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Guesstimates Won’t Cut It Anymore
Published: October 28, 2007

THE props holding up the values of risky mortgage securities finally started to give way last week. And that means the $30 billion in losses and write-downs taken by big brokerage firms in the third quarter are not likely to be the last.

Even as developments in the credit markets went from bad to worse this year, investors for the most part have remained upbeat about the values of the mortgage securities they held. One reason that they could keep their heads in the sand was that these complex securities are hard to value in good times, impossible during periods of stress.

Executives of companies with big stakes in mortgages also accentuated the power of positive investor thinking. Emerging periodically from their corner offices, these executives opined that in spite of rocketing delinquencies, most loans continued to perform well. Rating agencies, fending off complaints that they had been slow to downgrade, maintained that they would adjust their ratings only after they saw actual loan failures. Government officials trotted out regularly to contend that upheaval in the mortgage market was a minor scrape.

After last week, however, it was no longer plausible to deny that mortgage loans, and the complex securities derived from them, had crashed — and caused a lot of damage in the process.

First to face the music was Merrill Lynch, which stunned investors Wednesday with an $8.4 billion write-down, $7.9 billion of which was for mortgage-related assets. The write-down was $3.4 billion more than it had warned investors about just three weeks before.

Until that moment, investors had been willing to trust companies claiming to have limited exposure to the credit mess. But Merrill’s third-quarter results made clear that such confidence must now be earned, not presumed.

In a pained, hour-long conference call, Merrill’s top executives said that almost $8 billion of the firm’s capital had been vaporized in the third quarter because it had underestimated the degree to which its holdings of collateralized debt obligations, or C.D.O.’s, had tanked. C.D.O.’s are pools made up, for the most part, of mortgage securities divvied up into tranches of differing risk levels.

The executives on Merrill’s dismal conference call conceded that even after they decided to value their C.D.O. holdings more conservatively — resulting in losses — much of their methodology was based on “quantitative evaluation.” (For the rest of us, that means that Merrill was in the unfortunate position of still having to guesstimate its exposure to losses.)

ANALYSTS quickly responded by forecasting an additional $4 billion in write-downs on Merrill’s portfolio. Marking positions to model — a favorite reality dodge on Wall Street — just doesn’t cut it anymore.

To be sure, Merrill was especially overexposed in C.D.O.’s, choosing as it did to go into the business relatively late but in a very big, very voracious way. Other banks and brokerage firms are not likely to have as much junk on their books.

Nevertheless, Merrill’s decision to write down its holdings as it did gives a clear signal to other banks and brokerage firms that valuing similar assets at lofty levels is no longer acceptable or credible.

Then, on Friday, Moody’s Investors Service began downgrading C.D.O.’s. Despite the subprime turmoil, some of these securities had continued to carry high ratings — until Friday. Moody’s cut or placed on review for possible downgrade securities from dozens of C.D.O.’s, some rated as high as AAA. The C.D.O.’s that may be subject to a downgrade hold subprime mortgage loans worth $33 billion, and there are probably more to come.

Moody’s move was not a surprise. It warned several weeks ago that C.D.O.’s were finally coming under its microscope. But Moody’s downgrade is notable because many investors holding C.D.O.’s — like insurance companies — have to sell them when their ratings fall significantly.

With the C.D.O. market stopped dead in its tracks, it is not clear who will be willing to buy and at what price. But it’s a good bet that these forced sales aren’t going to add buoyancy to the market. A better bet may be to expect Wall Street to recognize further losses.

“We’ll definitely see a lot more write-downs,” said Josh Rosner, an expert on asset-backed securities at Graham-Fisher, an independent research firm in New York. “I think that the exposures that we are seeing and the announcement out of Merrill are the leading edge, not the end.”

ONE reason that Mr. Rosner expects more losses from banks and brokerage firms relates to the calendar. So far, the write-downs that banks and brokerage firms have taken have come during periods when managements were preparing their financial statements but hadn’t submitted them to outside auditors for a more thorough vetting.

Intense auditor scrutiny comes once a year, and that is the period we are in now — fiscal years at many big brokerage firms, Morgan Stanley, Lehman Brothers and Bear Stearns, for example, end in November.

“When it comes time for the auditors to attest, they are going to be very conservative,” Mr. Rosner said. That means write-downs will have to reflect the reality in the market, not some rosy scenario.

Way back in 2003, Warren Buffett defined derivatives — like those exploding on a balance sheet near you — as financial weapons of mass destruction.

“The derivatives genie is now well out of the bottle,” he wrote, “and these instruments will almost certainly multiply in variety and number until some event makes their toxicity clear.”

Last week, Merrill Lynch shareholders got a taste of that toxicity. Others will soon have their turn.


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