Prime and Subprime

The New York Times and Business Week led on subprime coverage. Others didn't.

The business press can always be counted on to explain in authoritative detail why we just lost a trillion dollars. The Wall Street Journal a few years ago won a Pulitzer, for some reason, for doing just that.

What’s Wrong? —- Venal Sins: Why the Bad Guys Of the Boardroom Emerged en Masse —- The Stock Bubble Magnified Shifts in Business Mores While Watchdogs Napped

June, 20, 2002

What’s wrong? Why ask us? This kind of after-the-fact financial reporting I equate with a National Transportation Safety Board investigation—kicking through smoldering wreckage after the plane has already crashed. There’s nothing intrinsically wrong with this kind of reporting. It just feels a little late. Also, I always find it disingenuous to talk about napping watchdogs, as in the headline above, when the Journal and the rest of the business press themselves slept on the job and had to scramble to catch up to the corporate scandals earlier in the decade.

Now, apparently, we again have problems on Wall Street.

Casual business readers, that is, most of us, have been following with some concern the accelerating problems in the financial markets, problems centered, it seems, on mortgages. We have lately learned what the term “subprime” means and now know that banks have been making loans to people who may or may not have had jobs and may or may not have had enough for a down payment and may have even borrowed the down payment under an ingenious arrangement known as a “piggyback” mortgage.

With help from The Wall Street Journal, The Financial Times and The New York Times and others, we know that the banks and investment banks aren’t really lenders anymore, that they put up money initially, but are reimbursed ultimately by the pension funds, mutual funds, hedge funds, and others who buy and hold securities based on the loans, and collect the interest. The banks these days are packagers and brokers and earn fees from each transaction.

We also understand now, I think, that Moody’s Investors Service, Standard & Poor’s, and Fitch Ratings are companies that act as investigative reporters of a sort; they examine the mortgages underlying the securities and grade the bonds according to their risk, AAA being the best grade.

Usually, however, when news readers wake up one day to find they must take a crash course in something as esoteric as the global bond market and the ins and outs of various “loan products” foisted on subprime rubes, whoops, I mean money loaned to qualified borrowers, then something has gone wrong; and chances are, news outlets have some explaining to do. Put it this way, we all know now that the city of Samarra is located in Iraq and that at one time it had a golden dome, that this shrine was deemed holy by Shias, the largest of three minority groups in Iraq, who were oppressed under the previous regime and now are in power, except for the Kurds in the north, etc., etc. We only know all this and more because something has gone wrong, and somebody didn’t tell us all this when it would have mattered.

Okay, back to the bond market. We casual business-press readers now understand that ultimately this deeply complex credit system depends on bond buyers’ ability to rely upon those “AAA” grades, or whatever Moody’s says the bonds deserved.

And I think we readers/vaguely alarmed citizens understand that a lack of confidence in the quality in the loans beneath the bonds causes broader problems in the economy. What if nobody is willing to lend money anymore? People can’t sell their houses, businesses can’t borrow for capital improvements, the stock market falls, perhaps the economy tips into recession.

Those are the basics, and we are all learning them now.

It is not good that we are learning at this late hour, for instance, that credit-rating agencies—Moody’s, etc.—are paid by the very Wall Street houses whose bonds they rate; that the agencies gave the same grade to bonds backed by loans to people who couldn’t afford a down payment as to bonds backed by loans to people who could; and that the shakier the bond issue, the more ratings agencies make, and that without these ratings, there are no bonds.

This has a familiar ring to us casual business-press readers.

It was not so long ago that the business press discovered—too late!—that Arthur Andersen and other accounting giants made more from consulting for Enron and other corporations than from auditing them, and hence were increasingly willing to fudge the books to please the client—and thereby retain the lucrative consulting business.

The business press, also not long ago, was shocked, shocked to learn, from the New York attorney general, of all people, that Wall Street stock research was indirectly funded by the very companies the analysts were analyzing. That research—paid for by Citigroup, Merrill Lynch, CSFB—all the major Wall Street firms—turned out to be fraudulent. Bogus. The business press then learned, also courtesy of Eliot Spitzer (that would be Governor Spitzer to you, WSJ editorial board) that insurance brokers made insurers pay them “contingent commissions,” also known as “kickbacks,” in return for steering them commercial business.

