HOT ZONE September 2009 Update

Risk and return - breaking the laws of economics...

If two investments offer the same return, but one investment is riskier than the other, all rational investors would, of course, prefer the safer investment. 

When two investments have the same risk profile, there is a long accepted maxim in economics that the investments should offer about the same return.  

In the rare situation where two fixed-income investments have an identical credit rating, but one of the investments offers a higher yield than the other, rational investors will buy the investment with the higher yield.  Such an oddity can happen for short time periods.  However, market forces should act on, and correct, the discrepancy in investment returns. 

For instance, fundamental economic laws are violated if two AAA investments have significantly different yields for an extended period.  And yet, AAA rated mortgage-backed securities (the highest investment grade rating) and AAA-rated CDOs consistently promised and produced higher returns than AAA rated U.S. Treasuries. 

How was this yield disparity possible? 

Why didn't economists scream from the rooftops that something was very wrong (disclaimer - we aren't economists)? 

Why didn't free market advocates say "this is a rigged market?"

In a free market, returns for different AAA investments should not not differ substantially for more than short aberrational periods. 

Unless...unless...  Unless the 'markets' (investment banks, commercial banks, etc.) and the ratings agencies understood that the AAA rating given to CDOs meant something different than the AAA rating given to U.S. Treasuries. 

The ratings agencies and investment banks, of course, did not warn investors that AAA for MBS and CDOs may not actually mean what a AAA rating had always meant in the past. Thus, even sophisticated investors and institutional fund managers would see a AAA rating and make the logical assumption that a CDO was filled with subprime mortgage-backed securities was as safe (or very nearly as safe) as a government bond. 

At the Sherman Law Firm, we believe there was collusion  between financial institutions and the credit rating agencies like Moody's, Standard & Poors, and Fitch.  Contact our firm to find out more...

 Prior "Hot Zone" posts...

On Housing, Highly Leveraged Assets, and Interest Rate Changes...  

Take away quote- 

"[W]ho in their right minds would base an entire industry (subprime lending and, by extension, mortgage backed securities) on the premise that there would not be high default rates ... after the cycle turned and interest rates climbed back toward historical averages (i.e., when rates started to trend toward the mean)?" 

A brief bit of common sense.

Warning. We are not about to offer any earth shattering insights in this short post.  However, when the world of finance reaches levels of complexity and duplicity capable of causing the most significant financial crisis since the Depression, simplicity and common sense are often relegated to the far back burner. So, we decided to pour ourselves a bowl of simple facts about housing.

Specifically: 

The housing market is hyper-sensitive to interest rate changes.

For a substantial majority of homeowners, houses are their most leveraged assets.  In other words, most people actually own very little of their houses.  For the most part, the bank or investor that owns our mortgage also owns most of our home.   

Interest rate changes so significantly impact housing because interest rate level often determines what type of home a family can afford.  Falling rates lead to refinancings and even downward resets of adjustable rate mortgages.  Most significantly, there is higher demand for homes and, eventually, higher prices.  When credit is cheap and easy to get, homes are more affordable (at least in the short run).  Thus, low interest rates generally equals more homeowners and, by the way, low rates of default and foreclosure. 

When rates go up, however, refinancings plummet, home sales (and, eventually, prices) decline because the higher cost of borrowing lowers buyer demand.  Adjustable rate mortgages reset upward.  The segment of the home-owning public that chose adjustable rate mortgages to stretch for houses that may have been unaffordable with traditional fixed rate mortgages can find themselves unable to make their new, higher monthly mortgage payments.  Thus, when interest rates increase, defaults and foreclosures follow suit.

As we said, nothing new here.  All common sense.  Which begs the question -who in their right minds would base an entire industry (subprime lending and, by extension, mortgage backed securities) on the premise that there would not be high default rates on ultra-low interest adjustable rate mortgage loans to people with poor credit histories succeed after the cycle turned and interest rates climbed back toward historical averages (i.e., when rates started to trend toward the mean)?  Who would make this bet?  Was anyone be surprised that bad credit borrowers would default in droves once their low initial monthly payments increased by hundreds of dollars a month? 

These are not hard questions now, and they weren't hard questions in 2002 or 2003 or 2004, 05, 06, or 07 either.  Wall Street drove the subprime lending explosion.  Wall Street understood interest rate cycles.  Wall Street knew rates would rise.  Wall Street knew defaults and foreclosures would spike.  Wall Street didn't care - the money was rolling in.  The fact that Wall Street itself got so badly burned was the product of greed and knowingly reckless risk-taking. 

Recent Hot Zone stories

THE HOT ZONE: 

The Sherman Law Firm's latest Press Release and / or our choice for top securities litigation news item(s)...

