For some reason, I was reminded of the movie about Mozart. Have you seen it? It was a wonderful film.
Emperor Joseph II: My dear young man, don't take it too hard. Your work is ingenious. It's quality work. And there are simply too many notes, that's all. Just cut a few and it will be perfect.
Mozart: [of his great opera, "Figaro"] Nine performances! Nine, that's all it's had! And withdrawn!
Salieri: I know, I know, it's outrageous. Still, if the public doesn't like one's work, one has to accept the fact gracefully.
Mozart: But what is it that they don't like?
Salieri: I can speak for the emperor. You make too many demands on the royal ear. The poor man can't concentrate for more than an hour... you gave him four.
Mozart: What did you think of it yourself? Did you like it at all?
Salieri: I thought it was marvelous.
Mozart: Of course! It's the best opera yet written, I know it... Why didn't they come?
Salieri: I think you overestimate our dear Viennese, my friend. You know you didn't even give them a good bang at the end of songs, to let them know when to clap?
Mozart: I know, I know, maybe you should give me some lessons in that...
frankly, I felt like a Viennese commoner through most of this, but I did know where to start clapping. Funny how CDS, the monster that allowed lending, appraisals and nearly very part of the mortgage system to break down, finds itself hanging by a thread at the end game. looks to me that what is happening now is pretty much required to keep that thread from unraveling the whole system through a forced ratings downgrade. how long do you think we have before the whole thing implodes and Moodys is sued into bankruptcy?
Geoff, I can imagine Moody's being served with papers from here to the end of the next opera, but honestly I for one can't imagine it bankrupting them. When did the rating agencies ever fail to include the little disclaimer to the effect that no one should ever rely on a rating for any purpose other than amusement value?
Hmmmmm...think of this whole thing by Bear as the left hand helping the right. After all, they own a sub-prime mortgage company now as do many of the big houses. Could mean the economic benefit is transparent to the world but makes (or will make)total sense for Bear's consolidated balance sheet. While there is no evidence that I am aware of to prove this (time will tell), we should not forget what will be different when the mortgage market sorts itself out is that the folks that bought all these loans now own companies that originate them.
I assume that the real problem here is that there are more swaps than underlyings. Swaps have been written and traded independently of any particular relationship to the underlying so that the pool may be insured many times over. if Bear is short the swaps, the payout on the swaps maybe be much much larger than any loss incurred by fixing up the underlying.
Tanta,
Thanks so much for that clearly stated [s]confirmation[/s] clarification of the issues in this Bear-Paulson. However the larger mortgage issue finally plays out, I hope it is completely unaffected by the fate of funds that have taken exposed positions in derivatives, which I assume is the underlying reason for Paulson's yelping.
libertas, with all due respect I don't consider that "the real problem." It is surely a real issue. But the point I was trying to make at such tedious length is that, as DEC reminds us, all transactions have become "economic" to someone who owns a piece of every known interest in the whole thing.
I'm fully convinced that the payout on the swaps would be much larger than any loss incurred by the restructuring.
I'm not yet convinced that the actual bondholders are hurt by Bear doing this. Until someone can show me that, I'm left to observe that the bondholders are, in fact and in law, the ones to whom Bear-as-servicer owes the fiduciary duty. If the hedgies engaged in a transaction that would make sense only to the extent Bear-as-servicer ignored its duty to the bondholders, the hedgies have an odd position from which to claim "manipulation."
I think one of the weaknesses in the position of the hedgies who are complaining about BearS' actions is that the inside knowledge on which BearS is acting is not knowledge which they have due to the hedgies having trading accounts with them (which it would be a breach of fiduciary duty for them to exploit) -- rather it is knowledge that they inevitably have by virtue of having sold bond default insurance (aka "credit swaps") on the securities in question, and which they therefore have regardless of whether a buyer of that default insurance also has trading accounts with them.
The crux of the problem for the hedgies is that they've been buying default insurance on securities they don't own -- if they owned them, they'd have no complaint about BearStaking action to prevent the defaults. And there'd be no great profit for BearS in preventing the defaults, as its gains on the credit default swaps would be offset by losses on the mortgages. But since BearS may have collected "insurance premiums" on swaps for many times the amount of the bonds actually outstanding, it also avoids on the insurance side many times the loss it will take on the mortgages.
Although I still don't know what is going on (but I think only buying or modifying individual mortgages would work and buying bonds would not work), I'm sure the crux of the problem is that apparently the amount of notional derivatives is larger that the underlying bonds. It's like BearS insured a house multiple times. And if the house gets fire, BearS has to pay multiple value what the house is worth to somebody else. So it is worth for them to buy a house which is about to burst in flames for full value and lose only 1x of its value and not multiple.
Ironic is that hedgies that lobby against regulation of the derivative market now are worried about dirty play here.
jm, poszi, what I really take away from your points is, then, that it's not directly the amount of the notional derivatives that's the problem (that's the symptom of the problem). The important point is that we can hereby agree to stop calling this "insurance." It seems to me that if we refused to allow the parties in question to continue to get away with that bit of mystification, we might move the ball forward a few yards.
While this market-driven process has evolved in remarkable ways over the years, the process is now clearly under stress. Significant changes in the subprime mortgage market in recent years have substantially complicated the relationship between borrowers and lenders. Mortgages have become commodities, involving multiple players. As a result, it may be easier to get credit but its much harder to resolve troubled loans. When the market turns as weve seen in recent months, workout strategies for troubled loans in securitized structures are much tougher to put together.
Further complicating the situation is the fact that the investors may see their interests differently, with each other, or with the borrower. As all of you know, the problems in this market are a major concern for the FDIC. In March, the FDIC and other federal bank regulators jointly proposed new guidelines for underwriting and marketing subprime mortgages. Weve received over 100 public comments on the guidelines. And we hope to finalize them later this month.
Id like to end by pointing to the obvious. Were all in this together. All of us bear some responsibility for the turmoil in the subprime market. And all of us need to be a part of the solution. And lets be honest about it. Hybrid ARMs were never made based on the assumption that the borrowers would be able to make the payment once the loan reset. They were designed as two- or three-year bullets, with the assumption that home appreciation would allow the borrower to refinance at or before reset. Given current conditions in the housing market, this business model is no longer viable. But market participants should not now claim to be shocked that borrowers are in distress.
The accusations have to be, by necessity, non-specific. What Paulson et al are worried about is the prospect of Bear (and other dealers) or other HF manipulating a deal IN THE FUTURE whereby they would sell protection/insurance (going long risk)on a large (200-500mm) amount of a single Baa2/Baa3 NOW. They could/would use the income to buy out/modify just enough loans in the deal for perpetuity. You don't empasize enough that often the servicer owns the residual and hence can optimize the waterfall payments (either by the traditional method ensuring step down or this new concept of failing trigger and not writing down). In either case the servicer can say that the deal is being improved and pass the litmus test. Bragging about making $1bn on the trade and then moaning about potential dirty tricks in an industry built on them is indeed ironic.
Are we being confused by the language that BearS "bought out" these loans? Is, perhaps, what's being alleged that BearS is refinancing selected loans -- enough to make a profit on the derivatives through the magic of leverage -- but that accusations of refinancing wouldn't pass the laugh test?
It may be, by the way, that BearS can identify borrowers it's servicing who could have been put in a prime fixed rate mortgage, but were sold an ARM on its teaser rate (there have been reports that there are many such); can offer those borrowers a fixed rate mortgage at a payment lower than they've reset to; and still make a profit on the refinance (not necessarily immediately), as well as on the derivative.
Reuter, 7/7/07 (quote)Paulson's statement was provoked by language Bear Steans had suggested for CDS documentation on April 3, in which the bank stated that sellers of protection may buy certain delinquent loans as part of their role as a mortgage servicer.
Tom Marano, global head of mortgages and asset-backed securities at Bear Stearns said the proposed language, which was not included in the credit default swap contracts, was "in response to a suggested change that would have modified those rights and obligations."
"We proposed a clarification of what the rights were in order to ensure participants understood the terms of the underlying documents," Marano said in an emailed statement.
"When market participants said they believed the documentation was already adequate, we withdrew our proposal."
Marano added that decisions made by the bank in servicing its mortgage loans do not take into consideration their potential impact on CDS prices.
"Our servicing decisions -- such as modifying loans when people can't pay their mortgage, or buying out loans when rep & warranty issues are involved in the underwriting process -- stand on their own," Marano said. "None of the servicing decisions we make are driven by any activity or outstanding positions in the CDS market."
In December, law firm Linklaters said, in a letter on behalf of an unidentified client to Markit, which administers credit derivative indexes based on subprime mortgage debt, that the CDS contracts should include language to prohibit intervention by protection sellers in buying the underlying loans.
The letter argues that because volumes in the credit derivative contracts can outstrip the underlying securities, mortgage servicers have a powerful incentive to buy loans in order to protect their swap positions.
The size disparity between the markets "creates a powerful financial incentive, in the event that the index suffers significant losses or is reduced to zero, for protection sellers to consider influencing index performance by subsidizing the trust issuers of the component securities of the index," the letter said.(end quote)
In a nutshell, Bear is protecting their bondholders by taking reasonable and defensible positions. Hedge funds salivating at the possiblity of massive gains due to losses are pissed.
The mother bear protecting the wonded cub from th circling vultures, vulture are pissed at the loss of dinner. Not that the bear has't picked off a few wounded babies in it's time.
This entire exercise of removing one security here and there is likely to be nothing more than a temporary blip on the radar. There's got to be a cost benefit curve somewhere at BS that defines a point where this practice is no longer going to work, in economic terms. Once RE prices drop sufficiently, the individual losses become sufficiently great and the numbers pile up as the FBs elect to simply deposit their keys rather than do any modification, this whole onesy twosy mod practice vanishes and the insurance will kick in anyway.
Tanta, you're certainly making sense and I'm not saying the what Bear is doing is counter to the interest of the bondholders HOWEVER I imagine that is coincidental in that the bondholder's interests and Bear's happen to be aligned. Bear would only be worried about its fiduciary responsibilities if it thought there was an imminent liability problem.
"Innovation has brought about a multitude of new products, such as subprime loans and niche credit programs for immigrants. . . . With these advances in technology, lenders have taken advantage of credit-scoring models and other techniques for efficiently extending credit to a broader spectrum of consumers. . . . Where once more-marginal applicants would simply have been denied credit, lenders are now able to quite efficiently judge the risk posed by individual applicants and to price that risk appropriately. These improvements have led to rapid growth in subprime mortgage lending . . . fostering constructive innovation that is both responsive to market demand and beneficial to consumers." (Greenspan)
All this reminds me of the time a guest of mine decided to "help" me prepare dinner. Said guest cried out in dismay that my Cuisinart was "broken." That certainly got my attention; it's a pricey piece of kitchen equipment. I leaned over, took a look, and pointed out that it wasn't "broken." It was not supposed to start if the safety latch wasn't completely closed.
Had my guest "fixed" my food processor by breaking off the little part that was causing the "problem," I think I might have had grounds for not appreciation the "assistance."
You don't empasize enough that often the servicer owns the residual and hence can optimize the waterfall payments (either by the traditional method ensuring step down or this new concept of failing trigger and not writing down)
It is only in the last two or three years that there has ever, ever, been in this business sufficient serious loan failures occurring so early that they are enough to affect the triggers like that before the step-down. We must remind ourselves that the step-down is not the date that 100% of expected losses are supposed to have happened already. To talk about servicers being able to have that kind of noticeable impact on the waterfall by modifiying a few loans is to concede that this circumstance is extraordinary. Anyone worrying that maybe someday this might possibly happen in a normal--not a hideously distorted market is FOS.
What does anyone think a servicer would do, when it comes right down to it, if it didn't own the residual? Surely there has been enough attention drawn to the problem of market participants with no skin in the game lately that we can see through this one? Dear God. The AFS document is, yes, supposed to be shoring up the verbiage in new PSAs such that it is clearer what the servicer must do if its loss-mit practices could give preference to the resid rather than the funded tranches. OK, fine, we solved a possible conflict of interest. I remain convinced that this isn't a big enough problem to justify the somewhat hysterical nature of the claims being made to the press. Harvey Pitt, for Peat's sake.
Maybe somebody needs to explain to some folks how a "loss curve" works. I don't know. I do know that anyone who thinks what is going on now is some deep-seated structural problem with servicing contracts is a johnny-come-lately to this business.
The ABX index is based on too small a sample of mortgages. It is this that makes it vulnerable to being manipulated relatively easily. Investors, both long and short knew this - this may be hardball but where is the illegality?
This also reminds me of the time I had to explain to a furious co-worker why certain stock option exercises were taxed as ordinary income instead of capital gains. In that particular case it was a young person who might have had some excuse for not understanding who was actually taking the risk and ought--at least as far as the tax code goes--to be rewarded for it. You might wonder why options were being handed out at that level, but don't get me started. In any case I also sniff a similar problem here.
I imagine that is coincidental in that the bondholder's interests and Bear's happen to be aligned
Coincidental? I am firmly convinced that if it weren't a matter of contractual obligations and fear of jail time, Bear would screw every bondhonder on the planet. I'm not suggesting that they're those warm, fuzzy, altruistic kinds of fiduciaries. I am wondering why we are trying to "fix" a set of legal constraints that forces them to behave themselves even when it is not "coincidentally" in their best interests.
For instance, take that right (but not obligation) of the servicer to buy out a delinquent loan out of your contracts? Because it makes you happy today because today it seems to be in the servicer's favor? You just wait until tomorrow when you find out it's in your interest for that but it's now illegal because last year you were so worked up you wanted to make ad-hoc contract amendments that you thought would be "heads I win tails you lose."
This is as simple as a classic short squeeze. Every hedge fund out there was in effect short subprime collateralized bonds by buying credit default insurance on the ABX index. Bear Stearns simply noted that nearly 100x "default insurance", in terms of notional value, had been sold relative to the actual stock of the debt outstanding which was being insured. Indeed, much of this insurance had been sold at spreads north of 1000 basis points (or 10% of the face value of the bonds). So let's see- Wall Street has collected $1,000 worth of premium to insure $100 worth of bonds (and indirectly $100 worth of dodgy mortgages). In order to collect the premium and have the insurance expire worthless, it is well worth it for Bear and other WS dealers to simply buy the pool of mortgages for a $100 (even if they are worth $0), and collect $900 in profit. The hedge funds here have commited a classic speculator's mistake dressed up in the modern language of derivatives- collectively they have shorted many times the value of the underlying security, and are now getting caught by Bear and others who are buying to squeeze them. "He who sells what isn't his'n, must buy it back or go to prison."
I suppose Bear Stearns also owns the lower tranches and equity on those deals.
What would this mean? It would mean Bear Stearns would take the losses anyway, so they sold insurance multiple times on those unavoidable, obvious, soon-to-happen losses.
And now they take the losses OUTSIDE the securitization, and KEEP the insurance premiums.
