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By Martin Hutchinson
Contrary to what Wall Street would have you believe, this appalling sloppiness that created the subprime mortgage scandal has not been a feature of every housing boom for the last half century. It's actually quite new, the result of the misdirected incentives caused by the mortgage-securitization business.
Traditionally, mortgage loans were made by small local institutions that took the credit risk themselves and who knew the borrowers personally. You can see how it worked in the 1946 classic movie, "It's a Wonderful Life." Actor Jimmy Stewart plays George Bailey, heir to a local building-and-loan company, who battles the evil local capitalist Henry F. Potter to change the character of his hometown, Bedford Falls, by offering affordable housing loans to the poor but upwardly mobile.
It is an appealing model, with only one real flaw; if a local savings and loan is in financial difficulty [as was Jimmy Stewart's in 1932] it will not be able to attract deposits, and no mortgage loans will be made in that locality. With the rise of interstate banking, that problem would have been soluble - mortgage loans would be more expensive in an area if a large national bank was their only potential source, but they would still be available.
The Sad Emergence of Securitization
But Jimmy Stewart and his peers were forced out of business by the 1974-82 inflationary surge, which caused short-term interest rates to rise sharply, while long-term returns on the lender's mortgage loans remained fixed. By 1982, the great majority of mortgage lenders in the United States were insolvent, in that their capital had been lost. It took nearly another decade for them finally to go out of business, but the damage had been done.
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Securitization was thus Wall Street's response to a genuine problem: the savings-and-loan sector's shrinking capital base and its limited ability to lend. There were other possible solutions to the problem, notably a federally financed S&L bailout that did not force them to disappear.
Another solution could have made use of another new Wall Street product: The interest rate swap, under which S&Ls could have locked in a fixed rate on their deposit funding, thus securing their business against fluctuations in interest rates. Through securitization, however, Wall Street was able to take control of the enormous pool of mortgage loans, which showed obvious opportunities for massive profits.
Under securitization, instead of making mortgage loans directly, mortgage bankers only "originated" the housing loans - doing whatever paperwork was thought necessary - before selling them to a Wall Street broker. The broker combined all the loans it was purchasing into a shell company, which enabled it to repackage the debt and sell the resultant products to bond investors.
Fannie, Freddie and Mac
The government gave a huge assist to Wall Street in its efforts to take over the market by establishing Fannie Mae (FAN) and Freddie Mac (FRE). Without these two government-sponsored entities (GSE), the credit risk of each mortgage would be different, so it would have been very difficult to do the first bond issues. However, with Fannie Mae and Freddie Mac guaranteeing most mortgages, the mortgage packages became quite standardized so that investors no longer needed to worry about the mortgages themselves.
In bull markets, like the one that ran from 2000 to 2007, investors would buy mortgages even without the Fannie/Freddie guarantee - especially the so-called "jumbo" mortgages for large amounts that Freddie and Fannie could not legally provide a guarantee for.
However, without Freddie and Fannie, the securitization market might never have arisen. But it did arise, and with it came a big problem. As is now quite painfully clear, the central problem with securitization is that nobody is really responsible for the credit risk:
- Instead of taking loans onto their own balance sheet, and losing money if they default, mortgage companies merely sell the loans they originate to Wall Street, pocketing a fee.
- Wall Street, in turn, retains very little of the resulting mortgage packages; it turns around and sells them to investors, who can hardly expect Wall Street to be responsible for each individual mortgage.
In fact, it's almost as if everyone connected with the mortgage has turned into a salesman. Since it's no longer necessary to have a balance sheet to originate mortgages, mortgage brokers became pure sales operations. The sales business being what it is, the more unscrupulous and aggressive the sales operation, the more business it did. To keep getting more aggressive, new products like "liar loans" were invented. [Originally known as "low-documentation" or "no-documentation" mortgages in which the prospective borrower is permitted to list such key items as income and assets on the loan application - without having to provide the documentation that's usually an essential part of the mortgage process. Since the assertions were accepted as fact, meaning the applicant could write down almost anything they chose, they gained the derisive nickname, "liar loans"].
You would expect that in a free market, the move to a new product such as securitization would have led to cheaper mortgages.
But it hasn't been so.
The Sad Reality of Securitization
Back in the 1971-1976 time frame - the period before securitization really took hold - the average differential between Treasury bond yields and 30-year mortgage yields was just over 1%.
In 2000-06, before the housing finance crash made mortgages even more expensive than they had been, the average differential was more than 1.5%. In other words, securitization has boosted mortgage costs by half a percentage point compared with the Jimmy Stewart days, something free-market theory says shouldn't happen.
But in reality, you can see just how it happened: It was driven by aggressive salesmanship.
In the days of the old "Bailey Bros. Building & Loan," thrifts weren't very profitable. Many were unable to survive anything but optimum market conditions and failed, meaning not much new capital moved their way.
In more recent times, specialized mortgage brokers and Wall Street securitizers made huge amounts of money for the aggressive sales types and quants who peopled them. Naturally, the hard sell beat out the traditional provider, at considerable expense to homeowners. As capital flowed their way, they got increasingly greedier and also more aggressive - creating such new products as the "low-documentation" loans we now refer to as "liar loans."
So each time you write out your monthly mortgage check, just remember that half a percentage point on your home-loan rate has no economic purpose at all - and is nothing more than a reward to the hard-sell artists and lordly titans of Wall Street.
With the mess the subprime crisis has made of the mortgage sector, perhaps this will change. But it will be painful. Fannie and Freddie are currently aggressively buying up more loans. Since they have far too little capital, it's possible they'll be forced into a rescue situation by taxpayers. If that happens, and Congress is on the ball, it can close them down, forcing mortgage loans to be held or sold on their own merits, without the extra government guarantee.
At that point, given the problems that have occurred, securitization will become very difficult -- there will be few investors interested in securitized mortgage bonds, which will make these once-popular securities relatively unprofitable and uninteresting for Wall Street to sell. If we are lucky, that will allow the re-emergence of local mortgage lenders, who will once again nurture relationships with their local customers and who will also hold the mortgage loans on their balance sheets.
When that happens, we'll tell George Bailey that we have a great job opening for him.
And this time around, we won't let the Henry Potters, or the greedy salesmen of Wall Street, force that neighborhood thrift into bankruptcy.
[Editor's Note: Money Morning Contributing Editor Martin Hutchinson, an expert on the international-banking and global-bond markets, has been covering the subprime-lending crisis since it broke last year. His most recent reports have been highlighting key trouble spots in the debt markets. In his most recent articles, Hutchinson has explained how Wall Street helped create the credit crisis and how U.S. investors can profit from the dollar's decline - before it rebounds.]
News and Related Story Links:
Money Morning Financial:
How Wall Street Bankers Helped Create the Current Credit Crisis.
Money Morning Financial Analysis:
It's a Wonderful Life.