They were financial inventions that would limit risk, provide great returns, were grounded in solid assets. They were perfect, and perfectly popular. Then they failed, and nobody wanted them. Residential mortgage-backed securities, structured investment vehicles, collateralized debt obligations, collateralized mortgage obligations—all beautiful models, now tattered and forlorn.Yet, upon closer scrutiny, the welding that holds mortgages and investment vehicles together was bound to fail, due to a poorly understood tension between home owners and investors.
As the great credit catastrophe continues to unfold—in the second half of 2007 reported losses were $70 billion—it infects everything from “safe” government investment pools in Florida to remote Norwegian towns to Japanese fisherman and farmers. Some smaller banks may have been prescient enough to avoid the tempting dishes; some investment banks may have been alert enough to time their exits with great success. But the credit market remains disturbingly dysfunctional, and bank stocks in general are being pummeled — even those of the very best performers — in the wake of sagging investor confidence.
What’s predictable is the boisterous blaming and shaming; the rolling of high-level heads along with the news of thousands of financial-sector pink slips; and the sanctimonious scolding of suddenly wakeful politicians. But how does this fix the problem? It doesn’t, and the argument that this smacks of the fallout of the savings and loan crisis of the early ’90s doesn’t hold water. The aftershocks of this tsunami are being felt globally, and there’s no going back.
The idea of asset-based structured investment vehicles is not insane. Indeed, they would seem logical partners of the commodities markets. Orange groves are subject to frost, blight and drought. Orange groves can, at times, produce more fruit than desired. The futures market spreads the price risk inherent in these factors; the options market mitigates the price further. Oranges are assets. Copper, oil, gold—all assets accompanied by particular risks, all with fully developed futures and options markets.
Financial engineers viewed residential mortgages as a reasonable asset to shoehorn into an SIV. After all, mortgages represent brick and mortar, and the home, something solid. This solidity would similarly inform the SIV, with promises of greater efficiency, lower costs and increased access to credit in the mortgage market.
What the architects of this new financial age ignored was the traditional social component baked into the legal and financial contract struck by banks and home owners and how the vast and voracious secondary market would alter that. Little consideration was given to the possibility that the much vaunted risk models could fail.
Mortgages, the industry is learning the hard way, are vastly more complex and emotionally charged than other “commodities.” They are not oranges or pork bellies. Abandoning the mortgage-backed market is neither possible nor desirable, but a better, more sophisticated understanding of the relationship between the underlying securities (the dream of owning a home) and the dynamics of the secondary market (the dream of profits) must arise.
This long-ignored tension has now opened a fault line for all to see that must be bridged before the mortgage industry can heal itself: On the one hand are the millions for whom a mortgage means home, as has been the case for a century now. In the U.S., mortgages were popularized in the early 1900s, despite the onerous 50 percent down payment required. President Franklin Roosevelt revived a moribund mortgage business in 1934 with the creation of Federal Housing Administration, mortgage insurance and the 30-year fixed-rate loan; in 1938, he created Fannie Mae. The VA allowed World War II GIs to secure mortgages without down payments.
On the other hand are investors. For much of the past 100 years, investors were, in fact, the lending institutions. Often located in the community and sometimes even owned by the local populace through credit unions or thrifts, these lenders tried their hardest to vet their debtors; they obviously had a vested interest in doing so and that ensured strong fundamentals, and that the mortgage was right for the borrower.
But a strange thing happened over the last decade: As more and more banks sold off the mortgages they originated and investors in those mortgages became more remote from the original community, the balance of power shifted, too. The result? For much of this decade, until the subprime crisis arose, the community of global investors drove the issuance of mortgages, not the homeowner. Banks and mortgage companies scrambled to fill the voracious appetite of these investors with less and less regard for the borrower. And while few can argue against the profit motive, the risk models didn’t account for the change, and so the market gorged itself on subprime paper.
The pendulum of power swung too far into the investors’ court. The market must now seek a more rational balance.