Remember, this is all in the early innings of resets. When it becomes clear that there are more fly specks than pepper, the scale and nature of operations will have to change. Then we'll see who gets tossed to the vultures and/or bears at that time. The guys like this guy, Harry S. Dvis comes out of the wings
(qoute)
Manhattan Investment Fund, Ltd. Litigations (S.D.N.Y., N.Y Sup. Ct. and Bankr. S.D.N.Y.): Ongoing representation of Bear Stearns Securities Corp. in connection with a series of individual and class action lawsuits filed by shareholders of Manhattan Investment Fund, Ltd. and the Funds bankruptcy trustee after the collapse of this hedge fund following disclosure that the hedge funds manager concealed approximately $400 million in losses through the creation of false account statements. Successfully obtained dismissal of Bear Stearns from cases brought by investors alleging that Bear Stearns aided and abetted the Fund managers fraud and breach of fiduciary duty by continuing to provide clearing services to the Fund after allegedly learning of the Fund managers fraud. See Cromer Finance Ltd. v. Berger, et al., 137 F. Supp.2d 452 (S.D.N.Y. 2001) (dismissing putative class action claims against Bear Stearns); Argos, et al. v. Berger, et al., 2001 U.S. Dist. LEXIS 6282 (S.D.N.Y. May 15, 2001) (dismissing claims asserted by 28 investors seeking $92.3 million in compensatory damages and $1 billion in punitive damages against Bear Stearns). Also successfully obtained dismissal of fraudulent transfer claims brought by bankruptcy trustee seeking $3.6 billion in damages. See Gredd v. Bear Stearns Securities Corp., 257 Bankr. Rep. 190 (S.D.N.Y. 2002).
(end quote)
I haven't, actually, heard anyone make the unambiguous claim that Bear owns these deals, although I can't believe they haven't got a dealer shelf that would make my hair stand on end.
But which idiot agreed to the other side of this trade either 1) knowing Bear owned the bonds or 2) not knowing who owned the bonds?
Can you really be accused of "manipulating" anyone that dumb?
Back in February, the shorts looked like they were making a great trade. Many hedge funds had been shorting a derivative index called the ABX that is tied to a basket of subprime bonds with weak credit ratings. The index had a value of 100 when it was launched this past July.
By late February it had plunged to a low of 63, bringing millions of dollars in paper profits to the short-sellers. The plunge also caused ripples of worry through the stock and bond investors about the broader health of the U.S. economy. The index has since turned around, reaching 77 in mid-May before sinking back to 73, according to its administrator Markit Group.
Back in January, at a Las Vegas industry conference, Bear's head mortgage trader, Scott Eichel, talked with a small group of traders over drinks in the Venetian hotel about propping up the ABX index by buying and rescuing some struggling subprime bonds, say two people who were there. A Bear Stearns spokesman said Mr. Eichel disagrees with the account, but wouldn't elaborate with any details.
The recovery of the ABX index has led to howls from hedge funds which are short subprime, including Mr. Paulson, who manages a $12 billion hedge fund. Mr. Paulson says Bear wanted to prop up faltering mortgages-backed securities by purchasing individual mortgages that were rapidly losing value to avoid doling out billions in swap payments.
Bear denies the allegations. "None of the [mortgage] servicing decisions we make are driven by any activity or outstanding positions in the CDS market," says Tom Marano, who runs Bear's mortgage business.
In April, when the ABX was trading at about 74, Paulson executives called Mr. Eichel to ask whether he was contemplating a plan to repurchase mortgage-backed securities. "Maybe we are, maybe we're not," Mr. Eichel replied, according to two Paulson executives, who say he added they should call him if they were interested. A Bear spokesman said the Paulson executives' recollection of the conversation is inaccurate.
The prior day, Bear's mortgage desk had sent Paulson a copy of new language it was proposing to the International Swaps and Derivatives Association, the industry group that represents traders of swaps and other complex market instruments.
It exacerbated the controversy. The proposed rules would codify its right to prop up a faltering pool of home loans in a mortgage security, even if it knew its clients bet those loans wouldn't perform.
"We were shocked," says Paulson vice president Michael Waldorf, that a firm "like Bear would introduce language that would try to give cover to market manipulation." Also on his mind: With a big bearish bet on the ABX, his firm stood to lose a lot if the index didn't fall.
Mr. Marano says Bear was simply trying to clarify trading rules to "ensure participants understood the terms of the underlying documents."
Paulson fired off letters of complaint to Bear and ISDA. The firm also began rounding up othe
Nearly 30 players, including the San Francisco hedge fund Passport Capital, the Dallas hedge fund Hayman Capital, and Deutsche Bank AG's Deutsche Bank Securities unit rallied behind it.
"All we're after is very simply to maintain the market's integrity," says Kyle Bass, a former Bear employee who is now managing partner of Hayman Capital, which oversees about $3 billion in the subprime market.
Tanta, I don't "know" if they own them, but if people are saying Bear is taking loans out of the securitization and eating the losses, it's because Bear Stearns makes something out of it.
The mechanism I described is quite possible, especially since we know Bear Stearns owns equity and lower tranches in many securitizations.
As for people buying insurance on those CDOs, well, those hedges probably sought out the CDOs with the lousiest exposure (Florida, CA, "Stated Income", etc). At the time they might have known who was servicing the CDOs, who created them, etc, etc, but they probably didn't know who owned what.
Incognitus, I'm not trying to be tedious, but this is the problem. Every time we get a report on this, we get this conflation of "buying bonds" versus "buying loans out of bonds" and so on. Look at what Neal just posted again: an article in which from one paragraph to the next we go from the accusation that Bear is buying bonds in order to prop up the market to the accusation that Bear is buying bonds out of securities it does not own to prop up the performance of those "reference entities."
So it matters that we be careful. Frankly, my dear, if Bear can buy the bonds, Bear can do whatever the fork it wants to do with the loans. Remember Lew Ranieri talking about having to drag 400 bondholders to the Coliseum to vote on mods? Well if you buy everyone else out and you are the only bondholder, it's no longer "voting." You can tell the servicer to stuff $50 bills in the borrower's payment statements if you want.
That said, we are talking about MBS, not CDOs. CDOs are, exactly, "managed" portfolios. REMICs are "static pools" and not managed. So, OK, I'm sure there are hedgies being fleeced by CDO managers who are buying and selling God knows what.
But if you tell me that this whole uproar between Paulson and Bear comes down to some nitwit confusing that with an MBS??? I'll explode for real.
Again, I can't see why anyone making claims of "manipulation" should be taken seriously for six seconds if that person cannot be bothered to talk about the business at hand with some degree of exactitude. It's possible we're just getting the garbled version because the reporters are the clueless parties. But I'm telling you now, from my perspective as a fairly informed part of the mortgage side of this, the things these people are saying do not add up. That's all.
This Kool Aid about how you can financial-wizard-engineer some magical step in the chain where risk just disappears and everybody is perfectly hedged is insanity.
Insanity, my dear Tanta, but for a select club of usurers, very profitable insanity.
One man's insanity is another man's perfect crime.
At the risk of offending you, wake up and smell the coffee. You are talking about mens rea Tanta. Mens rea.
You think Sandy and Chuck didn't know they were cheating people?
arbogast, what I think I am being told, after all the angst here, is that some hedge funds bet on Bear Stearns being stupid about what it takes to be its own best interests.
I am in no mood to be called the naif at the table.
Anyway, what seems to be happening is that enough people placed bets on something happening, that it pays for Bear Stearns to make sure that even if that something happens (people default), it doesn't really happen (Bear buys those people out, so reality is now different).
If this is happening, it calls into question just how crazy it is to scream "manipulation". To "manipulate" is to subvert the normal workings of a market so that it produces a different result from what it would otherwise, and to do so for your own benefit. In that sense, Bear Stearns does seem to be "manipulating", no matter what exactly they are doing (given what people are screaming, Bear is making sure insurance is not producing the payoffs that the existing level of defaults would produce without their intervention).
Bear Stearns probably saw "the opportunity". It's not like people were betting that they are stupid, it's that they entered the picture afterwards and changed the market's workings.
I wonder how much of the incredible rally we've witnessed in the stock markets isn't something similar.
I also always wondered why large institutions don't place "one way bets" on the days futures expire. You'd just have to buy/sell them ALL day long. At the end of the day they'd expire and you'd get paid.
It's quite an amazing market we live in today. Imagine this scenario ...
1) You put out a very obvious pig of a structure, with all the lousy loans you want to get rid of, keeping most of it yourself since you can't sell it to anyone else - nobody will buy it.
2) Everybody and their mother "shorts" your obvious pig by buying loads of insurance on it defaulting. You, the pig creator, sell all this insurance at the very high premiums such pig deserves.
3) You buy out all the bad stuff the pig has in it. These losses you were always going to take, but now, miracle, since you take the losses you were always going to take OUTSIDE the structure, you get to keep ALL those premiums - bets - on how the thing was going to blow up!
Man, this innovation is really getting out of hand.
I like to shop at Yasai market for my produce. Small, owner-operated, good quality. In the far corner they always have the "bargain bags" -- an assortment of stuff slightly off, or soon-to-be. For example, you can get an eggplant, three onions and a bell pepper, all past their prime, for $.99 let's say. Full retail might be $1.98.
It sounds like these hedge funds want to buy the bargain bag and return the bell pepper and two of the onions because they are shocked to find out that they have a bruise. Then they want to resell the eggplant and one onion at near retail, (and a profit) because they are in great shape.
It can't be that simple, can it? I mean we all know why the veggies are in the bargain bag, and we know it's caveat emptor, and you get what you pay for, right?
I guess what I'm saying, Tanta, is that it's quite a table...not one that I would personally want to touch with a barge pole, and one that I would be thrilled to be the naif at.
"If that puts Bear and Paulson both in jail or in damages, fine by me. Just get them out of the drivers seat of the residential mortgage market and the price of having a roof over your head before we cripple the real economy past the point of redemption. Please stop helping us."
Tanta, Bear and the hedgies don't give a rats rump about the economy, homeowners or the mortgage market, it is all about being on the right side of the trade.
Have you ever read Other Peoples Money by Nomi Prines? It is very insightful look at the investment banks and well worth the read.
If the IB's get caught doing something a little underhanded it's a fine which is a fraction of the gains made which is paid without admitting guilt or any wrongdoing and then back to the races.
I don't disagree with you something should be done but I just don't see Wall Street moral hazard changing anytime soon.
I know it's not insurance and I have only compared to an insurance. But it probably more resembles insurance that anything else. Buyers of these type of "protection" need to regularly pay for the protection and they receive the payment proportional to the loss of the underlaying assets. So the trigger is not binary. The more defaulted underlaying bonds, the bigger payout.
But the normal insurance market is regulated. Insurance fraud is prosecuted. You will never get multiple payment of one loss. With these swaps it is possible. So it is the problem of multiples of notional value. If notional value was limited to the value of the underlying assets, it would have perfectly worked as an insurance and no such tricks would have been possible.
And over at the NY Times, we have Gretchen Morgenson weighing in on the further cascade of defaults in the next 12 months, brought about by ARM resets. [If any CR readers were daunted by the length of Tanta's post, just look at the stuff that Morgenson gets wrong in her briefer piece, and you will have new respect for our Tanta. All the resets are in sub-prime?] So, even if Bear wants to buy some loans out of its portfolios in the whole Bear -hedge dance, the bigger question is how long Bear Sterns has the resources/capital/fortitude to keep doing when the seemingly endless supply of compost continues to hit the fan...
There are two things I am taking away from this Credit Default Swap bitchfest between the hedgefunds and Bear Stearns:
Maybe there are some funds out there who were counting on these derivatives to pay out (I mean, they know all about love and war.. why start a news campaign about this now?). Maybe they're overextended?
If you scare away all the speculators by implying that all these derivatives they're buying are just smoke, then it is possible that this era of low volatility will come to an end.
It's a windy path though:
Owners of the main paper.. can feel safer by believing that there will always be some big bank who will manipulate the underlying to keep it propped up.
Then what happens? No one wants to play the derivatives game.. cause if it's so blatantly fixed when it comes to these swaps.. why not with all derivatives? I mean you may have sellers.. but no buyers (well, I might be a buyer if they sell real cheap.)
But, to be slightly more unclear, I believe that this would just make people more complacent or blind.. this idea that Bear Stearns has it under control and the banks can just manage the numbers on the paper.. It's a dangerous idea.
This will just make things a lot worse if the banks (or the PPT or the "greenspan put" or whatever safety valves one believes in) lose control.
That is, fundamentally, the problem (notional value of "insurance" exceeding the notional value of the underlying!)
This sort of thing causes all kinds of interesting disruptions in the equity markets from time to time. PUT contracts that exceed the float, for instance, can cause some WICKED moves.
But in this case it appears to be particularly perverse in that the argument is that Bear WROTE THE CONTRACTS!
So now we've got a situation where Bear has been handed a "no lose" trade. They can simply EAT the mortgages and collect the "overcollateralization" represented by the "extra" swaps.
I'd love to be able to buy 10x the value of my home's in insurance for less than it would actually cost to rebuild it - if I could collect. Then when the next hurricane comes I'll just pack up and leave with the doors and windows wide open! Oops - the house got destroyed. Darn. PAY ME!
IF this is what it all boils down to then yes, there's a problem. But whether the problem lies in the way the swaps are written or in the original servicing and securitization agreements is unclear - along with who is the dumb-dumb.
The obvious question is whether you really can complain about the fact that the Roulette wheel has a built-in mathematical disadvantage in the form of "0" and "00" after you lose, when you're able to see the numbers on the wheel before you bet.
poszi, I'm sure you and I don't disagree. If we're going to call it "insurance," then we regulate it like insurance and stop this crap. If we won't regulate it, then it's Vegas, and we regulate it like Vegas. As far as I know, not even in the casinos on the strip are you allowed to mark your cards or weight your dice. However, you if you don't do those things, you don't get to yell "mulligan!" when you lose a bet. It seems to me worth the time to try to figure out whether we have "illegal manipulation" here or a bunch of sore losers.
Incognitus, you sketch out a convincing scenario for Bear's actions here. But why does it keep sounding like the hedgies never knew any of this was going on, and had all one-way bets themselves?
What the article I quoted here says, in essence, is that Bear is doing something perfectly legal but "non-economic." The implication is that nobody like Bear does anything "non-economic" without a reason, ergo Bear is squeezing the credit shorts. So what? So Paulson and Pitt want the rules on securitizations changed so that an owner of a bond cannot engage in perfectly legal restructuring of it???
I have to assume these folks aren't whining to the press just because they want their own investors to find out how badly they've been had. I understand the universal unwritten rule that a fund manager doesn't state publically that its investment strategy is lookin' ugly unless it is forced to do so, or it thinks it can get bailed out somehow. I therefore must assume that Paulson wants the rules changed so that your scenario would become legally impossible for Bear to engage in. Do you agree that there are grounds for this? I can't see any workable solution except to make it illegal to enter into a contract if you have conflicts of interest. Current law says only that those have to be disclosed. Am I reading the whole thing wrong?
Good heavens, what a karmic convergence. I think I was busy trying to write something that eli and Karl said better than I did.
I am, however, still not convinced that Bear owns anything other than the residuals on the ABS in question. I need to see that in print, clearly, from a reputable source, not a spin-meister. I'm not saying it isn't true. But my whole post was based on the initial assumption that Bear is sponsor/servicer, not One and Only Holder of Funded Tranches. That, Karl, is why I'm not so sure yet that Bear was buying 10x notional coverage on its own asset. I keep being told the "reference" for the CDS was the ABX. Someone has to prove to me that Bear owns enough of the deals in the ABX to "own the index."
If, actually, this is all about a firewall problem at Bear: its CDS desk is out there writing deals while having information from its mortgage servicing side it shouldn't have, then fine, that's another (unsurprising) conflict of interest problem on the street.
