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How To Harvest an Immigrant
From The Big Short, by Michael Lewis
Good read and even though it's not necessarily news, it is a very interesting read about the entire financial fiasco we are currently in. He dedicated an entire chapter to a topic many of us might be familiar with: Loan sharking immigrants. Text in red is all u need to read to get the gist.
-Sabzon
In Bakersfield, California, a Mexican strawberry picker with an income of $14,000 and no English was lent every penny he needed to buy a house for $724,000.
The more they examined the individual bonds, the more they came to see patterns in the loans that could be exploited for profit. The new taste for lending huge sums of money to poor immigrants, for instance. One day Eisman's housekeeper, a South American woman, came to him and told him that she was planning to buy a townhouse in Queens. "The price was absurd, and they were giving her a no money down option adjustable-rate mortgage," says Eisman, who talked her into taking out a conventional fixed-rate mortgage. Next, the baby nurse he'd hired back in 2003 to take care of his new twin daughters phoned him. "She was this lovely woman from Jamaica," he says. "She says she and her sister own six townhouses in Queens. I said, 'Corinne, how did that happen?'" It happened because after they bought the first one, and its value rose, the lenders came and suggested they refinance and take out $250,000--which they used to buy another. Then the price of that one rose, too, and they repeated the experiment. "By the time they were done they owned five of them, the market was falling, and they couldn't make any of the payments."
The sudden ability of his baby nurse to obtain loans was no accident: Like pretty much everything else that was happening between subprime mortgage borrowers and lenders, it followed from the defects of the models used to evaluate subprime mortgage bonds by the two major rating agencies, Moody's and Standard & Poor's.
The big Wall Street firms--Bear Stearns, Lehman Brothers, Goldman Sachs, Citigroup, and others--had the same goal as any manufacturing business: to pay as little as possible for raw material (home loans) and charge as much as possible for their end product (mortgage bonds). The price of the end product was driven by the ratings assigned to it by the models used by Moody's and S&P. The inner workings of these models were, officially, a secret: Moody's and S&P claimed they were impossible to game. But everyone on Wall Street knew that the people who ran the models were ripe for exploitation. "Guys who can't get a job on Wall Street get a job at Moody's," as one Goldman Sachs trader-turned-hedge fund manager put it. Inside the rating agency there was another hierarchy, even less flattering to the subprime mortgage bond raters. "At the ratings agencies the corporate credit people are the least bad," says a quant who engineered mortgage bonds for Morgan Stanley. "Next are the prime mortgage people. Then you have the asset-backed people, who are basically like brain-dead." Wall Street bond trading desks, staffed by people making seven figures a year, set out to coax from the brain-dead guys making high five figures the highest possible ratings for the worst possible loans. They performed the task with Ivy League thoroughness and efficiency. They quickly figured out, for instance, that the people at Moody's and S&P didn't actually evaluate the individual home loans, or so much as look at them. All they and their models saw, and evaluated, were the general characteristics of loan pools.
Their handling of FICO scores was one example. FICO scores--so called because they were invented, in the 1950s, by a company called the Fair Isaac Corporation--purported to measure the creditworthiness of individual borrowers. The highest possible FICO score was 850; the lowest was 300; the U.S. median was 723. FICO scores were simplistic. They didn't account for a borrower's income, for instance. They could also be rigged. A would-be borrower could raise his FICO score by taking out a credit card loan and immediately paying it back. But never mind: The problem with FICO scores was overshadowed by the way they were misused by the rating agencies. Moody's and S&P asked the loan packagers not for a list of the FICO scores of all the borrowers but for the average FICO score of the pool. To meet the rating agencies' standards--to maximize the percentage of triple-A-rated bonds created from any given pool of loans--the average FICO score of the borrowers in the pool needed to be around 615. There was more than one way to arrive at that average number. And therein lay a huge opportunity. A pool of loans composed of borrowers all of whom had a FICO score of 615 was far less likely to suffer huge losses than a pool of loans composed of borrowers half of whom had FICO scores of 550 and half of whom had FICO scores of 680. A person with a FICO score of 550 was virtually certain to default and should never have been lent money in the first place. But the hole in the rating agencies' models enabled the loan to be made, as long as a borrower with a FICO score of 680 could be found to offset the deadbeat, and keep the average at 615.
