Was Subprime Lending Just as Dishonest as Madoff? 22 comments
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Bernie Madoff took dishonestly about $50 billion from investors through a Ponzi scheme. A 20 times greater amount, about a trillion dollars, has been taken from naïve investors (both bank and non bank) who invested in subprime loans in a way which is as dishonest as the Madoff Ponzi scheme, at least in a moral sense. The only big difference between the two scams is that the Madoff scam we can blame on Madoff, but Subprime is the fault of the system. While no one individual is responsible for the Subprime problem, the general greed for profits led all the bankers to deceive themselves and their investors. Government must be held responsible for not having fundamental regulation to protect its banks and investors from the stupidity of the banks that promoted subprime.
First, let's look at the claim it is dishonest, at least morally. Subprime is a specific type of transaction more generally called CMO's (Collateralized Mortgage Obligations) and CDS (Credit Default Swaps). Subprime depended basically on brokers who did not care whether the borrower could pay his loan because they got paid their commission at closing, on banks that also did not care much whether the borrower could pay since the loan was being sold off, on packagers of loans who cut and sliced the packages of loans so that some could be called AAA rated loans (generally called CMO's). They paid credit rating companies to put triple A ratings which could not possibly be justified with any analysis of the underlying package of loans. Finally, they paid credit insurance companies to give guarantees (Credit Default Swaps) that they would cover any default when the credit insurance companies did not have the financial ability to pay if called on to pay. To make it even better, everyone seems to have had the idea that real estate prices would always go up. Finally, we even had President Bush saying all this was good because we were increasing housing without looking at the inevitable results. This is brilliantly shown on a YouTube video called "The Subprime Primer."
Let's compare the Madoff Ponzi scheme to the Subprime lending to see similarities. The Madoff scheme depended on:
- Exceptional financial results, even though they were unbelievable given serious analysis.
- A public explanation of how these results were obtained, even though experts said it could never work.
- Keeping everyone happy by consistently paying out money to previous investors with new investors' money.
- Having a lot of highly respected people saying this was a great investment.
The subprime followed all four of these rules.
- Financial Results: There was never a history of the returns. Financial institutions and their sales representatives told everyone that this was an exceptional investment. They talked about a piece of paper that is "triple A rated "and "guaranteed by insurance through Credit Default Swaps." While Madoff peddled dishonest results, here banks peddled a dishonest idea without any results.
- Public Explanation of the process: Salesmen only explained these were triple AAA rated investments "structured so that they could not fail." Furthermore, there was an insurance guarantee just in case. When it all fell apart, we naturally got the obvious truth that the so called protection never existed in reality. When the problem was obvious, Merrill Lynch (MER) sold these triple A rated bonds with insurance guarantees for 22 cents on the dollar and most people said the real value for Merrill was only 5 cents on the dollar. Madoff's explanation was no phonier than the banks explanation of the value of Subprime triple A rated with CDS guarantees.
- What kept the fraud going? While Madoff had to pay out early investors, this fraud did not even depend on really paying investors off. The only ones who really collected on this were the bankers who earned bonuses or a percent of the profits (which can be 40% of the transactions' profits) when these subprime loan packages were sold. The finance community had never made so much money on an idea like this. Who was going to say that it would not work? Here is a clear case that the personal greed of the bankers led to their own demise and that of their investors. Probably anyone that wanted to cut back on the system was probably told to shut up. As a former banker, I know the pressures put on people. "X bank is making all that money. What is wrong with you?" If you try to say it is a bad idea, most people get run over by the system. Years ago, former Fed Chairman Greenspan said that he trusted the bankers to protect their own interests. He recently said in congress that he made a terrible mistake in this assumption. And in this simple mistaken assumption, we see a root cause of the problem.
- Professional Opinion: The personal interest of bankers led them to tell all their investors that this is a splendid investment. In this case, the professional bankers did a 20 times greater disservice to themselves and their customers than all of the Madoff salesmen.
