Have We Diagnosed the Major Sources of the Financial Crisis Correctly?
(Or Whose "Skin" Ought to Be in the Game?)

June 14, 2010

The basic facts about the financial crisis that originated in the home mortgage market are not in dispute:

  • The housing bubble that preceded the financial crisis was reinforced by an excessive liberalization of mortgage lending terms that produced toxic mortgages – these were mortgages that could not be repaid unless house prices continued their rapid rise.

  • Each player involved in the process was able to pass on the risks associated with these mortgages to the next player in the process – until it ended up with the investor purchasing the security that was issued against the mortgages. Among all the parties involved in the process, the investor typically was the least capable of controlling or assessing the risk.

Remedies Focused on Loan Origination

Policy remedies designed to prevent it from happening again have focused mainly on the loan origination process. The logic is simple: prevent the origination of toxic mortgages and we prevent future crises. This logic underlies the drastic tightening of underwriting requirements by Fannie Mae, Freddie Mac, large lenders and regulators.

But a tightening of underwriting rules after the crisis that should have been done before the crisis is not logical at all. My mailbox these days is stuffed with letters from potential borrowers with impeccable credentials who can’t get loans today because of new and ill-considered underwriting rules. Tragically, these rules are preventing large number of borrowers with mortgages in good standing from refinancing at today’s low rates. 

"Skin in the Game" Requirements

A focus on the need to regulate loan originations also underlies more comprehensive reform proposals. A common argument is that every party involved in creating the mortgage – the retail lender making the loan, the wholesale lender buying it from the retail lender, and the investment bank buying it from the wholesale lender to place in a security -- should be required to assume part of the risk of loss. In my view, this argument misses the point. Requiring a lender to retain 5% of the risk of loss on a toxic mortgage that it originates to sell will force the lender to increase his markup by enough to cover the risk, but it won’t deter the lender from making the loan if there is a ready buyer for it.

Strategic Role of the Secondary Market

The reason toxic mortgages were originated was that there was a secondary market for them. Without that market, there would have been no sub-prime or Alt-A mortgages. The skin that is needed to fix the game is that of the issuers of mortgage-backed securities (MBSs). All MBSs should be full-faith liabilities of the issuer, meaning that they assume 100% of the risk.    

The private MBSs developed by wall street were all “stand-alones” -- the reserves and other forms of credit enhancement on a given security were available only to investors in that security. If not needed, the credit enhancements on a security were withdrawn, paid either to the issuer or to a third party who purchased them. They were not available to investors in another security that suffered losses that exceeded the credit enhancements available on that security. 

For this reason, the private secondary market was a house of cards. High-loss rates on MBSs issued late in the bubble, which swamped their available credit enhancements, caused a cascading loss of confidence in all of them. In a relatively short period, the market ceased to function effectively.  

The breakdown of the private MBS market was major factor in the unfolding crisis. Institutions holding private MBSs in their portfolios had to write down their value, which could deplete or eliminate their capital. This was a factor in the case of the five major financial institutions that either failed or were forced into government-assisted mergers in 2008 – Bear Stearns, Washington Mutual, Lehman Brothers, Wachovia, and Merrill Lynch.  

Write-downs in the value of MBSs also had a major impact on short-term borrowing secured by MBS collateral. This created a major problem for investment banks, who were accustomed to borrowing enormous amounts over-night in this way. As the value of the collateral became increasingly suspect, lenders kept asking for more and more collateral. The failure of Bear Stearns and Lehman Brothers was due not only to the depletion of their capital, but also to their inability to post enough acceptable collateral to secure their overnight borrowings. 

The Different Experience of Denmark

Contrast our experience with that of Denmark. They had a housing bubble much like ours, and all the mortgages written in Denmark are placed in securities issued by private mortgage banks, but not one security went into default. During the worst part of the crisis in 2008, when the private MBS market in the US was shut down, it was business as usual in Denmark.  Why the difference?

Where private MBSs in the US are stand-alones, mortgage bonds in Denmark are full-faith liabilities of the mortgage banks issuing them. This means that if the default rate on the mortgages underlying one of the bonds issued by a bank turned out to be unusually high, investors in that bond would be protected by all the resources of the issuing bank. There has never been a default on a Danish mortgage bond in over 200 years.  

Loan originators did a lot of nasty things during the housing bubble, but that should not blind us to the root source of the problem, which is the private MBS market. Making loan originators assume 5% of the risk on the loans they sell would not bolster that market at all, though it would create enormous record-keeping problems. What is needed to prevent the creation of another house of cards is a requirement that issuers of MBSs accept 100% of the risk. Then an MBS will fail only if the issuer fails, which in Denmark has never happened, but if it did happen, MBSs issued by other firms probably would not be affected. 

Note: The Senate’s Proposed Restoring American Financial Stability Act of 2010 would require security issuers to retain 5% of the credit risk on the security, or less than 5% by the amount of risk retained by the originator selling the loan to the issuer. The 5% requirement could also be reduced if the loans had “reduced credit risk”. This reads like it was written by investment banks. 

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