Investment Banks Pumped Up Demand for Risk-Laden Subprime Bonds

As sellers and purchasers of large volumes of bonds, investment banks created the market for subprime securities, overvalued these securities, re-packaged them, and pushed demand to unsustainable levels.

Commentators often peg blame for the surge in the subprime-related bond market on nebulous market pressures, such as investor appetite, ignoring the degree to which investment banks generate investor demand through their roles as the prime movers in the secondary market. The investment banks buy and sell securities in extremely large volumes, work their sales networks to convince investors to purchase the securities, frequently maintain large positions in these securities in order to profit through proprietary trades, control investors such as hedge funds that take large positions in these securities, inflate the value of the securities, and then turn around and re-package them in new structures in order to re-start the cycle and generate more revenues. The investment banks fueled the supply of subprime loans to fulfill high levels of demand for which they were primarily responsible. In other words, they worked both ends of the deal to “make” this market.

A. INVESTMENT BANKS WIELD SIGNIFICANT INFLUENCE OVER INVESTOR DEMAND

Investment banks influenced investor demand for subprime mortgage-backed securities by making markets for them, controlling hedge funds that purchased these securities, and trading the securities for their own account:

1. Making Markets - The investment banks facilitated customer sales and purchases of subprime mortgage-backed securities by buying and selling large quantities of the securities. In-house computer models also allowed them to rapidly calculate prices for the complex securities. In the world of finance this is known as “making markets,” because the investment bank does the important work of providing liquidity in the market – meaning that the securities are rendered tradeable by the investment banks’ positions. As part of this process, investment banks leveraged their clout with big investors in their sales networks to convince them to buy subprime mortgage-related securities.
2. Hedge Funds - Investment banks control many of the world’s hedge funds. Goldman Sachs, for instance, is the world’s number one manager of hedge funds. Hedge funds were often top customers for subprime bonds during the boom.^[1] The investment banks also control many hedge funds indirectly by lending them money through their prime brokerage segments. The Economist reported in a September 22, 2007 article that “the hedge funds that buy mortgage-linked debt also borrow heavily from the prime-brokerage arms of banks that originated many of the underlying loans. So a bank can push risk out of the front door, only to find it sneaking through the back.”^[2]
3. Proprietary Trading - Investment banks also make large bets with their own money as part of their proprietary trading operations. Much of the revenue in fixed income divisions over the past several years was reportedly generated by these trades. Goldman Sachs appears to have managed to escape the subprime turmoil by making a large bet, with its own money, against the subprime market. Other investment banks, obviously enough, did differently.

Between making markets, tapping sales networks, controlling hedge funds, and taking large proprietary positions in subprime-backed bonds, investment banks both fueled and accounted for much of the investor demand that is frequently attributed to a more generalized appetite for risk in the financial markets.

B. COMPLEX INNOVATIONS IN STRUCTURED FINANCE OBSCURED RISK, FUELED MARKET

Many structured financial products that rely heavily on mortgage-backed securities are recent Wall Street innovations that are untested, unregulated and little understood by even the most sophisticated investors. Investment banks played a leading role in pushing these instruments to the forefront by developing them, selling them to customers, and stamping them with their approval, even though the products were untested.

It was also in the interest of investment banks to develop as many of these new bonds as possible: every time they re-packaged mortgage-backed securities into one of these complex structures, they earned fees for putting the deal together and selling the securities. The underwriters who structured the offering also typically earned more for these deals because there was a higher level of complexity.

There are many types of structured financial products, but two of the most important for the purposes of this report are CDOs (explained in Section I) and SIVs – or more accurately, the short-term bonds that these SIVs issue.

Structured Investment Vehicles (SIVs) are quasi-independent banking entities set up by investment banks to take advantage of interest rate spreads. SIVs issue short-term commercial notes – called asset-backed commercial paper – with lower interest rates in order to fund purchases of long-term mortgage-backed securities with higher interest rates (very often subprime mortgage-backed securities). As long as the returns from the long-term assets outpace the expenses of the borrowing the entity is doing in the short-term, SIVs make off with a profit. In recent months, the market for the SIVs’ short-term paper has dried up over concerns about the value of the long-term mortgage-backed securities that are supposed to cover payments on the short-term paper.

