How the bankers of Wall Street hatched the sub-prime plot
5:00AM Saturday December 29, 2007
By Mark Pitman
Representatives of five of Wall St's dominant investment banks gathered around a blond wood conference table on a February night almost three years ago.
Their talks over Chinese takeaways led to the perfect formula for a United States housing collapse.
The host was Greg Lippmann, then 36, a fast-talking Deutsche Bank AG trader who aspired to make mortgage securities as big a cash cow for Wall St as the US$12 trillion ($15.58 trillion) corporate credit market.
His allies included 34-year-old Rajiv Kamilla, a trader at Goldman Sachs Group with a background in nuclear physics, and Todd Kushman, 32, who led a contingent from Bear Stearns. Representatives from Citigroup and JPMorgan Chase were also invited.
Almost 50 traders and lawyers showed up for the first meeting at Deutsche Bank's Wall St office to help to set the trading rules and design the new product.
"To tell you the truth, it's not very glamorous," Lippmann says. "Just a bunch of guys eating Chinese discussing legal arcana."
Those meetings of the "group of five", as the traders called themselves, became a turning point in the history of Wall St and the global economy.
The new standardised contracts they created would allow firms to protect themselves from the risks of sub-prime mortgages, enable speculators to bet against the US housing market, and help to meet demand from institutional investors for the high yields of loans to homeowners with poor credit.
The tools also magnified losses so much that a small number of defaulting sub-prime borrowers could devastate securities held by banks and pension funds globally, freeze corporate lending, and bring the world's credit markets to a standstill.
For a while, the sub-prime boom enriched investment bankers, lenders, brokers, investors, realtors and credit-rating companies. It allowed hundreds of thousands of Americans to buy homes they never believed they could afford.
It later became clear that these homeowners couldn't keep up with their payments. Defaults on sub-prime mortgages have so far produced about US$80 billion in losses on securities backed by them. The market for the instruments is so opaque that many firms still aren't sure how much they've lost.
Chief executives at Citigroup, Merrill Lynch and UBS AG were replaced. To forestall a housing-led recession, the Federal Reserve has cut its benchmark rate three times since August and is injecting as much as US$40 billion into the credit system to encourage banks to lend to each other.
This is the story of how Wall St transmitted the practices of southern California's go-go lending industry and the inflated US real estate market to the global financial system:
* In Orange County, California, a mortgage lender named Daniel Sadek was among those who took notice of the increase in Wall St's appetite for sub-prime loans. He turned the staff at his firm, Quick Loan Funding, into a sub-prime mortgage factory. "You can't wait," said his ads, aimed at high-risk borrowers. "We won't let you."
* In Dallas, a hedge-fund manager named Kyle Bass taught himself to use the contracts pioneered by Lippmann's group, then went looking for mortgage-backed securities to bet against. He found them in instruments based on loans Sadek made.
* In New York, the ratings companies Standard & Poor's, Moody's Investors Service and Fitch Ratings put their stamp of approval on securities backed by loans to people who couldn't afford them. They used historical data to grade the securities and didn't adjust quickly enough for the widespread weakening of criteria used to qualify high-risk borrowers. Among the securities on which they bestowed investment-grade ratings: those backed by Sadek's loans.
Lippmann was a Wall St renaissance man, with a strong appetite for sushi and an online restaurant guide so comprehensive one blogger labelled him "the Robert Parker of raw fish". He opened the kitchen of the US$2.3-million Manhattan loft he lived in then to an Italian cooking class.
The goal of Lippmann's group that evening in 2005: to design a new financial product that would standardise mortgage-backed securities, including those based on high-yield sub-prime loans, paving the way for their rapid growth. Of the firms involved that night, Lippmann's Deutsche Bank is based in Frankfurt, UBS in Zurich and the others in New York.
In February 2005, pension funds, banks and hedge funds owned fixed-income securities that were earning returns close to historic lows.
AAA-rated securities based on home loans offered yields averaging a full percentage point higher than 10-year Treasuries at the time, says Merrill.
The trouble was that most creditworthy borrowers had already refinanced their houses at 2003's record-low mortgage rates. To meet demand for mortgage-backed securities, Wall St had to find a new source of loans. Those still available mainly involved sub-prime borrowers, who paid higher rates because they were seen as credit risks.
While the group of five banks had packaged billions of dollars in sub-prime-based securities, in February 2005 none was among the leaders in the home-equity bond business. Countrywide Securities, RBS Greenwich Capital Markets, Lehman Brothers Holdings, Credit Suisse Group and Morgan Stanley dominated the industry.
The banks wanted more mortgage-backed securities to sell to clients. Creating a standardised "synthetic" instrument, or derivative, would leverage small numbers of sub-prime mortgages into bigger securities. In this way, the firms could produce enough to meet global demand.
"We called up the guys we felt like we knew and could work with," Lippmann says.
So the traders and lawyers sat down to design a new product and create what would soon become one of the world's hottest capital markets.
The meetings were monthly, at 5pm, and lasted three hours or more.
"In the beginning, everybody brought their lawyer," says Lippmann.
The group sought to bring "transparency", or openness, and "liquidity", or trading volume sufficient to ensure ease of buying and selling, to the mortgage market.
The most important issues centred on how to account for the eccentricities of mortgage bonds, perhaps the hardest Wall St securities to value. Unlike corporate bonds, home loans can be paid back at any time.
