OverLeveraged — A Blog About Debt

"You will only be successful if you truly try to satisfy that burning desire inside you. And for you, that burning desire is to tell that story." – James McBride

How Allan Sloan Created His House Of Junk

The 2007 Fortune feature “House Of Junk” exposed the flaws of a ballooning market of mortgage-backed securities prior to its crash and became not only an award-winning story but also an Academy-winning movie. And it all started with a journalist in between jobs and publicly available document that nobody had bothered to read.

It is not often a young quarterback with sky-high aspirations gets the opportunity to throw ball with Tim Tebow, or an up-and-coming swimmer gets to work on his stroke side by side with Matt Grevers, but on rare occasions even these moments become reality. Similarly, when I first read “House of Junk,” Allan Sloan’s award-winning dissection of a particularly toxic Goldman Sachs-issued mortgage-backed security, little could I anticipate that I one day would get to hear first-hand about the inception of that story.

But on the twenty-sixth day of November in the year of 2012, I did, and I was, according to Sloan himself, one of the first people to ever ask about it. Although flattered I remain realistic: I can only assume that Goldman’s Lloyd Blankfein never found the time to call Sloan and ask how the hell he could so accurately peg down something that neither the analysts at Moody’s and Standard & Poor’s nor thousands of investors across the globe could figure out.

Allan Sloan is something along the lines of a 15 year younger Warren Buffett: both decorated veterans in their fields, hiding razor-sharp minds behind thick walls of self-depreciation and chuckles. They also share the habit of describing their achievements stemming from utterly trivial work — Buffett making a fortune from finding attractive investments using seemingly self-evident tenets and Sloan simply reading publicly available documents that nobody else have the perseverance to get through.

Very well. As U2′s Bono once so eloquently put it: “Good things don’t happen to people who wait. Good things happen to people who work their asses off.”

It all began in early 2007. Having just left a seven-year stint at Newsweek, Sloan had some time off before he was to begin his new job at Fortune Magazine. If given a few months, or even weeks, off at age 62 after having worked in business journalism for the past four decades, it would be my fair guess that most people would do anything but work. Maybe jump on a cruise to Bahamas. Hike the Appalachian Trail. Hit up Las Vegas. Evidently, that is not Allan Sloan’s style.

When invited by a first-hand source to learn about the mortgage market, he immediately seized the opportunity. The prevalence of and demand for U.S. mortgage-backed securities had been growing exponentially over the past decade, fueled by lax credit standards and booming house prices. The securitization of mortgages relied on the basic premise that real estate values would continue to increase, but prices had begun to curb off in late 2006 and showed a slight decline in early 2007. Investors here and there began to ask questions.

Workaholic Sloan got hooked on the topic, seeing a potentially great scoop.

Realizing that the entire system would be too complex to explore in a single feature, he asked a crucial question. “Could you guys pick out for me the absolutely worst mortgage-issue you could think of that was written by a firm with a real name?” That day, he walked away with a 315-page prospectus on a particular mortgage-backed security that had been issued by Goldman Sachs in the spring of 2006.

A prospectus is a document that hammers out the details of a financial security. Stuffed with legal disclaimers and finance lingo it is by no means an easy read – one could even claim that most investors, and evidently also the credit rating agencies, either lacked the perseverance or the knowledge to read through and fully understand such documents – or both. But Sloan did – a seemingly impressive deed by a man who over the course of his life has taken only one economics course (he was an English major in undergrad and proceeded to receive his master’s degree in journalism). He takes great pride in having an old-school ability to muscle through dense institutional documents to dig up hidden irregularities, particularly in an era that rapidly has come to be increasingly dominated by quick journalism and a subsequent lack of, in his words, “serious research.”

Sloan initially turned to the documents at the dawn of his career after realizing that several of the people he pursued for information simply would not talk to him. He describes how he’d put his kids to sleep at night and proceed to stay up for hours, dissecting thick piles of documents from various governmental and financial institutions. “The better I got at documents, the less I needed people,” he told me, “and the less I needed people, the more eager people got to talk to me, because they started to realize what would happen to me if they didn’t.

After obtaining the prospectus, a period of extensive research followed. Accompanied by senior reporter Doris Burke, Sloan dug into the 8,274 underlying loans to find indications that S&P’s and Moody’s credit ratings on the security’s twelve tranches were flawed. Needless to say, they found plenty of indicators.

Most of the loans could be traced to California, Florida, and New York – areas where the real estate market was particularly overheated, resulting above-average foreclosure rates. The average equity, meaning the down payments borrowers had made on the loans, was at less than one percent. There was a substantial lack of documentation of the borrowers’ residential status and income levels. When the duo began tracking down the actual houses the mortgages were taken out on, they found nothing but secondary mortgages, meaning that the owner of the house also owned other properties, not in accordance with the 98 percent of borrowers who on their applications claimed that they would be living in their newly purchased home. And secondary mortgages are considered speculative and borrowers should therefore have been charged higher interest rates.

It became evident that they were onto something big. One of his numerous background sources confided, “whoever showed you this gave you the right one, because this is a disaster.”

When the article was published in October 2007, Sloan could simply sit back and watch the storm unravel at his feet. Goldman Sachs initially “reacted the right way – didn’t say a word,” but the situation was brought to another level when Lehman Brothers fell eleven months later and the magnitude of the housing speculation became evident as the banking sector worldwide was balancing on the verge of collapse. What gathered most attention may have been the revelation how Goldman Sachs hedged their portfolio of mortgage-backed securities by short-selling indices on the same type of securities; a position that increased in value as the indices dropped, putting the firm at a positive net result while many investors and homeowners lost massive amounts of money. Or, as senator Carl Levin later put it to Goldman executives in the Congressional hearing in 2010: “betting against your customers.”

With “House Of Junk” Sloan earned his seventh Gerald Loeb Award, given out specifically for distinguished business and financial journalism, and the story later became the framework for the 2011 Academy Award-winning documentary Inside Job. Simply because he “just got lucky and was handed the right issue by these people.” And, should be added, didn’t consider the opportunity to take a vacation while between two jobs.

Sloan himself attributes the Loeb Award to the fact that he, despite the complex nature of the topic, kept the story very short and simple. His editor returned the first draft asking him to explain the concept and purpose of tranches. Keeping it simple, Sloan came up with an analogy featuring a chicken. By slicing it into pieces – legs, thighs, breasts, and so on – the pieces become more valuable to the wholesaler than if he sold each bird as a whole, and the customers were given the opportunity to pick their pieces according to individual preference.

“The whole story actually came out 500 words short of budget,” Sloan said. “They told me ‘you should add another 500 words’ but I told them ‘I don’t want to add another 500 words, I don’t need to!’ The idea is to have something to say, say it, and then stop.”

He adds: “I’m good with numbers and quickly getting to the gist of things. And that’s what this story was all about. Numbers that were disclosed to everybody but that nobody read.”

One comment on “How Allan Sloan Created His House Of Junk

  1. Simon Burnett
    October 26, 2013

    A super roundup of the background to Allan Sloan’s story, which I only recently read. An exposure of ruthless cheating by the sell side (because it could get away with it), information disequilibrium (meaning the buy side got screwed all the way down the line), and sloppiness by those buyers who themselves got screwed but who could pass the risk on to other buyers–often the man and woman on the street.

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This entry was posted on November 27, 2012 by .

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