It was just over two years ago that I finished my manuscript on the mortgage market meltdown.
No such book would be complete without a prescription to fix the problems. Even though the most serious events of the meltdown were still in the future at the time (AIG, Lehman and Fannie/Freddie conservatorship), my prediction of the problems coming from simplistic crisis reaction came true (unfortunately).
The taxpayer was put on the hook for the ill advised lending that had gone on, and the private financing business was destroyed.
Now, we’re watching the politicians attempt to put Humpty-Dumpty together again, and they are missing some key requirements that would make the market self-policing.
It’s very easy to blame investors, borrowers, brokers, hedge funds, rating agencies, Federal Housing agencies, Alan Greenspan, Congress, or anti-government ideologues serendipitously put in charge of government. Which set of players in this rogue’s gallery get lambasted by any given observer seems to depend on that observer’s political bias rather than reality.
Unfortunately, a number of people opining on the solution are simply trying to reinforce their own preconceived notions of how to run the world, an approach that promises to make the same problems worse, if adopted.
I’m an equal-opportunity critic on this last point. The crowd that blames CRA, Fannie and Freddie is just as mendacious and wrong as the crowd that blame the evil big banks.
I just re-read my May, 2008 concluding chapter of Mortgage Market Mayhem, and in a small way, I think it’s worth putting into the public discussion as we go through the final laps of what has already been a several year long process of reforming our lending markets.
That said, here’s Chapter 28:
Transparency is the Solution
Markets need transparency and liquidity to survive and serve the participants. If a market has transparency, liquidity in the form of capital and leverage will follow. The credit markets, especially the US mortgage markets, are “broken”, and lack of transparency is the reason.
From end to end, from loan origination through “pooling” and securitization, and finally to trading in the market, areas of shadow persisted. It was under the cover of that darkness that most of the problems of greed, fraud or unwarranted optimism developed. What the investors couldn’t know definitely hurt them, and by extension, all of us.
As Attorneys General and politicians contemplate trying to fix what’s wrong, they need to bear in mind that the ultimate reason the mortgage market exists is to facilitate home buying and safe investing. By far the bulk of the money provided to the home buyers comes from institutional investors, in both the government sponsored MBS and the private label MBS markets.
These institutions, especially the ones that purchase the AAA bonds, aren’t just rich people looking for a place to have their money earn more money. They are mostly funds managed for the benefit of ordinary people.
They are pension funds, insurance companies, banks and mutual funds, all of whom are looking for safe investments to earn a return until the employees retire and get their pensions, the families of the insured need that death benefit to go on with their lives, the bank has to pay off a maturing CD, or the small investor needs to sell his or her mutual fund shares.
Financial crises are precipitated by loss of confidence. They also have their roots in too much confidence. The issue now facing us is how investors can regain enough confidence in our mortgage credit system to allow it to work again.
The most important single element in establishing investor confidence is timely access to reliable information, also known by the single word “transparency”. A close second in importance is a system that rewards and punishes participants according to their performance over time.
In a sense, the second goal, that of rewarding good performance and punishing bad performance, is also a matter of transparency, since investors can punish and reward when they make their investment decisions, if they have the information.
The temptation will be to legislate to achieve a narrow goal, which almost always sets up the next problem. As we saw in the savings & loan crisis as it developed over the 1980’s, the next problem is often worse than the one the new laws attempted to fix.
The damage may take years to repair, especially if non-economic “solutions” are forced on the market. There was a time for the regulators to step in to restrain unregulated subprime lending, and they chose not to. Now the legislators will try to fix the problems.
We can only hope that the legislators don’t go too far, or in the wrong direction. The initial “solutions”, which basically consist of transferring more risk to taxpayers, seem doomed to create an even bigger problem down the road. This is a prime example of going the wrong direction, as taxpayers are now taking on risk for mortgages, student loans and credit cards that were in the private market until the meltdown.
We need to give investors a reason to trust their money to private funding of mortgage loans rather than pushing them to the point that they can only trust government sponsored securitization.
To fix any problem, we need to have a goal. In this case, the goal should be to renew trust in the privately funded system. That will only be done by full disclosure and by independent verification, at every stage in the process.
The most important force in the reform of the system will be the investors who provide the capital for the lenders. Getting the investors full and timely data and providing a way to verify that data is the solution, and any new laws or regulations should help ensure that the data are available and accurate.
For most of the abuses in the system that led to the meltdown, investors would avoid the bad actors, if only they know about them. Economic consequences are usually the best way to control and correct the excesses of greed or optimism.
Punishment should be reserved for borrowers, lenders or investors who set out to defraud others. Regulation should have two goals, to help the capital flows move efficiently, and to set standards of behavior and reporting that all participants in the market are obliged to follow.
