After the Music Stopped – Part III

The following is an excellent excerpt from the book “rAFTER THE MUSIC STOPPED: The Financial Crisis, the Response, and the Work Ahead” by Alan S. Blinder from Chapter 3 “The House of Cards” on page 71 and I quote: “There were other, even more exotic forms of subprime mortgages, like “option ARMs” and “negative amortization mortgages.” With no option ARM, the borrower has a choice each month. He can make the contractual payment, which includes some amortization; he can pay only the interest, leaving the mortgage balance intact; or he can even pay less than the interest due, adding the unpaid amount to his principal and thus sinking deeper into debt. Presenting options like those to sophisticated people of means, who may be inclined to take calculated gambles on real estate, is fine. But they never should have been offered to unsophisticated—sometimes barely literate—borrowers who could ill afford to take a loan. It was disgraceful that they were.
The lesson here for financial regulators is one they should not have needed to learn, though they apparently did. Making loans that are “designed to default” to financially unsophisticated borrowers who likely do not know what they are getting themselves into violates every principle of sound banking.–not to mention of human decency. It should have been banned, period. Yet a serious look at the data shows that mortgages designed to default could not have been a major cause of the crisis. Mortgages that clearly were not designed to default failed almost as often.
Fannie Mae and Freddie Mac, the two government-sponsored enterprises (GSEs), came relatively late to the bad-mortgage party. But once they arrived, their huge size added some kick to the punch bowl.
The GSEs were given a congressional mandate to support low-and moderate-income housing in 1992, and they started gradually dipping their toes, then their feet, then their knees into these waters in the 1991s. But it was intense competition from private-sector securitizers after, say, 2003 that really drove the GSEs to lower their underwriting standards. That was about when subprime and Alt-A mortgages started exploding, and the market shares of Fannie and Freddie began to erode. There is some debate over whether Fannie and Freddie went more heavily into subprime as a deliberate business strategy, having drunk the Kool-Aid like everyone else, or were pushed into doing so by Congress and the White House. Whatever the reason, they acquired—and guaranteed—far too much junky paper.
It is nonetheless notable that the two GSEs’ overall balance sheets shrank slightly over the 2003-2007 period—just the time when the balance sheets of private banks and investment banks were roughly doubling in size—and that their market shares in the mortgage business fell dramatically. GSE purchases of subprime MBS actually peaked in 2004, and they were concentrated in the safest tranches. Right up to the present time, GSE mortgages have far lower default rates than non-GSE mortgages. Facts like these make it hard to see how anyone can cast Fannie and Freddie in leading roles in the run-up to the crisis, and the FCIC’s majority agreed with this assessment. Others do not, however.
VILLAIN 5: COMPLEXITY RUN AMOK – Why were so many bad loans made in the first place? The answer is that everyone downstream thought they had something to gain. That brings us straight to the securitizers, whom we have mentioned before. Here, in vastly oversimplified form, is how securitization of mortgages worked.
Suppose Risky Bank Corporation (RBC) has made one thousand subprime mortgage loans averaging $200,000 each—all, let us say, in the Las Vegas area. RBC’s highly concentrated portfolio of $200 million in mortgage loans, is, to say the least, risky. Many of these loans are probably “designed to default,” and the creditworthiness of many of the borrowers is somewhat dubious. Should an economic downturn or natural disaster hit the Las Vegas market, many of these homeowners would likely stop paying, perhaps taking RBC down with them. So the bank would like to find a buyer for these loans while they are still good.
Enter Friendly Investment Bank (FIB), a securitizer from Wall Street. FIB offers RBC an attractive deal: “Sell us your $200 million in subprime mortgages. We will pay you cash immediately, which you can lend out to other borrowers. We’ll than combine your mortgages with others from around the country, and package them all into well-diversified mortgage-backed securities. The MBS will be less risky than the underlying mortgages because of geographical diversification. Then we will spread the risk around by selling pieces of the security to investors all over the world.” FIB is not proposing an act of altruism, of course. It stands to earn handsome fees for its services.
