By Bob Ivry
December 21, 2007
SourceDec. 21 (Bloomberg) -- When California homeowner Christopher Aultman stopped writing mortgage checks, Charles Prince of Citigroup Inc. paid.
Some of the $16.6 billion that Prince's New York-based bank estimates it lost on wrong-way subprime bets flowed to investors who for the first time were able to wager that U.S. mortgages would collapse. The subprime derivatives market created in 2005 by a group of Wall Street bankers made that payday possible.
The derivatives were based on subprime mortgages, given to borrowers with bad or incomplete credit. Securities firms packaged and sold that debt in structured financial products where the risk was hidden by investment-grade ratings and the values proved impossible to calculate.
``These structured products were crazy profitable for Wall Street until they blew up,'' says Randall Dodd, senior financial sector expert for the International Monetary Fund in Washington. ``Ultimately it's about excessive risk-taking and greed.''
The risks were amplified by the derivatives, contracts whose values are derived from packages of home loans and are used to hedge risk or for speculation. The vehicles allowed investors to bet against particular pools of mortgages.
The magnified losses caused by derivatives made it possible for a small number of defaulting subprime borrowers to freeze world credit markets.
Credit Squeeze
That's what happened in July after payments in the first quarter stopped on 13.8 percent of subprime mortgages representing 4.8 percent of total U.S. borrowers.
The defaults caused demand for subprime securities to dry up. Uncertainty over the value of the financial products spread to investment funds globally. Corporate lending stopped because no one knew what collateral was worth. By Aug. 10, the Federal Reserve and the European Central Bank were forced to inject a combined $275 billion into the banking system to keep money flowing.
The hedging offered by derivatives made investors feel invulnerable, says Paul Kasriel, chief economist at Northern Trust Co. in Chicago.
``Derivatives don't reduce risk, they shift risk,'' Kasriel says. ``The development of the derivatives market enabled investors to shift risk at a lower cost, and that encouraged them to take on more risk.''
Wagering Against Mortgages
From 2001 to 2006, as U.S. home prices rose 50 percent nationally, owning the debt and guessing that borrowers would keep current paid off. Since July 2006, however, when housing supply began to outstrip demand and the number of late payments started to rise, the short position, or wagering against the performance of mortgages, has prevailed.
Many of those responsible for the economic upheaval caused by subprime derivatives have also been its victims.
Mortgage salesmen peddled loans ``based on the borrowers' ability to refinance rather than the borrowers' ability to repay,'' said David Einhorn, co-founder of Greenlight Capital LLC in New York and a former director of New Century Financial Corp., the second-biggest subprime lender in 2006, at an investors conference in October. If the borrowers defaulted, the mortgage salesmen still got their commissions.
Now many of them are jobless and broke.
Sadek Closes Shop
Daniel Sadek, who says his Costa Mesa, California, subprime lender Quick Loan Funding catered to borrowers with credit scores as low as 420 out of 850, had to close shop in August when Citigroup cut the company's $400 million credit line.
``I'm surprised they went under,'' says borrower Kathy Cleeves of Tenino, Washington. ``They made a fortune off us.''
Borrowers bought houses and took out equity loans they couldn't afford. That didn't matter. As home prices kept rising they could always refinance. Now many of them face foreclosure.
Aultman, a Union Pacific Railroad mechanic with an average credit score of 465, took $21,000 in cash out of a 2005 refinance with Quick Loan Funding. The payments on his house in Victorville, California, adjusted to $2,650 this month, almost double what he was paying for the fixed-rate mortgage he had before the refinance. He was planning to refinance again before he discovered that he couldn't qualify.
Bankers bought loans to turn into securities that gave them the highest yield. If the borrowers defaulted, the bankers still got their fees. Now the losses are piling up.
Billions Lost
The biggest securities firms worldwide are collectively expected to write down about $89 billion in subprime-related losses in the second half of 2007.
Citigroup, the biggest U.S. bank, said it will write down as much as $11 billion in assets on top of $5.6 billion already announced. Citigroup was one of a ``group of five'' Wall Street firms that created the subprime derivatives market.
Morgan Stanley, the second-biggest U.S. securities firm, wrote down $9.4 billion in mortgage-related investments this week.
``Our assumptions included what at the time was deemed to be a worst-case scenario,'' Chief Financial Officer Colm Kelleher said on Dec. 19. ``History has proven that that worst- case scenario was not the worst case.''
Bear Stearns Cos. announced a $1.9 billion writedown on mortgage losses yesterday, sending the New York-based firm to its first quarterly loss since it went public in 1985.
`The Risk Remained'
Merrill Lynch & Co., the world's largest brokerage, and UBS AG, Europe's biggest bank by assets, dismissed their chief executives after they reported a combined $11.4 billion in subprime-related losses in the third quarter. Merrill may post an additional $8.6 billion in losses for the fourth quarter, David Trone, an analyst at Fox-Pitt Kelton Cochrane Caronia Waller, said yesterday.
``Derivatives led a lot of people to believe that risk was being dispersed in a way that made things safer, but the risk remained after people thought they'd moved it off their balance sheets,'' says Bose George, a mortgage industry analyst at Keefe, Bruyette & Woods Inc. in New York.
Investors didn't know what they were buying, says Sylvain Raynes, a principal in New York-based R&R Consulting Inc. and co-author of the book, ``The Analysis of Structured Securities.'' It didn't matter if a certain number of borrowers defaulted because the returns on some parts of the financial instruments were as much as 3 percentage points higher than 10- year Treasury yields.