Another change our regulatory system needs is to regulate activities, not institutions. Taking the subprime mortgage business as an example, we had banks, independent financial companies, Wall Street broker-dealers, industrial companies, hedge funds and insurance companies all in the business of making mortgage loans.
Clearly the activity of mortgage lending should be regulated, no matter what the organization is called that does the lending. Similarly, if regulations on swaps are created, the same oversight and safety rules should apply to all, probably from a single regulator.
Some observers seem to be saying that the risk transfer system of securitization should be thrown out entirely. This is why so many think the solution is that lenders should just keep the mortgages until maturity. People advocating that “solution” haven’t thought about the consequences of going back to that system.
Deposits in banks are short-term. Home mortgages are long-term. It just doesn’t work to borrow short and lend long, so let’s hope we don’t have to learn that simple lesson yet another time.
Others say that subprime lending should be banned, or ARMs, or prepayment penalties, or loans without full income documentation in the form of W-2 statements. My response is that these “solutions” are like Prohibition as a solution for drunk driving, potentially causing more harm than they prevent.
Even after a year of “subprime meltdown” headlines, the Mortgage Banker’s Association reported that in the fourth quarter of 2007 just 17.3% of the outstanding subprime mortgages in the US were delinquent. The other 83% were paying on time.
This statistic does not include the loans that went into foreclosure or had been foreclosed already. The Mortgage Banker’s Association also reported that in the last quarter of 2007, 5.29% of the subprime ARMs and 1.52% of the fixed rate subprime loans began the foreclosure process.
It sells papers and boosts ratings to talk about losses and interview families suffering through the loss of their dreams. It doesn’t sell papers telling the stories of the majority who are making it (so far).
Whatever ends up being done to prevent abuses, we should bear in mind that about three fourths of the subprime loans in the US weren’t in trouble after the worst year for housing in post-depression American history.
Millions of people that were spending $1,000 a month on rent and building no wealth whatsoever now have a good shot at owning a house. History tells us that home ownership is the single most important source of family wealth building, far more important than either stocks or pensions.
It isn’t just the subprime borrowers who benefited from the securitization market. The banks that make mortgage loans to their customers were able to avoid a repeat of the Savings and Loan crisis, with its enormous cost.
The direct savings to American homebuyers in every credit range has been substantial. Each new kind of deal structure that appealed to investors tended to raise the value of the mortgages, which lowered the interest rates paid by borrowers.
A quick estimate of the amount of money saved by consumers and available to the rest of the economy might be helpful. For more than twenty years, the outstanding balance of publicly traded mortgage bonds has been around half the size of the entire economy.
At an average savings of about 2% per year for the borrowers, that gives the mortgage securitization market a “ballpark” positive effect around 1% the size of our national GDP. That’s well over $100 billion a year in savings to the borrowers, without considering the multiplier effect for the economy as whole.
This crisis does give us the opportunity to fix the problems, if we can avoid letting politics take over. A few changes will actually make the system more efficient when it’s working, although the major changes will primarily be to prevent another occurrence.
Fortunately the ultimate investors, the people who end up with most of the financial risk, can dictate most of the needed changes. With some amount of legislative and regulatory cooperation, common sense credit underwriting and end-to-end responsibility and transparency can be achieved.
Starting at the beginning and building on what we already have, borrower/lender relationship needs to have at least a few rules. Unregulated lending with multiple parties profiting no matter how the loan ultimately performed cannot continue.
To begin with, the borrower needs to understand what they are agreeing to. They also need to understand the risks they take, and the consequences if the optimistic outcome they hope for is not what happens.
Willingness and ability to pay does not have to require strict conforming guidelines like those imposed by the quasi-governmental housing Agencies. Higher LTV loans, or even stated income loans should not be banned, nor should prepayment penalties, interest only loans, or ARMs.
A one-page disclosure that summarizes all the terms of the loan, and its costs, should be part of every mortgage lending transaction. That one-page summary should be given to the borrower days before the closing, and it should lay out in plain terms the initial monthly payment, what that payment could adjust to, along with the other costs of owning the home like insurance, taxes, municipal sewer or water charges, etc. All these costs should be expressed as a percentage of the borrower’s income which the borrower should agree is actually what they expect to earn.
For refinancing, this mortgage summary should include a standardized benefit analysis that lays out the old and new situations for the borrower. ARMs should also include an “affordability” analysis that shows the same monthly cost and percentage of income calculations as if the mortgage had already reset and what the numbers look like if the mortgage went to its maximum rate.
