Subprime-mortgage meltdown: A series of bad bets
Subprime-mortgage meltdown caused by series of bad bets
The meltdown in the subprime-mortgage market was caused by lending decisions that were based on assumptions that left little room for error. The mortgage crisis is "a case study on the way that greed convinced everyone there wasn't risk," said Ivy Zelman, CEO of Zelman & Associates. Problems are spreading in dominolike fashion and could continue for some time.
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- Behind Subprime Woes, A Cascade of Bad Bets
- One Loan's Journey Shows Culture of Risk
- The Fall of a Fund Whiz
By CARRICK MOLLENKAMP and IAN MCDONALD
October 17, 2007; Page A1
Three years ago, Colorado truck driver Roger Rodriguez was in the market for a new mortgage loan. With radio and Internet ads trumpeting easy approvals, he picked up the phone.
That call set into motion Mr. Rodriguez's descent into the subprime mortgage mess. Over the next several months, his adjustable-rate loan passed through many hands. These included a local Denver broker, Livingston, N.J., finance company CIT Group Inc. and a Greenwich, Conn., unit of Royal Bank of Scotland Group PLC. Eventually, a piece of Mr. Rodriguez's loan landed in mutual funds run by a Tennessee investor named James C. Kelsoe Jr.
Little good has come to any party that touched the loan. Mr. Rodriguez, now 61 years old, has lost both his job and his home. All the middlemen, from the broker to CIT to RBS, have either shuttered their mortgage businesses or are struggling. Mr. Kelsoe, once a star mutual-fund manager, has hit a career low as defaults on subprime mortgages decreased the value of his investments.
The paper trail from Mr. Rodriguez to Mr. Kelsoe illustrates how the mortgage market meltdown scalded millions of homeowners and investors. It also foreshadows how the domino effect stands to continue.
Much of the mortgage lending of the past several years, as well as investments in mortgage-backed securities, was based on assumptions that left little room for error. As a result, even slight deviations from a perfect world -- in which people act prudently, unemployment stays low, lenders keep lending and house prices rise -- pose risks in the form of more defaults, foreclosures and other investment losses.
Behind the market turmoil of recent months: Lending standards were more lax than most people imagined, a fact that surfaced when house prices stalled.
The mortgage crisis is "a case study on the way that greed convinced everyone there wasn't risk," says Ivy Zelman, CEO of Zelman & Associates, an independent real-estate research firm.
Should house prices fall by 10% over the next two years -- an outcome analysts see as entirely possible -- losses stand to be staggering. Thomas Zimmerman, head of mortgage credit research at UBS in New York, estimates that in such a scenario losses due to defaults could wipe out as much as 16% of the nearly $600 billion in subprime-backed securities issued in 2006. In August, such losses were equivalent to less than 1% of the total.
The jobs market also plays a key role. If the unemployment rate ticks upward by a percentage point or more, Mr. Zimmerman believes losses due to defaults could easily exceed 20% -- enough to hit even some of the most highly rated securities.
Back in 2004, Mr. Rodriguez didn't realize he was meandering into trouble. Two decades earlier, he had moved from Powell, Wyo., to start a new life in Colorado after struggling as a sugar-beet farmer. He, his wife, Irene, and two grandchildren, now 4 and 12, took up residence in a modest development called Prospector's Point in the town of Westminster, where their home boasted unobstructed Rocky Mountain views. Mr. Rodriguez held a steady job driving a recycling truck for Waste Management Inc.
Sometime in the fall of 2004, Mr. Rodriguez decided he could use some money for debt consolidation. He turned to a company called EquityRelief.com, which promoted itself on the radio and the Internet with slogans such as "Debt relief is stress relief at EquityRelief.com."
The Denver company already had handled his $70,000 mortgage two years earlier, he says. Still suffering from marginal credit, he enlisted the mortgage broker once again.
Within a matter of weeks, Mr. Rodriguez had secured a new mortgage, for $88,000, from finance company CIT Group. That was enough to settle his outstanding home loan, as well as cover auto debts and a few home repairs. His income -- about $4,000 a month before taxes -- enabled him to pay the $544.70 initial monthly note, plus living expenses and installments on his credit-card debts. But with hardly any savings, he had little wiggle room in case something went wrong. Beyond that, the monthly payment was scheduled to reset after two years, most likely to a higher level -- a common feature of so-called adjustable-rate mortgages, or ARMS.
