This page has been archived and commenting is disabled.
Guest Post: Bloomberg Takes A First Step At Piercing The Veil Of Secrecy Surrounding CDOs
Submitted by David Fiderer
A recent Bloomberg story about one of the CDOs insured by AIG, Davis Square Funding III, is a stark reminder of one of the bedrock principles of real estate lending: Timing is everything. Davis Square III, originally underwritten by Goldman Sachs, was comprised of pieces of mortgage bonds issued in 2004, two years before the home prices peaked.
As the chart from Moody's demonstrates, when home prices stopped rising in 2006, loan losses soared. So when Davis Square III's investment manager, Trust Company of the West, substituted 2004-vintage bonds with subprime deals issued in 2006 and 2007, AIG got stuck insuring an obligation far more toxic than one it had bargained for. The basic tenet of structured finance--what you see is what you get--seems to have been short-circuited. And the ultimate cost was borne by the taxpayers, who now own a slice of Davis Square III in an AIG bailout vehicle called Maiden Lane III.
The asset substitutions may look like a bait-and-switch, but Trust Company of the West, or TCW, had simply exercised the latitude afforded it under the documentation. And Davis Square III is not unique. Davis Square Funding VI, and VII, also underwritten by Goldman and managed by TCW, were also designed to allow for similar asset substitutions.
But except for Davis Square III, we don't know whether any asset substitutions occurred. Virtually all CDOs remain shrouded in secrecy. Their financial reports remain hidden from public view, unavailable to anyone except actual CDO investors, who are bound by a non-disclosure agreements. Bloomberg's coup was to pierce that veil of secrecy, and to drill down into the details of one CDO.
Credit Ratings and Deep Subordination
It's easy to see how the Davis Square CDOs seemed like low-risk propositions five years ago. If you only looked at the historical loss rates on subprime mortgages issued prior to 2005, and relied on the underlying bonds' credit ratings, then everything looked fine. In both Davis Square VI and Davis Square VII, the most important portfolio criteria pertained to credit ratings. At least 55% of the investments held by the CDO had to be rated AA- or higher, and none of the investments could be rated below A-.
If you are unfamiliar with mortgage bonds, you may not realize that a tranche rated AA- is very deeply subordinated. Subprime mortgage bonds all have pretty much the same capital structure. Anything that isn't rated AAA ranks in the bottom 20% of seniority. Anything rated below AA- ranks in the bottom 10% of seniority. The capital structure of Structured Asset Investment Loan Trust 2005-HE3, or SAIL 2005-HE3, a deal underwritten by Lehman, followed the standard template:
SAIL 2005-HE3 was a microcosm of the broader market, in that the amount of bonds rated AAA was about six times as large as those rated between AA+ and A-. Consequently, it seems likely that the Davis Square deals were initially stuffed with many subprime tranches rated AAA, which initially improved those portfolios' blended credit ratings.
But the AAA tranches get paid down first. And if the underlying home loans are prepaid quickly, the AAA tranches tended to shrink dramatically, thereby affording TCW the flexibility to insert later-vintage AA- tranches into the portfolio. Again, SAIL 2005-HE3 example was typical; 30% of the principal had been prepaid within a year of the deal's initial closing.
Why Subprime Borrowers Were So Quick to Prepay
But why would so many homeowners with bad credit who were stretched thin decide to rapidly prepay their mortgages? At that point, they weren't refinancing to take advantage of lower interest rates, and almost all of them faced prepayment penalties. The answer reflects the dirty little secrets of the subprime sector. SAIL was also typical in that about 33% of its mortgages were no doc loans, otherwise aptly named liar loans.
After the subprime market began collapsing in 2007, Fitch reviewed a sampling of subprime mortgages with characteristics similar to those held by SAIL 2005-HE3. Fitch found that the vast majority of loans in its sampling were secured by fraud. About 2/3 of the loans involved occupancy fraud. In other words the borrowers claimed the property has their home but lived somewhere else. Almost half of the borrowers falsely claimed to be first-time homebuyers, who, in fact, had held mortgages somewhere else. A slight majority of the loans involved some kind of appraisal fraud. Clearly, a lot of these borrowers were seeking to make quick money by flipping a piece of real estate financed by a lender who didn't ask too many questions. Almost half of the mortgages in the Fitch sampling were in the state with the biggest bubble, California. Of course, none of this was news. Back in 2000, HUD Secretary Andrew Cuomo was alerting everyone that fraud had gone viral in the subprime mortgage sector.