Losses Worldwide
Now the losses are spreading. Florida schools and cities pulled almost half their deposits from a $27 billion state investment pool linked to subprime mortgages.
A hospital management company in suburban Melbourne, Australia, lost a quarter of its portfolio in July on subprime- linked investments.
Japan's 36 banks booked combined losses of 244 billion yen ($2.17 billion) in the fiscal first half on subprime-related assets, according to the Financial Services Agency.
Sumitomo Trust & Banking Co., Japan's fifth-largest bank by market value, says fiscal first-half profit fell 41 percent on higher provisions for bad loans.
Eight towns in northern Norway, including Hattfjelldal, a village where reindeer outnumber the 1,500 residents, lost a combined 350 million kroner ($64 million) on securities containing subprime mortgages.
``We are a stoic people, used to fighting against the forces of nature, so we'll manage,'' says Hattfjelldal Mayor Asgeir Almaas. ``We won't let this break us.''
`Not Bedtime Reading'
Information about investments in derivatives, such as so- called synthetic collateralized debt obligations, was voluminous and available. A lot of it was also unread.
``These documents are not bedtime reading,'' Gerald Corrigan, managing director in charge of risk management at Goldman Sachs, told a U.K. parliament committee. ``You have to work at it.''
The three biggest ratings companies -- Moody's Investors Service, Standard & Poor's and Fitch Ratings -- were forced to lower ratings on a record number of CDOs last month, according to a Morgan Stanley report, as subprime-backed securities deteriorated.
S&P says it downgraded 16 percent of subprime vehicles issued in 2005 and 29 percent of the 2006 vintage. By comparison, the company says it upgraded 0.07 percent of its 2005 securities and 0.08 percent of 2006.
Sniffing Out the Worst
Those who bet against the mortgage industry fared better.
J. Kyle Bass of Hayman Capital Partners in Dallas hired private investigators to help him sniff out the worst lenders. He says he turned a $110 million stake into about $600 million.
Deutsche Bank AG's writedowns on subprime losses were 2.16 billion euros ($3.09 billion) -- less than they would have been if not for the offsetting short trades of Greg Lippmann, the bank's global head of asset-backed securities trading.
Goldman Sachs avoided the losses other banks suffered by betting that U.S. homeowners would walk away from their debts.
John Paulson of New York-based Paulson & Co. made similar bets. One of his hedge funds returned 436 percent in the first nine months of 2007, based on data compiled by Bloomberg.
``The people who dug deep and analyzed the underlying collateral of the securities made a lot of money betting against them,'' says Girish Reddy, former co-head of equity derivatives at Goldman Sachs and managing partner of Prisma Capital Partners LP in Jersey City, New Jersey.
Savannah Loses a Bicycle
Nobody paid more dearly than Savannah Nesbit. The six-year- old and her family lost their house in Boston's Dorchester neighborhood last month after failing to pay a subprime mortgage that adjusts higher every six months.
Savannah got her first bicycle for her birthday in August, pink with streamers dangling from the handlebars. She decorated the present from her grandmother with stickers of Dora the Explorer, her favorite animated character.
When sheriff's deputies emptied the house and changed the locks, they left Savannah's bike behind.
``She cries about that bike every night, and she wants me to buy her another one, but I can't afford it right now because I have my own financial problems,'' says Savannah's grandmother, Anne Marie Wynter, whose home is also in foreclosure.
Sadek `Under Water'
Sadek's Quick Loan Funding had 700 employees at its 2005 peak. Now Sadek is making payments on three residential properties he mortgaged in a failed attempt to keep his firm afloat. He also owns a restaurant in Newport Beach, California.
``I'm under water,'' he says, puffing on a Marlboro Light. ``I'm trying to sell everything, and nothing is being sold.''
His attempts to bankroll a film career for his former fiancee, soap opera actress Nadia Bjorlin, came to naught. Last month, Bjorlin returned to her role as Chloe Lane on ``Days of Our Lives.''
Aultman, the railroad mechanic, teeters on the brink of foreclosure. He has been trying to modify his loan terms with Countrywide Financial Corp., which now owns his mortgage.
``It's scary, very scary,'' Aultman says. ``Sometimes I'll walk through the house and touch the walls and say to myself, `This is mine.'''
Moody's, S&P and Fitch continue to be arbiters of the quality of securities, though their reputations have suffered.
State, SEC Probes
The Connecticut attorney general is investigating the three companies, including whether they rank debt against issuers' wishes and then demand payment, whether they threaten to downgrade debt unless they win a contract to rate all of an issuer's securities, and the practice of offering ratings discounts in return for exclusive contracts.
The Securities and Exchange Commission and two other states, New York and Ohio, have launched separate investigations of the ratings companies. Moody's also faces a shareholder lawsuit.
Deutsche Bank recently began meetings to create a new index on another security, Alt-A mortgage bonds. It will allow hedging against defaults by Alt-A borrowers, who have prime credit and get mortgages without verifying their incomes.
Investors will also be able to wager that Alt-A homeowners will quit making payments, potentially turning losses into more and bigger paydays.
To contact the reporter on this story: Bob Ivry in New York at
bivry@bloomberg.net .
Last Updated: December 21, 2007 00:18 EST