Mr. Rodriguez's low credit score meant it would have been difficult for him to obtain a prime loan. He says he chose an ARM, with an introductory rate of 6.3%, because that's what the broker offered. "I just went along with it," he says. "They made it so easy." At the time, a prime, 30-year fixed-rate mortgage had an interest rate of 5.87%. But the introductory rate on Mr. Rodriguez's ARM would apply for just two years before resetting -- up to a maximum of 12.3%.
Bryon Veal, who ran the brokerage, says he typically warned customers to use adjustable-rate products only if they planned to be in a property for a short period of time. Mr. Veal also says his firm advised borrowers that rates would increase.
Around this time, hundreds of thousands of borrowers, and the lenders who served them, were beginning to make even more optimistic assumptions about their ability to handle subprime debt. Lenders frequently approved borrowers for loans based only on their credit score and often without verifying income and they effectively ignored the fact that monthly notes would later reset. The universal, hopeful assumption: With house prices rising, borrowers would be able to refinance before the rate increases hit.
Back in 2004, lenders in the subprime sphere had little reason to worry whether borrowers were getting in over their heads. That's because they often quickly resold some of the loans at a profit. Wall Street banks snapped them up, packaged them into securities and sold them on to investors. CIT was no exception. In 2004, the company, which offers loans for everything from heavy equipment to college tuition, was building its business of originating and selling home mortgages.
Within five months, CIT had sold Mr. Rodriguez's loan along with others to RBS Greenwich Capital, a unit of the Royal Bank of Scotland located in the tony financial hub of Greenwich. To obtain such loans, RBS had to outbid other investment banks active in the mortgage market, such as Lehman Brothers Holdings Inc., J.P. Morgan Chase & Co., Deutsche Bank AG and Bear Stearns Cos.
RBS was making an aggressive bet on the mortgage business, sharply boosting its capacity to buy and package loans. By 2005, it had risen to third place among investment banks by volume of U.S. residential mortgage-backed securitizations, according to Thomson Financial. That was up from sixth place in 2000.
RBS and CIT declined to say how much they profited at various points in the mortgage-securitization process. Generally speaking, as the loans progress through the chain, buyers and sellers skim a bit from each sale. Profits from the securities are usually determined by a complex set of factors, including cash flow -- which is affected by timely payments from borrowers like Mr. Rodriguez.
In February 2005, RBS packaged Mr. Rodriguez's loan -- along with 4,853 others -- into a trust called Soundview 2005-1. The trust slices the cash flows from the loans into notes with different levels of risk and return. Within five days, RBS's sales team had sold $778 million in Soundview 2005-1 notes to investors around the world.
One buyer was Mr. Kelsoe, a senior portfolio manager at the asset-management unit of Morgan Keegan & Co., a Memphis, Tenn., investment firm and unit of Regions Financial Corp. At the time, Mr. Kelsoe was riding the housing boom by investing heavily in mortgage-backed securities. At the end of 2005, his RMK Select High Income Fund showed a five-year average annual gain of nearly 14%, according to Morningstar Inc. That performance beat all U.S. high-yield funds as well as the Dow Jones Industrial Average. His success brought him a bit of celebrity. He appeared on CNBC, was quoted in The Wall Street Journal and gave investing lectures at universities.
"He talked about the importance of identifying and assessing risk," says Wilburn Lane, head of the business school at Lambuth University in Jackson, Tenn. Mr. Kelsoe spoke there in October 2006 to some 300 local businesspeople over a chicken-and-vegetables lunch. Mr. Lane, who says he was impressed with the 44-year-old's track record, later invested in one of the seven funds managed by Mr. Kelsoe.
Mr. Kelsoe's big returns, though, depended heavily on the good fortune of borrowers such as Mr. Rodriguez.
