January 2011

The Mortgage Mess: How We Got Here

Author: Robert Star

So we find ourselves in a gut wrenching real estate market where home values have decreased by 30 percent or more and vacant lots by much more. Homeowners are being forced to negotiate short sales, being foreclosed on, or strategically defaulting on their loans to cut their losses. Due to the huge volume of mortgages originated from 2004-2007, suspect loan underwriting standards and sloppy and inadequate mortgage loan documentation, we are now faced with a crisis never before seen in the financial markets. To truly understand the mortgage mess, one must take a moment to understand how mortgage lending and the business of banking got to where it is today.

Banking before the Crash of 1929 was on the Bailey Building and Loan model, as seen in the movie It’s a Wonderful Life. Banks took in deposits, paid a fair interest rate on those deposits and charged a greater interest rate on loans. Banks made a reasonable profit from the spread. Since the management of these assets and liabilities was indeed the core business of banking, profits were generally assured, as leverage was limited and earnings were predictable.

However, in 1933, Fannie Mae, and the Federal Home Loan Banking System were created in response to the Great Depression, and the Glass Steagall Act was enacted to separate the business of banking from investment banking.

Fast forward to the mid 1980s; banking deregulation started to occur when Glass Steagall was repealed and banks began heavily leveraging their balance sheets. The idea of leveraging the balance sheet as a financial tool for mortgage lenders really took hold in the 1990s in the form of securities. These securities allowed financial institutions to leverage their capital and to lend multiples of what they used to lend.

Banks created investment alternatives to corporate bonds and treasuries that were structured financial products based on a pool of underlying residential mortgages. These investments were packaged or securitized into large pools known as Residential Mortgage Backed Securities (RMBS) and were sold to large institutional investors, endowments, foreign banks, and then to retail customers at large brokerage firms.

The investors all believed in the stability and growth of the United States housing market. This created a demand for RMBS that could only be satisfied by banks offering loans to anyone and everyone. Unfortunately, this also created an illusion that there really was demand for housing and it was a safe investment, which may have worked if the banks maintained the It’s a Wonderful Life loan model. Remember, banks took in deposits, lent the money and made a profit on the spread. However, Wall Street bankers are much more creative today.

A simple example of the switch to leveraged lending is when XYZ Bank lends $1 billion in mortgage loans and then securitizes them. Securitization is the process whereby the $1 billion that was lent by the bank to borrowers/homeowners is then pooled and packaged into one large security instrument or bond. These bonds are then sold to investors such as a large institution like an insurance company, hedge fund, foreign bank or split up among hundreds of investors. XYZ Bank then gets their $1 billion in principal returned, plus a premium. This premium could be as much as five percent of the $1 billion lent to borrowers or $50 million for selling that pool of loans. Banks repeated this over and over again, sometimes six and seven times a year on the same $1 billion in capital. Using our example, they would earn a gross return of 30-35 percent on each billion dollars lent, which demonstrates the idea of “leverage” that enables a modern bank to lend multiple times in a year, utilizing the same amount of capital. This went on from 1993 and grew to a trillion dollar a year industry in 2007.

Now let us fast forward and take a look at the financial collapse of September, 2008, when we saw financial institutions like Bear Stearns, Lehman Brothers, Washington Mutual, Countrywide, Merrill Lynch, Wachovia and others fail. The collective wisdom generally blames the subprime mortgage industry and borrowers who purchased more house than they could afford. However, it was sloppy or no underwriting standards and leverage known as collateralized debt obligations (CDO’s) that were at the center of the technical manifestation of the collapse.

These ills and losses caused the banking system to seize up; short-term capital markets, the repo or repurchase markets, commercial paper conduits and overnight swaps failed to function. In short, the life blood of the world economy was severely curtailed. Liquidity or access to short-term borrowings, between and among financial institutions became non-existent. The world’s largest financial institutions were essentially scared to trade with each other. They did not know who the next Lehman Brothers could be, and they were concerned about counter party risk. This is the risk that the other party in a financial transaction would default.

Sophisticated financial institutions and large publically traded companies approached a point where there was no access to cash or liquidity to conduct normal operations, like make payroll! The stock market was moving with abnormal volatility, and the world was essentially a deer in headlights. It took a bail out and closed door negotiations between financial institutions to restore order amongst the chaos. Fortunately for all of us, the financial markets have moved forward and day-to-day commerce is working again.

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