Traditionally, the best mortgage traders have been those who can read macroeconomic trends to guess when homeowners will prepay their loans. Until recently, early repayment was perceived as the biggest risk faced by Wall St's mortgage desks.
One concern with creating a standardised contract for mortgage-backed securities was that it was difficult to agree on a simple method of determining how market-changing events affected the values of the complicated, layered instruments.
To deal with the complexity, the group of five decided on a "pay-as-you-go" system. When something happened affecting the cash flows underlying the security, the seller would have to make cash payments to the buyer immediately, and vice versa.
As the group nailed down the details, the International Swaps and Derivatives Association, which sets trading terms for dealers, arranged conference calls that included more of Wall St.
To this point, some of the biggest mortgage underwriters - Lehman Brothers, Merrill, Bank of America Corp. and Morgan Stanley - hadn't been included in the negotiations. These firms heard about the talks and demanded to be let in.
On the conference calls, which included the market leaders, things got testy. One point in dispute was whether the contract should be traded on the basis of price or yield.
"Some of those points of detail were getting a little heated on the calls, and it was just thought it would be better to have a meeting face to face to move beyond those points," says Edward Murray, a London-based partner of the international law firm of Allen & Overy who was the chairman of the meeting and the outside counsel for ISDA. "To be frank, the dealers that were not in the group of five were not that happy that there was a group of five."
ISDA sought to resolve the differences by calling a sit-down meeting at its New York headquarters.
"Rajiv would say something, and I'd be absolutely convinced about what he said," Murray says. "And then Todd would say, 'Well, I don't agree.' And I would be absolutely convinced about what Todd said. And then Rajiv would say, 'Well, the reason you're wrong is' and so on."
Kamilla and Kushman declined to discuss the negotiations.
Michael Edman, one of Morgan Stanley's representatives at the ISDA conference, was less chipper, Murray says. "Arms folded, frown on his face ... There wasn't any shouting or anything, but the talk was very firm."
Edman, no longer at Morgan Stanley, declined to comment.
By June, the differences were sorted out, the new contract was endorsed, and banks that hadn't been party to the group of five negotiations signed on. The banks would go on to create similar derivative contracts to trade securities backed by loans for commercial buildings and collateralised debt obligations, or CDOs, which are securities backed by various kinds of debt.
Another necessary step was to create an index to represent the market and help to hedge general market exposure. It was called the ABX-HE and would be similar to the indexes traders use for baskets of stocks. This, participants believed, would add to the market's liquidity, or depth, by attracting more trading.
By September 2005, some within Deutsche Bank were beginning to worry about defaults on sub-prime mortgages and how that might affect the securities based on them. Deutsche Bank analysts warned of growing sub-prime market risks.
The ABX-HE index started trading on January 19, 2006. At 8am on the first day, John Kane of Sorin Capital started phoning dealers. Kane, then 27, was a trader at Sorin, which runs hedge funds that invest in mortgages and other securities.
His car mechanic, in describing the debt burden he was carrying to own a home, had planted the idea in Kane's mind that the housing market might be in trouble. Kane thought it through, ran an analysis on available data, and decided to wager against, or "short," sub-prime. To do that, he turned to the portion of the ABX index dealing with the lowest investment-grade sub-prime securities.
The trouble was that quotes from brokers selling the ABX were already dropping, indicating several investors wanted to do the same thing.
"All the other dealers were already scared" and dropping their bids, Kane said in November. "All but Goldman. So I bought from them."
On its first day, the index traded more than US$5 billion.
The cost of wagering against the securities was rising. An early warning was visible to anyone who knew where to look.
The new derivatives were a hit among the group of five's customers - the banks and other institutional investors that bought them to lock in high yields.
In the months to come, Deutsche Bank and at least one other member of the group of five, Goldman Sachs, began using sub-prime derivative contracts to bet the other way and guard against the possibility that sub-prime mortgages might default.
Lippmann says he didn't have "any secret knowledge" of the damaging events about to unfold in the US housing market. Rather, he says, he thought the risks of a downturn were significant enough to justify the millions of dollars it would cost to "short" sub-prime securities.
He says he told his bosses: "If we're right, we're looking at a sixfold gain. And since a housing market slowdown is not as big a long shot as that, we should take the risk."
Lippmann disputes that the derivatives the group of five helped to create - which banks packaged into CDOs - caused the sub-prime crisis.
"Derivatives enabled more CDOs to be created and the stakes to be bigger. But the transparency made people realise the problem faster."
Others see things differently. Rod Dubitsky, director of asset-backed research for Credit Suisse, says derivatives are "like wearing a seatbelt that allows you to drive faster ... No question, it changed the game dramatically".
High stakes game of home loan finance
One week in 2002, Daniel Sadek was US$6000 ($7800) short of covering the payroll for his new sub-prime mortgage company, Quick Loan Funding Corporation. So he flew to Las Vegas and put a US$5000 chip on the blackjack table.
"I could have borrowed the money, I suppose," Sadek says.
That wouldn't have been his style. With his shoulder-length hair and beard, torn jeans and T-shirts with slogans such as "Where is God?" Sadek looked more like a guitarist for Guns N'Roses than a mortgage banker.
Sadek says he was dealt a jack, then an ace. Blackjack. He would make payroll. Quick Loan Funding, based in Costa Mesa, California, would survive and, for a while, prosper as one of 1300 mortgage lenders in the state vying to satisfy Wall Street's thirst for sub-prime debt.
