By Martin Hutchinson
Director of Global Investing Research
If we travel back in time to the period from 1972 to 1978, we would find that the average "spread" between conventional 30-year home mortgages and long-term Treasury bonds was 1.09%.
From that distant point, let's fast-forward to the stretch from 2000 to 2006. The "spread," then, was 1.59%.
In other words, in the context of overall interest rates, you are paying half a percentage point more today than you would have 30 years ago. So with a 5% long bond, you would have paid 6.09% for your home mortgage back in the 1970s, compared with a rate of 6.59% today. And yet, the Wall Street mortgage brokers of today are making far more money than their counterparts were back in the day of Jimmy Stewart's George Bailey, and the friendly Downtown Bedford Falls Bailey Brothers Building & Loan.
Do ya think there might be a connection?
As anybody who has lived in an economically attractive suburb [without a butler to answer the door and telephone] will know, salesmanship is the bane of life in these United States. And this is especially true in the home-mortgage market. Back in the 'Good Old Days,' as viewers of the 1946 cinema classic "It's a Wonderful Life" will recall, if you wanted a home mortgage, you saved for several years with the Building & Loan, and then if Jimmy thought you were an OK guy with a decent character and were also a reasonable credit risk, you got one.
This resulted in a high level of savings, and collectively allowed lots of folks in Bedford Falls to buy homes they otherwise could never have afforded [so they'd end up living in a rat-infested dump in Potter's Fields, the small-town slums owned and operated by Henry F. Potter, the "richest and meanest man in Bedford Falls"]. And because there were hundreds, if not thousands, of Bedford Falls all across the country, this system also resulted in a high-rate of savings for the entire U.S. economy.
It was a good system, too, and everyone knew it. So that meant that all the Jimmy Stewart lenders all across the country were very careful about just who got home mortgages, because their Building & Loan balance sheets were on the line if mortgage recipients defaulted and losses occurred. And in those days, they were real losses – not the kind that could be hidden behind quarter-after-quarter of supposed "one-timer" charge-offs, the kind of serial write-downs that have become standard operating procedure with so many companies that takes real effort to tell how their businesses are actually doing. And that's just how those companies want it.
There was a lot to like about the Bailey Brothers Building & Loan approach to the home-lending business. But there were also two major problems:
- First, in some of the most-rapidly growing areas there weren't enough savers to satisfy mortgage demand, so it became difficult for lots of prospective homebuyers to get a mortgage.
- And, second, with the invention of the money market fund in 1974, savers found that they had alternatives that sometimes yielded more than their account at the local Building & Loan [which, by then, were called savings & loan associations, or S&Ls, to be more in tune with the times].
Those were the salad days for the local S&Ls. Executives used the so-called 3-6-3 strategy, which enabled them to be both highly profitable, and quite happy, at the same time. They attracted capital by paying depositors 3%, loaned it out at 6%, and were out on the golf course by 3 each afternoon.
But the 3-6-3 days didn't last. As interest rates rose during the 1970s, S&Ls found that they had to pay more for deposits than they were earning on the mortgages that they'd already made, and more than they could even charge for new mortgages, and still be competitive. By 1982, many S&Ls found that most of their capital had been wiped out. In some regions – such as Maryland – the S&L crisis actually hit full-force by the middle of the decade; by the late 1980s, it was a nationwide problem.
That's where Wall Street stepped in. Some home mortgages – for low-income borrowers – had always been government-guaranteed through the Ginnie Mae program.
But, between 1968 and 1970, Fannie Mae (FNM) and Freddie Mac entered the market, with each essentially putting a "sort of" federal government guarantee on home loans. With a government or Fannie/Freddie guarantee, these loans could be "securitized," or packaged, by Wall Street and sold around the world as mortgage bonds. (This would have been impossible without the guarantee because the investor would have had no secure means of collecting payment from a package of mortgages that had been collected all across the United States). Once the S&Ls were out of the game after the early 1980s, selling mortgage bonds became the most efficient way of financing mortgages.
What's more, all the low-paid, boring, retail-banking skills that the S&Ls had specialized in – such as knowing the borrower and analyzing his credit – became irrelevant. If you used a mechanized system of credit scoring, it didn't matter if some of the mortgages went bad; they could be sliced up, given debt ratings, and then sold to German banks looking for profit streams or international hedge funds.
The highly personal hand holding and community-relationship building that was crucial in the days of the Building & Loan gave way to the now-more-lucrative key skill of sales. And in a market environment like the one we had from 2003 to 2006 – where interest rates were low and credit was easy to get – both retail salesmen in the mortgage banks and the brokers, institutional traders and salesmen on Wall Street quite literally made out like bandits. So, too, did the lawyers.
With interest rates low and fairly stable, it would today be perfectly possible to recreate the S&L successors to the Bailey Brothers Building & Loan. The ideal institution would combine the highly personalized service of the S&Ls of yesteryear with some off the financial advances of today to create the modern-day Building & Loan.
Imbalances between regions could be smoothed out by money market funds, which would offer wholesale deposits to those S&Ls in more-rapidly growing regions that need the additional capital to help construction keep pace with the higher demand they face. Interest-rate fluctuations during more-volatile periods (unlike today's market, in which rates are fairly stable). Interest rate fluctuations could be smoothed out through the use of derivatives — but wouldn't need very much attention in a market like today's, where interest rates are low and fairly stable. As was true back when George Bailey was still at the helm of the Building & Loan, mortgage loans would be made locally, and under normal market conditions, a prospective homeowner would require several years of saving to build up the down payment.
As the interest-rate comparison at the start of this article suggests, mortgage rates under such a system would be about half a percentage point cheaper for borrowers than today's securitized mortgage-bond market. But there is a downside: It would create only low and medium paid jobs, spread throughout the country in each local community.
As such, it would probably be unacceptable to Wall Street. Pity!