The Last Word on What Went Wrong
This article is from the archive of The New York Sun before the launch of its new website in 2022. The Sun has neither altered nor updated such articles but will seek to correct any errors, mis-categorizations or other problems introduced during transfer.

Who is to blame for the mortgage mess? There are plenty of candidates, including the mortgage brokers, the ratings agencies, the lenders, and the borrowers.
Helping to sort through the debris is Andrew Davidson of the eponymous risk management firm, who has laid out in an intelligent piece in his monthly newsletter how all these participants and more combined to upend this important financial market. I had the opportunity to visit with Mr. Davidson and thought his views hit the nail on the head.
Mr. Davidson has spent his entire career in the mortgage-backed securities arena, and now he has a chic office at Broadway and Spring Street. He has more than 120 clients who rely on him to sort out the mysteries of the MBS business, and that number is rising. By 11 a.m. on the day of my visit last week, he had already heard from five potential new clients, including one large bank that wanted his firm to comb through its portfolio, just to be sure. His credentials, in short, are excellent. As has been his reading of the marketplace. He manages a portfolio of mortgages and was short most of the year. “Nothing that’s going wrong is a surprise,” he says. “It’s just the extent to which it has gone wrong.” Mr. Davidson’s main point in his article “Six Degrees of Separation” is that “the people responsible for making loans had too little financial interest in the performance of those loans and the people with financial interest in those loans had too little involvement in how those loans were made.” In other words, there were too many links between ultimate borrower and ultimate lender, so that “the transfer of risk [led] to a lack of diligence, and the markets [became] dysfunctional.”
Pretty simple, right? It gets more complicated when he begins to sort out the roles played by the mortgage brokers who have contact with the borrowers and who arrange the loans; the mortgage bankers who fund and then sell the loans; the aggregators (possibly broker-dealers) who buy and then package the loans into a security bought by investors; the CDO managers who buy portfolios of MBS for a trust that issues debt backed by those securities; and finally the poor sap (the investor) who buys the CDO. And don’t forget the servicers that collect payments from the borrower and the rating agencies that rate the MBS. Mr. Davidson would argue that as you move along this chain, there is a steady drop in knowledge of, and control over, the value of the original credit. Early on, the mortgage market requires something called “representations and warranties” on purchased loans. “These reps and warrants, as they are called, are designed to ensure that the loans sold meet the guidelines of the purchasers,” he says, but in fact they are often not backed by capital sufficient to make good in the case of a default. By the time you get to the last link in the chain, there is virtually no financial backing of the loans.
Unique to CDOs, the rating agencies do not get paid unless a transaction occurs and the CDO is created. In other sectors, the ratings agencies are called in to rate a company or a transaction that already exists or that is likely to occur. In the case of the CDO, if the agency puts too low a rating on the security, the trust will be unable to borrow money or tack on enough leverage to offer investors competitive rates of return. As a result, the CDO will not be created. If that happens, the rating agency does not get paid. As Mr. Davidson says, “In my view, there are very few institutions that can remain objective given such a compensation scheme.”
CDOs also have issues. “In many cases CDO managers receive fees that are independent of the performance of the deals they manage,” Mr. Davidson writes. Though not always the case, often the CDO manager had little exposure to the value of the underlying bonds.
Mr. Davidson concludes that “there was too little capital at risk in key parts of the mortgage origination and investment chain” and makes two recommendations about how this complex process could be improved upon going forward.
First, he advocates making sure there is “capital at the origination end of the process.” The mortgage brokers, or whoever is dealing with the borrower, should be licensed and bonded, just like stockbrokers who are also responsible for giving clients financial advice. Also, he suggests that “firms in the chain of reps and warrants need to maintain sufficient reserves to support their financial promises.” Otherwise, those guarantees are meaningless.
Mr. Davidson’s second proposal is that there should be limits on the amount of leverage used by CDOs. He argues that this could be accomplished de facto though the ratings agencies, or through rules on leveraged investment vehicles. Though for the time being the subprime part of the CDO market will not attract investors and will therefore not be an issue, there are other types of CDOs where problems might also arise.
In the short run, he hopes the government will continue to infuse liquidity into the system, and that a good many lenders will work out ways in which the much feared “resets” coming up in some adjustable rate mortgages will be refigured to make them less onerous. “There will be a lot of loan modifications,” he predicts.
Reviewing the carnage, Mr. Davidson says: “All the people that knew what was going on had no power to change the process. In addition, everyone liked the result; home ownership had very strong support throughout the government, so no one really wanted to stop it.”