By JENNY ANDERSON and VIKAS BAJAJ
As the subprime loan crisis deepens, Wall Street firms are increasingly coming under scrutiny for their role in selling risky mortgage-related securities to investors.
Many of the home loans tied to these investments quickly defaulted, resulting in billions of dollars of losses for investors. At the same time, many of the companies that sold these securities, concerned about a looming meltdown in the housing market, protected themselves from losses.
One big bank that saw the trouble coming, Goldman Sachs, began reducing its inventory of mortgages and mortgage securities late last year. Even so, Goldman went on to package and sell more than $6 billion of new securities backed by subprime mortgages during the first nine months of this year.
Of the loans backing the Goldman deals for which data is available, nearly 15 percent are already delinquent by more than 60 days, are in foreclosure or have resulted in the repossession of a home, according to data compiled by Bloomberg. The average default rate for subprime loans packaged in 2007 is 11 percent.
"There is a maxim that comes to mind: `If you work in the kitchen, you don't eat the food,'" said Josh Rosner, a managing director of Graham Fisher, an independent consulting firm in New York.
The New York attorney general, Andrew M. Cuomo, has subpoenaed major Wall Street banks, including Deutsche Bank, Merrill Lynch and Morgan Stanley, seeking information about the packaging and selling of subprime mortgages. And the Securities and Exchange Commission is examining how Wall Street companies valued their own holdings of these complex investments.
The Wall Street banks that foresaw problems say they hedged their mortgage positions as part of their fiduciary duty to shareholders. Indeed, some other companies, particularly Citigroup, Merrill Lynch and UBS, apparently did not foresee the housing market collapse and lost billions of dollars, leading to forced resignations of their chief executives.
In any case, the bankers argue, buyers of such securities — institutional investors like pension funds, banks and hedge funds — are sophisticated and understand the risks.
Wall Street officials maintain that the system worked as it was supposed to. Underwriters, they say, did not pressure colleagues on trading desks or in research departments to promote securities blindly.
Nevertheless, the loans that many banks packaged are proving to be increasingly toxic. Almost a quarter of the subprime loans that were transformed into securities by Deutsche Bank, Barclays and Morgan Stanley last year are already in default, according to Bloomberg. About a fifth of the loans backing securities underwritten by Merrill Lynch are in trouble.
Data from another firm that tracks mortgage securities, Lewtan Technologies, shows similar trends. The banks declined to comment on the default rates.
The data raises questions about how closely Wall Street banks scrutinized these loans, many of them made at low teaser rates that will reset next year to higher levels.
The Bush administration is close to a plan to freeze mortgage rates temporarily for some homeowners who are threatened with foreclosure.
In recent years, Wall Street aggressively pushed into the complex, high-margin business of packaging mortgages. At the same time, banks expanded their roles to selling investments to clients while trying to make money on their own holdings. Now, with the collapse of the credit bubble, Wall Street's risk management, as well as the multiple and often conflicting roles it plays, has been laid bare.
As early as January 2006, Greg Lippmann, Deutsche Bank's global head of trading for asset-backed securities and collateralized debt obligations, and his team began advising hedge funds and other institutional investors to protect themselves from a coming decline in the housing market.
"He was really pounding the pavement," said one hedge fund trader, who asked not to be identified because it could jeopardize his relationship with Wall Street banks.
Mr. Lippmann's trade ideas — documented in a January 2006 presentation obtained by The New York Times — were not always popular inside Deutsche Bank, where the origination desk was busy selling mortgage securities. In the fall of 2006, Mr. Lippmann pitched bearish trades to the bank's sales force at the same time the origination desk was bringing them mortgage deals to sell to clients.
Last year, Deutsche Bank underwrote $28.6 billion of subprime mortgage securities, according to Inside Mortgage Finance, an industry publication. In the first nine months of this year, the bank underwrote $12 billion.
Goldman Sachs also moved early to insulate itself from potential losses. Almost a year ago, on Dec. 14, 2006, David A. Viniar, Goldman's chief financial officer, called a "mortgage risk" meeting. The investment bank's mortgage desk was losing money, and Mr. Viniar, with various officials, reviewed every position in the bank's portfolio.
The bank decided to reduce its stockpile of mortgages and mortgage-related securities and to buy expensive insurance as protection against further losses, said a person briefed on the meeting who was not authorized to speak about the situation publicly.
Goldman, however, did not stop selling subprime mortgage securities. The bank, like other firms, retains a piece of the securities it sells. A Goldman spokesman said the firm was not betting against the mortgage securities it underwrote in 2007.
Like Goldman, Lehman Brothers also started to hedge its huge inventory of home loans in the second quarter of this year, concerned about poor underwriting standards. But Lehman also continued to sell mortgage securities packed with shaky loans, underwriting $16.5 billion of new securities in the first nine months of 2007. About 15 percent of the loans backing these securities have defaulted.
At the center of the boom in mortgages for borrowers with weak credit was Wall Street's once-lucrative partnership with subprime lenders. This relationship was a driving force behind the soaring home prices and the spread of exotic loans that are now defaulting in growing numbers. By buying and packaging mortgages, Wall Street enabled the lenders to extend credit even as the dangers grew in the housing market.
"There was fierce competition for these loans," said Ronald F. Greenspan, a senior managing director at FTI Consulting, which has worked on the bankruptcies of many mortgage lenders. "They were a major source of revenues and perceived profits for both the originators and investment banks."
The battle over these loans intensified in 2005 and 2006, as home prices approached their zenith. (Home sales peaked in mid-2005.) At the same time, buyers of these securities, which carry relatively high interest rates, were fueling demand. Lehman Brothers, the dominant Wall Street player in this field, underwrote $51.8 billion of subprime mortgage securities in 2006, followed by RBS Greenwich Capital, which arranged $47.6 billion of sales.
Not all banks continued to expand their subprime business. Credit Suisse, which had been a major player in 2005, pulled back aggressively, with its underwriting down 22 percent in 2006, compared with 2004.
But other Wall Street banks, pushing to catch these market leaders, reached out to subprime lenders. Morgan Stanley, which expanded its subprime underwriting business by 25 percent from 2004 to 2006, cultivated a relationship with New Century Financial, one of the largest subprime lenders. The firm agreed to pay above-market prices for loans in return for a steady supply of mortgages, according to a former New Century executive.
"Morgan would be aggressive and say, `We want to lock you in for $2 billion a month,'" said the executive, who asked not to be identified because he still works with Wall Street banks.
Loans made by New Century, which filed for bankruptcy protection in March, have some of the highest default rates in the industry — almost twice those of competitors like Wells Fargo and Ameriquest, according to data from Moody's Investors Service.
Fremont General and ResMae, which also had high default rates, were big suppliers of loans to Deutsche Bank. Merrill Lynch had a close relationship with Ownit Mortgage Solutions, which filed for bankruptcy in December. Merrill also acquired another lender, First Franklin, for $1.7 billion in late 2006.
"The easiest way to grab market share was by paying more than your competitors," said Jeffrey Kirsch, president of American Residential Equities, which buys home loans.
What is clear is that home loans were highly lucrative to Wall Street and its bankers. The average total compensation for managing directors in the mortgage divisions of investment banks was $2.52 million in 2006, compared with $1.75 million for managing directors in other areas, according to Johnson Associates, a compensation consulting firm. This year, mortgage officials will probably earn $1.01 million, while other managing directors are expected to earn $1.75 million.
Copyright 2007 The New York Times Company
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