By Michael Olenick & Abigail Field
The Financial Meltdown and its aftermath have spawned a still evolving mythology, a modern financial counterpart to what Greece and Rome created. Zeus, the central character, is played by the claim that dishonest borrowers preyed on unsuspecting banks to cause the meltdown. One version of the myth is laid out in a 2009 version of a widely used Business 101 textbook:
“The capitalist system relies heavily on honesty, integrity, and high ethical standards. Failure of those fundamentals can weaken the whole system. The faltering economy of 2008 – 2009 was due in large part to such failure. Some mortgage lenders, for instance, failed to do the research necessary to ensure their borrowers creditworthiness. Many subprime borrowers forfeited their loans. The ripple effects of these unpaid debts not only cost many people their homes but also reduced the value of the housing across the country and made it difficult even for business borrowers to get new loans. Part of the blame for this economic disaster can be placed on the borrowers who didn’t tell the truth about their income or who otherwise deceived the lenders.“
“It is easy to see the damage caused by the poor moral and ethical behavior of some businesspeople. What is not so obvious is the damage caused by the moral and ethical lapses of the everyday consumer — that is, you and me.”
– Understanding Business, Nickels, McHugh, McHugh, 9th edition, McGraw-Hill Irwin, 2009, pgs. 14-15. (emphasis added)
“Some mortgage lenders” failed to verify borrowers’ creditworthiness? How about “By the peak of the bubble, lender-initiated fraud had grown so much that the biggest lenders, including Countrywide, WaMu, and others had set up elaborate document-faking processes to invent income for borrowers, often without their knowledge.” Another sentence that could be added would run something like: “Wall Street firms knowingly sold investors loans of much worse quality than promised, as detailed in various discovery-backed lawsuits, such as those by the FHFA (Fannie and Freddie’s overseer.)
Worse, an entire central character is entirely omitted, as if Zeus sprang full-formed sans parents: “That massive securities fraud would not have been possible, however, without the complicity of the Ratings Agencies, who evaluated junk-filled Mortgage Backed Securities (MBS) as safe as US Treasury debt, knowing that global investors relied upon their analysis.” If the textbook were really committed to “moral and ethical behavior”, it would disclose that its publisher, McGraw-Hill, owns Standard & Poor’s (S&P), one of the big three ratings agencies. More fundamentally, if S&P were committed to moral and ethical behavior, a review of the loans in a typical MBS would show that S&P’s ratings made sense.
Before examining one, however, it’s important to understand why S&P’s ratings matter so much. And that means understanding the role of investors in our housing market.Investors provide the money that actually funds most mortgages. Mortgage companies, and many other consumer companies, make loans but are quickly paid back by investors, allowing the mortgage companies to fund more loans. Or at least that’s how it worked for decades; a direct consequence of the massive mortgage backed securities fraud is that almost no secondary mortgage market remains, the primary reason mortgage loans are so hard to come by now.
MBS loans are spread all over a very big country, and investors are spread over an even larger globe, so it’s crucial that ratings agencies like S&P accurately assess the security, the bundle of loans, for investors.
When S&P communicates to MBS investors, it’s talking to the true lenders to the homebuyers, lenders who openly relied upon S&P’s meaningful opportunity to look at the actual underwriting of the loans. Investors — pension funds, European villages, and other governments — relied on S&P because they trusted S&P. Paraphrasing S&P’s own standards, investors relied heavily on S&P’s honesty, integrity, and high ethical standards.
In hindsight, investors should have been as wary about S&P as borrowers should have been about their mortgage broker and property appraiser. Indeed, Goldman-Sachs CEO Lloyd Blankfein, referred to a “dilution of the coveted AAA [rating],” while speaking to the Council of Institutional Investors. In 2008 only 12 companies were rated AAA, Blankfein noted, but 64,000 structured finance products received the top rating.
