Investment Banks Provided Subprime Lenders with Critical Funding

In return for subprime mortgages to convert to lucrative bonds, the investment banks provided lenders with essential funding streams.

“Someone is financing these companies to begin with. Someone is buying these mortgages, and it is Wall Street."^[1]

-Andrew Cuomo, then Secretary of Housing and Urban Development, at a hearing on predatory lending, May 2000

Wall Street investment banks were subprime mortgage lenders’ single most important source of capital, and therefore wielded tremendous power in the subprime mortgage market. These lenders raised cash for their lending activities through frequent private-label securitizations, which are controlled by investment banks and shielded from government oversight. By buying up mortgages, the investment banks granted lenders quick access to capital for further lending activities. The investment banks, in turn, were able to produce the lucrative subprime-related bonds that generated so much revenue and bonus money over the past several years.

A. THE CRUCIAL ROLE OF MORTGAGE SECURITIZATION

Mortgage securitization is the key source of capital for subprime mortgage lenders, which use the process to quickly convert mortgages into money for further lending, rather than wait for the borrower to pay out over the life of the loan.

In a typical securitization, the lender sells off mortgages – which it has either originated directly through retail channels or purchased from independent brokers – to an investment bank. The investment bank pools the loans and places them in a trust, then sells securities (bonds) that are backed by payments from the mortgages in the trust to investors. Investment banks are typically known as the underwriters for the securities offerings, because they structure the offerings and take on the risk of having to sell the securities. Investment banks – the crucial links between lenders and investors – are the most powerful players in the subprime mortgage securitization process.

Source: Inside Mortgage Finance.

The rapid rise of Subprime. Subprime mortgage securitizations went from a small segment of the mortgage market to a dominant one – around 20% of all mortgage securitizations by 2006.

An absence of government oversight adds to the investment banks’ power in the subprime mortgage securitization process. A great deal of mortgages are securitized by government related entities – Fannie Mae, Freddie Mac, and Ginnie Mae – but mortgages which do not meet the underwriting standards of these entities (non-conforming loans), such as subprime mortgages, have to go through private-label, or non-agency securitizations, in which the issuer of the securities is a private entity.^[2] In private-label securitizations, the endorsement of a government-backed entity like Fannie Mae and the sense of safety this provides investors is replaced by the endorsement of a prestigious investment bank such as Goldman Sachs or Morgan Stanley.^[3]

Source: Asset-Backed Alert^[4].

Stunning growth in private-label securitization (this is not just a subprime problem). Private-label securitizations put many risky products into the mortgage markets: subprime, Alt-A (for borrowers with FICO more than 620 but less than prime), and jumbo (loans larger than $417,000). These loans typically don’t meet agency standards, but investment banks were more than willing to underwrite offerings of them over the past six years.

B. SUBPRIME LENDERS DEPEND HEAVILY ON STRONG RELATIONSHIPS WITH INVESTMENT BANKS

Because investment banks run the securitization process, subprime lenders must develop strong relationships with them in order to access capital.^[5] Rather than merely carry one of these companies through an offering of securities, investment banks are constantly providing capital to subprime lenders with whom they do business.

The typical subprime mortgage originator has strong ties to several investment banks, and typically notes these relationships in annual reports and SEC filings (if publicly traded) as a sign of their strength as a company. For instance, in its 2006 annual report, New Century Financial, a subprime lender, listed “Long-Standing Institutional Relationships,” as a competitive advantage:

New Century Financial on its “competitive advantage”: “We have developed long-standing relationships with a variety of institutional loan buyers, including Credit Suisse First Boston (DLJ Mortgage Capital, Inc.), Goldman Sachs, JPMorgan Chase, Lehman Brothers, Morgan Stanley, Residential Funding Corporation and UBS Real Estate Securities Inc. These loan buyers regularly bid on and purchase large loan pools from us, and we frequently enter into committed forward loan sale agreements with them.”^[6]

Of course, as will be illustrated in part E of this section, these buyers can pull the plug at a moment’s notice, and when they do, the subprime lenders collapse very quickly. This was the case for New Century, which imploded in March 2007 when loan buyers wanted out.

