Solving the Securitization Problem: Some Suggestions for Regulators

Securitization is a very interesting topic and one which has aroused heated debate. Based on my last post, I want to clarify I few things about the role of securitization in the credit crisis. The blanket statement that securitization caused the credit crisis is overly simplistic and quite misleading.

In my last post I illustrated that in the years leading up to the credit crisis, securitization created moral hazards. However, the foundation of the moral hazards that arose were not so much created by securitization per se, but rather the lax regulation that allowed it to operate with few rules.

Securitization actually has many benefits for everyone (not just the banks which profited immensely). First, securitization lowers the cost of credit. What this means is that borrowing money is cheaper; small businesses, large businesses, and individuals alike benefit from cheaper credit in the form of lower interest rates on loans. Second, securitization expands credit – more opportunities are created for borrowing (see my prior post on the topic). Cheaper and more abundant credit fueled economic expansion and innovation, creating new jobs. 

The problematic moral hazards that occurred were not due to securitization. By this, I mean that securitization does not inherently have to cause a situation of moral hazard. This is a key element of the story. In fact, I can think of many ways that regulators could have allowed securitization to exist and eliminated moral hazards. For instance, let’s say a mortgage lender originates one thousand mortgages and then securitizes these into a mortgage pass-through security.  If it sells the entire mortgage pass-through security to investors it will have no concern for the quality of the mortgages that were originated. Future defaults by borrowers will not cause the bank to lose money, but rather the losses will be the burden of investors that bought the mortgage pass-through security. However, if regulators were to require the bank to hold onto a certain portion of the mortgage pass-through security, the bank’s interests would be aligned with the investors. Both the bank and the investors would then have an inherent interest in making sure borrowers do not default.  Tragically, no such regulation existed and even today, a full two years since the start of the crisis, the government has failed to implement any such meaningful regulation to correct this problem. 

Moral Hazard Here, Moral Hazard There

One of the major themes in this story is that of moral hazard. If we recall the classical mortgage model, banks originated loans to borrowers and the banks held those loans, receiving principal and interest.  In this situation, the bank is highly motivated to perform due diligence on the borrower. What is the borrower’s FICO score? Do they have a history of credit problems? How much other debt does the borrower have? Has the borrower’s income and employment been verified? All of these things are crucial to the lender if they want to minimize the possibility that the borrower will not be able to pay off the loan. We call the inability of a borrower to repay a loan “defaulting” and when many borrowers default on loans at the same time, the lenders lose a lot of money.

All of these due diligence questions that we have discussed can be summed up under the umbrella term “underwriting standards”. Underwriting standards refer to the level of scrutiny the bank performs on the borrower. For the bank, the upside of stricter underwriting standards (more due diligence) is that the bank will most likely weed out risky borrowers and there will be less defaulting loans. The downside, however, is a lost business. All the risky borrowers that the bank declines because they don’t pass the stricter due diligence are lost business. It is a trade-off that banks must consider.

But wait. Banks no longer give loans to borrowers and then hold these loans until they are paid off. Most loans are securitized in mortgage pass-through securities! There is an inherent moral hazard now. The banks no longer have to worry about performing detailed due diligence on a prospective borrower. Because really, the bank doesn’t care that much if the borrower defaults: they no longer hold the loan! The loan has been securitized in a mortgage pass-through security and sold to an investor.  And so underwriting standards got less and less rigorous – lenders allowed individuals to borrower without verifying information and many individuals that would never have been able to borrower before, were now getting approved for large loans. As the story unfolds we will see that these borrowers would never be able to pay back these loans. 

Culpability and Emotions

It has now been two full years since the credit crisis began. In my opinion, the credit crisis, even more so than the ongoing war in Iraq or Afghanistan, provokes strong emotions. Fear, disdain, contempt, hatred, scorn, and jealousy are just some of the many emotions that have been provoked by recent economic events. Is it our constant infatuation with money that provokes these emotions, or perhaps it’s the proximity? Is it easier to get emotional about something happening here in America, rather than something halfway around the world? Naturally emotions tend to get directed towards certain ideas (capitalism?), people (Dick Fuld?), and institutions (the Fed?). We chastise and criticize many for what happened. And everyone has personal thoughts about who is to blame. We will continue the story of how we got to where we are, but I open the floor to all to share personal thoughts on who/what is to blame. Please feel free to post in the comments section and I will anonymously aggregate the comments into a blog post. 

A Dry Primer on Monetary Policy

To understand why interest rates were declining in the years leading up to the credit crisis we need to take a step back and look at some broader concepts in economics. The U.S. Federal Reserve has the difficult task of trying to promote general economic prosperity. In broad terms, economic prosperity can be thought of as low unemployment, low and stable inflation, and high Gross Domestic Product (GDP). The concept of GDP, although it sounds complex, is quite simple. GDP is the sum of all labor and services performed in a country. It is the sum of the output of every member’s contribution: the value of all cars produced by Ford, all of the computer chips manufactured by Intel, the value of all of the services offered by McKinsey Consulting, etc. Higher employment almost always leads to higher GDP – more people are working and contributing to the total output of society.

