Loans From Hell
Bill Bonner
The
Daily Reckoning
Mar 17, 2007
The Daily Reckoning PRESENTS: Like a comically misplaced banana
peel, the subprime mortgage industry has slipped up more than
a few big names in the housing industry. But as Bill Bonner explains,
when the collateral on these loans rests on white lies, lenders
are left slipping and sliding... with nothing to grab hold of.
Read on...
"Credit issues are there
but they are contained."
-Hank Paulson, March 6, 2007
You can take the temper of
an era by looking to see what its brightest minds take up. Pythagoras
applied himself to geometry. Alexander Fleming discovered penicillin.
Wernher von Braun built rockets to blow up London.
But if St. Augustine were alive
today, he'd probably be touting the benefits of globalized markets.
Isaac Newton would be running a hedge fund in London. And Henri
Poincare would be working for Goldman Sachs, calculating the
return on a tranche of BBB-rate subprime debt.
Scientists and philosophers
alike have turned their focus to the greatest challenge and opportunity
of our time: Relieving other people of their money. We are voyeurs...
gawkers at the merry and absurd world of money. And now comes
the part that makes this sorry métier of ours worthwhile.
This week, traders at the big
financial houses in the City and Wall Street were marking down
their own paper. Merrill equity analysts, for example, cut their
recommendations on Goldman, Lehman and Bear Stearns shares (as
well as those of European banks Deutsche Bank and Credit Suisse
Group) from 'buy' to 'neutral.'
As for the bonds of the three
biggest securities firms - they are judged by bond traders (many
of whose paychecks come from these same big securities firms)
at prices more suitable to junk bonds than to the masters of
the universe. On Tuesday, Goldman astonished analysts with higher
earnings than any had seen coming; still, investors sold off
the stock.
The banana peel on which these
august figures skidded was subprime mortgage lending. Looking
closer, we see that the inside surface was slick with a special
kind of mortgage, known institutionally as a 'low documentation'
loan... and known colloquially as a 'liar's loan.'
As to their ability to pay
(and perhaps even as to their name and address) lenders took
the borrowers at their word. With no solid incomes to boast about,
nor any real assets to wave as collateral before the lenders'
turned up noses, the poor borrowers had to fib a little. Yes,
they had been employed as a bank president for more than a dozen
years. Yes, they owned an oil refinery in central London and
were mentioned, briefly, in Howard Hughes' will. No, they called
no man a creditor... and yes, they were only borrowing money
to buy a house because they didn't want to take any of their
own capital out of the high-performance hedge funds in which
it was earning 50% per year.
Any simpleton could see that
'liars' loans' would be a disaster for someone. But it took a
near meltdown in the mortgage market to bring the point home
to the geniuses in the financial industry.
The entertainment began on
February 7, when HSBC announced that it had fired its head of
North American operations, after its bad debt - much of it from
subprime 'piggyback' loans - rose to $6.8 billion.
And then it continued, when
New Century Financial, the second biggest subprime lender in
America (carrying $23 billion in debt), came crashing down. The
stock fell from $66 to near zero... giving up 43% in just three
days in February, and most of the rest when the NYSE halted trading
last week.
"The banks also appear
to have been caught unawares by the scope of New Century's problems,"
says an article in the New York Times. " For instance, a
week after the company said it would have to restate its financial
statements for the first nine months of last year, Goldman Sachs
extended to May 14 a credit line to New Century that was set
to expire on Feb. 15."
And what of the nation's numero
uno in the subprime market? According to the press reports, in
2006, Wells Fargo & Co. leaped ahead of Ameriquest Mortgage
Co., and New Century Financial Corp. to become the biggest funder
of subprime mortgages. And as of December, when other lenders
were already in retreat, Wells Fargo was still charging ahead,
increasing its lending to the least creditworthy buyers.
Subprime lending is like selling
used cars in bad neighborhoods; it is not for those with delicated
scruples or refined manners. Wells Fargo has been accused of
'predatory lending' - and that maybe so. But subprime lenders
now look more like fools than knaves.
On one of the many websites
that seems to have been set up for Wells Fargo customers to kvetch,
we find this interesting thread:
Poster #1: "Check out
this beauty at 2909 Allenhurst St. This property was purchased
on September 30, 2005 for $264,000. However, due to the inability
of the borrower to make payments, Wells Fargo foreclosed on these
folks on January 29, 2007. Now the property is listed for sale
for $225,000... "
Poster #2: "Multiply this
outcome by the thousands and you can get the picture of how this
speculative mania will end... Right now there are 100-150 NOD's
[notice of default] filed a week in Kern County; I predict that
in a year we will have 200-250 NOD's per week in Kern County.
Credit is tightening, inventory is increasing and foreclosures
are rising... the pain is only beginning."
Poster #3: "The house
is worth 125K at the most. Probably one of those late seventies
shacks off Ashe."
Poster #4: "The house
was just sold on 1/29/07 $204,000."
How much did Wells Fargo lose
on this transaction? Twenty percent? Fifteen percent? How many
of these banana peels could there be?
