The Subprime Mortgage Mess: Viewed From a 12-Year Rear View Mirror

We are still in a financial pickle triggered by the subprime mortgage meltdown.

The mess is becoming clearer. What isn't clear is -- what the heck happened, and how did we get here in the first place?

First, the present.

Two excellent articles describe the situation as of 2007.

The Wall Street Journal follows the sorry path of a single mortgage, from a truck driver in Denver who loses his job and condo and turns suicidal, to his mortgage's eventual home in the mutual fund portfolio of a Tennessee financial hotshot gone cold (though probably not suicidal).

Fortune dissects just one of those subprime funds -- Goldman Sachs' GSAMP Trust 2006-S3, a fund of second mortgages -- tranche by tranche, detailing the infectious rot of loans gone bad (and defining "tranche" on the way).

At every step these articles read like the Wild West. No controls; no principles; no overview. You can't help but ask: how did things get this way?

Set the wayback machine to 1995, Sherman.

To a Harvard Business School Press book, The Global Financial System: a Functional Perspective. It is a functional analysis of the financial system by a Who's Who of financial academia, including Dwight Crane, Kenneth Froot and Robert Merton.

Crane's Chapter ("The Transfer of Economic Resources") describes the history of mortgage securitization:

Mortgage loans in most countries were historically made by local institutions. This system encouraged risk management -- the local S&L knew its borrowers, and owned its loans. It also meant high loan cost, and immobile funds. A low risk, but high cost, system. A classic cottage industry.

Securitization aimed to reduce cost by increasing efficiency -- the classic Western formula for economic development. Interestingly, the government -- via Fannie Mae and Ginnie Mae -- led the way to securitizing mortgages; they set product standards and made guarantees, and became models for private-sector securitization.

Securitization made mortgage lending a national, even global, market. It made more money available, at lower rates, with greater accessibility. It did what it set out to do.

The shift was dramatic. Local savings institutions held 58% of outstanding US mortgages in 1950 -- that dropped to 15% in 1993. And by 1993, 63% of mortgages were securitized.

But what about risk?

The local model kept risk low through long-term relationships. Lenders knew borrowers personally, over a long time; lenders kept loans for the long-term; and borrowers owned houses for the long-term.

Here is Crane in 1995, explaining why risk management was under control in a securitized world:

In the modern market a) the criteria for loan approval are easily spelled out in terms of appropriate loan-to-value ratios and other variables; b) criteria used for mortgages to be put in the pool are also clearly specified, and c) there is an audit process that checks for compliance. In addition, the issuer of the securities has an incentive to manage the quality of mortgages put into the pool because d) a good reputation allows future deals to be done...[and] e) the buyers have an incentive to maintain the property since they retain ownership.

Fast forward to 2007.

a. Loan-to-value ratios may have been spelled out, but no one cared -- Goldman's GSAMP trust had an average loan-to-value ratios of 99%;

b. Criteria for loans to be put in the pool is anything but clear;

c. 58% of the mortgages in the GSAMP product were no-doc mortgages. The "audit" process had defaulted to S&P and Moody's, both of whom were either wildly deluded or denied their responsibility for the role -- or both;

d. If Goldman's incentive to manage portfolio quality was its reputation, then its reputation was being priced awfully low. On the other hand, the short-sale bets Goldman (successfully) made against the very sort of subprime mortgage pools it was peddling look like pretty powerful incentive. Why invest in managing a reputation when you can lay off the risk just by placing a bet against your own team?

e. Rather than "maintaining" an owned property, many buyers were in it to flip it.

How far apart had things fallen? The average equity held by the borrowers in Goldman's GSAMP Trust 2006-S3 was 0.71%. That's right--the ratio of the loan to the value of the underlying property was 99.29%. Picture you taking out a 99.29% mortgage.

As Fortune puts it:

A total of 93% [of GSAMP] was rated investment grade. That's despite the fact that this issue is backed by second mortgages of dubious quality on homes in which the borrowers (most of whose income and financial assertions weren't vetted by anyone) had less than 1% equity and on which GSAMP couldn't effectively foreclose.

The price we paid for efficient markets was higher risk. Was it a good deal overall?

Very possibly so, even given the dislocations; remember the S&L crisis? Mortgage securitization helped replace that mess.

But good grief, couldn't we have done better? Yes. In retrospect, the system assumed that better information flow would enable trust.

It didn't happen.

Financial theorists tend to describe capital markets in terms of information. If you can package information, subject it to standards and audits and controls, then you can "trust" it.

That emperor is looking naked. Trust is not about information alone. It is about people, and in particular about people's relationships to other people.