On the surface, this little bit of financial engineering seems to make good sense. RBS is relieved of a substantial risk that could threaten its very existence. If all goes according to plan, FIB’s securitization of all those mortgages really should reduce risk in the two ways claimed. While real estate prices in Las Vegas may fall, it is highly unlikely that real estate prices would drop simultaneously in Los Angeles, Chicago, Orlando, and so on. (What happens if they do? Don’t ask.) And with the risks parceled out to hundreds of investors all over the world, no single bank is left holding the bag. Or at least that was the theory. Unfortunately, it turned out not to work so well in practice.
There is more to the story. Many mortgage-related assets were far more complex than suggested so far. The earliest MBS were simple mortgage pools, sort of like mutual funds of mortgages. If an investment bank pooled, say, two thousand mortgages with an average interest rate of 7 percent and an average principal value of $200,000, it created a security with a par value of $400 million, which paid 7 percent interest, minus whatever small losses came from defaults. If some investor bought $1 million worth of this security, she purchases an asset whose risk characteristics were inherited directly and straightforwardly from the underlying mortgages—mainly from interest-rate fluctuations, prepayment, and defaults. For example, if the loan-loss experience on the whole pool averaged 0.5 percent, she would receive not $70,000 in interest (7 percent of $1 million). But only $65,000, reflecting her pro rata share of the losses. Investing in mortgages this way is far less risky than trying to pick individual mortgages. Good idea. If only the complexity had stopped there.
It didn’t. In the years leading up to the boom, Wall Street invented and marketed a dizzying array of pieces of mortgage risk—sometimes with other types of loans thrown in as well. Some of these securities were so complex that few investors understood what they really owned. Let me start with one such complexity, called tranching.
Instead of selling straightforward shares in the mortgage pool, as mutual funds do, FIB could “tranche” the pool—that is, slice it up. The most junior tranche, which came to be called the “toxic waste,” would absorb, say, the first 8 percent of losses in the pool ($32 million)–no matter which mortgages defaulted. The middle, or “mezzanine,” tranche might absorb the next 2 percent ($8 million), leaving owners of the top-rated, or “senior,” tranche vulnerable only to losses above 10 percent ($40 million)–an event that seemed so unlikely as to be nearly impossible. Call the resulting three-tranche bundle of securities a CDO (collateralized debt obligation). This example is unrealistically simple, by the way. Typical CDOs had seven or right tranches; some had more.
Now, think about what happens to the various tranches of the CDO as losses on mortgages rise from negligible to monumental. As long as loan losses remain below 8 percent, only the owners of the toxic waste take any hit. Owners of the two higher tranches continue to receive full payment. That’s the outcome almost everyone expected, because losses on mortgages used to be quite low. An 8 percent loss rate was literally off the charts. But if losses rise above 8 percent, the mezzanine tranche starts to absorb every additional dollar of loss. And since these mezzanine tranches were often quite thin, such an event would chew through them quickly. Only once losses top 10 percent of the pool do owners of the senior tranche lose even a penny—suggesting a kind of immunity from loss. As long as the good times rolled, the junior tranche would sell at a discount for expected losses while the other two tranches sold at par—much like highly rated corporate bonds. Not incidentally, the rating agencies blessed the senior tranches with coveted—and formerly rare—AAA ratings.
Now, imagine a real mortgage meltdown, and remember that the underlying pools are stuffed with crummy mortgages designed to default. A more and more mortgages start to become imperiled, the perceived risks in the junior tranches rise like mad, driving down their prices. As panic sets in, investors start worrying that even the mezzanine tranches may have to absorb losses, maybe large ones. So their market values drop precipitously, too. In a worst-case scenario—which, of course, is what we had—even the senior tranches lose their immunity from losses and start falling in value. Thus, the market values of all MBS tranches fall—never mind those lofty AAA ratings—though by very different amounts.