So how does the Federal Reserve control employment, GDP, and inflation? The primary tool the Fed uses is interest rate management. By controlling interest rates, the Fed can help generate new jobs (raise employment. If interest rates are low, people are more willing to borrower and they spend more money. Businesses too are more likely to borrower, expand, and hire more workers. In the economic sphere, we call this expansionary economic policy: lower interest rates expand the economy. Sounds great but there is a downside – inflation.

The mechanism by which the Fed sets the interest rate is by controlling the amount of money printed. The Fed cannot just announce interest rates and then magically a new interest rate is set. What the Fed literally does is print more money. Just like other rare items (think gold, silver, Michael Jordan rookie cards), the more abundant the item is, the less valuable. The Fed can print as much money as it wants, but the more it prints, the less valuable we consider it.

So why was the Fed lowering interest rates in the years leading up to the credit crisis? After the attacks of September 11^th, 2001 and the collapse of the dot-com bubble, there were legitimate fears that the economy might contract, people would loose their jobs, spend less money and a recession might ensue. To combat the recessionary fears, the Fed stepped in and sharply reduced interest rates.

Cheap Money

The truth is that the rise of mortgage pass-through securities is only part of a much larger story. Borrowers are rational individuals. If a bank offers you a mortgage at an interest rate of 12% you might decide that it would be too expensive to accept that loan, and instead decide to rent a home. But what if the bank offered you a loan at an interest rate of only 5%? You would certainly be more inclined to take the loan with the lower interest rate. While the first part of the story explained how credit was getting easier to obtain, the second part of the story is that borrowing was becoming cheaper (interest rates were declining). The Federal Funds interest rate is the rate at which banks can borrow money from the Federal Reserve. Take a look at interest rates in the years leading up to the credit crisis.

... And Then We All Had Mortgages

With the introduction of mortgage pass-through securities (see prior post), virtually any investor could partake in the buying and selling of securities backed by home loans. And this is exactly what happened: hedge funds, wealthy individuals, mutual funds, pension funds, university endowments, and even the banks that initially originated the loans bought these securities with great zeal. For many, home loans seemed a great investment that would yield strong returns. Instead of the banks earning the principal and interest on the loans they had originated, it was now these investors that would receive the principal and interest payments on the loans. (Side note - we call these securities mortgage pass-throughs because the borrowers’ principal and interest payments are literally passed through the security to the investor who receives them). With such a large demand for these securities, mortgage bankers originated more and more loans to individuals. Again, they were able to do this because the banks could package the loan into a mortgage pass-through security, sell it to investors and receive cash for selling those loans. The bank used this cash to make more loans.

Homeownership increased at an exponential rate. While it was once true that it was quiet difficult to get a mortgage, now almost anybody who applied could get approved for a loan. It was not a problem if an applicant made $30K a year, had no cash for money down, or had poor credit history. In fact, a borrower did not even need to supply paperwork to support his or her income or employment. Borrowers applying for $350K loans were stating that they made $80K as an employee at McDonalds and nobody was asking questions, or requesting income verification.  Home loans became abundant and credit (borrowed money) was increasingly easy to obtain. 

The Year That Changed Everything: 1970

The story begins in the year 1970 when something profoundly changed the financial sector.  Banking used to be a simple process: banks would accept deposits from customers. The banks would pay customers interest on their checking and savings account balances and would then take the deposits and lend those funds out to other customers.  These loans were made for many purposes, but by far the largest group of borrowers were homebuyers. The banks would extend loans to new homeowners in the form of a mortgage (a loan with a house used as collateral). The borrower then repays the loan with interest - usually on a monthly basis over an extended period of time; typically thirty years.   The bank makes money because it is able to charge the borrower (the mortgage borrower in this example) a much higher interest rate than it offers to those customers which deposit funds at the institution.  One of the problems with this business model is that when the bank extends a mortgage to a borrower, it must patiently wait upwards of thirty-years to recover the money it lent.  If the bank wants to keep extending more and more loans, they will run out of money to lend to borrowers. Remember, the bank’s main source of money to lend comes from depositors of checking and savings accounts. The pool of deposits is not infinite.

So what happened in 1970?  The first mortgage pass-through security was created.  For the first time ever, banks were able to sell thousands of loans, which they had just previously originated, and within days, package them into one big loan and sell that big loan to someone else.  The bank no longer had to wait thirty years for the borrower to pay back the loan and free up funds to extend new loans. Now, with the cash received from selling these mortgages to someone else, the bank could now continue to extend more loans. It was a cycle that could be repeated almost endlessly and proved extremely profitable for the banks. 

Welcome

Hi All. As we take a step back and begin to absorb the roller coaster that began in 2007, many questions come to mind. How did our financial system, arguably the most resilient in the world, collapse at such a record pace? What caused the credit crisis and why does what happen on Wall Street affect what happens on Main Street? Is the crisis finally past, and what have we now learned from it?

The annals of history may not remember the exhaustive details: The fed funds target rate is currently 0 – 0.25% (what's the fed funds rate?). More than one hundred banks have failed so far in 2009 (who cares?). Nevertheless, let's gather up the broken fragments of the past two years and construct a mosaic of what transpired. I hope to use these pages to give a simple, informative and enlightening view of our economy and current events in the financial markets.