Who’s Misleading Who?

Two former Bear Stearns fund managers were arrested today.  Matthew Tannin and Ralph Cioffi are accused of misleading investors about the sub-prime mortgage backed securities. 

 

Tannin and Cioffi were responsible for funds with more than $20 billion in assets.  They touted the fund until it collapsed in June of 2007.  Investors sued, of course.  Barclay’s Bank PLC accuses Bear Stearn’s of knowing that the investments were overvalued. Tannin’s attorney says he is being used as scapegoat.  Hmmm…well, maybe so… someone’s gotta pay, right?

 

I wonder if the investors had any red flags at all that could’ve put them wise to risk.  Well, investments in general carry some risk.  So there’s that.  Oh…how about this?  Sub-prime, as a definition, is a HUGE red flag.

 

 

 

Sub – (prefix) under, beneath, below;  subordinate portion of; less than completely or perfectly.   Prime – (adjective) having the highest quality or value. In Merriam-Webster Online Dictionary. Retrieved June 19, 2008, from http://www.merriam-webster.com/dictionary/prime

 

In 2005 and 2006, banks went on a lending spree.  What fun it was too!!  Everyone was working, making money, buying shoes for baby.  The market was up and it was never gonna end!  What kind of fun are we talking about here?  I’m talking the kind of party you have when the parents are gone and you think you won’t get caught…until someone burns down the house…u-oh.  Of course, we’re the grown-ups here.  We’re supposed to be responsible and ethical and honorable.  So what did we, as grown-ups, accomplish during our easy credit party?

 

 

During those two years alone, investment banks sold over $1.2 trillion in MBS’ that were backed by sub-prime loans.  Wow!  Banks had the best liquidity ever and could lend even more money!  It could go on forever!  Right?  I’m mean, look at who they were lending this money to?

 

 

These sub-prime loans were given to borrowers with poor credit!  That’s great!  Lend money to people who have a history of not honoring their contracts.  Back to the definition…below the highest quality, less than perfect.  Taken a step further, the sub-prime lending was very well known to include just about anyone who couldn’t get credit by conventional means.  If Fannie or Freddie wouldn’t qualify you, no problem.  There were thousands of “sharks” out there waiting for the kill.  And don’t forget, there were plenty of consumers out there willing to take the money too.  “What difference did it make if the payment was going to increase beyond our means to pay.  We’ll just sell for a profit.  I mean, real estate never depreciates…right?”

 

And where were the banks getting all this money?  Why, from the investors!  After all, the ratings agencies rated the securities pretty high, sometimes very high.  Surely if there were serious risk, the rating would reflect that.

 

Investors in theses mortgage backed securities rely on ratings from agencies like Moody’s, Fitch and Standard & Poor’s.  The quality of the mortgages included in the package is one of the MAJOR factors that are considered.  If a pool of sub-prime mortgages are packaged for the investor market, with a rating from Moody’s, Fitch and S&P that is acceptable, then as an investor you are accepting the risk.  I’m not sure I care what the rating is…risk is risk.  Well, I take that back.  If a security has a AAA rating, I certainly don’t expect the high risk associated with sub-prime mortgages. (And yes, sub-prime mortgages ALWAYS carried the risk; it was a known risk anywhere in the industry.)

 

So of course, the ratings agencies are taking some of the blame, as they should.  After all, they were aware of the questionable loans.  Why didn’t their ratings account for the possible default’s  that I’m sure statistics could justify were coming.  If not statistics, then common sense.  In 2007, the ratings agencies began downgrading the investments as the default rate of the mortgages became evident.  Surprise, surprise!  In my opinion, if the probability of default had been accounted for in the rating to begin with, the investor’s would have been choosing to invest in B funds rather than the AA to AAA funds that were subsequently downgraded.

 

Security firms shopped the ratings agencies of course.  Everybody shops.  They had to get the best rating for their product, right?  After all, investors won’t sink their funds into speculative securities.  With a little fear from threats of regulation, as of June 5^th, the ratings agencies agreed to change the way they do business.  Securities firms will now be required to pay to have the structure of the MBS reviewed.  This is supposed to eliminate “shopping” for the best rate.  I’m not sure it’ll work over the long run.  After all, if there’s enough money to be made, security firms will pay, once…twice…three times.  Whatever it takes, right?  Simple economics says if the return is greater than the cost, go for it.

 

Let’s not forget the consumer in all this.  The consumer, captured by desire for more, really didn’t think through the actual costs of their mortgage obligations.  Some could say it wasn’t explained properly, and that may be the case in some instances.  I’d say the most of the time, the consumer knew exactly what they were doing. 

 

We all think we’ll win the lottery, or get a raise, or a new job.  Most of us are dreamers.  And as dreamers, we imagine a world better than the one that exists in our own reality.  All of the self-improvement gurus say to think positive, The Secret will bring you abundance, live like there’s no tomorrow.  My head bows in sorrow at their predicament today.  I am truly sorry for their lack of reason.  I truly am. 