That's what made the old system work. For those who think trust is scalable through information alone, the subprime crisis should be sobering food for thought.

Data won't kill trust. But a steady diet of data alone will starve trust soon enough.

Comments

[dadw5boys]

The properties were over valued on the loan papers most over valued $100,000.00 or more to make to deals look good on paper.

The Loan officers and Apraisers scamed the process to make their money.

[Sundialsvc4]

The banking industry is in enormous trouble, and the more that I hear it babbling its nonsense-talk the deeper I know the trouble is.

But... I see signs of that trouble every single day as I drive through town. The factories are still closed, and pawn-shops and cash-advance and title-loan outfits are everywhere. I know, furthermore, that many of them are silently backed by major-brand banks.

I read the ending pages of the annual reports of dozens of companies from the last five years or so, and the absurdity of it all is obvious. The music was apparently still playing, then.

But it all really does come down to "the customer," and when you squeeze anything too hard for too long it finally breaks. If your response to that is to rush to the government for a fat-cat bailout, then I know implicitly that the D-E-P-R-E-S-S-I-O-N will be that much worse.

[mmckinl]

Trust ? ........ Poppycock!

It is not about trust. It is about effective regulation that creates good practice and transparent accounts.

It is no secret that Greenspan failed to regulate the loan industrry in 1994. That's why all these loans got made. Greenspan never saw a new fangled financial contraption that needeed to be regulated. Trust is why we have a bubble every 4-5 years.

This author needs to get real.
.

[Soulsurfer]

This is/was the biggest swindle since the Savings and Loan scandal under Rayguns. Under the guise of allowing people with less-than-stellar credit into the housing market, it allowed the whole housing sector (bankers, agents, contractors, speculators) to blow housing prices out of range for a generation to come. You can't take on a mortgage without at least 10% down, and that's generous. Here in California housing prices are at least double what they should be, due to everyone clamoring to get in on artificially low interest rates, sky rocketing prices, and mass hysteria. Greenspan ought to be shot for keeping interest rates too low for so many years, mostly to keep the bush administration from having to deal with a terrible economy, which his policies helped create. Very few people, especially first time buyers, can afford a home now. How many young couples do you know with access to 100,000 dollars for a down, and can afford 3-5,000 per month for a mortgage? But the players got theirs while the gettin' was good......so tough luck suckers. That's the American Dream.

[FightingTheRight]

When "interest only loans and 0 down payment loans" were just beginning to be promoted to people, as commercials say "with less than perfect credit", the bankruptcy laws were changed to favor the lending institutions over consumers.

This in turn encouraged the lending institutions to further promote these loans to even less qualified applicants, with the idea being, that borrowers could not legally walk away from them and the lending institutions wouldn't be left holding the bag.

With the large number of people who are not able or willing to be left holding said bag, and more than willing to walk away from their mortgages and face the consequences, the whole scheme is starting to collapse.

[outnow]

Many states have "anti-deficiency statutes" that made purchase-money mortgage loans "non-recourse," but otherwise you are correct.

That means that any purchaser can walk away with a foreclosure on his credit as the worst consequence other than losing his downpayment, if any. The assumption in these states has been that the market will be going up and the buyer can "flip" the deal at any time, and not even have a down payment. This comes to an end the day that willing buyers are no longer willing to pay an ever-increasing price for the home.

When the market gets "too hot," the entire process collapses. Hyping the market creates a bubble. Bubble after bubble are created by "market-makers." The "insiders" are the market-makers.

[FightingTheRight]

When "interest only loans and 0 down payment loans" were just beginning to be promoted to people, as commercials say "with less than perfect credit", the bankruptcy laws were changed to favor the lending institutions over consumers.

This in turn encouraged the lending institutions to further promote these loans to even less qualified applicants, with the idea being, that borrowers could not legally walk away from them and the lending institutions wouldn't be left holding the bag.

With the large number of people who are not able or willing to be left holding said bag, and more than willing to walk away from their mortgages and face the consequences, the whole scheme is starting to collapse.

[realitytrumpsbull]

Like the man said, figures don't lie, but liars
figure, and the green-eyeshaders knew they
were hanging a butt-cheek out in the breeze
with a lot of this stuff, well, the wheels
finally fell off, people finally started
asking questions about stuff like interest-only
mortgages, and then other questions about
standards and practices throughout both
the real estate and mortgage industries,
bluntly spoken someone set the treadmill
a little too fast, and people started falling
off. I don't know if the mortgage mess is
going to be big enough to cause a total
economic train wreck, but there's going
to be more karma from this fiscal funny
business, most likely, so prepare to hear
more sunny predictions and other sunshine
stories in the future...just keep one hand
on your wallet and stay away from the nice
man with the real estate pin on his suit...