Quick prepayments were also prompted by crooked lenders like Ameriquest, which engaged in loan flipping schemes, designed to get borrowers to refinance within two years so the firm could earn upfront fees.
Another other dirty little secret of the industry was a euphemism known as "distressed prepayments." If a borrower became delinquent in his monthly payments, he either sold his house and downsized, or covered the deficiency with a larger cash-out mortgage attained with a higher home appraisal. Almost half of all subprime loans were for cash-outs.
Flipping schemes and distressed prepayments may have harmed consumers, but they did not cause loan losses so long as home prices kept rising. And home prices continued to rise so long as Alan Greenspan and Wall Street kept up their easy money policies. When home price appreciation stalled in 2006, those flipping schemes and distressed prepayments suddenly became problem loans. That's why mortgage bonds that closed in 2006 performed so much worse than those issued one year earlier.
From early 2006 onward, worsening delinquency statistics showed that a lot of subprime investors would get wiped out. But TCW, as the investment manager for the Davis Square CDOs, was not bound by any due diligence standard. Ratings from Moody's and Standard & Poor's were used as a substitute for due diligence. TCW could replace a solid AAA 2004-vintage investment with a toxic AA- tranche of a 2007 subprime deal, in accordance with the discretion afforded TCW under the "structure."
The Truth About CDOs Remains Hidden
Whatever happened with Davis Square VI or VII or the CDOs underwritten by Goldman and managed by TCW remains a mystery. All of the players tied to subprime CDOs, acted with the expectation that their decisions would never be subjected to public scrutiny. It's high time that the government required all mortgage securitizations, including privately placed CDOs, to disclose all of their monthly performance reports. There is no legitimate business purpose for keeping that information secret.
Finally, the investors who reaped billions by betting against CDOs utilized that other financial instrument of secrecy, credit default swaps. Nothing better reflects Wall Street's culture of secrecy that the position taken by The Depository Trust & Clearing Corporation, which operates a clearing house for credit default swaps. Prior to March 23, 2010 the DTCC refused to provide regulators access to specific counterparty information.
»
- 4354 reads
- Printer-friendly version
- Send to friend
- advertisements -
Wait, all is good,the SEC is seeking tighter rules on asset-backed securities and Goldman denies conflict of interest on subprime. LOLLLLLLLL!!!!!!!!!!!
BTW, excellent post.
The basic tenet of structured finance is:
Obfuscate and get a big bonus doing it.
"Obfuscate and get a big bonus doing it."
That was my first thought as well after reading the opening paragraph.
I had read reports a couple of years ago about the structures that allowed the substitution of collateral in the CDOs. It seemed almost unbelieveable. Who could possibly give it a rating of any kind or even figure out what would be in the package. The same scheme was also used for some of the issues backed by corporate debt, not just the MBS deals.
AIG certainly was stupid to not know what they were insuring any better than this. That Bloomberg article was really pretty amazing. It did not really go into the opportunities for price scalping and asset dumping. A bit more confounding is the finding that some of the traders for TCW actually owned some of the more toxic pieces of these deals.
The collateral substitution periods were purposefully designed this way. The rating agencies are very slow to up/downgrade these things because the big suckers (ins. cos, pensions) that buy solely on ratings want ratings stability. The revolving period was designed in part to arb this timeframe. Even more ridiculous was the fact that for purposes of the collateral tests at various points in the cap deck you could substitute a bond trading at 70 and mark it at par, completely gaming the level of O/C.
"The rating agencies are very slow to up/downgrade these things..."
Hell's bells...about the only time they actually downgraded them was after a credit event was triggered and the payouts began.
Your SAIL example even understates the subordination that was in place at the time of issuance, as every loan with an LTV over 80 also had MI on it. So at issuance, they had even more protection that just the subordination and OC.
Of course, the MIs are now crying foul and refusing to pay their claims.
On the closing date, Mortgage Guaranty Insurance Corporation, PMI MortgageInsurance Co. and Republic Mortgage Insurance Company will provide primary
mortgage insurance for certain of the first lien mortgage loans with original
loan-to-value ratios in excess of 80%.
I wonder why AIG would insure something like that at all. It does not seem prudent to me to insure something that the insured has a contractual right to replace with something of less value and more risk.
