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February 14, 2008

State Level Predatory Lending Rules Were Blocked

Eliot Spitzer says some states tried to pass rules to limit predatory lending, but the Bush administration blocked the efforts:

Predatory Lenders’ Partner in Crime: How the Bush Administration Stopped the States From Stepping In to Help Consumers, by Eliot Spitzer, Commentary, Washington Post: Several years ago, state attorneys general and others involved in consumer protection began to notice a marked increase in a range of predatory lending practices by mortgage lenders. … These … practices, we noticed, were having a devastating effect on home buyers. In addition, the widespread nature of these practices, if left unchecked, threatened our financial markets. …

Predatory lending was widely understood to present a looming national crisis. This threat was so clear that as New York attorney general, I joined with colleagues in the other 49 states in attempting to fill the void left by the federal government. Individually, and together, state attorneys general of both parties brought litigation or entered into settlements with many subprime lenders that were engaged in predatory lending practices. Several state legislatures, including New York’s, enacted laws aimed at curbing such practices.

What did the Bush administration do in response? Did it reverse course and decide to take action to halt this burgeoning scourge? … Not only did the Bush administration do nothing to protect consumers, it embarked on an aggressive and unprecedented campaign to prevent states from protecting their residents…

The administration accomplished this feat through an obscure federal agency called the Office of the Comptroller of the Currency (OCC). The OCC has been in existence since the Civil War. Its mission is to ensure the fiscal soundness of national banks. For 140 years, the OCC examined the books of national banks…, an important but uncontroversial function. But a few years ago, for the first time in its history, the OCC was used as a tool against consumers.

In 2003, during the height of the predatory lending crisis, the OCC invoked a clause from the 1863 National Bank Act to issue formal opinions preempting all state predatory lending laws, thereby rendering them inoperative. The OCC also promulgated new rules that prevented states from enforcing any of their own consumer protection laws against national banks. The federal government’s actions were so egregious and so unprecedented that all 50 state attorneys general, and all 50 state banking superintendents, actively fought the new rules.

But the unanimous opposition of the 50 states did not deter, or even slow, the Bush administration… In fact, when my office opened an investigation of possible discrimination in mortgage lending by a number of banks, the OCC filed a federal lawsuit to stop the investigation.

Throughout our battles with the OCC and the banks, the mantra of the banks and their defenders was that efforts to curb predatory lending would deny access to credit to the very consumers the states were trying to protect. But the curbs we sought on predatory and unfair lending would have in no way jeopardized access to the legitimate credit… Instead, they would have stopped the scourge of predatory lending practices that have resulted in countless thousands of consumers losing their homes and put our economy in a precarious position.

When history tells the story of the subprime lending crisis and recounts its devastating effects on the lives of so many innocent homeowners, the Bush administration will not be judged favorably. The tale is still unfolding, but when the dust settles, it will be judged as a willing accomplice to the lenders who went to any lengths in their quest for profits. …

Posted by Mark Thoma on Thursday, February 14, 2008 at 12:44 AM in Economics, Financial System, Market Failure, Regulation

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How a Good Subprime Call
Came to Hurt Morgan Stanley

By RANDALL SMITH
November 9, 2007; Page C1

Sometimes, even good bets can go bad.

Before the market for subprime mortgages cracked in February, some smart Wall Street players, including securities firm Morgan Stanley, were correctly betting it would go south.

Morgan Stanley executives had just gained a window into that market from the acquisition in December of a subprime-mortgage company. And a bearish bet helped Morgan Stanley report a 70% jump in profit to a record $2.67 billion in its first quarter ended in February.

Fast forward eight months. Even though the market for subprime mortgages — which are loans extended to the riskiest borrowers — continues to deteriorate, the same bearish bet has now cost the firm $3.7 billion, or $2.5 billion after tax, wiping out most of any profits Morgan Stanley might have made for the fourth quarter that ends later this month.

What went wrong? It turns out Morgan Stanley’s hit has a lot in common with a much larger write-down of $7.9 billion incurred by rival Merrill Lynch & Co. Both firms wound up with huge positions of super-senior segments of collateralized debt obligations, or CDOs, which are securities backed by pools of mortgages and other assets.

