Mortgage Backed CDOs - The Wall Street Piece

[fly]

So we've heard about all the cogs generally in the sub-prime crisis. The Fed, the banks, the realtors, etc. This is an interesting article about how exactly the whole mortgage backed CDO scam worked, written by a somewhat accidental insider.

Thought some of you might find it interesting.

http://www.portfolio.com/news-marke...8/11/11/The-End-of-Wall-Streets-Boom?tid=true​

 

[Jonny_B]

it wasn't a scam. a scam is something devised with the intent to defraud others.

edit: i should say they aren't a scam, and CDO's are still being built every day.

the problem turned out to be misleading data and a bad assumption based on that data.

 

[fly]

it wasn't a scam. a scam is something devised with the intent to defraud others.

Did you read it????

 

[zengirl]

My mortgage guy just called me. I guess he's with another company now and wants me to refinance my loan with him. I had some issues negatively repping my credit score which are now cleaned up so he's offering me a 1% lower rate, which reduces my payments $150 a month for $900 closing cost.

My spidey senses are tingling but it's still a FHA loan so I dunno?

 

[Jonny_B]

Did you read it????

not yet, but i've already consumed vast amounts of information regarding the most recent wallstreet collapse. a good place to start is the "Giant Pool of Money" podcast by This American Life in conjunction with Planet Money.

 

[fly]

My mortgage guy just called me. I guess he's with another company now and wants me to refinance my loan with him. I had some issues negatively repping my credit score which are now cleaned up so he's offering me a 1% lower rate, which reduces my payments $150 a month for $900 closing cost.

My spidey senses are tingling but it's still a FHA loan so I dunno?

Do it! As long as it doesn't change your PMI and/or add prepayment penalties...

not yet, but i've already consumed vast amounts of information regarding the most recent wallstreet collapse. a good place to start is the "Giant Pool of Money" podcast by This American Life in conjunction with Planet Money.

Well, according to this article it WAS a scam, mostly perpetuated by the ratings companies and the fuckheads reselling BBB tranches as AAA. This guy was making money on the whole thing by shorting them and accidentally helping to create the market.

edit: And I refuse to use podcasts. <3

 

[Jonny_B]

Do it! As long as it doesn't change your PMI and/or add prepayment penalties...


Well, according to this article it WAS a scam, mostly perpetuated by the ratings companies and the fuckheads reselling BBB tranches as AAA. This guy was making money on the whole thing by shorting them and accidentally helping to create the market.

edit: And I refuse to use podcasts. <3

they weren't rating incorrectly on purpose, they though that mortgage default rates would remain the same as they've been for decades. that means that only the lower tranches should have been affected (those with less than AAA ratings) and the people buying those knew the risk when they did so.

what surprised everyone was when mortgage default rates began to skyrocket, and when home values started to shrink. no one took into account that creating a massive demand for loans to turn into MBS's and CDO's would lower the quality of the loans and result in higher default rates.

everyone just got it wrong. it's shocking looking back, because it seems so obvious now, but as someone who had MBS's and CDO's explained to them about two years ago by my brother in law, I can tell you that it didn't seem obvious until it all broke down. It seemed weird, don't get me wrong, but the math worked.

 

[Jonny_B]

you can listen to the episode here: http://www.thislife.org/radio_episode.aspx?episode=355

click the second orange button to listen to it without downloading.

the second one is here: http://www.thislife.org/Radio_Episode.aspx?sched=1263

 

[eileenbunny]

It just took me nearly 3 hours to read that article and understand what they were talking about. I must have been bored. I wish I had bothered to read something like that sooner. I feel sick now.

And Johnny, according to the article (which I believed) they were rating incorrectly on purpose.

 

[Jonny_B]

“They were just assuming home prices would keep going up,” Eisman says.

there's one of the bad assumptions

All that was required for the BBB bonds to go to zero was for the default rate on the underlying loans to reach 14 percent. Eisman thought that, in certain sections of the country, it would go far, far higher.

there's a hint of the other bad assumption, which was that mortgage default rates would remain the same. there was a disconnect between the people creating the financial instruments and those originating the loans.

 

[Jonny_B]

‘I truly believe that our rating will prove accurate.’

from the article also.

 

[Jonny_B]

To evaluate the situation, he urged his audience to “just throw your model in the garbage can. The models are all backward-looking."

the models were wrong. in order for malicious intent to have been present the models would have had to be right, and then ignored by the people running them intentionally.

 

[fly]

there's one of the bad assumptions


there's a hint of the other bad assumption, which was that mortgage default rates would remain the same. there was a disconnect between the people creating the financial instruments and those originating the loans.

Was there?

But he couldn’t figure out exactly how the rating agencies justified turning BBB loans into AAA-rated bonds. “I didn’t understand how they were turning all this garbage into gold,” he says. He brought some of the bond people from Goldman Sachs, Lehman Brothers, and UBS over for a visit. “We always asked the same question,” says Eisman. “Where are the rating agencies in all of this? And I’d always get the same reaction. It was a smirk.”

from the article also.

