The Daily Reckoning PRESENTS: Like a comically misplaced banana peel, thesubprime mortgage industry has slipped up more than a few big names in thehousing industry. But as Bill Bonner explains, when the collateral onthese loans rests on white lies, lenders are left slipping andsliding...with nothing to grab hold of. Read on...LOANS FROM HELLby Bill Bonner“Credit issues are there but they are contained.”- Hank Paulson, March 6, 2007You can take the temper of an era by looking to see what its brightestminds take up. Pythagoras applied himself to geometry. Alexander Flemingdiscovered penicillin. Wernher von Braun built rockets to blow up London.But if St. Augustine were alive today, he’d probably be touting thebenefits of globalized markets. Isaac Newton would be running a hedge fundin London. And Henri Poincare would be working for Goldman Sachs,calculating the return on a tranche of BBB-rate subprime debt.Scientists and philosophers alike have turned their focus to the greatestchallenge and opportunity of our time: Relieving other people of theirmoney. We are voyeurs...gawkers at the merry and absurd world of money.And now comes the part that makes this sorry métier of ours worthwhile. This week, traders at the big financial houses in the City and Wall Streetwere marking down their own paper. Merrill equity analysts, for example,cut their recommendations on Goldman, Lehman and Bear Stearns shares (aswell as those of European banks Deutsche Bank and Credit Suisse Group)from ‘buy’ to ‘neutral.’As for the bonds of the three biggest securities firms - they are judgedby bond traders (many of whose paychecks come from these same bigsecurities firms) at prices more suitable to junk bonds than to themasters of the universe. On Tuesday, Goldman astonished analysts withhigher earnings than any had seen coming; still, investors sold off thestock. The banana peel on which these august figures skidded was subprimemortgage lending. Looking closer, we see that the inside surface was slickwith a special kind of mortgage, known institutionally as a ‘lowdocumentation’ loan...and known colloquially as a ‘liar’s loan.’As to their ability to pay (and perhaps even as to their name and address)lenders took the borrowers at their word. With no solid incomes to boastabout, nor any real assets to wave as collateral before the lenders’turned up noses, the poor borrowers had to fib a little. Yes, they hadbeen employed as a bank president for more than a dozen years. Yes, theyowned an oil refinery in central London and were mentioned, briefly, inHoward Hughes’ will. No, they called no man a creditor...and yes, theywere only borrowing money to buy a house because they didn’t want to takeany of their own capital out of the high-performance hedge funds in whichit was earning 50% per year. Any simpleton could see that ‘liars’ loans’ would be a disaster forsomeone. But it took a near meltdown in the mortgage market to bring thepoint home to the geniuses in the financial industry. The entertainment began on February 7, when HSBC announced that it hadfired its head of North American operations, after its bad debt - much ofit from subprime ‘piggyback’ loans - rose to $6.8 billion.And then it continued, when New Century Financial, the second biggestsubprime lender in America (carrying $23 billion in debt), came crashingdown. The stock fell from $66 to near zero...giving up 43% in just threedays in February, and most of the rest when the NYSE halted trading lastweek.“The banks also appear to have been caught unawares by the scope of NewCentury’s problems,” says an article in the New York Times. “ Forinstance, a week after the company said it would have to restate itsfinancial statements for the first nine months of last year, Goldman Sachsextended to May 14 a credit line to New Century that was set to expire onFeb. 15.”And what of the nation’s numero uno in the subprime market? According tothe press reports, in 2006, Wells Fargo & Co. leaped ahead of AmeriquestMortgage Co., and New Century Financial Corp. to become the biggest funderof subprime mortgages. And as of December, when other lenders were alreadyin retreat, Wells Fargo was still charging ahead, increasing its lendingto the least creditworthy buyers.Subprime lending is like selling used cars in bad neighborhoods; it is notfor those with delicated scruples or refined manners. Wells Fargo has beenaccused of ‘predatory lending’ - and that maybe so. But subprime lendersnow look more like fools than knaves.On one of the many websites that seems to have been set up for Wells Fargocustomers to kvetch, we find this interesting thread:Poster #1: “Check out this beauty at 2909 Allenhurst St. This property waspurchased on September 30, 2005 for $264,000. However, due to theinability of the borrower to make payments, Wells Fargo foreclosed onthese folks on January 29, 2007. Now the property is listed for sale for$225,000...”Poster #2: “Multiply this outcome by the thousands and you can get thepicture of how this speculative mania will end... Right now there are100-150 NOD’s [notice of default] filed a week in Kern County; I predictthat