As home prices rose and hunger for high-yield investments grew, Sadek found his niche, pushing mortgages to borrowers with poor credit. Such sub-prime home loans grew to US$600 billion, or 21 per cent, of all US mortgages last year from US$160 billion, or 7 per cent, in 2001, according to Inside Mortgage Finance, an industry newsletter. Banks drove that growth because they could bundle sub-prime loans into securities, parts of which paid interest as much as 3 percentage points higher than 10-year Treasury notes.
"I never made a loan that Wall Street wouldn't buy," Sadek says. He worked hard to build the business, he says, and the company did nothing illegal.
In 2005 and 2006, New York bankers expanded the market for mortgage-backed securities by creating new sub-prime derivatives contracts.
The derivatives allowed Wall Street firms to sell more sub-prime securities and offered a new way to bet against the US housing market. Investors from Germany to Japan poured about US$1.2 trillion into mortgage-backed securities in those two years, according to Global Insight, an investment research firm in Waltham, Massachusetts.
Now the US economy is paying the bill for that easy credit. Nearly one in six sub-prime borrowers has missed a monthly payment, sending home prices to their first annual decline since the Great Depression.
The Federal Reserve cut its main interest rate three times to fend off recession, and Wall Street firms that posted record profits for the last three years have written down more than a combined $80 billion on sub-prime-related losses.
Sadek, now 39, got into the lending business in 2002, just as home prices were in the early stages of a record five-year surge.
Staked by banks including Citigroup, Sadek and others in his industry tripled the sub-prime market in five years.
"I was working every day, all day, from dusk to dusk," says Sadek, who pumped gas and sold cars before creating Quick Loan Funding.
"I slept in my office sometimes. I worked about 80 or 90 hours a week."
Part 2:
Charismatic mortgage broker went for hard sell
5:00AM Monday December 31, 2007
By Kathleen M. Howley and Mark Pittman
When homeowner Christopher Aultman, a mechanic for Union Pacific Railroad, called Quick Loan Funding in July 2005, a man identifying himself as Tim answered.
"He was friendly and he sounded like he knew what he was talking about," Aultman says.
Aultman wanted to refinance the 30-year fixed-rate mortgage on his four-bedroom home in Victorville, California, 129km northeast of Los Angeles. He needed to tap US$20,000 ($25,883) in equity to pay off mounting debts, and he wanted to build a backyard play area for his three children.
His average credit score was 465 out of a possible 850, according to Aultman's loan documents. That is well below the United States median of 720, according to Fair Isaac, whose software measures consumer credit-worthiness.
Daniel Sadek's sub-prime mortgage company, Quick Loan Funding, was the only lender that would talk to him, Aultman says.
"We'd been struggling and running away from bills, and I was tired of living that way," says Aultman, now 35.
"I wanted to be responsible and take care of my debts and wipe the slate clean."
A year earlier, Aultman had paid US$204,000 for the house.
Quick Loan Funding's appraiser said it was worth US$360,000. When Aultman called back later with questions, he says he was told Tim no longer worked there.
"I was passed from loan officer to loan officer," Aultman says.
"It just didn't feel right. But I was praying it was going to come through. I was desperate."
Loan officers were hired and fired all the time at Quick Loan Funding's 2415sq m call centre in Irvine, says Bryan Buksoontorn, who joined the company in 2004. By then, Irvine had become a hotbed of sub-prime lending companies.
"We were motivated by fear," says Buksoontorn, 28, who is now an independent mortgage broker. "It was a boiler room. You had to make your numbers."
Buksoontorn's job: get the caller's credit card and charge US$475 for an appraisal, he says.
"You told the callers what they wanted to hear and you got the credit card," says Steven Espinoza, 39, an employee from 2003 to 2005.
Sadek and his managers would berate the sales staff, many of whom had no experience or training, Buksoontorn says.
"They would get in your face," he says. "'Why aren't you ordering appraisals? Why aren't you selling?"'
Sadek brought a car salesman's mentality to mortgages, Espinoza says.
"It's the same type of hard sell," Espinoza says. "Close 'em, close 'em, close 'em."
Former employee Lisa Iannini, who was vice-president for compliance and risk management, says she tried to make sure the hard sell didn't result in bad loans.
"I went to work every day as an uninvited hall monitor at a fraternity party," Iannini says.
Sadek says 95 per cent of Quick Loan Funding's mortgages were made to sub-prime borrowers.
"If we had a prime borrower on the line, we hung up on them," Buksoontorn says.
"We were geared toward sub-prime because they were easier to close. We were giving them money no other bank would dare to give them."
Sadek says that with the support of Citigroup, which funded the loans, he pioneered lending to homebuyers with credit scores of less than 450.
Citigroup spokesman Stephen Cohen said the bank would not comment
on its relationships with clients.
"We made most of our money from selling loans to banks," Sadek says.
Quick Loan Funding, like many sub-prime companies, specialised in 2/28 loans - 30-year mortgages that start with lower "teaser" interest rates and ratchet higher after two years.
A key selling point was the 50 per cent rise in home prices nationally from 2001 to 2006, according to the National Association of Realtors.
Mortgage salespeople told homeowners that as long as values continued to increase, they could refinance or sell before their interest rates jumped.
It wasn't a lie. Year after year, prices had not fallen since the 1930s, according to the Realtors group.
The belief that values would form a stairway even seduced Quick Loan Funding employees who took out 2/28 loans themselves, says Marcus Bednar, 32, a former sales manager.
"They believed everything the borrowers believed, that the market was going to go up," Bednar says. "It wasn't just something we were pushing because we tried to rip people off."
