CDOs And Other Subprime Securities Sold In 2006 And 2007 -- Doomed From The Start?
The collateralized debt obligations (“CDOs”) and other subprime securities sold to investors in 2006 and 2007 were virtually guaranteed to pose big problems for investors. The harsh reality is that most of these securities were nothing more than bets by Wall Street that home prices would continue to rise at unrealistic rates in the future. Moreover, even if housing prices rose at their historic norms, the painful truth is that these securities were still likely to fail.
While investors continue to lose millions of dollars as the collapse of the subprime housing market continues to have ripple effects throughout the U.S. economy, many cannot help but question how we ever got into this morass. Indeed, hardly a day goes by without a news report suggesting that credit problems are worsening or that a major economic slowdown, if not recession, looms on the horizon. Surprisingly, the answer may be much simpler than some experts have led us to believe.
The sad fact is that many subprime mortgages issued in 2006 and 2007 -- estimated to total $362 billion -- were in default even before interest rates on these loans reset to new higher rates in 2008. While interest rate adjustments will certainly contribute to the record number of residential mortgage defaults and foreclosures that housing industry analysts predict will occur in future years, they are not the primary cause of the turmoil in the subprime market. The problem is not that when the loan resets, the higher loan payments will be beyond the homeowner’s means. The problem is that the borrower could never afford the home in the first place regardless of the low initial “teaser” interest rate.
This conclusion is supported by recent developments. The home loan delinquency rate last November on subprime mortgages issued in 2007 was over 11 percent, even though these loans have not yet experienced interest rate increases. This indicates that approximately 300,000 new homeowners have already defaulted on loans they had for less than a year. In many cases, borrowers had lived in the home for only a few months before defaulting. Some homeowners reportedly failed to make even the first payment on their mortgages. As shocking as this fact may seem on the surface, when one examines the irresponsible lending and subprime securitization environments of the past few years, it should come as no surprise.
With Wall Street’s encouragement, mortgage brokers and lenders routinely approved borrowers for loans that they had little or no chance of ever affording, even at low interest rates. A huge number of these loans financed 100 percent of the purchase price or required no money down. Low “teaser” rates, interest-only payment options and other liberal loan terms were based on lenders’ expectations, if not belief, that home values would continue to skyrocket. When coupled with lax underwriting standards, the scenario was ripe for disaster.
Swept up in the frenzy of rising home prices and the belief that homeownership was an entitlement rather than a dream, borrowers were plentiful and mortgage brokers and lenders were quick to encourage them to sign on the dotted line. Borrowers showed no reluctance in doing so. And why should they? Although many borrowers were first-time homebuyers, who had little experience managing debt, no one asked if they could manage the payments. No one asked for proof of income or other assets. No one asked how long they had held a job. It is no exaggeration to say that the underwriting standards of some irresponsible lenders became nothing more than the following: “No credit, no problem. No down payment, no problem. No documentation, no problem.” To those buyers who did question how they would be able to afford higher payments in the future, lenders gave an easy answer: with home prices soaring year after year, equity in their homes would rise faster than their debt.
As early as 2005, many experts observed that the relaxed underwriting standards and exotic loan structures posed a risk to the high-flying housing market. These experts recognized that a decline in prices could be disastrous for households, who have very little equity in their homes. Furthermore, many experts were predicting that home prices, rather than continuing to increase, would flatten or decline. The risk of default increased in 2006 and 2007 when reportedly 60 percent of subprime borrowers obtained mortgage loans with little or no documentation of their ability to pay. Under the terms of many subprime and Alt-A mortgages, borrowers were not required to show proof of income or assets. Even those with very low credit scores and a history of delinquency or late payments in the past easily qualified for these loans. At the same time, the housing market slowed dramatically in 2006 with prices flattening or declining in many markets.
Despite clear signs that the housing market was weakening in 2006 with supply far exceeding demand, lenders took no corrective action. Throughout 2006 and 2007, lenders made more exceptions to their standard underwriting practices, approving prospective buyers with poor employment histories or insufficient proof of income or other assets. According to analyst Michael Youngblood, whose comments were featured in a recent CNNMoney.com article by Les Christie, these exceptions “generally amounted to no more than 5 percent [of subprime loans] before 2006, but they represented the majority of these loans issued in 2006 and 2007.”
In other words, rather than tightening underwriting standards and reducing the number of risky loans, lenders simply continued lending. They did so because, as Doug Duncan -- chief economist of the Mortgage Bankers Association -- noted in the CNNMoney.com article, “investors continued to buy the loans.” Indeed, Wall Street’s appetite for these loans seemed incapable of being satisfied. All the leading Wall Street firms -- Merrill Lynch, Citigroup, UBS, Morgan Stanley and Bank of America, among others -- were only too eager to purchase these loans from lenders. The firms then packaged the subprime loans with other assets into many mortgage-backed securities and collateralized debt obligations, earning huge profits in the process. Investors, lured by the promise of high yields and comforted by the fact that many of these securities carried AAA and AA ratings, could not help but view them as relatively safe, conservative investments. Many of the bond mutual funds that the leading firms sponsored also included mortgage-backed securities and CDOs that consisted, in large part, of subprime residential mortgages.
For investors, the fact that lenders issued exotic mortgages to unqualified borrowers during 2006 and 2007 -- and persisted in doing so in the face of overwhelming evidence that default rates on the loans were rising -- has devastating implications. The dramatic increase in loan delinquencies expected in 2008 means that individuals who purchased ostensibly low risk and “safe” mutual funds and other investments will inevitably lose money because, unbeknownst to them, the funds often invested a large portion of their assets in CDOs and other securities backed by subprime mortgages. Similarly, many pension plans, non-profit organizations and municipalities that purchased these CDOs and subprime securities are facing huge losses from these so-called “safe” investments.
Page Perry, LLC is an Atlanta-based law firm with over 125 years collective experience representing investors in securities-related litigation and arbitration. While past results are not indicative of future success, Page Perry’s attorneys have recovered over $1,000,000 for clients on more than 30 occasions. Page Perry’s attorneys are actively involved in working with individual and institutional investors regarding their subprime investment problems and the options available to such investors. For further information, please contact us.
