Investment Banks Provided Subprime Lenders with Critical Funding

In return for subprime mortgages to convert to lucrative bonds, the investment banks provided lenders with essential funding streams.

Wall Street investment banks were subprime mortgage lenders’ single most important source of capital, and therefore wielded tremendous power in the subprime mortgage market. These lenders raised cash for their lending activities through frequent private-label securitizations, which are controlled by investment banks and shielded from government oversight. By buying up mortgages, the investment banks granted lenders quick access to capital for further lending activities. The investment banks, in turn, were able to produce the lucrative subprime-related bonds that generated so much revenue and bonus money over the past several years.

Mortgage securitization is the key source of capital for subprime mortgage lenders, which use the process to quickly convert mortgages into money for further lending, rather than wait for the borrower to pay out over the life of the loan.

In a typical securitization, the lender sells off mortgages – which it has either originated directly through retail channels or purchased from independent brokers – to an investment bank. The investment bank pools the loans and places them in a trust, then sells securities (bonds) that are backed by payments from the mortgages in the trust to investors. Investment banks are typically known as the underwriters for the securities offerings, because they structure the offerings and take on the risk of having to sell the securities. Investment banks – the crucial links between lenders and investors – are the most powerful players in the subprime mortgage securitization process.

The rapid rise of Subprime. Subprime mortgage securitizations went from a small segment of the mortgage market to a dominant one – around 20% of all mortgage securitizations by 2006.

An absence of government oversight adds to the investment banks’ power in the subprime mortgage securitization process. A great deal of mortgages are securitized by government related entities – Fannie Mae, Freddie Mac, and Ginnie Mae – but mortgages which do not meet the underwriting standards of these entities (non-conforming loans), such as subprime mortgages, have to go through private-label, or non-agency securitizations, in which the issuer of the securities is a private entity.^[2] In private-label securitizations, the endorsement of a government-backed entity like Fannie Mae and the sense of safety this provides investors is replaced by the endorsement of a prestigious investment bank such as Goldman Sachs or Morgan Stanley.^[3]

Stunning growth in private-label securitization (this is not just a subprime problem). Private-label securitizations put many risky products into the mortgage markets: subprime, Alt-A (for borrowers with FICO more than 620 but less than prime), and jumbo (loans larger than $417,000). These loans typically don’t meet agency standards, but investment banks were more than willing to underwrite offerings of them over the past six years.

B. SUBPRIME LENDERS DEPEND HEAVILY ON STRONG RELATIONSHIPS WITH INVESTMENT BANKS

Because investment banks run the securitization process, subprime lenders must develop strong relationships with them in order to access capital.^[5] Rather than merely carry one of these companies through an offering of securities, investment banks are constantly providing capital to subprime lenders with whom they do business.

The typical subprime mortgage originator has strong ties to several investment banks, and typically notes these relationships in annual reports and SEC filings (if publicly traded) as a sign of their strength as a company. For instance, in its 2006 annual report, New Century Financial, a subprime lender, listed “Long-Standing Institutional Relationships,” as a competitive advantage:

Of course, as will be illustrated in part E of this section, these buyers can pull the plug at a moment’s notice, and when they do, the subprime lenders collapse very quickly. This was the case for New Century, which imploded in March 2007 when loan buyers wanted out.

Subprime lenders typically enter into arrangements with investment banks that provide them with financing. These can take a number of forms, but the most common are purchase agreements and warehouse lines of credit.^[7]

These funding cycles encourage lenders to make as many loans as possible, with very little regard to quality. Lenders are also very dependent on these agreements and facilities, which they usually enter into with a handful of investment banks. Without this financing from investment banks, the lenders often cannot sustain their operations. This dependence is frequently acknowledged in SEC filings.^[9]

D. INVESTMENT BANKS PURCHASED SUBPRIME LENDERS IN ORDER TO KEEP THE BOND MATERIAL COMING

As the subprime market took off over the last six years, major investment banks rushed to acquire subprime mortgage lenders in order to bring the lending operations in-house. The industry publication Mortgage Banking explored this phenomenon in depth in an article called “The Vertical Integration Strategy,” and attributed the rise in subprime lender acquisitions to a hunger for bond-related revenues.

Lehman Brothers and Bear Stearns were market leaders in this respect, though other major investment banks also acquired subprime lenders in recent years: Morgan Stanley (Saxon Capital); Merrill Lynch (First Franklin); and Goldman Sachs (Southern Pacific).

Subprime mortgage lenders typically depend on investment banks to keep funding them, rather than holding assets that they can easily convert to cash through trades (liquid assets). As a result, they have no capital on hand to see them through rocky periods – they only have a massive investment bank standing behind them and feeding them money.

Two mechanisms allow investment banks to withdraw support from the lenders very quickly, and offer evidence of just how much power the banks wield over lenders:

Once these subprime lenders stop making money, investment banks typically use these mechanisms to pull the plug on the lender, and this frequently causes lenders to collapse.

This scenario played out with two subprime lenders who went bankrupt in late 2006, and was well illustrated in a Mortgage Line article titled “The B&C Meltdown: It’s All About Capital”:

Ten investment banks served as underwriters for 70% of the $486 billion in subprime mortgage securitizations in 2006. Because they control such large shares of the market, individual investment banks have extraordinary clout with the various players in the market – the lenders who originate the mortgages, the servicers who collect payments from the securitized mortgages, and the ratings agencies who assign ratings to the mortgage-backed securities. The ramifications of this will be explored in upcoming sections.

