Growth of the Subprime Industry

A bond trader from Salomon Brothers, Lewis Ranieri, pioneered the concept of “private label” securitization for home purchase mortgages in the 1970s. Salomon Brothers purchased only conventional “A” credit quality single family first lien mortgages, not second lien or “nonconforming” mortgages, meaning they bought only those that conformed to the high credit standards imposed by federal-government-backed Fannie Mae and Freddie Mac. Prudential Securities, a midsize Wall Street firm, pioneered the concept of subprime securitization. The book Chain of Blame describes the process:

“If [the subprime lender ]Aames originated a $10,000 second lien, Prudential would offer “105” for it, which meant it paid five points (5 percent) or $10,500 for it. Aames would still retain a fee to service the loans it sold to Prudential. The Wall Street firm paid those five points because after figuring out all those years of interest payments, five points was a bargain…Thanks to Prudential opening the subprime door for Wall Street [other subprime firms] found willing lenders in New York at the investment banking houses of Bear Stearns and Deutsche Bank….”

Wall Street investment firms developed the concept of bundling together a portfolio of subprime mortgage back securities into subprime credit derivative known as “structured” collateralized debt obligation products (CDO). The big five investment firms – Goldman Sachs, Merrill Lynch, Morgan Stanley, Lehman Brothers and Bear Stearns – broke new ground in mortgage finance and fed the demand by advancing the concept of private sector mortgage securities. Securitization fundamentally altered the role of the mortgage lenders from long-term lenders of money to suppliers of mortgages. As subprime lending gradually spread throughout the country, the unique relationship between mortgage originators and homeowners, fashioned and cultivated over several decades, became fundamentally transformed.

Enthralled by the higher yield, capital market investors —insurance companies, mutual funds, pension funds and global investors — provided continuing funding for this “shadow banking system.” Wall Street institutions eagerly extended warehouse lines of credit and cheap money worth billions of dollars to subprime mortgage suppliers. These suppliers packaged subprime mortgages into mortgage-backed private-label securities, and issued them to investors in the global finance marketplace as “structured” investment products, creating a bewildering array of mortgage products and innovative debt instruments defying barriers imposed in the past by federal regulators.

In his book The Big Short Michael Lewis, best-selling author and former Wall Street bond trader, described the process as “towers of debt” comprised of three floors:

A basement, called the “equity,” which takes the very first losses and is not an investment-grade security; the lower floor, called the “mezzanine,” with triple-B rating; and the upper floor, with triple-A rating, and generally referred to as the “senior.” In practice, the towers were far more finely sliced: a CDO might have fifteen different tranches, each with a slightly different rating, from triple-B-minus all the way up to Triple-A; triple-B-minus, triple-B, A-minus, A, and so on.”

This Wall Street-supported “originate-to-distribute models” allocated large quantities of mortgage products in a sector of the housing market with little federal supervision or governmental oversight. As noted in Poser’s text, A Failure of Capitalism:

Securitization also played a role in encouraging short-term profit maximization. Instead of having to wait twenty-five to thirty years to receive the full return on a residential mortgage, exchanging the mortgage for a security gave a bank the present value of the loan up front, increasing the bank’s current profits, some part of which would accrue to the bank’s executives in the form of salary, bonus, benefits, or stock. A bank could always have sold a mortgage, but securitization made the mortgage market more liquid.

Subprime specialist developed customized software systems using complex mathematical algorithm models to make high-speed pricing risk credit assessments. Countrywide Loan Underwriting Expert System (CLUES) was the first to process conventional, Alt-A, and subprime mortgage applications. Countrywide underwriters used CLUES at branch locations in 300 decentralized branches covering 42 states. Prior to the use of CLUE, the typical Countrywide underwriter spent 50 minutes reviewing each loan application, with CLUES the review process averaged 15 minutes on each loan. First Franklin Financial “Arc System” reduced the largest subprime lenders in the country processing time from 24 hours to eight hours or less, increasing the subprime broker specialist lending volume from 7,000 to 50,000 applicants a month, producing over $450 billion in subprime mortgages. New Century promised subprime mortgage brokers on its website that with their automated underwriting system “We’ll give you loan answers in just 12 seconds!”

Demand for subprime mortgage products and subprime-backed credit derivative securities grew exponentially. Merrill Lynch, Citigroup, Goldman Sachs, UBS, and Deutsche Bank advanced more and more creative and highly leveraged investment tools in order to fulfill investor demand—including, for example CDO and  so-called “CDO-squared.” As explained by GillianTett, the author of Fool’s Gold

Banks repackaged mortgage-based bonds in ever-more-creative ways. The best known was CDO of asset-backed securities, or CDO of ABS. This was usually (but not always) filled with mortgage-linked bonds. In a sense, then, CDOs of ABS were like CDOs of CDOs. They had an added layer of complexity to add more leverage. Within that field, another popular product was known as a “mezzanine CDO of ABS,” which took pools of subprime mortgage loans and used them as the basis for issuing bonds carrying different degrees of risk. The bankers would then take just the risky bonds, say those rated BBB, not A or AAA, and create a new CDO composed entirely from those BBB bonds. That CDO would then issue more notes that were also ranked according to different levels of risk. The scheme looked fiendishly complex on paper, but it essentially involved bankers repeatedly skimming off the riskiest portions of bundles, mixing them yet more risk, and then skimming them yet again—all in hope of high returns…

A report from the Comptroller of the Currency recorded that the notional amount of subprime credit derivatives in the second quarter of 2007 rose from $10 trillion to $11.8 trillion, an increase of 16 percent. The top banks in the subprime credit derivative market were JP Morgan Chase, Citibank, Bank of America and Wachovia, along with the top Wall Street investment firms Merrill Lynch, Bear Stearns, Lehman Brothers, and American International Group (AIG).

The synthetic CDO market allowed investors to gain “long exposure” to portfolios of subprime credit derivatives without actual owing any subprime mortgages. Wall Street firm increasingly turned to the derivatives market to reduce its risk, by purchasing a credit derivative known as the credit-default swap. A credit-default swap is a bilateral “side-bets” or “insurance” contract transferring the credit risk on investment of subprime bonds from one party to another for a specified duration. Credit default swaps protected an investor against the loss from par (dollar for dollar) on subprime bond investments in the event of default.  In return for this “protection” the counterpart of the swaps pays a premium. Credit-default swaps stipulations and prospective financial impacts were largely hidden form federal regulators. Hedge funds, unregulated investment vehicles that cater to institutions and wealthy individuals, relied upon the principle of “hedging” its exposure by “shorting”, against losses by taking multiple positions at once. That is, on the backside betting against the CDO subprime market.

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