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The Trusted Adviser

October 2008 | Volume 1 - Number 5

The Origins of the Subprime Mortgage Crisis

by the Honorable Thomas L. Perkins
U.S. Bankruptcy Judge
Central District of Illinois

The following article is excerpted from Judge Perkins' presentation at the October 10, 2008, ATG Legal Education, LLC seminar, "America's Mortgage Crisis: Looking Out for Your Client"; portions have been added or edited to make the oral presentation translate to written form more clearly.

Introduction
I usually speak on my specialty, which is bankruptcy. This topic, the subprime mortgage crisis, may result in a large increase in my business in the future, but it is something that is not directly within my professional expertise. It is a very difficult topic to get your arms around. It is complex, it is convoluted, and sometimes those in positions of power intentionally obscure the truth. It is something that I come at mostly as an observer, a concerned citizen, with a measure of financial expertise in the bankruptcy arena.

My remarks will focus on the investment banks and the credit rating agencies. There are a lot of ways to come at this very difficult and complex problem: My approach will be from the "big picture" angle. I will not attempt to teach you details about the products that were being used or about the way loan brokers worked. There are a number of details that are contained in the books listed below and in other resources that are important, but not necessarily pertinent to what I am setting out to do—which is to make sure you have an understanding, as I think I do, of the big picture of this crisis. How did we get to this point, and more importantly, why did we get to this point? You will remember, it was George Santayana who said, that he who ignores history is doomed to repeat it. Words to the wise: If we don't understand how we got to this critical crisis, we run the risk of repeating it in the future. I would like to give you a little background and educate you as I think I have educated myself with regard to this problem.

Background
Let me begin with a quote from Australian economics writer Peter Martin: "The most dangerous moment in any financial market boom is the one where the suppliers of funds stop paying attention." I think that statement captures the essence of the subprime mortgage crisis. The suppliers of funds in the secondary mortgage market in this country—the investors who bought the mortgage backed securities, the Wall Street investment banks, and to a lesser extent Fannie Mae and Freddie Mac—simply stopped paying attention. The question of why they did so is a very interesting one and I would like to shed some light on it. On the one hand, the investors who bought what are called "mortgage backed securities" or MBSs, who are run mostly by professional money managers, were lured into complacency by the yield premium available on the mortgage backed securities that carried high ratings, often AAA investment-grade ratings, which were considered to be a stamp of approval from credit rating agencies. The investment bankers, on the other hand, were seduced by the prospect of unimaginable wealth, personal wealth. In my view, they were overcome by an irrational exuberance, to use one of Alan Greenspan's terms, for profits that were seemingly unlimited.

For example, from 1998 through 2002, the investment bank Merrill Lynch averaged $2.1 billion in annual operating profits. From 2003 through 2006, which were the peak years of subprime mortgages, it averaged two and a half times that or $5.2 billion in annual operating profits, almost all of which were paid out in bonuses to employees. In 2007, for example, the top five investment banks paid out $36 billion in bonuses alone, a figure that does not include salaries. I would suggest to you that that kind of money is intoxicating—even addictive—and the pursuit of profits was really a siren song that was absolutely irresistible.

We now know that that pursuit ended in ruin, for the investment banks and investment banking community is no more. It is gone, simply destroyed. It also spelled ruin for the secondary mortgage market in this country, for the worldwide credit system, and for the stock markets around the world. The US economy is still teetering on the brink of what might be a severe recession. I don't think any of that is hyperbole.

In March 2008 a report issued by the President's working group on financial markets concluded as follows, "The turmoil in financial markets clearly was triggered by a dramatic weakening of underwriting standards for US subprime mortgages beginning in 2004 and extending into early 2007." The truth of that conclusion is now widely accepted. The question that I hope to answer today is, why did underwriting standards deteriorate, how was that allowed to happen? Before I get to that, let's look at the size of the problem so you can get an idea of what we are dealing with in terms of scope.

Understanding the Scope in U.S. Dollars
From 2004 through 2007 the total amount of sub prime mortgage loans originated in the United States was $2.4 trillion or one-fifth of all mortgage loans funded during that four-year period. That amounts to between 12 and 15 million mortgage loans that were subprime. With subprime loans that existed before the 2004 era, there are currently about $3 trillion in subprime loans that are currently outstanding. All outstanding US residential mortgage loans together total about $10 trillion, so about 30% of the total outstanding mortgage loans are subprime. By October 2007, about one quarter of all subprime loans were in default. That amounted to about $750 billion worth of face value calculation of loans that were in default. The numbers have increased from there, making the size of the problem simply mind-boggling.

