Confidence Game - Christine Richard [102]
The scenario—hundreds of A-rated securities all defaulting—sounded far-fetched. But as Deutsche Bank’s Greg Lippman had pointed out to the investment team at Pershing Square just a few months earlier, it was not. In a good housing market, with double-digit annual gains in home values in many markets, losses on subprime loans had run about 6 percent. Deutsche Bank figured that if home-price appreciation fell to 4 percent a year, subprime losses would jump to 8 percent. A market in which home prices remained flat would completely wipe out triple-B-rated bonds. A triple-B rating is a low investment-grade-rated security. A decline in home values would cause the damage to move up the rating scale, putting even single-A-rated bonds in jeopardy.
The subprime market contained the hallmark of every Ponzi scheme. It worked only as long as more money was put into the scheme. When home prices were rising, overextended borrowers usually could pay off their first mortgage—and often a home-equity loan and credit-card bills on top of that—by selling their house in a rising market. Once home prices stopped rising, the game was over, and home prices would plummet.
The mortgage market may have become perilous in many places, but MBIA executives said the company remained open for business. There was strong demand for bond insurance, and the premiums that insurers could command in the current market had improved, said Patrick Kelly, head of CDOs and structured products at MBIA. “We want to take advantage of the current situation where we can, even in the ABS CDO market,” Kelly said. “We also want to avoid getting stuffed with the risk that people are just looking to get off their own books.”
THREE WEEKS LATER, on August 24, 2007, Merrill Lynch’s head of fixed income, Osman Semerci, along with three other executives from Merrill, boarded a helicopter for the short flight to MBIA’s Armonk headquarters.
Janet Tavakoli, a CDO guru who runs her own structured finance research firm in Chicago, later dubbed Merrill Lynch’s last-ditch effort to dump toxic securities on MBIA the “Apocalypse Now helicopter ride,” a reference to the scene in the Francis Ford Coppola movie in which U.S. helicopters level a Vietcong village while blaring Wagner’s highly dramatic “Ride of the Valkyries.” These CDOs were so loaded with toxic subprime mortgages that Tavakoli expected the bond insurer to take losses on this so-called “super-senior” exposure.
In her book on CDOs, Structured Finance and Collateralized Debt Obligations (2008), Tavakoli calls super-seniors “the greatest triumph of illusion in twentieth century finance.” A major motivation of creating super-senior tranches of CDOs, she says, is that this layer of risk is very difficult to price. Investors know what the going rate is for a security rated A or triple-A, but what yield should an investor earn on something that’s rated higher than triple-A?
Over the last several years, Merrill Lynch, known as the “Bullish on America” stockbroker to millions of retail investors, had become a huge player in the mortgage business. The firm hired Christopher Ricciardi, a Credit Suisse trader, in 2003 to ramp up its presence in the CDO business. Ricciardi turned Merrill into what the Wall Street Journal later dubbed “the Wal-Mart of CDOs.” In 2006 and 2007, Merrill underwrote 136 CDOs, raking in $800 million in underwriting fees on the business, according to Thomson Financial. To assure a steady supply of raw material for these CDOs, Merrill in late 2006 bought First Franklin, a subprime-mortgage originator.
When the music stopped in the housing market in late 2006, Merrill Lynch’s balance sheet was loaded down with exposure to risky borrowers. “By September 2006, Merrill Lynch carried on its books inventory that included at least $17 billion in RMBS CDO securities, as well as an additional $18 billion in mortgage-backed bonds, and a further