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Home > Blogs > Anthony Harrington > Subprime debacle – the truth emerges: Part 1

Subprime debacle – the truth emerges: Part 1

Subprime mortgage crisis | Subprime debacle – the truth emerges: Part 1 Anthony Harrington

While global liquidity imbalances were, at bedrock, responsible for generating the hunt for yield that pumped up the global asset bubble, subprime residential mortgage securitizations were undoubtedly the vehicle that gave us the 2008 global financial meltdown. The mechanics of this have been gone into at great length elsewhere, but what is now emerging bears further scrutiny.

In testimony to bodies such as the FCIC, in reflections on those testimonies, and in well researched books that are now emerging, such as Michael Hudson’s The Monster: How a Gang of Predatory Lenders and Wall Street Bankers Fleeced America—and Spawned a Global Crisis, the mind boggling mixture of outright criminality and blind folly that became the subprime engine, has been traced in all its shoddiness.

The importance of the topic warrants a few blogs which may serve as a rapid summary of the saga and which will also serve as a jumping off point for readers with strong stomachs to more in-depth material. All of this will be fought out through the American courts in the next few years as pension funds and institutional investors go after Wall Street banks. The evidence that is mounting up cannot but help investors as they seek to recover losses from investment banks who knowingly gilded lead and sold it to them, its valued clients, as pure gold.

While many of the actions will doubtless settle out of court, the potential losses for the banks – quite apart from their exposure to duff commercial real estate loans, duff residential mortgages and duff credit card debt, is going to rattle the US financial system and will hugely impede America’s ability to fight off the headwinds of deflation and depression.  

Our focus initially will be on testimony to the Financial Crisis Inquiry Commission (FCIC). John Mauldin gave an excellent summary version of some of this testimony in his October 23 newsletter, “Thoughts from the Front Line – The Subprime Debacle: Act 2 Part 2.” ( Those who want to browse the FCIC’s sheaf of testimonies by those most closely involved in the mechanics of subprime securitizations can find them on

Mauldin goes straight to the testimony of Richard Bowen, former senior vice-president and business chief underwriter with CitiMortgage Inc. His job was to examine samples of subprime mortgages from securitizations which Citi was representing to investors such as Fannie Mae and Freddie Mac, but also including other mainstream banks and institutions. Citi’s role in this was to give investors assurance that the securitized bundle of mortgages had gone through the due diligence process and were solid. Bowen’s role, and that of his team, was to check the soundness of the whole package through sampling techniques.

What actually happened, according to Bowen, is that when he flagged up issues, they were ignored. This perturbed him since, as a sensible professional he could see that ultimately Citi was writing business that could rebound on it to the tune of billions of dollars. The normal legal process would mean that investors who got burned by a securitized bundle that turned bad, would return to City and demand that Citi buy back those mortgages, making good the investor and taking huge losses on its own books. Here’s Bowen’s testimony:

"In mid-2006 I discovered that over 60% of these mortgages purchased and sold were defective. Because Citi had given reps and warrants to the investors that the mortgages were not defective, the investors could force Citi to repurchase many billions of dollars of these defective assets. This situation represented a large potential risk to the shareholders of Citigroup.

"I started issuing warnings in June of 2006 and attempted to get management to address these critical risk issues. These warnings continued through 2007 and went to all levels of the Consumer Lending Group.

"We continued to purchase and sell to investors even larger volumes of mortgages through 2007. And defective mortgages increased during 2007 to over 80% of production."

Interestingly, in his testimony Bowen says that Citi had a policy to which its Quality Assurance department had to comply, to the effect that no more than 5% of the mortgages Citi bought for onward resale as securitized investments were to be classified as defective. This meant that 95% had to be classified as approved ("agreed" in Citi parlance). How anyone can give a QA department in advance a rule about the quantity of work it must approve is incredibly difficult to understand. The cumulative result follows from the results of each individual inspection and by definition that cannot be determined in advance of inspection. It is logically possible for an entire batch to be defective and where is the 5% rule then? Even telling a QA department not to be too pernickety will skew QA results with unpredictable effects.

What happened in the Citi instance was that its QA department, rather ingeniously (or ingenuously, if you prefer) came up with two variants of "agree", an out and out "agree", and a "contingent agree". The "contingent agree" meant that the underwriting on the original loan actually failed because the documentation was poor or missing. For example, as Bowen explains:

"...the selling mortgage company underwriter may have approved a mortgage file showing a 45% debt to income ratio, which was within Citi policy criteria for the product. However, the required proof of income documentation confirming the borrower income used in the underwriting decision might be missing from the file. In this instance the Citi underwriter would assign an "agree contingent" decision to the file. The agree decision would be contingent upon receiving the income documentation proving the income utilized in the originating underwriter decision."

In other words until and unless proper documentation was received, there would be no way of knowing if the missing documentation was innocent or covering a fraudulent misstatement of earnings. Despite this danger, the QA department added the "agree" and the "agree contingent" totals together to make up the 95%, as if they were all tickety boo. Bowen told the FCIC that when the results were analysed, what they showed was that 5% of the mortgages were defective, 55% were missing documentation and just 40% were "agreed" in the real meaning of the term. This is how he reaches his 60% defective figure for June 2006.

The danger to Citi in giving assurances that the whole batch met its due diligence process stares you in the face. If I was a Citi shareholder I'd be extremely miffed.... Since a very large chunk of Citi is now owned by the US taxpayer the US taxpayer has a right to be extremely miffed, especially when they are, in all probability, going to end up meeting some horrendous further demands.

As Mauldin notes in his newsletter,

“He (Bowen) was the guy they hired to pay attention to the risks, and they ignored him. How could a senior manager get such an email (those sent out repeatedly by Bowen according to his own testimony) and not notify his boss, if only to protect his own ass? They had to have known what they were selling all the way up and down the ladder.”

This (that “management knew”) is an assumption that the courts will doubtless test more rigorously, but what this shows is that nuts and bolts risk management and regulation is not the issue, the issue is management. Citi had the right processes in place to check risks and management apparently didn’t do its job when the risks were flagged up.

Or rather, management seems to have misconceived its job. It thought the game was all about going for everything and hang the risks. If you think that, how can you listen to the Bowens of this world? Management had lost its head. That is what exuberant greed does. Could a strong regulator have spotted that the party was now wildly out of control? Certainly. But this is a tautology. “Strong” here means “able to stop the party”. In reality, the US regulatory machine was completely sold on the benefits of financial innovation as a prime growth driver for the US economy and had turned into the sector’s chief cheerleader.

So who regulates the regulators? This is what bodies like the international Financial Stability Board are currently wrestling with. The hope appears to be that a supra national approach with a large college of regulators from a variety of locations will provide enough sensible souls with their feet on the ground and their thumbs on the pulse, to avoid the regulatory machine getting whirled about by the party goers. That may be so, but just what tools they will have at their disposal to wrestle the punch bowl from the revellers remains to be seen.

Further reading on the US subprime mortgage crisis and the global crash:

Tags: CitiMortgage , Fannie Mae , Financial Stability Board , Freddie Mac , global liquidity imbalances , residential mortgage backed securities , securitization , subprime mortgages
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