Bednar adds, "We were never encouraged to do anything shady."
Borrowers with sub-prime adjustable-rate mortgages are seven times more likely to default than those with prime fixed-rate mortgages, according to the Mortgage Bankers Association.
Quick Loan Funding, like most sub-prime lenders, wrote so-called stated-income or "no doc" loans that don't require the borrower to document income with pay stubs or tax forms. They are also known as "liar loans".
In 2004, Bohan Group, a due diligence underwriting company, was hired by a bank to double-check the suitability of mortgages written by Quick Loan Funding that the bank was looking at buying and turning into securities. Bohan sent Nicole Singleton, 39, to the Irvine office. She reviewed 40 loans and rejected every one, she says.
Sadek says he fostered a competitive selling atmosphere, and underperforming workers "either quit because they're not making money or they're fired because they don't work."
He says Quick Loan Funding "thrived on customer service, so the idea of hanging up on callers is not right".
"If the loans were so bad, why did Wall St keep buying them?"
In July 2005, Espinoza, Buksoontorn, Bednar and other employees sued Quick Loan Funding in federal court alleging various workplace abuses, including failing to pay overtime and not providing adequate lunch breaks. Sadek later settled with the employees, agreeing to pay them more than US$3 million, says Jon Mower, an Irvine attorney who represented the loan officers.
"I don't think Quick Loan Funding was much different than many of the other sub-prime companies."
Sadek denies the charges, adding that it's the type of lawsuit a jury would never decide in the employer's favour. "They see me as a rich guy and who do you think they are going to believe?" he says.
To get US$20,000 in cash from the Quick Loan Funding refinance, Aultman was told, his monthly payments would rocket to US$2264 from US$1464.
"I said I can't do this," Aultman says. "They said take the mortgage, make the payments and once everything is paid off, within 30 days your credit will shoot up 150 points and we'll get you a better rate and everybody wins."
They convinced him, he says. The company sent a notary to his house with the documents to sign.
It was 9.30pm. Aultman was worn out from work and the rest of the family was in bed.
Aultman says he didn't see the pre-payment penalty in his contract. If he refinanced within two years, he'd have to pay six months' interest.
He also says he didn't notice his income on the contract: US$5950 a month. At the time Aultman says he made US$3420.
Sadek says he watched employees closely and anyone caught falsifying information would be "fired on the spot".
For a US$247,500 mortgage, Aultman paid Quick Loan Funding US$10,813, including origination fee, application fee, processing fee, underwriting fee and quality control fee, according to his loan documents.
The average closing costs for a mortgage of that amount in California is about US$5000, according to Pete Ogilvie, president of the California Association of Mortgage Brokers.
Sadek defends charging those fees by saying he took more of a risk by lending to people with such lousy credit. If legislators want to limit fees, they ought to pass laws against them, he says.
Aultman received US$21,674.70 in cash, according to the documents.
The monthly payments proved too steep and he fell behind.
"I feel burned," Aultman says. "There's a lot of nights I've gone into my son's room and watched him sleep and I've cried."
Quick Loan Funding's survival, like that of other non-bank mortgage lenders, depended on a stream of new borrowers like Aultman. To fund the mortgages, the company had US$400 million in short-term credit from Citigroup. To pay that off, Quick Loan Funding sold the mortgages to securitisers as soon as it could.
Sadek collected a fleet of cars that included a Lamborghini, a McLaren, a Ferrari Enzo, a Saleen S7 and a Porsche, frequented casinos and was engaged to soap opera actress Nadia Bjorlin.
"Daniel was charismatic, crazy, unconventional and passionate about his company and his borrowers," says Iannini.
Sadek would try to help Bjorlin break out of TV's Days Of Our Lives, co-writing and spending US$35 million to produce Redline, a feature film about illicit car racing, starring Bjorlin as a daring leadfoot.
By August 2005, Sadek was spending most of his time working on his movie. He hired Iannini to upgrade the company's risk management.
"My biggest problem day to day was reining in uneducated loan officers," Iannini says.
"You have to almost use police force tactics and threaten brutality on a sales floor of a lending institution and have that whip ready to crack, because you never know what employee will be pressured by what influences on any given day."
Iannini had worked at two other mortgage lenders before joining Quick Loan Funding. She says Sadek's firm was the most committed of the three to maintaining lending standards.
Asked about borrowers who have trouble making their payments, Sadek quickly leafs through a loan application. He stops, folds over the pages and points to the line that says, "Cash to borrower".
"Who's getting ripped off?" he says.
Sadek was featured on TV newscasts in March. During a publicity event for Redline at an Irwindale racetrack, comedian Eddie Griffin, a star of the movie, drove Sadek's US$1.2 million Ferrari Enzo into a concrete barrier, wrecking it.
Sadek, who appears in Redline as a poker player, also intentionally trashed two of his own Porsches in the making of the movie. In one scene, a Carrera is catapulted high in the air before it crashes.
Sadek may be in trouble, too. The California Department of Corporations wants to revoke his lending licence. The state says he tried to use the bank account of his escrow company, Platinum Coast, to apply for markers, or gambling loans, at three Las Vegas casinos in April and May.
"It was a bank error," Sadek says. "No money ever left the account."
He holds up a copy of the marker application. It has his name at the top and his signature at the bottom. In the middle of the page is a bank-account number.
He says he thought it was his personal account, but it turned out to be Platinum Coast's. He says he didn't know what he was signing.