C. INVESTMENT BANKS PROVIDE SUBPRIME LENDERS WITH DAY-TO-DAY FINANCING

Subprime lenders typically enter into arrangements with investment banks that provide them with financing. These can take a number of forms, but the most common are purchase agreements and warehouse lines of credit.^[7]

• Purchase agreements – Subprime lenders enter into these agreements with investment banks so that they are guaranteed a buyer for the mortgages they make. Investment banks, in turn, are assured access to a batch of mortgages to securitize. As part of the agreement, the investment bank typically sets the prices and quantities of the types of loans it wants to buy.
• Warehouse lines of credit – Lenders use these to fund cycles of mortgage lending, tapping them on a day-to-day basis as short-term financing for new loan originations that will eventually be sold off for securitization. In return for this line of credit, the subprime lender typically agrees to grant the investment bank the right to either buy the mortgages or sell securities on a certain portion of the mortgage pool. Warehouse lenders have detailed knowledge of the lender’s operations, according to an unnamed source for an Investment Dealers Digest article: "They have that day-to-day pipeline exposure to what the mortgage lender's doing.”^[8]

These funding cycles encourage lenders to make as many loans as possible, with very little regard to quality. Lenders are also very dependent on these agreements and facilities, which they usually enter into with a handful of investment banks. Without this financing from investment banks, the lenders often cannot sustain their operations. This dependence is frequently acknowledged in SEC filings.^[9]

D. INVESTMENT BANKS PURCHASED SUBPRIME LENDERS IN ORDER TO KEEP THE BOND MATERIAL COMING

As the subprime market took off over the last six years, major investment banks rushed to acquire subprime mortgage lenders in order to bring the lending operations in-house. The industry publication Mortgage Banking explored this phenomenon in depth in an article called “The Vertical Integration Strategy,” and attributed the rise in subprime lender acquisitions to a hunger for bond-related revenues.

Mortgage Banking: “Why have the Wall Street firms so aggressively embraced this vertical-integration strategy? The answer is to protect and leverage the returns from their mortgage underwriting and securitization desks that purchased and securitized the bulk of alt-A and subprime loans in 2005. In fact, revenues from the fixed income divisions currently represent the largest component of the revenue mix for these broker-dealers, validating the core focus that Wall Street has assigned to the mortgage market.”^[10] [emphasis added]

Lehman Brothers and Bear Stearns were market leaders in this respect, though other major investment banks also acquired subprime lenders in recent years: Morgan Stanley (Saxon Capital); Merrill Lynch (First Franklin); and Goldman Sachs (Southern Pacific).

E. INVESTMENT BANKS CAN EASILY PULL THE PLUG ON SUBPRIME LENDERS

Subprime mortgage lenders typically depend on investment banks to keep funding them, rather than holding assets that they can easily convert to cash through trades (liquid assets). As a result, they have no capital on hand to see them through rocky periods – they only have a massive investment bank standing behind them and feeding them money.

Two mechanisms allow investment banks to withdraw support from the lenders very quickly, and offer evidence of just how much power the banks wield over lenders:

• Margin Calls – Warehouse financing agreements allow the investment banks to re-evaluate the value of the mortgage collateral offered by subprime lenders to secure outstanding borrowings. If the bank determines that the subprime lender needs to post more collateral, it makes a “margin call” and requires the subprime lender to post more. If the lender cannot post enough collateral, they lose the line of credit, and this can trigger other margin calls.

• Repurchase agreements – These agreements allow the investment banks to force subprime lenders to buy back loans that the lender has sold to the investment bank that are in foreclosure or otherwise deficient, based on certain terms.

Once these subprime lenders stop making money, investment banks typically use these mechanisms to pull the plug on the lender, and this frequently causes lenders to collapse.

This scenario played out with two subprime lenders who went bankrupt in late 2006, and was well illustrated in a Mortgage Line article titled “The B&C Meltdown: It’s All About Capital”:

“It’s All About Capital.” “Wall Street (Merrill Lynch, others) said to Ownit and MLN [the subprime lenders]: buyback the delinquent loans you sold us or we won't lend you more money. MLN and Ownit said: can't we talk about this? We don't have a lot of money. (I'm paraphrasing.) Wall Street said: we can talk all you want but we want our money. The rest you read about in National Mortgage News, MSN and American Banker, not to mention some of the bigger dailies.”^[11]

F. A HANDFUL OF INVESTMENT BANKS CONTROL FUNDING FOR THE SUBPRIME MARKET

Ten investment banks served as underwriters for 70% of the $486 billion in subprime mortgage securitizations in 2006. Because they control such large shares of the market, individual investment banks have extraordinary clout with the various players in the market – the lenders who originate the mortgages, the servicers who collect payments from the securitized mortgages, and the ratings agencies who assign ratings to the mortgage-backed securities. The ramifications of this will be explored in upcoming sections.

Source: Inside Mortgage Finance

No major investment bank skipped the subprime securitization binge. These ten controlled 70% of the market in 2006 – a strong indicator of where power was concentrated. (Countrywide is a special case in that it has its own securities arm that acts as underwriter for many of its deals)

Footnotes