Even the smartest lenders -
the world's leading financial institutions, including Britain's
number one bank - were providing money to the subprime salesmen,
all of them presumably aware that their collateral rested on
white lies.
And so now they are all slipping
and sliding... grabbing for something to hold onto.
Until only a few months ago,
the constant welling up of house prices gave them some traction.
When a sad-sack subprime buyer gave up and defaulted, the lenders,
and the lenders to the lenders, and the lenders to the lenders
to the lenders, could still tread confidently, secure in the
knowledge that they could sell the shacks and get their money
back - and more.
What they didn't seem to realize
was what seemed most obvious - that house prices wouldn't go
up forever. Indeed, some day they might even go down. And when
they went down, lenders would have neither a strong borrower
to make payments, nor decent collateral to sell, nor even a buyer
with any money to sell it to.
What bothered New Century Financial
was that the people they lent money to could not pay them back.
What now bothers Goldman, Merrill and the rest of the smarty-pants
businesses is no different. Their credits are going bad. All
the way up the financial food chain, they applied the same 'low
documentation' standards to the mortgage-backed securities business
that the New Century applied to the mortgage itself.
Now, for readers who may be
as unfamiliar with mortgage backed securities (MBSs) and collateralized
debt obligations (CDOs) as we are, we supply the following elucidation
of these two life-enhancing inventions: Imagine the entire mortgage
market as a giant pig and the financial industry as a rendering
plant. After the best lenders have taken the AAA++ hams and ribs,
there remain many body parts you might show to your daughter
only if you wanted to see her make a face and hear her say 'eeewwww.'
In the mortgage industry, as in the slaughterhouses, those cuts
do not get the 'prime' label. In lending, they are known as 'subprime.'
The low-priced stuff is too
disgusting for most people to put directly on the table, so the
unidentified scraps are typically run through the grinder. Then,
they are packaged into old-fashioned, pure pork mortgage-backed
sausages. Even at this level, the investors never met the borrowers
(and often not even the lenders) and were never privy to the
particular lies that coaxed the animal into the abattoir in the
first place. Nevertheless, the markets are familiar with these
things; they know more or less what is in them... and have some
slim idea of what they are worth.
But then the St. Augustines,
the Newtons, and the Poincares of our time go to work. The tranches
of meat are repackaged according to the latest scientific formulas
- mixing the parts together ever so carefully so that they don't
go bad all at once. Then, they are resold as CDOs, either of
the regular or synthetic variety. The whole is better than the
sum of its parts, they claim.
For mysterious reasons, the
rating agencies have agreed. And the buyers, with neither the
time nor the competence to double-check the assumptions or carefully
inspect the sausages - tend to go along too. And thus it is that
the crème de la crème of the financial industry
finds itself in the same position as the subprime lenders themselves
- taking the liars at their word.
The big difference is that
the original liars - who bought the subprime houses with money
they didn't have - could leave as they came in. The CDO investors,
on the other hand, had something to lose. They paid real money
for the subprime debt. When they leave, they leave poorer than
they came in.
But the way to make money in
a gold rush, say the old-timers, is not to dig in the ground
for it yourself, but rather to sell the miners picks and shovels.
In the mad rush for profits of the 21st century, Goldman, Merrill,
HSBC and the rest of them did a lot of both.
The trouble now is, the pick
and shovel business may be turning down. No matter how many shovels
Goldman may have sold in the boom, it is sure to sell fewer in
the bust.
As for its own mining claims,
a number of them seem to be going to the devil. Goldman's own
Global Alpha fund, the hedge fund where its own insider scientists
dig for gold, lost 6% last year when the S&P actually was
up over 15% and the average hedge fund was up 13%.
And now, the subprime mine
seems played out. "What has been a credit concern seems
to be morphing into a liquidity crunch for all parties involved,"
wrote Morgan Stanley in its daily bulletin on subprime. Who are
the parties? Morgan Stanley spelled it out: "HEL [home-equity
loan] borrower, HEL originator - and finally - HEL trader/investors."
Regards,
Bill Bonner
The Daily Reckoning
P.S. In the upcoming Survival
Report, we give a full expose of Goldman Sachs and its role in
the current subprime housing fiasco. In addition to two other
outstanding reports, this third report is included free as a
special bonus for charter members who sign up now. For details,
click here:
The Survival Report
http://www.isecureonline.com/Reports/SUR/ESURH300
Regards,
Bill Bonner
email: DR@dailyreckoning.com
website: The
Daily Reckoning
Bill Bonner
is the founder and editor of The Daily Reckoning.
Bill's book,
Mobs,
Messiahs and Markets: Surviving the Public Spectacle in Finance and
Politics, is a must-read.
He is also the
author, with Addison Wiggin, of The Wall Street Journal best seller
Financial
Reckoning Day:
Surviving the Soft Depression of the 21st Century (John Wiley
& Sons).
In Bonner and
Wiggin's follow-up book, Empire
of Debt:
The Rise of an Epic Financial Crisis, they wield their sardonic
brand of humor to expose the nation for what it really is - an
empire built on delusions.
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