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THE 2007 SUB-PRIME MORTGAGE PROBLEM
This is our analysis of the 12/6/07 article in the NY Times -- "Wary of Risk, Bankers Sold Shaky
Mortgage Debt" -- By JENNY ANDERSON and VIKAS BAJAJ
Abstract -- Wall Street firms are coming under scrutiny for their role in selling risky
mortgage-related securities to investors. This analysis is our attempt to simplify the article and
make it more understandable to the general public
Click here for the original article -- http://www.nytimes.com/2007/12/06/business/06hedge.html?
n=Top/Reference/Times%20Topics/Subjects/B/Banks%20and%20Banking
We are hoping that Jenny Anderson and Vikas Bajaj follow with other articles and perhaps a
book that explains this problem in depth. In our opinion, the public and Congress are unlikely
to truly understand the problem unless the reporting is simplified and more detailed.
The above referenced article is from the NY Times of 12/6/07.
Here is the last paragraph. "What is clear is that home loans were highly lucrative to Wall
Street and its investment bankers. The average total compensation for managing directors in
the mortgage divisions of investment banks was $2.52 million in 2006, compared with $1.75
million for managing directors in other areas, according to Johnson Associates, a compensation
consulting firm. This year, mortgage officials will probably earn $1.01 million, while other
managing directors are expected to earn $1.75 million." We are talking about serious money.
Summarizing --- In 2006, managing directors in the mortgage divisions of investment banks
were each personally making $2.52 million dollars / year on the average ... This year, they will
only make $1.75 million / year.
What did the managing directors of the investment banks do to earn that money? (A) They
purchased large numbers of home mortgages from commercial banks who originally lent the
money on those mortgages. (B) The investment banks put those mortgages into pools and,
(C) they sold "tranches" of the pools to large investors like pension funds, banks, cities, hedge
funds and whatever. Read the definition of "tranche" (immediately below) from my computer's
dictionary.
"Tranche" -- a division or portion of a pool or whole; specifically : an issue of bonds derived
from a pooling of like obligations (as securitized mortgage debt) that is differentiated from other
issues especially by maturity or rate of return.
To simplify -- In other words -- these investment bankers would buy, for instance, a $100,000
mortgage (which is essentially a promise to pay $100,000 at some interest rate over some
specified period of time) and sell it to pension funds and the like along with other similar
mortgages (presumably) for more than $100,000. They would keep (earn) the difference (profit)
between the purchase price and the selling price.
Question -- Why would the banks who originated the mortgages, sell them?
Answer -- I think it is obvious that selling the mortgages allowed the banks to sell off risky loans.
Question -- Why did the Investment banks buy these risky loans?
Answer -- The investment banks did not care what the loans were worth. They planned to
"bundle" the mortgages and sell the inscrutable bundles to "institutional investors like pension
funds, banks and hedge funds" at a large profit.
Question -- Why would the "investors" buy the shaky mortgages from the investment banks?
Shouldn't they have known they were not worth the price?
Answer -- They obviously did not know what they were buying. They were either (A) stupid or
(B) misled.
When you consider that the managing directors of the investment banks bought poor quality
mortgages and sold them at inflated prices -- you can see how they could have "earned" their
enormous yearly income ($2 million / year ++)
Is this "Alice in Bankingland" -- or what?
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