INTRODUCTION
In order to function, the subprime securities market required (1) lenders - funded or owned by Wall Street investment banks - to find and make home loans to an endless stream of borrowers with bad-credit, and (2) subprime borrowers to keep current on home mortgage payments that many of them could barely afford.
In other words, the entire subprime mortgage-backed securities industry rested on the ability and desire of millions of people with an established history of not paying their bills suddenly flipping a switch and making regular mortgage payments on a consistent basis for long periods of time.
Sound like an idea destined to work, or an idea destined to fail?
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The Subprime Story - How it all worked (the short, short version)
In 2002-2003, Bear Stearns subprime guru and hedge fund manager Ralph Cioffi understood that securities backed by the value of subprime or near subprime mortgages (terms with which most Americans were then unfamiliar), would be hugely successful in the then-prevailing climate of low interest rates and rising home prices. Cioffi also knew, however, that subprime mortgages could never form the backbone of a securities market capable of performing reliably over the long run. That so many others apparently failed to grasp this fact is largely attributable to the fact that the power players in the subprime markets - aware that there was an Achilles heel inherent in their products - went to great lengths to cloak their jobs in mystery.
It was crucial for Ralph Cioffi and men like him to give subprime-backed securities and all credit derivative products reputations as exotic and complex instruments. They wanted the public, and the press too, to give collective shoulder shrug and leave things to the experts. Cioffi and company were successful in this regard because there legitimately were mysterious and highly complicated elements to what they did. The securitization process, for example, and the way the securities traded without any actual exchange.
When subprime experts at the various Wall Street firms spoke publicly or gave interviews they generally stuck to what theyin terms of making the credit markets work on Wall Street. What they didn'ttalk about was the equally necessary activity that was happening at the beginning of the assembly line. The market could only sustain itself with the ongoing generation of massive numbers of subprime mortgages, the majority of which required borrowers who could and would make their monthly payments. Moreover, Wall Street itself was the driving force behind the explosive growth of subprime mortgages. Firms like Bear Stearns funded huge quantities of subprime loans with giant warehouse loans to subprime lenders who often acted as Bear's private mortgage broker. Bear Stearns also owned several mortgage brokers of its own, including EMC Mortgage.
Subprime mortgages, of course, are home loans extended to individuals with poor credit. People with credit problems usually have a history of late payments and/or defaults on obligations to creditors. One of the most common reasons that people don't pay their bills on time is insufficient income. In other words, people with bad credit frequently got that way because they couldn't afford to pay bills. These were the people - the ones that couldn't pay their bills in the past - that Bear Stearns, Lehman Brothers, Citigroup, and others needed to be placed in adjustable rate subprime home mortgages in a never-ending supply. To call this concept unethical and ridiculous does not come close to providing an adequate description. Anyone unable to see that the subprime machine had to fail, resulting in both a securities crisis and a housing crisis, any extended sampling of time should immediately cease thinking. This tragedy was more than reasonably foreseeable (a legal standard), it was a stone cold guarantee (not a legal term).
Returning to 2002-03, Ralph Cioffi knew that the historically low interest rates and rising home prices then prevailing were ideal environment in which to make a lot of money in the subprime market. In this environment, millions of subprime borrowers would be able to afford the low teaser rates on adjustable rate subprime mortgages. The vast majority of borrowers could - for a time - afford their home loans. However, there was an intrinsically understood shelf life for how long many low credit homeowners would be able to keep current. The length of that shelf life depended on whether and how much interest rates might increase before the loan payment amount adjusted and, critically, whether home prices continued their skyward march. The pace of price appreciation was the ultimate key to the whole subprime scam, since the borrower acquired what amounted to free equity as the home value appreciated, that extra equity was theoretically a supplement for what might otherwise be unaffordable payments after a loan adjusted. So, for the foreseeable future at least, Cioffi could see that the combination of low interest rates and rising home prices were a 'perfect storm' of sorts that should allow him and Bear Stearns to make many, many millions of dollars in the credit derivative markets. Still, Cioffi was making a deal with the devil and he absolutely had to know it.
With Bonds built by bundling subprime or near subprime mortgages, usually received high credit ratings from agencies like Moody's and SP&P (each of the major credit rating agrencies has been investigated, and continues to come under scrutiny). The high ratings served a very important purpose, making the securities seem much less risky then they were and permitted the investments to pass the rigorous standards required by institutional investors like pension funds. uninsurable. Cioffi knew that those big institutional investors - including investment banks themselves - would love mortgage-backed securities.
As long as interest rates remained low, CDOs were preferable investments to other fixed income products with similar credit ratings that could not produce the same income stream. institutions. CDO's also were attractice because institutions were reluctant to invest quite as heavily in stocks as they had before the stock market crash, then only a few years earlier. All of these factors made subprime-based CDO's and similar asset-backed securities great investments for a brief period market cycle, just as Cioffi had anticipated. The subprime securities market went through the roof. Profits, profits, and more profits - for Bear Stearns and for Ralph Cioffi. There are hardly ever any tough questions from supervisors or regulators when the money rains down. Perhaps those are the times when scrutiny should be most intense.
Of course, it was always inevitable that things would turn. From late 2005 on, subprime problems were all over the place. Cioffi and Bear Stearns (and other Wall Street firms) demanded more and more mortgages from subprime lenders. Since Wall Street was funding the loans, the lenders (some of which were owned by Wall Street firms) lowered lending standards to the point where they were practically giving mortgages to anyone with a pulse. These sub-sub prime borrowers (usually barely vetted by underwriters) were very unlikely to meet their mortgage payment obligations. And that made the loans as waste of time. They were worthless to Wall Street.
Interest rates steadily climbed, so did the default rate on subprime loans. More and more defaults followed, partly because more loans were adjusting upward in response to the higher rates. Suddenly, disaster. Housing prices stopped climbing. There was excess inventory in the real estate market. Home equity - subprime's temporary safety net - completely evaporated.
The housing bubble went pop and home foreclosures reached into the millions. Securities backed by subprime loans plummeted in value. And then, almost immediately, they were totally illiquid, worth nothing at all. Investors lost billions. Bear Stearns own accounts, filled with CDOs, Credit Default Swaps, and similar securities (or as Wall Street was now calling these securities -"toxic waste"). Bear's eulogy at that point was only a formality.
Ralph Cioffi always knew that basic economics would one day cause the speeding locomotive he was riding to crash. No doubt, had hoped for a softer impact. But he had to know the end wouldn't be pretty. Cioffi understood that you can't build a successful product with staying power if it depends on the performance of people who cannot be counted on to perform. For subprime loans and subprime backed securities, unusual economic conditions helped deceive investors by masking Cioffi's inherent and unavoidable problem for a few profitable years. But the problem with masks is that eventually somebody notices you are wearing one.
