That’s how Lew Ranieri, one of the creators of the mortgage-backed security (MBS), greeted his audience at a well-attended housing conference in New York City last week. Ranieri and four other financial and economic experts were there to talk about whether securitization, whose excesses are blamed for much of what ails the housing and banking industries today, is the best way to finance homeownership going forward. What the audience heard was that abuse of that financial instrument, not the MBS itself, is what put the housing market so out of tune.
Ranieri, who currently runs his own financial services company, presented a useful short history of mortgage securitization, which first surfaced in the late 1960s to bolster a banking system that couldn’t keep up with home buyer demand. At the time, thrifts were originating most mortgages, so the solution was to use the loans themselves to create a credit mechanism that kept debt off of the banks’ balance sheets.
“The essence of finance is the lender worrying ‘am I going to get paid?’” said Lawrence Wright, an economics professor at New York University’s Stern School of Business. MBS financing, not unlike government-sponsored entities like Fannie Mae, “gave lenders confidence,” he said. However, the Achilles’ heel of securitization, explained Ranieri, has been “the sheer number of players in the process,” including builders, real estate agents, “loan arrangers” such as brokers, banks, and mortgage companies like Countrywide Financial; and issuers that included the federal government and Wall Street.
“The big problem was that everybody kept saying ‘I’m an agent,’ and not a fiduciary, to the point of intolerability,” said Ranieri, who insisted that loan servicers must be the sole fiduciaries to make securitization work. With everyone thinking someone else was on the hook for the debt, what emerged was “a reduced appreciation of risk in general, and not just in the mortgage arena,” added Wright, noting that junk bonds at the time were trading at spreads with lower yields, and lenders were placing fewer covenants on mortgage loans.
But contrary to the conventional wisdom that banks and mortgage companies were originating shaky loans because they were able to pass along risk to MBS investors, “a big part of the current crisis is that many of our financial institutions had skin in the game,” said Wright, pointing specifically to Washington Mutual, Wachovia, Indy Mac, and Franklin Bank, all of which have evaporated under the heat of the credit meltdown.
Austan Goolsbee, one of President Obama’s economic advisors, caused a minor stir at the conference when he stated that securitization foundered because it removed risk from both the originating lender as well as the buyer. “‘Subprime’ are essentially people who don’t pay their bills,” he asserted. “But we created a system where the deal worked as long as there was house-price appreciation.” Goolsbee softened his stance, though, after Ranieri and other panelists pointed out that the majority of subprime borrowers aren’t delinquent on their loans. “It’s not the consumer; it’s the underwriting and structure that are the problems,” Ranieri said. “‘Subprime’ has come to mean 2/28s and 3/27s; that’s not subprime,” referring to adjustable-rate mortgages with low teaser interest-rates that left loads of unsuspecting borrowers with loans they didn’t understand and ultimately couldn’t afford.
One possible alternative to securitization that is discussed with greater fervor lately by economists and financial experts is covered bonds, which require lenders to keep the debt on their books and, theoretically, make them more cautious in the process. For example, Denmark mandates that mortgages stay on its banks’ balance sheets, said panelist Peter Engberg Jensen, chairman for the Association of Danish Mortgage Banks and CEO of Nykredit Realkredit A/S. He noted that if a loan lapses into default in his country, the bondholder has a dual claim against the borrower and the lender. Jensen added that the “covered pool” of loans is “actively managed” so that it can be adjusted if house prices start dropping. (An issuer can, in effect, tax borrowers if a loan’s margin drops.) Such loans are also full recourse, so walking away from an underwater mortgage wouldn’t absolve a homeowner of the debt.
Some banks in America have issued covered bonds. Paul Jorissen, a partner with the law firm Mayer Brown, noted that WaMu underwrote covered bonds that had different collateral than its subprime and Alt-A loans. However, there was general agreement on the panel with Goolsbee’s observation that even if all mortgages in the United States had been covered bonds, “the banks would still be getting wiped out.”
While none of the panelists had a silver bullet that would solve the mortgage malaise, they mostly concurred that securitization should still be a viable tool to finance homeownership. But changes are in order. Jorissen thinks there must be more competition among debt-rating services beyond the big three—Standard & Poor’s, Moody’s, and Fitch—that in their quest for higher fees during the housing boom turned a blind eye to dubious underwriting standards. “I can’t explain why it took the rating services until 2007 to use the piggyback as the real criterion for [assessing] the first loan,” said Ranieri.
Ranieri also noted that the slicing and dicing of mortgages into securitized commodities further complicated matters. “Once you could take subordinated tranches, like CDOs [collateralized debt obligations], and put them into [more vague] securities that could be bought all over the world, the level of investor sophistication deteriorated.”
Jensen, however, suggested that the financial crisis was exacerbated by too much sophistication. “One of the biggest mistakes was the notion that everything can be calculated, when it might have been better just looking out of the window to see what was going on in the real world.”
John Caulfield is senior editor with BUILDER magazine.
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