AEI’s March 28, 2007 Subprime Seminar – III
Almost every homeowner knows that a mortgage is a complicated beast, but have you ever given a thought to the people who are putting up the money for that loan? In the "good old days," the money would have come from your neighborhood banker, and he would be getting that money from the deposits in the bank. Nowadays, however, it’s not that simple. Mortgages are pooled together and funded collectively. That process is called securitization, and it has become more and more complex over time. The people and institutions who are actually putting up the money these days are those who buy products like bonds that ultimately contain mortgages.
Just like it’s possible to get into a toxic mortgage where you don’t know you are getting in over your head, you might buy a "toxic bond" that is a riskier investment than you thought. Over at Calculated Risk, blogger Tanta has been posting a series [1] explaining the securitization process for Mortgage Backed Securities (MBS), and the most recent installment went into detail on how risk is distributed around. The AEI has been following this issue for some time, and at their March 28th seminar,[2] they discussed whether the present system conveys to the purchasers of bonds an honest picture of the risks those bondholders are taking on. That’s just the flip side of the predatory lending question.
Independent banking consultant Bert Ely is something of an institution at the American Enterprise Institute. Whenever they have a panel discussion on banking it is customary for him to ask the first question. This time he focussed on whether modern mortgage securitization has actually broken the essential linkage between risk and the ultimate lender.
Two panelists picked up the ball. Both responses confirmed that this is a serious issue. I’ve taken the liberty of emphasizing some of the interesting bits. Transcript times represent the audio recording of the seminar. The video times run about 20 seconds greater.
Bert Ely (1:20:30): Bert Ely, banking consultant. You know an interesting question here is what are the underlying causes of this mess, and in particular what role does securitization play in it. And I’d like to just read to the panel this … what I thought was an interesting comment that the moderator made yesterday in a Congressional hearing [3] and get your reaction to him. He said, "securitization typically breaks the link between the originator of the mortgage loan and and who actually bears the credit risk. This usually results in riskier and less careful lending. The financing engine of the subprime mortgage boom was securitization. This structure has greatly suffered, as is now clear. From just this break in credit decisions, from credit risk breaking / risk bearing. The subprime mortgage financing system is very far from this ideal of linking credit risk to the lender." [4]
What are your thoughts about that and, in particular as we look ahead, both in terms of what will happen in the marketplace and from a public policy standpoint, what does this say about the fate of mortgage securitization particularly in the subprime area.
Alex Pollock (1:21:35): Outside of the fact that the comments were brilliant, we’ll see if the other panelists want to react. … to the question, the question is, the breaking of the credit decision from the credit riskbearing.
Tom Zimmerman: Right, but all these financial innovations, I know, I come out of a commodity background and a lot of people were really concerned about all the speculators in the corn markets several years ago, you know. You get a lot of financial innovation, and a lot of risk gets passed around to different people — is that good or bad? I don’t … that’s been debated for the last hundred years I guess. And securitization is just one more of those advances that allows … you know there was one time when we had a mortgage market that was, you know, done mainly out of the thrift industry. And now was it good to get away from those local decisions where every banker knew his customer? I mean, maybe that was the best way, maybe we should go back to a thrift industry where the thrift would actually know, ‘Mr. Jones, I know you and your family and we’ll take care of you.’ Yeah, things are different, we’ve moved ahead, but I’m not arguing that’s not part of the problem, I’m just saying I doubt if we’re going to go back. It’s a proven mechanism for transferring risk, moving, you know, moving risk around, owning what part of this risk you want, whether you want to be a servicer, you want to own the risk of the loan, you want to own the servicing, none of the above … I agree that there in all these markets there is this dislocation between, often in the …
Here’s a great story, a friend of mine went to Japan a year ago, was talking with one accountant, and he was talking about investing in some subprime securities, and the accountant said, ‘no, no, no, I don’t want any subprime securities, I want a CDO.’ [laughter] [5] So, you know, that’s, yeah, there’s an issue, but I …
Alex Pollock: Thanks Tom, Chris?