Enter Fannie and Freddie
Let's go back in time and focus on a little history. The Federal National Mortgage Association, nicknamed Fannie Mae, was founded in 1938 as a government agency to facilitate liquidity and stability in the United States mortgage market. In 1968, the government converted Fannie Mae into a government sponsored enterprise (GSE), which meant that although the company was privately owned and operated by shareholders, it was protected financially by the support of the Federal Government. In 1970, the government created the Federal Home Loan Mortgage Corporation (FHLMC), commonly known as Freddie Mac, also a GSE. Freddie Mac's purpose was to compete with Fannie Mae and thus facilitate a more robust and efficient secondary mortgage market. These GSEs have played an integral part in the development of the most successful mortgage market in the world.

The American Dream: A Wonderful Life
Why was the secondary market and therefore these GSEs necessary? Before 1980 most home mortgage loans were made by savings and loans, which were in fact successors to buildings and loans, such as in the movie "It's a Wonderful Life," a Frank Capra classic that featured the Bailey Building and Loan. In fact, I would suggest to you that maybe the first subprime loan in the history of the world was the one George Bailey made to Ernie Bishop, the cab driver in the movie. Ernie had a very low FICO score as you can imagine. The Bailey Building and Loan was actually very typical: It collected deposits and when it had enough funds, it made mortgage loans. Those loans stayed on its books, they weren't sold on some secondary market, and they were repaid over thirty years. When it acquired enough money through loan repayments it made more loans. If it didn't have enough funds it couldn't make more loans for the lack of liquidity. Simple. Remember the scene in the movie, right after George and Mary got married? It depicted a bank run, which led to a similar run on the Bailey Building and Loan. It was pouring rain outside. The people in the Building and Loan office had worried looks on their faces. Police sirens could be heard from the street outside, and all the depositors were looking at George saying that they wanted their money. What did George say? He said, "You're thinking of this place all wrong. As if I had the money back in a safe. The money's not here. Your money's in Joe's house . . . right next to yours. And in the Kennedy house…and a hundred others. Why, you're lending them the money to build, and then, they're going to pay it back to you as best they can." And that was true. That description of a building and loan's lack of liquidity illustrated the problem faced by lenders without a secondary market to sell their mortgages and replenish their funds.

That scene from Capra's film depicted the era just before the Great Depression. Fast forward a few years to 1938 when Fannie Mae was formed, then later Freddie Mac. These enterprises were formed to purchase mortgages from lenders to allow lenders to immediately replenish their funds rather than having to keep these mortgages on their books, collect payments for 30 years, and wait until the mortgages were repaid before they could make more loans. The secondary market furthered the Federal Government's long-time policy of encouraging home ownership. In 1977, when the Community Reinvestment Act was passed (and many occasions since then) there has been a consistent governmental policy through Democratic and Republican administrations alike encouraging home ownership and trying to expand the percentage of Americans who own their homes. But Fannie and Freddie were not doing a great job of providing liquidity to the mortgage lenders. They had strict underwriting standards. There was lots of paperwork involved in order to sell your mortgage to Fannie and Freddie. There really wasn't at that point, I'm going back now to the 70s and before, a huge unfilled demand for mortgage loans.

The Birth of Mortgage Backed Securities
Then in the early1980s, Lewie Ranieri, an investment banker of Salomon Brothers, came up with the idea of securitizing residential mortgages and selling them to investors who were looking for higher yields than treasury bills or municipal bonds offered. The trick was to create a large enough pool of mortgages to be able to predict on an actuarial basis how many of the loans were likely to go bad and go into default, and then account for that risk in how the security was priced. Ranieri was able to convince lenders that it was a good idea to allow Salomon Brothers to securitize the mortgages and convince investors that the securities were a reasonably safe investment. Thus the mortgage backed security or "MBS" was born. Pretty soon all the Wall Street investment banks were securitizing and selling residential mortgages and they were getting paid handsome transactional fees for doing so. The investment banks were now in direct competition with Fannie and Freddie. They were in the business of purchasing mortgages from lenders and it wasn't long before nearly all the mortgages that were being written were being sold on the secondary market shortly after origination.