Against the backdrop of S&P’s parent talking about moral and ethical behavior, however, that stat looks less like a reason to chide investors than a reason to question S&P’s character. But let’s do more than question S&P’s character. Let’s take a close look at one of those “AAA” rated MBS and see what S&P’s ratings of it reveal about S&P’s ethics and morals: Securitized Asset Backed Receivables LLC Trust 2006-NC1 (2006-NC1). Michael chose 2006-NC1 because it is typical of that year’s vintage, and downloaded the 3,757 mortgages into a spreadsheet for analysis.
An S&P AAA Subprime MBS By the Numbers
S&P thought the world of New Century Mortgage’s 2006-NC1, or at least that’s what it told investors. S&P rated 98.2% of the loan bundle, 3,691 loans, as investment grade debt. Specifically, 86% was rated AAA, 6.2% rated AA (the same credit rating S&P downgraded US Treasury debt to last summer), 4.7% received an A, and 1.4% earned an A- rating. Only 1.8% of the pool, 66 loans, were rated non-investment grade; the lowest rating was BBB-. Those must be some well-underwritten subprime loans, right?
After all, S&P had the opportunity to get the rating right: it was well-paid to carefully evaluate this bundle of loans. Indeed, since 2006-NC1 is a subprime MBS, S&P demanded and received a premium. So let’s look at 2006-NC1, and examine why S&P found it so strong.
We’ll start with some of the characteristics of this pool. 1,273 of the loans, 33.9%, are stated income, 42 are limited documentation, and 2,442 contained full documentation. Ok, take note: fully a third of the loans in this Safer-than-Treasuries security have no documentation, loans commonly referred to as “liars loans” back in 2006, when this security was being rated. Arguably, S&P by then read this 2005 FBI report saying 80% of mortgage fraud involved “industry insiders,” which made fraud in liars loans even more likely, because the gatekeepers were in on the fraud or organizing it. Despite the knowledge that a third of the loans had a high likelihood of being fraudulent, S&P rated 98.2% of these loans as investment grade.
Well, maybe S&P was getting its confidence from borrowers’ credit scores. So let’s take a look: 691 of these investment grade loans went to people who had FICO scores between 500-549, and another 693 to people with FICO scores between 550-599. That means that almost 40% of the loans have FICO scores considered bad credit.
Of the stated income loans, 96 went to people with FICO scores from 500-549, 166 with scores from 550-599, 399 with scores from 600-649, 408 to people with scores from 650 to 699, and the remaining 204 to borrowers with scores of 700 or higher. In short, about half the stated income borrowers had good but not great credit scores (between 650 to 749), while half had lower scores. Fully documented loans had a higher percentage of borrowers with low scores. While it makes sense that low credit scores generally required documentation for funding, it’s hard to see how this overall mix looks safer than Treasuries.
Maybe the fact these were all first liens raised S&P’s enthusiasm; maybe S&P thought that meant the buyers had equity, making them reliable. The problem with that theory, however, is that. 1,094 of the loans, 29.1%, reported “simultaneous seconds,” under a header ominously referred to as “Silent Second Flag.”
Borrowers didn’t invent these “80/20″ loans, banks did. Banks wrote two loans simultaneously, typically to avoid private mortgage insurance, which had the effect of transferring default risk from insurers to investors. Borrowers didn’t usually care, since non-deductible mortgage insurance payments became deductible second loans.
Moreover six percent of these first loans are for investment properties. Those loans are much riskier than purchase money loans for a primary residence.
Perhaps S&P reassured itself in the face of all those risk factors with the idea that these investors were in for the long haul. But that’s hard to see since 1,194 were balloon loans, a structure that only makes sense if you intend to sell or refinance.
Alright, maybe S&P was simply sure that when you take out a mortgage to buy a house, you’re intrinsically low risk, regardless of your documentation, credit score, second loan, investor status or long term commitment to the property. Maybe S&P thought, “hey, these people want to purchase a house, and they’ll take care of it and never put lenders at financial risk.” But even that kind of wishful thinking can’t explain the investment grade ratings. Fully 2,065 (56%) of the loans were cash-out refi’s — people using their homes as an equity piggy-bank — while another 384 were refinancing for interest rate purposes; only 1,308 (35%) were actually buying a property.