Chris Whelan (1:23:35): Yeah, Bert’s absolutely right, I think, if I understand the implication, the union between the Wall Street sales machine and the origination of the loans is why we have this issue. When the Street figured out that they could buy production from everybody and anybody, and package it up and sell it, and make more money on that than on almost any other product in the house except for over-the-counter derivatives, which are about the same magnitude, that was the boom, and if you just look at banks, if you exclude the independent broker-dealers, what else were they going to do to make this kind of money.
I mean I was telling people at lunch today … I have friends in the banking business in North Jersey who had clerks who were filling out loan applications who made hundreds of thousands of dollars in a single year, just on commissions from their production. That’s another red flag, by the way. But I think ultimately you’ve got to remember that the deals that are rated investment grade oftentimes are rated that way because a rating agency gave them that blessing based on the collatoral and the enhancement, and there’s probably a hedge fund or somebody else who’s provided a credit derivative enhancement to that structure, and they may have to be called upon to perform. And if we see default rates go back and achieve the same levels we saw in the early 1990s or higher, which is what some of the data you’ve seen today suggests is possible, then we’re definitely going to stress those assumptions. And I think you’re going to see not only rating agencies, but a lot of hedge funds who have been writing default insurance below economic rates really get into a lot of trouble.
You know, go back to what I was saying before. People were being paid a point or two points a year in a premium on a credit derivative contract to insure a portfolio that’s going to throw off ten or fifteen percent a year defaults. You know, what’s wrong with this picture? And that to me is the underlying issue, really, with Bert’s question is, you know, these securitizations are seen as good sales. But maybe they won’t be, but we’ll leave that up to the trial lawyers.
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Notes and References
[1]: "MBS For UberNerds III: Credit Risk, Credit Enhancement, and Ratings", by Tanta, CalculatedRisk blog, May 5, 2007. Links to parts I & II are at the beginning of the part III post.
[2]: "Mortgage Credit and Subprime Lending: Implications of a Deflating Bubble", Event, American Enterprise Institute & Professional Risk Managers’ International Association, March 28, 2007.
[3]: "Subprime and Predatory Mortgage Lending: New Regulatory Guidance, Current Market Conditions and Effects on Regulated Financial Institutions", House Subcommittee on Financial Institutions and Consumer Credit Hearing, March 27, 2007.
[4]: "Subprime Mortgage Lending Problems in Context (PDF)", by Alex Pollock, testimony at [3] above, March 27, 2007. Here’s the passage Bert was quoting from.
In economics, nothing is ever free. To preserve the fixed rate mortgage no longer provided by savings and loans in the 1980s, it was necessary to depend on vastly expanded securitization. Securitization typically breaks the link between the originator of the mortgage loan and who actually bears the credit risk. This usually results in riskier and less careful lending.
The financing engine of the subprime mortgage boom was securitization. This structure has greatly suffered, as is now clear, from just this break in credit decisions from credit risk bearing.
I believe that in an ideal mortgage finance system, the loan originator should always maintain a significant credit risk position in the loan, which creates a superior alignment of incentives– this is always my advice to developing countries as they consider housing finance ideas. The subprime mortgage financing system is very far from this ideal.
[5]: A Collateralized Debt Obligation (CDO) in this context is a security cobbled together from the sludgiest bits of the the subprime MBS. There will likely be a detailed discussion in a future episode of [1].
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Another classic Bert first question took place at a February 3, 2005 AEI seminar on receivership powers for the GSEs. This one did have a transcript, and I provide links, annotation, and some irreverent commentary at my July 31, 2006 post The Safety Net That Never Was – Part III: Break out the Popcorn and Watch this Movie.
Just got some kind words from Tanta, and …
This relates to [3] and [4] above.
“After the Subprime Lending Bust”, by Alex Pollock, AEI Online, May 15, 2007.
Bert got a nice quote in this important article about hedgies going into default servicing.
“Bad Loans Pit Vranos Against Cayne as Hedge Funds Outbid Street”, by Bradley Keoun, Bloomberg, June 18, 2007.