Mortgage Loans and More Mortgage Loans
At this point, lenders of all types—state banks, national banks, credit unions, etc.—were all heavily involved in mortgage lending. Once the economy picked up in the 80s and interest rates declined, the demand for housing was at an all time high. But throughout the 1980s, for the most part, only prime or conforming mortgages were being made, that is, mortgages that conformed to the underwriting standards used by Fannie Mae and Freddie Mac. These lenders were all regulated by either federal or state regulators. Their loans were audited on an annual basis. They were all subject to safety and soundness standards. If a person came in for a loan to a regular lending institution and they did not qualify for a prime rate loan, they simply got turned down for the loan. That is, until the concept of risk-based pricing became approved.

Community Reinvestment Act: An End to Redlining
Earlier in this presentation I referred to the 1977 Community Reinvestment Act, a federal law designed to encourage commercial banks and savings associations to meet the needs of borrowers in all segments of their communities, including low- and moderate-income neighborhoods. It was intended to reduce discriminatory credit practices against such neighborhoods, a practice known as "redlining." Redlining was the process where a bank (usually in an urban community) would have a map of the neighborhoods in its community up on the wall and they would literally take a red marker and draw lines around particular neighborhoods in which they would not make loans. These neighborhoods were populated mostly by lower income people that the banks decided could not afford loans. The 1977 Act, while well-intentioned, simply didn't work in and of itself because the borrowers who lived in those neighborhoods simply could not qualify under traditional standards. By "traditional standards," I refer to the underwriting standards that were promulgated by Fannie and Freddie. So, in the early 1990s the regulators approved what is called risk-based pricing.

Risk-Based Pricing Gives Way to Subprime Lending
Risk-based pricing allowed banks for the first time to be able to charge a higher interest rate on mortgage loans to less qualified or riskier borrowers. The more risky you were, the higher rate you got charged. In some sense that is counter intuitive because the people who could least afford it were paying the highest rates—but that was the way it had to work to ensure banks maintained their safety standards. This opened the door to subprime lending. It also opened the door to a whole new market of millions of potential borrowers who were previously shut out of the mortgage arena.

While banks began to make some subprime loans, there was the problem of bank loan officers, who were trained to be conservative and were simply not willing, for the most part, to relax their standards. This led to the rise of the non-bank lenders, which are critical to the understanding of the subprime mortgage crisis.

Non-Bank Lenders on Every Corner
Who are the non-bank lenders? Most of them were started by former savings and loan owners, officers, or others who had experience in the savings and loan industry. You will recall that the savings and loan industry collapsed in the late 1980s and early 1990s, which led to a surplus of refugees from that industry who were looking to get back into the finance or mortgage loan business. Many of them found that opportunity in the form of state-chartered loan companies. It is important to recognize that state-chartered loan companies don't accept deposits, so they are not regulated by the FDIC, are not part of the Federal Reserve System, and there is no federal regulation. The state regulation is really nonexistent with regard to the substance of the transactions in which they are engaged, so it really is a situation where these non-bank lenders are, for all intents and purposes, simply unregulated by any government regulatory agency.

Warehouse Lines of Credit or Free Money?
Where did they get capital, these non-banks who don't accept deposits? Where do they get capital to avoid the Bailey Building and Loan lack of liquidity problem? Well, our old friends the investment bankers heard the call and they answered. They provided what are called warehouse lines of credit to these non-bank lenders. The biggest warehouse lenders were Bear Stearns, Lehman Brothers, and Merrill Lynch. None of whom exists anymore. The non-banks mostly used independent mortgage loan brokers to generate loans. They didn't have a staff of trained loan officers who were employees. They simply went out and made arrangements contractually with independent loan brokers to market their products, which were mortgages.