Where to find the borrowers with high FICO scores? Here the Wall Street bond trading desks exploited another blind spot in the rating agencies' models. Apparently the agencies didn't grasp the difference between a "thin-file" FICO score and a "thick-file" FICO score. A thin-file FICO score implied, as it sounds, a short credit history. The file was thin because the borrower hadn't done much borrowing. Immigrants who had never failed to repay a debt, because they had never been given a loan, often had surprisingly high thin-file FICO scores. Thus a Jamaican baby nurse or Mexican strawberry picker with an income of $14,000 looking to borrow three-quarters of a million dollars, when filtered through the models at Moody's and S&P, became suddenly more useful, from a credit-rigging point of view. They might actually improve the perceived quality of the pool of loans and increase the percentage that could be declared triple-A. The Mexican harvested strawberries; Wall Street harvested his FICO score.
The models used by the rating agencies were riddled with these sorts of opportunities. The trick was finding them before others did--finding, for example, that both Moody's and S&P favored floating-rate mortgages with low teaser rates over fixed-rate ones. Or that they didn't care if a loan had been made in a booming real estate market or a quiet one. Or that they were seemingly oblivious to the fraud implicit in no-doc loans. Or that they were blind to the presence of "silent seconds"--second mortgages that left the homeowner with no equity in his home and thus no financial incentive not to hand the keys to the bank and walk away from it. Every time some smart Wall Street mortgage bond packager discovered another example of the rating agencies' idiocy or neglect, he had himself an edge in the marketplace: Crappier pools of loans were cheaper to buy than less crappy pools. Barbell-shaped loan pools, with lots of very low and very high FICO scores in them, were a bargain compared to pools clustered around the 615 average--at least until the rest of Wall Street caught on to the hole in the brains of the rating agencies and bid up their prices. Before that happened, the Wall Street firm enjoyed a perverse monopoly. They'd phone up an originator and say, "Don't tell anybody, but if you bring me a pool of loans teeming with high thin-file FICO scores I'll pay you more for it than anyone else." The more egregious the rating agencies' mistakes, the bigger the opportunity for the Wall Street trading desks.
In the late summer of 2006 Eisman and his partners knew none of this. All they knew was that Wall Street investment banks apparently employed people to do nothing but game the rating agencies' models. In a rational market, the bonds backed by pools of weaker loans would have been priced lower than the bonds backed by stronger loans. Subprime mortgage bonds all were priced by the ratings bestowed on them by Moody's. The triple-A tranches all traded at one price, the triple-B tranches all traded at another, even though there were important differences from one triple-B tranche to another. As the bonds were all priced off the Moody's rating, the most overpriced bonds were the bonds that had been most ineptly rated. And the bonds that had been most ineptly rated were the bonds that Wall Street firms had tricked the rating agencies into rating most ineptly. "I cannot fucking believe this is allowed," said Eisman. "I must have said that one thousand times."
Eisman didn't know exactly how the rating agencies had been gamed. He had to learn. Thus began his team's months-long quest to find the most overrated bonds in a market composed of overrated bonds. A month or so into it, after they bought their first credit default swaps on subprime mortgage bonds from Lippmann, Vincent Daniel and Danny Moses flew to Orlando for what amounted to a subprime mortgage bond conference. It had an opaque title--ABS East--but it was, in effect, a trade show for a narrow industry: the guys who originated subprime mortgages, the Wall Street firms that packaged and sold subprime mortgages, fund managers who invested in nothing but subprime mortgage-backed bonds, the agencies that rated subprime mortgage bonds, the lawyers who did whatever the lawyers did. Daniel and Moses thought they were paying a courtesy call on a cottage industry, but the cottage was a castle. "There were so many people being fed by this industry," said Daniel. "That's when we realized that the fixed income departments of the brokerage firms were built on this."