OK, no matter how we slice and dice the data, we can’t figure out how the borrower or loan financial characteristics justified the ratings. But surely there was a reason (besides the S&P’s fee, right? A moral and ethical reason?) Perhaps these homes were so geographically dispersed that S&P knew investors’ money would be as safe as US Treasuries, right? Let’s see, 908 of the loans, 24.2%, were in CA and 487, 13%, were in FL. That’s more than 1/3 concentrated in two states S&P should have known were in a pricing bubble; add in TX, AZ, NY, IL, PA, NJ, and NV and you get another 1/3. Ouch.
Investors in S&P’s AAA tranches are still waiting to see what will happen. The $360 million A1 tranche was paid out in December 2008 with no reported losses. Borrowers are still working their way through the A-2 tranche, though only $9.7 million remains as of the 12/27/2011. As we work to and through the A-3 tranche it will be interesting to see how well that S&P AAA rated — safer than US debt! — shelves hold up. Investors have already taken a $17.9 million hit on the AA-rated M-1 tranche, a $37.5 million loss on the A rated M-2 tranche, and a $10.5 million loss on the A- M-3 tranche. S&P’s BBB tranches look more like trenches; the entire $14.1 million has vaporized.
There are some interesting stats buried in investor reports besides financials. Some loans turned started to stink faster than if fish had been wrapped in the promissory notes. The trust closed in May, 2006; by the end of the year 226 loans were delinquent, ten borrowers were in bankruptcy, 143 foreclosures had been filed, and eight of the properties managed to reach REO status. By June, 2009 — three years after our trust closed — we find it with 1,844 loans remaining. Of those, 221 were delinquent, 50 of the borrowers in bankruptcy, there were 347 foreclosures, and 284 REO properties. That is, within three years half the loans were seriously screwed-up.
Things have improved slightly, in the sense that what remains is doing a little better. By Dec., 2011, there were 1,138 loans left; 126 were delinquent, 50 borrowers were in bankruptcy, there are 225 foreclosures, and 47 houses lingering as REO’s, so as liquidations have rolled along only 39% of the loans in this highly rated trust are in trouble. Shall we set up a betting pool on how many loans will survive to the end?
After understanding just how thoroughly S&P failed to demonstrate moral and ethical behavior in rating the typical deal above, and after thinking about how crucial those AAA ratings were to fueling the housing bubble that created our current mess, reread that quote from its parent company’s textbook focusing on this sentence in particular: “Part of the blame for this economic disaster can be placed on the borrowers who didn’t tell the truth about their income or who otherwise deceived the lenders.”
We suggest a more accurate revision would read “Virtually the entire blame for the economic disaster came from two sources. First, a price bubble fueled by excess capital, money that flowed into the system from investors relying upon incompetent, conflicted, and flawed rating bureaus, including S&P, a subdivision of the company publishing this textbook. Second, Wall Street needed highly-rated asset-backed loans, mortgages, because these loans served as collateral and allowed Wall Street to secure their own loans — generally called leverage — so they could gamble with somebody else’s money.” We predict that this revision is about as likely to make its way into a McGraw-Hill textbook as those loans were to perform at the level S&P rated them.
- WhaleMu – JP Morgan’s Next Surprise?
- Au revoir Allonhill: OCC Finally Pulls The Plug
- I’ve been posting way too little but…
- FRB: Blame “collective self-fulfilling mania” rather than Bad Banking
- Woody Guthrie: The Jolly Banker
- OCC Hack (er, head) John Walsh Is Gone
- Fannie & Freddie Signal Congress By Spending $600K at the MBA Convention
- State of the American Economy: RepoGames, by Spike TV
- Congratulations To My Close Friend Lynn Szymoniak, Toughest Anti-Fraud Attorney In the US
- Common Financial Crisis Myths, Part I
- PNC: “We Don’t Do Fraud” .. Except, Of Course, They Do
- Obama Administration Fights For Higher Rents
- Trouble For the Triple A’s
- Four Year Old Foreclosure .. Oops, Wrong Bank
- MBA & Florida Foreclosure Mill Lawyers: MBS Bond Investors Aren’t “Frustrated”