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They did it again, those skilled, polished Wall Street middlemen. Beginning six or seven years ago, they sold mortgages to questionable Main Street buyers using teaser rates and other gimmicks. At the time, nobody much cared. Interest rates were low and housing values were on a double-digit upward gallop.

The lenders knew this, and also knew they had to turn around and sell those loans--lay off the risk--to other institutional buyers while credit was cheap and home borrowers still had the ability to meet their debt obligations.

There's a bevy of answers, some simple, some complicated, all of them related, according to mortgage finance experts.

The confluence of factors--riskier mortgage loans, rising delinquencies, more foreclosures--with less obvious ones--little regulation, complicated securitization investment strategies, failures by ratings agencies--conspired to keep the investment dollars pouring in while the "stealth" risk continued to build, the experts say.

"I can't really point a finger at one factor, because it comes down to an aggregation of things that all arose around the same time," says Joe Mason, a finance professor in the LeBow College of Business at Drexel University in Philadelphia and an expert on collateralized debt obligations (CDOs). "All of the factors led to increased risk, so that, by the time risk manifested itself, a large potential loss was on the line."

Adds Adam McDonough, president and CEO of the San Francisco office of Lockton Insurance Brokers Inc., "I can't speak to the regulatory agencies because I don't know how rigorous their scrutiny is, but in an environment where money is cheap and credit is available, the market forces tend to drive some of the behavior we've been seeing."

Richard Urbach, executive vice president, quantitative finance, at DFA Capital Management Inc., a Purchase, N.Y., provider of financial analysis software for the insurance and financial services industries, says his initial reaction to how things got out of control is "not that complicated."

Urbach's work focuses on tracking economic events and cycles against 300 years of history in the markets. He and DFA do that by creating an artificial economy that allows insurance clients to simulate economic and markets events,such as the subprime mortgage crisis for example,to help in investment decision-making.

"Anyone with a bit of financial acumen can understand that, if you loan to people who are stretched financially using low-interest rates with variable or short-term fixed loans, rates are bound to rise and those borrowers would have problems," says Urbach, author of a book titled Footprints of Chaos in the Markets.

(While property/casualty carriers have little exposure to U.S. subprime mortgages, thanks perhaps to pressing for more lender disclosure, experts are divided over just how much carriers will be liable on the D&O and E&O front.)

"Do I think the lenders were kind of idiotic? Yes," says Michael Klaschka, a principal in the New York office of Integro Insurance Brokers. He says that as much as 70 percent of his financial services clients have some degree of exposure. "Whether it's a hedge fund or a bank or an insurance company, somebody has got it," Klaschka says.

Urbach adds that old-fashioned greed certainly played a role, as it always does in these bubble situations. And the complexity of the mortgage business, combined with complexity in the investment products, easily could lead to hidden risk. "You have people responsible for running businesses with complicated structures, pounding the pavement getting people into the housing market," he says. "The subprime markets made millions for the people who made these loans and who put together mortgage-backed securities (that depended on subprime loans)."

Urbach explains that in both cases the sellers certainly knew the risks, but they were selling to people/investors who probably did not. "In the end, it's the buyer who owns the risk," he says. "Many people didn't understand what they were buying. For investors, buying on yield alone can get very complicated when it comes to CDOs."

Bottom line, he explains, is that investors didn't carefully investigate the risks involved, and there were people willing to invest in order to get high yields. "You had a time bomb underneath it all," Urbach says. "If the underlying collateral is subprime mortgages, when it finally ignites, it will burn like a brushfire in Australia."

Urbach says ratings agencies, such as Moody's Investors Service and Standard & Poor's, played a role in trusting the financial institutions who put together the CDOs, although he adds that the agencies might not have grasped the complex investment structures either.

After all, mortgage-backed bonds that plunged in value during the subprime crisis were highly rated by these agencies until they downgraded billions of dollars worth of them in midsummer. "The rating agencies have to be well aware of the risks," says Urbach. "If not, they are not doing their job."

COMPLEXITY MASKS RISK

Mason says that more and more legal cases involving investor complaints are based upon multidimensional risks, which are often hard to understand.

"That's where an investor is thinking narrowly about risk and the selling firm is representing the situation as a simple risk, but it is actually very complex." Mason says sometimes investment firms have misrepresented the risk or investors didn't bother to investigate it fully.

"People often don't read their contracts, and don't understand that there is more than interest rate to a loan contract," he says.

In fact, Mason says his view is that this is technically not a subprime crisis, but a structured finance crisis. "You will see the same financial engineering and the same hidden risks applied to credit cards, auto loans, student loans, etc.," he says. "It's being applied to the whole business of securitized investments."

Mason believes the signs of a subprime crisis came as early as the summer of 2006, as mortgage borrowing underwriting standards became much too loose, to the point where almost anyone could get a loan. At that point, poor performance of the loans and a rise in "first-payment" defaults signaled rough times ahead.

At the same time, the mortgage-backed securities market had undergone significant changes over the past couple of years. For example, nonagency, or "private label," securities, which are not guaranteed by the government or government-sponsored enterprises, now accounted for the majority of MBS issued.