But it sounds to me like we're talking about the claim that servicers shouldn't be allowed to buy DLQ loans out of a pool. Hang on! Let's not "fix" a CDS market problem by utterly fouling up the nature of an MBS servicing agreement. Particularly when this suggestion for how those servicing agreements work is being made by people like Paulson or his pet Pitt who don't own the securities (apparently).
I agree with you on this "whining to the press" issue. To me, this is the biggest part of the story.. the details about what Bear Stearns is buying up or if it's legal or illegal doesn't really matter.
What matters is that there's smoke here. Hedge funds are whining to the press for some reason.. and Bear Stearns is buying up some sort of paper somewhere because they sold a, presumably, huge amount of paper derivative of this paper.
Did Bear Stearns sell a lot of other derivatives? How long can they soak up paper? What other positions do these hedge funds have?
There's no guarantee for a beautifully raging fire.. but one can always dream.
I believe Mehta is correct. The central problem is that the ABX "insurance" is not based on the performance of the actual bond that an investor owns. The ABX is based on a small number of reference securities that are supposed to be good proxies for all the other similar securities that were sold in a similar time frame.
I believe what people are complaining about is that Bear is interfering with the performance of the reference securities so that they are no longer good proxies for the market as a whole. Some group of investors bought ABX "insurance" to cover bonds that were not actually represented in the ABX index. The ABX reference bonds are performing OK because Bear is pumping money into them. The other securities are performing much worse, but the ABX hedge isn't making up the difference.
Of course, some group of punters just bought the insurance and they are not collecting as much as they would like. Both groups are complaining that the product isn't really acting like insurance (or a hedge, or a put option, or whatever they thought it would act like) because the proxy relationship of the reference securities to the broader market was misrepresented or is being actively interfered with.
The interesting thing is that Bear may be pumping money into securities that it doesn't have any interest in at all just to make sure that it doesn't have to pay off all those ABX claims. I assume an unrelated servicer can't be faulted for accepting Bear's offer to buy defaulted loans at par.
Not having the knowledge or education combined with the sheer volume of cold medication Im currently going through, Im not at all sure that this would be germain to the conversation but thats never stopped me before...
Would the fact that the PSAs for the trusts in which loans are being removed contain language giving the servicer in this instance Bear right of first refusal to purchase a non-performing loan out of the trust be at all relevant here?
Depending on just how these loans are re-securitized and, more importantly who is doing it, the incentive may simply be to keep servicing the already defaulted loans by modification/forbearance etc. in order to bleed the borrower as much as possible until it becomes time to foreclose and ultimately sell the property. Ive read some rather disturbing language in trust PSAs recently that states that, among other things, servicers can keep any profits from REO sales as additional servicing compensation as opposed to returning it back to the mortgagor.
Such being the case, would this be any potential motivation for Bear et al?
I assume an unrelated servicer can't be faulted for accepting Bear's offer to buy defaulted loans at par.
I don't think that's possible, albrt.
Only the servicer of the deal has the right, but not the obligation, to buy a DLQ loan out at par. I was assuming for the sake of argument that Bear is the servicer of these deals, since that is the only way Harvey Pitt's claim makes sense to me.
Bear isn't, as far as I know, wandering around buying loans out of deals it doesn't service. If it is, those deals are not REMICs, because REMICS can't hold loans for sale.
Bear may be buying up the bonds in the ABX to support their price--I have no idea, but I've seen that suggested--but it isn't "buying up loans" unless I've personally lost my mind about how REMICs work. That's possible, but no one has yet shown me where I'm wrong on that.
Howls of derisive laughter- like Wall Street has ever been anything but a giant wealth reallocator.
Hedgies thought that things move like physics and Black-Scholes!!!
Hedgies are the new victims, I thought that was clear with the Amaranth fiasco, and the small guys should be running like scared deer in the headlights.
The only problem is mainstreet gets flattened in the process, oh well.
Does anybody start wondering if Humongous Bank and Broker is engineering a Black Swan event?
I am beginning to wonder if we have the potential for a new Glass Segal out of this.
Ive read some rather disturbing language in trust PSAs recently that states that, among other things, servicers can keep any profits from REO sales as additional servicing compensation as opposed to returning it back to the mortgagor.
Mike, are you sure about that? The application of REO proceeds is a matter of 1) state law and 2) the terms of the mortgage or DOT document itself. I know of no state, and no state-specific uniform instrument, in which it says that a servicer can keep proceeds over the amount secured.
Please read my post again. A servicer does not have to buy a loan out to modify it or do a forbearance agreement. It can buy a loan out, in some cases, if it chooses to. But if the point is to make money as a mortgage servicer, you don't buy the loan out, you let the security continue to own it so that the security takes the losses.
Let's assume that Bear actually isn't the servicer on the pools in question here. So, theoretically, they would not have the right to buy defaulted loans out of the pool. What's stopping them from going to the servicer and saying, "Hey, we need you to prop up a few of these securities, so if you buy the loans out at par, we'll take them off your hands for you." That sounds like a win-win situation for everyone but the hedge funds -- the bond investors get paid at par on a seriously delinquent note, the servicer doesn't take a hit on it because they can turn around and resell to Bear, and Bear doesn't have to pay out on their (presumably large) default swap position.
A slight twist on Zach but don't what to add to the roster of assumptions so consider this a rhetorical or, probably more descriptively, a stupid twist/question: If BearS didn't already own and/or service the underlying loan pool(s) is there anything preventing them from going out and buying the it/them?
I mean if I was selling puts or CDS's on an index such as ABX that didn't have too many components and I was heavily leveraged doing so why wouldn't I just take some of my (current) profit and acquire enough of the underlying -- someone somewhere must be looking to sell, particularly those increasingly scary equity tranches -- to assure those puts expired worthless; hedging the hedge of the hedge so to speak?
Zach, your scenario is certainly a possibility. I would imagine it going like this: I'm sitting in my office doing whatever it is I do, and my Bear sales rep calls me to say Bear has a great bid on modified seasoned loans, and do I have any I want to sell? So I go to a meeting with my servicing people, and I tell them about this, and they say well, we don't have much we own, but we could probably take a few out of some pools. And so it could happen.
To make it work on a large scale, on targeted bonds (presumably the ones in the ABX basket)? I dunno. The fact is Bear is a big servicer, so it doesn't take much to imagine perhaps a combination of such things. As you note, of course, it's neither illegal nor in violation of anyone's fiduciary responsibilities.
RW, in fact my original assumption, until I saw the current article with the Pitt quote, was that Bear probably was buying up the bonds. It's just that that would make Pitt's claim even more ridiculous than it is if you assume Bear's just the servicer. It's one thing to accuse Bear/servicer of buying someone else/bondholder's defaulted loans (a "noneconomic transaction") in order to avoid the CDS payout. But to accuse Bear of buying out its own defaulted loans? That's unintelligible.
On buying the underlying to make PUTs worthless - no, other than the cost of doing it.
There IS a price at which this might make sense. Rumors are that some of these tranches are going for a dime on the dollar - that might be low enough to make the trade work, especially if you WROTE a bunch of those PUTs and and don't want to see them in the money!
But - the problem I see here is that I don't understand how Bear gets standing to do it unless they're the servicer. If what's being complained about here is some sort of collusive action with SOME OTHER servicer, well, that suddenly gets a LOT more interesting.
There's just not enough detail here for me to figure out EXACTLY what is being alleged; claiming that the ABX is being "manipulated" sounds nasty but whether it really is depends on exactly what sort of agency relationships exist between the various parties AND the underlying elements of the index that are allegedly being played with.
There is one wicked potential consequence to this that folks better watch though.
That is the fact that the plunge in February was foretold a couple of days earlier by a severe whack in the ABX indices. If these are now being "manipulated" then you can no longer look to PUBLIC credit market data as a "tell" for potential equity market dislocations. That sucks, because the underlying RISK of the dislocation doesn't go away - just the "tell".
The WSJ and this latest article never quite made sense to me because, as you said, it lacked specifics and appeared to be written by people who did not understand securitization.
Though I don't know if I believe this nonsense about buying out loans and making modifications to securitizations, the ABX indes has come under fire for quite a while now as not being representative of the ABS/MBS market. In Feb, there were cries that the various ABX indices had fallen way faster than the actual market for similar securities. Had it been a "spread" index, it might have been easier to verify, but, as it stands, it is a price-based and the assumptions used to price the bonds are not made public and are only known to the big investment banks that are participants and mark the securities. I have tried to get access myself, and they won't give the info if you are not a participant. Maybe, someday, Markit will publish the avg spread and default assumptions so that they can be verified against the market, but I wouldn't hold my breath.
I guess the other reason I'm a bit skeptical of a grand collusion among Bear and a bunch of subprime servicers is that Bear, and its buddies the other IBs, have spent a large part of the last year putting back loans to and yanking the warehouse lines of a significant number of subprime servicers, effectively putting them into BK or damned close.
You kind of have to assume these folks are going to turn around and offer to take even the ten minutes' worth of risk between the day they buy a defaulted loan and the day they sell it to Bear just to make Bear happy? I have this idea that there are a number of servicers out there who would leap onto the back of the first Bear salesman who showed up on the premises and wrestle him to the ground. Just a thought.
So now this really, really doesn't make sense to me. I don't know a lot about these markets, but if the hedge funds were buying "insurance" which would pay out if the ABX indices were to fall, and if the notional value of these contracts is big enough to make it worth Bear's money and effort to prop up the bonds in those baskets, well, that just strikes me as being incredibly foreseeable. You can say what you want about the ethics of some of the people who run hedge funds, but they are generally not stupid -- and what we're being asked to believe here is that a lot of not-stupid people paid out a lot of money for these contracts, and it just happens to turn out that Bear can make the contracts expire worthless just by moving the price of a few financial instruments in a market that's neither terribly deep nor terribly liquid? I'm not buying it. If that's really the case, then the hedge funds would do better to confine their gambling to the horse track, where you're at least guaranteed a semi-fair shake, and I'm due to re-evaluate my opinion of the intelligence of the hedgies.
Tanta, I'm not suggesting at all that the servicers would do what I'm suggesting just to make Bear happy. I am, however, suggesting that if I'm a servicer, and Bear calls me up and offers to pay 102 for a bunch of crap that's not performing, that I want out of my pools because I have a slice of the equity, and that, as the servicer, I have the right to buy out of the pool for 100, I'd have a hard time turning them down. And if the notional value of these swaps is big enough, then it may make sense for Bear to do just that, even if the loans are worthless on the open market. I just have a hard time believing that nobody who was buying the swaps saw this coming.
"There was total bad faith by the evil forces of self interest among the too-big to be average bond fund type of players who can only make money by manipulating the public into doing the wrong thing, sort of like an undertaker praying for plague in order to prosper or a sage hyping the total 100% certainty of another disaster so he can raise rates." -VICTOR NIEDERHOFFER
In the trivia dept. Wikipedia insists that it is the Glass-Steagall Act.
And all these years I thought they were saying... 'Gassed Seagull Act'.
Great thread Tanta & all, better than reading a summer pulp thriller. So when do we start seeing 'bodies'... that's what I want to know. So far we're just setting the scene - I want blood, I want it now.
Zach's point is a good one, although not necessarily the only way to interfere. Maybe they really were slipping $50 bills in the borrowers' billing statements. I bet the docs don't say you can't do that.
Zach:
Based on the low margin, low default assumptions everyone was using to create these monsters, Bear's actions would have been uneconomic and therefore unforeseeable. It was only when all the assumptions went out the window and all the hedge funds started piling onto one end of the teeter totter that this became a plausible squeeze. It happened fast, so Bear may have figured this out only a few days or weeks before the hedge funds realized they'd been had.
"Founded in 2001, Markit enjoys the sponsorship of 13 financial institutions who manage assets in excess of $10 trillion. This sponsorship allows us to create financial market transparency and increase the markets processing productivity. With this sponsorship, Markit is typically first-to-market with innovative services, that evolve on a real-time basis to meet emerging market challenges."
See, nothing to worry about, the ABX is just "evolving on a real time basis" like dinosaurs learning about asteroids.
dryfly, sorry about all the scene-setting and not enough sword-fights. All these pirates, you'd think we'd get to see some nekkid steel, but not yet. But I promise to do a follow-up report as soon as there are carcasses to deplore.
Is it just me, or does the name "Markit" remind anyone of the name "Ownit"? One of these funds is going to name itself "Swapit" and then Bear will have to change its name to "Screwit" . . .
It seems a lot of the confusion here resides in the fact that Bear MIGHT be persuaded to engage in uneconomic transactions because the CDS market has grown far larger than the underlying pools of mortgages upon which it it based.
Then there is this comment by you=
"It is only in the last two or three years that there has ever, ever, been in this business sufficient serious loan failures occurring so early that they are enough to affect the triggers like that before the step-down."
The CDS market has grown like Topsy over the past few years - did the growth of the CDS market act as a fertilizer for the subprime market? Essentially speculators threw a bunch of shit down and forced up a bean plant to grow so fast that it couldn't stand straight?
Reminds me of the quote from Keynes
"Speculators may do no harm as bubbles on a steady stream of enterprise, but the position is serious when enterprise becomes the bubble on a whirlpool of speculation."
PS(sorry if this is completely wrong or if I'm just figuring out what you've been saying for a while)
Maybe Im interpreting these the wrong way then, Tanta. Im also coming across prepayment penalties being given to servicers as additional servicing compensation in some prospectuses as well.
WACHOVIA ASSET SEC CORP MORT PASS THR CERT SER 2002-1
p. s-53
"The Pool Distribution Amounts also will not include any profit received by the Servicer on the foreclosure of a Mortgage Loan. Such amounts, if any, will be retained by the Servicer as additional servicing compensation."
WASHINGTON MUTUAL MOR SEC CORP MOR PASS THRU CERT SER 2001-3
p.56
"However, if a gain results from the final liquidation of a defaulted Mortgage Loan which is not required by law to be remitted to the related Mortgagor, the Company or Servicing Entity, as applicable, as Master Servicer, or the Servicer, as applicable, will be entitled to retain such gain as additional servicing compensation unless the applicable Prospectus Supplement provides otherwise. See "Description of Credit Enhancements"."
COUNTRYWIDE HOME LOAN LP MAS SERV ASSET-BAC CER SER 2004-4
p.29
REPORTS TO SECURITY HOLDERS
"Prior to or concurrently with each distribution on a distribution date the master servicer or the trustee will furnish to each security holder of record of the related series a statement setting forth, to the extent applicable to such series of securities, among other things:
the related amount of the servicing compensation retained or withdrawn from the Security Account by the master servicer, and the amount of additional servicing compensation received by the master servicer attributable to penalties, fees, excess Liquidation Proceeds and other similar charges and items;
I see your point, but if the hedge funds really believed the low-default assumptions that went into creating these bonds, why would they buy swaps that paid off when the bonds blew up? It sounds to me like they were banking on the bonds getting into deep shit, and when they found Bear willing to sell them a product that could pay them when that happened, they jumped at it. They expected those assumptions to not hold up -- so what was unforeseeable about this? They seriously didn't expect Bear to notice that they could save a pile of money on their swap obligations by just bailing out the bonds in the ABX basket? I don't get it.
who else besides the HF's is long subprime risk and may have used these ABX puts to hedge themselves? If Bear gets away with this then it is these who have incorrectly viewed the ABX as a hedge against general subprime deterioration. Are MBIA and AMBAC uing this as a hedge?