These loan brokers were paid a commission for each acceptable loan generated. They were usually paid out of the points that the borrower paid at closing, so they got paid in full right at the time of closing. It is reported that the best brokers in the peak years of the subprime boom could earn between $1 and $3 million in commissions. The profits (or "yield premiums," as they are called) in the mortgage backed securities were so large that the investment banks got into hot competition with each other in the race to buy and securitize these subprime mortgages. It got to be so competitive that the investment banks offered to provide warehouse lines of credit to the largest non-bank lenders at a no-cost or on an interest-free basis if the lenders would agree to sell their mortgages to the banks that were providing the credit on an exclusive basis. So that is really what it came down to, that these were so lucrative that the investment banks were simply offering free money, free capital to finance the making of the loans as long as they got the opportunity to securitize these subprime mortgages and sell them on the secondary market.

The investment banks all had marketing representatives who were out in the field who were really driving the lenders, mostly the non-bank lenders, to make the subprime loans to satisfy what had become an insatiable demand for mortgage backed securities. The subprimes were so profitable that Wall Street began to pay a premium. They would buy, for example, a $100,000 face value mortgage from one of the non-bank originators for $105,000. So the non-bank originator could book immediately a $5,000 profit. That mortgage went off their books. They no longer had any risk of default from that point forward, except for there was about a 60- or 90-day period where these non-banks had to repurchase these loans if they went bad, but 60- or 90-days is nothing in the life of a 30-year mortgage. So really they were enormously profitable for the investment banks, they were enormously profitable for the non-bank lenders. The lenders simply couldn't make enough of the subprime loans and Wall Street could not buy enough of them. There wasn't any government regulation on this process.

Vertical Integration
Eventually Wall Street would vertically integrate its hold on the market by owning and operating their own retail mortgage lending companies. Lehman Brothers, for example, owned and operated Aurora Loan Services, one of the big non-bank originators of subprime loans. Bear Stearns owned and operated EMC Mortgage. Merrill Lynch first bought a $100 million stake in a California lender, then later started its own in-house mortgage lending group. Then in September of 2006 (fairly late in the game for subprime mortgages) Merrill Lynch bought First Franklin, a non-bank lender that used only independent loan brokers who were paid on commission. These brokers specialized in making loans with adjustable rate mortgages or "ARMs," with initial low teaser rates (slightly different from conforming ARMs). They also specialized in what are called 80/20 loans where there is an 80% first mortgage that is given to the borrower and then on top of that a 20% second mortgage or deed of trust that is given to the borrower, so the borrower in effect is not making any down payment at all. The borrower is borrowing 100% of the purchase price of the house. So a borrower who was completely broke could now buy a house and get financing for 100% of the price. Is that the American Dream?

The Perfect Money Machine or The Perfect Storm
It also was the case that these privately held mortgage originating companies who were owned by the investment banks (and some who were not owned by investment banks) were also large mortgage servicers, so they were also servicing the very mortgages that were issued, securitized, and sold to the investment community. As one commentator put it, Merrill Lynch was "doubling down" on subprime mortgages. Think about it in these terms: Merrill Lynch and the other investment banks were originating the subprime loans as well as buying some from other non-bank originators, to whom they were supplying warehouse lines of credit, they were securitizing those loans in the mortgage backed securities. They were taking the riskier segments of those mortgage backed securities and they were re-securitizing them into what are called collateralized debt obligations, or "CDOs," which are a form of derivative. They were then selling those mortgage backed securities and those collateralized debt obligations to investors, some of whom bought on credit supplied by those very same investment banks—on top of that, they were servicing those mortgages as well. It was really the perfect money machine.

The investment banks were making a profit at every step of that entire process. It was a perfectly vertically-integrated market. The investments banks were involved from the origination, to the securitization, to the sale, to the servicing, every step of the way. When you think about it like that, it almost takes your breath away doesn't it?

The Role of the Credit Rating Agencies
The investment banks succeeded in cornering the subprime mortgage market, but they couldn't have done it alone. They needed the help of the credit rating agencies. Most of these subprime securities were sold to institutional investors, many of whom were foreign investors. That is why we have the global problem that we do today and why we have seen the worldwide credit market seize up like we have. These institutional investors are largely, almost exclusively I would say, conservative institutional investors, managed by professional money managers, whose funds are controlled by these managers. They are pension funds, they are insurance companies, they are banks, they are municipalities, and they are other government entities. They are all subject to strict fiduciary investment standards and guidelines. They simply are not permitted to invest in risky securities or other risky investments. If they do the money managers not only risk losing their jobs, they risk going to prison. So there is a long history of conservative investing on the part of these institutional investors.

