I were to tell you Sen. Edwards is no longer seeking the Democratic
nomination for president you would probably stop reading here.
Old news right? Similarly, when one accepts the commonly used
definition for a recession (two consecutive quarters of negative
growth): that is old news. If we buy into that reasoning, we
will have to wait until July before we can determine if the
economy is in a recession. The definition is problematic since
it is based upon historical data rather than current conditions.
Besides, you do not want to wait for an Administration flaunting
its dubious record on productivity and low unemployment, to
tell you there is a recession. When I hear the president talk
about his administration’s achievements, I am reminded of an
enormously flawed and conflicted but brilliant American literary
figure who said, “[t]here are three kinds of lies: lies, damned
lies, and statistics”.
The president and likeminded economists claim
they do not want to “talk down the economy” but when you look
at the conditions of the marketplace and the actions of the
Federal Reserve, it is difficult for any reasonable person to
not conclude that we are traveling at an accelerated pace for
an economic meltdown. The Federal Reserve’s (Fed) proposal to
loan $200 billion to financial institutions, using mortgage-backed
securities as collateral, in addition to the $180-plus billion
from the previous 2 weeks is nothing short of a welfare check.
The only difference is the recipients are wealthy White men
instead of single moms.
The mortgage backed securities the Fed is using
as collateral are next to worthless on today’s market. Mortgage
Backed Securities (MBS) are investment instruments consisting
of mortgage loans. The mortgage loans are packaged (securitized)
into securities and sold to investors. Payments to the investor
will be made by the servicer (company collecting principal,
interest and escrow payments) upon receiving the homeowners’
mortgage payments. Should the homeowner refinance or payoff
the mortgage, that loan is replaced in the portfolio with another
loan of similar characteristics--interest rate, pre-payment
penalty, loan-to-value ratio, etc. What happens when there is
a portfolio of 1,000 loans and 300 of the loans goes into foreclosure
and/or the market value of 200 loans decrease by an average
of 15%? This is not a hypothetical. The frequency in which these
events (foreclosure or diminution in value) occur today has
created a lack of confidence and instability in financial markets.
we will use one of Goldman
Sachs’ securities that is commonly referred to as one of those
horror deals for all parties involved, except Goldman Sachs.
In April, 2006, Goldman issued security GSAMP
Trust 2006-S3, which consisted of 8,274 second mortgage loans.
58% of the individual loans were underwritten to no doc and
low doc standards, meaning there were no proof of income or
employment and the average combined loan to value (cltv) was
99.29%; as a result, the average homeowner equity for this pool
was less than 1%. One-third of the loans came from California,
a hot market at the time. These were multiple risk factors (layered
risks) which should have signaled to investors, extraordinary
due diligence was required. Goldman Sachs did file a 315-page
prospectus, however, Standard & Poor’s and Moody’s gave
an Investment Grade rating to 10 of the 13 tranches and three
of the tranches received a Junk rating. Tranches are sections
or pieces of a security which are best described by comparing
the way beef is graded - prime, choice, select, standard, etc.
were 13 tanches in Goldman’s security and depending on what
the investor bought - AAA (prime) down to bb (canner or cutter
beef) - determined the amount of risk in the security. Investors
who purchased AAA tranches had less risk and the expected return
was less. Those investors who purchased the three tranches rated
as Junk expected to receive a higher return on their investment
because there were greater risk in those tranches (probably
all of the risk factors stated above, a lower credit score,
minimal reserves, none owner-occupied, etc.). The top three
tranches (prime) were sold for $336 million and the next 7 tranches
of varying grades were sold for $123 million. Morgan Keegan
High Growth Income Fund bought the $8 million non-investment
grade (Junk) tranche and the $13 million non-investment tranche
was purchased by UBS’ Absolute Return Fund, foreign investors.
Goldman kept the final $14 million non-investment grade tranche
for putting the deal together.
Late 2006 and the beginning of 2007, borrowers
in general began to default on early payments (1st three payments)
at a much higher rate than historical data indicated they would.
The market value of homes was beginning to depreciate and interest
rates were rising. Lenders and federal regulators started to
impose stricter underwriting guidelines. As the second mortgage
holder, GSAMP could not foreclose unless they paid off the first
mortgage, thus if the borrower continued to pay their first
mortgage, there was nothing GSAMP could do. Being in that position
is the greatest risk a second mortgage holder faces - the inability
In February of 2007, less than one year after
the security was issued, Moody’s and Standard & Poors downgraded
the Goldman security and only the top three tranches remained
above the Junk grade. By the end of September, 2007, 18% of
the loans in the GSAMP security had defaulted. This was bad
news for those investors holding the bottom 7 tranches. The
way these deals are structured, the investors with the greatest
risk take the losses first. Those investors at the top are exposed
to the risk (borrower going into default) last. Thus to the
extent a borrower does not pay the loan back, those investors
with the higher risk tranches are exposed first.
Please Note: in an earlier paragraph where mortgage-backed
securities was defined, I said if a loan is paid off or refinanced,
it is replaced in the pool with a loan of similar quality, the
caveat to that statement is the terms of the agreement between
the issuer and the investor.
