The meteoric rise of subprime

From the Wall Street Journal:

How Wall Street Stoked The Mortgage Meltdown
Lehman and Others Transformed the Market For Riskiest Borrowers
June 27, 2007; Page A1

Twelve years ago, Lehman Brothers Holdings Inc. sent a vice president to California to check out First Alliance Mortgage Co. Lehman was thinking about tapping into First Alliance’s lucrative business of making “subprime” home loans to consumers with sketchy credit.

The vice president, Eric Hibbert, wrote a memo describing First Alliance as a financial “sweat shop” specializing in “high pressure sales for people who are in a weak state.” At First Alliance, he said, employees leave their “ethics at the door.”

The big Wall Street investment bank decided First Alliance wasn’t breaking any laws. Lehman went on to lend the mortgage company roughly $500 million and helped sell more than $700 million in bonds backed by First Alliance customers’ loans. But First Alliance later collapsed. Lehman landed in court, where a federal jury found the firm helped First Alliance defraud customers.

Today, Lehman is a prime example of how Wall Street’s money and expertise have helped transform subprime lending into a major force in the U.S. financial markets. Lehman says it is proud of its role in helping provide credit to consumers who might otherwise have been unable to buy a home, and proud of the controls it has brought to a sometimes-unruly business.

Now, however, that business is in deep trouble, and some consumer advocates and policy makers are pointing the finger at Wall Street. Roughly 13% of subprime loans stand in or near foreclosure, bringing turmoil and sometimes eviction to tens of thousands of homeowners. Dozens of lenders have gone out of business. Bear Stearns Cos. is trying to bail out a hedge fund it manages that was hurt by subprime mortgage losses.

Critics say Wall Street firms helped create the mess by throwing so much money at the market that lenders had a growing incentive to push through shaky loans and mislead borrowers.

At a hearing in April, Sen. Robert Menendez (D., N.J.), said Wall Street firms “looked the other way” as they profited from questionable loans, “fueling a market that has very little discipline over itself.”

Federal Reserve chief Ben Bernanke said in a May speech that some lenders focused more on feeding the marketplace than on the quality of loans, in part because most of the risks that loans would go bad were passed to investors. As a result, “mortgage applications with little documentation were vulnerable to misrepresentation or overestimation of repayment capacity by both lenders and borrowers,” he said.

At the sector’s peak in 2005, with the housing market booming, loan defaults remained low. Wall Street pooled a record $508 billion in subprime mortgages in bonds, up from $56 billion in 2000, according to trade publication Inside Mortgage Finance. The figure slid to $483 billion last year as the housing market slumped and subprime defaults picked up.

Lehman’s deep involvement in the business has also made the firm a target of criticism. In more than 15 lawsuits and in interviews, borrowers and former employees have claimed that the investment bank’s in-house lending outlets used improper tactics during the recent mortgage boom to put borrowers into loans they couldn’t afford.

Twenty-five former employees said in interviews that front-line workers and managers exaggerated borrowers’ creditworthiness by falsifying tax forms, pay stubs and other information, or by ignoring inaccurate data submitted by independent mortgage brokers. In some instances, several ex-employees said, brokers or in-house employees altered documents with the help of scissors, tape and Wite-Out.

“Anything to make the deal work,” says Coleen Columbo, a former mortgage underwriter in California for Lehman’s BNC unit. She and five other ex-employees are pursuing a lawsuit in state court in Sacramento that claims BNC’s management retaliated against workers who complained about fraud.

Lehman officials say there’s no evidence to support such claims. They say the firm has tough antifraud controls and goes to great lengths to ensure that it works with mortgage brokers and lenders who meet high standards and that loans are based on accurate information.

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19 Responses to The meteoric rise of subprime

  1. James Bednar says:

    From Bloomberg:

    Capital One Cutting 2,000 Jobs Amid Loan Losses

    Capital One Financial Corp., the largest independent U.S. credit card issuer, is cutting 2,000 jobs, or about 6 percent of its workforce, amid mounting loan losses and a slowdown in the mortgage industry.

    Capital One faced pressure to cut costs as new foreclosures set a record in the first quarter after it acquired GreenPoint Mortgage Funding Inc. through its $13.6 billion purchase of North Fork Bank in December. The company fell short of analysts’ earnings estimates in April, posting a 24 percent decline in first-quarter profit to $675.1 million as customers missed debt payments and its mortgage business had a loss.

  2. James Bednar says:


    Kushner sells much of NJ property in $2B deal

    Controversial developer Charles Kushner pulled off one of the largest real estate deals in New Jersey history today, selling his company’s portfolio of nearly 17,500 apartments to an investment firm for roughly $2 billion.