And this was the easy stuff to figure out. In the cases of the most complex and opaque securities, nobody really knew what they contained or what they were worth—which is a surefire cause for panic once doubts creep in. Let me take the example a step further.
One day, some ingenious Wall Street rocket scientist looked at all the junior tranches, with their pitiably low credit ratings, and said to himself, “Eureka! [More likely it was an expletive.] I can turn lead into gold!” To make his idea concrete, imagine that there were five CDOs just like the one in our previous example. In each case, say, the junior tranche comprised 20 percent of the total and thus had a par value of $80 million. If you packaged all five of these junior tranches into a brand-new CDO—with a face value of $400 million—you could tranche that one, too. What does that rigmarole accomplish? Get ready; here comes the alchemy.
The lowest tranche of the resulting CDO of CDOs (which Wall Street cutely dubbed a “CDO2”) would absorb, say, the first 8 percent of losses that accumulate across all five underlying mortgage pools. If you viewed each of the pools as posing independent risk—a huge mistake that was nevertheless made—there was not much default risk left in the other four tranches. [Footnote: Think about flipping a fair coin three times, with tails representing default. Your probability of getting three tails is 1:8. Unlikely, but certainly possible. But the probability of getting six tails in a row is 1:64, and that the probability of getting nine in a row is 1:512—that is, almost impossible. Because these flips are independent, the probability of an all-tails “coincidence” drops precipitously as the number of flips rise. But if you just double or triple your bet on the same three flips, the risk does not fall. The betting odds remain 1:8.]
They were protected by the lowest-rated tranche. Voila! Our financial engineer has managed to turn $320 million worth of toxic-waste tranches—80 percent of the new CDO—into putatively safe assets. In a rhetorical triumph of hope over reason, the top-rated tranches of such CDO2 were even named “super senior,” indicating that they were so safe you could sell them to your grandmother.
By now you may be getting dizzy, but there is one more step. So far, we have pools of complex mortgages, many of them designed to default and much too concentrated demographically and geographically. Then they are sliced and diced into complicated CDOs, mind-boggling CDO2s, and other concoctions. That’s bad enough. Now, let’s write complex derivatives on these already shaky securities, as Wall Street did with reckless abandon. For example, you could buy or sell a CDS on the CDO. That security promised to pay off if the CDO failed. And if that wasn’t complicated enough, Wall Street offered other ways to place bets on either the success or failure of the subprime mortgage market. It was a remarkable casino, with no agents of the state gaming commission present.
Yes, far too much risk was taken. But my main point here is somewhat different—it’s about complexity and understanding. Each link in the daisy chain—and there are others I have not mentioned—added complexity. And that, in turn, created opacity—or maybe utter confusion.
The mortgage originators knew something about their local markets and creditworthiness of their borrowers—except in such cases as liar loans. The investment banks that did the securitizing knew less, but what did they care? They were going to pool thousands of mortgages together and see the MBS quickly. The Wall Street financial engineers who created the CDOs and CDO2s were performing mathematical exercises with complex securities; they had no clue about—and little interest in—what was inside. And the ultimate investors, ranging from sophisticated portfolio managers to treasurers of small towns in Norway, were essentially clueless. About all they knew were that some illustrious Wall Street names stood behind securities—way behind, as it turned out—and that Standard& Poor’s or Moody’s had blessed them with the coveted AAA rating; safe enough for Grandma. If ignorance is bliss, there was a lot of bliss going around before the crash.
In October 2008, the Deal magazine published the flowing “wiring diagram” of how the whole system of mortgage finance looked in 2006. It was not satirical, though it looks it. Don’t feel bad if you can’t quite figure the whole thing out. Nobody else could, either. Complexity had run amok.
You many now be asking yourself a question: Why create such a complex system? Didn’t anyone remember the KISS principle? (Keep it simple, stupid.) The answer is, in fact, simple, and not at all stupid: Complexity and opacity are potential sources of huge profit.
