The Justice Department announced its long-awaited $7.2 billion settlement with Deutsche Bank over subprime-era misdeeds Tuesday. As expected, it's a doozy. It's also one of the last big settlements to come out of the government's post-crisis mortgage-backed securities working group, so it's worth savoring.
As is customary, no individuals were named or charged. But in its 71-page statement of facts, the government gives the reader all the tropes we've come to expect of the crisis-era settlement genre: Juicy quotes describing subprime loans as “shit,” traders cynically representing that shit to investors, and detailed descriptions of how that shit got shoved under the proverbial rug.
But what makes this settlement interesting is how clearly some of Deutsche Bank's employees seemed to predict how that rug would get pulled out from under them. Not only does the onetime Wall Street powerhouse engage in all the worst behaviors of the subprime era, but its traders correctly identify the rot at the heart of the system.
Deutsche Bank jumped headlong the subprime business. By 2007 it was the third-biggest seller of mortgage-backed securities in the world, packaging at least $100 billion of the stuff. But by 2005, some of its top mortgage traders knew things smelled funky. In March of that year the bank's diligence supervisor wrote the mortgage finance team that originators like Ameriquest had loosened their underwriting guidelines to a worrying degree. His take: “It’s definitely a Seller’s market!”
A year later, the same supervisor described how lax the originators had become in verifying that borrowers had the ability to pay back loans. “I once heard that OOMC will approve anyone with a pulse,” he quipped, referring to Option One. “I would move that to half a pulse.”
Yet Deutsche Bank continued vacuuming up the faulty loans, wiping the dirt off and selling them to an oblivious marketplace. Not long after noting Option One's lazy underwriting guidelines, our friend the diligence supervisor flagged a loan document that implausibly listed a Post Office employee as making more than $100,000 a year. In a bit of foresight, he extrapolated the long game from the pay stub, which had been altered, or “marked out,” by the mortgage originator:
The marked out paystub is just an example of how misdirected lending practices have become; we tolerate misrepresentation. What goes around will eventually come around; when performance (default) begins affecting profits and/or the investors who purchase the securities, only then will Wall St. take notice.
Of course, this employee was no innocent victim. The Justice Department's settlement outlines numerous instances in which he was party to Deutsche Bank fudging FICO scores, misrepresenting underwriting guidelines, shoehorning bad loans into securitizations, misstating loan-to-value ratios and sundry other alleged frauds. But the diligence supervisor, like all of Deutsche Bank, continued to trudge into the heart of the crisis, even as Deutsche traders recognized danger ahead.
Perhaps the best demonstration of Deutsche Bank's kamikaze tendency was its January, 2007 purchase of MortgageIT, an originator that supplied Deutsche with thousands of subprime loans. Even before the acquisition, Deutsche Bank employees had called the company's practices “sloppy.” Things only got worse from there.
In mid-2007, a managing director on the mortgage trading desk diagnosed MortgageIT's ills. The company “made money by overaggressive lending that got bailed out by positive HPA [home price appreciation],” he wrote, noting however that “the downward turn in HPA blows this strategy apart.” As loans came due, defaults were bound to rise. “Risk is not easily distributable because of the poor credit and origination processes,” he said. He went on:
The “design of [MortgageIT’s] business model does not create accountability” because “account executives are paid for origination, not performance.” “This type of attitude,” he explained, “creates an atmosphere where the riskiest loans are pushed through the system.” [He] admitted that, “undefinedn a time of strong HPA this is fine because they end up in someone else's hands but now they end up in ours.”
Change a few words and he could be describing Deutsche Bank.
This trader's concerns spurred Deutsche Bank to do a forensic review of a sample of MortgageIT's loans, which found at least 15 percent of the company's mortgages were unsuited to be sold, vindicating the trader's worries. But that didn't stop him from packing 1,500 MortgageIT loans into a series of securitized products. The last of these, marketed in late 2007, came too late in the cycle to attract buyers.
Did Deutsche Bank's traders know the whole financial system was set to implode? It's impossible to tell. But they certainly knew their own little corner of the market was going the way of the dodo. They just didn't want to let anyone else in on the fun until the end came.