Insider's Game

John Paulson, the hedge fund investor behind the toxic CDO referenced in the S.E.C. complaint, ratcheted up his nobody-saw-it-coming rhetoric, with a letter nominally addressed to his own investors but clearly intended for a broader audience of ignoramuses and amnesia victims:

“It is easy to forget that before the collapse, the overwhelming view of investors, ratings agencies and economists was that the housing market was strong and would continue to get stronger.”

The opposite is true. Nobody was saying that the housing market was strong and would continue to get stronger during the weeks prior to April 26, 2007, the closing date of Goldman’s notorious Abacus 2007-AC1. There are countless ways to discredit Paulson’s statement, just as there are countless ways to discredit his claim that he operated in “good faith.” (As Vanity Fair was kind enough to point out, Paulson’s bad faith manipulations were first highlighted here on HuffPo seven months ago.)

Here’s a brief sampling of the evidence that reveals Paulson’s deliberate intent to deceive:

January 18, 2007: Moody’s: “Early Defaults Rise in Mortgage Securitizations”

Mortgages backing securities issued in late 2005 and early 2006 have had sharply higher rates of foreclosure, real estate owned (REO) and loss than previously issued securities at similar, early points in their lives. These “early default” measures have been primarily visible in the subprime universe, but are not limited to that sector. Moody’s is currently assessing whether this represents an overall worsening of collateral credit quality or merely a shifting forward of eventual defaults which may not significantly impact a pool’s overall expected loss.

What Moody’s Overlooked And What John Paulson Understood: That last sentence, above, makes no sense. If the loan write-offs are front-loaded, the total loss, by definition, is worse, because fewer well-performing loans provide less interest and principal amortization in the subsequent years. It’s Finance 101. Regular mortgage-backed securities, as opposed to CDOs, are static portfolios. They are not like a dynamic loan portfolio managed by a bank, which may suffer a higher-than-expected loss in one quarter to be offset by a higher-than-expected profit in a subsequent quarter.

The well-performing loans in a mortgage pool will never pay back more than 100% of their respective principal and interest. And a sooner-than-expected credit loss erodes the equity cushion present at closing. As noted earlier here and here, these deals were capitalized with $103 worth of mortgages for every $100 worth of debt. The ratings agencies assumed that the 6% lifetime credit losses would be somewhat back-loaded, so that the pool would generate interest income to offset the expected credit defaults. Moody’s assumed that about 80% of the credit losses would be spread out over years 3 through 6.

By year-end 2006, the rate of foreclosures plus REO for the ABX (2006-1), a composite of subprime bonds like those in Abacus 2007-AC1, was 5.7%. One month later, it was 6.3%. This percentage, which had been growing at double-digit rates for more than a year, foretold that the BBB and BBB- tranches, in the bottom 5% of capitalization, would get wiped out.

February 22, 2007: Bloomberg: “The BBB- rated portions of ABX contracts are ‘going to zero,”’…

The BBB- rated portions of ABX contracts “going to zero,” said Peter Schiff, president of Euro Pacific Capital, a securities brokerage in Darien, Connecticut. “It’s a self-perpetuating spiral, where as subprime companies tighten lending standards they create even more defaults” by removing demand from the housing market and hurting home prices, he said.

Peter Schiff wasn’t psychic. He had done the math, and, unlike so many so-called sophisticated investors, did not piggyback off of someone else’s due diligence.

February 22, 2007: MarketWatch: “Sub-prime gloom picks up after HSBC warning”

Foreclosures jumped 35% in December versus a year earlier, according to recent data from RealtyTrac. For the fifth straight month, more than 100,000 properties entered foreclosure because the owner couldn’t keep up with their loan payments.

March 12, 2007: CNNMoney.com: “Subprime: The risk to Wall Street

As subprime woes widen, the money machines at Morgan Stanley, Goldman and other banks may sputter.”

March 13, 2007: CNNMoney.com: “Scary math: More homes, fewer buyers”

Subprime lenders are already getting crushed, but the impact rising mortgage delinquencies will have on home prices overall is still an open question. At a minimum, it means financing is drying up for those with less-than-perfect credit and that spells fewer home buyers.

And foreclosed properties will add supply to a housing market that already has too much.
“It’s going to be a really big deal,” says Dean Baker, co-director of the Center for Economic and Policy Research. “[National] inventory is 20 percent higher than last year, vacancy rates have soared and prices are down about 3 percent,” he says. “Now, with the tightening of credit, I don’t see how prices don’t fall another 5, 6 or 7 percent.”

 

The tightening of credit could take as many as one million buyers out of the market, says Baker, citing Bear Stearns research. “Even if you cut that in half, say to 400,000 or 500,000, that’s huge.”

 

Mark Zandi, chief economist for Moody’s Economy.com, is also concerned. “I think the subprime problems will take housing activity to a whole other level,” he says. Zandi is projecting a doubling of subprime defaults this year to 800,000. “Those homes will go on the market at a discount and will weigh on the market,” he says.

March 19, 2007: Forbes: “Subprime: The Next Wave Of Corporate Fraud Probes?”

New Century Financial Corporation, a major subprime mortgage lender, is a good illustration of the trends roiling the industry. During the first nine months of 2006, New Century has been forced to repurchase hundreds of millions of dollars of mortgage loans. On Feb. 7, 2007, the company announced that it would restate its earnings for the first three quarters of 2006 due to accounting errors in connection with repurchases.

Now, New Century has received a grand jury subpoena in a criminal investigation by the Department of Justice, and also faces a parallel civil investigation by the SEC. Numerous states have barred New Century from making new loans, and are now conducting their own investigations. And the company’s shares have been delisted from the New York Stock Exchange.

Back then, people did not know how bad things would get because, after all, 40% of subprime mortgages were extended with limited or no documentation, which is why they were known as “liar loans.” But they knew it would be bad, and they knew, if they did the math, that the BBB- rated tranches would get wiped out. Paulson wants us to believe that almost no one else had figured this out. Alan Greenspan claims, “there’s a very small group — most of whom are my friends — who got it right for the right reasons…I know four or five people who are really good. I don’t know six, seven, eight or nine.” At least that’s what John Paulson pays him to say.