How long had these practices been in place? Decades.

And how long have the ratings-agencies labored under their own conflict? Since the 1970s, according to Jesse Eisinger in Portfolio, when the Securities and Exchange Commission designated them a “public good” and required them to drop their subscription model and charge the subjects of their work.

Point is, the financial system is riddled with conflicts of interest. Some are unavoidable. Many can be managed. But all must be watched. This is why we have a business press, in my view.

It is good to point out that information providers such as McGraw-Hill Companies’ Standard & Poor’s overrated the quality of some bonds in order to win more business and fueled the “subprime mess.”

“CREDIT AND BLAME: —- How Rating Firms’ Calls Fueled Subprime Mess —- Benign View of Loans Helped Create Bonds, Led to More Lending

The Wall Street Journal
Aug. 15

But, as the lead paragraph explains, S&P did that seven years ago.

in 2000, Standard & Poor’s made a decision about an arcane corner of the mortgage market. It said a type of mortgage that involves a “piggyback,” where borrowers simultaneously take out a second loan for the down payment, was no more likely to default than a standard mortgage….

But credit-rating firms also played a role in the subprime-mortgage boom that is now troubling financial markets. S&P, Moody’s Investors Service and Fitch Ratings gave top ratings to many securities built on the questionable loans, making the securities seem as safe as a Treasury bond.

Now you tell us. You don’t have to be an S&P analyst or a business reporter to know that someone who borrowed a down payment is more likely to default than someone who didn’t.

That’s why I put a higher premium on this kind of business reporting. Check the date:

Still, the rating agencies have yet to downgrade large numbers of mortgage securities to reflect the market turmoil…Meeting with Wall Street analysts last week, Terry McGraw, chief executive of McGraw-Hill, the parent of S.& P., said the firm does not believe that loans made in 2006 will perform ”as badly as some have suggested.”

Nevertheless, some investors wonder whether the rating agencies have the stomach to downgrade these securities because of the selling stampede that would follow.

“Crisis Looms in Mortgages”
By Gretchen Morgenson
The New York Times
March 11

The fact is, theTimes has been hitting the subprime issue harder and longer than Forbes, Fortune , The Wall Street Journal, The Financial Times, and other publications devoted solely to business and financial news. This should not be, but it is. The Times has a large business staff, but it is not really part of the business press. It’s a general circulation newspaper. It also has a good sports section, which is more than the business press can say.

It’s not that other coverage has been bad. But this is better. A story in April told us that while the mortgage industry touted as recently as January the benefits of subprime lending as a tool to raise homeownership rates, it will actually serve to decrease those rates. The Times, led by the indispensable Gretchen Morgenson, explains the trapdoor terms of the deals: “reset” rates that would raise monthly payments, prepayment penalties that preclude refinancing, and no escrow accounts, so property taxes aren’t set aside, making monthly payments seem lower than they are. Those loans are not doing borrowers a favor, and lenders know it.

But according to experts on lending practices, the products devised to propel homeownership did so only as long as housing prices kept rising. Now that prices have started to fall, these products look instead like a transfer of wealth to mortgage lenders from those who can least afford it: subprime borrowers.

I like, too, the Times’s unapologetically quoting the nonprofit Center for Responsible Lending in the story; too often the business press ignores nonprofits and trial lawyers, believing them to be biased whiners, which is fair, except that it also describes most companies and trade groups, too.

My point is that anyone who really wanted to know about the mortgage market would have done well to read the Times in recent months. This thought, for instance, came in early March:

‘The problems are far broader than subprime,’ said Josh Rosner, a managing director at Graham-Fisher in New York and an expert on mortgage securities. Mr. Rosner says he believes that, absent a huge jump in home prices, investors will soon recognize that credit quality problems have also begun to seep into ‘the upper tranches’ of the loan market.

