Mortgage Lending and the Financial Crisis: A Few Thoughts

I attended the Federalist Society annual convention in Washington, D.C., last week. One of the panels was entitled "The Latest in the Financial Services Crisis: Government Control v. the Free Market Roundtable". There were eight panelists, including a professor, a judge, a couple of people from think tanks and a special interest representative. They all had their points of view, some of them probably formed before the crisis even started. But of all the panelists, the one with the most convincing explanation of what happened was none of those. Instead, he was from the Office of Thrift Supervision in the Department of the Treasury.

The man from the Office of Thrift Supervision ("OTS") said the financial crisis was a perfect storm of everybody messing up at the same time, borrowers, lenders, government, mortgage brokers, rating agencies, etc. He said in the past mortgage delinquencies were usually the result of a divorce, loss of a job or a health problem. Now, however, there is a new problem, the mortgage itself is the problem.

He noted that housing and mortgages have moved to a world of private label securitization. In the old days (like when we bought our first house 30 years ago), you borrowed from a bank or a savings and loan. And they kept the loan; they didn’t transfer it to somebody else. Your loan was on their books and it was going to stay there, so they cared about whether you could repay.

But in the last few years the banks haven’t been keeping the loans. The profit wasn’t in keeping loans; it was in originating them. Many mortgage loans weren’t even made through banks. They were made through mortgage brokers, who just arranged the loans for somebody else. In some cases the loan was sold to another party. But in many cases, a large number of loans were bundled together and then cut up into a whole bunch of little pieces, with each piece owning a very small part of a lot of different loans.

It was the next part that was the key to getting people to actually be willing to buy these little pieces. Rating agencies were hired to give a rating to these groups of loans, telling investors allegedly how safe their investment would be. Once they got a good enough rating, the pieces were sold to other banks or investors (or the entire population of Iceland).

What this resulted in was a large number of people who were involved in the mortgage process but who made their money from the process of making and selling the loans, instead of from actually collecting the monthly payments. Brokers, rating agencies, banks. They originated the loans. They rated the loans. They sold the loans. None of them had any credit risk. The credit risk was transferred to people who were buying small pieces of something which itself was made up of lots of pieces.

The theory was that, with so many loans bunched together, a default on one of them would not affect the whole. But once defaults started, nobody could tell what their pieces of pieces really represented. So the rating agencies who once reassured investors by providing good ratings now caused panic by taking away those ratings. If you assumed house prices would always go up, it was easy. But once some houses started going down and a few people defaulted, you had to assume the worst because you couldn’t figure out what your pieces of pieces really represented.

Borrowers were at fault, too. As the person from the OTS said, no document loans and low doc loans were originally introduced for borrowers refinancing their loans. They had already established a payment history of four or five or six years. Why did they need to provide all the documents for a regular loan? But then no doc procedures started to be used for new loans, not just refinancings. That allowed people who wanted to lie, or who were "encouraged" by their broker to lie, to get loans they did not deserve. It also facilitated the whole process of people using their house as an ATM. It became easy for people to just take out a new mortgage to pay off your credit card balances. And then they just ran-up their credit card balances again.

Also, too many borrowers were taking out loans that were too big. 100% loans were not uncommon. That would mean, in a state like Illinois where taxes are paid a year in arrears, that a buyer actually come away from a house closing with money. Combine a 100% loan with an adjustable rate mortgage or a short, fixed term that needs to be refinanced in a few years, and you are asking for trouble.*

So, in sum, what caused the problem? First, though, let me note the reason to figure out what caused the problem is not to assess blame but to figure out how to avoid the problem again in the future.

Among the causes were these: Risk layering. Securitization of loans so complex that it was impossible to know what you were really buying or owned. Abuse of no-doc and low-doc loans. Lying. Refinancing to take more and more equity out of your house. 100% loans. (A no doc or low doc loan with no down payment is just silly.)

But mostly, the problem was that we had taken the risk out of mortgages for too many people in the process. Mortgage securitization allowed bankers not to be concerned with the borrowers’ ability to repay the loan because the credit risk was immediately moved off their books. Too many people were making money from closing mortgage loans, as opposed making money from borrowers repaying mortgage loans.

It reminds me of an interview with Phil Gramm that appeared in The Wall Street Journal back in about August. Gramm was defending large compensation packages for company CEOs on the basis that a good CEO could make hundreds of millions of dollars, or more, for a company and its shareholdesr. If they could do that, why shouldn’t they get paid mega-bucks, he asked.

But the point is the same: There was no risk for the CEOs. It is true that a good CEO could make a lot of money for his company and its shareholders by doing a good job. But he wouldn’t lose money himself if he failed. There was, effectively, no downside (or at least not enough downside) for him personally, so there was no reason for him not to roll the dice. The odds might not be good for the company but they were fine for the CEOs.

That is the bottom line for mortgage lending and the financial system, too: We need to put real risk back into the system so that the people in the system can and will act properly.

---------------
* Arizona even has a law that prohibits lenders from bringing a deficiency suit against single-family or two-family houses (on 2.5 acres or less).