Why Did the Mortgage Market Go Out of Control?

The mortgage market used to be a segregated, regional, illiquid and low margin but simple business. Local banks, acted as originators, and used to lend money to home buyers, hold the titles of their houses as collateral, and profit from the spread between higher mortgage rate received vs. lower interest rate paid to depositors.

In the good old days, mortgage lending officers were more careful to review and approve mortgages from homeowners. They evaluated the financial situation of mortgage applicants carefully on things such as household income, job security, total debt, net worth, and monthly obligations. Banks were more stringent in their lending practices, kept a close eye for local and regional real estate trends, and ensured enough cushion if there was an unexpected downturn.

The reason is that banks acted as both originators as well as life-long holders of these mortgages. Even though, from time to time, delinquencies and foreclosures were unavoidable, they wanted to avoid losses large enough to put them out of business. If losses happened, banks would be covered first by their spread (profit), and if that was still not enough, they would dip into their own capital and reserves. For mortgage officers, their current jobs and future careers were on the line if they were responsible for making careless loans. At that time, the home mortgage business was definitely not a lucrative one, but was a low margin and simple business like commercial banking.

However, for the last 10 years or so, the rise of home mortgage packaging, securitization and collectivization has thrown many good old practices out of the window. Local banks and mortgage companies nowadays are acting as agents, closing deals as originators, then selling the loans to large investment banks in order to earn a quick fees. Their role has changed from a loan quality controller to a salesman, doing as many deals as possible in order to earn higher commissions.

Then the structured finance groups at large investment banks collect thousands of mortgages from around the country, put them into a pool, package and securitize them, slice and dice them into many tranches (products with various credit ratings), then sell them to investors. The incentive profile has totally changed in this mortgage alchemy process. Who cares if a couple years later the loan is delinquent? Maybe I am the originator, but it is your problem.

This has created some very innovative and aggressive practices in mortgage lending, since the key to earn a fee here is volume, not loan quality anymore. This is similar to house flipping during the real estate bubble. When house price goes up 10% a year with no payment down, who doesn’t want to buy a multimillion house which can be flipped for a quick profit? Same motivation for the originators. The faster they finance and flip to sell a loan, the more money they can earn.

One day, a few smart people came up with a revolutionary idea called "subprime"; basically anyone with no income, no credit, no down payment, no nothing, has no problem to buy a house at almost any price. Or even better, anyone can get a loan for 110% equity of the house's appraisal value (since housing prices are going up 10% a year anyway). Not only is there no down payment, there is actually "free" money to be made by buying a house. It is such an ideal society, better than anything Karl Marx could have ever imagined.

More importantly, this securitization revolution has also brought many more players and their capital into the mortgage market. Instead of only local and traditional banks, which have a very limited capital base, lending money, we now have investors with large capital bases coming into this casino to make large bets. They are insurance companies, hedge funds, corporate and state pension funds, endowment funds, foundations, fixed income mutual funds, foreign central banks, foreign large commercial banks, the so-called 144A “sophisticated” (now we know how sophisticated they are!) financial institutions which are "qualified" to bypass any regulatory requirement and oversight.

Suddenly the pool of available capital is 100 times bigger than before. Coupled with next to no mortgage lending requirements, how could house price not go up? Since the 1970s, the median home price/median family income stayed at 2.8 most of the time, until 1999 when securitization just started and the figure has suddenly taken off all the way to almost 4 in 2005 to 6 a year's time: over 3 standard deviations.

As I mentioned earlier, this used to be a low margin and simple business in the good old days. But lately, before the collapse of real estate, every seller in the process of flipping mortgages got a cut, with the largest cut going to the structured finance group at Wall Street. Suddenly the home mortgage business became a lucrative and highly profitable business. Where did all this "free" money and high margins come from? I have seen many articles discussing subprime and MBS, even the very questionable lending practices, but I have read few articles explaining how and where this large profit was created. I want to provide a couple of my thoughts here.

1. Value was "added" or rather mispriced by pooling many mortgages across the country together in the securitization alchemy process. This is based on the argument that the sum of the portfolio is larger than its parts.

I use the S&P as an analogy here. To obtain the fair value of the S&P500, there are two ways to do this. One way, which I refer to as the correct way, is to evaluate each company separately by studying their financial statements, talking to management, attending earning calls, trade shows and industry symposiums, and building NPV models to come up with the fair values of all these 500 companies, then capital weight them to derive the fair value of S&P 500 Index. Even there are errors and biases here and there, but hopefully they offset each other and are canceled out at the end of the day.