Saying it and believing it are two different things. You really are going to try and sell me that EVERYONE was on the up and up about this whole thing????????????

the models were wrong. in order for malicious intent to have been present the models would have had to be right, and then ignored by the people running them intentionally.

But the models were obviously built to show the data they wanted. You couldn't even PLUG IN NEGATIVE NUMBERS!!!

 

[Jonny_B]

and in the end we live in a capitalist country. these are the outcomes that are to be expected. it was the realization of this that prompted Alan Greenspan to comment recently that he "made a mistake in presuming that the self-interests of organizations, specifically banks and others, were such that they were best capable of protecting their own shareholders and their equity in the firms,"

 

[fly]

and in the end we live in a capitalist country. these are the outcomes that are to be expected. it was the realization of this that prompted Alan Greenspan to comment recently that he "made a mistake in presuming that the self-interests of organizations, specifically banks and others, were such that they were best capable of protecting their own shareholders and their equity in the firms,"

Still there was intent to defraud even in going public by some of these institutions, simply so that the risk was passed on to the stockholder.

 

[Jonny_B]

Was there?





Saying it and believing it are two different things. You really are going to try and sell me that EVERYONE was on the up and up about this whole thing????????????



But the models were obviously built to show the data they wanted. You couldn't even PLUG IN NEGATIVE NUMBERS!!!

1) Yes, there was. The people originating the loans were shocked that they were able to originate NINA loans (no stated income, no stated asset) and have them immediately purchased by firms creating mortgage backed securities. At least, those that had been in the industry long were shocked. A lot of people originating those loans were brand new to the business and had no idea that they were unusual. Mortgage origination firms cropped up all over because the demand for home loans to turn into mortgage backed securities was insatiable.

The reason that demand was insatiable was because of a couple of things. Firstly, US Treasury Bonds were down at 1%, and weren't going to go up anytime soon (because Alan Greenspan said he wasn't going to raise the rate). Because of this, money invested in T-Bills couldn't even keep up with inflation. That meant that if you had money you needed to keep safe, you had to find some place else to do it. One very safe place was Mortgage Backed Securities because they had a decent return and a very low default rate. The people at the top started pouring all their money into MBS's and the CDO's created from MBS's. This raised the demand for mortgage paper, which resulted in the decreased quality of loans that would be originated. With three or four levels in between the people investing in CDO's and those originating the loans very few saw that the historically low default rates would soon rise drastically.

2) Bond rating agencies are only as valuable as their reputation. If you get a reputation for rating bonds incorrectly your company goes into the shitter, and there's no money in rating things higher than they should be. When they did the math, the bonds they rated AAA appeared to be AAA. The math was wrong.

3) The models couldn't accept negative numbers because home prices had never fallen in the US before. The models were built to determine how to price mortgage backed securities and collateralized debt obligations built on MBS's. The intent was to figure out if a home is worth x dollars and the mortgage is y dollars and the payment rate is z and the home will rise in value at a rate of w and the market in that area is blah blah blah then we should charge d dollars for this MBS or for this tranche of this CDO. They simply always assumed that w would be positive because they didn't expect that home values could fall. They wouldn't have either, if it weren't for the bubble created by what they were doing. Like he said, all the models looked backwards. None took into account the effects of the new market they were creating.

 

[Jonny_B]

Still there was intent to defraud even in going public by some of these institutions, simply so that the risk was passed on to the stockholder.

every public company does that. the risk to GM is held by GM's stockholders too. They're currently getting hosed. Google's risk is also held by their stockholders. In that case they're doing well.

 

[Jonny_B]

Still there was intent to defraud even in going public by some of these institutions, simply so that the risk was passed on to the stockholder.

The shareholders who financed the risks had no real understanding of what the risk takers were doing, and as the risk-taking grew ever more complex, their understanding diminished.

Isn't 'don't invest in companies you don't understand' one of the cardinal rules?

Once again, if anyone had understood what was going on they could have tried to stop it. Apparently Eisman understood. What did he do? Shorted stocks and bonds to profit from his information. Why aren't you railing against him for not trying harder to enlighten people? If what he said to people was so obviously right at the time, why didn't they join him in taking short positions?

Everyone screwed up. There is no blame.

 

[fly]

1) Yes, there was. The people originating the loans were shocked that they were able to originate NINA loans (no stated income, no stated asset) and have them immediately purchased by firms creating mortgage backed securities. At least, those that had been in the industry long were shocked. A lot of people originating those loans were brand new to the business and had no idea that they were unusual. Mortgage origination firms cropped up all over because the demand for home loans to turn into mortgage backed securities was insatiable.

While I agree that the loan originators probably didn't understand what was going on and the final holders of the MBS' obviously didn't know, somewhere in between a lot of people knew.

