October 27, 2007

What the Hell Happened

THE RANT WOULD like to give a tip of the hat to Mr Allan Sloan, a senior editor-at-large of Fortune magazine, for writing one of the best pieces yet on the collapse of the subprime mortgage market.

Simply put, if you want to understand why everything went to hell in the market, causing untold pain and woe to hedge-fund investors and foreigners and other folks who snapped up these miserable loans like hotcakes on Sunday morning, then you should read this article. Hell, read it anyway -- it's some of the best business reporting I've seen in a good long while. Besides, you'll learn what a "mezzanine tranche" is, and will sound smart at parties.

Anyway, Mr Sloan looks at the origination, sale and disposition of a loan bundle known as GSAMP Trust 2006-S3, a collection of $494 million worth of subprime mortage loans that Goldman Sachs packaged up together, and then sliced up for sale. He then looks at what happened to them, and it ain't pretty.

Mr Sloan writes:

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In the spring of 2006, Goldman assembled 8,274 second-mortgage loans originated by Fremont Investment & Loan, Long Beach Mortgage Co., and assorted other players. More than a third of the loans were in California, then a hot market. It was a run-of-the-mill deal, one of the 916 residential mortgage-backed issues totaling $592 billion that were sold last year.

The average equity that the second-mortgage borrowers had in their homes was 0.71%. (No, that's not a misprint - the average loan-to-value of the issue's borrowers was 99.29%.)

It gets even hinkier. Some 58% of the loans were no-documentation or low-documentation. This means that although 98% of the borrowers said they were occupying the homes they were borrowing on - "owner-occupied" loans are considered less risky than loans to speculators - no one knows if that was true. And no one knows whether borrowers' incomes or assets bore any serious relationship to what they told the mortgage lenders.

You can see why borrowers lined up for the loans, even though they carried high interest rates. If you took out one of these second mortgages and a typical 80% first mortgage, you got to buy a house with essentially none of your own money at risk. If house prices rose, you'd have a profit. If house prices fell and you couldn't make your mortgage payments, you'd get to walk away with nothing (or almost nothing) out of pocket. It was go-go finance, very 21st century.

Goldman acquired these second-mortgage loans and put them together as GSAMP Trust 2006-S3. To transform them into securities it could sell to investors, it divided them into tranches - which is French for "slices," in case you're interested.

There are trillions of dollars of mortgage-backed securities in the world for the same reason that Tyson Foods offers you chicken pieces rather than insisting you buy an entire bird. Tyson can slice a chicken into breasts, legs, thighs, giblets - and Lord knows what else - and get more for the pieces than it gets for a whole chicken. Customers are happy, because they get only the pieces they want.

Similarly, Wall Street carves mortgages into tranches because it can get more for the pieces than it would get for whole mortgages. Mortgages have maturities that are unpredictable, and they require all that messy maintenance like collecting the monthly payments, making sure real estate taxes are paid, chasing slow-pay and no-pay borrowers, and sending out annual statements of interest and taxes paid. Securities are simpler to deal with and can be customized.

Someone wants a safe, relatively low-interest, short-term security? Fine, we'll give him a nice AAA-rated slice that gets repaid quickly and is very unlikely to default. Someone wants a risky piece with a potentially very rich yield, an indefinite maturity, and no credit rating at all? One unrated X tranche coming right up. Interested in legs, thighs, giblets, the heart? The butcher - excuse us, the investment banker - gives customers what they want.

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READER: Hinkier? What the hell kind of word is hinkier?

"Hinkier" is a cognate of the word "Jinkies!" -- a made-up exclamation of surprise used in the old Scooby-Doo cartoons. This and other strange sayings -- such as "ZOINKS!" -- evolved because the writers couldn't use normal exclamations such as "Holy shit!' and "CHRIST JESUS!" back in the late Sixties.

Anyway, as we know, this all ended very badly and the investors who bought these loans were left uttering exclamations -- on par with "ZOINKS!" -- when they opened their hedge-fund statements, or tried to redeem their investments from the funds. It really went badly for the folks who held the riskier tranches of the debt. Basically, as Mr Sloan explains, they were the first ones to get wiped out. Mr Sloan's analysis, although boiled down, may still seem a bit dense, so let's boil things away.

Everyone, of course, got interest payments, no matter what tranche they bought into. The tranches dealt with the loans' principal as well. Basically, when the loans got divided up, people who bought into the safest pool were due to get their principal repaid first, while investors in the riskiest pools got repaid last. The safer tranches (A1, A2 and so on) had the lowest interest rates, which got higher as risk increased, up to an X (or unrated for credit purposes) tranche.

In theory, if all the loans had been paid off, the X tranche would have paid off like gangbusters, and it would have paid for years and years and years. The A1 tranche, in contrast, would have paid well, but for a shorter time -- until the share of the total principal associated with it was paid back. When the A1 tranche was paid off, the A2 tranche would start to get paid off, and so on down the line. They would have gotten away with it too if it hadn't been for those meddling homeowners.

But where does one begin in looking at all this? I mean, the greed and stupidity is just mind-boggling here.

When I talked with Mr Kepple tonight about this, he expressed amazement at the credit rating agencies' actions. Why the devil would bunches of second mortgages, written to people who had no equity in their homes and no proof they could actually pay back the money, earn a AAA-grade rating? I mean, come on. I don't have any sympathy for the investors who bought the debt, for there is such a thing as caveat emptor, but for the credit agencies to screw the pooch like this is unbelievable.

Of course, I also don't know what the buyers of the debt were thinking either. I don't understand why these very smart people, who can do things with money I can't even imagine, suddenly took leave of their senses and approached things so amateurishly. But there are lessons to be drawn from this, of course:

A) It pays to do your homework;
2) If something seems too good to be true, it probably is, and:
C) Sometimes, Wall Street exists to take your money.

Oh, yeah. You see, as Mr Sloan revealed, this past quarter Goldman Sachs cleverly shorted an index of mortgage-backed securities, so it made a whole bunch of money in the meltdown even as its customers were getting their heads handed to them. If you read Mr Sloan's article, it's actually not nearly as cold-blooded as it sounds. Besides, the times change and Wall Street changes with them.

Still, it does bring to mind that old quip about customers' yachts.

Posted by Benjamin Kepple at October 27, 2007 10:24 PM | TrackBack
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