In summary, the Subprime issue has been a greater cause of loss for reasons that are very similar to the Madoff Ponzi scheme. While we do not have just one person to blame, as in the case of Madoff, the results of Subprime Scheme were essentially the same as the Madoff Ponzi scheme and the losses were far greater to the public than the Madoff scheme. The $50 billion loss of Madoff pails in front of the $1 trillion loss on subprime and the amounts lost by banks, municipalities, states, schools and other non bank investors is far greater than the Madoff $50 billion. To see a sample of the pain inflicted on innocent investors, see the "Subprime tragedy."
Policy footnote: Four issues result from this sad trillion dollar loss on subprime loans.
- The problem of subprime is bad credit, not a lack of liquidity in the banks. We cannot hope to fix the problems until we deal with the real problem of poor credit. The original hope of TARP was to create more liquidity in banks. This idea died stillborn and no money was spent on this erroneous solution to the problem.
- Now half of the TARP money has been spent on equity investments in the banks, with the hope that the recipient banks will lend the money to needy borrowers. The banks were stupid once with subprime, but they are not going to repeat the problem by lending again in the same terms. As a result, the TARP money is sitting in banks, being used for the purchase of other banks or being used for employee bonuses. In short, $350 billion has been spent without a productive benefit for needy US borrowers. There has been one short term benefit which the pressure of the banks going broke has been reduced, but this is only a temporary benefit.
- US Treasury recognized that Fannie Mae (FNM) and Freddie Mac (FRE) were near bankruptcy. The government intervened, changed the president and strengthened the indirect guarantee of the US government. But then nothing changed in terms of credit policy. Now they have trillions of dollars of assets and liabilities, but no capital. This "new" problem will be exploding at any moment. If you have a credit problem, you need to fix it. You cannot say the old management is bad and then continue to do the same thing.
- A new version of the subprime problem is on the horizon for 2009. While interest rate resets are slowing for existing subprime loans, 2009 will bring major interest rate resets for conventional mortgages for both housing and commercial real estate. There will be a whole new wave of loan failures of very major importance.
The subprime problem is better explained as a type of fraud than the popular version of reasons like liquidity in banks. Until public policy recognizes the true problem, which is fundamentally bad credit, we cannot hope to find practical solutions to our problems. Even pretending subprime is the problem condemns us to not learn from the problem. Bad credit, explained away by people who envision inordinate profits from the sale of these instruments, puts at risk our ability to correct these fundamental problems.
Disclosure: no stock positions.
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This article has 22 comments:
FIrst of all, subprime lending began years ago...I met my first subprime lender in 1981...so any performance history should have been known...
Second, I saw no doc/stated income loans beginning in 1984...so these ALT loans are not new....and their performance history should be known....
Third...in 2006, my subprime clients had higher credit scores than did my conforming/GSE clients....and several of my Subprime lenders said that their average credit score was in the 650 range...
Fourth, all aspects of theeconomy require new customers and money regularly to function.....
The root of the housing problem is in the lack of consistency in credit guidelines...what ever the rules ... we need to keep them consistent...
Most of the ALT-A loans which are the primary source for projected 2009 problems are tied to a 1 month, 6 month or 1 year LIBOR index. With the indices below 3% the projected failures from resets should remain low. If the indices should rise dramatically this could change, however in the absence of a significant change in the index the most likely cause of failure will be that the applicant was not qualified for the loan in the first place.
In the ALT-A product area the average Margin was around 2.5% yielding an effective rate of roughly 5.250-5.500%. If the borrowers can't afford the loans at these rates the loans never should have been made in the first place and the Ponzi scheme continues... I suspect this is the case. I also think more will be caught in the full amortization of previously negative amortization loans, aka Option ARMS, than will be pushed to default by simple adjustments on conventional loans.
NO-DOC loans have also been around but it was not until the late 90's that these loans began to be offered at even a 90% loan to value and at that time the credit score requirement was 720+.
The problems began when purchase money subprime loans at high loan to value percentages started being made to applicants whose credit histories had always sucked. With NO-DOC loans towards the end a 620 credit score could get you a 100% mortgage on a home which was generally over valued by the appraisal process.