Source: Asset Backed Alert

Market for Asset-Backed Commercial Paper Takes Off, Dries Up. Levels of outstanding ABCP (which is issued by SIVs) remained relatively flat until 2004, when the subprime wave apparently caught up with this market. These figures are for the first week in November in each of the past seven years – note the sheer drop from 2006 to 2007, a clear sign that this market was boosted in large part by the subprime mortgage market.

There will be more on the off-balance sheet nature of SIVs and the problems they are currently posing in the next section.

Source: Thomson Financial.^[3]

CDO Underwriting in 2006: Merrill and Citigroup in the lead, but others close behind. CDO underwriting was a major money maker for these banks, because the fees for structuring these deals were about three times higher than they were for other bond issues. Merrill Lynch, for instance, could have earned between $500 million and $1 billion for just putting together these offerings – before it even began generating fees through trading activities.

Because the field of structured finance is relatively new and grew so fast, it is not tightly regulated. In 2002, however, Investment Dealers Digest noted that regulators had been moving to increase oversight of this segment of the bond market.

Investment Dealers Digest in 2002: structured finance is threatened by regulation. “In the never-ending drive to wring more profits out of a traditionally low-margin business, Wall Street banks have steered structured finance into more esoteric, more lucrative and riskier waters. Such moves are earning bankers a big payday, but are also driving federal regulators and accounting standard-setters to begin making the most serious and possibly harmful changes in the market's history.”^[4]

Evidently, the changes were not sufficient, and bankers in these fields continued to earn a “big payday.”

C. INACCURATE MODELING INFLATED THE VALUE OF SUBPRIME-BACKED BONDS

Investment banks typically determined the value of mortgage-backed securities using complex mathematical models. These models predicted rates of foreclosure, default and prepayment, as well as market declines and other variables that affect payment streams from the underlying mortgages.

Despite their sophistication, the investment banks’ models turned out to be dead wrong. The models severely underestimated the number of borrowers who would enter default and face foreclosure and inflated the value of the bonds that the investment bank sold.

How could this happen? A recent Forbes article offers one explanation:

Forbes: “Wall Street firms like Merrill Lynch, Citigroup and Bear Stearns spend tens of millions of dollars a year managing risk. They field departments full of smart analysts to assess market, credit, liquidity and operational risk. The process is marked by a formal governance structure and risk-tolerance limits.

That's what the banks tell investors, anyway. When it came to their exposure to the subprime mortgage market, none of this seemed to matter. ‘Executives believe what they want to believe,’ says Frederick Cannon, a bank analyst at Keefe, Bruyette & Woods. ‘They know [booms] are going to end, but they don't know when. In the meantime, it's a lot of fun to make money.’”^[5] [emphasis added]

The article goes on to note that “by any risk manager’s measure, bonds backed by exotic subprime mortgages were a dubious bet,” and they were relatively untested.

No matter what these complex models were saying, a closer look at the characteristics of the loans underlying these securities reveals obvious signs of trouble.

A Goldman Sachs securitization profiled by Fortune had some obvious problems, including:

• 58% of the 8,274 loans in the pool assembled by Goldman were low- or no-documentation loans, meaning that many important characteristics of the borrowers had not been verified.

• The average equity of the second-mortgage borrowers was 0.71% – an extremely high loan-to-value ratio of 99.29%. This means that homeowners were essentially borrowing the entire cost of the home.

Fortune noted that months after Goldman sold the securities, the “mathematical models used to assemble and market this issue - and the models that Moody's and S&P used to rate it - proved to be horribly flawed.”^[6]

D. INVESTMENT BANKS SHAPED MORTGAGE-BACKED BOND RATINGS

Rating agencies such as Moody’s, Standard and Poor’s, and Fitch’s assign ratings to mortgage-backed securities that are intended to inform investors of the credit risk associated with the securities. Ratings are absolutely critical to the valuation of bonds. The ratings agencies have been coming under fire recently for inflating the ratings of subprime-related bonds. But it is important to recognize that these rating agencies are compensated by the same investment banks whose bonds they rate.