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New York, NY  -- Long before their respective employers ceased to exist as independent companies, former Merrill Lynch Top North American Economist David A. Rosenberg and former Bear Stearns Chief Equities Investment Strategist Francois Trahan published research reports with explicit warnings about asset and credit bubbles in the U.S. housing and mortgage markets.

As early as August 2004, Mr. Rosenberg, Chief Economist at Merrill Lynch for North America, published a detailed analysis regarding the precarious state of the American housing market. Rosenberg warned that there could serious problems ahead in an Economic Commentary entitled: "Housing: If not a Bubble Then an Oversized Sud."

Former Bear Stearns Chief Equities Investment Strategist Francois Trahan first published a report that raised serious questions about housing and real estate investments in a May 2005 report called "REIT all About it." Trahan and his team at Bear Stearns followed their 2005 report with publications in 2006 that explicitly warned about the difficult future facing the U.S. housing market and even raised the possibility of a global credit crisis. The 2006 Bear Stearns reports definitively described the housing market as an unsustainable "bubble" and further cautioned that the term bubble was not one the Bear team used lightly.

It was not until 2008 that overcommitments to mortgage-backed securities (a byproduct of the housing boom), CDO's and related products tied to residential and commercial mortgages caused Merrill Lynch and Bear Stearns to suffer backbreaking losses so severe that Merrill sold itself to Bank of America and Bear Stearns narrowly avoided bankruptcy with a Fed-assisted fire sale to JP Morgan.

--Background

Along with a number of other Wall Street firms, Merrill Lynch and Bear Stearns lost tens of billions of dollars because of their firms' respective commitments to securities backed by mortgages in the "subprime" and "Alt-A" categories. Subprime and Alt-A residential mortgages are considered risky loans because they carry higher default rates than "conforming" mortgages (also called prime mortgages, or agency-quality mortgages). Typical subprime or Alt-A borrowers cannot qualify for a conforming mortgage due to factors that include, but are not limited to, bad credit histories, personal bankruptcies, insufficient income, and the inability to make sufficiently large down-payments.

--Significance of the Merrill Lynch and Bear Stearns reports

While the ultimate import of the reports remains to be seen, The Sherman Law Firm, The Sherman Law Firm says there is no doubt that the documents are crucial to the touchstone litigation element of foreseeability. "In a litigation sense," said Managing Attorney Brett Sherman, "the question of foreseeability asks at what point in time senior management at these investment banks should have foreseen the possibility of the disasters that eventually befell them."

According to The Sherman Law Firm, the reports at issue may show that senior management at Merrill Lynch and Bear Stearns should have foreseen the liklihood of a looming financial crisis with ample time to permit business model shifts that may have prevented crippling losses and, ultimately, the end of these former pillars of Wall Street as independent companies.    

--Likely Defenses and Response

When confronted with documents like the reports at issue, senior managers may respond that they cannot be expected to read the huge volumes of research produced by their companies. The view of Brett Sherman, Managing Attorney of The Sherman Law Firm is that "the significance of these reports is that they conclusively establish the views of top economic analysts at Merrill Lynch and Bear Stearns. Whether plaintiffs' attorneys prove that senior management at the two investment banks actually read the reports ought to be immaterial."

Litigation strategist and recently retired attorney Lee Sherman - a frequent consultant to The Sherman Law Firm, former municipal court judge, and founding partner of a top Philadelphia area firm - concurred. "These aren't simply the comments of some junior level analysts," Sherman said. "I mean, we're talking about the Senior North American Economist of Merrill Lynch and the Chief Equities Strategist at Bear Stearns. Any claims by their CEOs and the other senior decision makers at these banks to the effect that they should not have been well-aware of the opinions and outlooks of the top economic and market experts at their companies are simply not credible.

Lee Sherman continued: "Remember, from mid-2004 until the subprime crisis had clearly arrived, the Fed steadily raised interest rates. For lesser quality borrowers, most of whom had adjustable rate mortgages, higher interest rates meant higher default rates. To say the least, there was great uncertainty as rates were rising about where we were headed. Then, the housing market slowed. I'm talking about 2005 now, before home values really fell off the table. It strikes me as incredible that the kinds of warnings in these reports were out there for years, yet seem to have gone unheeded."

The Sherman Law Firm represents investors in securities fraud / investment loss claims of all types, including claims against investment banks for losses related to mismanagement and other misconduct during the housing and credit bubbles.

--Disclaimer

This release is for informational purposes only. Nothing in this release is intended to be, or should be construed as, legal advice.

The Sherman Law Firm represents investors in securities fraud claims.

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