Part 2 of 'Securitisation Fail' - my RC Report

The Introduction to this blogpost can be found here.

1. GREED FOR SECURITISATION PROFITS SPAWNED RAMPANT PREDATORY LENDING


Predatory Lending practices in Australia have been well canvassed by Denise Brailey, Phillip Soos, and Paul Egan, including in lengthy submissions to Senate Enquiries and the current Royal Commission into Banking. Some characteristics of predatory loans are:

• NINJA  (No Income, No Job, No Assets) loans and ARIP (Asset Rich, Income Poor) loans were widely given as they provided loans with a higher default risk than normal to securitise.
• Interest only.
• Income stated on Loan Application Forms was fraudulently increased by banks without Borrowers’ knowledge so as to provide loans that were more likely to default.
• Lo-Doc and No-Doc loans were designed to fail within about 5 years. Securitisation is structured in such a way that more money is made out of defaults than with loans that are paid out before or by the due date.

There’s a lot more to Predatory Lending than that, but it’s not the subject of this Report. The key take-home for the purposes of this discussion is that the main ‘Why?’ of the Predatory Lending that became rampant from the early 2000’s is Securitisation Profits.

Securitisation Trusts are Involved in Loan Origination and Loan Settlement


It’s clear that the Securitisation Trusts, and not just Originators, are involved in the origination and settlement of Loans and Mortgages.  One could come to the mistaken conclusion that this is to ensure all transactions are legal, or that loans are affordable, or that the documents are in order, or that they honour their duty of care to customers. The last two decades bear testimony to the fact that these things simply aren’t true.

Their interest in securing loans is simple - huge securitisation profits.

Even before the loans are originated, the Securitisation Trust is already involved. eg. The Consolidated Trust Deed (CTD) for PUMA S-2, into which my mortgage was sold, states in its Third Schedule Loans that , ‘All evidence of title and ancillary documents and insurance must be verified by the Trustee or the Manager (of the Securitisation Trust) prior to the loans being originated or acquired, and the corresponding Mortgage being treated as an Approved Mortgage.’

Then, once the loan is approved, but before settlement, the next step is to send the documentation ‘to an approved panel lawyer or title insurer with instructions to prepare the associated security documentation.’ (PUMA S-2 Master Information Memorandum p47)

It’s also clear that the settlement of the loan is intricately tied in with the mortgaged property's suitability for Securitisation - not with the ability of a ‘borrower’ to repay. Page 47 of PUMA S-2 Trust’s Master Information Memorandum (MIM) describes the ‘Documentation and Settlement Procedures’  and states that it’s only after ‘the proposed security property is (assessed as) acceptable and complies with the PUMA Parameters’ that the loan is ready to settle, at which point the Trust Manager is requested to arrange the funding of the loan.

These facts in themselves aren’t criminal. However, because of the potential for iniquitous profits with no risk to themselves, banks and trusts became more and more reckless in their lending practices and created loan products, secured by mortgages, that fed their frenzy for securitisation profits. 

Incentives for Predatory Lending



There were plenty of incentives for Predatory Lending - but they all pretty much boiled down to three key things - profits, profits, and more profits. Wherever the Securitisation industry flourished, so did predatory lending, as faceless banks and trusts, directed by men and women with no conscience, pursued the almighty dollar with gusto.

• As stated above, iniquitous profit with no risk to themselves, was a huge incentive.
• CEO’s and other ‘bigwigs’ were paid the kind of bonuses that rewarded and encouraged the predatory culture to continue.
• The original mortgagee was not at risk if there was a failure to pay so didn't care how risky the loan for the borrower.  All risk is passed to the end investors.
• High risk loans were preferred over ‘full doc’ loans because more money was made
    
  - via higher interest rates 
    
  - and in the case of defaults, via insurance payouts.

