Corporate & Securities Law

J'accuse Wall Street: con men in corner offices

By Brett D. Sherman

Subprime's fate was sealed from the start

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By Brett D. Sherman; The Sherman Law Firm

Subprime lending on a massive scale always had a limited shelf life.  The only reason it worked at all was an unprecented and clearly temporary confluence of conditions:

Confluence is a great word.  It means, in essence, a "coming together."  Most often the term confluence is used in connection with rivers.  Probably, the most famous confluence of rivers is in Pittsburgh where three major American rivers eventually become one somewhere around the Steel city's semi-famous (at least to geography buffs) golden triangle. One gold star goes to the first person who can name the big three rivers.  But I digress.

I was referring to a vert rare confluence (coming together) of economic conditions. These days, Wall Street executives frequently invoke terms like hundred year storm, perfect storm, and act of god when they cross their fingers and deny responsibility they certainly deserve for pocketing millions and millions of dollars as a reward for threatening the future of the the entire world economy.  The confluence of economic conditions that Wall Street happily exploited was truly a hundred year storm.  

Okay, enough stalling by me.  But you all know the story already anyway -   

• First, the combination of the bursting internet stock bubble followed by the humongous shock the the U.S. economy from the September 11 terror attacks resulted in historically low interest rates that remained historically low longer than ever before;  

• Second, low interest rates meant Treasury yields were so low that bond funds and other major instituions needed investment grade instruments with significantly higher returns than United States bonds in order to avoid having to invade fund principals to make required payouts to investors (expansion on this topic requires its own blog post).  For purposes of this post, it is only necessary to understand that fixed-income fund managers, managers pension fund managers, and institutions that were restricted to investment grade securities were desperate for yield.  This is situation, if not unprecented (I am a lawyer, not an economist) is extremely unusual.  

When interest rates rose - as Wall Street knew they eventually would - adjustable rate mortgages held by so many subprime borrowers adjusted right on up with them as soon as they reached their reset dates.  This was a major problem for those who could just barely afford their mortgage payments at the original payment level.  Rising rates ultimately would slow down, stall, and end the housing boom/bubble.    

The death of subprime wasn't just predictable, it was a sure thing from day one. 

So why didn't the public - or even sophisticated  fund managers get it?  Because the whole enterprise was a scam, a con, and the people running the con - from lenders to investment bankers - had a vested interest in keeping the process as mysterious as possible.  

At that, they unfortunately were quite successful.

The irony is that investment banks like Lehman Brothers and Bear Stearns might have gotten away relatively unscathed if the money machine they invented and turned loose hadn't turned on them like Frankenstein's monster.  But I am getting ahead of myself.  

Here's the climax of the story.  Nearly all of the biggest investment banks wound up the same toxic junk that they'd been selling to the public with the representation that MBS and CDOs were practically as safe as Treasuries.  And the banks wound up with tons of the stuff.  In some cases the reason was that the higher yield proved to big a temptation to resist and traders knowingly "drank the cool-aide" buying mortgage securities and financing them with, you guessed it, by jacking up leverage higher and higher.  Other firms got stuck holding MBS that they had been unable to sell before Bear Stearns lit the fuse on the subprime crisis and blew the whole MBS market to kindom come.    

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Full post as published by Wall Street Law Blog on June 09, 2009 (boomark / email).