Tuesday, February 12, 2008

Greed, Fraud and Duplicity: How the Housing/Lending Bubble Inflated


Author Richard Bitner was kind enough to send me a copy of his new book Greed, Fraud & Ignorance: A Subprime Insider's Look at the Mortgage Collapse which I can recommend to you as a concise account of the entire subprime lending bubble and implosion.

Bitner has a unique view of all the players, as he was a major subprime mortgage broker for many years prior to the implosion. He was unashamed to describe himself as a subprime mortgage broker before the excesses consumed the business, as he felt that even though the system was less than perfect, the subprime market served a valuable purpose to those with impaired credit. With proper vetting and risk management, the higher-risk borrowers were rejected and those whose credit history supported their ability and willingness to pay could buy a house by paying higher interest rates.

I can't summarize a 191-page book in a few paragraphs, but this is my primary take-away from this very clearly written account:

When everybody from the borrowers to Wall Street began gaming the system, all credibility was lost. It is still lost, and will remain lost until the entire model of payment for all players is radically restructured.

Bitner reports that up to 80% of all subprime loan applications were rejected by honest subprime mortgage brokers. This stunning statistic suggests the frenzy which overtook the nation as people who were clearly below-average credit risks stormed the housing market, trying to get in and get rich just like everybody else.

While there is nothing remarkable about this human behavior--we all want to get in on the Get Rich Quick Scheme of the Day--what is remarkable is that Wall Street and the credit ratings agencies went for the Get Rich Quick scheme in the same frenzied fashion. (OK, so there's nothing remarkable about that, either.)

But unlike a subprime borrower, Wall Street and the rating agencies (Moodys et. al.) could approve their own terms and grant themselves a high rating. In Bitner's memorable description, "Not only was the fox guarding the henhouse, he hired a contractor and built a separate wing so he could feast at his convenience."

Bitner describes how Wall Street's securitization of mortgages fragmented what was once an integrated process. The granting of a mortgage used to be--and still is, in smaller local banks--an integrated process within the bank. The loan officer verifies employment and income of the borrower, hires a trusted local appraiser, confirms the loan meets all underwriting requirements, confirms the down payment wasn't borrowed, etc.

As Bitner writes:

"In addition to creating a renewable source of capital, mortgage securitization helped fragment the industry. An entire process originally performed by one entity was divided into separate components. This fragmentation gave each player a claim of plausible deniability."

A great strength of this book is its clearsighted exploration of the greed, fraud and duplicity which was engineered by every player. Interestingly, the automation of the mortgage process via computer risk modeling--a credit score of 580 enabled this mortgage product to be approved, while a score of 620 gained approval for this product, and so on--allowed brokers to fudge and finesse applications to squeak in and get approved.

With the help of a less-than scrupulous mortgage broker, the borrower could "forget" items which might lower his credit score. The broker, knowing the underwriting rules, might write the loan only in the wife's name, as her credit score was 20 points higher. There were innumerable ways to game the system and get a loan approved.

The entire system flourished because the incentives were all wrong. The borrower got the money by lying,"forgetting" or fudging. The broker only made money by getting a lender to fund the loan, while the lender only made a fat profit if the mortgage was sold to Wall Street for securitization, and Wall Street only made money if they sold the mortgage-backed security to an investor with a high rating from Moodys or Fitch, who only made money if they rated the MBS as AAA regardless of its true risk.

It wasn't always this way. As Bitner explains, the ratings agencies in the 1970s received income on an entirely different subscription model. The SEC (securities and Exchange Commission changed the model: "Instead of buying a subscription, the companies would pay the agencies for rating their debt. In hindsight, this may have been the single greatest mistake in the history of the SEC."

Back in the early 90s, private investors were the only buyers of subprime debt. Obviously, if you sold a poor-risk loan to an investor who was subsequently burned, that was your last sale to that investor. Word would get around and your business would dry up and blow away. But once Wall Street got into the act, according to Bitner the demand for mortgages to securitize was insatiable.

And to feed this ravenous, supremely profitable maw, the mortgage industry conjured up a raft of new products to sell--products which were scored for risk like traditional mortgages. Only the new "exotic" loans were highly risky--a fact which every player from the broker up to the rating agencies cloaked for their own benefit.

The rating agencies played a huge part. Bitner quotes two sources as snapshots of the agencies' power to manipulate the system:

"Only slightly more than a handful of American non-financial coprorations get the highest AAA rating, but almost 90% of collaterialized debt obligations (CDOs) that receive a rating are bestowed such a title. Are we willing to believe that these securities are as safe as those of our most honored corporations?" (Josh Rosner)

"There are two superpowers in the world today in my opinion. There's the United States and there's Moody's Bond Rating Service. The United States can destroy you by dropping bombs, and Moody's can destroy you by downgrading your bonds. And believe me, it's not clear sometimes who's more powerful." (Thomas Friedman)

Bitner does an excellent job of describing the inherent conflicts of interest in the entire mortgage lending and selling of MBS process:

"In some ways, the investment firm-rating agency relationship mirrors the dysfunctional nature of the broker-lender relationship. If the broker is having trouble getting a deal approved, his account executive will tell him how to structure the loan. When the investment bank has a security filled with garbage loans, the agencies advise then how to structure the deals in order to maximize profit.

The agencies defend themselves by issuing 100-page disclaimers to go with the ratings. It's equivalent to building a car and sticking a label on the inside that reads, "We want you to know we can't stand behind anyone who had anything to do with the assembly of this vehicle. If the steering wheel falls off, motor falls out or any bodily injury comes to you as a result of driving this car, just remember, we told you so."

You have probably read about each piece of the subprime lending puzzle somewhere, but this book puts the puzzle together in admirably clear fashion. You can download the first chapter for free on the website The Mortgage Insider where you can of course buy a copy as well.

As with all books I discuss here: I receive no compensation, fee, commission, etc. from the author or publisher. I decide whether to discuss the book on its merits to readers. If you purchase a copy of Greed, Fraud & Ignorance: A Subprime Insider's Look at the Mortgage Collapse via this amazon.com link, I receive a 3-4% slice which costs you nothing (amazon pays me, your price is the same whether you buy it from this site or not.) If you prefer to buy a copy from the author's site or another bookseller, I receive nothing, which is fine with me.

This book provides the most succinct account of the subprime complex I have found. Others have done great jobs with one slice or another, but this book covers it all, from appraisers who have to play ball if they want to survive to duplicious brokers all the way up to the Federal Reserve's role.

Bitner concludes with some suggestions on fixing the mess. While I generally agree with his ideas, I don't think trust can rebuilt without the entire edifice being rebuilt from the ground up. The entire inherently conflicting models of payment for the rating agencies, appraisers, brokers, lenders, and Wall Street all have to be radically changed.

The model will simply blow up again unless appraisers are paid for the accuracy of their appraisals, not by those with a vested interest in the highest appraisal. Ditto for the ratings agencies and everyone down the line. As long as everyone only gets paid by foisting off high-risk debt onto the next chump, the system is destined to fail, and can never regain the trust of global investors.

Is such a rebuild from the ground up possible? Not at this time. The entire edifice will have to fail catastrophically before the players will accept a new regulatory world.






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