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Yet, investment banks and sophisticated investors did not take huge write-downs on their inventory backed by dodgy loans in first quarter 2007. Dodgy mortgage loans (and securities backed by dodgy mortgage loans) were priced using a mark-to-model. Investment banks with an incentive to use rosy assumptions controlled the models, and the result reminded me of Warren’s comment about the value of derivatives often being a mark-to-myth.

The SEC as regulator of the investment banks had the power, but it did nothing to halt securitization activity. Instead, investment banks accelerated securitization activity in the first part of 2007.

A typical residential mortgage-backed security, backed by a pool of subprime and other mortgage loans, has several levels of risk known as tranches. The risk of the first few loans to default in the portfolio is borne by the equity investor sometimes called the preference share investor, and so on up the line. In a typical deal, the lowest-rated BB tranche is protected by the equity investor, who absorbs the first 3.25 percent of the losses in the portfolio, if any.This is also known as 3.25 percent subordination. An investment-grade tranche rated BBB is protected by investors taking the first 5.5 percent of the loans to default, if any. In other words, it is protected by the combined losses absorbed by the first loss investor and the BB investor. An investor in the A rated tranche is protected by other investors taking the risk of the first 10 percent of the loans to default, and an investor in the AA rated tranche is protected by other investors taking the first 16 percent to default. The lowest AAA tranche is protected by 24 percent subordination, and the highest AAA rated tranche is protected by 70 percent subordination.

Investors might have felt safe with that much “protection” under the AAA rated tranche, but by December 2007, loans that were 60 days or more late in payments or in foreclosure had climbed to 22 percent (according to LoanPerformance) and recovery rates for subprime loans were very low and varied from pennies on the dollar to 50 percent or so for a first mortgage. Second mortgage loans were often worthless. Collateral rapidly vaporized. Deals made up of piggyback (second lien) loans had principal losses eating through tranches rated “AAA.” Investors with deals backed by first lien loans found that losses ate corrosively right through AA tranches, the higher tranches required massive and multilevel downgrades, and that was for deals that did not include a high concentration of loans from mortgage lenders with allegations of fraud. Based on past experience with unsound lending practices like in the manufactured housing market, these problems were foreseeable, and many professionals, including Whitney Tilson (of T2 Partners LLC and the Tilson Funds) and William Ackman (of Pershing Capital) sounded the alarm.

After his bad experience with the Oakwood investment, Warren had warned that securitization distanced the supplier of funds (the investment banks) from the lending transaction (mortgage lenders using mortgage brokers) and “the industry’s conduct went from bad to worse.”16 Human nature has not changed.

As for Merrill, it continued its securitization activity in 2007, despite red flags from failing mortgage lenders, including Ownit. For example, in early 2007, it created a package of loans including piggyback loans issued by Ownit.17 Around 70 percent of the borrowers had not provided full documentation of either their income or assets. Most of the loans were for the full appraised value (no down payment), and home prices were already showing weakness if not outright falling. In the deal documents, Merrill mentioned that Ownit went bankrupt, but did not mention it was Ownit’s largest creditor. Can Merrill say it did an “arms-length” transaction with Ownit when a Merrill officer sat on Ownit’s board? In early 2008, both Moody’s and Standard and Poor’s downgraded the AAA rated tranche (an investment