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 globalised 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 paycheques 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 USD $6.8 billion.
And then it continued, when New Century Financial, the second biggest subprime lender in America (carrying USD $23 billion in debt), came crashing down. The stock fell from USD $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 USD $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 USD $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 NODs [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 29/01/07 for USD $204,000.”
How much did Wells Fargo lose on this transaction? 20 percent? 15 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 realise 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 collateralised 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 all go bad 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.”
Markets and Money