I’m not saying others didn’t write about it.

Bethany McLean flagged credit-rating conflicts in Fortune back in April.[1]

Forbes made a good call on Countrywide in 2004:

The Art of Unhatched-Chicken Accounting; Mortgage firms’ dubious assumptions” Elizabeth MacDonald 15 March 2004

Just before it made a bad call on Countrywide.

Fastest-Growing Big Companies: Countrywide Branches Out Beyond Mortgages, April 16, 2004

Eisinger’s piece in the latest Portfolio moves the ball forward by showing just how entangled rated and rater became, by reporting that the agencies actually help “structure,” or write the terms of, the securities they are rating, through what the agencies called an “iterative process.”

I like the headline: “Overrated: The subprime-mortgage meltdown could—finally—end the credit-ratings racket”

And much credit must go to Business Week (also owned, as it happens, by McGraw-Hill) which took a hard look when it counted:

When Home Buying By the Poor Backfires; For many families, a house can be a bad investment By Peter Coy 1 November 2004

And this one two years ago:

HOUSING THE MORTGAGE TRAP; Lenders are cranking out an ever-growing array of financing schemes and lowering standards to keep the boom going.
By Dean Foust, with Peter Coy in New York, Sarah Lacy in San Mateo, Rishi Chatwal in Atlanta.
27 June 2005

The best, I thought, was the work of Business Week reporter Mara Der Hovanesian, who wrote last year, among other things, about abusive mortgage-industry lending practices. Other business publications are only beginning to catch up.

The ‘Foreclosure Factories’ Vise; The predatory tactics of some mortgage servicers are squeezing homeowners

The December 25, 2006, story described the Rimstad family of Minnetonka, Minnesota, who refinanced their house in 2004 to replace a furnace and pay for a daughter’s wedding, then saw monthly mortgage payment leap as their adjustable mortgage jumped three full percentage points, or, as these things are measured on Wall Street, 300 basis points.

On Dec. 5, Option One Mortgage Corp., a Kansas City (Mo.)-based unit of H&R Block Inc. (HRB), foreclosed because the Rimstads owed more than $18,000 in late charges and attorney’s fees, on top of their past-due payments. After 24 years under the same roof, the Rimstads face an uncertain future. “I don’t know what will happen to us,” says Randy, 57. “We don’t have any place to go.” Option One says it can’t comment on the specific amount owed, but that it has been working with the Rimstads and will continue to “explore options toward a solution.”

H&R Block. Who knew? They seemed so friendly. And the broadening graph:

Millions of other families in the U.S. could soon find themselves in the same dire straits. Some $1.2 trillion in adjustable mortgages will shift to higher rates in 2006 and 2007, more than half of which are to borrowers with less-than-perfect credit, or subprime borrowers, like the Rimstads.

That’s $1.2 trillion, with a “t,” in adjustable mortgages, issued when rates were at historic lows and could only go in one direction. Anybody out there regulating this system?

But nothing beats sustained, drumbeat coverage from a daily newspaper—even if it reads a bit, um, dryly at times. The Times did that. Good for it.

The business press performs a useful role when it allows sophisticated reporters to get into the weeds of complex financial situations, question industry assumptions, point out conflicts, and report back warnings. Not all of these stories are for the general reader. That’s why there’s a business page. Many should be targeted at equally sophisticated top decisions-makers—regulators overseeing the industry, money managers buying its products, and top executives edging further out on the risk curve—to provide the information they need to make decisions.

Among other benefits, this kind of journalism obviates the need for authoritative “explanatory” pieces about how the unfortunate crash just happened and how warnings signals were available for anyone bothering to look.

Dropping The Ball
How the credit-rating agencies got in the middle of the subprime-lending crisis. And why it could be getting worse.
2 April 2007

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Dean Starkman Dean Starkman runs The Audit, CJR's business section, and is the author of The Watchdog That Didn't Bark: The Financial Crisis and the Disappearance of Investigative Journalism (Columbia University Press, January 2014). Follow Dean on Twitter: @deanstarkman.