wanted to do so.
Surprise, surprise: studies have shown “discrepancies” between what such borrowers say they earn and what they actually earn, in 95 per cent of these loans.
These mortgages are now colloquially known as “liars’ loans”.
But liars’ loans are just the extreme manifestation of a US system for generating home loans which is predicated on turning a blind eye to economic reality.
When a borrower has difficulty making repayments on a loan, a mortgage broker would typically encourage them to pay off that loan by taking out a new one for an even greater amount! These are the infamous “rolling loans” which “gather no losses”.
When a loan is rolled over, no one need know that defaults loom – at least not for a while.
Wall Street’s sausage machine
What happens to all these hundreds of billions of dollars in home loans?
Well the paperwork and administration is usually done by specialist home loans companies, such as New Century Financial (which went into bankruptcy protection in the spring).
Then the debt itself goes into a giant mincing and mixing machine on Wall Street operated by the biggest US investment banks, led by Goldman Sachs, Morgan Stanley, Merrill Lynch and the like.
They take all this debt and they process it into asset-backed securities, or bonds.
Note that Goldman, Morgan et al have NO CONNECTION with the borrowers and NO IDEA whether an individual borrower is a good risk or a bad risk.
But they have historic data on default rates.
And this data allows them – or so they claim – to assess whether a bond is a good risk or a poor risk, and therefore to price it for consumption by international investors.
What’s more, verification of the riskiness of a bond is provided, for a fee, by the specialist credit-rating agencies, led by Moody’s and Standard & Poor’s (let’s for now ignore the obvious conflict-of-interest that as the market for these bonds expands, the rating agencies make bigger profits).
There’s a conspicuous problem here. An important part of the US home loans market, the sub-prime mortgages provided to those with poor credit histories, is a young market which has grown like topsy.
Or to put it another way, data gathered from past performance of loans in a small market may not be much of a guide to the future performance of a trillion dollar plus market.
But that hasn’t stopped the big investment banks citing this questionable data to convert sub-prime loans into bonds that they claim are risk-free and which have a so-called triple-A credit rating.
Here’s how they do the clever engineering.
For argument's sake, let’s say that they estimate that as many as one in two home loans will default and that on average there will be a 40 per cent loss on those defaulting loans. That, in turn, gives a maximum risk of 20 per cent losses on a portfolio of these loans.
Bad news? Not for creative investment bankers. Out of this portfolio of low-quality loans, they can create supposedly high quality bonds by putting in place covenants which stipulate that the first 20 per cent of losses would be attributed to one bunch of really poisonous bonds, usually called toxic waste, leaving the rest of the bonds almost as safe as US Treasury bonds (in theory).
Before we move on, it’s probably worth recapping the phony assumptions made by the investment banks as they create these bonds:
1) That historic data on default rates is useful even though the market has exploded in size
2) That data of any sort is useful even though the system for originating the loans, with mortgage brokers paid by the volume of loans they make, actually encourages fraud.
So far, so disturbing. But it gets worse.
Because the demand for toxic waste isn’t as huge as all that (some purchasers of this poison have suffered horrendous losses), investment banks have looked for ways to slice and dice the toxic waste, to create something almost edible.
They’ve mixed it up with other securities in collateralized debt obligations, which are bonds created out of other bonds – or sometimes they are bonds created out of bonds, that are in turn created out of other bonds (collateralized debt obligations squared, as if you wanted to know).
Even these bonds made of bonds rely to a worrying extent on all that dodgy historic data to determine their risk of default – the credit risk – or the risk that they’ll be vulnerable to interest-rate changes.
But notice too that once the original sub-prime loan is in a collateralized debt obligation, that loan could be one of perhaps a million different loans all mashed together to form this new bond.
What that means is that the eventual purchaser of the collateralized debt obligation has no more idea what’s in that bond than a sap eating a Turkey Twizzler knows what he or she is eating. Little wonder that when there’s a global scare about what may actually be in these bonds, no one wants to touch them.
That said, the investment banker will argue, on the basis of portfolio theory, if you put one load of toxic waste with another seemingly independent load of toxic waste, then the risk of holding them will fall. But for that to be true, each bunch of toxic waste would have to be uncorrelated to the other bunch – and that ain’t necessarily so.
Here’s the bottom line: for the past few years, Wall Street has operated a giant machine for turning mind-boggling amounts of US home loans – which are hugely vulnerable to losses from fraud and the inescapable cycles in interest rates and housing prices – into supposedly risk-free investments for risk-averse investors in Asia, the Middle East and (as it turns out) for Europe’s big banks.
Now if I worked for Goldman Sachs, Morgan Stanley, Merrill Lynch or the other big US investment banks, I might be considering my career options at the moment. It is inconceivable that they will escape unscathed from this debacle. Whatever the financial cost to these banks, which will not be trivial, there will also be significant damage to their reputations.