Bailout Nation (19 page)

I
t's plain to see how historically low rates led to a housing boom. But how did something as seemingly innocent as rising home prices lead to a subprime mortgage crisis and create the great Bailout Nation circa 2008-2009?

We've seen how these mortgage-backed securities were rated triple-A, the highest designation, by the top credit rating agencies. The paper was based on mortgages originated by legitimate Main Street banks. The RMBSs were securitized by the top Wall Street firms. The underlying mortgages were frequently funded and purchased by government-sponsored enterprises (GSEs), such as Fannie Mae and Freddie Mac.

Buyers of these securities should have paused a moment to consider one simple fact: These CDOs rewrote the laws of economics. They promised to be as safe as U.S. Treasuries, but paid out a significantly higher yield. In other words, for the same exact risk, the reward was much greater. This should have been recognized as an impossibility. In the markets, greater reward always means greater risk. Someone would either be winning a Nobel Prize in economics—or going to jail.

It was the financial equivalent of cold fusion. Managers were getting something (increased yield) for nothing (identical low risk). That this was not clearly recognized immediately was a function of both
selective perception
and
cognitive dissonance.
Managers wanted,
needed
to believe these securities could solve their yield problem. Rather than challenge the fundamental economic flaw of CDO math—greater performance for the same amount of risk was impossible—they instead simply bought into the scheme.

Over the past few years, a variety of techniques have been employed to get more yield without taking on
considerably
more risk: Some managers crept further and further down the quality scale in exchange for higher interest rates. Some took on just a little more risk, hoping no one would really notice. Others borrowed money in nations with low interest rates and invested it in countries with higher rates (aka the carry trade). Some used leverage, although that has a variety of inherent problems. Some clever folks tried complexity, which hides the additional risk you are taking on from the view of most observers.

One particular group of folks checked the box marked “All of the above”: hedge funds.

Aggressive fund managers borrowed lots and lots of money from their prime brokers and, suitably leveraged up, went out and dove into the alphabet soup of RMBSs, CMBSs, CDOs, CLOs, and CMOs.

Under normal circumstances, that might not matter much. However, these were not normal circumstances. The demand for these securitized products created a land rush for mortgage-backed securities. From 2003 to 2007, there was an enormous creation of credit:

I
n hindsight, it's clear this “more yield, same risk” scheme was a house of securitized cards destined to come tumbling down. But in the early part of the aughts, fund managers wandering in the desert created by Greenspan's radical rate cutting were just discovering securitized mortgage products. To many, they seemed a reasonable way to capture the higher yields their clients were demanding. From 2002 until 2006, AAA-rated CDOs seemed like manna from heaven.

The housing boom was the ideal environment for these products, and residential mortgage-backed securities (RMBSs) were especially popular. Bundling thousands of mortgages together, Wall Street wizard's created CDOs composed of a series of tranches of underlying mortgages of varying quality. Each tranche had a different risk level, and offered higher (or lower) yield levels. This allowed fixed-income managers to choose exactly the returns they needed. Those seeking greater returns had to take on more risk—but AAA or AA was still investment grade, right?

Note that this wasn't a U.S.-only phenomenon: Mortgage-based paper was repackaged as CDOs and purchased en masse by fixed-income managers around the world. Global fund managers—in Europe, in the Middle East, but especially in Asia—were big buyers of mortgage-backed securities. This is how the U.S. housing bust became a global issue. It explains how subprime borrowers in Southern California could default on their mortgages, setting off a chain reaction that ended with the collapse of Iceland.

This was the financial bedrock upon which our modern Bailout Nation was built. When that bedrock was found faulty, the entire economic edifice built atop it crumbled.

Source
: By permission of John Sherffius and Creators Syndicate, Inc.

—Confucius

 

 

H
ow did all manner of exotic subprime mortgages and their derivatives wind up festooned all over the global financial system? To understand that question, we need to put on our detective caps and do some digging.

In the old days, traditional lenders—depository banks—accounted for the lion's share of mortgage writing. They are fairly well regulated by both the Federal Reserve and the Federal Deposit Insurance Corporation (FDIC). These banks typically are run in a very conservative, purposeful fashion. Banks have a funny way of looking at lending:
It's not the loans you reject; it's the ones you approve that get you into trouble.

Hence, traditional lending tended toward borrowers who could put down a large down payment, had good income and credit histories, and could service the debt easily. These were the prime borrowers, and they tended to make safe bets for lenders.

Over time, other nonthrift participants got increasingly involved in the home loan industry. Independent mortgage brokers were able to steer loans to
any
bank. The savvy ones developed a reputation for knowing which bank offered the best rates at any given time.

Some developed an expertise in home buyers who did not quite meet the high standards of the major banks. Borrowers with lesser bona fides were considered subprime. Perhaps their credit scores were not as strong, their down payments smaller, or their incomes not as great. This was a small niche market that was serviced by a handful of firms. Given the inability of subprime borrowers to get a prime loan, along with the increased risk of default due to the weaker ratios, these lenders were able to charge a premium for their services.

Most large, reputable banks steered clear of subprime. It was too messy, with too many defaults. It simply didn't fit in with their risk-averse model.

Starting in the early 2000s, conservative lending became unfashionable and aggressive risk taking appeared. Fiscal prudence was replaced with weakened (and eventually, irresponsible) lending standards. It soon reached a point where much of the industry tossed out the garden-variety mortgages that had served them so well, and replaced them with jungle-variety loans.

In the new era of banking, “lend to securitize” became the industry's standard operating procedure, and the subprime mortgage machinery's assault on suburban America began.

O
ne of banking's major changes in the latter part of the twentieth century was the rise of the nondepository mortgage originator. Often located in California, these lenders used an army of independent brokers to push their products. Like so many mushrooms in cow dung after a summer rain, these brokers sprouted up in the early 2000s. They were the prime salespeople of the subprime adjustable-rate mortgage (ARM).

These firms were not like traditional banks. They had no depositors to provide them with a capital base. They started with seed money, but once that grubstake was exhausted, they could not write more loans. To do more business, they had to move the existing paper off their balance sheets and replace it with fresh capital. Hence, they had little choice but to sell the mortgages they underwrote just as soon as they could. They found a willing buyer in Wall Street, which was all too happy to purchase these loans for securitization purposes.

Wall Street's insatiable demand for mortgages to securitize led originators to completely abdicate all lending standards. If you could fog a mirror, you qualified for a mortgage. The best example of this was found in California. Anthony Ha reported in the
Hollister Free Lance
that Alberto Ramirez, a strawberry picker earning just $14,000 a year, was able to obtain a mortgage to buy a home for $720,000.
¹

That was just the most egregious example. Anyone with a modicum of experience in the mortgage industry will confirm the rampant disregard for lending standards during the boom years. This was very different from the way traditional banks operated. To your local banker, a mortgage is a reliable and secured form of lending. With few notable exceptions, lending standards by banks had always been rigorous. When a traditional depository bank originated a mortgage, it assumed it would hold on to the loan for the full 15- or 30-year term; depository banks felt no compulsion to resell them. Guarding against default over the life of that loan was the key to not only being profitable, but staying in business.