[iswearington]

THE WHOLESALE SUBSIDIZING OF GREED AND CORRUPTION IN THE HOUSING INDUSTRY MAKES ME SICK.THE CROOKS TAKE 50,000 DOLLARS WORTH OF BUILDING MATERIALS AND 50,000 DOLLARS LABOR COST TO BUILD A HOME...CHARGE A BUYER 200,000 TO OWN IT...AND THEN WHEN THE POOR BUYER CAN'T MAKE THE PAYMENTS..THE DEAL IS CALLED A BAD LOAN. YOU GODDAMNED BETCHA IT WAS A BAD LOAN. IT WAS A CRIMINAL LOAN AND THE CONTRACTORS, REAL ESTATE PEOPLE...BANKERS AND MORTAGE HOLDERS SHOULD BE TRIED IN A COURT OF LAW AND JAILED. WHAT WERE THESE POOR PEOPLE SUPPOSED TO DO...LIVE IN A ONE ROOM TRAILER OR A CARD BOARD BOX? DON'T ALL AMERICANS HAVE A RIGHT TO HAVE A ROOF OVER THEIR HEADS. IF THOSE HOMES WERE SOLD AT 50-75 PERCENT OVER THE COST OF BUILDING THEM...NO ONE WOULD BE BEHIND ON PAYMENTS.ANY LOAN THAT IS NOT A FIXED RATE SHOULD BE ILLEGAL.IF A HOME ONERS PAYMENTS ARE 1200 PER MONTH...HIS TAXES AND HOMEOWNERS POLICY IS PROBABLY ANOTHER 300 PER MONTH IN ADDITION.NO CROOK SHOULD BE ALLOWED TO MAKE A 100 PERCENT PROFIT ON ANYTHING BUILT BY MAN.

[mmckinl]

Trust ? ........ Popppycock!

It is not about trust. It is about effective regulation that creates good practice and transparent accounts.

Trust is why we have a bubble every 4-5 years.
.

[nancytheragingliberal]

mmckinl: Yes, old fashioned "effective regulation." I loved regulation in every way, because it was good for my pocketbook. Yes, those were the days when banks were on the up and up, along with all energy bills/corps. , you name it. Now, the American people bend over for the corp's and pay through the nose. Don't get too excited folks, there is no recourse from your so-called "elected officials", as they too are feeding at the same trough. Just keep bending over and pay triple the amount you paid seven years ago....for everything. Under Bill Clinton, my bills were stable. Under Mr.'s oil, energy, and gas "men," watch your $ fly out of your wallets. Americans voted for this, twice? Pay up. This is what your hand voted for in 2000 and 2004.

[RealSoft]

This is another example of the .com like greed that makes speculators look smart when it goes up, and then stupid when it comes crashing.

[jwpilcher]

Great post. Seems like we learn the same lesson every 6 years or so...remember the lending environment we used to joke about that preceded the S&L crisis where banks lent on future value? Ha, ha!

In the late 90's we were told of the "new new" economy and sold on a bill of investments based on companies that didn't need cash flow, only eyeballs and stickiness.

Now we're back to real estate again. As the economist H. Minsky postulated, all bull cycles inevitably end this way as ponzi schemers take over the market and the markets ability to allow legitimate participants an ability make a clean dollar becomes more and more difficult.

I've been in the securitization mortgage business for 11 years and can say we've all known this was coming. The solution is so simple too.

1. Make all lenders of mortgages retain the non investment grade bonds (alignment of interests; borrower to lender to investor).
2. Reform how rating agencies are paid so that investors pay them, eliminating the current conflict of interest (alignment of interest; rating agencies to investors.

[Kendo Nagasaki]

How about this for a solution?

All mortgage debt is herewith cancelled.

[LeftRight]

Plus we also have to consider the fact that corporations have as their sole cause PROFIT. While the primary lenders were small town banks, they also knew the people involved, and had to live in the same town. Profit took a backseat to making the town better.

[oldpotsmuggler]

I remember a piece of New Deal legislation that placed a freeze on those nice local bankers evicting the nice folks from their nice homes. At some point even the nicest banker wants to get his money repaid.

From that experience, FHA and Fannie Mae were born. Both of them are a huge improvement over what the Savings and Loans degenerated into in the eighties, and both are still functioning very well today, thank you. Oh, and the mortgages involved in both programs have been and are taken to market as Mortgage Backed Securities.