Saturday, February 6, 2010

Re-creating the Dubious Foundation of The House of Cards

I will try not to let this become an arcane post on arcane points of financial regulation. But among an assortment of news items this morning that made me believe the Democratic Congress is well on its way to botching financial reform every bit as badly as it has so far botched health care reform, was a story on securitization in this morning's New York Times: Seeking a Safer Way To Securitization.

I suppose before I dip in to the article, I should explain a few basic items about securitization of loans. Securitization is the process through which a lender takes a bundle of loans, packages them together, and then sells that package to investors in the form of market securities, similar to bonds. The investors recoup their money as the loans are paid back. You may also occasionally hear about "tranches." Those are different parts of a securitized bundle of loans. The safest loans within the bundle can be sub-bundled and sold as one sort of security with one rate of return and guarantees, while the riskier loans can be sold as a different tranche with a different rate of return.

The process of securitization is not necessarily an inherently bad thing. It lets a lender spread a bit of the risk of its loan portfolio, and in return investors get something to invest in -- presumably with a rate of return that corresponds with the riskiness of the loans.

However, the way that securitization of loans worked in our economy for at least the last decade is that lenders would generate large batches of loans, securitize them, provide their own estimate of risk for the various tranches, and either sell the entire loan on the market or sell all but a tranche whose repayment was guaranteed at the expense of the higher-risk tranches. The rates of risk for the various tranches presented to investors were often grossly misrepresented. The lender's profit no longer came from the repayment of loans with interest; the lender's profit came from selling off bundles of securitized loans.

This means that a lender could generate loans with the profit guaranteed, regardless of how ill-conceived the loans themselves were or whether they were ever paid back. Loan risk was divorced from lending profit, and available credit mushroomed as lenders generated loans with nary a thought as to whether they could or would ever be repaid. Borrowers took this cheap credit and invested in homes, often basing their lending decisions on the assumption that housing prices would always rise at a rate that outpaced their interest rate. Many of them didn't just invest in a home for themselves to live in. They leveraged the easy credit into a series of home purchases well beyond their means as they tried to "flip" their way to wealth.

Even ordinary mortgage borrowers, who just wanted a place to live, found themselves forced to take on far more debt than they might have wanted to incur because housing prices had risen so high, so quickly. They could at least reassure themselves with the rationalization that the bank wouldn't loan them the money if the bank didn't think they could repay the loan, little knowing that the bank no longer cared whether or not they could repay the loan.

Thus a bubble in housing prices was created.

But remember this. The problem was not that home prices eventually fell. The problem is that borrowers were given loans that they could not repay. And the heart of the problem is that those borrowers were able to borrow money that they could not repay because securitization now fully insulated lenders from any risk that the loan would not be repaid. Those bad loans could have inflated a bubble in anything: airline stocks in the 1920s, dot-coms in the 1990s, or tulip bulbs in Holland in the 1630s. In the Naughts, it was housing.

These dubious securitized loans formed the foundation of the house of cards that was our financial system in the Naughts: easy credit for bad loans. Several more layers of unregulated risk in the form of assorted derivatives and credit default swaps were built atop this shaky foundation. I won't get into them today. Suffice it to say that the home loans defaults couldn't have wrecked our financial system without help from those other things.

Okay, so I may have tip-toed towards financial system arcana there, but hopefully you found it useful. Back to this morning's New York Times article: Seeking a Safer Way To Securitization. The article features remarks to a meeting of the American Securitization Forum by John C. Dugan, the U.S. Comptroller of the Currency, the official whose department is charged with maintaining the safety and security of our banking system.

Here's what he said that has me bothered today:

“A requirement intended to improve the securitization market by improving the quality and trustworthiness of underwriting could significantly curtail the number of securitizations that are actually done,” he said. “And that, of course, could materially reduce the amount of credit available for housing or any of the other sectors that have traditionally benefited from securitizations.”

In other words, he's worried that regulating the securitization process in a way that discourages lenders from dumping bad loans onto investors would keep lenders from generating the sorts of bad loans that created the housing bubble in the first place.

And this is what worries me today. I don't see any willingness in Washington to fix the basic regulatory failures that brought our nation to the brink of utter ruin in 2008 and that caused The Great Recession. Instead, I see Democrats who are unwilling to engage in serious reform, and Republicans who are so unable to take accountability for any of their actions when they ran the country for eight years that it's impossible to take anything they say seriously.

Oh, and let me add to that a Comptroller of the Currency who apparently seems to think that we shouldn't create regulations for securitization if the regulations discourage banks from lending money to people who can't repay it.

Yeah, I got a feeling the upcoming bout of "financial reform" is going to make the health-care debacle look like a shining city on the hill before Congress is done with it.


  1. Thanks for the useful arcana.

  2. When we moved to Gettysburg, it was at the height of crazy house prices. Rich desperately wanted to buy a house in the Gettysburg school district. This led to the discussion where I explained to him that we couldn't afford the Gettysburg school district. We couldn't afford a shack on the wrong side of the tracks in the GSD. Rich asked how other people were doing it and I explained that many of them were opting for interest only loans and variable rate loans and that mean old me wasn't letting us get one of those. So our thirty year fixed rate bought us a 2 bedroom house on the side of a mountain in the middle of nowhere. But that was what we could realistically afford. Sometimes the truth hurts and people still don't want to believe it.

    A second thought that sprung to mind was our annoyance when we got our 30 year fixed mortgage. We went to our community bank because we wanted our mortgage to be with someone we knew. A 30 year fixed with 20% down? They had our mortgage sold to someone else as soon as we closed. We were probably the good risk loan that was bundled with a poor risk loan.