"I also always wondered why large institutions don't place "one way bets" on the days futures expire. You'd just have to buy/sell them ALL day long. At the end of the day they'd expire and you'd get paid."
No you wouldn't. If you sold, then there would be buyers, who would have exactly the opposite interest than yourself. Consider a future on a stock index. E.g. suppose you sold futures. You can only be sure of making a profit if you're a massive seller of the underlying index stocks during the period when the future's maturity value is determined. So your strategy of selling more and more futures works only if you're willing to sell more and more stocks. If you already have stocks to sell, then that may work. But if you don't, then you'll have to buy them back afterwards, with very painful results.
rcryan, I'm certainly not saying no deal ever failed its triggers before the last few years; that's why step-down triggers are there. But yes, I am certainly saying that the "loss curve" changed dramatically on subprime in the last few years. Between the EPDs (loans failing in the first six months), which historically happened in subprime at around 1.00% and has in 2005-2006 pools been anywhere from 6-10%, and the famous first adjustment failures of the 2/28s, we are seeing unprecedented losses in the first three years of these deals. (I don't think I've ever seen one with a step-down date before 3 years.) So you already have a situation where the deal is more likely than not to fail to release OC at the first possible step-down date.
The argument floating out there is that servicers can manipulate this via modifications (i.e., modify those failing loans to current ones, so that the deal passes at the step-down). Well, maybe. But that is my point: how did these servicers end up with so many early defaults to modify? To claim that one is only worried about this happening "potentially" or in future deals--and therefore we should make major changes to deal documents--is just disingenuous, then: if the loans were sturdy enough to perform like a typical loss curve--and with a big enough pile of loans, they should "revert to the mean"--there would be no question of modifying anything except the usual trivial numbers that just can't affect the waterfall or the triggers in a significant way.
So I am making both claims: the presence of this "insurance" (those CDS where someone was betting on success) created a moral hazard, such that extremely high-risk loans were originated, resulting in the failures some of the hedgies were betting on.
Also, some hedgies were betting on failure, not success, and insofar as they were right about credit quality--the loans did start failing in droves--they were wrong about what the servicers would do next: attempt to mitigate losses (via mods, among other things). Perhaps they were naive about servicing contracts; I think that's part of it. Mostly, I think, they forgot about HPA.
They forgot, that is, that earlier vintages "performed" because of rising prices, which gave defaulting borrowers options to sell or refi, and that gave struggling borrowers a reason to keep struggling. When so many borrowers ended up upside down, they failed more often. But that very fact means that foreclosing is less attractive an option.
It's funny, but it's true: I can get people from other parts of the financial world to understand things like prepayment risk: the tough part of investing in mortgages is that you often get your money back at exactly the time you don't want it, and you don't get it back fast enough at exactly the time you'd like to.
What we can't seem to get them to understand is that foreclosures work the same way: if you have to foreclose, that's usually at exactly the wrong time to be foreclosing. These folks are crying foul about modifications as if there were a better option. In a "normal pool" with a "normal" loss curve, the world's crookedest servicer still couldn't manage to do enough mods to affect the waterfall noticeably. If mods are affecting the waterfall noticeably, we are not in a normal environment.
This gets to Mike's post: Mike, first, there are not many jurisdictions in which a servicer can make a "profit" here. In most cases where it's possible, it's because the borrower skipped or disappeared and isn't claiming money that would be due to him or her.
But back up a minute: we aren't foreclosing on properties that are worth more than the loan amount these days. It wouldn't matter if local law gave a servicer the right to excess proceeds if there aren't any excees proceeds. This is why servicers are modifying instead of foreclosing: foreclosures are losing propositions right now. If there's any equity at all, the borrowers are selling voluntarily, or they're asking for mods or forbearance.
This is the principle: you can "make a profit" on foreclosures only in those market environments in which you don't have to foreclose. If you have to foreclose more than 0.14% of the time, you won't be making a profit.
You can "manipulate" the waterfall with modifications only in those markets where the alternative is no waterfall at all: would you like less cashflow (a "manipulated waterfall") or no cashflow (foreclose at a loss)? Anyone who thinks he's got another choice with these deals hasn't grasped the underlying problem.
Tanta, I'm not suggesting at all that the servicers would do what I'm suggesting just to make Bear happy. I am, however, suggesting that if I'm a servicer, and Bear calls me up and offers to pay 102 for a bunch of crap that's not performing,
OK, I've had some coffee. I guess the reason I'm doubtful is that if one is a reasonably well-capitalized servicer with a realistic hope of making it through this mess, even getting 102 on some mods (after having taken the risk of buying them out and holding them long enough to get the mod done) is picking up nickels in front of the steamroller.
If you're in such dire straits that picking up nickels sounds good, you probably are already in court with Bear at the other table with the other lawyers.
That is, Bear might have some giant CDS trades going where we're talkin' big money, but I'm struggling to believe that the pool servicers left standing right now (other than the IBs' own servicing platforms) can see enough change on the table to make the risk worth it.
I should note that I am reliably informed that bids on new subprime paper (full warranty, loans, if aged any, fully performing) aren't much better than 101. So a 102 bid on something that was 90 or more days down until it got some shaky mod, is going to catch some auditor's attention, or is likely to. It's not necessarily illegal, but do I, the servicer who presumably doesn't need to take this risk, need to take this risk?
Surely if someone is paying 102 for a mod of a defaulted loan, that's prima facie evidence of manipulative intent.
Regarding the Rating Agency comments from Geoff and Tanta. Although the rating agencies "always include" the disclaimer that their "opinions" should not be used for investment decisions in official literature - I think their little disclaimer veil is bound to cost them a lot of attorney fees in coming months.
A case in point, on page 11 of last week's Asset-Backed Alert (an industry rag) there is a full page ad from Fitch, and I quote... "At Fitch Ratings, we know you rely on our opinions ... Presale reports provide ... the information you need to make informed decisions". This is days after Fitch was quoted for a Bloomberg article on CDO Subprime losses, "Fitch ... says its analyses are just opinions and investors shouldn't rely on them". Both quotes are abbreviated.
Surely if someone is paying 102 for a mod of a defaulted loan, that's prima facie evidence of manipulative intent.
Yes, but I'm not sure it's illegal. I'm not even convinced it's particularly unethical -- there's no reason Bear should stand there and take their lumps if they can reasonably avoid it. I'm going to defer to your knowledge of what a servicer would or would not typically want to do; my impression is still that this is a damn atypical situation, and that there are some very perverse incentives in play.
This has been a very interesting conversation; I'm finding out how irretrievably weird some of this financial business is. I think I'd better stick to physics and index funds. Either that, or start my own hedge fund -- after all, I get my 2% either way, yes?
Oh, Zach, you're right, it is absolutely legal to pay too much for a loan. God help us, we'd all have been in jail years ago if it weren't.
My problem is having spent too many years working for a mortgage servicer with a bad habit of wanting to stay in business beyond the next quarter. So I do tend to think there are occasionally opportunities to make a buck you should pass up.
Obviously I am no more fit to work in the mortgage industry these days than the guy sitting next to me at the bus stop.
As you said earlier in this post, Harvey Pitt's "concern" about the subprime market is rather transparent. If he is out to help borrowers, I have a bridge for sale.
On the other hand he makes a good point about manipulation in the swap market, and it behooves regulators to ask which other types of swaps are vulnerable to manipulation of underlying reference securities. There are hundreds of billions of dollars of CDS's out there, and they are unregulated, over the counter securities. I could care if any single one of them gets in trouble; no one, however, wants to see systemic risk.
sunlight, I agree with you 100% about the systemic risk concern.
That said, I'll cut Pitt some slack as soon as he starts all his sentences with, "Now that we've made all the boatloads of money we can possibly make off this racket, we must observe that there's a potential for manipulation."
Tanta,
Regarding risk. This entire idea of random risk in these markets is nonsense. I have no knowledge of the computer modeling that goes on, but the idea of Monte Carlo risk shows that random error is expected. Everybody uses random error to predict statistical events, insurance companies, manufacturers, product testers etc. Let's say you make motors. You have a good design, good manufacturing, yet in the course of operations 1 motor in 100,000 will fail. That would generally be considered random error or failure.
In the mortgage industry, this would be analagous to a stable couple purchasing a home with standard financial ratios 28/33 with a respectable downpayment. In the course of life the husband got laid off, the wife had unforeseen medical bills, the economy tanked etc. You can relate foreclosure to unemployment or GDP growth and predict certain random events, foreclosures with statistical methods ie Monte Carlo modeling.
The last years of mortgage origination have undermined the random nature of default. By ignoring time tested ratios, using introductory rates etc, they have designed in foreclosures. They have made a motor with material that is designed to fail. This is no longer random risk it is systemic risk. There is absolutely no point in using Monte Carlo methods as they are not statistically valid
Tanta, all I have to offer to back me up at the moment is this:
delawareonline.com | Wilmington | The News Journal
"Attorney General Beau Biden said his office has seen scams related to the rising foreclosures. In some cases, foreclosure "consultants" promise to help struggling homeowners, but actually deceive them into signing over the rights to their property.
Another problem comes after a foreclosed home goes to a sheriff's sale.
"When a home is sold in foreclosure and there is money left over, the money belongs to the former homeowner," said Biden. "People are not always aware that this money belongs to them."
Superior Court has more than $5 million waiting to be claimed.
Now some people are persuading distressed homeowners to sign over their rights to the residual money in exchange for an upfront payment. In some cases, homeowners have signed away as much as $30,000 in exchange for $1,000.
Consumers who believe they may be victims of a foreclosure scam can call the Delaware Department of Justice's Consumer Protection Unit at 577-8600, Biden said."
As far as foreclosures and making money are concerned, my argument has been the same all along - lenders don't lose money on foreclosures especially when the loans are securitized because the pools are insured. Claims are made on those policies - correct me if I'm wrong. SERVICERS, on the other hand, make money hand over fist during the entire foreclosure process, due largely in part to those "additional servicing compensation" clauses i.e. assumption fees, modification fees, forbearance fees, late payment fees, etc,. The actual foreclosure is just the final act of laundering the property off of the books. And that may not even take place until after teh servic er has purchased the physical property and sold it themselves for a profit.
It's THEN that the servicer makes additional money on the sale because the servicer has paid bottom dollar - most likely just the remainder of what is owed on the note plus fees, etc. for the property. And that hasn't always come close to FMV of a property in the last several years. And that is money that the original mortgagor won't see because the sale of the property from the note holder to the servicer effectively terminates the contractual obligation between note holder and mortgagor. It doesn't wipe out everything that the parties agreed to up to that point - it just effectively ends the agreement between them at the time the servicer purchases the property.
There is an entirely different argument to be made about legal obligations that note holders and/or servicers have to make every effort to get top dollar for FC properties ehich never seems to happen either... I'll leave that alone.
It looks to me that since there are very loose regulations on these bonds what we have here are a trial balloons being placed by both Bear Sterns and the Paulsen hedge funds. They both are seeing what they can get away with. They are both trying to protect their positions so they will try to manipulate markets in any way they can to protect themselves.
It's clear that BS can not buy every bad loan out of a securitization and protect the overall value of the bonds. However, if they can create a perception that they can do this it may create some price support.
The Hedge funds are pushing the opposite side and crying foul over this.Each side has their own little agenda, Reduce losses or maximize profits.
These cat fights usually don't go public. I guess that is why it is so interesting to us all.
Tanta has the right idea with what she said about Harvey Pitt
"I'll cut Pitt some slack as soon as he starts all his sentences with, "Now that we've made all the boatloads of money we can possibly make off this racket, we must observe that there's a potential for manipulation"
Bear, hedge funds and their executives were making boatloads on these deals for years. As is always the case a good percentage of it is off the backs of those who can least afford it the, middle class.
Now we are supposed to worry about the potential impact on Bear Sterns Quarterly Earnings or whether Some hedge fund gets to maximize the profit on a position.
Lets feel some compassion for all the average folks who are losing jobs and homes as a result of this mess.
What is the ABX? Is it a true reflection of the value of the underlying bonds? or is the market evaluation of the bonds from the trading in the ABX? If the "insurance" is oversold and there is less demand for the product, the ABX goes down. Those selling the product know when the value of the ABX does not coincide with the underlying securities. If the lenders are in hock to the same people selling the insurance, who are able to sell until the bonds are priced so low that the collateral isn't large enough, margin calls happen. The absolute worst timing. Lenders either go bankrupt or sell at depressed prices. Shareholders take the hit, and the assets of the lenders go on firesale. It all has an aroma. Why are the primes buying these lenders who are going down? Value? When the primes own the paper, they can support the underlying security on which lots of insurance has been sold. The primes rework the underlying security, these produce, the insurance doesn't get paid, and the real profit isn't in the mortgages, it is in selling the insurance.
The primes are taking major bets on a the duration of a cockroach fight and giving the cockroaches steroids.
If there is manipulation in the trading of the ABX, it is not as transparent as the manipulation of the stock market via options. When the SEC allowed the options market maker to hedge his positions by naked shorting, the OMM could sell infinite puts, hedge by naked shorting the stock. The OMM sells the puts and the counterfeited shares to the same party who then dumps the shares into the market and drives the shares down making his puts valuable. The OMM is able to do risk-free insurance writing, doesn't have to borrow or pay for the stock for his hedge. The buyer of the puts has no money on the table once he dumps his recent purchase of counterfeited shares. How does he guarantee a profit in the puts? He keeps buying more puts and more counterfeited shares and dumps more and more shares into the market. And the brilliant folks at the SEC have allowed this because they have determined that a short squeeze is not economic for certain players. They grandfathered the illegal sales and will have kept this in place for nearly three years and added the OMM exemption in Reg SHO. Yesterday, when the SEC commissioners voted to rescind the grandfather clause, they exposed themselves. They not only have been allowing the sale of unregistered securities via the market maker exemptions, they have been purposefully manipulating the market to avoid "volatility", which is neither their job nor within their authority. The regulators are either stupid or bought to have ever done this.
Then you have the ABX.. Is the ABX used to manipulate the value of the bonds? The mm's in the bonds can't naked short the bonds as a hedge when they sell the puts. They have to support the bonds to avoid paying insurance.
Thank the nimrods at the SEC. All we need is the Harvey Pitt clones to allow the market makers of the ABX to naked short the bonds. It isn't fair for the Primes to be exposed to risk when the options market maker is afforded a risk-free put writing by naked shorting the underlying stock. When the market makers become the counterparties to the trades, they have incentive to determine where the prices of the underlying securities go.
For some reason, I was reminded of the movie about Mozart. Have you seen it? It was a wonderful film.
Emperor Joseph II: My dear young man, don't take it too hard. Your work is ingenious. It's quality work. And there are simply too many notes, that's all. Just cut a few and it will be perfect.
Mozart: Which few did you have in mind, Majesty?
Mozart: [of his great opera, "Figaro"] Nine performances! Nine, that's all it's had! And withdrawn!
Salieri: I know, I know, it's outrageous. Still, if the public doesn't like one's work, one has to accept the fact gracefully.
Mozart: But what is it that they don't like?
Salieri: I can speak for the emperor. You make too many demands on the royal ear. The poor man can't concentrate for more than an hour... you gave him four.