That's also when they made their first face-to-face contact with the rating agencies. Greg Lippmann's people set it up for them, on the condition they not mention that they were betting against, and not for, subprime mortgage bonds. "Our whole purpose," said Moses, "was supposed to be, 'We're here to buy these securities.' People were supposed to think, 'Oh, they're looking to buy paper because it's getting to attractive levels.'" In a little room inside the Orlando Ritz-Carlton hotel, they met with both Moody's and S&P. Vinny and Danny already suspected that the subprime market had subcontracted its credit analysis to people who weren't even doing the credit analysis. Nothing they learned that day allayed their suspicion. The S&P people were cagey, but the woman from Moody's was surprisingly frank. She told them, for instance, that even though she was responsible for evaluating subprime mortgage bonds, she wasn't allowed by her bosses simply to downgrade the ones she thought deserved to be downgraded. She submitted a list of the bonds she wished to downgrade to her superiors and received back a list of what she was permitted to downgrade. "She said she'd submit a list of a hundred bonds and get back a list with twenty-five bonds on it, with no explanation of why," said Danny.
Vinny, the analyst, asked most of the questions, but Danny attended with growing interest. "Vinny has a tell," said Moses. "When he gets excited he puts his hand over his mouth and leans his elbow on the table and says, 'Let me ask you a question about this...' When I saw the hand to face I knew Vinny was on to something."
Here's what I don't understand, said Vinny, hand on chin. You have two bonds that seem identical. How is one of them triple-A and the other not?
I'm not the one who makes those decisions, said the woman from Moody's, but she was clearly uneasy.
Here's another thing I don't understand, said Vinny. How could you rate any portion of a bond made up exclusively of subprime mortgages triple-A?
That's a very good question.
Bingo.
"She was great," said Moses. "Because she didn't know what we were up to."
They called Eisman from Orlando and said, However corrupt you think this industry is, it's worse. "Orlando wasn't even the varsity conference," said Daniel. "Orlando was the JV conference. The varsity met in Vegas. We told Steve, 'You have to go to Vegas. Just to see this.'" They really thought that they had a secret. Through the summer and early fall of 2006, they behaved as if they had stumbled upon a fantastic treasure map, albeit with a few hazy directions. Eisman was now arriving home at night in a better mood than his wife had seen him in a very long time. "I was happy," says Valerie. "I thought, 'Thank God there's a place to put all this enthusiastic misery.' He'd say, 'I found this thing. It's a gold mine. And nobody else knows about it.'"
Good read and even though it's not necessarily news, it is a very interesting read about the entire financial fiasco we are currently in. He dedicated an entire chapter to a topic many of us might be familiar with: Loan sharking immigrants. Text in red is all u need to read to get the gist.
-Sabzon
In Bakersfield, California, a Mexican strawberry picker with an income of $14,000 and no English was lent every penny he needed to buy a house for $724,000.
The more they examined the individual bonds, the more they came to see patterns in the loans that could be exploited for profit. The new taste for lending huge sums of money to poor immigrants, for instance. One day Eisman's housekeeper, a South American woman, came to him and told him that she was planning to buy a townhouse in Queens. "The price was absurd, and they were giving her a no money down option adjustable-rate mortgage," says Eisman, who talked her into taking out a conventional fixed-rate mortgage. Next, the baby nurse he'd hired back in 2003 to take care of his new twin daughters phoned him. "She was this lovely woman from Jamaica," he says. "She says she and her sister own six townhouses in Queens. I said, 'Corinne, how did that happen?'" It happened because after they bought the first one, and its value rose, the lenders came and suggested they refinance and take out $250,000--which they used to buy another. Then the price of that one rose, too, and they repeated the experiment. "By the time they were done they owned five of them, the market was falling, and they couldn't make any of the payments."
The sudden ability of his baby nurse to obtain loans was no accident: Like pretty much everything else that was happening between subprime mortgage borrowers and lenders, it followed from the defects of the models used to evaluate subprime mortgage bonds by the two major rating agencies, Moody's and Standard & Poor's.