- BLOOMBERG
Bloomberg
5:00AM Saturday December 29, 2007
By Mark Pitman
Representatives of five of Wall St's dominant investment banks gathered around a blond wood conference table on a February night almost three years ago.
Their talks over Chinese takeaways led to the perfect formula for a United States housing collapse.
The host was Greg Lippmann, then 36, a fast-talking Deutsche Bank AG trader who aspired to make mortgage securities as big a cash cow for Wall St as the US$12 trillion ($15.58 trillion) corporate credit market.
His allies included 34-year-old Rajiv Kamilla, a trader at Goldman Sachs Group with a background in nuclear physics, and Todd Kushman, 32, who led a contingent from Bear Stearns. Representatives from Citigroup and JPMorgan Chase were also invited.
Almost 50 traders and lawyers showed up for the first meeting at Deutsche Bank's Wall St office to help to set the trading rules and design the new product.
"To tell you the truth, it's not very glamorous," Lippmann says. "Just a bunch of guys eating Chinese discussing legal arcana."
Those meetings of the "group of five", as the traders called themselves, became a turning point in the history of Wall St and the global economy.
The new standardised contracts they created would allow firms to protect themselves from the risks of sub-prime mortgages, enable speculators to bet against the US housing market, and help to meet demand from institutional investors for the high yields of loans to homeowners with poor credit.
The tools also magnified losses so much that a small number of defaulting sub-prime borrowers could devastate securities held by banks and pension funds globally, freeze corporate lending, and bring the world's credit markets to a standstill.
For a while, the sub-prime boom enriched investment bankers, lenders, brokers, investors, realtors and credit-rating companies. It allowed hundreds of thousands of Americans to buy homes they never believed they could afford.
It later became clear that these homeowners couldn't keep up with their payments. Defaults on sub-prime mortgages have so far produced about US$80 billion in losses on securities backed by them. The market for the instruments is so opaque that many firms still aren't sure how much they've lost.
Chief executives at Citigroup, Merrill Lynch and UBS AG were replaced. To forestall a housing-led recession, the Federal Reserve has cut its benchmark rate three times since August and is injecting as much as US$40 billion into the credit system to encourage banks to lend to each other.
This is the story of how Wall St transmitted the practices of southern California's go-go lending industry and the inflated US real estate market to the global financial system:
* In Orange County, California, a mortgage lender named Daniel Sadek was among those who took notice of the increase in Wall St's appetite for sub-prime loans. He turned the staff at his firm, Quick Loan Funding, into a sub-prime mortgage factory. "You can't wait," said his ads, aimed at high-risk borrowers. "We won't let you."
* In Dallas, a hedge-fund manager named Kyle Bass taught himself to use the contracts pioneered by Lippmann's group, then went looking for mortgage-backed securities to bet against. He found them in instruments based on loans Sadek made.
* In New York, the ratings companies Standard & Poor's, Moody's Investors Service and Fitch Ratings put their stamp of approval on securities backed by loans to people who couldn't afford them. They used historical data to grade the securities and didn't adjust quickly enough for the widespread weakening of criteria used to qualify high-risk borrowers. Among the securities on which they bestowed investment-grade ratings: those backed by Sadek's loans.
Lippmann was a Wall St renaissance man, with a strong appetite for sushi and an online restaurant guide so comprehensive one blogger labelled him "the Robert Parker of raw fish". He opened the kitchen of the US$2.3-million Manhattan loft he lived in then to an Italian cooking class.
The goal of Lippmann's group that evening in 2005: to design a new financial product that would standardise mortgage-backed securities, including those based on high-yield sub-prime loans, paving the way for their rapid growth. Of the firms involved that night, Lippmann's Deutsche Bank is based in Frankfurt, UBS in Zurich and the others in New York.
In February 2005, pension funds, banks and hedge funds owned fixed-income securities that were earning returns close to historic lows.
AAA-rated securities based on home loans offered yields averaging a full percentage point higher than 10-year Treasuries at the time, says Merrill.
The trouble was that most creditworthy borrowers had already refinanced their houses at 2003's record-low mortgage rates. To meet demand for mortgage-backed securities, Wall St had to find a new source of loans. Those still available mainly involved sub-prime borrowers, who paid higher rates because they were seen as credit risks.
While the group of five banks had packaged billions of dollars in sub-prime-based securities, in February 2005 none was among the leaders in the home-equity bond business. Countrywide Securities, RBS Greenwich Capital Markets, Lehman Brothers Holdings, Credit Suisse Group and Morgan Stanley dominated the industry.
The banks wanted more mortgage-backed securities to sell to clients. Creating a standardised "synthetic" instrument, or derivative, would leverage small numbers of sub-prime mortgages into bigger securities. In this way, the firms could produce enough to meet global demand.
"We called up the guys we felt like we knew and could work with," Lippmann says.
So the traders and lawyers sat down to design a new product and create what would soon become one of the world's hottest capital markets.
The meetings were monthly, at 5pm, and lasted three hours or more.
"In the beginning, everybody brought their lawyer," says Lippmann.
The group sought to bring "transparency", or openness, and "liquidity", or trading volume sufficient to ensure ease of buying and selling, to the mortgage market.
The most important issues centred on how to account for the eccentricities of mortgage bonds, perhaps the hardest Wall St securities to value. Unlike corporate bonds, home loans can be paid back at any time.
Traditionally, the best mortgage traders have been those who can read macroeconomic trends to guess when homeowners will prepay their loans. Until recently, early repayment was perceived as the biggest risk faced by Wall St's mortgage desks.