Mozart: What did you think of it yourself? Did you like it at all?
Salieri: I thought it was marvelous.
Mozart: Of course! It's the best opera yet written, I know it... Why didn't they come?
Salieri: I think you overestimate our dear Viennese, my friend. You know you didn't even give them a good bang at the end of songs, to let them know when to clap?
Mozart: I know, I know, maybe you should give me some lessons in that...
Amadeus (1984) - Memorable quotes
frankly, I felt like a Viennese commoner through most of this, but I did know where to start clapping. Funny how CDS, the monster that allowed lending, appraisals and nearly very part of the mortgage system to break down, finds itself hanging by a thread at the end game. looks to me that what is happening now is pretty much required to keep that thread from unraveling the whole system through a forced ratings downgrade. how long do you think we have before the whole thing implodes and Moodys is sued into bankruptcy?
Geoff, I can imagine Moody's being served with papers from here to the end of the next opera, but honestly I for one can't imagine it bankrupting them. When did the rating agencies ever fail to include the little disclaimer to the effect that no one should ever rely on a rating for any purpose other than amusement value?
Hmmmmm...think of this whole thing by Bear as the left hand helping the right. After all, they own a sub-prime mortgage company now as do many of the big houses. Could mean the economic benefit is transparent to the world but makes (or will make)total sense for Bear's consolidated balance sheet. While there is no evidence that I am aware of to prove this (time will tell), we should not forget what will be different when the mortgage market sorts itself out is that the folks that bought all these loans now own companies that originate them.
I assume that the real problem here is that there are more swaps than underlyings. Swaps have been written and traded independently of any particular relationship to the underlying so that the pool may be insured many times over. if Bear is short the swaps, the payout on the swaps maybe be much much larger than any loss incurred by fixing up the underlying.
Tanta,
Thanks so much for that clearly stated [s]confirmation[/s] clarification of the issues in this Bear-Paulson. However the larger mortgage issue finally plays out, I hope it is completely unaffected by the fate of funds that have taken exposed positions in derivatives, which I assume is the underlying reason for Paulson's yelping.
libertas, with all due respect I don't consider that "the real problem." It is surely a real issue. But the point I was trying to make at such tedious length is that, as DEC reminds us, all transactions have become "economic" to someone who owns a piece of every known interest in the whole thing.
I'm fully convinced that the payout on the swaps would be much larger than any loss incurred by the restructuring.
I'm not yet convinced that the actual bondholders are hurt by Bear doing this. Until someone can show me that, I'm left to observe that the bondholders are, in fact and in law, the ones to whom Bear-as-servicer owes the fiduciary duty. If the hedgies engaged in a transaction that would make sense only to the extent Bear-as-servicer ignored its duty to the bondholders, the hedgies have an odd position from which to claim "manipulation."
Does that make sense?
Great post, Tanta!
I think one of the weaknesses in the position of the hedgies who are complaining about BearS' actions is that the inside knowledge on which BearS is acting is not knowledge which they have due to the hedgies having trading accounts with them (which it would be a breach of fiduciary duty for them to exploit) -- rather it is knowledge that they inevitably have by virtue of having sold bond default insurance (aka "credit swaps") on the securities in question, and which they therefore have regardless of whether a buyer of that default insurance also has trading accounts with them.
The crux of the problem for the hedgies is that they've been buying default insurance on securities they don't own -- if they owned them, they'd have no complaint about BearStaking action to prevent the defaults. And there'd be no great profit for BearS in preventing the defaults, as its gains on the credit default swaps would be offset by losses on the mortgages. But since BearS may have collected "insurance premiums" on swaps for many times the amount of the bonds actually outstanding, it also avoids on the insurance side many times the loss it will take on the mortgages.
Although I still don't know what is going on (but I think only buying or modifying individual mortgages would work and buying bonds would not work), I'm sure the crux of the problem is that apparently the amount of notional derivatives is larger that the underlying bonds. It's like BearS insured a house multiple times. And if the house gets fire, BearS has to pay multiple value what the house is worth to somebody else. So it is worth for them to buy a house which is about to burst in flames for full value and lose only 1x of its value and not multiple.
Ironic is that hedgies that lobby against regulation of the derivative market now are worried about dirty play here.
jm, poszi, what I really take away from your points is, then, that it's not directly the amount of the notional derivatives that's the problem (that's the symptom of the problem). The important point is that we can hereby agree to stop calling this "insurance." It seems to me that if we refused to allow the parties in question to continue to get away with that bit of mystification, we might move the ball forward a few yards.
American Securitization Forum (ASF) Annual Meeting
Remarks of FDIC Chairman Sheila C. Bair
June 6, 2007
some bits:
link:http://www.fdic.gov/news/news/speeches/chairman/spjun0607.html
While this market-driven process has evolved in remarkable ways over the years, the process is now clearly under stress. Significant changes in the subprime mortgage market in recent years have substantially complicated the relationship between borrowers and lenders. Mortgages have become commodities, involving multiple players. As a result, it may be easier to get credit but its much harder to resolve troubled loans. When the market turns as weve seen in recent months, workout strategies for troubled loans in securitized structures are much tougher to put together.
Further complicating the situation is the fact that the investors may see their interests differently, with each other, or with the borrower. As all of you know, the problems in this market are a major concern for the FDIC. In March, the FDIC and other federal bank regulators jointly proposed new guidelines for underwriting and marketing subprime mortgages. Weve received over 100 public comments on the guidelines. And we hope to finalize them later this month.
Id like to end by pointing to the obvious. Were all in this together. All of us bear some responsibility for the turmoil in the subprime market. And all of us need to be a part of the solution. And lets be honest about it. Hybrid ARMs were never made based on the assumption that the borrowers would be able to make the payment once the loan reset. They were designed as two- or three-year bullets, with the assumption that home appreciation would allow the borrower to refinance at or before reset. Given current conditions in the housing market, this business model is no longer viable. But market participants should not now claim to be shocked that borrowers are in distress.
BIAV
The accusations have to be, by necessity, non-specific. What Paulson et al are worried about is the prospect of Bear (and other dealers) or other HF manipulating a deal IN THE FUTURE whereby they would sell protection/insurance (going long risk)on a large (200-500mm) amount of a single Baa2/Baa3 NOW. They could/would use the income to buy out/modify just enough loans in the deal for perpetuity. You don't empasize enough that often the servicer owns the residual and hence can optimize the waterfall payments (either by the traditional method ensuring step down or this new concept of failing trigger and not writing down). In either case the servicer can say that the deal is being improved and pass the litmus test. Bragging about making $1bn on the trade and then moaning about potential dirty tricks in an industry built on them is indeed ironic.
Are we being confused by the language that BearS "bought out" these loans? Is, perhaps, what's being alleged that BearS is refinancing selected loans -- enough to make a profit on the derivatives through the magic of leverage -- but that accusations of refinancing wouldn't pass the laugh test?
It may be, by the way, that BearS can identify borrowers it's servicing who could have been put in a prime fixed rate mortgage, but were sold an ARM on its teaser rate (there have been reports that there are many such); can offer those borrowers a fixed rate mortgage at a payment lower than they've reset to; and still make a profit on the refinance (not necessarily immediately), as well as on the derivative.
I Love the motocycle analogy
Reuter, 7/7/07 (quote)Paulson's statement was provoked by language Bear Steans had suggested for CDS documentation on April 3, in which the bank stated that sellers of protection may buy certain delinquent loans as part of their role as a mortgage servicer.
Tom Marano, global head of mortgages and asset-backed securities at Bear Stearns said the proposed language, which was not included in the credit default swap contracts, was "in response to a suggested change that would have modified those rights and obligations."
"We proposed a clarification of what the rights were in order to ensure participants understood the terms of the underlying documents," Marano said in an emailed statement.
"When market participants said they believed the documentation was already adequate, we withdrew our proposal."
Marano added that decisions made by the bank in servicing its mortgage loans do not take into consideration their potential impact on CDS prices.
"Our servicing decisions -- such as modifying loans when people can't pay their mortgage, or buying out loans when rep & warranty issues are involved in the underwriting process -- stand on their own," Marano said. "None of the servicing decisions we make are driven by any activity or outstanding positions in the CDS market."
In December, law firm Linklaters said, in a letter on behalf of an unidentified client to Markit, which administers credit derivative indexes based on subprime mortgage debt, that the CDS contracts should include language to prohibit intervention by protection sellers in buying the underlying loans.
The letter argues that because volumes in the credit derivative contracts can outstrip the underlying securities, mortgage servicers have a powerful incentive to buy loans in order to protect their swap positions.
The size disparity between the markets "creates a powerful financial incentive, in the event that the index suffers significant losses or is reduced to zero, for protection sellers to consider influencing index performance by subsidizing the trust issuers of the component securities of the index," the letter said.(end quote)
In a nutshell, Bear is protecting their bondholders by taking reasonable and defensible positions. Hedge funds salivating at the possiblity of massive gains due to losses are pissed.
The mother bear protecting the wonded cub from th circling vultures, vulture are pissed at the loss of dinner. Not that the bear has't picked off a few wounded babies in it's time.
Delaying the inevitable?
This entire exercise of removing one security here and there is likely to be nothing more than a temporary blip on the radar. There's got to be a cost benefit curve somewhere at BS that defines a point where this practice is no longer going to work, in economic terms. Once RE prices drop sufficiently, the individual losses become sufficiently great and the numbers pile up as the FBs elect to simply deposit their keys rather than do any modification, this whole onesy twosy mod practice vanishes and the insurance will kick in anyway.
Tanta, you're certainly making sense and I'm not saying the what Bear is doing is counter to the interest of the bondholders HOWEVER I imagine that is coincidental in that the bondholder's interests and Bear's happen to be aligned. Bear would only be worried about its fiduciary responsibilities if it thought there was an imminent liability problem.
BS is just innovating some more..
"Innovation has brought about a multitude of new products, such as subprime loans and niche credit programs for immigrants. . . . With these advances in technology, lenders have taken advantage of credit-scoring models and other techniques for efficiently extending credit to a broader spectrum of consumers. . . . Where once more-marginal applicants would simply have been denied credit, lenders are now able to quite efficiently judge the risk posed by individual applicants and to price that risk appropriately. These improvements have led to rapid growth in subprime mortgage lending . . . fostering constructive innovation that is both responsive to market demand and beneficial to consumers." (Greenspan)
All this reminds me of the time a guest of mine decided to "help" me prepare dinner. Said guest cried out in dismay that my Cuisinart was "broken." That certainly got my attention; it's a pricey piece of kitchen equipment. I leaned over, took a look, and pointed out that it wasn't "broken." It was not supposed to start if the safety latch wasn't completely closed.
Had my guest "fixed" my food processor by breaking off the little part that was causing the "problem," I think I might have had grounds for not appreciation the "assistance."
You don't empasize enough that often the servicer owns the residual and hence can optimize the waterfall payments (either by the traditional method ensuring step down or this new concept of failing trigger and not writing down)
Maybe somebody needs to explain to some folks how a "loss curve" works. I don't know. I do know that anyone who thinks what is going on now is some deep-seated structural problem with servicing contracts is a johnny-come-lately to this business.
The ABX index is based on too small a sample of mortgages. It is this that makes it vulnerable to being manipulated relatively easily. Investors, both long and short knew this - this may be hardball but where is the illegality?
This also reminds me of the time I had to explain to a furious co-worker why certain stock option exercises were taxed as ordinary income instead of capital gains. In that particular case it was a young person who might have had some excuse for not understanding who was actually taking the risk and ought--at least as far as the tax code goes--to be rewarded for it. You might wonder why options were being handed out at that level, but don't get me started. In any case I also sniff a similar problem here.
I imagine that is coincidental in that the bondholder's interests and Bear's happen to be aligned
Coincidental? I am firmly convinced that if it weren't a matter of contractual obligations and fear of jail time, Bear would screw every bondhonder on the planet. I'm not suggesting that they're those warm, fuzzy, altruistic kinds of fiduciaries. I am wondering why we are trying to "fix" a set of legal constraints that forces them to behave themselves even when it is not "coincidentally" in their best interests.
For instance, take that right (but not obligation) of the servicer to buy out a delinquent loan out of your contracts? Because it makes you happy today because today it seems to be in the servicer's favor? You just wait until tomorrow when you find out it's in your interest for that but it's now illegal because last year you were so worked up you wanted to make ad-hoc contract amendments that you thought would be "heads I win tails you lose."
This is as simple as a classic short squeeze. Every hedge fund out there was in effect short subprime collateralized bonds by buying credit default insurance on the ABX index. Bear Stearns simply noted that nearly 100x "default insurance", in terms of notional value, had been sold relative to the actual stock of the debt outstanding which was being insured. Indeed, much of this insurance had been sold at spreads north of 1000 basis points (or 10% of the face value of the bonds). So let's see- Wall Street has collected $1,000 worth of premium to insure $100 worth of bonds (and indirectly $100 worth of dodgy mortgages). In order to collect the premium and have the insurance expire worthless, it is well worth it for Bear and other WS dealers to simply buy the pool of mortgages for a $100 (even if they are worth $0), and collect $900 in profit. The hedge funds here have commited a classic speculator's mistake dressed up in the modern language of derivatives- collectively they have shorted many times the value of the underlying security, and are now getting caught by Bear and others who are buying to squeeze them. "He who sells what isn't his'n, must buy it back or go to prison."
I suppose Bear Stearns also owns the lower tranches and equity on those deals.
What would this mean? It would mean Bear Stearns would take the losses anyway, so they sold insurance multiple times on those unavoidable, obvious, soon-to-happen losses.
And now they take the losses OUTSIDE the securitization, and KEEP the insurance premiums.
It is manipulation indeed. And obvious at that.
That was beautiful, though complicated, thank you.
Josh
Remember, this is all in the early innings of resets. When it becomes clear that there are more fly specks than pepper, the scale and nature of operations will have to change. Then we'll see who gets tossed to the vultures and/or bears at that time. The guys like this guy, Harry S. Dvis comes out of the wings
(qoute)
Manhattan Investment Fund, Ltd. Litigations (S.D.N.Y., N.Y Sup. Ct. and Bankr. S.D.N.Y.): Ongoing representation of Bear Stearns Securities Corp. in connection with a series of individual and class action lawsuits filed by shareholders of Manhattan Investment Fund, Ltd. and the Funds bankruptcy trustee after the collapse of this hedge fund following disclosure that the hedge funds manager concealed approximately $400 million in losses through the creation of false account statements. Successfully obtained dismissal of Bear Stearns from cases brought by investors alleging that Bear Stearns aided and abetted the Fund managers fraud and breach of fiduciary duty by continuing to provide clearing services to the Fund after allegedly learning of the Fund managers fraud. See Cromer Finance Ltd. v. Berger, et al., 137 F. Supp.2d 452 (S.D.N.Y. 2001) (dismissing putative class action claims against Bear Stearns); Argos, et al. v. Berger, et al., 2001 U.S. Dist. LEXIS 6282 (S.D.N.Y. May 15, 2001) (dismissing claims asserted by 28 investors seeking $92.3 million in compensatory damages and $1 billion in punitive damages against Bear Stearns). Also successfully obtained dismissal of fraudulent transfer claims brought by bankruptcy trustee seeking $3.6 billion in damages. See Gredd v. Bear Stearns Securities Corp., 257 Bankr. Rep. 190 (S.D.N.Y. 2002).
