snake oil con men
© Hugh
Earlier this year, as the US auto sales miracle unfolded on the back of record loan terms and record high average monthly payments, we continually argued that underwriting standards were likely to deteriorate going forward as competition for the finite pool of creditworthy borrowers heats up.

Helping to drive (no pun intended) the shift towards looser lending standards is the proliferation of the originate-to-sell model - the same originate-to-sell model that helped steer the US housing market right off a cliff in 2007/2008. The concept is simple: if you're making loans with the intention of carrying them on your books, you're likely to care far more about the creditworthiness of the borrower than you are if you're simply going to ship the loans off to Wall Street to be run through the securitization machine and then sold off to investors via MBS [mortgage-backed securities]. That same dynamic is now at play in the market for car loans. Auto-backed ABS issuance should come in at around $125 billion this year - that's up 25% from 2014 and accounts for more than half of total consumer loan-backed supply.

As was the case during the lead up to the housing market collapse, this dynamic embeds an enormous amount of hidden risk in the paper backed by the shoddy loans. This paper is very often highly rated because despite what happened in 2008, the idea still exists that although one risky loan may be properly viewed as a speculative investment, a whole bunch of pooled risky loans are somehow safe as can be.

But even as alarm bells are going off in the subprime auto market and also in the market for student loan-backed paper, there hasn't been as much concern for the MBS market where apparently, everyone seems to think that market participants (lenders, borrowers, and Wall Street gamblers) have learned their lesson. Of course no one ever, ever learns which is why we weren't at all surprised to hear that "liar loans" - a relic of the good old days - are back and, in keeping with everything said above, are creeping into mortgage-backed paper. Here's Bloomberg with the story of Velocity Mortgage Capital LLC:
The pitch arrived with an iconic image of the American Dream: a neat house with a white picket fence.

But behind that picture of a $2.95 million home in Manhattan Beach, California, were hints of something darker: liar loans, those toxic mortgages of the subprime era.

Years after the great American housing bust, mortgages akin to the so-called liar loans -- which were made without verifying people's finances -- are creeping back into the market. And, like last time, they're spreading risks far and wide via Wall Street.

The Manhattan Beach story -- how the mortgage on that house was made and subsequently packaged into securities with top-flight credit ratings -- recalls a time when borrowers, lenders and investors all misjudged the potential danger.

The story begins earlier this year, when a TV producer bought the cream-colored home. His lender, Velocity Mortgage Capital LLC, says it writes mortgages for people buying homes only for business purposes, such as renting them out, and requires all customers to sign documents stating their intentions.

Soon Velocity was bundling the $1.92 million mortgage and hundreds of other loans into securities through Wall Street's securitization machine. Kroll Bond Rating Agency featured a picture of the house in a report on the $313 million deal, most of which was rated AAA. Marketing documents for the offering, which was managed by Citigroup Inc. and Nomura Holdings Inc., characterized the buyer as an "investor."

But when a reporter recently knocked on the door in Manhattan Beach, the buyer answered and said he never planned to rent out the place. Nor, he said, had he signed documents stating he would. He was living in the house with his family.
So he lied. Got it. Bloomberg goes on to explain that Velocity essentially takes advantage of the fact that mortgages made for "business purposes" are exempt from federal regulations designed to ensure that lenders are verifying borrowers' finances.

But don't worry, because there are safeguards in place. Velocity, for instance, ensures that borrowers are telling the truth by ... taking their word for it. Here's Bloomberg again:
Chris Farrar, Velocity's chief executive officer, says his company takes steps to ensure customers really are buying homes for business purposes. These include having every borrower hand write and sign letters testifying to their plans.
And then there's Kroll which, you're reminded, also plays a rather large role in rating subprime auto deals, who doesn't seem to be all that interested in knowing whether or not Velocity has done enough due dillegence:
In assigning AAA grades, Kroll partly relied on Velocity's promise to buy back any loans that fell short of the standards, said Nitin Bhasin, a Kroll managing director.

"That's a question for Velocity, I think: How do they make sure when they're making a loan that it's not owner-occupied," Bhasin said.
Bhasin is correct. It is a question for Velocity. And one you'd think Kroll would want a very concrete answer to before assigning an AAA rating especially given what we learned in the lead up to the crisis about investors' strange propensity to, you know, rely on ratings agencies to do their jobs before giving a deal the triple-A stamp of approval.

And because we wouldn't want anyone to think that the problem is confined to a handful of "liars" taking out mortgages for "business purposes," we'll leave you with the following from FT who reports that the ZIRP-induced hunt for yield has opened the door for the triumphant return of subprime non-Agency RMBS:
For "subprime", read "non-prime".

Yield-hungry investors are ready to endorse a revival of bonds backed by riskier US residential mortgages, as lenders warm to housebuyers who do not meet strict borrowing guidelines introduced after the financial crisis.

But the now toxic label of subprime mortgages has been dropped. Instead, Angel Oak Capital is in the process of pricing a deal for a bond offering of so-called "non-prime mortgages" — a term funds are using to describe mortgages that do not meet government standards. Lone Star Funds completed a deal worth $72m in August.