So how was it that these highly conservative institutional investors accumulated such large amounts of what turned out to be the most risky securities out there? That is the $64,000 question. The institutional investors relied in fact on the ratings that were assigned by Standard & Poor's, Moody's, and Fitch—the big three credit rating agencies. Let me tell you a little bit about how credit rating works: The principal and the interest that is paid on the pool of mortgage loans is paid out to the investors in a specific order or hierarchy, which is divided up into tranches. "Tranche" is a French word meaning "slice." Typically a mortgage backed security, as a whole, would receive a certain rating. Take a whole pool of mortgages—it might be 1,000, it might be 5,000, and it might be 10,000 mortgages—that are pooled together in a single large MBS, 80% of the cash flow that was spun off by that security was able to be allocated an AAA rating. That is the highest investment grade rating that there is. AAA rating is tantamount to being as safe as a treasury bill. There is very little difference between treasury bonds and AAA rated bonds. An additional 11% were given an AA rating, just one little step right below that highest rating. An additional 3% were given a BAA rating, a little bit lower; and another 4% were given a B rating, which is the lowest investment grade rating available. There is a 2% equity tranche that was typically of junk bond status; it wasn't rated and it really wasn't sold to investors. It was usually held by the originator or maybe sold to a hedge fund. It definitely wasn't sold to traditional conservative institutional investors.

Fact: Even Conservative Investors Chase Yield
The senior AAA tranches of that security are sold with the lowest rate of interest because they are the safest of the securities. The lower the rating the higher the rate of interest paid in order to attract investors. So the more risky or the lower the rating, the higher rate of interest you have to pay in order to get investors to buy that security. It is true that investors, even institutional investors who are conservative by nature, chase yield. That is, the higher rates of interest. The interest rates, as I have said, reflect the risk just like the credit ratings that they were given. But the interest rates can be sliced more finely than the credit ratings can, to hundredths of a basis point. So if you are trying to sell a B-rated tranche for example, the trick is to offer just a slightly higher rate of interest than the other B-rated securities that are out there on the market. That will attract investors to your security because when you are talking about hundreds of millions or maybe even billions of dollars in investments—and that is the kind of dollars these people were investing—the difference of a few hundred basis points is big dollars in the end. So it doesn't take a whole lot of differentiation between interest rates to attract some of these institutional investors. The investment banks were really quite successful at tweaking or nuancing the structure of the mortgage backed securities in order to maximize the credit ratings while at the same time offering a favorable interest rate within each rating class. That was really what they were trying to do and they were very, very successful.

The Assumption that Led to the Problem
How were the investment banks so successful? Residential mortgages were considered one of the safest debt instruments because the underlying real estate almost always appreciates in value. At least that was the assumption that led to this problem. Not since the Great Depression has there been a broad-based substantial decline in residential real estate values in the United States. The default rates on the US residential mortgages have been very consistent over time and very low for a long, long time. They were considered to be very, very predictable. The rating agencies used statistical models to rate these mortgage backed securities and the models rely on historical default rates to predict future default rates. They were using what happened in the past to predict the future with regard to these default rates. The predicted default rate is then plugged into the bond formula to see whether the projected cash flow is sufficient to make the required payments. Even if the expected default occurs, there is a capital reserve that the rating agencies require so that if a default rate exceeds by some percentage, the predicted default rate then there is an equity cushion that will cover the excess default rate so it won't destroy the bonds entirely. The rating agencies assumed a 1-1.5% default rate on prime mortgages. That has been a historically consistent figure. With regard to subprimes they assumed a 3-5% default rate, which we now know is off by a factor of about 7. Remember that subprimes were a fairly new product and there were many different variations coming into the market rapidly. I mentioned Adjustable Rate Mortgages and 80/20 loans earlier; there were also what were called "Stated Income Loans," or as they were known in the industry, "liar loans." I am not making this up.

Loan Products Gone Wild
A Stated Income Loan is one where the borrower goes into the bank or the non-bank and applies for a mortgage loan. The loan officer or loan broker asks the borrower how much he makes per year, the borrower says $100,000—and the loan officer or broker accepts that without requiring any documentary substantiation. These borrowers are not required to provide tax returns or wage statements, so as the name implies—the whole deal is done based on stated income. The borrowers state their income, the banks or non-banks accept it as such and require no proof—in the industry those came to be called liar loans. You can guess why.