(end quote)
Incognitus, how do you get that?
I haven't, actually, heard anyone make the unambiguous claim that Bear owns these deals, although I can't believe they haven't got a dealer shelf that would make my hair stand on end.
But which idiot agreed to the other side of this trade either 1) knowing Bear owned the bonds or 2) not knowing who owned the bonds?
Can you really be accused of "manipulating" anyone that dumb?
Back in February, the shorts looked like they were making a great trade. Many hedge funds had been shorting a derivative index called the ABX that is tied to a basket of subprime bonds with weak credit ratings. The index had a value of 100 when it was launched this past July.
By late February it had plunged to a low of 63, bringing millions of dollars in paper profits to the short-sellers. The plunge also caused ripples of worry through the stock and bond investors about the broader health of the U.S. economy. The index has since turned around, reaching 77 in mid-May before sinking back to 73, according to its administrator Markit Group.
Back in January, at a Las Vegas industry conference, Bear's head mortgage trader, Scott Eichel, talked with a small group of traders over drinks in the Venetian hotel about propping up the ABX index by buying and rescuing some struggling subprime bonds, say two people who were there. A Bear Stearns spokesman said Mr. Eichel disagrees with the account, but wouldn't elaborate with any details.
The recovery of the ABX index has led to howls from hedge funds which are short subprime, including Mr. Paulson, who manages a $12 billion hedge fund. Mr. Paulson says Bear wanted to prop up faltering mortgages-backed securities by purchasing individual mortgages that were rapidly losing value to avoid doling out billions in swap payments.
Bear denies the allegations. "None of the [mortgage] servicing decisions we make are driven by any activity or outstanding positions in the CDS market," says Tom Marano, who runs Bear's mortgage business.
In April, when the ABX was trading at about 74, Paulson executives called Mr. Eichel to ask whether he was contemplating a plan to repurchase mortgage-backed securities. "Maybe we are, maybe we're not," Mr. Eichel replied, according to two Paulson executives, who say he added they should call him if they were interested. A Bear spokesman said the Paulson executives' recollection of the conversation is inaccurate.
The prior day, Bear's mortgage desk had sent Paulson a copy of new language it was proposing to the International Swaps and Derivatives Association, the industry group that represents traders of swaps and other complex market instruments.
It exacerbated the controversy. The proposed rules would codify its right to prop up a faltering pool of home loans in a mortgage security, even if it knew its clients bet those loans wouldn't perform.
"We were shocked," says Paulson vice president Michael Waldorf, that a firm "like Bear would introduce language that would try to give cover to market manipulation." Also on his mind: With a big bearish bet on the ABX, his firm stood to lose a lot if the index didn't fall.
Mr. Marano says Bear was simply trying to clarify trading rules to "ensure participants understood the terms of the underlying documents."
Paulson fired off letters of complaint to Bear and ISDA. The firm also began rounding up othe
other hedge funds to voice concerns.
Nearly 30 players, including the San Francisco hedge fund Passport Capital, the Dallas hedge fund Hayman Capital, and Deutsche Bank AG's Deutsche Bank Securities unit rallied behind it.
"All we're after is very simply to maintain the market's integrity," says Kyle Bass, a former Bear employee who is now managing partner of Hayman Capital, which oversees about $3 billion in the subprime market.
Tanta, I don't "know" if they own them, but if people are saying Bear is taking loans out of the securitization and eating the losses, it's because Bear Stearns makes something out of it.
The mechanism I described is quite possible, especially since we know Bear Stearns owns equity and lower tranches in many securitizations.
As for people buying insurance on those CDOs, well, those hedges probably sought out the CDOs with the lousiest exposure (Florida, CA, "Stated Income", etc). At the time they might have known who was servicing the CDOs, who created them, etc, etc, but they probably didn't know who owned what.
can anyone say what the real value of the ABXs is ?
does this manipulated short squeeze continue ?
Much of the decline in Feb and the rise in May of lenders stock is duw to changes (1st Down later up) in the ABX.
Any way of knowing where we are today (short squeeze oevr ?)
what about other products such as CMBX ?
Incognitus, I'm not trying to be tedious, but this is the problem. Every time we get a report on this, we get this conflation of "buying bonds" versus "buying loans out of bonds" and so on. Look at what Neal just posted again: an article in which from one paragraph to the next we go from the accusation that Bear is buying bonds in order to prop up the market to the accusation that Bear is buying bonds out of securities it does not own to prop up the performance of those "reference entities."
So it matters that we be careful. Frankly, my dear, if Bear can buy the bonds, Bear can do whatever the fork it wants to do with the loans. Remember Lew Ranieri talking about having to drag 400 bondholders to the Coliseum to vote on mods? Well if you buy everyone else out and you are the only bondholder, it's no longer "voting." You can tell the servicer to stuff $50 bills in the borrower's payment statements if you want.
That said, we are talking about MBS, not CDOs. CDOs are, exactly, "managed" portfolios. REMICs are "static pools" and not managed. So, OK, I'm sure there are hedgies being fleeced by CDO managers who are buying and selling God knows what.
But if you tell me that this whole uproar between Paulson and Bear comes down to some nitwit confusing that with an MBS??? I'll explode for real.
Again, I can't see why anyone making claims of "manipulation" should be taken seriously for six seconds if that person cannot be bothered to talk about the business at hand with some degree of exactitude. It's possible we're just getting the garbled version because the reporters are the clueless parties. But I'm telling you now, from my perspective as a fairly informed part of the mortgage side of this, the things these people are saying do not add up. That's all.
This Kool Aid about how you can financial-wizard-engineer some magical step in the chain where risk just disappears and everybody is perfectly hedged is insanity.
Insanity, my dear Tanta, but for a select club of usurers, very profitable insanity.
One man's insanity is another man's perfect crime.
At the risk of offending you, wake up and smell the coffee. You are talking about mens rea Tanta. Mens rea.
You think Sandy and Chuck didn't know they were cheating people?
arbogast, what I think I am being told, after all the angst here, is that some hedge funds bet on Bear Stearns being stupid about what it takes to be its own best interests.
I am in no mood to be called the naif at the table.
Anyway, what seems to be happening is that enough people placed bets on something happening, that it pays for Bear Stearns to make sure that even if that something happens (people default), it doesn't really happen (Bear buys those people out, so reality is now different).
If this is happening, it calls into question just how crazy it is to scream "manipulation". To "manipulate" is to subvert the normal workings of a market so that it produces a different result from what it would otherwise, and to do so for your own benefit. In that sense, Bear Stearns does seem to be "manipulating", no matter what exactly they are doing (given what people are screaming, Bear is making sure insurance is not producing the payoffs that the existing level of defaults would produce without their intervention).
Bear Stearns probably saw "the opportunity". It's not like people were betting that they are stupid, it's that they entered the picture afterwards and changed the market's workings.
I wonder how much of the incredible rally we've witnessed in the stock markets isn't something similar.
I also always wondered why large institutions don't place "one way bets" on the days futures expire. You'd just have to buy/sell them ALL day long. At the end of the day they'd expire and you'd get paid.
It's quite an amazing market we live in today. Imagine this scenario ...
1) You put out a very obvious pig of a structure, with all the lousy loans you want to get rid of, keeping most of it yourself since you can't sell it to anyone else - nobody will buy it.
2) Everybody and their mother "shorts" your obvious pig by buying loads of insurance on it defaulting. You, the pig creator, sell all this insurance at the very high premiums such pig deserves.
3) You buy out all the bad stuff the pig has in it. These losses you were always going to take, but now, miracle, since you take the losses you were always going to take OUTSIDE the structure, you get to keep ALL those premiums - bets - on how the thing was going to blow up!
Man, this innovation is really getting out of hand.
Is it like this:
I like to shop at Yasai market for my produce. Small, owner-operated, good quality. In the far corner they always have the "bargain bags" -- an assortment of stuff slightly off, or soon-to-be. For example, you can get an eggplant, three onions and a bell pepper, all past their prime, for $.99 let's say. Full retail might be $1.98.
It sounds like these hedge funds want to buy the bargain bag and return the bell pepper and two of the onions because they are shocked to find out that they have a bruise. Then they want to resell the eggplant and one onion at near retail, (and a profit) because they are in great shape.
It can't be that simple, can it? I mean we all know why the veggies are in the bargain bag, and we know it's caveat emptor, and you get what you pay for, right?
I guess what I'm saying, Tanta, is that it's quite a table...not one that I would personally want to touch with a barge pole, and one that I would be thrilled to be the naif at.
Tanta,
"If that puts Bear and Paulson both in jail or in damages, fine by me. Just get them out of the drivers seat of the residential mortgage market and the price of having a roof over your head before we cripple the real economy past the point of redemption. Please stop helping us."
Tanta, Bear and the hedgies don't give a rats rump about the economy, homeowners or the mortgage market, it is all about being on the right side of the trade.
Have you ever read Other Peoples Money by Nomi Prines? It is very insightful look at the investment banks and well worth the read.
If the IB's get caught doing something a little underhanded it's a fine which is a fraction of the gains made which is paid without admitting guilt or any wrongdoing and then back to the races.
I don't disagree with you something should be done but I just don't see Wall Street moral hazard changing anytime soon.
Tanta,
I know it's not insurance and I have only compared to an insurance. But it probably more resembles insurance that anything else. Buyers of these type of "protection" need to regularly pay for the protection and they receive the payment proportional to the loss of the underlaying assets. So the trigger is not binary. The more defaulted underlaying bonds, the bigger payout.
But the normal insurance market is regulated. Insurance fraud is prosecuted. You will never get multiple payment of one loss. With these swaps it is possible. So it is the problem of multiples of notional value. If notional value was limited to the value of the underlying assets, it would have perfectly worked as an insurance and no such tricks would have been possible.
And over at the NY Times, we have Gretchen Morgenson weighing in on the further cascade of defaults in the next 12 months, brought about by ARM resets. [If any CR readers were daunted by the length of Tanta's post, just look at the stuff that Morgenson gets wrong in her briefer piece, and you will have new respect for our Tanta. All the resets are in sub-prime?] So, even if Bear wants to buy some loans out of its portfolios in the whole Bear -hedge dance, the bigger question is how long Bear Sterns has the resources/capital/fortitude to keep doing when the seemingly endless supply of compost continues to hit the fan...
There are two things I am taking away from this Credit Default Swap bitchfest between the hedgefunds and Bear Stearns:
It's a windy path though:
Owners of the main paper.. can feel safer by believing that there will always be some big bank who will manipulate the underlying to keep it propped up.
Then what happens? No one wants to play the derivatives game.. cause if it's so blatantly fixed when it comes to these swaps.. why not with all derivatives? I mean you may have sellers.. but no buyers (well, I might be a buyer if they sell real cheap.)
But, to be slightly more unclear, I believe that this would just make people more complacent or blind.. this idea that Bear Stearns has it under control and the banks can just manage the numbers on the paper.. It's a dangerous idea.
This will just make things a lot worse if the banks (or the PPT or the "greenspan put" or whatever safety valves one believes in) lose control.
That is, fundamentally, the problem (notional value of "insurance" exceeding the notional value of the underlying!)
This sort of thing causes all kinds of interesting disruptions in the equity markets from time to time. PUT contracts that exceed the float, for instance, can cause some WICKED moves.
But in this case it appears to be particularly perverse in that the argument is that Bear WROTE THE CONTRACTS!
So now we've got a situation where Bear has been handed a "no lose" trade. They can simply EAT the mortgages and collect the "overcollateralization" represented by the "extra" swaps.
I'd love to be able to buy 10x the value of my home's in insurance for less than it would actually cost to rebuild it - if I could collect. Then when the next hurricane comes I'll just pack up and leave with the doors and windows wide open! Oops - the house got destroyed. Darn. PAY ME!
IF this is what it all boils down to then yes, there's a problem. But whether the problem lies in the way the swaps are written or in the original servicing and securitization agreements is unclear - along with who is the dumb-dumb.
The obvious question is whether you really can complain about the fact that the Roulette wheel has a built-in mathematical disadvantage in the form of "0" and "00" after you lose, when you're able to see the numbers on the wheel before you bet.
poszi, I'm sure you and I don't disagree. If we're going to call it "insurance," then we regulate it like insurance and stop this crap. If we won't regulate it, then it's Vegas, and we regulate it like Vegas. As far as I know, not even in the casinos on the strip are you allowed to mark your cards or weight your dice. However, you if you don't do those things, you don't get to yell "mulligan!" when you lose a bet. It seems to me worth the time to try to figure out whether we have "illegal manipulation" here or a bunch of sore losers.
Incognitus, you sketch out a convincing scenario for Bear's actions here. But why does it keep sounding like the hedgies never knew any of this was going on, and had all one-way bets themselves?
What the article I quoted here says, in essence, is that Bear is doing something perfectly legal but "non-economic." The implication is that nobody like Bear does anything "non-economic" without a reason, ergo Bear is squeezing the credit shorts. So what? So Paulson and Pitt want the rules on securitizations changed so that an owner of a bond cannot engage in perfectly legal restructuring of it???
I have to assume these folks aren't whining to the press just because they want their own investors to find out how badly they've been had. I understand the universal unwritten rule that a fund manager doesn't state publically that its investment strategy is lookin' ugly unless it is forced to do so, or it thinks it can get bailed out somehow. I therefore must assume that Paulson wants the rules changed so that your scenario would become legally impossible for Bear to engage in. Do you agree that there are grounds for this? I can't see any workable solution except to make it illegal to enter into a contract if you have conflicts of interest. Current law says only that those have to be disclosed. Am I reading the whole thing wrong?
Good heavens, what a karmic convergence. I think I was busy trying to write something that eli and Karl said better than I did.
I am, however, still not convinced that Bear owns anything other than the residuals on the ABS in question. I need to see that in print, clearly, from a reputable source, not a spin-meister. I'm not saying it isn't true. But my whole post was based on the initial assumption that Bear is sponsor/servicer, not One and Only Holder of Funded Tranches. That, Karl, is why I'm not so sure yet that Bear was buying 10x notional coverage on its own asset. I keep being told the "reference" for the CDS was the ABX. Someone has to prove to me that Bear owns enough of the deals in the ABX to "own the index."
If, actually, this is all about a firewall problem at Bear: its CDS desk is out there writing deals while having information from its mortgage servicing side it shouldn't have, then fine, that's another (unsurprising) conflict of interest problem on the street.
But it sounds to me like we're talking about the claim that servicers shouldn't be allowed to buy DLQ loans out of a pool. Hang on! Let's not "fix" a CDS market problem by utterly fouling up the nature of an MBS servicing agreement. Particularly when this suggestion for how those servicing agreements work is being made by people like Paulson or his pet Pitt who don't own the securities (apparently).
Tanta,
I agree with you on this "whining to the press" issue. To me, this is the biggest part of the story.. the details about what Bear Stearns is buying up or if it's legal or illegal doesn't really matter.
What matters is that there's smoke here. Hedge funds are whining to the press for some reason.. and Bear Stearns is buying up some sort of paper somewhere because they sold a, presumably, huge amount of paper derivative of this paper.
Did Bear Stearns sell a lot of other derivatives? How long can they soak up paper? What other positions do these hedge funds have?
There's no guarantee for a beautifully raging fire.. but one can always dream.