Another way is to build a complex macro econometric computer model, download all the historical financial data, make assumptions on macroeconomic factors such as business cycle, interest rate, profit margin, earning increase, GDP growth, job market, payroll, inflation, etc. A lot of the modeling is to calibrate or forcefully fit historical data and trend into the model. This is what Abby Cohen at Goldman had done to forecast S&P earning and price target every year. This is not bad in bullish years since it is basically a trend following approach, but it would create bad calls during major economic turning points when future economic behavior is out of sync with historical data.

It is the same story, but with a much worse result, at the home mortgage securitization desk due to the lack of transparency and due diligence process (unlike the stock market.) When the structured finance group dumps many mortgages across the country into a pool, its aggregate price becomes more subject to the US real estate market assumptions including time frame models, historical data of delinquency, and default and payment patterns.

It is a big question of whether even the original mortgage data is correct due to questionable or fraudulent lending practices. In the model, I bet the delinquency and foreclosure rates were very low, and interest rate assumption was low so refinancing would never be a problem. They probably also assumed that US real estate had always been on an uptrend, never a down year for US as a whole since the Great Depression (this common myth was not true either, unless the data had been smoothed), and this uptrend would go on forever. Well, until 2007. Good times always end.

In the subprime area, it could not be worse. Without even getting into the fraudulent lending practices, there was no subprime 10 years ago. There is little historical data except from the last several years. How would the structured finance group at Wall Street come up with a reasonable estimate of default rate and payment pattern for the next twenty years? By assuming real estate will be up 10% every year forever? Or just grabbing a number in the thin air? These distorted assumptions dramatically amplify the nonlinear behavior on the pricing of the aggregate mortgage pool.

All this would not have happened in the good old days, when a loan officer did due diligence one borrower and one house at a time, similar to many stock analysts doing research on 500 S&P companies. This new alchemy process of mortgage securitization offers no transparency, no due diligence and makes no common sense at all. Investors basically let them twist the computer model to come up with whatever they think the future should look like, always resulting in higher aggregate price than the sum of its parts.

Another argument used repeatedly is the benefit of owning a diversified mortgage pool, so investors should pay a higher premium. A pool does offer lower risk, since mortgage investors are diversified from specific local and regional real estate markets but are subject only to general US real estate risk. This is similar to the fact that stock investors who invest in over 25 diversified stocks have diversified away most company-specific risk but are subject only to general market risk. However, why should investors pay a higher price for the pool? When stock investors buy more companies to construct a diversified portfolio, why would they have to pay higher price for each company per share, just because they are buying more than one company? This doesn’t make sense either.

II.. When structured finance groups slice and dice mortgages into many tranches in order to sell them, each tranch (product with a specific credit rating) is manipulated to create a price higher than it is actually worth, and thus further squeezes additional profits. This is based on the argument of charging a higher price premium by customizing products for customers with different risk profiles.

Through the magic hands of Wall Street banks, there are so many tranches being created, sometimes it is stripping out embedded options, another time it is a derivative on top of another derivative, called whatever squared or cubed, in order to squeeze more fees out of the pool. The more products, especially the more exotic products the banks can create and sell, the more profits for them.

Let us just look at the two most common derivatives of MBS: IO (interest only) and PO (principal only). Investors of IO vs. PO would only have rights to the interest payments vs. principal repayments paid by borrowers. IO will fall if the rate goes down, since more borrowers will be refinancing (no more interest payment to the original loans anymore), so called negative duration. PO is totally the opposite that borrowers will pay them back so quickly when the rate falls and they will have a free fall of cash, or positive duration.

A small deviation of default rate, interest rate movement and especially their timing assumption on payments would dramatically change the price for them. What is the right price? Only God knows. It is basically whatever the price the computer model says, and we will trust the computer and buy their products. Who wants and has time to dig behind the hundreds of thousands of lines of programming codes to figure that out? If you feel both IO and PO are way overpriced, that is too bad, since they are not like calls and puts of stock options which are governed by put-call parity and provide investors with arbitrage opportunity. There is no way to short IO and PO and long the original pool. Talking about market efficiency!