in a year we will have 200-250 NOD’s per week in Kern County. Creditis tightening, inventory is increasing and foreclosures are rising...thepain is only beginning.”Poster #3: “The house is worth 125K at the most. Probably one of thoselate seventies shacks off Ashe.”Poster #4: “The house was just sold on 1/29/07 $204,000.”How much did Wells Fargo lose on this transaction? Twenty percent? Fifteenpercent? How many of these banana peels could there be? Even the smartest lenders - the world’s leading financial institutions,including Britain’s number one bank - were providing money to the subprimesalesmen, all of them presumably aware that their collateral rested onwhite lies.And so now they are all slipping and sliding...grabbing for something tohold onto.Until only a few months ago, the constant welling up of house prices gavethem some traction. When a sad-sack subprime buyer gave up and defaulted,the lenders, and the lenders to the lenders, and the lenders to thelenders to the lenders, could still tread confidently, secure in theknowledge that they could sell the shacks and get their money back - andmore. What they didn’t seem to realize was what seemed most obvious - that houseprices wouldn’t go up forever. Indeed, some day they might even go down.And when they went down, lenders would have neither a strong borrower tomake payments, nor decent collateral to sell, nor even a buyer with anymoney to sell it to.What bothered New Century Financial was that the people they lent money tocould not pay them back. What now bothers Goldman, Merrill and the rest ofthe smarty-pants businesses is no different. Their credits are going bad.All the way up the financial food chain, they applied the same ‘lowdocumentation’ standards to the mortgage-backed securities business thatthe New Century applied to the mortgage itself.Now, for readers who may be as unfamiliar with mortgage backed securities(MBSs) and collateralized debt obligations (CDOs) as we are, we supply thefollowing elucidation of these two life-enhancing inventions: Imagine theentire mortgage market as a giant pig and the financial industry as arendering plant. After the best lenders have taken the AAA++ hams andribs, there remain many body parts you might show to your daughter only ifyou wanted to see her make a face and hear her say ‘eeewwww.’ In themortgage industry, as in the slaughterhouses, those cuts do not get the‘prime’ label. In lending, they are known as ‘subprime.’The low-priced stuff is too disgusting for most people to put directly onthe table, so the unidentified scraps are typically run through thegrinder. Then, they are packaged into old-fashioned, pure porkmortgage-backed sausages. Even at this level, the investors never met theborrowers (and often not even the lenders) and were never privy to theparticular lies that coaxed the animal into the abattoir in the firstplace. Nevertheless, the markets are familiar with these things; they knowmore or less what is in them...and have some slim idea of what they areworth. But then the St. Augustines, the Newtons, and the Poincares of our time goto work. The tranches of meat are repackaged according to the latestscientific formulas - mixing the parts together ever so carefully so thatthey don’t go bad all at once. Then, they are resold as CDOs, either ofthe regular or synthetic variety. The whole is better than the sum of itsparts, they claim.For mysterious reasons, the rating agencies have agreed. And the buyers,with neither the time nor the competence to double-check the assumptionsor carefully inspect the sausages - tend to go along too. And thus it isthat the crème de la crème of the financial industry finds itself in thesame position as the subprime lenders themselves - taking the liars attheir word.The big difference is that the original liars - who bought the subprimehouses with money they didn’t have - could leave as they came in. The CDOinvestors, on the other hand, had something to lose. They paid real moneyfor the subprime debt. When they leave, they leave poorer than they camein.But the way to make money in a gold rush, say the old-timers, is not todig in the ground for it yourself, but rather to sell the miners picks andshovels. In the mad rush for profits of the 21st century, Goldman,Merrill, HSBC and the rest of them did a lot of both. The trouble now is, the pick and shovel business may be turning down. Nomatter how many shovels Goldman may have sold in the boom, it is sure tosell fewer in the bust. As for its own mining claims, a number of them seem to be going to thedevil. Goldman’s own Global Alpha fund, the hedge fund where its owninsider scientists dig for gold, lost 6% last year when the S&P actuallywas up over 15% and the average hedge fund was up 13%.And now, the subprime mine seems played out. “What has been a creditconcern seems to be morphing into a liquidity crunch for all partiesinvolved,” wrote Morgan Stanley in its daily bulletin on subprime. Who arethe parties? Morgan Stanley spelled it out: “HEL [home-equity loan]borrower, HEL originator - and finally - HEL trader/investors.”Regards,Bill BonnerThe Daily Reckoning