Given the current environment this appears to be the worst possible time for anyone to even think about defending Wall Street. The markets have lost at least 40% of their value this year, Congress passed and implemented a very controversial bail-out bill, and yet Wall Street's bonuses still seem to be doing very well. However, as we clearly move into the "re-regulate" mode it will be easy to go too far given the current environment -- meaning that we throw out the financial baby with the bathwater. A well functioning financial intermediary system (banks, insurance companies and the like) is critical for our economy. We need to find the right balance between financial growth and prudent regulation. To that end I will discuss three areas of the financial markets -- securitization, credit default swaps and the overall structure of the financial system -- and propose regulations that provide the necessary balance between protection for the consumer, allowance for financial growth for the overall economy and allowance for growth for the financial industry as a whole. I will deal with one topic per article.
Securitization
First of all -- what is securitization? Let me answer that question this way. First, here is a picture of your mortgage:
(Please forgive my very undeveloped drawing program skills). The vertical line is simply how much you pay every month. This is a constant number. The horizontal line represents time. So as you go further to the right we're talking about a mortgage payment that will occur further and further in the future. The black triangle represents interest and the white triangle represents principal. In other words, your earliest payments are almost entirely composed of interest whereas the last payments are composed almost entirely of principal. Now -- let's take your mortgage and pool it with other people who have similar mortgages -- that is, they pay a similar interest rate for a similar period of time. This would create a big pool of mortgages that pretty much had the same characteristics as the diagram above -- meaning, the first payments were composed of interest and the last payments were composed of principal with middle payments composed of a mixture of income and principal.
Now let's add another set of people. Suppose you are a manager for an investment fund that invests entirely in bonds. You've just had a discussion with your actuaries and they have told you they expect an increase in withdrawals in 5 years as fund investors retire. So you need to figure out a way to raise cash in five years. It would be great if you could buy a bond that pretty much guaranteed payment of principal and interest within your time frame.
Let's add a few more people. Suppose there are more managers out there in a similar position -- they need cash that comes due within a specific time period. But their time period is different then yours -- some need the money now, some need the money in 30 years etc... How can we take these different people - the people paying the mortgage and the people who need money at a certain time and combine their interests?
This is where securitization comes into play. Instead of making one big pool of mortgages we "carve up the cash flows" -- meaning, we make a series of bonds that pay people at different times. For example, one bond will pay principal and interest to a specific bond holder for three years beginning 3 years from now and ending 5 years from. Another bond holder will get principal and interest payments for 7-10 years from etc.... That's all that securitization is -- pooling a group of mortgages with similar characteristic (interest rate, length of maturity) and directing the various cash flows to different people at different times. That's all.
This process has been going on for the better part of 25-30 years now without much incident. So -- what went wrong this time?
The biggest problem with securitization is no one has a vested interest performing due diligence on the borrowers -- the people taking out the mortgage loans. The mortgage brokers write the loan and sell it to a large investment bank. The investment bank pools the mortgage and carves it up into different bonds. The bond holders don't hold all the collateral, only pieces of it. As a result, no one really owns all the mortgages for an extended period of time. Instead, the most they own is a piece of a larger pool of mortgages.
Let's go back to the first few paragraphs. Remember -- we're using collateral composed of residential mortgages. What if we're writing a lot of mortgages to people who aren't credit worthy? That's the central problem with the mortgage securities market right now --mortgage brokers wrote a lot of loans to people who couldn't afford them. In other words, the collateral used as the basis for mortgage backed bonds was bad collateral. No matter how you carve the cash flows, you're still using collateral that will eventually default.
And that is that has been happening over the last few years. As loan defaults increased the bonds backed by the collateral stopped paying interest and principal. As a result, anyone who owned these bonds had to "write them down", meaning they had to say, "We thought these bonds were worth $100 but really they're worth $75".
So -- how do you solve this problem? Actually, it's pretty simple. There has to be oversight of the mortgage underwriting industry. There must be strict rules about who gets a loan and when they get a loan. This means some people will be (gulp) turned down for a loan at least initially. But that also means there is an opportunity for people to clean up their credit so they can get a loan in the future. This problem comes down to oversight of an industry. There have to be regulators who are looking over the shoulder of anyone who underwrites mortgages.
And that's it -- audit mortgage brokers on a regular basis. And make sure the regulators do their job this time.