The disclosure should say what the mortgage broker, mortgage banker, bank loan officer, title insurance company, closing company, appraiser, and any other party being paid for the loan origination gets paid. Mortgage brokers, mortgage bankers, and bank loan officers need to be licensed with a national standard, and their personal track record for complaints and loan defaults should be available to investors and borrowers.
Any individual receiving more than $1,000 in compensation for the loan origination should have some portion of that compensation held back or subject to recovery until a year has passed, and if the loan fails to perform, that money could only be released if extenuating circumstances (e.g. catastrophic medical bills) caused the loan to fail.
Appraisers should also be licensed, and records made available to investors regarding the subsequent sales of properties they appraised, and any losses incurred on loans for which they did the appraisal. There are already national professional associations for appraisers, so this step should be easy once the appraiser is included in the electronic loan file.
There are also several nationwide systems in place that can facilitate full disclosure about the ongoing status of any mortgage loan. Investors already use them, as do Fannie Mae, Ginnie Mae and Freddie Mac.
One such system, with 50 million mortgages already registered, is the MERS system, short for Mortgage Electronic Registration System. Except for one county clerk in Suffolk County, New York that resisted MERS until ordered by courts to use it, this system allows for any mortgage lien or mortgage servicing to be recorded electronically, and to be transferred electronically, with a secure system.
By using the MERS system to legally represent ownership and servicing rights for loans, the process of selling, securitizing, or transferring mortgage loans is far more efficient and error free. That single registration also allows for efficient modifications or settlements of loans in the future, as well as facilitating foreclosure, if needed.
If any mortgage that is sold were required to be registered in MERS, an additional notification of any additional lien placed later against a property could be automatically generated to inform the first mortgage holder. Thus investors could know if the loans they hold are subject to new risks later.
Another privately held reporting system that has substantial coverage of the mortgage universe in the US is the commercial system called Loan Performance. This service had gathered data on more than 43 million active mortgages as of February, 2008, and gave investors access to detailed monthly loan-by-loan performance data on the mortgages underneath more than $2 trillion in “private label” mortgage securities.
This technology provides a base for gathering and disseminating information on loans, and it could provide investors additional information as borrowers’ credit scores change over time or property values change. This kind of loan information was treated as if it didn’t change under the current system.
Another extension to this system would let investors see track records for individual mortgage brokers, appraisers, and others associated with the origination of each mortgage loan. Investors would pay more for deals that were originated by the better loan officers and appraisers, and sloppy or sleazy originators would be avoided.
In essence, that is what traditional investors in the mortgage market tried to do informally with their due diligence trips to originators and servicers before the bond market became a version of the Oklahoma Land Rush.
Based on credit performance history for various lending programs and the qualitative impressions gained through on-site visits, most investors viewed the mortgage market as having several credit quality “tiers” of securitizers. Even if the basic statistics like LTV and FICO score for one issuer’s deal was the same as another, investors would pay more for bonds from the better issuer.
Yield premiums were required to get investors to buy bonds from “tier three” or “tier two” mortgage securitizers, while the “tier one” lenders could get less expensive funding when they sold their bonds.
Where the legislators can help is by bringing our patchwork of local regulations and reporting up to a single national standard. Even before the meltdown, nationwide subprime mortgage operations literally paid millions of dollars per year attempting to keep up with state and local regulations and standards.
The mortgage lending industry has lobbied for standardization for years. But the change has been stymied by some states and even local governments who collect licensing fees from mortgage brokers, lenders and servicers.
Perhaps a compromise that allows certification or licensing costs to go back to the states where the brokers and lenders operate can be worked out. Still, this standardization is appropriate for the U.S. mortgage market — a national market — unlike real estate, a local market.
The other group that needs to step up is the regulators. The Federal Reserve had authority to regulate non-bank mortgage lenders, but they didn’t, choosing to believe the ideology that a free market takes care of its own excesses.
Commercial forces will likely extend the liability to six months for lenders to buy back loans that were delinquent in any of their first three payments. Even with the shorter 3-month window for these EPD’s that existed before the crisis, dozens of mortgage banks simply failed when called upon to buy back loans in 2007.
Clearly lenders such as mortgage banks and brokers will need to hold more capital to be accepted as counterparties by future wholesale loan buyers, and the Fed can require that.
While there are not many independent lenders left, in the future they may come back, as they do have a role in the system, especially when they build expertise in dealing with non-standard subprime loans and borrowers.
Reforms are also needed in the structuring and rating of securitized deals. These are primarily enhancements in disclosure, and they are likely to be adopted by the investment banks and the rating agencies if the investors want them.
For the rating agencies, I recommend disclosure similar to the disclosure that is now standard for stock analysts. For any rating, they should show a history of the results of the same ratings on other bonds in the same sector. That history should be clearly described, along with how many comparable bonds had been rated, and any changes that were made to those ratings year by year over periods up to ten years.
