Revisiting the MBS Debate (Which We Should Already Be Past)

Recently, Felix Salmon, Clusterstock, and others have been mentioning an essay from the Hoover Institute about the financial crisis. Now, I haven’t yet linked to the essay in question… I will, but only after I’ve said something about it.

I was on the front lines of the securitization boom. I saw everything that happened and am intimately familiar with one particular bank's--and more generally familiar with many banks’--approach to these businesses. I think that there are no words that adequately describe how utterly stupid it is that there is still a “debate” going on surrounding banks and their roles in the financial crisis.

There are no unknowns. People have been blogging, writing, and talking about what happened ad naseum. It’s part of the public record. Whomever the author of this essay is (I’m sure I’ll be berated for not knowing, in much the same way I was for not knowing Santelli — a complete idiot who has no place in a public conversation whose requisites are either truth or the least amount of intellectual heft), unless the essay was written on excesses of theoretical reasoning about a parallel universe, it’s a sure sign the author doesn't know what they are talking about given some of the points in the essay. Let’s start taking it apart so we can all get on with our day.

For instance, it isn’t true that Wall Street made these mortgage securities just to dump them on the proverbial greater fool, or that the disaster was wrought by Wall Street firms irresponsibly selling investment products they knew or should have known were destined to blow up. On the contrary, Merrill Lynch retained a great portion of the subprime mortgage securities for its own portfolio (it ended up selling some to a hedge fund for 22 cents on the dollar). Citigroup retained vast holdings in its so-called structured investment vehicles. Holdings of these securities, in funds in which their own employees personally participated, brought down Bear Stearns and Lehman Brothers. AIG, once one of the world’s most admired corporations, made perhaps the biggest bet of all, writing insurance contracts against the potential default of these products.

So Wall Street can hardly be accused of failing to eat its own dog food. It did not peddle to others an investment product that it was unwilling to consume in vast quantities itself.

(Emphasis mine.)

Initial premise fail. I had a hard time finding the part to emphasize since it’s all so utterly and completely wrong. Since I saw everything firsthand, let me be unequivocal about my remarks: the entire point of the securitization business was to sell risk. I challenge anyone to find an employee of a bank who says otherwise. This claim, that “it isn’t true that Wall Street made these mortgage securities just to dump them on the proverbial greater fool” is proven totally false. There’s a reason the biggest losers in this past downturn were the biggest winners in the “league tables” for years running. As a matter of fact, there’s a reason that league tables, and not some other measure, were a yardstick for success in the first place! League tables track transaction volume–do I really need to point out that one doesn’t judge themselves by transaction volume when their goal isn’t to merely sell/transact?

In fact, the magnitude of writedowns by the very firms mentioned (Merrill (BAC) and Citi (C)) relative to the original value of these investments imply that a vast, vast majority of the holdings were or were derived from the more shoddily underwritten mortgages underwritten in late 2006, 2007, and early 2008. In fact, looking at ABX trading levels, as of yesterday’s closing, shows the relative quality of these mortgages and makes my point. AAA’s from 2007 (series 1 and 2) trading for 25-26 cents on the dollar and AAA’s from early 2006 trading at roughly 67 cents on the dollar. The relative levels are what’s important. Why would Merrill be selling its product for 22 cents on the dollar if the market level is so much higher (obviously the sale occurred a few months ago, but the “zip code” is still the same)? This is a great piece of evidence that banks are merely left holding the crap they couldn’t sell when the music stopped.

Now, onto the next stop on the “How wrong can you get it?” tour.

It isn’t true, either, that Wall Street manufactured these securities as a purblind bet that home prices would only go up. The securitizations had been explicitly designed with the prospect of large numbers of defaults in mind — hence the engineering of subordinate tranches designed to protect the senior tranches from those defaults that occurred.

Completely incorrect. Several people who were very senior in these businesses told me that the worst case scenario we would ever see was, perhaps, home prices being flat for a few years. I never, not once, saw anyone run any scenarios with home price depreciation. Now, this being subprime, it was always assumed that individuals refinancing during the lowest interest rate period would start to default when both (a) rates were higher and (b) their interest rates reset. [Aside: Take note that this implicitly shows that people running these businesses knew that people were taking out loans they couldn't afford.] Note that the creation of subordinate tranches, which were cut to exactly match certain ratings categories, was to (1) fuel the CDO market with product (obviously CDO’s were driven by the underlying’s ratings and were model based), (2) allow AAA buyers, including Fannie and Freddie, an excuse to buy bonds (safety!), and (3) maximize the economics of the execution/sale/securitization. If there were any reasons for tranches to be created, it had absolutely nothing to do with home prices or defaults.

