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The Science of Hitting
The Science of Hitting
Articles (675) 

Looking Back at the Financial Crisis

Some interesting facts and stories from the financial crisis of 2008 and 2009

February 16, 2016 | About:

Ive spent the past few weeks reading All the Devils Are Here: The Hidden Story of the Financial Crisis. I planned on writing a book review, but I can sum up my takeaway in two words: Read it. The book is meticulously researched, outlining the role numerous actors (investment bankers, regulators, mortgage originators, rating agencies and others) played in the lead up to the financial crisis of 2008 and 2009. Authors Bethany McLean and Joe Nocera live up to the reputation theyve deservedly achieved through years of great journalism.

Instead of a book review, I thought Id put together a short list of a few amazing stories and statistics from the book. Hopefully a handful of these are new to you.

(1) New Century Financial, which originated about $60 billion worth of subprime loans in 2006, was the second largest subprime-only originator in the U.S. After years of increasing profits, the company was starting to face growing early payment defaults: mortgages where borrowers had difficulty paying almost immediately. When this happened, the securitization trusts that were buying New Centurys mortgages had the right to put them back to the originator. By the second half of 2006, the company had a backlog of more than $500 million in repurchase claims.

In early 2007, New Century filed an 8-K disclosing restated financials for the first three quarters of 2006. The filing disclosed the company had not been properly accounting for the repurchase requests, which had continued to increase. The value of these growing claims? $8.4 billion.

This wasnt the only problem; like many mortgage bankers, New Century relied upon warehouse lines to finance its business (as noted in "American Banker," warehouse lines are a vital cog of temporary funding that ferries loans to the eventual owners and clears the pathway for new originations). As company-specific and industry-wide issues surfaced in early 2007, creditors cut off access to new funds (dozens of smaller subprime lenders faced a similar fate).

New Century, which was valued at more than $3.5 billion a few years earlier by Mr. Market, was forced to file for bankruptcy in April 2007 without reporting a single quarterly loss.

(2) In 2005, a gentleman named Gene Park was put in charge of the multisector wrap business (selling credit protection on the AAA tranches) of AIG's (AIG) Financial Products division. As the name implies, multisector CDOs were highly diversified kitchen sinks, as one FP trade put it including credit card debt, student loans, mortgage backed securities and so on. The logic was that different, presumably uncorrelated asset classes offered diversification.

That brings us back to Gene Park, who had done an experiment. In 2005, Mr. Park had asked people involved in AIGs Financial Products business to guess the percentage of subprime MBS in recent multisector CDOs that AIG had wrapped (offered credit protection on). Most of the people he asked people who presumably knew and understood this business guessed around 10%. When Mr. Park asked them to actually look at recent deals, they found that subprime securities accounted for an astounding 85% of the securities in recent multisector CDOs.

Mr. Park helped convince AIG-FP to stop writing new CDO business. However, he wanted to go a step further: shorting securitized subprime mortgages to hedge existing exposure at AIG-FP. He spent some time preparing a deal, but it was ultimately vetoed by his bosses. They argued the cost 20 basis points, or two-tenths of one percent was too high. AIG-FPs exposure to the super-senior tranches of multisector CDOs was about $60 billion (notional value) by 2006.

(3) More than half of all subprime mortgage originations from 2001 to 2006 were refinancings. A large number were cash out refis where the borrower would refinance their mortgage based on the increased value of their home and then pull out the cash for other uses. The result: From 2000 to 2007, total household debt in the U.S. doubled to $14 trillion; roughly 80% of the increase was attributable to housing ($5.6 trillion, or roughly $17,000 for every man, woman and child in the country). Its estimated that less than 10% of subprime originations from 1998 to 2006 were for first-time homebuyers; the remainder were refis or second home purchases.

(4) As the housing bubble came to an end, loan quality completely deteriorated. At Countrywide, nearly 40% of the companys subprime originations in 2006 were on a stated documentation basis (meaning the applicant couldnt provide a tax return or pay stub verifying their income), three times higher than the percentage in 2001. In a lawsuit filed by Mortgage Guaranty Insurance Corporation, which insured Countrywides loans, it was estimated that one-third of borrowers with stated-income loans in 2006 overstated their actual income by more than 50%.

Countrywide wasnt alone. According to the Federal Reserve Bank of Atlanta, loans with incomplete documentation (liar loans) and low or no down payments accounted for roughly 20% of all subprime originations by the end of 2006 from nearly zero just five years earlier.

As a side note, Countrywide stock peaked at about $45 in February 2007; the company was purchased by Bank of America (NYSE:BAC) less than a year later at a price of ~$7 per share.

(5) The low quality tranches (BBB) of mortgage backed securities, which were harder to sell to investors, ultimately found a home in collateralized debt obligations (CDOs). At the peak of the housing bubble, CDOs were buying 85% to 95% of the BBB tranches that were being created (according to a structured credit strategist from Bear Stearns). These collections of low-rated MBS tranches were repackaged as a CDO. Through the magic of Wall Street and the ratings agencies, these CDOs could end up with about 70% of the tranches rated AAA (this was known as ratings arbitrage). Unsurprisingly, highly rated securities offering extra yield were swallowed up by investors: In 2000, $69 billion of CDOs were sold; in 2006, the number was $500 billion.

In the end, more than 90% of the AAA rated subprime residential mortgage backed securities (RMBS) issued in 2006 and 2007 were downgraded to junk status.

About the author:

The Science of Hitting
I desire to own high-quality businesses for the long-term. In the words of Charlie Munger, my preferred approach is "patience followed by pretty aggressive conduct." I run a concentrated portfolio, with the top five positions accounting for the majority of its value. In the eyes of a businessman, I believe this is sufficient diversification.

Rating: 4.4/5 (8 votes)

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Comments

Dr. Paul Price
Dr. Paul Price - 4 years ago    Report SPAM

Today's sub-prime car and truck loans will turn out the same way.

Don't even think about owning auto company stocks.

The Science of Hitting
The Science of Hitting - 4 years ago    Report SPAM
Dr. Paul,

Agreed on auto manufacturers (assuming that's what you meant). Charlie Munger (Trades, Portfolio)'s GM comments at the DJCO meeting were spot on: the industry is extremely competitive. I think I can do better elsewhere. Thanks for the comment!

Thomas Macpherson
Thomas Macpherson premium member - 4 years ago

Hi Science. Looks like a fantastic read. I remember in 2007 several of our investors in Nintai suggested we take a look at the mortgage backed securities as well as the CDO market. At that time I asked both investors - who were also Board members - to give us a value based investment case for either. The only caveat was they had 60 seconds to do so and could use nothing more complicated than basic arithmetic. After a relatively long and silent pause, I suggested if they couldn't do what they asked of me, they should feel free to withdraw their investment. Not every manager has the ability to speak to investors that way, but I think things would have worked out dramatically different in the general markets if more had done so in 2005-2007. Thanks again for a great review. - Tom

The Science of Hitting
The Science of Hitting - 4 years ago    Report SPAM

Tom,

That's a pretty amazing story - thanks for sharing! Did they come back a few years later and thank you for saving them a boatload of money? :)

Thomas Macpherson
Thomas Macpherson premium member - 4 years ago

Hi Science. The short answer is no. One rarely gets credit for being rude and right. It was an important lesson for all of us. Best - Tom

The Science of Hitting
The Science of Hitting - 4 years ago    Report SPAM

"Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally.”

Sounds applicable to me!

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