One concern with creating a standardised contract for mortgage-backed securities was that it was difficult to agree on a simple method of determining how market-changing events affected the values of the complicated, layered instruments.
To deal with the complexity, the group of five decided on a "pay-as-you-go" system. When something happened affecting the cash flows underlying the security, the seller would have to make cash payments to the buyer immediately, and vice versa.
As the group nailed down the details, the International Swaps and Derivatives Association, which sets trading terms for dealers, arranged conference calls that included more of Wall St.
To this point, some of the biggest mortgage underwriters - Lehman Brothers, Merrill, Bank of America Corp. and Morgan Stanley - hadn't been included in the negotiations. These firms heard about the talks and demanded to be let in.
On the conference calls, which included the market leaders, things got testy. One point in dispute was whether the contract should be traded on the basis of price or yield.
"Some of those points of detail were getting a little heated on the calls, and it was just thought it would be better to have a meeting face to face to move beyond those points," says Edward Murray, a London-based partner of the international law firm of Allen & Overy who was the chairman of the meeting and the outside counsel for ISDA. "To be frank, the dealers that were not in the group of five were not that happy that there was a group of five."
ISDA sought to resolve the differences by calling a sit-down meeting at its New York headquarters.
"Rajiv would say something, and I'd be absolutely convinced about what he said," Murray says. "And then Todd would say, 'Well, I don't agree.' And I would be absolutely convinced about what Todd said. And then Rajiv would say, 'Well, the reason you're wrong is' and so on."
Kamilla and Kushman declined to discuss the negotiations.
Michael Edman, one of Morgan Stanley's representatives at the ISDA conference, was less chipper, Murray says. "Arms folded, frown on his face ... There wasn't any shouting or anything, but the talk was very firm."
Edman, no longer at Morgan Stanley, declined to comment.
By June, the differences were sorted out, the new contract was endorsed, and banks that hadn't been party to the group of five negotiations signed on. The banks would go on to create similar derivative contracts to trade securities backed by loans for commercial buildings and collateralised debt obligations, or CDOs, which are securities backed by various kinds of debt.
Another necessary step was to create an index to represent the market and help to hedge general market exposure. It was called the ABX-HE and would be similar to the indexes traders use for baskets of stocks. This, participants believed, would add to the market's liquidity, or depth, by attracting more trading.
By September 2005, some within Deutsche Bank were beginning to worry about defaults on sub-prime mortgages and how that might affect the securities based on them. Deutsche Bank analysts warned of growing sub-prime market risks.
The ABX-HE index started trading on January 19, 2006. At 8am on the first day, John Kane of Sorin Capital started phoning dealers. Kane, then 27, was a trader at Sorin, which runs hedge funds that invest in mortgages and other securities.
His car mechanic, in describing the debt burden he was carrying to own a home, had planted the idea in Kane's mind that the housing market might be in trouble. Kane thought it through, ran an analysis on available data, and decided to wager against, or "short," sub-prime. To do that, he turned to the portion of the ABX index dealing with the lowest investment-grade sub-prime securities.
The trouble was that quotes from brokers selling the ABX were already dropping, indicating several investors wanted to do the same thing.
"All the other dealers were already scared" and dropping their bids, Kane said in November. "All but Goldman. So I bought from them."
On its first day, the index traded more than US$5 billion.
The cost of wagering against the securities was rising. An early warning was visible to anyone who knew where to look.
The new derivatives were a hit among the group of five's customers - the banks and other institutional investors that bought them to lock in high yields.
In the months to come, Deutsche Bank and at least one other member of the group of five, Goldman Sachs, began using sub-prime derivative contracts to bet the other way and guard against the possibility that sub-prime mortgages might default.
Lippmann says he didn't have "any secret knowledge" of the damaging events about to unfold in the US housing market. Rather, he says, he thought the risks of a downturn were significant enough to justify the millions of dollars it would cost to "short" sub-prime securities.
He says he told his bosses: "If we're right, we're looking at a sixfold gain. And since a housing market slowdown is not as big a long shot as that, we should take the risk."
Lippmann disputes that the derivatives the group of five helped to create - which banks packaged into CDOs - caused the sub-prime crisis.
"Derivatives enabled more CDOs to be created and the stakes to be bigger. But the transparency made people realise the problem faster."
Others see things differently. Rod Dubitsky, director of asset-backed research for Credit Suisse, says derivatives are "like wearing a seatbelt that allows you to drive faster ... No question, it changed the game dramatically".
High stakes game of home loan finance
One week in 2002, Daniel Sadek was US$6000 ($7800) short of covering the payroll for his new sub-prime mortgage company, Quick Loan Funding Corporation. So he flew to Las Vegas and put a US$5000 chip on the blackjack table.
"I could have borrowed the money, I suppose," Sadek says.
That wouldn't have been his style. With his shoulder-length hair and beard, torn jeans and T-shirts with slogans such as "Where is God?" Sadek looked more like a guitarist for Guns N'Roses than a mortgage banker.
Sadek says he was dealt a jack, then an ace. Blackjack. He would make payroll. Quick Loan Funding, based in Costa Mesa, California, would survive and, for a while, prosper as one of 1300 mortgage lenders in the state vying to satisfy Wall Street's thirst for sub-prime debt.