The big Wall Street firms--Bear Stearns, Lehman Brothers, Goldman Sachs, Citigroup, and others--had the same goal as any manufacturing business: to pay as little as possible for raw material (home loans) and charge as much as possible for their end product (mortgage bonds). The price of the end product was driven by the ratings assigned to it by the models used by Moody's and S&P. The inner workings of these models were, officially, a secret: Moody's and S&P claimed they were impossible to game. But everyone on Wall Street knew that the people who ran the models were ripe for exploitation. "Guys who can't get a job on Wall Street get a job at Moody's," as one Goldman Sachs trader-turned-hedge fund manager put it. Inside the rating agency there was another hierarchy, even less flattering to the subprime mortgage bond raters. "At the ratings agencies the corporate credit people are the least bad," says a quant who engineered mortgage bonds for Morgan Stanley. "Next are the prime mortgage people. Then you have the asset-backed people, who are basically like brain-dead." Wall Street bond trading desks, staffed by people making seven figures a year, set out to coax from the brain-dead guys making high five figures the highest possible ratings for the worst possible loans. They performed the task with Ivy League thoroughness and efficiency. They quickly figured out, for instance, that the people at Moody's and S&P didn't actually evaluate the individual home loans, or so much as look at them. All they and their models saw, and evaluated, were the general characteristics of loan pools.
Their handling of FICO scores was one example. FICO scores--so called because they were invented, in the 1950s, by a company called the Fair Isaac Corporation--purported to measure the creditworthiness of individual borrowers. The highest possible FICO score was 850; the lowest was 300; the U.S. median was 723. FICO scores were simplistic. They didn't account for a borrower's income, for instance. They could also be rigged. A would-be borrower could raise his FICO score by taking out a credit card loan and immediately paying it back. But never mind: The problem with FICO scores was overshadowed by the way they were misused by the rating agencies. Moody's and S&P asked the loan packagers not for a list of the FICO scores of all the borrowers but for the average FICO score of the pool. To meet the rating agencies' standards--to maximize the percentage of triple-A-rated bonds created from any given pool of loans--the average FICO score of the borrowers in the pool needed to be around 615. There was more than one way to arrive at that average number. And therein lay a huge opportunity. A pool of loans composed of borrowers all of whom had a FICO score of 615 was far less likely to suffer huge losses than a pool of loans composed of borrowers half of whom had FICO scores of 550 and half of whom had FICO scores of 680. A person with a FICO score of 550 was virtually certain to default and should never have been lent money in the first place. But the hole in the rating agencies' models enabled the loan to be made, as long as a borrower with a FICO score of 680 could be found to offset the deadbeat, and keep the average at 615.
Where to find the borrowers with high FICO scores? Here the Wall Street bond trading desks exploited another blind spot in the rating agencies' models. Apparently the agencies didn't grasp the difference between a "thin-file" FICO score and a "thick-file" FICO score. A thin-file FICO score implied, as it sounds, a short credit history. The file was thin because the borrower hadn't done much borrowing. Immigrants who had never failed to repay a debt, because they had never been given a loan, often had surprisingly high thin-file FICO scores. Thus a Jamaican baby nurse or Mexican strawberry picker with an income of $14,000 looking to borrow three-quarters of a million dollars, when filtered through the models at Moody's and S&P, became suddenly more useful, from a credit-rigging point of view. They might actually improve the perceived quality of the pool of loans and increase the percentage that could be declared triple-A. The Mexican harvested strawberries; Wall Street harvested his FICO score.
The models used by the rating agencies were riddled with these sorts of opportunities. The trick was finding them before others did--finding, for example, that both Moody's and S&P favored floating-rate mortgages with low teaser rates over fixed-rate ones. Or that they didn't care if a loan had been made in a booming real estate market or a quiet one. Or that they were seemingly oblivious to the fraud implicit in no-doc loans. Or that they were blind to the presence of "silent seconds"--second mortgages that left the homeowner with no equity in his home and thus no financial incentive not to hand the keys to the bank and walk away from it. Every time some smart Wall Street mortgage bond packager discovered another example of the rating agencies' idiocy or neglect, he had himself an edge in the marketplace: Crappier pools of loans were cheaper to buy than less crappy pools. Barbell-shaped loan pools, with lots of very low and very high FICO scores in them, were a bargain compared to pools clustered around the 615 average--at least until the rest of Wall Street caught on to the hole in the brains of the rating agencies and bid up their prices. Before that happened, the Wall Street firm enjoyed a perverse monopoly. They'd phone up an originator and say, "Don't tell anybody, but if you bring me a pool of loans teeming with high thin-file FICO scores I'll pay you more for it than anyone else." The more egregious the rating agencies' mistakes, the bigger the opportunity for the Wall Street trading desks.
