Mar

27

My partner and I recently listed the names of every entrepreneur we had worked with in three decades of doing business in California and then tried to decide whether or not any had provided income documentation for a business, auto, or home loan with "stated income" that varied significantly from what we knew their actual income was. The answer was that less than a quarter of our law clients and business associates had been "completely honest" when it came to filling out lenders' paperwork. That may be a damning commentary on our choice of associates, but there is an alternate explanation.

Credit scoring and credit documentation, at least as we have directly experienced it here in California, is based on the assumption that people work for government, the educational-industrial complex (by far the State's largest employer group), or a large corporation. Failures such as losing a job, having a business go under, or surrendering assets in a divorce can be excused, but only if one has reformed, i.e., worked for at least five years as a W-2 employee for a bureaucracy or company that cannot possibly go out of business. Having substantial assets but no current income, the common fate of entrepreneurs, is not seen not as the natural result of making one's living from deals. On the contrary, it is taken as a clear sign of having a questionable character.

People who work for themselves repeatedly go through these inquisitions. Being nothing if not resourceful, they soon learn how to "pass" as upstanding citizens. They form corporations that can "verify" their own personal incomes as employees. They learn how to provide copies of tax returns that "restated" their income appropriately. We do not know but strongly suspect that the decision of the Sandlers and CFC and WM (each of which we bought last week) to offer "no income verification" loans in California was a sensible response to the fact that income verification had become a bigger genre of show business than either CSI spinoffs or reality shows.

It has been a number of years since we have been involved with a start-up, and the entrepreneurs on our list and we are now all respectably successful. A few people we know have done time - one for drug dealing, another for securities fraud, but none has defaulted on their mortgages. We know nothing about the credit market other than the little we have gleaned from George Zachar's considerable wisdom. But the recent "discovery" of dishonesty on the part of sub-prime borrowers and their mortgage brokers seems to have at least some echoes of Claude Raines' expression of "shock" at discovering that there was gambling going on at Rick's.

Roger Arnold adds:

I concur with the assessment concerning the sensible response to an irrational marketplace by World, WAMU, and the other original members of the 11th district of federal home loan bank system (before most of them were bought by WAMU) to offer no income verification loans to self employed borrowers in California and then spreading that same offer throughout the US. They exploited a massive irrationality in the system.

Previously, it was incredibly difficult for these people to get loans. For some bizarre reason the banking system always looked at them with suspicion and underwrote their loans to much more strenuous standards than wage earners with far less assets. So, underwriting to two of the three c's of credit, character, and collateral, and negating the necessity to prove the 3rd c, capacity, with tax returns, and financial statements, was brilliant. But, then to extend that offer to wage earners in an attempt to maintain their own growth rates was imprudent, especially for World and the Sandlers.

If it had stayed that way it probably would have been OK too; but it didn't. The Sandlers and WAMU began to cannibalize their own track records. They began to monetize their good will and trade on their historical track record of prudence in underwriting by gaming the system they created. As they increasingly went out on the risk curve by offering no income verification loans to increasingly dubious borrowers they simply increased the margins on their loans to make up for it.

And then countrywide, in conjunction with the MBS, packagers created similar loan products and sold the idea and the bonds to investors using the historical track record of performance established by World and WAMU. The problem is that that track record was based on borrowers that are no longer reflective of the profiles of the borrowers that the track record was based on.

From 1990 to 2000 or so, World was ranked by Fortune and Forbes magazines as the best financial firm in the US. In the last five years or so, they gamed that reputation and WAMU and Countrywide did too by extension. Their balance sheets ballooned along with their earnings and last year the Sandlers cashed out at the top by selling World to Wachovia for 25 billion dollars.

But now, the traditional clientele World had, the high-end self-employed borrower, has left them because World abandoned them by raising rates to what are today close to subprime. Today, world savings is where borrowers needing no income verification loans go to get loans they can't get from WAMU or Countrywide. And if they fail to get a loan at World the next step is subprime.

That's a long way down from the prudent underwriting that the Sandlers grew World with. Just as GM had to put one billion into rescap don't be surprised if before too long Wachovia is asking the Sandlers for some money back, too.

George Zachar writes:

Everything I know about "liar loans" and the real-life history of no docs I learned on this list from Roger Arnold.


There's a huge discontinuity in knowledge between the ground troops originating loans, and the Air Force strategic forces playing with highly abstract tranched securities. At the latter level, it's all (pseudo?) quantified risk profiles and lots of comparative history on the trajectories of various securities under "Monte Carlo-ed" simulations.

The securities geeks don't believe they need to know, let alone care, about such origination details as W2s, FICO scores, etc. Once the tranches emerge from the sausage machine, it's just a matter of getting the AAA pieces to favored accounts, seducing options kids to assume convexity, and finding the dummies to take the dreck. The marketing material will map out how (supposedly) each slice "should" behave along various rate and default paths. Then it's old fashioned caveat emptor.

As I understand it the fatalities thus far have been among folks holding the hot potato raw products before they could pass through the Street's cuisinart.

Yes, the down-credit tranches and related derivatives have widened out, but nothing like parallel historic events. And the rest of the capital structure has hung in so well that even the cynical pros are scratching their heads.

There's an interesting pattern to how sophisticated folks are reading all this. Those close to the ground, watching the paperwork and hearing the horror stories, understandably fret about an economic disaster. Folks who pass their days in front of screens watching the relationships between securities, see a speed bump. Politicians and lawyers see the next three years of legislation and litigation.

A Rashomon economy.


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