Good WSJ Story on the Wall Street-Subprime Nexus

The Wall Street Journal has a good scoop on a story showing the connection of Wall Street to the shadier parts of the subprime industry.

It reports on a settlement between mom-and-pop investors, who got snowed into lending to a company called American Business Financial Services Inc., and J.P. Morgan, Bear Stearns, and Credit Suisse, who lent money to ABFS on the condition that it keep squeezing mom-and-pop investors. Here’s how the Journal explains what happened to the investors:

ABFS funded its operations partly by selling subordinated debt notes directly to the public, pitching them in newspaper ads and mass mailings that promised above-market interest rates.

When ABFS filed for bankruptcy in 2005, the uninsured notes became worthless, leaving 26,000 investors with more than $600 million in losses. Many of the investors were elderly.

If you somehow need further evidence of how asleep at the wheel regulators have been for a long while, consider the fact that they apparently didn’t step in even though a company was selling junior debt via newspapers and direct marketing. The highly technical term for that is “red flag.”

In ABFS we have a good example of the “crooked heart” of the crisis, as Audit Chief Cardiologist Dean Starkman has called it. Wall Street made lots of money in fees underwriting the securities that ABFS and lent it (secured debt, apparently, though the WSJ doesn’t say) money to finance those activities so long as it kept selling subordinated notes to what the Street disdainfully calls retail investors.

At least, I think so. The Journal doesn’t really explain this well. We know that Wall Street underwrote ABFS’s slicing and dicing of MBS (mortgage-backed securities) only from the tail end of a quote from the plaintiffs’ lawyer. I’m assuming the junior debt being sold to these investors was corporate-level debt and not the junkiest end of the junky subprime-mortgage securities. So who bought the securities and do they have a case?

Here’s how the Street kept its little game going by foisting off most of the risk onto mom-and-pop investors:

According to a March 2002 agreement between J.P. Morgan and ABFS, which was obtained by the bankruptcy trustee and reviewed by The Wall Street Journal, the subprime lender was required to maintain at least $375 million in subordinated debt as a condition of the credit line.

We’re not told how much the banks lost themselves when ABFS went under.

We do get what passes for a good guy here who knows how to get his bank’s attention:

Morgan Stanley stopped lending to ABFS in late 2001, after Kevin Rodman, a managing director who had questioned the note sales, forecast a possible “public relations nightmare.” J.P. Morgan and Credit Suisse continued lending to ABFS, requiring it to maintain a certain amount of note sales, court records show. Mr. Rodman now is a private consultant.

The settlements have cost these banks plus unnamed others $135 million and counting. Here’s the smoking gun for J.P. Morgan:

In February 2003, J.P. Morgan Chase & Co. managing director Richard S. Boswell wrote that “ABFS continues to intrigue me,” according to internal company documents. “Always appears that it is somehow defying gravity. A lot continues to rest on willingness of retail sub-debt [subordinated debt] investors to roll over their notes.”

Court records show the New York bank continued issuing credit to ABFS until late 2004. The subprime lender made more than $6 billion in loans between 1999 and 2004.

Six billion dollars. And they still cry “who could have known?”

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Ryan Chittum is a former Wall Street Journal reporter, and deputy editor of The Audit, CJR's business section. If you see notable business journalism, give him a heads-up at Follow him on Twitter at @ryanchittum.