• As Eric Halperin¹ said, “The banker makes more money if they put you in a subprime loan."
• Because banks and securitisation Trustees preferred to securitise higher risk loans secured by mortgages, they created incentives for brokers to promote Lo Doc loans over traditional loans by making them more profitable for brokers. 
Robert Gnaizda² stated that, "All the incentives that the financial institutions offered to their mortgage brokers were based on selling the most profitable products, which were predatory loans."
• Ratings Agencies are paid more for higher ratings - and high ratings are guaranteed. The Trust documents say so - even with high risk loans. My mortgage was placed in PUMA S-2 Trust. This Trust was fully subscribed with Lo Doc (sub-prime) loans, yet the Master Information Memorandum of that Securitisation Trust informs:  "It is a condition to the issuance of the Notes that the Class A Notes be rated Aaa by Moody's and AAA by Standard & Poor's and that the Class B Notes be rated at least AA by Standard & Poor's and Aa2 by Moody's.  "
In other words, poor quality Notes were all going to be given high level ‘risk free’ ratings - pretty much equal to ‘safe’ Government Bonds. Such ratings guarantee this scam will get investors - thus creating more incentive for the banks and trusts to continue their predatory habits.
• Profits vs Duty of Care to customers.  
Personally, I doubt there was much conflict between profits and duty of care. No-one seemed to have a conscience, and greed for iniquitous profits won hands down.
• More mortgage originations = more securitisation = more profit. It didn’t matter how the mortgages were obtained.
• ’Originate to Distribute’ became the rule of the game. ie. Lenders made loans with the intention of selling them, as opposed to holding loans through to maturity. This divested the banks of any risk, and provided them immediate huge profits.  The London based magazine, The Economist, reported in September 2017, “Until the early 1980s, finance hewed to an “originate and hold” model. Banks generally held loans on their balance sheets to maturity … This began to give way to an “originate and distribute” model … securitisation took off soon after, then paused before exploding in the 1990s."
• 
The Reserve Bank of Australia December 13th 2018 Bulletin cautiously admits that “Another selection effect that may be relevant relates to the ‘originate-to-distribute’ model of funding. If an institution originates a loan and sells off its entire exposure, then it may have less interest in how that loan performs.”
• Because securitisation passes risk to other parties, quality of loan no longer mattered. “Everybody in this securitization food chain, from the very beginning until the end; they didn't care about the quality of the mortgage; they were caring about maximizing their volume, and getting a fee out of it.”  Nouriel Roubini³.
• “In this context, moral hazard would relate to the potential for banks or IMPs to approve housing loans too readily, in the belief that they can shift the risk (including the risk of liability for breach of contract) to other legal entities.” Pelma Rajapakse⁴.

• The off-balance sheet treatment of assets in securitisation allows ADI’s to achieve much greater leverage.  Former Wall Street banker, Naomi Prins⁵ explains that besides making big profits by defrauding millions of homeowners, even greater profit comes from ‘leveraging’. "The (big) money was made because several layers up a pyramid, Wall Street investment firms and commercial bank investment groups decided to repackage these mortgages, create layers of them, that they then resold to investors." They leveraged up 30 times or more "against those (toxic) layers, which is the real crime and sold the junk to unwary buyers knowing that most of it would default. Adding layers of high-risk credit default swaps greatly compounded the problem …”


I think the narrative in one point of the Inside Job documentary put the whole thing succinctly…

“This system was a ticking time bomb.  

Lenders didn't care any more about whether a borrower could repay, so they started making riskier loans.  

The investment banks didn't care either; the more CDO's they sold, the higher their profits.  

And the rating agencies, which were paid by the investment banks had no liability if their ratings of CDO's proved wrong.”

END OF PART 2

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Endnotes
1.  Eric Halperin - Director of the Centre for Responsible Lending in Washington DC.  From Inside Job Documentary
2.  Robert Gnaizda - Former Director of Greenlining Institute.  From Inside Job Documentary
3.  Nouriel Roubini - Currently Head of World Bank. Senior Economist. Professor, NYU Business School Council of Economic Advisors (1998—2000). From Inside Job documentary.
4.  Dr Pelma Rajapakse - From her article: An Analysis of the Concept of Mortgage Backed Securities. Published in the Journal of Law and Financial Management (JLFM) 2011, Vol 10, Issue 1, Page 26.
5.   Naomi Prins - Former banker at Goldman Sachs and Bear Sterns who helped fashion some of the derivative products at the centre of the economic collapse.