Loans from Hell

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.”


Bill Bonner
The Daily Reckoning
March 16, 2007

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.

Editor’s Note: Bill Bonner is the founder and editor of The Daily Reckoning. 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. Daily Reckoning readers can buy their copy of Empire of Debt at a discount – just click on the link below:

Empire of Debt

Yesterday, we spoke of an enterprising restauranteur in New York who put a $1,000 pizza on his menu. Upon further reflection, we think it is a shame that eateries aren’t required to run small-print disclaimers, like stock offerings. We’d like to see what it might say:

“This pizza might not taste a bit better than any other pizza…in fact, with its caviar, crème fraiche, and lobster, most people will probably think it sucks. Diners are also advised that several animals were harmed in the creation of this culinary offering…that fossil fuels were used in its preparation…and that buying it may do damage to the acquirer’s balance sheet as well as to his intestines and his planet. Still, if you and your buddies have just laid off a few billion dollars worth of subprime distillate upon a pension fund for widows and orphans, what better way to celebrate?”

There is so much easy money flowing through lower Manhattan, even a pizza-man must think, “It’ll be a piece of cake to skim some off.”

And he’s probably right. Corporate profits, generally, have been on a tear. And no profits have risen further or faster than the profits of the financial industry.

But why so much money in Wall Street and London’s City?

We have lots of answers, but no good ones. The theory of capitalism is that rising profits will attract additional investment, which will increase production, which will provide people with more of what they really want at lower prices – and, coincidentally, reduce profit margins down to normal levels.

But, what people really seemed to want in the early years of the 21st century was financial services. Why? Because there was so much ‘flation available. A smart hedge fund manager or investment banker could make himself and his clients a lot of money. And there was enough hocus-pocus, regulatory restrictions and capital requirements to keep new competitors out of the market – at least for a while.

Thus it was (and still is) that the world’s most capitalistic businesses seem to defy its most fundamental rules. It’s as if you had drunk a shot of whisky and immediately turned stone sober; or if the Pope had interrupted mass to announce that he was an atheist. And there is no better emblem of this puzzling phenomenon than the latest profit report from gonzo banker, Goldman Sachs (about which there is more below).

But now, the story grows even more interesting.

You will recall how Ben Bernanke proposed to avoid following Japan into a long, dark slump. “We have a technology,” he said…reminding listeners that the feds could print up as many dollars as they wanted. Then, the chairman-to-be was a deflation fighter.

Now, he says it is inflation that should worry policy-makers. “The FOMC has continued to view the risk that inflation will not moderate as expected as the pre-dominant policy concern,” he announced recently.

We doubt that consumer price inflation is really of that much concern. We also doubt that Ben Bernanke could do much about it even if it were. Who’s going to raise interest rates when the bottom end of a $10 trillion mortgage market looks ready to shimmy and shake?

Not Ben Bernanke.

No, the next move in fed rates is likely to be not up…but down.

‘Flation comes in various deceits and disguises. But the way it has been dressed up these last five years, it’s been welcomed everywhere like a long lost son. While the supply of money and credit – liquidity – rose to record levels at record rates, consumer prices remained relatively restrained. This ‘flation stayed mostly on the top rungs of the socio-economic ladder while practically everyone, everywhere else scrambled up to get a whiff of it.

The middle and lower classes did not suffer this ‘flation the way they suffered the consumer price inflation of the ’60s and ’70s. There was so much capital around, and markets had become so globalized, the Chinese could expand production in order to keep prices low. The one benefit the hoi polloi got turned out to be a curse in disguise…their houses rose in price. Nationwide, housing rose 102% from ’96 to ’07, according to The Economist. This pushed Americans’ total housing values to $22 trillion.

But, unfortunately, the middle classes didn’t merely enjoy having the extra cash in their pockets – they enjoyed spending it. Now, their houses are falling in price – so where’s the cash to come from? The latest news from Orange County, California, is that house prices have fallen for the first time since 1996 – down 0.4% year over year, says the local paper. The 10-year boom has busted.

Now what will consumers consume with?

And here we pose our dear readers a question: Imagine a neighborhood where house prices have doubled – from $100,000 to $200,000. Now, all of a sudden, a neighbor sells his house. But he can only get $150,000 for it. What happened to all that extra ‘flation?

(Note to Ben Bernanke: Better limber up the printing press.)

More news….


Chuck Butler, reporting from the EverBank world currency trading desk in St. Louis…

“The data in the United States was mixed yesterday with PPI moving higher, which should have supported the dollar. But the markets have become very myopic at this point, and the only thing they see is the subprime meltdown.”

For the rest of this story, and for more market insights, see today’s issue of The Daily Pfennig


And more views…

*** Subprime plus two.

One of our axioms here at the Daily Reckoning, is that information degrades like magnetism or radiant heat – by the square of the distance from the source.

We mention it today, because it helps explain the troubles in the subprime mortgage market. The old fashioned banker used to sit at his oak desk, and if a man wanted to borrow money, he’d have to sit down in the chair opposite him and explain himself. The banker would then ask a lot of nosey and awkward questions. And then, unless the two men knew each other, he’d want to see some proof – tax forms, pay slips, deeds, etc.

The banker would already have the man’s banking records in front of him, because the man wouldn’t dare to ask for a loan unless he’d been a good customer for at least a few years. And the banker probably would have driven by to take a look at the house, too, just to make sure it looked solid.

The whole encounter was laced with suspicion and doubt. Would the borrower lose his job? Did he have a drinking problem? Were things okay between him and his wife? How much was the house really worth? In the unlikely event that the bank had to sell it to get its money back, would there be enough margin for error? Lend 100% of the purchase price? You’d have to take your business elsewhere!

But in the great housing boom of 2006-2007, the suspicion and doubts disappeared, along with the oak desks and nervous interviews. No credit? No money? No job? No problem…

And then, the whole affair took two giant steps away from the basic transaction. The loan originator, we suspect, may not have met his borrower in some cases. But there is no doubt at all that the financier who put the loan into a mortgage-backed security had never laid eyes on him at any time.

And the math whiz who invented the collateralized debt obligation into which the mortgage was eventually stuffed, could care less if there was even a human being attached at the other end of his geekery. By the time the mortgage finally came to rest in the hands of an investor he had no idea what he actually had.

More about that…below…too.

*** “Is the bathroom finished yet,” we asked. We got back from London last night. The apartment was still covered with dust, with boxes, plumbing supplies, ceramic tiles and tools piled in the corners.

For the last six months, our apartment has been undergoing renovation. The kitchen has been freshened up; we even have those amazing drawers that hesitate before lightly closing. But in the rest of the place, progress is so slow we may need another renovation before this one is complete.

“No…I’m afraid not. In fact, I don’t know what is going on,” Elizabeth replied. “The Portuguese crew has torn the place apart, and they don’t seem in a hurry to put it back together.

They’re a funny bunch. One of them is very bright and cheerful. The other never speaks. I thought he was a deaf mute…but then I heard him yelling at his brother…yes, they’re brothers. At least that’s what they said.

“I think they’ve turned our bathroom into a clubhouse. They come in the morning. They go in. Sometimes they bring other workers with them. I hear them in there. Talking. Laughing. And then at the end of the day, they go home. But when I look in the bathroom it looks just the same. Maybe they’re playing cards.”

Inside the former bathroom, a board has been placed across a group of paint cans to form a bench. A cooler is in the corner.

“Maybe you should charge them rent.”

The Daily Reckoning