The reason that demand was insatiable was because of a couple of things. Firstly, US Treasury Bonds were down at 1%, and weren't going to go up anytime soon (because Alan Greenspan said he wasn't going to raise the rate). Because of this, money invested in T-Bills couldn't even keep up with inflation. That meant that if you had money you needed to keep safe, you had to find some place else to do it.

One word. T.I.P.S.

One very safe place was Mortgage Backed Securities because they had a decent return and a very low default rate. The people at the top started pouring all their money into MBS's and the CDO's created from MBS's. This raised the demand for mortgage paper, which resulted in the decreased quality of loans that would be originated. With three or four levels in between the people investing in CDO's and those originating the loans very few saw that the historically low default rates would soon rise drastically.

That decrease in quality was done by someone. Someone who knew what the fuck they were doing.

2) Bond rating agencies are only as valuable as their reputation. If you get a reputation for rating bonds incorrectly your company goes into the shitter, and there's no money in rating things higher than they should be. When they did the math, the bonds they rated AAA appeared to be AAA. The math was wrong.

The mere mention of a smirk in that article leads me to believe that they knew what was going on and were more culpable than anyone in this mess. If I'm putting together a MBS full of liar loans, it doesn't take too much to figure out that the default rate is going to be exponentially higher than normal. You have to agree that they certainly could have figured it out if they looked closely, right?

The whole thing was a house of cards based on these ratings agencies. They likely got caught up in it just like everyone else and AAA'd junk. You're pollyanna if you think that the people working at those companies gave a shit about the reputation of their company over their third Maybach...

3) The models couldn't accept negative numbers because home prices had never fallen in the US before. The models were built to determine how to price mortgage backed securities and collateralized debt obligations built on MBS's. The intent was to figure out if a home is worth x dollars and the mortgage is y dollars and the payment rate is z and the home will rise in value at a rate of w and the market in that area is blah blah blah then we should charge d dollars for this MBS or for this tranche of this CDO. They simply always assumed that w would be positive because they didn't expect that home values could fall. They wouldn't have either, if it weren't for the bubble created by what they were doing. Like he said, all the models looked backwards. None took into account the effects of the new market they were creating.

You simply cannot make that kind of assumption with statistics. Especially considering that (according to my quick research) you only have about fourty years of data. You honestly think the thought of falling house prices NEVER CROSSED THEIR MINDS? More than likely, it didn't jive with the data they wanted to present.

every public company does that. the risk to GM is held by GM's stockholders too. They're currently getting hosed. Google's risk is also held by their stockholders. In that case they're doing well.

Yes, but I was referring to the article mentioning that they did it out of the desire to pass on risk.

 

[Jonny_B]

While I agree that the loan originators probably didn't understand what was going on and the final holders of the MBS' obviously didn't know, somewhere in between a lot of people knew.

One word. T.I.P.S.

That decrease in quality was done by someone. Someone who knew what the fuck they were doing.

The mere mention of a smirk in that article leads me to believe that they knew what was going on and were more culpable than anyone in this mess. If I'm putting together a MBS full of liar loans, it doesn't take too much to figure out that the default rate is going to be exponentially higher than normal. You have to agree that they certainly could have figured it out if they looked closely, right?

The whole thing was a house of cards based on these ratings agencies. They likely got caught up in it just like everyone else and AAA'd junk. You're pollyanna if you think that the people working at those companies gave a shit about the reputation of their company over their third Maybach...


You simply cannot make that kind of assumption with statistics. Especially considering that (according to my quick research) you only have about fourty years of data. You honestly think the thought of falling house prices NEVER CROSSED THEIR MINDS? More than likely, it didn't jive with the data they wanted to present.


Yes, but I was referring to the article mentioning that they did it out of the desire to pass on risk.

The people in the middle only knew their part of the business too. They did their job then went home and watched t.v. No one involved was watching the big picture.

Ok, I understated. They want some kind of return.

Yes, it was. The people buying paper bit by bit lowered the standards of what they would accept because the demand for what they were producing remained high.

If they could have, someone would have. You think everyone lost their asses buying crap on purpose? It's impossible to overestimate how much more obvious something seems when you're looking back at it.

If they had 40 years of data, they had 40 years of data. They couldn't create more data where home prices drop out of whole cloth. Like all programming, garbage in, garbage out.

The mention of a smirk is no kind of information. Yes, the mention of the smirk inflamed you. It was meant to. As for the maybach, it's not so much that as the desire of everyone in every industry to have someone else do their work for them. From doctors prescribing whatever was explained to them over lunch to some bond rating agency employee accepting the math provided by the CDO architect it's all the same.

The whole situation is much, much more complicated than presented in one article. You can blame everyone from the person taking out too large a loan to alan greenspan for keeping T-Bills at 1%. Picking one part of the industry and blaming them because of one article you read is ridiculous.