Commentary on Mortgage Back Securities

Thursday the NY Times had an article asking if the Rating Agencies (Moody and S&P) were duped by big banks on the mortgage backed securities (MBS) that helped spur the mortgage crisis. Congress and the Security and Exchange Commission are now reviewing these banks to see if charges should be filed. I’ll ruin this story quickly for you: SEC will file charges, Congress will grandstand, banks will deny and then settle for multiple millions maybe billions, investors in securities will get pennies on the dollar, Congress will pass a meaningless law and set more regulations, banks will lobby, bank’s Political Action Committees will donate millions to Congress, and finally we set the stage for the next crisis.

Doesn’t that make you feel a lot better? I hope your answer is no. The problem with this whole crisis is that we are dealing with two dangerous issues: greed and stupidity. One can cause an issue; both of them can cause a world crisis. Greed was not only on Wall Street, but it was also on Main Street. Main Street was trying to keep up with the Jones, while Wall Street was trying to keep up with the Jones richer cousin, the Howell’s. What people fell to realize is the greed on both streets help to feed the greed on the other street.

If Main Street needed a two day fixed period adjustable rate mortgage (I know these don’t exist), Wall Street created a security to sell to investors to fund this mortgage. There is some poor person out there who bought a house they knew they could never afford on one day and on the next bought a MBS in their IRA which contained the mortgage that they couldn’t pay. That story ends painfully.

On Wall Street and at the big banks, there are a plethora of highly sophisticated, intelligent people who are just plain stupid. How else do you explain all the derivative products and sophisticated financial models they create that assume “this and that” with the most important “this and that” being a rational market. The problem is markets are not rational nor are they efficient. They are bi-polar. So when the markets go wildly irrational the models or products they created do not calm the market down, they actually compound the problem.

Did the banks dupe the rating agencies? No, they found a willing sucker to go along with the heist. It was the rating agencies responsibility to understand the securities and their risk. To be objective as opposed to an accomplice. I just finished the book, The Big Short by Michael Lewis and let me use some of his explanations. MBS are broken into tranches from safest to riskiest (higher likelihood of having investment paid back to greater chance of default). The rating agencies then place ratings on each tranche with tranches with earlier paybacks given the higher ratings. Ratings may be AAA, AA, A, BBB, BB, B, etc. Triple BBB and higher is considered investment grade. Lower than BBB falls in to the term of junk. It was pretty non-existent for any MBS to be rated less than BBB. So you can reason, the BBB bonds were the least likely to get paid back and had borrowers with lower credit ratings. What would generally happen is that these banks would end up with the BBBs on their books because no investor wanted to take the risk.

The solution: BBBs in New York could not go bad at the same time as BBBs in California, Arizona, Georgia, Florida, and Nevada. The banks took the BBB tranches from different areas and packaged them together in the name of diversification. In genius like fashion BBBs added with more triple BBBs naturally equal AAAs. (Remember diversification.) Paraphrasing Lewis, if you have a pile of dog crap and mix it with two more piles of dog crap, you get roses? No, you have a significant pile of dog crap.

Here’s the long term problem: Congress will now intervene for the sake of the poor and misfortunate. So the way to solve greed and stupidity is by assigning the task to the individuals who help stimulate this mess. Remember Congress is the one thanks to the influence of Wall Street and big Bank donations, who decreased regulations while at the same time pushing for lower lending standards. If you do a simple Google search of “Wall Street Donations,” you will find numerous articles where the key people arguing for financial reform are beneficiaries of Wall Street.

If you do not think Congress is greedy, read this article. Members of Congress are allowed to insider trade. So when you see any of these individuals brow beat a CEO in front of the public, they may have just shorted his stock or invested in a competitor or a replacing technology. These individuals are supposed to have blind trusts, however if they will not ban insider trading by members, you have to question how blind are these trusts.

Many banks will get charged with fraud, however everyone will settle with the SEC for major bucks. The reason they will settle is part of the game. If you are convicted of fraud, you lose your license to conduct business. Congress will push hard enough to make the headlines look good and punishing, however at the same time take campaign contributions for future help.

I worked for a big firm for 4 ½ years. I can tell you these companies have highly intelligent people who are specialist at creating products to solve last year’s problems and gaming whatever system they are given.