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.