Mortgage bonds

No wonder the banksters are so jumpy. Felix Salmon:

This is where things get positively evil. The investment banks didn’t mind buying up loans they knew were bad, because they considered themselves to be in the moving business rather than the storage business. They weren’t going to hold on to the loans: they were just going to package them up and sell them on to some buy-side sucker.

In fact, the banks had an incentive to buy loans they knew were bad. Because when the loans proved to be bad, the banks could go back to the originator and get a discount on the amount of money they were paying for the pool. And the less money they paid for the pool, the more profit they could make when they turned it into mortgage bonds and sold it off to investors.

Now here’s the scandal: the investors were never informed of the results of Clayton’s test. The investment banks were perfectly happy to ask for a discount on the loans when they found out how badly-underwritten the loan pool was. But they didn’t pass that discount on to investors, who were kept in the dark about that fact.

I talked to one underwriting bank — not Citi — which claimed that investors were told that the due diligence had been done: on page 48 of the prospectus, there’s language about how the underwriter had done an “underwriting guideline review”, although there’s nothing specifically about hiring a company to re-underwrite a large chunk of the loans in the pool, and report back on whether they met the originator’s standards.

In any case, it’s clear that the banks had price-sensitive information on the quality of the loan pool which they failed to pass on to investors in that pool. That’s a lie of omission, and if I was one of the investors in one of these pools, I’d be inclined to sue for my money back. Prosecutors, too, are reportedly looking at these deals, and I can’t imagine they’ll like what they find.

The bank I talked to didn’t even attempt to excuse its behavior. It just said that Clayton’s taste-testing was being done by the bank — the buyer of the loan portfolio — rather than being done on behalf of bond investors. Well, yes. That’s the whole problem. The bank was essentially trading on inside information about the loan pool: buying it low (negotiating for a discount from the originator) and then selling it high to people who didn’t have that crucial information.

This whole scandal has nothing to do with the foreclosure mess, but it certainly complicates matters. It’s going to be a very long time, I think, before the banking system is going to be free and clear of the nightmare it created during the boom.

Update: KidDynamite asks a good question in the comments: were the bond investors able to do their own due diligence on the loan pool? The answer is no, they weren’t — the prospectus did not include the kind of loan-level information which would enable them to do that.

3 thoughts on “Mortgage bonds

  1. Is this why Obama doesn’t want to halt foreclosures? Because he has a good idea what’s going to happen, better than we do? And is this why the administration is pretending that we don’t have a clue?

  2. How bad can this get? Denninger thinks really, really really bad…but I do not play in the bankster’s sandbox, or the hedgies’ playpen, and have only a second hand understanding of what’s going on. I try to keep up with the econ bloggers such as Yves, but lots is in truth over my head. So, what’s up, what’s coming down, etc.

    Is this what Geithner, Summers, Obama et al were trying to cover up by shoveling trillions through the Fed’s backdoor to the banktsers? And by, as I understand it, forcing Freddie and Fannie to take on lots of the Banksters’ bad, bad paper?

    Who will rid us of these theiving paper pushers and cheaters?

    Not the Roberts’ Court. Not Repubs. Probably not Obama et al. Elizabeth Warren, who has no real power?

  3. Maybe some savvy and aggressive state atty general? Some private lawyer willing to take on the Big Big Big Boys?

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