Mathematics cannot substitute for ethics

Multi-billion dollar losses at big banks are making the news these days.

Big name investment bankers assembled dubious mortgage loans into securities, the ratings companies gave these products investment grade ratings, and investers purchased this blessed junk.

No doubt these will all claim good faith effort and take refuge in the excuse of the failure of their mathematical models of risk. But the models were premised on eternally rising housing prices, which is an absurd assumption. You don't need any sophisticated quant analyst to tell you that.

It seems very clear to me that the lure of ringing up immediate transactions and making a profit in the short term greatly outweigh the long-term well-being of the bank for its employees, CEO downwards. Presumably they make their bonuses and are out doing something else when the whole thing blows up.

Just how bad they were is outlined in this dailykos story.

This is from Fortune magazine, quoted there:

In the spring of 2006, Goldman assembled 8,274 second-mortgage loans originated by Fremont Investment & Loan, Long Beach Mortgage Co., and assorted other players. More than a third of the loans were in California, then a hot market. It was a run-of-the-mill deal, one of the 916 residential mortgage-backed issues totaling $592 billion that were sold last year.

The average equity that the second-mortgage borrowers had in their homes was 0.71%. (No, that's not a misprint - the average loan-to-value of the issue's borrowers was 99.29%.)

It gets even hinkier. Some 58% of the loans were no-documentation or low-documentation. This means that although 98% 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.

....

In this case, Goldman sliced the $494 million of second mortgages into 13 separate tranches. The $336 million of top tranches - named cleverly A-1, A-2, and A-3 - carried the lowest interest rates and the least risk. The $123 million of intermediate tranches - M (for mezzanine) 1 through 7 - are next in line to get paid and carry progressively higher interest rates.

Finally, Goldman sold two non-investment-grade tranches [and kept one more, the riskiest, as its fee for the deal}

(...)

Even though the individual loans in GSAMP looked like financial toxic waste, 68% of the issue, or $336 million, was rated AAA by both agencies - as secure as U.S. Treasury bonds. Another $123 million, 25% of the issue, was rated investment grade, at levels from AA to BBB--.

Thus, a total of 93% was rated investment grade. That's despite the fact that this issue is backed by second mortgages of dubious quality on homes in which the borrowers (most of whose income and financial assertions weren't vetted by anyone) had less than 1% equity and on which GSAMP couldn't effectively foreclose.