Sense on Cents

Nora,

I always appreciate your messages. Back in November 2008 prior to my launching Sense on Cents in January 2009, I wrote a lengthy blog post about the Wall Street securitization business, that is the Wall Street model, at No Quarter.

The post entitled, The Wall Street Model Is Broken….and Won’t Soon Be Fixed!! explains the origination, bundling, securitization, distribution, and growth of Wall Street’s enterprise initiating in residential mortgages and then branching out into a wide array of other types of loans.

I wrote,

Posted by Larry Doyle on November 12, 2008 12:15 PM

Despite billions and now trillions of dollars in capital injections and equity investments made by our government, private equity, and sovereign wealth funds, our economic turmoil is a long way from being over. I do find it interesting that despite numerous Wall Street titans having indicated to us at different points over the last year that we were in the 7th inning of this fiasco, now a recurring theme is that we should not expect any real economic recovery until 2010. Actually, maybe we were in the 7th inning but it was the 7th inning of the first game of a 4 game series.

Well, if we want to figure out where and when we are moving forward, I think it would be beneficial to know from where and when we came.

For those over 50 years of age, perhaps you remember when mortgage money dried up. Perhaps you also recall the days of putting down 20% before you even thought of buying a home. In any event, the growth of the secondary mortgage market in the mid 1980s was a result of some very sharp financial minds on Wall St. who engineered a product called a Collateralized Mortgage Obligation (CMO).

CMOS, and their cousins that grew from that model, were and are not necessarily bad structures. However, much like prescription drugs, if and when they are abused, they can be deadly.

CMOs used the stream of cash flows from a standard fixed rate mortgage to create specific bonds which met the investment desires of a wide array of investors, including money market funds, bank portfolios, insurance companies, money managers, and pension funds. Prior to the development of the CMO, mortgages were an investment that typically only met the needs of bank portfolios.

As the CMO market grew, two developments occurred. First and foremost, Wall St. firms (which were making on average 1 point on each deal . . . on an average deal size of 300 million, the Wall St. underwriter made $3 million dollars . . . not too shabby) had an appetite for more and more mortgage collateral to do more and more deals.

In the mid-1980s, most CMO deals were done with private homebuilders such as Pulte Homes, Centex, Ryland et al. The second development was more substantial. If Wall St. could use mortgage collateral to execute CMOs, why couldn’t they use other forms of loans/assets to create similar sorts of structured products? Thus, in the late 1980s, the Asset Backed Securities market was launched using credit card loans, auto loans, computer leases, equipment leases, and the like. Again, all Wall St. was doing was using the stream of cash flows from these well underwritten loans to create securities that met the guidelines and needs of a wide array of investors. Prior to the developments of these markets, the banks underwrote these loans at rates and terms that met their own portfolio needs (REMEMBER THIS POINT!!).

In the late ’80s, Freddie Mac and Fannie Mae got a whiff of the profitability of these CMO deals and used their significant lobbying power to get legislation passed that made it advantageous from a tax standpoint for CMOs to be launched through them. While some Wall St. firms were reluctant to support Freddie and Fannie in this process, given F/F ‘s position in the business they won out. (REMEMBER THIS POINT!!)

As the CMO and ABS engines grew ever stronger throughout the early to mid 90s, Wall St. needed to find more and more collateral to continue to feed this profit monster. Some Wall St. firms either purchased or made strategic alliances with originators (Lehman Bros bought Aurora Mortgage in Aurora, Colorado . . . Bear Stearns owned EMC Mortgage in Texas . . . Merrill Lynch purchased First Franklin, a sub-prime originator, from National City Bank), while other originators formed their own broker dealers to retain the profits of distributing these products (Countrywide Mortgage formed Countrywide Securities, JPM Chase grew its own investment banking presence in the late ’90s, as did Bank of America).

In the midst of this growth, Wall St. continued to use this CMO model not only across other consumer asset classes but then branched out and used it with corporate loans as well. Thus Wall St. structured CLOs (collateralized loan obligations) using the same financial engineering.

While there were hiccups with different deals, for the most part the machine ran smoothly. The machine, though, was built on the premise of strict underwriting of the underlying loans and a robust ratings process.

At the turn of the century, however, there were two critically important developments that occurred to truly escalate the disastrous situation we have currently. A number of individuals from Wall St. realized that they could form their own firms (hedge funds) which allowed them a greater share of the profits from this structured financial engineering with less internal or external oversight. (REMEMBER THIS POINT!!)

A large number of qualified analysts from the rating agencies left those firms to come to Wall St. to participate in the profit machine. This shift of talent both to hedge funds and from ratings agencies dramatically exacerbated and accelerated the financial meltdown of the last two years. (***Given the amount of money in these hedge funds, as well as the amount “earned” by the hedge fund managers, it should be no surprise that they became very influential in currying political favor . . . especially with Barack this go round!!)

At the turn of the century, the Wall Street model was a pure “originate to distribute” model with little to no residual risk on behalf of the originators or underwriters. When there is no residual risk, those who “WIN” are the players that can purely process the most volume. Well, how does one get volume? Lower the credit standards, put fewer restrictions on borrowers, little to no covenants (NINA Loans: no income, no asset check). WOW!!! What were we thinking?? Well, Wall St. felt, “let’s worry about it tomorrow or maybe not at all because we are making too much money today.”

I hope this makes some semblance of ‘sense‘.

Nora, in my opinion, the model was a great one. It worked. For a number of years consumers did truly benefit. However, Wall Street abused the model and the regulators and pols were not smart enough nor seemingly interested enough in slowing the abuse …so the rest is history, including this story about college girls now prostituting themselves.

Sad, very sad.