Further, I would claim that there wasn’t even this level of detail applied to any analysis. We’ve seen the levels of model error that are introduced when one tries to be scientific about predictions. As I was told many times, “If we did business based on what the models tell us we’d do no business.” Being a quant, this always made me nervous. In retrospect, I’m glad my instincts were so attuned to reality.

As a matter of fact, most of the effort wasn’t on figuring out how to make money if things go bad or protect against downside risks, but rather most time and energy was spent reverse engineering other firms' assumptions. Senior people would always say to me, “Look, we have to do trades to make money. We buy product and sell it off–there’s a market for securities and we buy loans based on those levels–at market levels.” These statements alone show how singularly minded these executives (I hate that term for senior people) and businesses were. The litmus test for doing risky deals wasn’t ever “Would we own these?” it was “Can we sell all the risk?”

But wait, there’s more…

Nor is it plausible that all concerned were simply mesmerized by, or cynically exploitive of, the willingness of rating agencies to stamp Triple-A on these securities. Wall Street firms knew what the underlying dog food consisted of, regardless of what rating was stamped on it. As noted, they willingly bet their firm’s money on it, and their own personal money on it, in addition to selling it to outsiders.

One needs the “willingly bet [their own] money on it” part to be true to make this argument. I know exactly what people would say, “We provide a service. We aggregate loans, create bonds, get those bonds rated, and sell them at the levels the market dictates. It isn’t our place to decide if our customers are making a good or bad investment decision.” I know it’s redundant with a lot of the points above, but that’s life–the underlying principles show up everywhere. And, honestly, it’s the perfect defense for, “How did you ever think this made sense?”

And, the last annoying bit I read and take issue with…

Nor is it true that Wall Street executives and CEOs had insufficient “skin in the game,” so that “perverse” compensation incentives created the mess. That story also does not pan out. Individuals, it’s true, were paid sizeable bonuses in the years in which the securities were created and sold.

[...]

Richard Fuld, of failed Lehman Brothers, saw his net worth reduced by at least a hundred million dollars. James Cayne of Bear Stearns was reported to have lost nearly a billion dollars in a matter of a few months. AIG’s Hank Greenberg, who remained a giant shareholder despite being removed from the firm he built by New York Attorney General Eliot Spitzer in 2005, lost perhaps $2 billion. Thousands of lower-downs at these firms, those who worked in the mortgage securities departments and those who didn’t, also saw much wealth devastated by the subprime debacle and its aftermath.

Wow. Dick Fuld, who got $500 million, had his net worth reduced by $100 million? That’s your defense? And, to be honest, if you can’t gin up this discussion, then what can you gin up? The very nature of this debate is that all of these figures are unverifiable. James Cayne was reported to have lost nearly a billion dollars? Thanks, but what’s your evidence? The nature of rich people is that they hide their wealth, they diversify, and they skirt rules. So, sales of stock get fancy names like prepaid variable forwards. Show me their bank statements–even silly arguments need a tad of evidence, right?

Honestly, at this point I stopped reading. No point in going any further. So, now that you know how little regard for that which is already known and on the record this piece of fiction is, I’ll link to it…

Here ya go.

Felix does a great job of taking this piece down too (links above)… Although, he’s a bit less combative in his tone.

Comments

[robert.b.fe...:]

John: Greetings. Good article about a poor essay. Now that the courts have turned all bonds into junk bonds by allowing team Obama to abrogate our bankruptcy and contract law there is no safe haven. Not even dirt cheap RE.

Jun 10 09:29 AM

[ain't no fo...:]

Good article "John". I suppose with regard to Hoover, it might be suggested that if you're not part of the solution, you're part of the problem. Wonder how much WS funding went into Hoover's coffers during the glory years so that when the debt came due they could act as the pathetic, rationalizing apologist they are now being paid to be?

Jun 10 09:46 AM

[Larrysyr:]

Thanks for the inside view in this article.

I still wonder how any of these securities could earn a AAA rating. Your insight about structuring to meet the agencies' models sheds a little bit of light, but I think the whole mess brings every single rating ever issued by Moodys, S&P, and Fitch into question. Perhaps they should refund all the fees they've ever been paid.

Jun 10 11:03 AM

[CloroxCowboy:]

Your analysis is spot-on. I was also involved in this industry, trading loan pools for a sub-prime lender from '05 to '07 and I remember many of the same comments. Our "executives" knew plain and simple that the paper we sold was crap. To be a sales or underwriting manager at that company meant that you spent 90% of your day pressing the manual override button on loans that were kicked from our automated system. There was always some justification to push a loan through.

One of the most interesting meetings I remember was when I saw that our latest operating costs were hovering around 2%. This was mid-2007 and by that time our net revenue from sales to the secondary market was about 1.75%... You might be able to guess the company motto? "Outrun it with volume!" All we had to do was keep selling more loans each month than the month before, and we could make the dream last forever. Luckily, I found a new job soon thereafter.