In later years, teaser rate loans became very prevalent. Teaser rate loans are ARMs with extremely low introductory rates. While some traditional conforming ARMs come with an "introductory" interest rate for a set period of time, these introductory rates aren't true teasers, but rather are set according to pricing in the secondary mortgage market. Conforming ARMs were reasonable for some borrowers who knew they would be in their homes for a very short time, although it didn't work out so well for many borrowers. Teaser rate loans are different in that the introductory rate is usually substantially lower, and lasts only a very short time—maybe even one month. A low teaser rate predisposes an ARM to sustain above-average payment increases. Good for lenders, not so good for borrowers. Both types of ARMs are tied to a financial rating such as the LIBOR or London Interbank Offered Rate, the rate that the largest banks in the world use when they make loans to each other. As the LIBOR rate increases, ARMs reset at higher rates—at certain intervals. With the credit market being seized up right now, that LIBOR rate is at a historical high. So if you have a mortgage loan out there that is at the point of resetting because the time period has come due and it is tied to the LIBOR rate, your mortgage rate will go through the roof. Now, some ARMs have maximum levels that the interest rate can reset by, so there is some protection. However, when you are talking about starting off with a 3% rate and then migrating up to a 6% or 7% rate where your payment will almost double, I'd call that sticker shock at its worst.

Bond Insurance, Collateralized Debt Obligations, Derivatives
Because these products were all new, none had a historical track record. The rating agencies were going into unchartered territory when trying to predict the default rates on these subprime loans. The investment banks obtained bond insurance, particularly with subprime loans. Bond insurance provided comfort to the rating agencies and enabled many of the bonds and 80% of the tranches to be given AAA ratings. That was particularly so with regard to collateralized debt obligations. Bond insurance was obtained from companies like AIG, a company that has been in the news a good deal lately, and had to be bailed out.

Let's spend a little time on collateralized debt obligations or CDOs. As I said earlier, the structure of these bonds are 80% AAA, then there are the mezzanine tranches, the lower tranches that are anywhere from AA down to B. Those lower rated tranches are harder to sell because they are not considered to be as safe as the AAA tranches, so the investment banks figured out a way to try to make those more attractive. Investment banks would take those tranches of MBSs and pool them together. They would then pool together groups of mezzanine tranches and create a new security called a collateralized debt obligation. The CDO is being secured by the MBS, which is secured by the underlying real estate. So you are now two steps away from the actual collateral, which is why it is called a derivative. The investment banks would take those derivatives, which again were based primarily on mezzanine rate debts, not AAA-rated, to the rating agencies and because of the structure that was created, the rating agencies would actually give a large portion of those new securities AAA ratings. Of course with the bond insurance perhaps the rating agencies were just relying on the insurance back-up without really worrying too much about the complexities of the structure of those CDOs.

Rating Subprime Mortgage Securities: Lucrative and Competitive
There is one other important factor in regard to the rating agencies that I need to point out. This has been pointed out by economics writer Roger Lowenstein: The rating agencies are private for-profit companies and they used to make money simply by selling subscriptions to their rating guides. They were very sleepy, unexceptional companies in that regard. In the 1980s and the 1990s they started charging the issuers of the securities that they were rating a fee. However, it was done on a contingent fee basis, if you can believe that. They would only get paid if the deal that they were rating went through. This created an environment of competition, as you might imagine, among the big three rating agencies for what turned out to be the lucrative business of rating subprime mortgage securities. The rating agency could make upwards of $200,000 for rating a single complex bond issuance involving a number of tranches on a subprime mortgage bond. This was less than what the investment banks were making, but still pretty good money.