I believe Mehta is correct. The central problem is that the ABX "insurance" is not based on the performance of the actual bond that an investor owns. The ABX is based on a small number of reference securities that are supposed to be good proxies for all the other similar securities that were sold in a similar time frame.
I believe what people are complaining about is that Bear is interfering with the performance of the reference securities so that they are no longer good proxies for the market as a whole. Some group of investors bought ABX "insurance" to cover bonds that were not actually represented in the ABX index. The ABX reference bonds are performing OK because Bear is pumping money into them. The other securities are performing much worse, but the ABX hedge isn't making up the difference.
Of course, some group of punters just bought the insurance and they are not collecting as much as they would like. Both groups are complaining that the product isn't really acting like insurance (or a hedge, or a put option, or whatever they thought it would act like) because the proxy relationship of the reference securities to the broader market was misrepresented or is being actively interfered with.
The interesting thing is that Bear may be pumping money into securities that it doesn't have any interest in at all just to make sure that it doesn't have to pay off all those ABX claims. I assume an unrelated servicer can't be faulted for accepting Bear's offer to buy defaulted loans at par.
Where do I sign up for a BS backed mortgage? Time for a Dire Straits song track...
"That ain't workin' that's the way you do it
Get your money for nothin' get your chicks for free"
Not having the knowledge or education combined with the sheer volume of cold medication Im currently going through, Im not at all sure that this would be germain to the conversation but thats never stopped me before...
Would the fact that the PSAs for the trusts in which loans are being removed contain language giving the servicer in this instance Bear right of first refusal to purchase a non-performing loan out of the trust be at all relevant here?
Depending on just how these loans are re-securitized and, more importantly who is doing it, the incentive may simply be to keep servicing the already defaulted loans by modification/forbearance etc. in order to bleed the borrower as much as possible until it becomes time to foreclose and ultimately sell the property. Ive read some rather disturbing language in trust PSAs recently that states that, among other things, servicers can keep any profits from REO sales as additional servicing compensation as opposed to returning it back to the mortgagor.
Such being the case, would this be any potential motivation for Bear et al?
I assume an unrelated servicer can't be faulted for accepting Bear's offer to buy defaulted loans at par.
I don't think that's possible, albrt.
Only the servicer of the deal has the right, but not the obligation, to buy a DLQ loan out at par. I was assuming for the sake of argument that Bear is the servicer of these deals, since that is the only way Harvey Pitt's claim makes sense to me.
Bear isn't, as far as I know, wandering around buying loans out of deals it doesn't service. If it is, those deals are not REMICs, because REMICS can't hold loans for sale.
Bear may be buying up the bonds in the ABX to support their price--I have no idea, but I've seen that suggested--but it isn't "buying up loans" unless I've personally lost my mind about how REMICs work. That's possible, but no one has yet shown me where I'm wrong on that.
So the Bear has begun eating the children!!!
Howls of derisive laughter- like Wall Street has ever been anything but a giant wealth reallocator.
Hedgies thought that things move like physics and Black-Scholes!!!
Hedgies are the new victims, I thought that was clear with the Amaranth fiasco, and the small guys should be running like scared deer in the headlights.
The only problem is mainstreet gets flattened in the process, oh well.
Does anybody start wondering if Humongous Bank and Broker is engineering a Black Swan event?
I am beginning to wonder if we have the potential for a new Glass Segal out of this.
Criminal greed is leading general stupidity.
Someday this war is gonna end...
Ive read some rather disturbing language in trust PSAs recently that states that, among other things, servicers can keep any profits from REO sales as additional servicing compensation as opposed to returning it back to the mortgagor.
Mike, are you sure about that? The application of REO proceeds is a matter of 1) state law and 2) the terms of the mortgage or DOT document itself. I know of no state, and no state-specific uniform instrument, in which it says that a servicer can keep proceeds over the amount secured.
Please read my post again. A servicer does not have to buy a loan out to modify it or do a forbearance agreement. It can buy a loan out, in some cases, if it chooses to. But if the point is to make money as a mortgage servicer, you don't buy the loan out, you let the security continue to own it so that the security takes the losses.
Tanta:
Let's assume that Bear actually isn't the servicer on the pools in question here. So, theoretically, they would not have the right to buy defaulted loans out of the pool. What's stopping them from going to the servicer and saying, "Hey, we need you to prop up a few of these securities, so if you buy the loans out at par, we'll take them off your hands for you." That sounds like a win-win situation for everyone but the hedge funds -- the bond investors get paid at par on a seriously delinquent note, the servicer doesn't take a hit on it because they can turn around and resell to Bear, and Bear doesn't have to pay out on their (presumably large) default swap position.
"I am beginning to wonder if we have the potential for a new Glass Segal out of this."
of course we do.
take the 1929 banking rules and 10% margin accounts and look what it is today :
20:1 leverdge in unregulated hedge funds who make comlex deals with banks and others on the street.
same as 1929.
A slight twist on Zach but don't what to add to the roster of assumptions so consider this a rhetorical or, probably more descriptively, a stupid twist/question: If BearS didn't already own and/or service the underlying loan pool(s) is there anything preventing them from going out and buying the it/them?
I mean if I was selling puts or CDS's on an index such as ABX that didn't have too many components and I was heavily leveraged doing so why wouldn't I just take some of my (current) profit and acquire enough of the underlying -- someone somewhere must be looking to sell, particularly those increasingly scary equity tranches -- to assure those puts expired worthless; hedging the hedge of the hedge so to speak?
Any reason I couldn't do that?
Zach, your scenario is certainly a possibility. I would imagine it going like this: I'm sitting in my office doing whatever it is I do, and my Bear sales rep calls me to say Bear has a great bid on modified seasoned loans, and do I have any I want to sell? So I go to a meeting with my servicing people, and I tell them about this, and they say well, we don't have much we own, but we could probably take a few out of some pools. And so it could happen.
To make it work on a large scale, on targeted bonds (presumably the ones in the ABX basket)? I dunno. The fact is Bear is a big servicer, so it doesn't take much to imagine perhaps a combination of such things. As you note, of course, it's neither illegal nor in violation of anyone's fiduciary responsibilities.
RW, in fact my original assumption, until I saw the current article with the Pitt quote, was that Bear probably was buying up the bonds. It's just that that would make Pitt's claim even more ridiculous than it is if you assume Bear's just the servicer. It's one thing to accuse Bear/servicer of buying someone else/bondholder's defaulted loans (a "noneconomic transaction") in order to avoid the CDS payout. But to accuse Bear of buying out its own defaulted loans? That's unintelligible.
Yal; There is no margin on CDS products. Where does that put us?
On buying the underlying to make PUTs worthless - no, other than the cost of doing it.
There IS a price at which this might make sense. Rumors are that some of these tranches are going for a dime on the dollar - that might be low enough to make the trade work, especially if you WROTE a bunch of those PUTs and and don't want to see them in the money!
But - the problem I see here is that I don't understand how Bear gets standing to do it unless they're the servicer. If what's being complained about here is some sort of collusive action with SOME OTHER servicer, well, that suddenly gets a LOT more interesting.
There's just not enough detail here for me to figure out EXACTLY what is being alleged; claiming that the ABX is being "manipulated" sounds nasty but whether it really is depends on exactly what sort of agency relationships exist between the various parties AND the underlying elements of the index that are allegedly being played with.
There is one wicked potential consequence to this that folks better watch though.
That is the fact that the plunge in February was foretold a couple of days earlier by a severe whack in the ABX indices. If these are now being "manipulated" then you can no longer look to PUBLIC credit market data as a "tell" for potential equity market dislocations. That sucks, because the underlying RISK of the dislocation doesn't go away - just the "tell".
The WSJ and this latest article never quite made sense to me because, as you said, it lacked specifics and appeared to be written by people who did not understand securitization.
Though I don't know if I believe this nonsense about buying out loans and making modifications to securitizations, the ABX indes has come under fire for quite a while now as not being representative of the ABS/MBS market. In Feb, there were cries that the various ABX indices had fallen way faster than the actual market for similar securities. Had it been a "spread" index, it might have been easier to verify, but, as it stands, it is a price-based and the assumptions used to price the bonds are not made public and are only known to the big investment banks that are participants and mark the securities. I have tried to get access myself, and they won't give the info if you are not a participant. Maybe, someday, Markit will publish the avg spread and default assumptions so that they can be verified against the market, but I wouldn't hold my breath.
In the trivia dept. Wikipedia insists that it is the Glass-Steagall Act.
I guess the other reason I'm a bit skeptical of a grand collusion among Bear and a bunch of subprime servicers is that Bear, and its buddies the other IBs, have spent a large part of the last year putting back loans to and yanking the warehouse lines of a significant number of subprime servicers, effectively putting them into BK or damned close.
You kind of have to assume these folks are going to turn around and offer to take even the ten minutes' worth of risk between the day they buy a defaulted loan and the day they sell it to Bear just to make Bear happy? I have this idea that there are a number of servicers out there who would leap onto the back of the first Bear salesman who showed up on the premises and wrestle him to the ground. Just a thought.
Cripple the real economy? Morgan Stanley thinks the second qaurter is currently indicating more than 3% GDP growth.
So now this really, really doesn't make sense to me. I don't know a lot about these markets, but if the hedge funds were buying "insurance" which would pay out if the ABX indices were to fall, and if the notional value of these contracts is big enough to make it worth Bear's money and effort to prop up the bonds in those baskets, well, that just strikes me as being incredibly foreseeable. You can say what you want about the ethics of some of the people who run hedge funds, but they are generally not stupid -- and what we're being asked to believe here is that a lot of not-stupid people paid out a lot of money for these contracts, and it just happens to turn out that Bear can make the contracts expire worthless just by moving the price of a few financial instruments in a market that's neither terribly deep nor terribly liquid? I'm not buying it. If that's really the case, then the hedge funds would do better to confine their gambling to the horse track, where you're at least guaranteed a semi-fair shake, and I'm due to re-evaluate my opinion of the intelligence of the hedgies.
Tanta, I'm not suggesting at all that the servicers would do what I'm suggesting just to make Bear happy. I am, however, suggesting that if I'm a servicer, and Bear calls me up and offers to pay 102 for a bunch of crap that's not performing, that I want out of my pools because I have a slice of the equity, and that, as the servicer, I have the right to buy out of the pool for 100, I'd have a hard time turning them down. And if the notional value of these swaps is big enough, then it may make sense for Bear to do just that, even if the loans are worthless on the open market. I just have a hard time believing that nobody who was buying the swaps saw this coming.
"There was total bad faith by the evil forces of self interest among the too-big to be average bond fund type of players who can only make money by manipulating the public into doing the wrong thing, sort of like an undertaker praying for plague in order to prosper or a sage hyping the total 100% certainty of another disaster so he can raise rates." -VICTOR NIEDERHOFFER
Apologia, from Victor Niederhoffer : Daily Speculations
Another hedgie crying but he is probably correct.
In the trivia dept. Wikipedia insists that it is the Glass-Steagall Act.
And all these years I thought they were saying... 'Gassed Seagull Act'.
Great thread Tanta & all, better than reading a summer pulp thriller. So when do we start seeing 'bodies'... that's what I want to know. So far we're just setting the scene - I want blood, I want it now.
Tanta:
Zach's point is a good one, although not necessarily the only way to interfere. Maybe they really were slipping $50 bills in the borrowers' billing statements. I bet the docs don't say you can't do that.
Zach:
Based on the low margin, low default assumptions everyone was using to create these monsters, Bear's actions would have been uneconomic and therefore unforeseeable. It was only when all the assumptions went out the window and all the hedge funds started piling onto one end of the teeter totter that this became a plausible squeeze. It happened fast, so Bear may have figured this out only a few days or weeks before the hedge funds realized they'd been had.
"Founded in 2001, Markit enjoys the sponsorship of 13 financial institutions who manage assets in excess of $10 trillion. This sponsorship allows us to create financial market transparency and increase the markets processing productivity. With this sponsorship, Markit is typically first-to-market with innovative services, that evolve on a real-time basis to meet emerging market challenges."
See, nothing to worry about, the ABX is just "evolving on a real time basis" like dinosaurs learning about asteroids.
dryfly, sorry about all the scene-setting and not enough sword-fights. All these pirates, you'd think we'd get to see some nekkid steel, but not yet. But I promise to do a follow-up report as soon as there are carcasses to deplore.
Is it just me, or does the name "Markit" remind anyone of the name "Ownit"? One of these funds is going to name itself "Swapit" and then Bear will have to change its name to "Screwit" . . .
LOL, and then we'll see a return of the resolution trust but it will be called ARMpit.
T-
I'm trying to put a couple of things together.
It seems a lot of the confusion here resides in the fact that Bear MIGHT be persuaded to engage in uneconomic transactions because the CDS market has grown far larger than the underlying pools of mortgages upon which it it based.
Then there is this comment by you=
"It is only in the last two or three years that there has ever, ever, been in this business sufficient serious loan failures occurring so early that they are enough to affect the triggers like that before the step-down."
The CDS market has grown like Topsy over the past few years - did the growth of the CDS market act as a fertilizer for the subprime market? Essentially speculators threw a bunch of shit down and forced up a bean plant to grow so fast that it couldn't stand straight?
Reminds me of the quote from Keynes
"Speculators may do no harm as bubbles on a steady stream of enterprise, but the position is serious when enterprise becomes the bubble on a whirlpool of speculation."
PS(sorry if this is completely wrong or if I'm just figuring out what you've been saying for a while)
Maybe Im interpreting these the wrong way then, Tanta. Im also coming across prepayment penalties being given to servicers as additional servicing compensation in some prospectuses as well.
WACHOVIA ASSET SEC CORP MORT PASS THR CERT SER 2002-1
p. s-53
"The Pool Distribution Amounts also will not include any profit received by the Servicer on the foreclosure of a Mortgage Loan. Such amounts, if any, will be retained by the Servicer as additional servicing compensation."
WASHINGTON MUTUAL MOR SEC CORP MOR PASS THRU CERT SER 2001-3
p.56
"However, if a gain results from the final liquidation of a defaulted Mortgage Loan which is not required by law to be remitted to the related Mortgagor, the Company or Servicing Entity, as applicable, as Master Servicer, or the Servicer, as applicable, will be entitled to retain such gain as additional servicing compensation unless the applicable Prospectus Supplement provides otherwise. See "Description of Credit Enhancements"."
COUNTRYWIDE HOME LOAN LP MAS SERV ASSET-BAC CER SER 2004-4
p.29
REPORTS TO SECURITY HOLDERS
"Prior to or concurrently with each distribution on a distribution date the master servicer or the trustee will furnish to each security holder of record of the related series a statement setting forth, to the extent applicable to such series of securities, among other things:
the related amount of the servicing compensation retained or withdrawn from the Security Account by the master servicer, and the amount of additional servicing compensation received by the master servicer attributable to penalties, fees, excess Liquidation Proceeds and other similar charges and items;
Albert --
I see your point, but if the hedge funds really believed the low-default assumptions that went into creating these bonds, why would they buy swaps that paid off when the bonds blew up? It sounds to me like they were banking on the bonds getting into deep shit, and when they found Bear willing to sell them a product that could pay them when that happened, they jumped at it. They expected those assumptions to not hold up -- so what was unforeseeable about this? They seriously didn't expect Bear to notice that they could save a pile of money on their swap obligations by just bailing out the bonds in the ABX basket? I don't get it.
who else besides the HF's is long subprime risk and may have used these ABX puts to hedge themselves? If Bear gets away with this then it is these who have incorrectly viewed the ABX as a hedge against general subprime deterioration. Are MBIA and AMBAC uing this as a hedge?