But as you say, none of this is new. People still defending these business practices are probably also Holocaust deniers and would buy every stock Jim Cramer mutters about in his sleep.

Jun 10 12:21 PM

[Furrybeasty:]

Excellent critique of a piece of Wall Street fluff. I too saw the securitization dynamics running exactly the way it is described - run the model & structure purely to maximize the size of the senior credit tranches (which you can sell to lazy & irresponsible insitutional investors who only wanted a few bps over the rating's index level ), because the junior tranches & "equity" (rapidly named toxic waste, even back in 2002 when all was just starting) were virtually impossible to unload. So those sat on-books and limited the CBO desks' ability to create more product until they discovered ingenious ways to move out that residue. I am aware of 2, namely : 1) create CDO Squareds, whose base securities were the junior tranches themselves, but which magically allowed the banks to transform 80%-90% of their pool of that garbage into senior-rated securities and clear the way for more issuance of CDOs (I was staggered the other day to find out someone had even gotten CDO Cubeds out the door); and 2) start/sponsor your own hedge funds to invest in these various tranches, thereby unloading the junk onto the HF LPs, who of course got very excited about the huge initial returns they saw and bumped up their investments (remember what was the first crack in the ice? - Bear Stearns' in-house "Fixed Income " hedge funds).

Jun 10 12:23 PM

[Joseph L. S...:]

And thus has it always been. Lest some young person wanting to believe in the basic goodness of Wall Street be led astray, I should note that back in **1986** when I was head of Fixed Income Investments for Charles Schwab & Co., some "investment bankers" from Bear Stearns came around to try to get my team to offer Collateralized Mortgage Obligations (CMOs) to our clients.

Their entire “presentation” consisted of how much money Schwab brokers could make selling this stuff. They didn’t even bother to understand before seeking the appointment that none of Schwab’s employees were on commission.

It took us nearly an hour to get them to comprehend that our brokers were there to assist the customer even if that meant not selling something to them -- and none were on commission.

After at least a dozen variations of, “But look how much dough your //firm// can make pushing these…” they yielded to my demand that the describe the actual product itself.

They couldn’t do it! They left, giving us a six hour videotape, which they said would clarify all the points they weren't sure about. After all, they reminded us, they were on the Marketing side and a product this sophisticated (read: confusing) was best explained by Product Development. The people marketing this junk didn’t have a clue how it worked. (It was basically a precursor of securitized SMBs.)

1986. 2009. And the beat goes on. If Wall Street never learns, it is because they depend on us to never learn….

Jun 10 01:52 PM

[Crocodilian:]

There's a lot of interesting argument here. Let's take the "initial premise fail" -- the question of whether the large MBS positions at ML etc, indicate that they were "eating their own dog food".

My impression is that author is correct in discounting that assertion. My interpretation of the large MBS inventories carried by the firms was that it was seen as part of the "MBS manufacturing process"-- that is, you buy up mortgages, slice them into tranches and mark them up, and sell them on, and get paid your bonuses.

My guess is that the banks got stuck with "slower-moving" inventory as the price of putting these deals together. That is, they didn't carry the inventory because they _wanted_ it, they carried it because these were the parts that they were having a hard time selling.

Jun 10 09:24 PM

[CloroxCowboy:]

On Jun 10 09:24 PM Crocodilian wrote:

> My guess is that the banks got stuck with "slower-moving" inventory
> as the price of putting these deals together. That is, they didn't
> carry the inventory because they _wanted_ it, they carried it because
> these were the parts that they were having a hard time selling.

Your guess is correct.

Jun 11 03:38 PM

[Andrew Butter:]

Nice article, broadly I agree with your sentiments, I was involved doing MBS and everyone I was involved with were very serious and very straight.

I think you have a few things not quite right though:

1: I'm pretty sure the stuff ML sold was CDO.

2: Most of the stuff that got left behind with the banks was lower than AAA which gets hit first, the reason for that was they couldn't easily sell that, the demand was for AAA and better.

3: The essential flaw that I saw then and which I believe was critical is that no one not the bankers (why should they) nor the rating agencies, really understood real estate or how to value it . When you value real estate seriously you do it three ways (a) sales comparison (price today) (b) depreciated replacement cost (that has today's land cost in so it's a hybrid) (c) income capitalization (you can do that for owner-occupied housing if you know how to do valuations), then you stand back, if all three don't give the more or less the same answer, you know you have a problem.

The problem I saw was that the people putting the deals together got paid for success on the deals, and they didn't ask the right questions, there was only one box..."what's the value today" - if there had been a box "what will the value be in three years time", then things would have been different.

The people who knew how to work that out reliably were not asked that question.

Jun 12 04:24 AM