The firms held the super-senior CDOs — considered relatively safe investments — for different reasons. Merrill’s total CDO inventory of $32.1 billion June 29 was a byproduct of its league-leading franchise underwriting CDOs. Morgan Stanley’s $13 billion at the start of this year helped hedge and finance its bearish subprime bet, company officials said.

But one common element, Wall Street analysts and Morgan Stanley officials said, was the CDOs paid a higher interest rate than the firms’ cost of financing. That generated seductive profits for both firms until the bottom fell out in October after more modest declines in August and September.

In some respects, the way Morgan Stanley’s subprime bet went awry is similar to how some quantitative-hedge-fund bets soured over the summer. The hedge funds expected low-quality stocks to perform worse than “value” stocks in a downturn, but instead it was the higher-quality shares that got hit.

On a conference call with analysts late Wednesday afternoon, Morgan Stanley’s chief financial officer, Colm Kelleher, said the firm’s proprietary traders began making the bearish bet against the subprime market in December, the very month that Morgan Stanley acquired subprime lender Saxon Capital Inc. for $706 million.

Both the acquisition and the trading strategy were in line with Morgan Stanley Chief Executive John Mack’s stated determination in the fall of 2005 to take more risk with the firm’s capital, a goal that echoed that of former Merrill Lynch CEO Stan O’Neal, who left his position last month following his firm’s losses.

Armed with Saxon, Morgan Stanley quickly climbed to the No. 1 ranking in subprime-mortgage-securities underwriting this year, according to Inside Mortgage Finance, a trade publication in Bethesda, Md. That is up from No. 5 in 2005 and No. 3 in 2006. Merrill, which also acquired a subprime-mortgage company, rose to No. 2 this year from No. 4 in 2006 and No. 7 in 2005.

The subprime-mortgage-underwriting drive left Morgan Stanley with $2.9 billion in subprime loans and $4 billion in subprime-mortgage securities on its books as of August. But that position was hedged by an offsetting bearish subprime bet totaling $6.6 billion.

A Morgan Stanley official said the bearish subprime wager wasn’t begun in December to hedge the subprime underwriting of Saxon. But he said it might have been constructed partly from Saxon-generated assets. And he said it might have been informed by market data that Morgan Stanley was getting from Saxon’s activities.

The bearish subprime bet, which took the form of derivatives called swaps, required Morgan Stanley to pay interest on those contracts, the same official said. To offset the bearish subprime bet and help generate interest income to pay the cost of the swaps, he said, the firm amassed the CDO position that produced most of the losses announced Tuesday.

The biggest piece of the $3.7 billion in pretax paper losses, the firm’s data indicated, came from a write-down of the CDO position from $11.4 billion Aug. 28 to $8.3 billion Oct. 31 — a difference of $3.1 billion. Such securities fell as much as 4.4% in August and 4.5% in September but tumbled as much as 27% in October.

On the call with analysts, Mr. Kelleher said the mortgage-related bets “did not come out of our client-facing activities” such as underwriting.

Instead, he said, “we began with a short position in the subprime-asset class, which went right through to the first quarter.” But as the downturn spread to the senior CDO holdings that were meant to hedge the subprime bet, the firm’s exposure changed “from short to flat to long,” Mr. Kelleher said.

“You go short, expecting a certain predefined range of losses,” Mr. Kelleher said. He added, “That range of losses was burnt through by the excessive market action. And then you ended up effectively going long.”

Through the first nine months of the fiscal year through August, Goldman Sachs Group Inc. analyst William Tanona noted that the bearish subprime bet actually earned Morgan Stanley a profit of $1 billion. But the firm’s disclosure of the paper losses and the position sizes prompted two ratings firms to issue negative outlooks for the company’s credit.

Moody’s Investors Service said the news “raises questions regarding the effectiveness of Morgan Stanley’s trading risk management.” Merrill analyst Guy Moszkowski said the trade was “too big.” Morgan Stanley ousted a team of CDO traders a few weeks ago.

Write to Randall Smith at randall.smith@wsj.com