A Little, Accurate, History

avarice |ˈavəris|
noun
extreme greed for wealth or material gain.

Harry's definition; an uncontrollable urge to look the other way when, in the face of making huge amounts of easy money, otherwise astute managers allow their staff to do deals they do not understand - even remotely.

To really grasp what went wrong, one must go back to the immediate post ENRON period. The Financial Accounting Standards Board, FASB and the Securities Exchange Commission, that oversees it, were charged with coming up with new accounting guidelines that would dictate that ALL financial companies keep ALL of their assets on balance sheet. The new rules would eliminate the off balance sheet treatment used by ENRON (and most major banks) for "subsidiaries" referred to as Special Purpose Entities or Corporations (SPE's or SPC's). The abuses employed by the companies that used this off-balance sheet treatment was rotten to the core and really misstated their financial positions.

FASB actually came up with a decent set of new guidelines. The process took about two years to complete. When it was all over though, the new guidelines were completely gutted and loopholes inserted where there had originally been pretty tight reporting requirements, e.g., any parent company was to be required to consolidate all of its subsidiaries regardless of their SPE status. At the time, the new FASB requirements were aimed, primarily, at asset-backed commercial paper issuers. Most of these companies were were owned by large commercial banks. All of them were, effectively, guaranteed by those banks through the issuance of stand-by letters of credit. The regulators looked the other way though, in the face of a very effective lobbing effort by the ABA and the new regs. were gutted and the banks continued to use off-balance sheet entities as a way to generate new business with corporate borrowers.

Fast forward to the rise of sub-prime mortgage lending. As is the case with any non-agency MBS, there needs to be an issuer. The issuer needs to some kind of a corporate entity, usually and SPE and the SPE is usually owned by a shell company. The difference between mortgage finance and other types of ABS though, is that an MBS issue really needs to have actual equity. Some times, dependent upon the prospect for defaults, slow payments, fraud or etc., the equity classes of securities within a deal may be as high as 10 or 15%.

This might be a good time for a primer on the way ABS work. All deals are based upon cash flow. Cash flow is based upon a regression analysis of the way that a particular asset class has worked in the past. Credit cards and auto loans are considered to be the easiest to model and mortgages the most difficult on accounta the correlation between interest rates and mortgage re-finance or prepayments. Defaults, unlike other asset classes, were never a real issue in MBS until the introduction of sub-prime loans. So, cash flows were modeled and a couple of standard deviations were built into the rating process to protect buyers and hundreds of billions of deals were sold. Except for those times when there were were spikes in interest rates, resulting in extreme extension or shrinking of the lives of MBS assets, the market worked pretty well. This is owing to the fact that mortgages were really good loans. Fanny and Freddie were tough lenders that used well thought out underwriting standards and their guarantees were never tested because the default rate on conventional fixed-rate conforming loans stayed at less than 1/2 of 1% for decades. There were hiccups related to qualifying ARM's at teaser rates, but nothing like the current fiasco.

Back to the present: we were discussing the equity classes of MBS deals. This has always been where the risk has been buried in MBS finance. For the most part, if a lender understood the elements of prepayments, it could estimate risk within 100 basis points or so. Relating to sub-prime though, traditional cash flow analysis went out the window. It was replaced by analysis that was based on LTV as opposed to the strict underwriting qualification of borrowers. This meant, that if the shit hit the fan,
lenders had to rely on the liquidation of the underlying value of the mortgaged properties instead of the excess cash flow that was typically built into MBS deals. Now, LTV has always been important and it was in sub-prime as well. Except, the buyers of the equity class in sub-prime placed their bet on the continuation of a rising real estate market, not sound lending. As we now know, the deals had no excess cash flow. They had a bunch of defaulted loans and the underlying property has yet to be liquidated.

This gets me to the point that I have been trying to make in previous posts, e.g., there must have been a ton of money in these deals because there is no way on Earth that the Street would have bellied up to the bar to buy this crap unless there was. Now, we come around to off-balance sheet financing. I really don't know for sure because I wasn't there. However, there is a pretty good bet, that the entities that held the paper and for which the Street was the only source of financing were not reported until it was too late. In the case of Bear, they were "funds" and Bear was the sole agent responsible for doing the repurchasing agreements that kept them afloat. Bear was also the guarantor - just like the ABCP programs that were so effectively used by the commercial banks. So, one must ask ones self, if the FASB and the SEC had not caved when trying to eliminate off-balance sheet financing, would we be in this pickle now?