Mortgage securitization blew up the home price bubble and detonated the financial crisis. How?
The investor couldn't know what he was buying, since sales documents lied. There was no effective recourse by investors to originators and distributors who committed fraud. Hence quality was inevitably sacrificed to volume and margin.
A recent conversation with bank credit risk managers shows that proposals now on the table won’t prevent a repeat.
Me: "How do you verify ability to pay on mortgage applications?"
Banker: "We use IRS Form 4506-T, IVES. Costs $2."
Me: "That information is often more than a year out of date. Besides, it doesn't show stability of income. You could do much better."
Banker: "So what? We sell all the mortgages to the GSEs. IVES satisfies them. There'll be additional requirements, but we aim to avoid more verification of income and employment."
Translation: We don't care about actual ability to pay, we only have to satisfy the GSEs. We’ll take the cheapest route to satisfy requirements — even if this doesn't assure loan quality.
Yes, there will eventually be a mortgage ability-to-pay regulation, and even a new law. Tiny shreds of risk retention might survive.
Nothing will help if the originator of the mortgage has little or no incentive to care about quality. Because the devil is in the details. If the originator will not be severely hurt by losses, it will continue to bulldoze short cuts. The least scrupulous originator generates the highest volumes and profits. To reverse this race to the bottom, make the originator take the credit and fraud losses. "Full recourse." That's how the system used to work.
A 5% risk retention requirement won't do it. With 5% risk retention, if 10% of your mortgages go to 0, you'll lose a total of 0.5% of principal over the life of the loan. Small compared to the margin on origination and servicing. Yet 10% losses on mortgages would be systemically catastrophic. Historical loss rates were far smaller.
Recourse to originator is proven to work, it's normal. When credit card receivables are securitized, the originator/servicer must stand behind them 100%. If it doesn't replace the delinquents, make good the losses and provide the agreed return, then it goes broke. That happened to Advanta in the recent "crisis" — and to almost no one else, despite huge surges in card losses.
Because if the wages of sin is assured death, then there will be few sinners.
Non-recourse residential mortgage-backed securities is a crazy exception, awash in moral hazard.
At present there is a wide valuation gulf between securitizers and investors, hence few RMBSs are issued without a GSE guarantee. Unless that yawning gap is closed, irresistible pressure to maintain some form of Government guarantee will continue.
Close the gap by eliminating credit risk for the securities purchaser.
Republican members of the House proposed legislative standards to make securitized mortgages safe without recourse to the originating bank. Are they serious — or just posturing? That's impossible!
If Fannie, Freddie and assorted regulators failed to establish and enforce decency — then no new standards will be either honored or enforced. Furthermore, we have already seen how industry lobbying will weaken any requirements.
They sing an endless dirge: "You guys in D.C. don't understand markets. Only we do." Humbug. What they understand is how to make money for a while, honestly or not.
Look ahead. Standardization will either fail to reopen markets fully, or it will re-establish an implicit taxpayer guarantee — more likely, both.
Has securitization of mortgages with no effective recourse to the originator become, in the 35 years since Ranieri's brainstorm, a core and indispensable element of The American Dream? Is that because home values and hence dollar mortgage volumes, fueled by securitization, zoomed far beyond the risk-bearing capacity of originators? Did the price inflation vindicate affordable housing goals? No, it rendered them unattainable.
The bubble and crisis happened simply because there was so much quick, easy, seemingly riskless money to be made through dishonest securitization without recourse.
If originators hold onto the risk and control the servicing of their production, then we'll have more honest origination and less systemic risk — without government guarantees. This can be achieved via covered bonds or through pooling similar to credit cards.
Sure, the FDIC won't like this. Depositors and taxpayers might ultimately have to cover some catastrophic losses via the FDIC. But taxpayers will pay less if originators, not GSEs, stand between them and the losses. And the prudential regulators are less underfunded than the FHFA.
Andrew Kahr is a principal in Credit Builders LLC, a financial product development company, and was the founding chief executive of First Deposit, later known as Providian. He can be reached at firstname.lastname@example.org.