    Rambling rant over now.

  3. Agreed and agreed, to both comments above.
    As usual, John's explications are crystal clear. What a difference he may have made in the Congress had he been supported properly in his campaign, then...

  4. To your point, Susan, another line in the article that inspired this post, a line that struck me a lot was the following statement, which I must preface by saying that it speaks about one little items among a very few that our Comptrollers, Dugan, felt might be acceptable in terms of new regulation:

    "... and perhaps some rules to assure that mortgages are not securitized (sold off) until the borrower has met several monthly payments."

    Amazing... in other words, mortages were sold off by the banks (securitized) immediately upon being made. And now the Comptroller things that part of the solution is to require that banks not sell their new mortgage loans until a few months have passed... Stunning.

    For me, the real question raised by the article has to do with the premise, namely that "we need a vibrant, credible securitiaztion makret to help fund the real economy going forward."

    Yeah, well, if this is what our economy has come to, then we are in big, big trouble...

  5. Thinking a little more about "securitization", the word (unfortunately too long for a MY WORD game), I am wondering if it was chosen deliberately to disguise its real meaning of the lack of security for some....Orwell may be chuckling...

  6. To call this "securitization" is akin to calling a sewage treatment system a "perfumery." The logic? Well, sewage treatement certain deodorizes that which, as they say, "happens." And by extension, to deodorize might be understood to "perfume" the neighborhood with the good old smells of nature.

  7. Lets not forget the Fed's role in creating the problem. :-)

    By their ability to print money and flood the markets with cheap easy cash, they were the engine that enabled the banks to make dubious subprime loans.

  8. Let me preface this comment by saying that I'd need to do more research to be positive about what I say next:

    I'm not sure the Fed is all that guilty on this point. I suppose cheap money from the Fed may have made it a bit more convenient for banks to manage their cash flow around these loans, but really the point is that the banks were generating their persistent cash flow from the securitization of the loans, not by borrowing from the Fed.

    Borrowing money from the Fed to loan to consumers is a very 20th-Century business model. If you borrow from the Fed to loan to consumers and keep the loans on your books, you then need to meet certain capitalization thresholds to keep getting that sugar at Prime Rate. The point of securitizing those loans is that you take them off your books altogether, you pocket the money from the investors who buy the securities, and you don't need to carry extra capital around as a guarantee to the Fed against failed loans.

    So, as near as I can tell without researching further, eliminating the Fed's role doesn't substantially change anything in an unregulated securitization loop.

  9. Yes, the cash flow was coming from the securitization of the loans, but the money for the loans was coming from the Fed's unlimited supply. When the Fed wants to loan more money it just literally creates it out of thin air.

    Capitalism depends on capital being a scarce resource. There are limits on how much is available and this drives the use of capital to the most effective areas.

    When capital becomes an unlimited resource, it can be used in ways that aren't efficient and good for the economy. In this case, irresponsible sub-prime loans.

    Think of it this way. Without the continuous supply of cheap money coming from the Fed, the banks would have only had a limited amount of capital to loan on subprime mortgages.

    They would have lent their money and then they would have had the cash flow from their securitized loans, but then they would have been out of capital and couldn't have made more bad loans.

    They would have been making some money from the securitized sub-prime loans but not as much as they would have made from solid loans that were securitized.

    It was the easy money pouring into the real estate system from the banks being able to borrow cheap money from the Fed, that was created by the Fed out of thin air that allowed the housing bubble to inflate.

    Yes, allowing the banks to get the loans off their books allowed them to skirt the capitalization thresholds that were in place, however, allowing them an essentially unlimited supply of cheap cash is what let them keep on making bad loans.

  10. What's interesting about the financial crisis is that in the midst of our woes, many traditional lending institutions actually had great if not record years. Many of the banks that flourished in 2008 share some core banking values. They maintain banking standards that have been around since the mid 1800's. Strict loan to value standards, decent consumer credit scores and most important, making loans that are credible enough to hold instead of being launched into the economic stratosphere where bad things tend to happen. It doesn't matter how much money is made available for borrowing if strict lending standards are followed. As long as there are secondary markets available, banks are going to continue to make loans that they know are bad. We need a system that cares. The system that has the secondary market that's currently in place cares not about the most important part of the system, the borrower. Sometimes caring about the borrower does involve saying... right now you don't qualify to borrow, but work hard at cleaning up your financial life and come back to us when you can show that you have become more responsible. As with anything today, it seems that we have made a complicated mess out of something that could be easy all due to greed. KISS... Keep It Simple Stupid...

  11. What's also interesting and relevant, Marcus, is that a lot of those banks that took more conservative approaches were roundly criticized for doing so because they weren't generating the level of quarterly profits generated by the financial institutions that were involved in all of the fiscal shenanigans.

    It somehow reminds me of steroids in football and baseball during the 1980s and 90s, when there wasn't any testing. Somehow during that era the guys who *weren't* on the juice became the bad guys because they obviously weren't willing to put the team first.

    And to push the analogy to the securitization comments in that article further, it's as if the Comptroller of the Currency is now saying, "Well, let's not do anything rash like testing. These boys understand that it was wrong to take steroids. They promise not to do it again and to instead find wholesome, natural ways of building strength (Wink, wink. Nudge, nudge.)"

    Good heavens, it's as if Bud Selig was put in charge of regulating our nation's banking system! (Okay, that's too mean. But you all get my point.)