Concealed Danger
The dangers being cloaked by a housing boom and flawed AAA grades on mortgage debt were far from secret at the time.
In both residential- and commercial-mortgage securities, investors such as Scott Simon, Pacific Investment Management Co.’s mortgage head, said they were demanding AAA classes built with even more investor protection than rating firms demanded.
Credit graders’ “models are all insanely screwed up” because so many potential defaults were being averted through re-financings or home sales, Scott said during a panel discussion at a conference in New York in 2005.
That year, on a conference call for investors in which its analysts discussed a series of special reports S&P had published on the state of housing and related companies after its explosive gains, David Wyss, then the firm’s chief economist, said prices could fall 20 percent nationwide and almost 30 percent on the East and West coasts.
A ’Fizzle’
Still, he said he thought the most likely outcome was “that the bubble ends with a fizzle, not with a bang,” American Banker magazine reported at the time.
S&P in 2007 turned into “enablers of the grand fraud” in which banks created a final flurry of CDOs filled with credit- default swaps, according to Manal Mehta, founder of San Francisco-based hedge fund Sunesis Capital LLC. The swaps were side bets on the performance of mortgages, rather than being backed by actual loans.
In March of that year, S&P granted or confirmed initial ratings on $51 billion of CDOs, according to the complaint.
“Those CDOs magnified the impact of fraud in the system,” Mehta said. “Subprime on its own was a containable problem: Synthetic products such as CDOs which repeatedly copied and pasted the same faulty underlying collateral into multiple deals exacerbated the problems and blew up the world.”