Through various of his funds, Mr. Kelsoe invested nearly $8 million in one of the Soundview 2005-1 trust's riskiest pieces. The B-3 tranche, as it was called, offered a return of at least 3.25 percentage points above the London interbank offered rate -- a key short-term rate at which banks lend to each other. But if borrowers like Mr. Rodriguez began to default on their loans, any losses exceeding 1.25% of the entire loan pool could eat into the value of the B-3 tranche.
In February 2006, at least one borrower in the Soundview 2005-1 trust had a big piece of bad luck. After pulling into a Waste Management repair facility in the Denver suburb of Commerce City, Mr. Rodriguez detached the trailer from his 18-wheel rig but forgot to set the brake on the tractor. The tractor rolled across a street and hit a parked pickup truck, causing about $2,000 in damage. Soon afterward, says Mr. Rodriguez, Waste Management fired him. "They considered that a critical rollaway," he said. Waste Management confirmed that Mr. Rodriguez no longer works for the company, but declined to provide details.
"Ten seconds can change your whole life around," Mr. Rodriguez says a friend remarked to him recently.
Mr. Rodriguez took on odd jobs, working on a paving crew and in a bakery. But his income fell to about $1,800 a month in 2006. To make matters worse, the monthly note on his mortgage reset to more than $700 in November. He fell behind on the higher payments.
On Feb. 15, 2007, a Denver law firm, acting on behalf of the Soundview trust, began foreclosure proceedings against Mr. Rodriguez and his wife. The firm cited "failure to pay monthly payments of principal and interest" on an outstanding balance of $85,976.48, Colorado real-estate documents show. Mr. Rodriguez filed for bankruptcy protection on July 23, a move that extended the time he could remain in his home by several months.
Other borrowers in the Soundview trust also began to default on their loans. By June 2007, defaults had afflicted 3.44% of the loan pool, more than triple the level of a year earlier, according to people familiar with the trust's finances. About four in 10 loans were at least 30 days in arrears -- all in a period during which the U.S. economy was growing at a healthy pace and unemployment was low.
Because Mr. Kelsoe's investment in the B-3 tranche was so sensitive to losses, its market price plunged. In fact, as trading in subprime-backed securities dried up amid a broader panic, Mr. Kelsoe, like other investors with subprime holdings, had difficulty figuring out what the investments were worth.
At the end of June, the latest information available, Mr. Kelsoe's funds reported an estimated market value of the Soundview investment that was 35% below what they had paid.
A Morgan Keegan spokeswoman said Mr. Kelsoe wasn't available to comment because he was focused on managing his funds.
At the end of August, Mr. Kelsoe's Select High Income Fund posted a loss of nearly 28% for the month -- dead last among its peers for the year and for five years as well, according to Morningstar. The fund also postponed filing an annual report until earlier this month. When the fund filed the report with regulators on Oct. 4, Mr. Kelsoe said in a note to shareholders that the bond markets' "ocean of liquidity has quickly become a desert."
In a letter to a Memphis newspaper, Charles Reaves, an attorney who had invested in one of Mr. Kelsoe's funds, wrote that Mr. Kelsoe was "hiding under his desk" and "should have the fortitude to face the public and explain...what he intends to do."
Things haven't gone much better for the mortgage units at CIT and RBS -- though they did profit handsomely during the good times. CIT, citing a "problematic outlook" for the business, in July announced plans to shut down its mortgage business and lay off about 550 employees. A CIT spokeswoman says its mortgage portfolio performed better than peers.
Morale at RBS Greenwich had suffered in recent weeks as employees braced for layoffs. RBS Greenwich recently eliminated 44 of its 1,760 jobs.
In the first half of the year, total income for the company's U.S. asset-backed securities business, which includes mortgage-backed securities, fell 23% to $614 million. An RBS spokeswoman said, "In common with all players, our operations have been scaled back to reflect the lower volumes of business across the industry."
Late this summer, Mr. Rodriguez sat on a courthouse bench after his bankruptcy hearing. "I'm under a lot of depression to tell you the truth," he said a day earlier, tears brimming in his eyes. A worried Mrs. Rodriguez said she feared her husband was suicidal.
Soon afterwards, the couple had vacated their home of 22 years and moved into a low-income apartment in northwest Denver.
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