October 23, 2008
Alan Greenspan was wrong today when he said that investors did not look critically enough at the ratings. Finance is based upon trust, and these companies had been trustworthy for many decades. Here is the real story.
The very notion of pooling is and was illegal. Allocation of payments, recording statutes, recording fees, non-disclosure of lender (interfering with QWR and Rescission), non-disclosure of fees (TILA), non-disclosure of profits, non-disclosure of insurance (AIG), non-disclosure of Credit default swaps, uncertainty of possession, control and ownership of note, changing terms of note severing security instrument etc.
Why would you need all these insurance, cross collateralization, overcollateralization, and reserves if the mortgages were good paper? Because they didn’t have good paper. They dressed it up in a ballet costume, put some lipstick on it, got some judge to say it was the winner of a beauty contest and everyone (purchasers of mortgages and purchasers of mortgage backed securities) bought in reliance on the misrepresentations, fraud, non–disclosure etc. when if they had the true facts nobody would have bought.
To cover up the obvious illegality of pooling notes where the payments were mandated to be applied to the note obligation, they inserted buy-back arrangements that everyone understood would never be used and could not be used. It could not be used because the buy-back was between the mortgage aggregator, who no longer had possession, control or ownership of the note, and the lender who had already been paid. When it came to foreclosure and collection, whoever got the money either kept it or gave it someone else who kept it and used the same theory we are using — we’ll just keep this until we know who to pay.
Thus either the pretender lender or the mortgage aggregator or the investment banker KEPT the proceeds of the foreclosure without paying the only parties that MIGHT have had a claim to status of holder in due course. In plain words, they got paid twice over and perhaps more. The terms of the SPV provided for markdown of assets for an excess of non-performing assets. After the markdown, the investor was NOT entitled to any more of the actual proceeds than the markdown which was strictly within the sole discretion of the investment banker or the mortgage aggregator.
Add to this the fact that the economics of the finance market was turned on its head. REAL loans with REAL borrowers and REAL terms that were likely to remain in the status of performing loans had the least value in this securitization scheme.
For example: borrower has 800 FICO, $1 million in the bank, and an income of $5 million per year confirmed by income tax returns, the fact that he is the CEO of a public company where his income is disclosed, and through bank references in the usual manner of the usual loan. The loan is for $1,000,000, fixed rate at 6%. Title insurance, and property insurance included at closing and there is an escrow for taxes and insurance in the monthly payment. The interest income is $60,000 per year for 30 years. An investor might be willing to pay something close to $1 million for the $1 million loan. The lender makes sure it has one reliable honest appraisal which comes in at $1,200,000, and the due diligence review committee at the bank confirms the value of the house. Under normal circumstances, the parties in between would be getting a commission at the rate of some basis points on the deal, which is the way it always worked until the great mortgage meltdown of 2001-2008.
Now let’s look at what really happened. The borrower is a NINJA — no income, no job, no assets. First payment is $450, without any escrow for taxes or insurance, with the balance of the interest added to the principal as negative amortization. Title insurance, taxes and property insurance are in place for the first month. The loan is an option ARM, with resets eventually taking the loan up to an interest rate of 16.5% (this is a real case). Thus the interest income on the loan is stated as $165,000 despite the fact that the actual payments are at an annual rate of $5400, with no insurance payment and no guarantee the taxes will be paid. An investor knowing these facts would probably not be inclined to buy this loan at all.
It is obvious that somewhere in the first reset or second reset of payment the loan will become non-performing. Any person with a passing familiarity with mortgage loans would know that. If the investor was a risk-taker he would buy the loan at a deep discount, probably a few cents on the dollar. But if the investor did not know that this was a 16.5% NINJA loan and instead was presented with a purchase share in a pool of loans where the stated income was 6%, he would still pay full value.
Boiling the actual effect of this down to real dollars and cents, here is what happened inside the pool, unknown to the investor: they sold the 16.5% loan but they were only offering 6%. By doing that, they were able to sell the $100,000 loan to three groups of investors at full value pocketing nearly $300,000. This is only possible where the loan is “toxic waste” and the interest rate is therefore sky high. By hiding the loan in the pool, it looks to the investor as though he is buying the first loan in our example, but in fact he is buying worthless securities that are priced 100 times over market. This extra money made it possible to pay intermediaries 4-5 times their normal compensation and to press property appraisers into delivering appraisals that spiraled upward at the direction of the investment banker.
At the other end, the same thing was happening to the purchaser of the loan package — i.e., the borrower. Misled into thinking that the appraisal was a fair estimate of market value and misled into believing that the “lender” had a plan to refinance the loan every year or two, he came to reasonably believe that the finance people knew more than he did and took a loan that he would never have taken had he known the true facts. So you have two purchasers — a the borrower and the investor who would never have made the deal but for the outright criminal fraud of the intermediaries who cooked up the scheme to illegally issue unregulated securities.