As home prices rose and hunger for high-yield investments grew, Sadek found his niche, pushing mortgages to borrowers with poor credit. Such sub-prime home loans grew to US$600 billion, or 21 per cent, of all US mortgages last year from US$160 billion, or 7 per cent, in 2001, according to Inside Mortgage Finance, an industry newsletter. Banks drove that growth because they could bundle sub-prime loans into securities, parts of which paid interest as much as 3 percentage points higher than 10-year Treasury notes.
"I never made a loan that Wall Street wouldn't buy," Sadek says. He worked hard to build the business, he says, and the company did nothing illegal.
In 2005 and 2006, New York bankers expanded the market for mortgage-backed securities by creating new sub-prime derivatives contracts.
The derivatives allowed Wall Street firms to sell more sub-prime securities and offered a new way to bet against the US housing market. Investors from Germany to Japan poured about US$1.2 trillion into mortgage-backed securities in those two years, according to Global Insight, an investment research firm in Waltham, Massachusetts.
Now the US economy is paying the bill for that easy credit. Nearly one in six sub-prime borrowers has missed a monthly payment, sending home prices to their first annual decline since the Great Depression.
The Federal Reserve cut its main interest rate three times to fend off recession, and Wall Street firms that posted record profits for the last three years have written down more than a combined $80 billion on sub-prime-related losses.
Sadek, now 39, got into the lending business in 2002, just as home prices were in the early stages of a record five-year surge.
Staked by banks including Citigroup, Sadek and others in his industry tripled the sub-prime market in five years.
"I was working every day, all day, from dusk to dusk," says Sadek, who pumped gas and sold cars before creating Quick Loan Funding.
"I slept in my office sometimes. I worked about 80 or 90 hours a week."
Part 2:
Charismatic mortgage broker went for hard sell
5:00AM Monday December 31, 2007
By Kathleen M. Howley and Mark Pittman
When homeowner Christopher Aultman, a mechanic for Union Pacific Railroad, called Quick Loan Funding in July 2005, a man identifying himself as Tim answered.
"He was friendly and he sounded like he knew what he was talking about," Aultman says.
Aultman wanted to refinance the 30-year fixed-rate mortgage on his four-bedroom home in Victorville, California, 129km northeast of Los Angeles. He needed to tap US$20,000 ($25,883) in equity to pay off mounting debts, and he wanted to build a backyard play area for his three children.
His average credit score was 465 out of a possible 850, according to Aultman's loan documents. That is well below the United States median of 720, according to Fair Isaac, whose software measures consumer credit-worthiness.
Daniel Sadek's sub-prime mortgage company, Quick Loan Funding, was the only lender that would talk to him, Aultman says.
"We'd been struggling and running away from bills, and I was tired of living that way," says Aultman, now 35.
"I wanted to be responsible and take care of my debts and wipe the slate clean."
A year earlier, Aultman had paid US$204,000 for the house.
Quick Loan Funding's appraiser said it was worth US$360,000. When Aultman called back later with questions, he says he was told Tim no longer worked there.
"I was passed from loan officer to loan officer," Aultman says.
"It just didn't feel right. But I was praying it was going to come through. I was desperate."
Loan officers were hired and fired all the time at Quick Loan Funding's 2415sq m call centre in Irvine, says Bryan Buksoontorn, who joined the company in 2004. By then, Irvine had become a hotbed of sub-prime lending companies.
"We were motivated by fear," says Buksoontorn, 28, who is now an independent mortgage broker. "It was a boiler room. You had to make your numbers."
Buksoontorn's job: get the caller's credit card and charge US$475 for an appraisal, he says.
"You told the callers what they wanted to hear and you got the credit card," says Steven Espinoza, 39, an employee from 2003 to 2005.
Sadek and his managers would berate the sales staff, many of whom had no experience or training, Buksoontorn says.
"They would get in your face," he says. "'Why aren't you ordering appraisals? Why aren't you selling?"'
Sadek brought a car salesman's mentality to mortgages, Espinoza says.
"It's the same type of hard sell," Espinoza says. "Close 'em, close 'em, close 'em."
Former employee Lisa Iannini, who was vice-president for compliance and risk management, says she tried to make sure the hard sell didn't result in bad loans.
"I went to work every day as an uninvited hall monitor at a fraternity party," Iannini says.
Sadek says 95 per cent of Quick Loan Funding's mortgages were made to sub-prime borrowers.
"If we had a prime borrower on the line, we hung up on them," Buksoontorn says.
"We were geared toward sub-prime because they were easier to close. We were giving them money no other bank would dare to give them."
Sadek says that with the support of Citigroup, which funded the loans, he pioneered lending to homebuyers with credit scores of less than 450.
Citigroup spokesman Stephen Cohen said the bank would not comment
on its relationships with clients.
"We made most of our money from selling loans to banks," Sadek says.
Quick Loan Funding, like many sub-prime companies, specialised in 2/28 loans - 30-year mortgages that start with lower "teaser" interest rates and ratchet higher after two years.
A key selling point was the 50 per cent rise in home prices nationally from 2001 to 2006, according to the National Association of Realtors.
Mortgage salespeople told homeowners that as long as values continued to increase, they could refinance or sell before their interest rates jumped.
It wasn't a lie. Year after year, prices had not fallen since the 1930s, according to the Realtors group.
The belief that values would form a stairway even seduced Quick Loan Funding employees who took out 2/28 loans themselves, says Marcus Bednar, 32, a former sales manager.
"They believed everything the borrowers believed, that the market was going to go up," Bednar says. "It wasn't just something we were pushing because we tried to rip people off."