Conflict of Interest?
The investment bankers took advantage of that competitive environment between the rating agencies and they started shopping their business among the three agencies and playing them against each other. So the process of rating the MBSs really became a negotiation between the investment bank and the rating agency, except that all the economic leverage in that negotiation resided with the issuing investment bank, not with the rating agency. If the rating agency wanted the business and the large fees that went along with that, they had to simply capitulate usually to the issuer's demands for better terms. Normally that involved a reduced capital reserve amount that was to protect against the higher default rate. So they used that as a negotiating basis. For example, instead of keeping 1% or 2% of the face amount of the bonds in reserve, they might cut it down to half of a percent—and that got to be how the game was played with regard to obtaining the rating. So rather than providing what used to be neutral disinterested opinions of risk to investors, the rating agencies were now really selling negotiated concessions to the issuers, to the investment banks. I don't think it is unfair to characterize the agencies as operating with a significant conflict of interest and that is the conclusion that Lowenstein comes to in his New York Times Magazine article.

Regulation
Despite what you may be hearing on TV and in the media, the specific terms of mortgage loans have never been directly regulated. When banks were the only originators of residential mortgages, they followed the underwriting standards used by Fannie Mae and Freddie Mac, and adherence to those standards was approved by the regulators who regulated those banks. The mortgage loans made pursuant to those standards were deemed to be safe and sound, which was the primary concern of those regulators. Basically if the bank wanted to sell a mortgage loan on the secondary market, which was Fannie and Freddie, it better be one that conformed to those underwriting standards. Non-conforming loans early on were simply not able to be sold on the secondary market and they were held on the banks books. The banks simply accepted the risk of default on unsold mortgages. Since the bank held the risk of default there was really a strong disincentive against making risky loans to begin with. With the advent of the private label MBSs, the ones created by the investment banks upon the emergence of non-bank lenders, Fannie and Freddie's underwriting standards went by the wayside. There ceased to be a limitation on the amount of the non-conforming mortgage loans that were being made and also the extent of the nonconformance that those loans encompassed.

Devil-May-Care Lending Practices
The non-bank lenders sold all their loans on the secondary market. They didn't hold any loans on their own books. They never really had to be concerned about holding bad loans in their own portfolios and accepting any risks of nonpayment in the future. The reality of it was that any loan that an investment bank would accept was a good one, regardless of how exotic the terms of the mortgage were, regardless of how poor the borrower's credit history was, regardless of how lacking the documentation or the due diligence was, or even what the borrower's current financial situation was. The underwriting standards came to be looked at as simply a bothersome impediment to the ever increasing demand for mortgage loans. At that point the mortgage loans became nothing more than a commodity. The credit rating agencies, on whom the investment banks depended, really became the only defacto regulator in the system for the entire mortgage market. When the rating agencies' independence was compromised because of the negotiation with the investment banks, the absence of regulation in this market was complete. So as it turned out, the suppliers of funds and everyone else involved in the mortgage market had simply stopped paying attention.

Living is Easy with Eyes Closed
The CEO of Lehman Brothers testified this week before Congress. He said "we never saw this coming." I don't doubt that that was true as far as his statement goes. But he never saw it coming because he had his eyes closed. If he had kept his eyes open—paid attention—he would have seen that the real estate bubble that had come about in the value of residential real estate actually burst, we now know, in the spring of 2006 when house prices peaked and then began a steady decline that has continued without interruption since. Even with the decline in the value of real estate, the fast and furious pace with which these MBSs were created and subprime mortgage loans were made continued for another one and a half years. One and a half years after the real estate value bubble burst, we were still seeing the same pace in the creation of subprime loans. The feasibility of subprime mortgages, particularly the high volume of adjustable rate mortgages, is premised on the assumption of ever-rising real estate values, everybody knows that. Falling values renders subprimes simply unworkable. All the institutional players in the secondary market were well aware of that, but when values started to fall, they didn't or maybe they couldn't stop making these loans.

Conclusion
Thirty years ago investment banks were dominated by a culture that still viewed their role as the guardians of the financial system, the protectors of the integrity of the capital markets and the credit markets. At that time, investment bankers were always known as the masters of the universe, the smartest people in the room. And when it came to finance, they were. Somewhere along the way that culture and those values were lost. The investment banks, in my opinion, became little more than glorified hedge funds. They were chasing profits and their attitude basically was, to hell with everything else. And that is how we got in this mess.

 

 

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The author suggests the following reading:

Liar's Poker by Michael Lewis
Chain of Blame by Paul Muolo and Matthew Padilla
Financial Shock by Mark Zandi
The Subprime Solution by Robert J. Shiller

 

 

 

 

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[Last update: 10-22-08]