An Unsavory Slice of Subprime

By Allan Sloan
Tuesday, October 16, 2007

It's getting hard to wrap your brain around subprime mortgages, Wall Street's fancy name for junk home loans. There's so much subprime stuff floating around -- more than $1.5 trillion of loans, maybe $200 billion of losses, thousands of families facing foreclosure, umpteen politicians yapping -- that it's like the federal budget: It's just too big to be understandable.

So let's reduce this macro story to human scale. Meet GSAMP Trust 2006-S3, a $494 million drop in the junk-mortgage bucket, part of the more than half-a-trillion dollars of mortgage-backed securities issued last year. We found this issue by asking mortgage mavens to pick the worst deal they knew of that had been floated by a top-tier firm, and this one's pretty bad.

It was sold by Goldman Sachs. GSAMP originally stood for Goldman Sachs Alternative Mortgage Products but has become a name itself, like AT&T and 3M. This issue, which is backed by ultra-risky second-mortgage loans, contains all the elements that facilitated the housing bubble and bust. It's got speculators searching for quick gains in hot housing markets, it's got loans that seem to have been made with little or no serious analysis by lenders, and finally, it's got Wall Street, which churned out mortgage "product" because buyers wanted it. As they say on the Street, "When the ducks quack, feed them."

Alas, almost everyone involved in this duck-feeding deal has had a foul experience. Less than 18 months after the issue was floated, one-sixth of the borrowers had already defaulted on their loans. Investors who paid face value for these securities have suffered heavy losses. That's because their securities have either defaulted (for a 100 percent loss) or been downgraded by credit-rating agencies, which has depressed the securities' market prices. (Check out one of these jewels on a Bloomberg machine, and the price chart looks like something falling off a cliff.) Even Goldman may have lost money on GSAMP, but being Goldman, the firm has more than covered its losses by betting successfully that the price of junk mortgages would drop. Of course, Goldman knew a lot about this market: GSAMP was just one of 83 mortgage-backed issues totaling $44.5 billion that Goldman sold last year.

Now let's take it from the top.

In the spring of 2006, Goldman assembled 8,274 second-mortgage loans originated by Fremont Investment & Loan, Long Beach Mortgage and assorted other players. More than one-third of the loans were in California, then a hot market. It was a run-of-the-mill deal, one of the 916 residential-mortgagebacked issues totaling $592 billion that were sold last year. Most of the information in this article is based on our reading of various public filings.

The average equity the second-mortgage borrowers had in their homes was 0.71 percent. (No, that's not a misprint: The average loan-to-value of the issue's borrowers was 99.29 percent.) It gets even hinkier. Some 58 percent of the loans were no-documentation or low-documentation. This means that though 98 percent of the borrowers said they were occupying the homes they were borrowing on -- "owner-occupied" loans are considered less risky than loans to speculators -- no one knows if that was true. And no one knows whether borrowers' incomes or assets bore any serious relationship to what they told the mortgage lenders.

You can see why borrowers lined up for the loans, even though they carried high interest rates. If you took out one of these second mortgages and a typical 80 percent first mortgage, you got to buy a house with essentially none of your own money at risk. If house prices rose, you'd have a profit. If house prices fell and you couldn't make your mortgage payments, you'd get to walk away with nothing (or almost nothing) out of pocket. It was go-go finance, very 21st century.

Goldman acquired these second-mortgage loans and put them together as GSAMP Trust 2006-S3. To transform them into securities it could sell to investors, it divided them into tranches -- which is French for "slices," in case you're interested.

There are trillions of dollars of mortgage-backed securities in the world for the same reason that Tyson Foods offers you chicken pieces rather than insisting you buy an entire bird. Tyson can slice a chicken into breasts, legs, thighs, giblets -- and Lord knows what else -- and get more for the pieces than it gets for a whole chicken. Customers are happy because they get only the pieces they want.

Similarly, Wall Street carves mortgages into tranches because it can get more for the pieces than it would get for whole mortgages. Mortgages have maturities that are unpredictable, and they require all that messy maintenance like collecting the monthly payments, making sure real estate taxes are paid, chasing slow-pay and no-pay borrowers, and sending out annual statements of interest and taxes paid. Securities are simpler to deal with and can be customized.

Someone wants a safe, relatively low-interest, short-term security? Fine, we'll give him a nice AAA-rated slice that gets repaid quickly and is very unlikely to default. Someone wants a risky piece with a potentially very rich yield, an indefinite maturity, and no credit rating at all? One unrated X tranche coming right up. Interested in legs, thighs, giblets, the heart? The butcher -- excuse us, the investment banker -- gives customers what they want.

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