 

I say, think positive, but be realistic.  Believe in your right to abundance, but take calculated risks.  Use reason in your decision making.  Live like there’s no tomorrow by making each day count.  No one is saying “cast all reason aside.”  Think, plan, set goals, move always toward your dreams.  Just THINK!

 

I realize that many of those affected by today’s crisis are young and didn’t have the benefit of history to guide their choices.  Or perhaps are uneducated in the real estate business and didn’t even know what questions to ask.  Maybe they thought real estate was the road to riches.  However, this isn’t exactly new stuff.  Super high interest rates in the 70’s, plus the high price of gas and STAGflation, choked the real estate industry and the economy as a whole.  In the 80’s the reckless lending behavior of the savings and loan industry sent real estate reeling…remember the Resolution Trust Company?…and with it the rest of the economy.  That by itself took several years to work through.

 

The truth is, there’s plenty of blame to go around.  Greed among all and lack of ethics in business are the greater culprit here.  I think the culture of “business as war” has not served us well.  At the very least, the pitfalls of any real estate transaction should be clearly disclosed.  No beating around the bush; no legaleze; no specialized jargon.  Just plain talk to plain folks; say “here’s the way it is.”  Now you choose…and choose wisely.

 

 

 

“Mr. & Mrs. Borrower, you are signing a mortgage today that reflects an interest rate of 5.25`%.  This interest rate is variable.  Over the course of your loan, it can increase an additional 6%.  Those increases can come in 2% increments each year until the maximum is reached.  Do you understand?”   “Yes we do.” The proud homeowners are excited.  He looks at his watch wondering if they can just get on with it.   “Your loan amount is $100,000.  Your payment for the initial contract rate period, which is, as long as your loan is at 5.25%, will be $552.30.”   “Wow, that’s less than rent!”   “Of course you do understand that the 5.25% rate is only guaranteed for one year.  After that, the interest rate will adjust with the 1-year Treasury bill at a margin of 2.50%.  If interest rates increase, you will also see an increase, which will increase your payment.  Your interest rate will not increase more than 2% each year, assuming interest rates increase.  If the interest rates decrease, your maximum reduction in rate would also be 2%.  The maximum your rate will increase over the life of your loan is 6%.”   “Okay, what does that mean?  My payment might go up?”  Mr. Borrower shuffles in his seat a little.  Mrs. Borrower takes his hand.  They really want this house.  “It’s just 2% a year; how bad can that be?”   “I’ve prepared a chart that shows the payment increases over time.  As you can see, after year one, your payment will increase to $679.13; year two is $813.63; year 3 is $935.83.  That’s just in the first 3 years.  Are you prepared for theses payment increases should your interest rate increase”   “Well, no.  I mean, I only make $12 and hour, and my wife makes $24,000 a year at her job.  After the kids and all, well, it’d be hard.  Do you think they’ll really go up like that?”   “I can’t say sir.  There are no guarantees.”   Now what…..

  

I understand why these mortgage backed securities are needed.  They’ve been great for the economy and could’ve stayed so had they been used wisely and responsibly to keep cash flowing in the market.  I understand wanting a country full of homeowners.  That’s a great ideal to strive for.  Home ownership brings a certain amount of pride as a part of the American dream.  But why not educate people?  Make knowledge clear and meaningful. Help people understand fixed mortgages, ARM’s, down payments, and payment to income.  Whatever happened to the theory that a house payment (rent or mortgage) shouldn’t be more than 25% of your total income! 

 

I also have to mention greed.  I think a little greed is good.  It makes us competitive.  But we always have to remember, too much greed and we lose it all. 

 

 

 

The Dog and the Shadow                A fable by Aesop     It happened that a Dog had gotten a piece of meat and was carrying it home in his mouth to eat.  On his way home he had to cross a wooden plank lying across a little running creek.  As he crossed, he looked down and saw his own shadow reflected in the water below.  Thinking it was another dog with another piece of meat, he made up his mind to have that also.  So he made a snap at the reflection in the water, but as he opened his mouth the piece of meat fell out, dropped into the water and was never seen again.   And The Moral Is:   Beware lest you lose the substance by grasping at the shadow   Or   Too much greed and we lose it all.

 

 

 

 

Education is key…in ethical behavior, in the ramifications of excessive greed, and in basic economics. 

 

In the meantime, there has to be a scapegoat and we need a name.  That’s the American way.  It won’t end with Matthew Tannin and Ralph Cioffi.  After all, over 400 people have been indicted or arrested since March for various mortgage fraud schemes across the country.  These two guys are just a small part of a greater malfunction not only in the mortgage markets, but in society overall.