Monday, May 05, 2008

 

When the Music Stops


The FBI and the IRS and the Justice Department are intensifying criminal investigations of the mortgage industry. They think that some lenders may have winked when borrowers inflated their income to qualify for loans. It is not clear why they think there were any qualifications to inflate to. It is clear that they just don’t understand the system.

Banks and brokers do not make loans, they make money by setting up loans which are immediately sold to investment banks on an “as is” basis. Why would you expect a bank get fussy about risk if they are not planning to take any? The big investment banks like Bear Sterns make money by securitizing the loans by pooling them and issuing shares in the pool. Why would you expect them to worry about the details of the loans in the pool if the securities will all be rated by the rating agencies? It is all in the prospectus. The rating agencies make money by attaching a rating, AAA, to the securities, called CDOs. The rating agencies of course rely on the fact that the risk, if any, is spread over the thousands of loans in the pool. They are not expected to look at all the thousands of loan files.

Actually the ratings are not all AAA, since there are traunches. This means that the interests in the pool divided up among different seniorities of CDOs. The senior traunch gets paid first and is the AAA part. The lower traunches take later and may be lower ratings. The lowest traunch is the equity traunch, which gets the highest rate of interest if there is any left after the senior traunches get theirs. The lower traunches know all along that they have more risk than the senior, or else why would they be paid more if there is any?

Naturally, all the players know that if the system comes to a sudden stop, before you can unload the mortgages on the next tier, you can get stuck with a little risk. But, as Chuck Prince, the former CEO of Citigroup, said, “As long as the music is playing, you’ve got to get up and dance.”

Now where is the crime in all that?

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