In the disclosure offered with the bonds, the investment banks should expand their current disclosure to show a matrix of results. In the past, a range of prepayment speeds was all that was shown. Prominent among these was the “expected” speed vector, also known as the “pricing” speed.
By describing the expected future path of principal prepayments and the expected future path of credit losses for the pool of loans, the investment bank gives the investor one among many future scenarios to see. That one should be the scenario that can be justified by comparing the pool of loans backing the newly issued deal with the performance of similar loans in the past.
If an investor could see a grid of potential scenarios showing the investment results of the pool prepaying and defaulting as expected, and also at half the expected rates, 1.5 times the rates, twice and four times, that grid of 25 different investment outcomes would be very helpful to investors.
A small additional bit of reporting in the monthly remittance reports from the Trustees would also help investors. Those remittance reports have a wealth of information on the loan pools and the bonds, including what percentage of the pool is at various stages of delinquency, and how much money is paid to each class of the securitized deal and to the interest rate hedge providers.
We should see each month how the underlying collateral is performing, expressed as a percentage of the originally expected prepayment speed, default rate and credit loss rate. These disclosures should be shown in comparison to the experience since the deal was originated, and in comparison to the expected rates of prepayment, default or loss for the month being reported.
The reforms the market needs also apply to the trading of these securities. As we have seen, the financial system as a whole has been destabilized by sudden major changes in the market values of these bonds, even before credit losses occurred.
With the rise of the hidden synthetic Credit Default Swap bond market, it’s more important than ever that the whole market have some disclosure of the exposures that exist within the system.
Those that argue we cannot require offshore investment funds like hedge funds to disclose their positions fail to realize that we certainly do have the right to require disclosure of financial positions taken in our markets with our banks, brokerage firms, insurance companies, pension funds and endowments as parties to those trades. This should apply to any position that exceeds a certain threshold, perhaps 5% of the outstanding issue of any stock or bond.
Any fund that doesn’t want to disclose its positions (bull or bear) in our markets is welcome to limit their trading to markets that don’t have the need for transparency.
I propose that a monthly aggregation of net CDS exposures be prepared by any bank, investment fund or securities firm that does business in the US market be published, telling the market as a whole how many (net) dollars of CDS long positions and short positions are outstanding for each publicly issued bond, and for any privately issued bonds that used the public registration exemption called Rule 144A. These two categories represent most of the bonds in the US marketplace.
Those positions, though not identified as to which fund or bank has them, should still be published for all to see, with aggregate long and aggregate short positions visible to all participants in the market. Anything less is giving one group of investors an advantage over others.
For this disclosure to mean anything, the “net” exposure has to be defined very narrowly. Only offsetting CDS contracts with the same counterparty would be subtracted from the total. As we saw when the Bear Stearns purchase was subsidized by the Fed, the fact that Bear Stearns had two offsetting CDS contracts with two different counterparties mattered not one bit in determining the systemic risk.
An alternative would be to have all CDS contracts executed with a single central counterparty, even if arranged between two institutions. This is analogous to the central clearing system now used for most stock and bond trading, where each institution delivers or receives its securities from the Depository Trust & Clearing Corporation (DTCC). We could then have the new central CDS clearing entity report the monthly open position exposure for each unique debt instrument.
The final piece of the trading picture the market as a whole has a right to know is the total volume of trading in these sensitive segments of the credit markets. Perhaps nightly disclosure of the volume of settlements at the DTCC, broken out by market sector and credit rating only, thus protecting the institutional investors and trading firms from having proprietary trading strategies disclosed while giving the market information it needs.
While we’re at it, we should require the DTCC to disclose total long and short positions in our equity markets nightly for each stock, like several Asian markets do, along with nightly records of stock that has been sold but not delivered.
We should clean up the undelivered stock that burdens our market with additional supply. That can be done with a simple change in payment rules. No buyer of a stock should have their account charged for a trade until the delivery of the stock is completed, and no broker should get commission nor seller of a stock be credited with the money from the sale until the trade is complete.
Taken together, this list of changes would do a great deal to restore trust to the credit trading system. Without that trust, our housing market and our financial system will take more years and more money than we imagine to heal.
We need to do what we can to restore the system of private finance as quickly as possible rather than taking more and more of the risk into the public domain.
We also need to re-establish the private financing system for mortgages that fall outside the confines that make them appropriate for Agency credit guarantees. This includes both subprime loans and loans that rely on borrower assets rather than conventional income as the means of payment.
There are literally millions of households that can afford to own their homes for which the mortgage business can make reasonable loans at appropriately higher interest rates. Those families deserve the opportunity to succeed or fail in reaching for their piece of the American Dream.