It seems to me that the fraud is built in right into these CDOs then.
The risks were right there in the 1000 page prospectus your honor. If you cant understand it you shouldnt buy it. A search for yield in a low yield liquid environment creates the potential for it to happen (thanks doc greenspan). Same exact thing is happening right now.
fraudulent conveyance your honour.
the corporation had no right to pay bonuses given the amount of liabilities on its books.
fuck off, you structured finance fucks.
you speak nothing about income.
you have no idea about the depth of the problem that faces america today.
This is the best post on ZH today.
199 comments on Canadas Central bank vault holdings of gold and 9 posts here on CDO's is very telling especialy while the FCI hearings are being conducted in real time. Just goes to show how clueless and unsophisticated that even ZH readers are as the global financial melt down comes to a head.
http://fcic.gov/
Sad that these hearings are finnaly being conducted and ZH hasn't got anything going while Cassano & Greenspan et. all. walk after committing the largest property crime in the history of civilization.
Pretty pathetic that Tyler & co dropped this ball.
http://www.marketwatch.com/story/greenspan-housing-bubble-was-not-created-by-fed-2010-04-07?reflink=MW_news_stmp
http://www.cbsnews.com/stories/2010/04/06/eveningnews/main6369616.shtml
FNM and FRE were once the gold standard for enforcing quality loan underwriting. Once they made it clear that they wanted junk they got it. Lenders were required to originate junk or lose the banking license. It was only last month that FRE quit taking the interest only loans.
Greenspan probably did not know that in the course of just a couple of years the whole mortgage underwriting process had come unglued. Why exactly would he? But he does have some culpability for leaving rates too low for too long. And the same thing is happening again, except the buyers now are getting a tax credit to take on very cheap debt.
"Greenspan probably did not know that in the course of just a couple of years the whole mortgage underwriting process had come unglued. Why exactly would he?"
Take a look at what influence Greenspan had at the BIS Board and how he promoted realestate as DOUBLE the collateral value for the banking system.
It was an IMPRIMATUR on realestate lending
<sarcasm>Are you suggesting, Sir or Madam, that just because the top five banks constitute 63% of the US GDP (which means that taken together with the rest of the financial services sector, it now comprises over 83% of the GDP and economy), there is actually no real economy in the US of A?</sarcasm>
Great Post.
The degrees of separation from the actual collateral were astounding. I find the interviews with former AIG heads to be the most interesting pieces out there; were they really that dumb, did they know they would bail out at the right time, did they bank that the US had to save them?
How can you insure a fungible shell of an asset? Good question, you charge a ton of fees up front and retire just when things start to turn but before everyone really figures it out, leave the US or change your name.
TCW held the most toxic pieces because CDO managers almost always hold the equity tranche in a deal. That's way most CRE CDO managers have are special servicers. Smart ones like CW sold off enough so that their losses on the equity tranches were offset by their ridiculous fees and initial arbitrage while Centerline, LNR, and JE Roberts are all on the brink, or already have, failed. The commercial real estate world is a bad nightmare; subprime and RMBS are literally a hell created for the United States financial system.
What's nuts is all the wealth got transferred to the PE firms and vulture funds who are now buying up assets/failed institutions to re-establish them. Then they will sell them off at a nice profit only to let some fool run them back into the ground.
"..were they really that dumb, did they know they would bail out at the right time.."
According to interviews between the GAO and Hanky-panky Greenberg (then CEO of AIG), Greenberg had full comprehension of what was going on.
Latter (actually just awhile back), Greenberg now claims that he didn't understand them at all, that nobody "..understood those exotic instruments."
I think Greenberg is confusing thos "instruments" with the professional women from those escort services he patronizes?
And,
"What's nuts is all the wealth got transferred to the PE firms and vulture funds who are now buying up assets/failed institutions to re-establish them. Then they will sell them off at a nice profit only to let some fool run them back into the ground."
Brilliant insight, BoyChristmas, brilliant insight....
Good linux hosting option package offered by ucvhost which not only provides the best in terms of hosting packages but also believes in truly being there for the customer, 24x7. cheap hosting Moreover , they offer unlimited bandwidth as well as nearly 1GB storage along with database maintenance, email facility along with storage, availability of sub domain and many other important features for a very low price. windows hosting Thanks forex vps