Because of exotic and complex products like this, investors have gotten totally lost, were unable to understand the behavior and do any due diligence on the products they were buying. As a result, they have to rely on the opinion of the rating agencies and bond insurers. However, they never realized the rating agencies and bond insurers were actually in bed with Wall Street banks; not only they were paid by the banks with their revenue growth mainly from increasingly complex mortgage derivatives, but also they were all using the same computer models and assumptions, so structured finance groups could twist the models to push yield to the ultimate threshold for a particular credit rating.

No wonder mortgage derivatives could always pay higher yields than other bonds for the same rating. This alone has guaranteed that there would be no lack of yield-hungry investors from insurance firms, hedge funds (using leverage by borrowing short term repos to generate double digit return), pension funds (need to reduce their pension deficit and liability), foreign banks (too sophisticated to know what they were getting into).

At the end of the day, mortgage securitization is a sales business, and pricing of mortgage products is driven by making yields higher and more attractive for a particular credit rating. As Wall Street says, it doesn’t matter what the product really is, it is always how it is structured to make it look good in order to be sold. Now you know why the cosmetic industry has such a high profit margin by making some low cost powders and creams, since they make people look good. Home mortgage securitization makes yield hungry financial institutions and investors look good.

In order to guarantee their future profits, many investment banks bought mortgage originators to secure future sources of their fees, now they are guaranteed to secure future losses, write-offs, litigations and liabilities. The WSJ has several articles about the ongoing investigation on UBS about a Dillon Read mortgage trader being fired because he was trying to assign a more accurate price to an inflated mortgage product. Come on, be realistic, mortgage trader, if you tell people the truth, how would you still be able to sell them?

As Warren Buffett quoted a banker saying: “Why banks have to find new ways to lose money when the old way had worked just fine?” The problem is without new “creative” ways of losing money, where are all the lucrative fees, top salaries and yearend bonuses for investment banks coming from?

Comments

[syndicat]

Great explanation.

I think that something similar is going on with all the Master Limited Partnerships that are being created. Wall Street has figured out a way to restructure these assets and sell the pieces at a higher price in the new structure.

Most of these assets have been around for years as parts of pipeline companies like Texas Gas Transmission and Northern Natural Gas. Now they are being sliced and diced into new companies to be
sold, mostly to retail investors.

The outcome is very predictable.

[fatcat]

If everyone in the financial world had read this post 8 yrs. ago,I wonder if it would have changed things?

I knew things were terribly wrong when I saw some of the people getting loans they could not swing.I just didn't understand the derivitives and nobody ever wanted to explain...they didn't want anyone to know.

[Igorisky]

Well written article. The reason subprime did not exist in the past was because it is not good to lend money to people who have a high probability of no being able to pay back the loan. They are almost a sure bet to default on the loan.

Now, why do we want to bail them subprimers out with our taxpayer money? Except for a few whose subprime status was temporary, sooner or later, they will go into default. Helping them will just prolong the inevitable...at great cost to us taxpayers. Helping them will just lenghten the time when the economy will recover. A good example of this is Japan. How long did it take them to recover from the real estate crisis they had in the 80's?

This mortgage crisis is equivalent to the Enron fiasco, except it is so much bigger and worldwide in scope.

The lesson here for investors is when you see institutions selling new and creative instruments, watch out! Do your Due Diligence or if it is so complicated, stay away and stick with the tried and true and very sound practices of the past.

[sivere]

Ultimately it is because congress delegated its constitutional power and responsibility to maintain currency and credits to the Fed. The Fed allowed the mortgage industry to be turned into a gigantic casino.

Let's TakeBackTheFed.com

[Dalma]

Best article I've read this year - bully for you. No one has been able to explain the crash until now ! Pity it will reverberate around the Globe for many years to come. Greed's the motive. Wall Street has much to answer for. I guess, the more one weave's a diabolical intricate lie, the easier it becomes to con investors intent on double digit returns. Keep up the splendid work.

[User 187124]

Over the past ten years with the advent of sub-prime lending, there have been more buyers on the market with money to spend. The supply of money allowed competing buyers to bid up the property more easily. This has left us with inflated real estate prices. I feel for our children who have yet to enter into the market to purchase a home. The effect of all this has priced them out of the market!