    The sale – announced by the Kushner and buyers AIG Global Real Estate and Morgan Properties – comes eight months after Kushner bought 666 Fifth Ave. in midtown Manhattan for a record $1.8 billion, and is part of Kushner’s plan to transform his company into a New York-based entity focused on premium properties.

    Kushner, once considered the ultimate deal-junkie, is now staking his family’s fortune on a few choice acquisitions.

    While Kushner Cos. still owns some 800,000 square feet of commercial property, including warehouses, offices buildings and the Westminster Hotel in Short Hills, even those properties may soon change hands.

    “We’re contemplating it,” Jared Kushner said of a potential sale of the company’s remaining New Jersey holdings. “We are re-evaluating all of our assets.”

  3. James Bednar says:

    From Reuters:

    Beazer Homes USA fires chief accounting officer

    Beazer Homes USA Inc. said on Wednesday it fired its chief accounting officer Michael Rand due to violations of the company’s ethics policy stemming from attempts to destroy documents.

    In a regulatory filing, the sixth largest U.S. home builder said its board’s audit committee was conducting an internal investigation of the company’s mortgage origination business and related matters.

    On May 3, Beazer said the U.S. Securities and Exchange Commission was conducting an informal inquiry to determine if the company or its employees had violated securities laws.

    Beazer is the subject of several lawsuits as well as a U.S. Attorney’s investigation into practices related to its mortgage-origination business.

  4. James Bednar says:

    From Reuters:

    Moody’s sees downgrades of subprime CDOs rising

    Moody’s Investors Service on Wednesday said it expects to downgrade more subprime-related collateralized debt obligations this year and next than it did in 2006.

    “Given what’s been said about this market, (and) as we see expectations of cumulative losses increasing, yes, I do expect to see downgrades,” Yuri Yoshizawa, group managing director at Moody’s, told Reuters.

    The credit-ratings firm is likely to downgrade more subprime CDOs than it did last year, added Moody’s managing director Jonathan Polansky.

  5. lisoosh says:

    Just talked to a neighbour about mortgages, mortgage fraud, subprime and the housing bubble. She is in general a very well informed, political person (though not involved in finance obviously) and she had no idea about any of it. Primarily because she is not house hunting or particularly focused on the housing market.

    I don’t think psychology has really shifted yet among the general public. The news is only just beginning to filter out.

  6. James Bednar says:

    One heck of a storm moving across North Jersey.


  7. dreamtheaterr says:

    Imagine when psychology actually turns for the worse? A lot of sellers are still in the denial phase. When more buyers realize the RE market has turned, demand will dry up further as buyers ‘waits it out’. That’s when some reality will sink into sellers asking prices.

    Fool me once, shame on you. Fool me (twice), you can’t get fooled again.

  8. pretorius says:

    New Jersey’s long term economic future is bleak relative to that of New York City, and the most convincing evidence is being overlooked by everyone. Three local real estate sharpshooters are reducing their New Jersey presence to focus on New York City, illuminating that the smart money is quitting Jerz to focus on New York, but nobody seems to be noticing.


    SJP Properties, who have an office portfolio that is 95% New Jersey and 0% New York, spends $300 million to buy land next to Port Authority Bus Terminal to build a $1 billion office tower.

    Mack Cali, after years of stating that their focus was New Jersey and they didn’t have any interest in Manhattan, capitulates and announces a 9 figure deal in downtown Manhattan.

    Kushner buys New York City office building for $1.8 billion then sells a similar amount of New Jersey apartments.

    Implications for New Jersey residential real estate:

    Demand in Hudson County will be on fire, although price appreciation pressured by surging supply, while the rest of the state will remain sluggish even though not much is being built.

  9. BC Bob says:


    ……..and your analysis of Sam Zell? Not smart money?

    1095 Ave of Americas
    717 Fifth Ave

  10. sas says:

    “One heck of a storm moving across North Jersey”

    you talking weather or RE markets?

    I think NJ is set up for a perfect financial storm.

    debt, pension debt, RE, property taxes, state tax. yikes!!


  11. James Bednar says:

    Then Barrack launches into a parable. “I feel totally safe playing polo on a field full of pros,” says the bronzed 58-year-old. “But when amateurs are all over the field, someone can get killed. They have more guts than brains. They charge after every ball and don’t know when to hold back.” It’s the same with the U.S. real estate market right now: “There’s too much money chasing too few good deals, with too much debt and too few brains.” The amateurs are going to get trampled, he explains, taking seasoned horsemen, who should get off the turf, down with them. Says Barrack: “That’s why I’m getting out.”

  12. chicagofinance says:

    I’ve compromised about 4 or 5 promising clients leads in the last 3 months, because the individuals were dead set on maintaining or building an overexposure to NJ residential real estate. People still believe in the opportunity, and they think I’m nuts for telling them to ramp down, not up.