No major investment bank skipped the subprime securitization binge. These ten controlled 70% of the market in 2006 – a strong indicator of where power was concentrated. (Countrywide is a special case in that it has its own securities arm that acts as underwriter for many of its deals)

The worst of this happened under Bush’s watch and had little to do with fannie/freddie.

I don't really have any reason to defend GWB, but in his defense, the wheels were set in motion before he came to office. I read one article that credited Billy Jeff with getting some last minute regs in place at the end of '99, the timing of which could and should be questioned. Once the Rats set something in place, there is hell to pay when Pubbies attempt to right the indiscretions. The Dims and their media megaphone incessantly blast Pubbies for jerking food right out of the mouths of "the children" and taking a dump on other of their protected class of cultivated victims.

Not that GWB was blameless. He could have committed political suicide by rolling back affirmative action home ownership. Question is, was he even interested.

Anyway, more to your point, a money quote from a 2002 article: GOING SUBPRIME:

Interestingly, subprime market growth in the 1990s occurred largely without the participation of Fannie Mae and Freddie Mac. The GSEs started showing interest in this market toward the end of the decade and now purchase A-minus mortgages as a regular part of their business. National Mortgage News, a trade publication, estimates their combined market share in 2001 grew by 74 percent, representing about 11.5 percent of all subprime loan originations in that year. Some market analysts estimate that GSEs will soon be purchasing as much as one-half of all subprime originations.

Apparently much of the subprime business, at least in the early to mid 90's was investment bank generated. Fannie and Freddie didn't really start ginning up until after Billy Jeff's '99 "stroke of the pen". And that's the way it is on this the 3rd day of October, 2008.

You've probably seen these...

Most of it. Was the Boston Fed's "guidance" created in late 90's. They never seem to put any dates on these things, or not that I could find anyway. Note the pie chart in THE FOLLOWING:

Anatomy of the Crisis

The first visible indications of crisis came in early 2007. Subprime home mortgages that had been originated in the previous year were observed to be defaulting at rates far higher than expected, which called into question the value of securities collateralized by these loans. Some of those securities were, in turn, held by money market and cash management pools. Others became embedded in more exotic investment structures used by hedge funds and sophisticated institutions. As the condition of the subprime loans deteriorated, so did the securities that were backed by them, as well as the condition of investment vehicles that held these securities. The ripples spread quickly, and they often appeared to grow in magnitude as they developed. To understand how, it's helpful to review the how the system evolved.
Mortgage Market Share of the 67-Trillion-Dollar Global Debt Securities Market (as of year-end 2006)

Subprime loans make up a relatively small piece of total mortgage loans, and thus an even smaller fraction of total debt securities. But due to the manner in which subprime loans have been marketed to investors, they have become the tail that wagged the global fixed-income dog.
To see how, consider the detailed mechanics of the subprime loan system that had evolved by early last year. After a subprime loan was originated and closed, it was bundled with others of similar structure into a mortgage pool. The cash flows from that mortgage pool were then stratified according to their degree of risk, and each division was assigned to a different collateralized debt obligation, or CDO. Each CDO was then rated according to a series of assumptions about borrower performance.
Subprime payment histories over the previous decade suggested that borrowers generally kept their loans current for one year or more after origination, so payments made early in the life of even subprime loans were considered relatively risk free. It was also generally believed that the underlying real estate value would cover the principal obligation of a loan even if the loan were to be foreclosed. As a result of these assumptions, CDOs representing the earliest payments were generally given top investment grades by rating agencies (Typically AAA or Aaa, depending on the agency). With such grades, these short-term securities were eligible for use in money market funds, municipal government cash management pools, and a wide range of structured investment vehicles.
Loss histories for subprime mortgages in their first year after issuance formed a predictable pattern between 2000 and 2005, but the loss history for subprime loans issued in 2006 broke the mold during the first eight months of 2007. See below.

Unfortunately, the performance assumptions underlying the AAA/Aaa ratings began to break down in 2007. For one thing, anecdotal evidence suggests that loan underwriting standards appear to have changed; weaker borrowers may have entered the subprime pool in growing numbers, often through so-called NINJA (No Income, No Job or Assets) loans.
General subprime loan performance weakness was amplified by the first widespread real estate price declines since the Great Depression. The declines left many troubled property loans without enough collateral coverage to assure loan repayment in liquidation. The result was an unprecedented rise in losses on top-rated CDOs.
The first-order effect of this rise in subprime defaults was a heightened perception of risk in the mortgage market, which depressed values of many mortgage-related securities and reduced investor demand. This, in turn, created a series of second-order effects as funds (and institutions) which held CDOs began to report losses triggered by those declines. Many investors were surprised by the extent to which write-downs occurred in areas with no direct ties to the mortgage industry. This, in turn, made many investors reluctant to participate in any fixed-income market segment, freezing credit across a wide swath of the U.S. economy.
It is now possible to question whether bond markets might have overreacted and depressed some valuations much farther than might be justified by fundamentals. As a result, there are a wide range of opportunities for experienced bond managers to position their portfolios to benefit from a reasonably anticipated return to normality. It is also possible to profit from well-placed positions whose performance is contingent on continued market abnormality. What is more, a broad unwinding of financial structures should result in significant deleveraging across many sectors, a secular change that could create its own family of strategic investment opportunities.
The collapse of the subprime market has brought the bond market to a turning point, one that fundamentally shifts the nature of investment opportunity.
"We are in the midst of a global reckoning in the fixed-income market,'" said Steve Van Order, Calvert's fixed income strategist. "After five years of leverage, lax lending, and speculative frenzy in the U.S. housing market, we are entering what I call 'The Great Unwind' - a broad-based move in the credit market to revalue investments, write down overvalued securities, repent for past excesses, and repair the damage to portfolios."

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