Allenm:
I am beginning to wonder if we have the potential for a new Glass Segal out of this.
That's what I'm talkin about! An ass kicking bank regulator.
Under Siege 2: Dark Markets
At the end of the day I can't escape the impression that somebody at the hedge funds didn't do their homework.
"I also always wondered why large institutions don't place "one way bets" on the days futures expire. You'd just have to buy/sell them ALL day long. At the end of the day they'd expire and you'd get paid."
No you wouldn't. If you sold, then there would be buyers, who would have exactly the opposite interest than yourself. Consider a future on a stock index. E.g. suppose you sold futures. You can only be sure of making a profit if you're a massive seller of the underlying index stocks during the period when the future's maturity value is determined. So your strategy of selling more and more futures works only if you're willing to sell more and more stocks. If you already have stocks to sell, then that may work. But if you don't, then you'll have to buy them back afterwards, with very painful results.
rcryan, I'm certainly not saying no deal ever failed its triggers before the last few years; that's why step-down triggers are there. But yes, I am certainly saying that the "loss curve" changed dramatically on subprime in the last few years. Between the EPDs (loans failing in the first six months), which historically happened in subprime at around 1.00% and has in 2005-2006 pools been anywhere from 6-10%, and the famous first adjustment failures of the 2/28s, we are seeing unprecedented losses in the first three years of these deals. (I don't think I've ever seen one with a step-down date before 3 years.) So you already have a situation where the deal is more likely than not to fail to release OC at the first possible step-down date.
The argument floating out there is that servicers can manipulate this via modifications (i.e., modify those failing loans to current ones, so that the deal passes at the step-down). Well, maybe. But that is my point: how did these servicers end up with so many early defaults to modify? To claim that one is only worried about this happening "potentially" or in future deals--and therefore we should make major changes to deal documents--is just disingenuous, then: if the loans were sturdy enough to perform like a typical loss curve--and with a big enough pile of loans, they should "revert to the mean"--there would be no question of modifying anything except the usual trivial numbers that just can't affect the waterfall or the triggers in a significant way.
So I am making both claims: the presence of this "insurance" (those CDS where someone was betting on success) created a moral hazard, such that extremely high-risk loans were originated, resulting in the failures some of the hedgies were betting on.
Also, some hedgies were betting on failure, not success, and insofar as they were right about credit quality--the loans did start failing in droves--they were wrong about what the servicers would do next: attempt to mitigate losses (via mods, among other things). Perhaps they were naive about servicing contracts; I think that's part of it. Mostly, I think, they forgot about HPA.
They forgot, that is, that earlier vintages "performed" because of rising prices, which gave defaulting borrowers options to sell or refi, and that gave struggling borrowers a reason to keep struggling. When so many borrowers ended up upside down, they failed more often. But that very fact means that foreclosing is less attractive an option.
It's funny, but it's true: I can get people from other parts of the financial world to understand things like prepayment risk: the tough part of investing in mortgages is that you often get your money back at exactly the time you don't want it, and you don't get it back fast enough at exactly the time you'd like to.
What we can't seem to get them to understand is that foreclosures work the same way: if you have to foreclose, that's usually at exactly the wrong time to be foreclosing. These folks are crying foul about modifications as if there were a better option. In a "normal pool" with a "normal" loss curve, the world's crookedest servicer still couldn't manage to do enough mods to affect the waterfall noticeably. If mods are affecting the waterfall noticeably, we are not in a normal environment.
This gets to Mike's post: Mike, first, there are not many jurisdictions in which a servicer can make a "profit" here. In most cases where it's possible, it's because the borrower skipped or disappeared and isn't claiming money that would be due to him or her.
But back up a minute: we aren't foreclosing on properties that are worth more than the loan amount these days. It wouldn't matter if local law gave a servicer the right to excess proceeds if there aren't any excees proceeds. This is why servicers are modifying instead of foreclosing: foreclosures are losing propositions right now. If there's any equity at all, the borrowers are selling voluntarily, or they're asking for mods or forbearance.
This is the principle: you can "make a profit" on foreclosures only in those market environments in which you don't have to foreclose. If you have to foreclose more than 0.14% of the time, you won't be making a profit.
You can "manipulate" the waterfall with modifications only in those markets where the alternative is no waterfall at all: would you like less cashflow (a "manipulated waterfall") or no cashflow (foreclose at a loss)? Anyone who thinks he's got another choice with these deals hasn't grasped the underlying problem.
Fleck weighed in on this overnight.
"Public pension funds take a risky gamble: Looking for the spectacular return, many are investing in heavily hyped, oh-so-dangerous portions of the debt market. Ultimately, that market is going to melt down", Bill Fleckenstein, MSN Money, June 11, 2007.
Tanta, I'm not suggesting at all that the servicers would do what I'm suggesting just to make Bear happy. I am, however, suggesting that if I'm a servicer, and Bear calls me up and offers to pay 102 for a bunch of crap that's not performing,
OK, I've had some coffee. I guess the reason I'm doubtful is that if one is a reasonably well-capitalized servicer with a realistic hope of making it through this mess, even getting 102 on some mods (after having taken the risk of buying them out and holding them long enough to get the mod done) is picking up nickels in front of the steamroller.
If you're in such dire straits that picking up nickels sounds good, you probably are already in court with Bear at the other table with the other lawyers.
That is, Bear might have some giant CDS trades going where we're talkin' big money, but I'm struggling to believe that the pool servicers left standing right now (other than the IBs' own servicing platforms) can see enough change on the table to make the risk worth it.
I should note that I am reliably informed that bids on new subprime paper (full warranty, loans, if aged any, fully performing) aren't much better than 101. So a 102 bid on something that was 90 or more days down until it got some shaky mod, is going to catch some auditor's attention, or is likely to. It's not necessarily illegal, but do I, the servicer who presumably doesn't need to take this risk, need to take this risk?
Surely if someone is paying 102 for a mod of a defaulted loan, that's prima facie evidence of manipulative intent.
Regarding the Rating Agency comments from Geoff and Tanta. Although the rating agencies "always include" the disclaimer that their "opinions" should not be used for investment decisions in official literature - I think their little disclaimer veil is bound to cost them a lot of attorney fees in coming months.
A case in point, on page 11 of last week's Asset-Backed Alert (an industry rag) there is a full page ad from Fitch, and I quote... "At Fitch Ratings, we know you rely on our opinions ... Presale reports provide ... the information you need to make informed decisions". This is days after Fitch was quoted for a Bloomberg article on CDO Subprime losses, "Fitch ... says its analyses are just opinions and investors shouldn't rely on them". Both quotes are abbreviated.
Surely if someone is paying 102 for a mod of a defaulted loan, that's prima facie evidence of manipulative intent.
Yes, but I'm not sure it's illegal. I'm not even convinced it's particularly unethical -- there's no reason Bear should stand there and take their lumps if they can reasonably avoid it. I'm going to defer to your knowledge of what a servicer would or would not typically want to do; my impression is still that this is a damn atypical situation, and that there are some very perverse incentives in play.
This has been a very interesting conversation; I'm finding out how irretrievably weird some of this financial business is. I think I'd better stick to physics and index funds. Either that, or start my own hedge fund -- after all, I get my 2% either way, yes?
Oh, Zach, you're right, it is absolutely legal to pay too much for a loan. God help us, we'd all have been in jail years ago if it weren't.
My problem is having spent too many years working for a mortgage servicer with a bad habit of wanting to stay in business beyond the next quarter. So I do tend to think there are occasionally opportunities to make a buck you should pass up.
Obviously I am no more fit to work in the mortgage industry these days than the guy sitting next to me at the bus stop.
As you said earlier in this post, Harvey Pitt's "concern" about the subprime market is rather transparent. If he is out to help borrowers, I have a bridge for sale.
On the other hand he makes a good point about manipulation in the swap market, and it behooves regulators to ask which other types of swaps are vulnerable to manipulation of underlying reference securities. There are hundreds of billions of dollars of CDS's out there, and they are unregulated, over the counter securities. I could care if any single one of them gets in trouble; no one, however, wants to see systemic risk.
sunlight, I agree with you 100% about the systemic risk concern.
That said, I'll cut Pitt some slack as soon as he starts all his sentences with, "Now that we've made all the boatloads of money we can possibly make off this racket, we must observe that there's a potential for manipulation."
Tanta,
Regarding risk. This entire idea of random risk in these markets is nonsense. I have no knowledge of the computer modeling that goes on, but the idea of Monte Carlo risk shows that random error is expected. Everybody uses random error to predict statistical events, insurance companies, manufacturers, product testers etc. Let's say you make motors. You have a good design, good manufacturing, yet in the course of operations 1 motor in 100,000 will fail. That would generally be considered random error or failure.
In the mortgage industry, this would be analagous to a stable couple purchasing a home with standard financial ratios 28/33 with a respectable downpayment. In the course of life the husband got laid off, the wife had unforeseen medical bills, the economy tanked etc. You can relate foreclosure to unemployment or GDP growth and predict certain random events, foreclosures with statistical methods ie Monte Carlo modeling.
The last years of mortgage origination have undermined the random nature of default. By ignoring time tested ratios, using introductory rates etc, they have designed in foreclosures. They have made a motor with material that is designed to fail. This is no longer random risk it is systemic risk. There is absolutely no point in using Monte Carlo methods as they are not statistically valid
Tanta, all I have to offer to back me up at the moment is this:
delawareonline.com | Wilmington | The News Journal
"Attorney General Beau Biden said his office has seen scams related to the rising foreclosures. In some cases, foreclosure "consultants" promise to help struggling homeowners, but actually deceive them into signing over the rights to their property.
Another problem comes after a foreclosed home goes to a sheriff's sale.
"When a home is sold in foreclosure and there is money left over, the money belongs to the former homeowner," said Biden. "People are not always aware that this money belongs to them."
Superior Court has more than $5 million waiting to be claimed.
Now some people are persuading distressed homeowners to sign over their rights to the residual money in exchange for an upfront payment. In some cases, homeowners have signed away as much as $30,000 in exchange for $1,000.
Consumers who believe they may be victims of a foreclosure scam can call the Delaware Department of Justice's Consumer Protection Unit at 577-8600, Biden said."
As far as foreclosures and making money are concerned, my argument has been the same all along - lenders don't lose money on foreclosures especially when the loans are securitized because the pools are insured. Claims are made on those policies - correct me if I'm wrong. SERVICERS, on the other hand, make money hand over fist during the entire foreclosure process, due largely in part to those "additional servicing compensation" clauses i.e. assumption fees, modification fees, forbearance fees, late payment fees, etc,. The actual foreclosure is just the final act of laundering the property off of the books. And that may not even take place until after teh servic er has purchased the physical property and sold it themselves for a profit.
It's THEN that the servicer makes additional money on the sale because the servicer has paid bottom dollar - most likely just the remainder of what is owed on the note plus fees, etc. for the property. And that hasn't always come close to FMV of a property in the last several years. And that is money that the original mortgagor won't see because the sale of the property from the note holder to the servicer effectively terminates the contractual obligation between note holder and mortgagor. It doesn't wipe out everything that the parties agreed to up to that point - it just effectively ends the agreement between them at the time the servicer purchases the property.
There is an entirely different argument to be made about legal obligations that note holders and/or servicers have to make every effort to get top dollar for FC properties ehich never seems to happen either... I'll leave that alone.
It looks to me that since there are very loose regulations on these bonds what we have here are a trial balloons being placed by both Bear Sterns and the Paulsen hedge funds. They both are seeing what they can get away with. They are both trying to protect their positions so they will try to manipulate markets in any way they can to protect themselves.
It's clear that BS can not buy every bad loan out of a securitization and protect the overall value of the bonds. However, if they can create a perception that they can do this it may create some price support.
The Hedge funds are pushing the opposite side and crying foul over this.Each side has their own little agenda, Reduce losses or maximize profits.
These cat fights usually don't go public. I guess that is why it is so interesting to us all.
Tanta has the right idea with what she said about Harvey Pitt
"I'll cut Pitt some slack as soon as he starts all his sentences with, "Now that we've made all the boatloads of money we can possibly make off this racket, we must observe that there's a potential for manipulation"
Bear, hedge funds and their executives were making boatloads on these deals for years. As is always the case a good percentage of it is off the backs of those who can least afford it the, middle class.
Now we are supposed to worry about the potential impact on Bear Sterns Quarterly Earnings or whether Some hedge fund gets to maximize the profit on a position.
Lets feel some compassion for all the average folks who are losing jobs and homes as a result of this mess.
Great thread.
What is the ABX? Is it a true reflection of the value of the underlying bonds? or is the market evaluation of the bonds from the trading in the ABX? If the "insurance" is oversold and there is less demand for the product, the ABX goes down. Those selling the product know when the value of the ABX does not coincide with the underlying securities. If the lenders are in hock to the same people selling the insurance, who are able to sell until the bonds are priced so low that the collateral isn't large enough, margin calls happen. The absolute worst timing. Lenders either go bankrupt or sell at depressed prices. Shareholders take the hit, and the assets of the lenders go on firesale. It all has an aroma. Why are the primes buying these lenders who are going down? Value? When the primes own the paper, they can support the underlying security on which lots of insurance has been sold. The primes rework the underlying security, these produce, the insurance doesn't get paid, and the real profit isn't in the mortgages, it is in selling the insurance.
The primes are taking major bets on a the duration of a cockroach fight and giving the cockroaches steroids.
If there is manipulation in the trading of the ABX, it is not as transparent as the manipulation of the stock market via options. When the SEC allowed the options market maker to hedge his positions by naked shorting, the OMM could sell infinite puts, hedge by naked shorting the stock. The OMM sells the puts and the counterfeited shares to the same party who then dumps the shares into the market and drives the shares down making his puts valuable. The OMM is able to do risk-free insurance writing, doesn't have to borrow or pay for the stock for his hedge. The buyer of the puts has no money on the table once he dumps his recent purchase of counterfeited shares. How does he guarantee a profit in the puts? He keeps buying more puts and more counterfeited shares and dumps more and more shares into the market. And the brilliant folks at the SEC have allowed this because they have determined that a short squeeze is not economic for certain players. They grandfathered the illegal sales and will have kept this in place for nearly three years and added the OMM exemption in Reg SHO. Yesterday, when the SEC commissioners voted to rescind the grandfather clause, they exposed themselves. They not only have been allowing the sale of unregistered securities via the market maker exemptions, they have been purposefully manipulating the market to avoid "volatility", which is neither their job nor within their authority. The regulators are either stupid or bought to have ever done this.
Then you have the ABX.. Is the ABX used to manipulate the value of the bonds? The mm's in the bonds can't naked short the bonds as a hedge when they sell the puts. They have to support the bonds to avoid paying insurance.
Not so with the options market.. thank the nim
got truncated..
Thank the nimrods at the SEC. All we need is the Harvey Pitt clones to allow the market makers of the ABX to naked short the bonds. It isn't fair for the Primes to be exposed to risk when the options market maker is afforded a risk-free put writing by naked shorting the underlying stock. When the market makers become the counterparties to the trades, they have incentive to determine where the prices of the underlying securities go.