The rise of collateralized debt obligations combined with the relaxation of lending standards and the implementation of loan-mitigation practices of trying to forestall foreclosures created the environment of understated risk to MBS investors.

Mason adds that, while collateralized debt obligations are currently the most mature and complex of consumer-structured finance products, the biggest obstacle and a prime reason for hidden risk is lack of "transparency" within the MBS industry itself.

For example, structural changes in the residential mortgage-lending industry, including reductions in down-payment requirements, conspired to relax underwriting standards. In addition, the movement to automated valuation and underwriting systems largely went unnoticed by MBS investors until only recently.

Of course, the subprime lending industry also has grown significantly since the mid-1990s, from representing less than 5 percent of all originations to about 20 percent.On a dollar volume basis, it grew from $35 billion in 1994 to $625 billion in 2005.

The years 2005 and 2006 saw massive deteriorations in subprime mortgage performance, particularly in "nontraditional" hybrid, interest-only and negative-amortization loans. The percentage of subprime mortgages packaged into bonds and delinquent by 90 days or more, in foreclosure or already turned into seized properties increased to 10 percent by 2006.

It was the worst level in nearly a decade. "This poor performance in the subprime market and the recent revelation of 'hidden risks' calls into question the capabilities of lenders, securitizers and investors to reliably estimate peak charge-off rates," Mason says.

Like others, Mason says many of the current difficulties in MBS and CDOs can be attributed to a misapplication of agency ratings.

"Changes in mortgage origination and servicing make it difficult to evaluate the risk of MBS and CDOs," he says. "The 'big three' ratings agencies are often confronted with an array of conflicting incentives, which can affect choices in subjective measurements of risk."

Mason, co-author of two studies detailing the risks of subprime loans and CDOs, says that, apart from just rating securities, ratings agencies also worked closely with the underwriting teams to determine the size of each tranche, or slice of rated debt in a deal. The agencies are active in the entire structuring of CDOs to achieve a rating target.

"Securitization has its purpose, and its limitations," he adds. "We see that clearly in the subprime mortgage situation."

Guy LeBas, the chief fixed income strategist with Philadelphia-based investment firm Janney Montgomery Scott LLC, says that, although the value of many mortgage-backed securities may have plummeted, many of them still contain strong enough credit supporting tranches to maintain high ratings, even as the delinquency and default rates of their subprime tranches accelerate.

"There are securities out there and, while they are increasing in risk and rated subprime, are highly unlikely to see any credit risk downgrade, but they have seen severe losses nonetheless," LeBas says.

"Would I own them? No."

In the end, Urbach says history suggests the volatility of the summer will last a maximum of about three months. He says it bears a strong resemblance to the dollar-yen dislocation of 1994, when many hedge funds experienced severe losses.

"Far too many people have been running after yield and the spreads have narrowed to the point where they do not compensate for risks," he says. "In the case of CDOs, the amount of value destruction will vary depending upon how much 'toxic waste' investors have been convinced to buy."

Randy Marshall, a managing director at Protiviti, a provider ofinternal audit, business and technology risk consulting services, says the key missing element in the subprime crisis was the lack of "stress testing." Just like engineers need to test an aging bridge to see if it can carry the required weight, he says, investors and ratings agencies should have been looking at scenarios to see if subprime delinquencies were bound to become more prevalent.

In other words, investors and ratings houses should have been doing what insurance underwriters have been doing for the past year and continue to do.

"Capital markets were not necessarily consciously pulling the wool over anyone's eyes," he says. "But having said that, a lot of their models gave them more optimism than the portfolios could deliver. So in that way, there was a sense of masking the risk," Marshall says.

Given the complexity of CDOs and MBS and the perhaps irrational optimism that flooded the stock market in 2005 and 2006, and the residential real-estate market in particular, the ratings agencies can't bear too much blame for current events, says LeBas.

"Ratings agencies perhaps were too aggressive, but I believe they did their work accurately with the information available," he says.

Whether the ratings agencies fulfilled their mandates of accurately rating institutional borrowers or not is a question best answered in court.

In the meantime, as financial regulators telegraph that meaningful action on the issue may be coming sometime this year, and as plaintiffs' attorneys line up to take their best shots, underwriters have been asking tougher questions, ratcheting up premiums and limiting coverage for institutions that can't explain the excess of subprime volume on the books.

"If you have any direct or indirect exposure to subprime, the underwriting process has become much more laborious," says Paul Kim, a New York-based managing director in the Aon Financial Services Group.

That direct or indirect exposure is going to mean a grilling for a number of risk managers in the financial services industry this time around on their renewals. The penalties insurers are imposing in this softer market are not so much increases in premiums but holding out on premium reductions.

"If you do have material exposure to subprime, you are certainly not enjoying the market premium decreases that other companies are enjoying," Kim says.

Nor have investors taken kindly to the midsummer write-downs of billions of dollars in mortgage-backed securities. Class-action lawsuits against the likes of Moody's and Countrywide Financial Corp. have already hit the federal court dockets. It's a good bet that many more are on the way.

TOM STARNER lives in Philadelphia. In addition, Risk & Insurance® Senior Editor Dan Reynolds contributed to this story.

October 15, 2007

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