November 15, 2010
A Modest Proposal to Avert Another Mortgage-Backed Securities Disaster
At its core, the mortgage-backed securities crisis is the product of an inadequately regulated mortgage-industry system. This inadequacy resulted in a massive transfer of wealth from you and me to lenders and investment banks, and an economic crisis that continues the plague the country.
So I've been playing a thought-game: what's the smallest amount of regulatory reform that would completely prevent this disaster from recurring?
I've got a nominee.
Before I explain it, I need explain how we got to the point where we need it. To that end, here's the mortgage-backed securities crisis, in 10 easy-to-understand steps!
(follow the bump)
OK, here's the mortgage-backed securities crisis in 10 easy-to-understand steps:
(1) At one time, lenders who made mortgage loans kept those loans in-house; they got the benefit from the loan payments, and they got the cost from default. Their insurance against the cost of default was foreclosure and sale.
(2) That system shut down during the Great Depression. To get home lending working again, the federal government created a brilliantly-conceived secondary market for mortgage loans: lenders could make loans, and then rather than hold onto them, sell them to someone else. This lessened lenders' risks, so they were more willing to make loans.
(3) The entity that purchased these loans from lenders was an newly created government agency called the Federal National Mortgage Association (FNMA). But -- and this is critical -- the FNMA would only purchase loans that met certain quality standards. The borrower had to produce a significant downpayment (usually 20%), borrow money at a fixed-rate, take a long-term loan, and could not take on debt that exceeded a modest debt-to-income ratio. That meant that (a) the risk of default, and thus foreclosure, was quite small, and (b) the U.S. housing market was remarkably sound and stable.
(4) The FNMA eventually held over 80% of the mortgage loans in the United States. It was ideologically distasteful to have a government agency hold such a huge portion of private loans in a capitalist economy, so FNMA was privatized and became the company known as Fannie Mae.
(5) Investment banks and new lenders began to compete with Fannie Mae to purchase loans on the secondary market, because they could pool the loans together and sell securities in the pool to investors.
(6) Investors loved these mortgage-backed securities, because they were perceived as a very safe and reliable investment: after all, the U.S. housing market had been remarkbaly sound and stable.
(7) Investment banks and lenders competed with Fannie Mae by purchasing loans that did not meet the FNMA's quality standards: no money down, no income-to-debt ratio, adjustable rates, short term loans. Fannie Mae responded by lowering its standards. A race to the bottom began. Soon, Fannie Mae and the investment banks were securitizing pools of very,very low-quality mortgage loans.
(8) Investors, relying on a historically stable U.S. housing market without considering that the conditions that created that stability (i.e., FNMA's quality standards) had been undermined, continued to buy up mortgage-backed securities.
(9) Lenders, who made their profits not by receiving a stream of payments on loans, but instead by making loans and instantly selling them on the secondary market, had every incentive to make as many low-quality loans as possible as quickly as possible.
(10) Borrowers took on loans they couldn't afford and would have to re-finance in short order. They secured those loans with their homes.
It was a house of cards that couldn't possibly last, and both lenders and investment banks knew it. Borrowers didn't know it. Investors in mortgage-backed securities didn't know it. But lenders and investment banks knew it. It is bitterly ironic therefore that we, through the Bush Administration's TARP rescue program, saved lenders and investment banks, but not borrowers or investors.
Now we are caught in a continuous spiral. Foreclosures flood the market, which drives down home values. Home values fall below the amount outstanding on short term mortgage loans that need to be re-financed. Those homes can't be re-financed, because their re-sale value in the event of foreclosure won't cover the amount borrowed. The homeowner in need of re-financing now must either pay the entire principal on the loan, or go into foreclosure. Foreclosures flood the market, which . . . . You get the grim picture.
I don't know how to get us out of this mess, but I do have a modest proposal to help prevent it from recurring. One solution would be to keep Fannie Mae nationalized, re-convert it to the FNMA, and re-impose its old quality standards on the secondary market. But politically? Ain't happening. Apparently it's still, despite everything we've been through, too ideologically distasteful.
So how about this? From now on, lenders have to keep a certain percentage of their loans in-house. Say 20%. But here's the key: they don't get to choose which ones. That's decided randomly. No lender who has a 20% chance of having to bear the cost of a low-quality loan is likely to make one without some serious pause. Think of it as forcing lenders to internalize some of the risk of their behavior.
One regulation. Call it the 'toxic-asset roulette' rule. The rest of the de-regulated mortgage-backed securities system can stay in place.
What do you think? What are your ideas?
Mark A. Edwards
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One more suggestion: Most commercial construction loans have "at will" or "on demand" clauses that allow a bank to call a loan without cause. Outlaw those clauses and make the bank have to prove cause to call a loan.
One of the big problems with those clauses occurred when big banks such as NCB got in trouble. Bank officials across the nation were told to get out of real estate and construction loans as quickly as possible. That set up conditions whereby highly-placed and informed people within and outside those banks could select the most valuable properties for foreclosure, set up fraudulent conditions to put the owners under, then buy the foreclosed property for a fraction of its value. Not only did such games stiff the bank itself of millions of dollars, but developers, contractors, multiple vendors, workers and others working in good faith to finish good projects were bankrupted or financially damaged, and smaller banks holding accounts receivables loans layers down from the primary bank were stiffed as well.
Because the bank making the loans was going under, the primary borrower (put into bankruptcy by the games) and his tiers of contractors had no recourse, since the bank liabilities were fobbed off to the FDIC, which has no money to pay the hundreds of thousands of dollars such lawsuits would cost. The resultant loss of tiers of jobs then led to more home mortgage foreclosures.
Posted by: jacke | Nov 16, 2010 1:27:02 PM
Great suggestion, Jacke!
Posted by: Mark A. Edwards | Nov 16, 2010 4:37:13 PM