Laird Minor, one of our commentariat who has spent a lifetime in this sector of the financial industry felt the first article on the subprime financial crisis gave an incomplete picture. He proceeded to fill in the rest of the story in such fine form that I am re-posting his comment here on the front page so that it will, in conjunction with the first article, give our readers a much better idea of what is going on and what to expect.
Having been a participant in one way or another in the subprime mortgage industry for over 20 years, this is a topic in which I possess a fairly substantial degree of expertise. The first article is reasonably accurate as far as it goes, but there is a lot more to the story. I could probably write a book on this, but I will try to keep this post as brief as I can.
The CRA only applies to banks, and while banks are the originators of a large number of mortgage loans, non-bank lenders have come to comprise a substantial portion of the mortgage industry. This is especially true in the subprime sector. Thus while the CRA was a typically bad Washington idea, propounded by “poverty lobby” zealots with no conception of how the market works, it isn’t really the principal source of the problem. That honor goes to Wall Street.
Subprime loans are not “agency-eligible”, which means that they can not be sold to Fannie Mae or Freddie Mac, the two huge quasi-governmental agencies that dominate the mortgage world. For this reason subprime lending remained a fairly small segment of the market, much like “payday lenders” are in a different market, until Wall Street figured out how to securitize the loans. Securitization is an extremely valuable financial tool, as it allows loans, which in essence are nothing more than streams of cash flows, to be combined into giant pools and carved up into separate “tranches” having different characteristics as to timing, default risk, etc. By separating these cash flow streams the tranches can be sold to different investors with different investment criteria (insurance companies, for example, have clear actuarially-determined timing needs for cash) which results in better pricing. Overall, securitization created a more efficient market for mortgages, which benefited everybody. Unfortunately, it got out of hand, primarily because of the rating agencies and, to a lesser extent, the monoline bond insurers.
Mortgage-backed securities are rated by Moody’s, Standard & Poors, and Fitch, to determine their investment grade. This affects both price and the appropriate universe of investors. As more and more subprime mortgages and especially unusual ones like “pay-option ARM” loans began to be placed into securitization pools, the rating agencies failed miserably in analyzing them and forecasting their performance characteristics. Monoline insurers, who provide bond insurance for the highest-grade bonds, similarly failed to adequately model these loans’ performance, and thus imposed inadequate credit enhancements (loss reserves, subordination levels, etc.) on the deals. Lenders found that they could sell all the loans they booked, with no meaningful penalty for weak credit quality, so of course they expanded their guidelines. They were merely reacting rationally to signals the market was sending, and do not deserve all the blame for the ultimate melt-down.
So the mortgage pools got riskier and riskier, but no one really appreciated that fact until delinquency levels began to surge last summer: there is a fairly long lag time between mortgage origination and delinquency. Once investors realized how bad the pools had gotten they stopped buying the bonds. The market for mortgage-backed securities ground to a halt almost overnight; pricing for existing securities went into free-fall, and new deals simply couldn’t be completed. And since banks and other financial institutions which own most of those securities are required to write them down to current market values, their paper (unrealized) losses ballooned. This is the reason for such events as the Bear Stearns failure; it had pledged those securities for its borrowings, and when the bond values plummeted and the loans were called they could not come up with the cash.
It is a typical Wall Street “bi-polar” overreaction, but the pain is very real. Property values, which had been driven up by speculative excesses and cheap money (as noted in the first article), are falling rapidly, especially in the areas where they had risen the most (Florida, southern California, Arizona, etc.), and until they bottom out the liquidity crunch will continue. Eventually that will happen, though, and when it does things will return more or less to normal. Hopefully the participants in this market will have learned something from the experience, but I am not sanguine about long-term wisdom; Wall Street has a short memory, and the next generation of traders will probably repeat at least some of these mistakes.
So there is blame to go around: foolish laws and regulations; inadequate understanding of the effects of weakened credit standards; a few, but very few, truly predatory lenders taking advantage of unsophisticated borrowers; and greedy borrowers who were speculating in real estate values or who simply wanted to extract all of the equity in their homes for current consumption. In my opinion this last group is getting far too little of the blame. It was a market failure of monumental proportions, but as long as the politicians will stay out of the way the market will correct itself; it always does. Unfortunately, it now appears that politicians, who always want to be seen as “doing something”, whether it makes sense or not, will muck around in matters which they don’t understand and make things worse.
The Law of Unintended Consequences will come back to bite us. It always does.