The Home ATM Machine

It would require another book to recount the long and tortuous history of the shadowy mortgage securitization ecosystem that LB Kiel stumbled into via its North Street CDO deal. Had it not been for two decisive factors, American mortgage lending might have stayed largely on bank balance sheets, as it did in Europe. One factor was the 1980s savings and loan crisis, which discredited traditional bank lending in the United States and forced troubled banks to sell their mortgages to Wall Street. Even more important was the role of the U.S. government in guaranteeing mortgages that got securitized. Since the 1960s, three government-sponsored enterprises — Fannie Mae, Freddie Mac, and Ginnie Mae — had bought residential mortgages from banks. Beginning in the 1970s, they had securitized these mortgages but insured investors against homeowner default, creating bonds known as agency debt.

The three agencies protected themselves from having to pay out on this insurance by imposing restrictions on the mortgages they would buy — insisting, for example, that borrowers make minimum down payments and document their income. But if they did have to pay out, where would the money come from? As the home lending market took off in the 1980s and investors flooded in, the two privatized agencies, Fannie and Freddie, increasingly exploited the assumption that the U.S. government was standing behind them.

That assumption became so widespread that by 2002, agency debt was being bought in massive quantities by China and Saudi Arabia as a substitute for Treasury bonds. In the shadow of this government-backed, trillion-dollar market, a private sector mortgage securitization market emerged, including subprime as well as what were considered prime mortgages: those ineligible for the Fannie or Freddie umbrella because the amounts borrowed were too large (so-called jumbo loans) or where a creditworthy borrower didn't have the right documentation (known as Alt A). The packages of subprime and other “nonconforming” loans were controlled by financial robots lurking inside a mailbox that borrowed money from investors according to a program laid down by a distant investment bank. In the U.S. mortgage and consumer finance industry, the androids did not hide under a Caribbean beach umbrella along with other tax exiles. They wore the Stars and Stripes and the proud badge of an SEC registration, protected by Reagan-era 1986 tax reforms that nurtured home equity lending.

On the SEC Web site, there are currently about ten thousand androids listed, and most are mortgage related. They cluster like sheep around the financial giants that spawned them: Morgan Stanley has two hundred fifty androids, while Lehman Brothers left over one thousand of these orphans, each of them mindlessly sucking up repayments from borrowers and sifting the cash through pumps and valves to investors.

 How did these mortgage robots get to be so numerous? Fannie and Freddie played a role, according to FDIC chairman Sheila Bair. She recalls how a combination of weak governance of the two mortgage agencies and government encouragement of minority home ownership kick-started the subprime boom: “I remember very well when I was at Treasury in 2001 when a broader government effort to expand homeownership was launched. It was well intentioned and turned out to be a significant driver.”

She says that Fannie and Freddie got around restrictions on mortgage eligibility by letting Wall Street package subprime loans and then invest in the end product — with U.S. government backing. “I was very worried at the time, because Fannie and Freddie would not directly guarantee these loans, but they would buy the private-label mortgage-backed securities (PLMBS) that funded these mortgages. So, they really provided the market to buy these. And they loved it because they were like a hedge fund, right?”

Yet Fannie and Freddie were not enough on their own. It took robot investors — CDOs bought by institutions like LB Kiel — to inflate a bubble. In other words, CDO robots investing in subprime robots. One can track where some of the money invested by LB Kiel went. Take the NCHET 2001 deal, whose full name is New Century Home Equity Trust 2001. Of the $500 million Waas signed over to UBS in March 2002, Karl invested $13 million in a slice of NCHET. He probably bought it from Citigroup's Salomon trading desk, which in turn built the android with New Century's name on it, and filed a form with the SEC telling them that the android lived inside Salomon's Manhattan offices. The actual lending had been done the previous year, when New Century lent about $500 million to some thirty-five hundred homeowners whose credit scores didn't qualify them for prime loans. The majority were in four states — California, Florida, Texas, and Michigan — and most of these subprime borrowers were using hybrid adjustable-rate mortgages to do a “cash-out refi.” In other words, they were using their homes as an ATM.

Everyone's ideal of a traditional mortgage has cautious lenders helping cautious borrowers who end up owning a home after thirty years. In this new world of mortgages, people have little to lose and a lot to gain. About half the New Century borrowers were “stated income” or “limited documentation,” what would later be known as “liar loans,” and most were borrowing about 80 to 90 percent of their home's value. Those mortgages were financially suicidal as long-term products, affordable for just two years, after which so-called payment shock would arrive, driving the borrowers' interest rate up to as much as 15 percent. Any sane borrower would want to escape from shackles like that, either by refinancing (assuming house prices kept rising) — or by defaulting and handing back the keys.

New Century very quickly got these primed-to-explode loans off its books — after all, it was not a bank, but rather a “mortgage finance company.” Brokers handled the individual loans, and New Century gave them a cut of all the fees embedded in the mortgages they sold. Appraisers hired by New Century checked the value of homes that served as collateral. Then, in April 2001, the completed bundle of loans was handed over to Salomon Brothers. By September, NCHET was dressed up for market with its own investor prospectus, ready to start borrowing money. A company called Ocwen was appointed as “servicer” and, in return for fees, would collect money from the thirty-five hundred borrowers (and chase the deadbeats), while U.S. Bancorp was named “trustee” to look after the internal cash plumbing system on behalf of investors. The final step was to bring in Standard & Poor's and Fitch to provide ratings for the slices of debt that NCHET sold in the market. There was plenty to preoccupy the ratings agencies: they would crunch the actuarial math to show that mortgages in California, Texas, and Florida might diversify each other, as well as demonstrate how good New Century was at appraising houses and how good Ocwen was at servicing subprime borrowers. Branded with a single-A stamp, the $13 million slice of NCHET was paraded on the market and ended up in UBS's North Street 4 deal.

The long chain of specialists — mortgage brokers, New Century, Salomon Brothers, Ocwen, U.S. Bancorp, UBS, Standard & Poor's, and Fitch — that helped transfer excess capital out of Schleswig-Holstein into the California economy was, advocates claimed, the market working at its best. The expertise of all those specialists ensured that people in California could buy houses they never could have afforded in the past.

 It ensured that LB Kiel's processed dinner, although full of unfamiliar ingredients, was safe to eat.

That said, North Street 4 was not particularly nourishing for the Germans, because the risk-processing specialists had already taken much of the “nutrition” out of it. On the $500 million investment LB Kiel made, Karl and his traders would enjoy the profits of trading $3 billion worth of bonds for up to fifteen years. In return, UBS was required to pay LB Kiel just $6 million per year as a return on its investment. Put another way, LB Kiel was paying a hefty “rent” in return for its heavily processed exposure to the U.S. consumer.

A rent-seeking opportunity like that was not going to be enjoyed by UBS alone. Wall Street was already looking for ways to crank that money machine up to the limit.

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