Was Subprime Lending Just Rocket Science?

A while back, Bearn Stearns launched a hedge fund that invested mainly in complex packages of subprime mortgages. The fund did so nicely that Bear Stearns last year launched a second, more highly leveraged version.

Too bad so many people with subprime mortgages can't pay them off, especially when their low teaser rates expire. The first Bear Stearns fund is now worth nine cents on the dollar. The second, as FT. com reports, is not worth a dime:

Bear Stearns on Tuesday told investors in two stricken hedge funds managed by the bank that one fund had lost all its value and the other had about nine cents remaining for every dollar invested following bad bets on the US subprime mortgage market. The losses, especially for the less leveraged of the two funds, were worse than investors expected. “They are a big investment house. They are supposed to be professional,” said one fund of funds executive. “There is nothing to do now except maybe go shoot the guy who did it.”

Counting leverage, the two funds at their peak may have been worth $16 billion or more. But before we shoot the hedge fund managers who gambled and lost, pause to reflect. Who created this whole subprime mess is the first place?

The New York Times identified a leading suspect back in March: The Subprime Loan Machine($).

Edward N. Jones, a former NASA engineer for the Apollo and Skylab missions, looked at low-income home buyers nearly a decade ago and saw an unexplored frontier. Through his private software company in Austin, Tex., Mr. Jones and his son, Michael, designed a program that used the Internet to screen borrowers with weak credit histories in seconds.

***

The old way of processing mortgages involved a loan officer or broker collecting reams of income statements and ordering credit histories, typically over several weeks. But by retrieving real-time credit reports online, then using algorithms to gauge the risks of default, Mr. Jones’s software allowed subprime lenders like First Franklin to grow at warp speed.

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The rise and fall of the subprime market has been told as a story of a flood of Wall Street money and the desire of Americans desperate to be part of a housing boom. But it was the little-noticed tool of automated underwriting software that made that boom possible. Automated underwriting software spawned an array of subprime mortgages, like those that required no down payment or interest-only payments. The software effectively helped move what was a niche product only a decade ago into the mainstream. Automated underwriting “replaced the ways we used to extend credit,” said Prof. Nicolas P. Retsinas, director of the Joint Center for Housing Studies at Harvard.

Loan approval by algorithm proved extremely efficient. Remember the ads? “We’ll give you loan answers in just 12 seconds!”

That's not much time to work miracles, even with the help of rocket science. In comes a loan application. The applicant presumably couldn't get approved for a standard mortgage. Whoosh! Twelve seconds later, the applicant is qualified for a costlier (after teasers expire) subprime mortgage.

“Farce is tragedy played
at a thousand revolutions per minute"
– John Mortimer

Let's hope this farce doesn't end in too much tragedy. You can read Bear Stearns letter to clients, reporting the closing of the two hedge funds, here.