The more complex and customized the security, the harder it is to comparison shop for the best price. And without comparison shopping, there is little effective competition. Compare buying a customized OTC derivative on a complicated CDO2 with buying a call option on Google stock. The broker-dealer warns a king’s ransom on the former, where there is hardly any competition, and a nickel on the latter, where competition is fierce. That, of course, is why Wall Street is still fighting so hard against standardizing derivatives and trading them on organized exchanges. Standardization would spell the end of free markets, they claim. Yeah, sure, just as regulating derivatives would have done in 2000.
And opacity? That’s what enables the sharpies to take advantage of the suckers. When Goldman Sachs’ infamous trader, the “Fabulous” (by his own assessment) Fabrice Tourre, helped legendary hedge fund operator John Paulson bet against especially poor subprime mortgages by designing made-to-order synthetic CDO, whom do you think he envisioned as the buyers?” [Footnote: Goldman Sachs settled the case in July 2010, admitting to “mistakes” but not to fraud, and paying a record fine of $550 million. Tourre was put on paid leave from Goldman, and in August 2012 the Justice Department decided not to file criminal charges.] One of Tourre’s own answers was : Belgian widows and orphans. Nice, huh? In a widely quoted e-mail, he bragged to his girlfriend that he was the “only potential survivor, the fabulous Fab. . . standing in the middle of all these complex, highly levered, exotic trades he created without necessarily understanding all the implications of those monstrosities.” That’s opacity for you. By the way, he added that he was “not feeling too guilty about this.”
Not every trader was like Tourre, and all this might have been comical had it not ended so tragically. Here’s the basic problem: Those who make and dominate the markets–”Wall Streeters,” for short—love complexity and opacity as long as the party continues. It helps them make their millions—or billions. But once the music stops, their great but fair-weather friends, complexity and opacity, can become their worst enemies. As prices fall, investors start realizing that they don’t really understand what they own, or what is being offered to them—not to mention “what those damn things are worth.” [Footnote: This was Ben Bernanke’s memorable answer when he was asked, at the Economic Club of New York in October 2007, what he would like to know that he didn’t know. It was a long time before anyone knew.]”

“Some observers argue that large global forces were the major culprits of the crisis. Blinder disagrees, arguing that the problem started in the United States and spread abroad, as complex, opaque, and overrated investment products were exported to a hungry world, which was nearly poisoned by them. The second part of the story explains how American and international government intervention kept us from a total meltdown. Many of the U.S. government’s actions, particularly the Fed’s, were previously unimaginable. And to an amazing—and certainly misunderstood—extent, they worked. The worse did not happen.
Blinder offers clear-eyed answers to the questions still before us, even if some of the choices ahead are as divisive as they are unavoidable. After the Music Stopped is an essential history that we cannot afford to forget because history teaches that it could happen again.”


LaVern Isely, Progressive, Independent Overtaxed Middle Class Taxpayer and Public Citizen and AARP Members


About tim074

I'm a retired dairy farmer that was a member of the National Farmer's Organization (NFO). Before going farming, I spent 4 years in the United States Air Force where I saved up enough money to get my down payment to go farming. I also enjoy writing and reading biographies and I write about myself as well as articles and excerpts I find interesting. I'm specifically interested in finances, particularly in the banking industry because if it wasn't for help from my local Community Bank, I never could have started farming which I was successful at. So, I'm real interested in the Small Business Administration and I know they are the ones creating jobs. I have been a member of Common Cause and am now a member of Public Citizen as well as AARP. I have, in the past, written over 150 articles on the Obama Blog ( and I'd like to tie these two sites together. I'm also on Twitter, MySpace and Facebook and find these outlets terrifically interesting particularly what many of these people did concerning the uprising in the Arab world. I believe this is a smaller world than we think it is and my goal is to try to bring people together to live in peace because management needs labor like labor needs management. Up to now, that hasn't been so easy to find.
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