    The upshot? Most will take some losses. At best one will call me up in about 2-3 years and proceed to become one of the best clients in my practice.

  13. James Bednar says:

    From Reuters:

    TCW’s Gundlach sees subprime problem worsening

    The subprime mortgage problem will worsen over the next year and the rate of loan delinquencies could rise further, an influential fund manager specializing in mortgage backed securities said on Wednesday.

    Jeffrey Gundlach, chief investment officer at the Trust Company of the West (TCW) who oversees about $60 billion in assets, also said the worsening subprime woes would slow the economy down and lead to a cut in interest rates.

    “The subprime area is a total unmitigaged disaster and it’s going to get worse,” Gundlach told Morningstar’s annual investment conference in Chicago.

    Gundlach, picked by research firm Morningstar as the best fixed income manager for 2006, said delinquencies in loans made to risky borrowers could rise as housing prices in the United States are declining, supply is growing and credit to subprime borrowers has been tightened, making refinancing difficult.

  14. pretorius says:

    Sam Zell has done great. I will never criticize a real estate entrepremeur who started with nothing and became a billionaire. In addition, he is the father of the modern REIT market, which has allowed small investors to participate in real estate investments formerly available only to institutions.

    Still, Zell’s crown jewel, Equity Office Properties, was recently sold to Blackstone who flipped a large proportion of it at substantial premiums shortly after EOP sold out.

  15. rhymingrealtor says:

    One heck of a storm moving across North Jersey

    Just got in- drove home in the start of it on 78 east, glad I’m home


  16. chicagofinance says:

    doh! as it were

    Credit Crunch Time
    June 28, 2007; Page A12
    The hedge-fund meltdown at Bear Stearns was a trifecta of modern financial bugaboos, combining subprime mortgages gone bad, hedge funds taking on water, and opaque derivatives. It has already led to questions about whether all of these need better (read: more) regulation. What they really need is what they’re so far getting, which is an Adam Smith cleansing.

    Financial bets gone wrong are not a crime. In fact, they are essential. Financial innovation has been a great boon to the American economy, but innovation entails risk, and risk means the potential for failure. The key point is that, when financial players step out too far on the risk curve in order to earn larger rewards, they are then allowed to suffer the requisite market penalties for reckless driving.

    Take the case of the Bear Stearns hedge funds, which focused on subprime debt securities. The fund manager, Ralph Cioffi, was a hero to his boss and his investors as he developed new mortgage instruments that returned 20% a year while the fun lasted. But he got in over his head because he had taken on hedges that didn’t hedge his exposure to the subprime market in the way that he imagined. The losses led to margin calls from creditors, and eventually to Bear’s offer of a $3.2 billion lifeline to one of the two ailing hedge funds.

    You’d think a hedge fund would know how to hedge. But many of today’s debt instruments and derivatives are new enough that they haven’t been tested in a downturn. The index against which the Bear Stearns funds were trying to hedge has only been in existence for 18 months, so no one knew how it would behave when the subprime market swooned. That turned out to be bad for Mr. Cioffi, and it’s probably worse if you’re one of his investors, but it’s a long way from market failure.

    We may not have heard the worst in the subprime space, and almost certainly not in high-yield credit markets either (see above). As failures unfold, we’re willing to bet that some investment banks will be found to have overcharged for innovative products of limited value, even if they seemed like a good idea at the time. People will have invested their money in places they shouldn’t have and “lost everything.” Shakeouts are never pretty, but they’re necessary because mistakes do get made in a free-market financial system, and if the mistakes are not paid for by those who made them, the whole system suffers.

    This is not to say that there are never any genuine victims. We’ll posit that somewhere out there someone sold someone else a subprime home mortgage for the sole purpose of collecting the origination fees on the loan, knowing full well that the borrower couldn’t afford the payments. And maybe some boiler-room operations forged income documents to push through loans that should never have been made. But last we checked, fraud is still a crime. The myriad investigations, lawsuits and regulatory inquiries currently swirling around the subprime-mortgage industry hardly show that we need stricter laws.

    It may be that underwriting standards on adjustable-rate mortgages need another look, but a lot of this is happening anyway; banks want loans to be paid back. When it comes to securitizing and reselling those loans, buyers who’ve been burned may also demand more in the way of disclosure and guarantees that the securities are what they purport to be, and that’s also all to the good. Until things went south in the subprime space, even sophisticated investors didn’t necessarily know what information was important to have. They’re learning from recent mistakes.

    As for the regulators, the main goal should be to protect the financial system from any specific failures, not to protect the bankers and their investors who made the failed bets. If it gets bad enough, regulators should clean out the equity holders as a lesson to others who might want to take risks that they too don’t understand.

  17. UnRealtor says:

    RE: Capital One Cutting 2,000 Jobs Amid Loan Losses

    What’s in your wallet?

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