In the late summer of 2006 Eisman and his partners knew none of this. All they knew was that Wall Street investment banks apparently employed people to do nothing but game the rating agencies' models. In a rational market, the bonds backed by pools of weaker loans would have been priced lower than the bonds backed by stronger loans. Subprime mortgage bonds all were priced by the ratings bestowed on them by Moody's. The triple-A tranches all traded at one price, the triple-B tranches all traded at another, even though there were important differences from one triple-B tranche to another. As the bonds were all priced off the Moody's rating, the most overpriced bonds were the bonds that had been most ineptly rated. And the bonds that had been most ineptly rated were the bonds that Wall Street firms had tricked the rating agencies into rating most ineptly. "I cannot fucking believe this is allowed," said Eisman. "I must have said that one thousand times."
Eisman didn't know exactly how the rating agencies had been gamed. He had to learn. Thus began his team's months-long quest to find the most overrated bonds in a market composed of overrated bonds. A month or so into it, after they bought their first credit default swaps on subprime mortgage bonds from Lippmann, Vincent Daniel and Danny Moses flew to Orlando for what amounted to a subprime mortgage bond conference. It had an opaque title--ABS East--but it was, in effect, a trade show for a narrow industry: the guys who originated subprime mortgages, the Wall Street firms that packaged and sold subprime mortgages, fund managers who invested in nothing but subprime mortgage-backed bonds, the agencies that rated subprime mortgage bonds, the lawyers who did whatever the lawyers did. Daniel and Moses thought they were paying a courtesy call on a cottage industry, but the cottage was a castle. "There were so many people being fed by this industry," said Daniel. "That's when we realized that the fixed income departments of the brokerage firms were built on this."
That's also when they made their first face-to-face contact with the rating agencies. Greg Lippmann's people set it up for them, on the condition they not mention that they were betting against, and not for, subprime mortgage bonds. "Our whole purpose," said Moses, "was supposed to be, 'We're here to buy these securities.' People were supposed to think, 'Oh, they're looking to buy paper because it's getting to attractive levels.'" In a little room inside the Orlando Ritz-Carlton hotel, they met with both Moody's and S&P. Vinny and Danny already suspected that the subprime market had subcontracted its credit analysis to people who weren't even doing the credit analysis. Nothing they learned that day allayed their suspicion. The S&P people were cagey, but the woman from Moody's was surprisingly frank. She told them, for instance, that even though she was responsible for evaluating subprime mortgage bonds, she wasn't allowed by her bosses simply to downgrade the ones she thought deserved to be downgraded. She submitted a list of the bonds she wished to downgrade to her superiors and received back a list of what she was permitted to downgrade. "She said she'd submit a list of a hundred bonds and get back a list with twenty-five bonds on it, with no explanation of why," said Danny.
Vinny, the analyst, asked most of the questions, but Danny attended with growing interest. "Vinny has a tell," said Moses. "When he gets excited he puts his hand over his mouth and leans his elbow on the table and says, 'Let me ask you a question about this...' When I saw the hand to face I knew Vinny was on to something."
Here's what I don't understand, said Vinny, hand on chin. You have two bonds that seem identical. How is one of them triple-A and the other not?
I'm not the one who makes those decisions, said the woman from Moody's, but she was clearly uneasy.
Here's another thing I don't understand, said Vinny. How could you rate any portion of a bond made up exclusively of subprime mortgages triple-A?
That's a very good question.
Bingo.
"She was great," said Moses. "Because she didn't know what we were up to."
They called Eisman from Orlando and said, However corrupt you think this industry is, it's worse. "Orlando wasn't even the varsity conference," said Daniel. "Orlando was the JV conference. The varsity met in Vegas. We told Steve, 'You have to go to Vegas. Just to see this.'" They really thought that they had a secret. Through the summer and early fall of 2006, they behaved as if they had stumbled upon a fantastic treasure map, albeit with a few hazy directions. Eisman was now arriving home at night in a better mood than his wife had seen him in a very long time. "I was happy," says Valerie. "I thought, 'Thank God there's a place to put all this enthusiastic misery.' He'd say, 'I found this thing. It's a gold mine. And nobody else knows about it.'"
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I attached the entirety of Chapter 4 since I can't post more than 15,000 words.
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