By July, 2007, Standard & Poors had downgraded
418 securities collateralized by closed-end second mortgages
originated between January, 2005 and January, 2007, for a total
value of $62 billion. During this same period there were $2.5
trillion in private label first mortgages that were underwritten
to similar standards. Private label is defined as non-agency
loans or loans that are not underwritten to Fannie Mae (FNMA)
or Freddie Mac (FHLMC) guidelines.
The removal of a rating agency’s higher rating,
not only results in asset-backed securities losing value in
the marketplace but it shakes the investors’ confidence in that
particular investment vehicle, decreasing demand which, in turn,
puts downward pressure on the value of the asset. This cycle
is repeated until the asset is almost worthless. So far, investment
houses have written down approximately $160 billion in losses
and counting, which brings us to the collapse of another fund
owned by the Carlyle Group that has many layers to peel away.
The Carlyle Group was started in 1987 by William
Conway, Daniel D’Aniello and David Rubenstein. Carlyle is a
global private equity firm with over $80 billion under management.
It is well-known for employing some very heavy hitters - both
Bush presidents, James Baker, former British prime minister,
John Major and a long list of others from the US
and around the world. There is a humorous story of how our president
became a member and was unceremoniously dumped.
But the Carlyle Group has the reputation of having
“the Midas touch”. The firm has engineered many renown deals but two in particular are contrary to the Midas
touch reputation, Caterair, for which the president was affiliated
with before he became Texas
governor and the one we will briefly discuss today, Carlyle
Capital Corp. (CCC). CCC became operational in the summer of
2007 and is based off an island (Guernsey) in England.
As a private equity fund, CCC, invested primarily in agency
mortgage backed securities, not of the subprime variety but
Fannie Mae and Freddie Mac issues. CCC leveraged approximately
$670 million and acquired loans from Bear Stearns, JP Morgan
Chase, and others to purchase $21.5 billion in securities.
The rapid decline in the value of mortgage-backed
securities over the past 6 months forced lenders to issue a
margin call (additional capital or assets as collateral for
the transaction). The CCC received an addition $150 million
from parent company, Carlyle Group. The market-value of the
securities further declined and the lenders asked for an additional
$400 million. Last week, the fund allegedly went into default
and collapsed. Nothing more about it was forthcoming. The news
no longer was about the Carlyle Group but headlines were the
Federal Reserve (Fed) would make available $200 billion to member
banks through its Discount Window and the Fed would take mortgage
backed securities as collateral.
collapse of the $21.5 billion equity fund of CCC represents
one of hundreds of funds that went into default. The $160-plus
billion that was noted as being written off referenced only
that which has been taken off the balance sheets of investment
houses. We have a $6 trillion housing bubble that has burst
and now you will see many equity funds collapse, pensions will
be lost and insurance rates will increase. They invested in
the mortgage-backed securities and derivatives market and the
paper is worthless. There is no demand for mortgage-backed securities;
too many are on the market. Easy access and lowered cost have
not triggered demand in the marketplace for these instruments
because they are collateralized with mortgages. Homeowners are
not paying their mortgages because of the resets on adjustable
rate mortgages, they are upside down/underwater or they have
lost their job, accordingly, housing values continue to decline
as the foreclosures escalates.
had been rumors about Bear Stearns’ soundness because it was
so heavily invested in mortgage backed securities, agency and
non-agency. Unfortunately for Bear Stearns, they were not eligible
for the welfare checks the Feds were handing out at the Discount
Window. If it were eligible, Bear Stearns could dump their worthless
mortgage backed securities on the Fed (taxpayers) and participate
in the give-away that is free of the “moral hazard”. Only bailouts
for taxpayers represent moral hazards, presumably, investment
banks will not repeat this behavior.
Shortly after the Fed’s announcement, Bear Stearns
confirmed it was in trouble and was in negotiations with JP
Morgan Chase to resolve their financial woes. Bear Stearns and
the Carlyle Group could not take advantage of the welfare checks
being disbursed at the Discount Window but JP Morgan Chase could.
Thus, the fix was on. The Fed assured JP Morgan that it would
not lose any money on the deal and pledged $30 billion to help
JP Morgan if it should sustain any losses. The path has been
cleared for the Carlyle Group and Bear Stearns to unload their
worthless securities on the American taxpayer adding insult
There is one other wrinkle to this Carlyle Group
and BS (I do not mean Bear Stearns) saga. What you do not hear
in the marketplace is Fannie Mae (FNMA) and Freddie Mac (FHLMC)
are on their deathbeds. The priest has been called in. Succinctly,
the Fed is trying to bailout Fannie and Freddie. On March 12,
2008, when all interested parties were notified by a well-known
company which monitors mortgage-backed securities, that the
value in mortgage-backed securities had diminished considerably,
a principal at the Carlyle Group reported that Carlyle owns
agency mortgage-backed securities, the implication being this
type of security is backed by the full faith and credit of the
US Government. After 40 years (Fannie became a stockholder-owned
company in 1968) of rebuttals by government officials and that
FNMA is not backed by the federal government, now the Fed has
to reverse itself and bailout Fannie and Freddie because their
operations are completely intertwined in the massive derivative
crisis, tainted and just as toxic as all the other worthless
mortgage-backed securities on the market. To Be Continued.
BlackCommentator.com Guest Commentator, Lloyd Wynn was a
consultant in the secondary market. Lloyd is the author of Residential Real Estate Finance:
From Application Through Settlement. Click
here to contact Lloyd Wynn.