New Century Financial used to claim that the average credit score of their Sub-Prime borrower was 680. That was simply not true.
Mortgage underwriting is like evaluating the strength of a 3 legged stool. The 3 legs are credit, capacity and collateral. By 2006 lenders were expecting these stools to simply levitate and hold themselves up because they were underwriting to stated income with credit scores as low as 600-620 with appraisals that were questionable at best. Failure was inevitable.
On Dec 26 08:52 AM John Preston wrote:
> Not so brilliant....the general economy....investment advisors....educationa...
> counselors....all of these...and more... require THE FOUR RULES ABOVE....
>
>
> FIrst of all, subprime lending began years ago...I met my first subprime
> lender in 1981...so any performance history should have been known...
>
>
> Second, I saw no doc/stated income loans beginning in 1984...so these
> ALT loans are not new....and their performance history should be
> known....
>
> Third...in 2006, my subprime clients had higher credit scores than
> did my conforming/GSE clients....and several of my Subprime lenders
> said that their average credit score was in the 650 range...
>
> Fourth, all aspects of theeconomy require new customers and money
> regularly to function.....
>
> The root of the housing problem is in the lack of consistency in
> credit guidelines...what ever the rules ... we need to keep them
> consistent...
Mortgage processors and closing agents FALSIFIED doc's on combo loans of 20% high interest "down payment" money with 80% low interest mortgages to avoid the added cost of PMI.
In that respect, the actions of the greedy who falsified doc's to close loans that required but did not have PMI were just as fraudulent as Madoff.
Madoff will be prosecuted. So far, not one Attorney General - Federal or State - has prosecuted a single person responsible for the fraud to avoid PMI. One might ask WHY ??
For those that read this as a case of moral hazard on the part of the mortgage companies that knew they were going to sell the loan anyway, I would agree. But that moral hazard should have been offset by some notion of risk on the part of the investment banks and hedge funds that bathed in mortgage backed debt. They were so smart they thought they had outwitted the system with credit default swaps covering their butts. But it was all just pride before the fall.
> jack
Since the meltdown began, has any bank official been charged under SO?
Was SO another Congressional scam on the public?
All 50 state attorneys general tried to attack this problem but were aggressively blocked by the Bush administration.
www.washingtonpost.com...
In the old days the issuing bank would keep the loan. Since they were on the hook they were careful about making the loan in the first place.
Further down the line investors bought things they did not know were risky. Once might invest in a bank or institution which had purchased some instruments marked AAA. You didn't or couldn't look inside and see the real risk you were buying into. I bank at Wells Fargo and it is only luck on my part that they did not purchase any of these instruments. How did they know to stay away?
The cusp is where the first repackaging and sale took place. Here is where the packagers knew they had bad debt and thought they had a way to launder it. Were they being clever or was this fraud? The original purchasers had the opportunity to honestly evaluate what they were buying. These are supposed to be the smart guys. Did they not know what they were buying? Perhaps they thought they could pass it all off to someone else even though they knew it was bad in which case we have fraud again.
On Dec 26 12:05 PM BerkeleyBob wrote:
> I don't understand the poster's final comment that 2009 will be bad
> because conventional mortgages will reset and interest rates reset
> will cause large scale loan failures. Isn't a conventional mortgage
> fixed? Isn't a conventional mortgage not an Alt-A, not a no Doc?
> If interest rates remain low and stable, maybe some re-financing
> activity but a re-finance is not feasible with less than a .5% interest
> reduction and is expensive in terms of taxes, fees, etc.
He described this mortgage as being created for sales people who had high, but fluctuating incomes. Those products obvisouly didn't cause a problem when they were marketed to the person they were intended for. It was only when those products began being marketed as a way to get yourself in too a bigger house than you could normally afford that they became a problem.
Ditto to a previous poster on the 80/20 loan, ridiculous how these things were allowed to pass muster by the main mortgage bank.