Bednar adds, "We were never encouraged to do anything shady."
Borrowers with sub-prime adjustable-rate mortgages are seven times more likely to default than those with prime fixed-rate mortgages, according to the Mortgage Bankers Association.
Quick Loan Funding, like most sub-prime lenders, wrote so-called stated-income or "no doc" loans that don't require the borrower to document income with pay stubs or tax forms. They are also known as "liar loans".
In 2004, Bohan Group, a due diligence underwriting company, was hired by a bank to double-check the suitability of mortgages written by Quick Loan Funding that the bank was looking at buying and turning into securities. Bohan sent Nicole Singleton, 39, to the Irvine office. She reviewed 40 loans and rejected every one, she says.
Sadek says he fostered a competitive selling atmosphere, and underperforming workers "either quit because they're not making money or they're fired because they don't work."
He says Quick Loan Funding "thrived on customer service, so the idea of hanging up on callers is not right".
"If the loans were so bad, why did Wall St keep buying them?"
In July 2005, Espinoza, Buksoontorn, Bednar and other employees sued Quick Loan Funding in federal court alleging various workplace abuses, including failing to pay overtime and not providing adequate lunch breaks. Sadek later settled with the employees, agreeing to pay them more than US$3 million, says Jon Mower, an Irvine attorney who represented the loan officers.
"I don't think Quick Loan Funding was much different than many of the other sub-prime companies."
Sadek denies the charges, adding that it's the type of lawsuit a jury would never decide in the employer's favour. "They see me as a rich guy and who do you think they are going to believe?" he says.
To get US$20,000 in cash from the Quick Loan Funding refinance, Aultman was told, his monthly payments would rocket to US$2264 from US$1464.
"I said I can't do this," Aultman says. "They said take the mortgage, make the payments and once everything is paid off, within 30 days your credit will shoot up 150 points and we'll get you a better rate and everybody wins."
They convinced him, he says. The company sent a notary to his house with the documents to sign.
It was 9.30pm. Aultman was worn out from work and the rest of the family was in bed.
Aultman says he didn't see the pre-payment penalty in his contract. If he refinanced within two years, he'd have to pay six months' interest.
He also says he didn't notice his income on the contract: US$5950 a month. At the time Aultman says he made US$3420.
Sadek says he watched employees closely and anyone caught falsifying information would be "fired on the spot".
For a US$247,500 mortgage, Aultman paid Quick Loan Funding US$10,813, including origination fee, application fee, processing fee, underwriting fee and quality control fee, according to his loan documents.
The average closing costs for a mortgage of that amount in California is about US$5000, according to Pete Ogilvie, president of the California Association of Mortgage Brokers.
Sadek defends charging those fees by saying he took more of a risk by lending to people with such lousy credit. If legislators want to limit fees, they ought to pass laws against them, he says.
Aultman received US$21,674.70 in cash, according to the documents.
The monthly payments proved too steep and he fell behind.
"I feel burned," Aultman says. "There's a lot of nights I've gone into my son's room and watched him sleep and I've cried."
Quick Loan Funding's survival, like that of other non-bank mortgage lenders, depended on a stream of new borrowers like Aultman. To fund the mortgages, the company had US$400 million in short-term credit from Citigroup. To pay that off, Quick Loan Funding sold the mortgages to securitisers as soon as it could.
Sadek collected a fleet of cars that included a Lamborghini, a McLaren, a Ferrari Enzo, a Saleen S7 and a Porsche, frequented casinos and was engaged to soap opera actress Nadia Bjorlin.
"Daniel was charismatic, crazy, unconventional and passionate about his company and his borrowers," says Iannini.
Sadek would try to help Bjorlin break out of TV's Days Of Our Lives, co-writing and spending US$35 million to produce Redline, a feature film about illicit car racing, starring Bjorlin as a daring leadfoot.
By August 2005, Sadek was spending most of his time working on his movie. He hired Iannini to upgrade the company's risk management.
"My biggest problem day to day was reining in uneducated loan officers," Iannini says.
"You have to almost use police force tactics and threaten brutality on a sales floor of a lending institution and have that whip ready to crack, because you never know what employee will be pressured by what influences on any given day."
Iannini had worked at two other mortgage lenders before joining Quick Loan Funding. She says Sadek's firm was the most committed of the three to maintaining lending standards.
Asked about borrowers who have trouble making their payments, Sadek quickly leafs through a loan application. He stops, folds over the pages and points to the line that says, "Cash to borrower".
"Who's getting ripped off?" he says.
Sadek was featured on TV newscasts in March. During a publicity event for Redline at an Irwindale racetrack, comedian Eddie Griffin, a star of the movie, drove Sadek's US$1.2 million Ferrari Enzo into a concrete barrier, wrecking it.
Sadek, who appears in Redline as a poker player, also intentionally trashed two of his own Porsches in the making of the movie. In one scene, a Carrera is catapulted high in the air before it crashes.
Sadek may be in trouble, too. The California Department of Corporations wants to revoke his lending licence. The state says he tried to use the bank account of his escrow company, Platinum Coast, to apply for markers, or gambling loans, at three Las Vegas casinos in April and May.
"It was a bank error," Sadek says. "No money ever left the account."
He holds up a copy of the marker application. It has his name at the top and his signature at the bottom. In the middle of the page is a bank-account number.
He says he thought it was his personal account, but it turned out to be Platinum Coast's. He says he didn't know what he was signing.
- BLOOMBERG
Bloomberg
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