Every bad outcome demands a bad actor

There are plenty of candidates. Me, for one. Fortunately, I wasn’t sent to the gulag, just met with some luck-of-the-draw misfortunes unlikely to much interest anyone. But I haven’t yet told my insider take on what happened when The Great American Cashout Mortgage Refi ATM stopped spitting out free money.

Readers are cautioned

I am a cashiered mortgage backed securitization lawyer. Conversations with people like me usually end after a minute or so with the victim recalling an urgent need to check in with their life insurance agent to make sure of adequate protection against the god forbids. So, reading this will be like deep-in-the-weeds inside cricket. I have more accessible stuff to come.

The July deal calendar

I was Senior Vice President/Associate General Counsel of Washington Mutual Bank with primary responsibility for securitizations. The month started with the normal five deals to close, pools of 10,000, billions and billions served. These were “prime” and “Alt-A” pools, as opposed to the recently distressing “subprime” variety. The last subprime deal marketing had suffered a hiccup on its Cayman Islands piece that almost tanked everything. That and a deteriorating performance of the 2006 vintage put the subprime deal market off its feed. We speculated about *contagion*, the tendency of troubles in one asset class (the subprime) into another (the deals about to start). But, so far so good.

Until 7 days later, when there were no deals. At all. A month without a deal hadn’t happened for a very long time. Years. The next deal would come never, ever. WaMu had only 13 months to live.

BNP Paribas wises up

Later that month, a French bank began to worry about an institutional borrower. Whether they relied on Gallic logic, divine revelation or just luck, they followed up the bad feelings with some fact finding. The facts were not encouraging. The mortgage backed securities that they held as collateral for the loan were still performing as advertised, paying monthly installments of scheduled principal and interest. Given the ratings on the securities, the interest rate, the estimated remaining months until payment and the anticipated losses putting a market valuation on the position should be simple. Banks do that so they can sell the collateral if the value drops below what it would take to pay off the customer’s loan.

Mortgage backed securities aren’t something that you can trade in a listed exchange like the NYSE or a quotation system like NASDAQ. There is no section of the Financial Times that you can open to look up prices. The price is a rumor to be discovered by gossip with traders on other desks. That is, the price is the consensus of what people you routinely do business with think what everyone else thinks about the price. The only ones who actually know the price are market makes, dealers who stand ready to make an offer to buy the actual securities. They do that only if they have another customer ready to flip them to. This is part of the “information arbitrage” by which the original lead underwriter racks up its spread.

In the process of trader talk a few hard facts taken at second or third hand, a mix of “I’ve heard,” speculation and hopes and fear echo throughout the day to distill into an *everybody thinks*. What the desk at BPN Paribas reported was that everyone thinks the nightclub is on fire and it’s time to rush the exits. Which they did and went on to freeze withdrawals from some investment funds it sponsored on the basis that liquidity had evaporated and net asset value could not be established.

That was the panic in a nutshell: I can’t have this stuff if I can’t put a trade value on it. In the vernacular, the securities had become worthless even as they continued to pay handsomely each month. But you can’t put out a fire without liquidity.

Next time: Read and follow label directions. How investors were warned, and why they didn’t care.