Greed, Quest for Yield, Failure of Rating Agencies, Rising Housing Price Expectations, 'Pulse and Pen Lending, Excessive Leverage, Derivatives, 'Holy Alliance turned 'Unholy'....
At a national symposium last month sponsored by the Federal Home Loan Bank of Des Moines, I was invited to speak about the future of residential lending finance along with other long time industry participants. Before we could focus on what the future might look like, we spent some time analyzing the recent past and identifying exactly what went wrong. I presented 8 factors I believe caused the greatest financial debacle in decades.
1>Greed: First and foremost, the single greatest contributing factor. There was indeed plenty of greed to go around on several levels.
Let's start at the top. Investors wanted to make more money. Wall Street investment banking firms saw a multi billion-dollar sales opportunity. Rating agencies could make record profits. Lenders were interested in making bigger profits than they could achieve in the conforming loan market. By my calculation, up to ten times more profit.
Borrowers were anxious to acquire their dream home more quickly than they could realistically afford to do so. Each group had a lot to gain. There were plenty of gains until the music stopped, then plenty of losses.
2>Quest for Yield: Since the ten-year Treasury was at a low 3% in 2007 many were still reaching for higher yielding returns. Subprime loans yielded a much higher return than the plain vanilla conforming mortgage loans. Wall Street firms became very adept over a twelve period at learning how to slice and dice portfolios with both conforming and subprime loans to deliver the precise yield an investor was looking for. The old adage proved true, 'No risk, no reward.'
3>Failure of the Rating Agencies: Without the egregious errors made by the rating agencies, the subprime lending disaster would have been only a fraction of what it turned out to be today. The market had a lot of confidence in the rating agencies and the independence of their ratings.
As a consequence, an investor believed when they were buying a 'AAA' rated security they were in fact buying a security with and extremely low probability of default. The math wizards of the Wall Street firms were able to show research, algorithms and formulas predicting securitized pools with tranches of subprime loans would continue to perform very well.
The rating agencies completely failed to detect the multiple inherent risks in subprime lending and the resulting risk to the entire pool of loans they were part of. The agencies also missed the systemic risk to the housing system when over 10% of the loans originated were subprime loans.
This omission is very curious as nearly all of the 8,000 community banks in this country chose not to originate subprime loans. Ninety four per cent of banks did not engage in subprime lending.
Why? Community banks understood when a borrower has a terrible track record with re-paying credit, has an unstable work history and no money for a down payment; a higher interest alone is not enough of a compensating factor to offset all of the risk the lender is taking on.
The tremendous fees they were paid by rating the mortgage pools they were securitizing no doubt unduly influenced them. If one firm were to issue a lower rating, another firm was ready to provide a triple 'A' rating.
4>Rising Housing Price Expectations: Based on past history, there was the assumption by most in the residential finance industry that housing prices would continue to go up. After all, they had done so for decades. This proved to be a very costly assumption.
In the tech stock bubble of 2000, people bought tech stocks because they were going up every quarter and every year for a while until the bubble burst. There were not many who believed residential real estate could ever become over inflated. In fact, the tech bubble may have driven many people to invest in real estate, as it was perceived as a much safer bet. In the extreme case, there were investors that owned dozens of speculative condos in Florida.
Ultimately, the supply side exceeded real demand by traditionally qualified homeowners. In classic macroeconomics, when supply outstrips demand, prices fall. Of course, lots of foreclosed and vacant homes expedited the process as home values dropped much faster.
5>'Pulse and Pen Lending': Residential lending had previously always been a trust, but verify type of business. Lenders who were lending their money wanted to ensure they would be paid back with a reasonable amount of interest.
When subprime lenders started making loans and selling them without regard to repayment, since they were not lending their money, they were willing to play fast and loose with other people's money. As long as someone was willing to buy the loan, it made it much easier to originate a loan without having to do much if any verification of what the borrower was stating to be true on the loan application. Hence the additional term that came into the vernacular, 'liar loans.'
In some cases, unethical loan officers at subprime firms coached along the borrowers telling them exactly what to state in order to qualify for the loan. The borrower got the loan and home and the loan officer made thousands in commissions at the loan closing.
6>Excessive Leverage: Banks have historically leveraged their balance sheets at levels approaching 10 to 1. The non-regulated Wall Street Investment banks and hedge funds decided to take considerably more risk in pursuit of substantially bigger profits by leveraging themselves to levels never previously seen in the market, from 20 to 1 to 40 to 1. Huge profits flowed into these firms until the bottom fell out. Since all of the investment banks are essentially operating as commercial banks, this type of leverage will theoretically not be possible again.
7>Impact of Derivatives: The financial wizards won prizes for creating the Black-Sholes methodology for valuing stock options. Working through what previously was viewed as a nearly impossible calculation inspired other aspiring financial wizards to find methodologies to value the CDS', CMO's and CDO's -- various types of debt instruments that involve valuing derivatives.
Perhaps one of the greatest investors was vindicated when Warren Buffet called derivatives, "weapons of mass destruction." Alan Greenspan viewed them as "shock absorbers in the financial system." Greenspan's blessing made investors and markets more comfortable owning varying types of derivatives. Of course, Wall Street was only too willing to sell them and pocket the enormous fees they earned in doing so. I suppose you could make the old argument, 'caveat emptor'-in this case the buyers had trillions of dollars in investments to beware of.
8>'Holy Alliance" turned Unholy: I remember sitting in the audience listening to a speech Jim Johnson, then head of Fannie Mae in the early 1990's was giving. Johnson proclaimed they were going to raise the level of home ownership in the United States closer to 70%, putting millions more Americans in homes. Each percentile increase equates to one million additional homeowners. There was a seemingly 'holy' alliance for such a noble goal among the elected officials, the white house, the housing agencies, lenders, potential homeowners and consumer groups. All understood the value of home ownership as a way of helping Americans to gain a more secure economic future. There was a type of mandate and urgency to make this dream come true.
The clever and cunning were able to take this public service mandate and apply to new types of lending. If certain borrowers did not qualify in the traditional, conventional or the more credit relaxed FHA programs; not to worry -- there would be a new way to get these people into homes--with subprime loans. They were able to push a very successful as well as safe and sound business of mortgage lending into a brand new arena filled with lots of risk.
Ironically, it is precisely because mortgage loans and mortgage securities had performed so well for decades that buyers were even willing to consider investing in these types of loans. It was on the backs of those who had paid their loans as promised for decades and the lenders who made appropriate lending decisions, the market had the confidence to venture further down the risk chain.
What next? Through it all, very few called out for review of the potential problem subprime loans could have on the system. Investors had a lot of faith in the rating agencies and the Wall Street firms selling them product. Perhaps everyone should have been suspicious, as it all seemed just to good to be true. Therein lies the lesson presumably. No regulations and regulators will emerge to attempt to ensure we don't repeat these mistakes.
I suppose we also need whistleblowers to point out future problems before they turn into major catastrophes.
William A. Donius was appointed to a two year term to the U.S. Federal Reserve's TIAC Council in 2008. He was invited to speak at the Federal Home Loan Bank of Des Moines Symposium on the Future of Residential Finance last month in St. Paul, Minn. He spoke at the educational sessions for bank board members at the invitation of banking regulator, Office of Thrift Supervision during the spring and summer. He is currently writing a non fiction book.
Donius served as the Chairman and CEO of Pulaski Bank in St. Louis until May 2009 and May 2008 respectively. He is a former board member of America's Community Bankers and the Missouri Bankers Association. He currently serves on a dozen boards and committees in the St. Louis area.