The system warps rating agencies’ incentives, similar to the way food critics would be influenced if they were paid by restaurant owners, or movie critics’ reviews would be skewed if they were compensated by producers. It also gives investment banks undue control over mortgage-backed bond ratings.

Columbia Law School Professor John Coffee argued that investment banks had unique power over mortgage-backed bond ratings in testimony to Congress at a September 26, 2007 hearing titled “The Role and Impact of Credit Rating Agencies on the Subprime Credit Markets.”

John Coffee, Professor of Law at Columbia, to Congress: investment banks have unique control of ratings. “What's causing this [inflation of ratings]? I give a number of reasons, but one distinctive factor is this market is behaving very differently in its rating of corporate bonds as opposed to its rating of structured, financed products. And I think that's because structured finance gives new power to the investment banks. They are assembling large pools of securitized assets, they are repeat players, and they can remove their business if they don't get what they like. They have much more power than the traditional corporation, which was only .01 percent of the agency's business.”^[7]

The system allows investment banks to shop around for the best ratings, and they do. In an interview with the Wall Street Journal, Mark Adelson, a former Moody’s executive, said that "it was always about shopping around,” but Wall Street called it by other names, like "best execution" and "maximizing value.”^[8]

Moody’s lost two-thirds of its market share in rating commercial mortgage-backed securities upon establishing tougher standards in that sector. The Wall Street Journal reported in July that Moody’s had gone from 75% market share in rating CMBS issuances to 25% in the three months after it began requiring additional credit enhancement for those securities.^[9] Moody’s executives guessed that investment banks were seeking laxer standards from other agencies. Morgan Stanley refused comment when asked why they had sought ratings from other agencies on its CMBS issuance.

Ratings agencies, like other players in the securitization market, played a part in causing the current situation. Still, their role is overshadowed by investment banks’ control of the system. At a Senate hearing in April 2007, Senator Robert Menendez asked witnesses whether ratings agencies and investment banks were responsible for the subprime mess. Predatory lending expert Christopher Peterson answered that investment banks were the “primary culprit.”

Christopher Peterson, Professor of Law at University of Florida: “So as far as the yes or no question that you asked earlier, responsibility – I would give for the rating agencies – you know, maybe they didn't do as good a job as they could have, but ultimately I don't in the end see them as the primary culprit. They're trying to sell a product, accurate ratings, and maybe I'll regret this statement later, but I'd probably give them more or less a pass. But I do think that the investment banks are very much responsible for this. I think that a lot of them knew or should've known that this sort of thing could happen, and they were profiting from the transaction fees and packaging and selling these loans.”^[10]

E. INVESTMENT BANKS ALLEGEDLY SUPPRESSED DUE DILIGENCE REPORTS ON SUBPRIME BONDS

As part of the due diligence process for mortgage-backed bonds, investment banks commission reports from outside firms. These were allegedly ignored and suppresed by investment banks during the subprime boom in order to enhance the value of the securities being offered.

Credit Suisse First Boston is being sued for suppressing thees due diligence reports. The attorney for the institutional investor, an insurer, argues that his client would not have invested in the mortgage-backed securities if they had had access to the due diligence reports available to CSFB.^[11]

Investors do not have access to the investment banks’ due diligence reports, and prospectuses filed by the underwriter do not include information from the due diligence reports. When they rate mortgage-backed bonds, ratings agencies have access to report summaries but not the entire report.

Employees at due diligence firms claim that their findings were frequently ignored by the investment banks that asked them to ascertain whether blocks of mortgages conformed to certain standards.

Keith Johnson, president of Clayton Holdings, a large due-diligence firm, to Reuters: “In some cases we felt that we were potted plants.”^[12]

Footnotes