[coyoteyogi]

This is a good article and it goes a long way to explaining many of the 'nuts and bolts' that make up the mortgage business. However, I think the author misses the more fundamental point and it is this point more than even the structure and incentives that will determine the final outcome. This point is that the foundation for any and all financial products are the values of the people who make them. Implicit is the need for people to tell each other the truth. If everyone is lying, and I mean EVERYONE, then no amount of computer modeling or even old fashioned due diligence will reveal the problem. The entire edifice of mortgage backed securities is the belief that people will sweat, struggle and sacrifice to pay that money back for decades to come. That belief is a fantasy. People will make the most rational decision for themselves and their families. For many people this perfectly rational decision will be to walk away. This decision will be independent of their credit score. In fact, over time, a good credit score will become less and less valuable. As more people default and walk away the pool of 'poor' credit risks grows ever larger.
Without the values of rigorous honesty and personal integrity the entire system really does become a house of cards. Too many people want to clip coupons and there are not enough people willing to spend their lives sending in their checks. The necessary resurgence and renaissance of personal values and responsibility is and must be local_ person to person. That implies renewed communities of people where you know your neighbors, employers, bankers and customers. That in itself will guarantee a significant contraction. Plant a garden. Be scrupulously honest.

[bendra]

This article presents a big oversimplification. I did IT work for a major mortgage company back in 1998 and the great majority of their loans at that time were originated from a different bank; the business of buying and selling loans was already commonplace. You'd have to go back at least 15-20 years to get to a time when small local banks held and serviced the mortgage loans they originated. Why did the situation spin out of control in the last 10 years? For me a better question is why it took as long as it did.

[billddrummer]

A brilliant article. Thank you.

To bendra,

You're right about the securitization process occurring back in the mid-1990s. I believe that two things contributed to the change, which were laid out terrifically in this article: The proliferation of securitization products which based their values on the underlying securities, rather than the mortgages themselves, thereby improving yield to the final investor but decoupling from the mortgages' performance; and the simultaneous proliferation of exotic mortgage products, designed to widen the pool of potential homebuyers, but leaving behind the basic tenets of sound underwriting--down payment adequacy (skin in the game), income stability, cash reserves, and borrowing history and 'appetite.' Said another way, you now have to prove you intend to pay the money back.

Since the pendulum is now moving back to traditional underwriting as the basis for making mortgage loan decisions, the pool of potential buyers has shrunk, prices have fallen, yet inventory remains high in many areas of the country. Recovery will depend, in my view, on how quickly the inventory overhang can be absorbed. That points to a regional-based recovery starting in areas not subject to the highest appreciation over the past 5 years--the Midwest, South (outside metro areas like Atlanta and Charlotte), and the mountain states of MT and ID. When those areas work off their excess inventory, look for the recovery to begin in the high-bubble markets--CA, NV, FL, New England, and urban centers across the country. Don't be surprised, however, if prices within those high-bubble markets aren't 30-40% lower than they are now before they begin to rise again.

But it will take more than a year to accomplish. Perhaps by the next election, we'll see a recovery in housing. Then again, perhaps not.

[Joyful Alternative]

I can move things back further than Bendra did. The very conservative insurance company I worked for in 1978 was buying blocks of home mortgages from local banks thousands of miles away for geographic diversification. The local banks continued servicing the loans for a fee.

That's a far cry from slicing and dicing mortgages and selling tranches of the chopped mystery meat, but it wasn't Norman Rockwell days either.

Although at the same time I was paying my own mortgage to a mortgage association with no physical location that met monthly to review proposed loans and accept payments on existing loans. Mortgagees were required to appear monthly in person, and most of them paid cash.

[thomast2]

Thank you all very much for your comments.

Syndicat, you raised an interesting point about MLP. I think it is similar to REIT as a legal structure, but I suspect there are a lot more of tax loopholes on MLP for those private equity senior partners to evade taxes, which is probably the original purpose of setting up MLP. Need more time and research on this.

For Bentra and others, as Billddrummer indicated and well said, most of the price distortion is from the securitization process, which is only about 10 years old with proliferation only in recent years.

During this packaging process, fundamental elements of underwriting get stripped out, replaced with macroeconomic assumptions by the computer model. It is similar to the situation that, instead of buying company stock one at a time after you do research on their fundamentals, now Wall St gives you a basket of 500 companies and charge you a premium, because they claim that, based on Abby Cohen of Goldman, US economy will go on strongly in double digit growth forever.

Unlike equity securities, for mortgage securities, even you know they are mispriced, distorted, overvalued, manipulated, there is no mechanism to do arbitrage to return the price equilibrium, since investment banks at Wall St. controls both the market and the source of those illiquid mortgage securities and their derivatives.

So it becomes an one sided seller’s market, structured finance groups at Wall St. set their price, tell you their value, determine their risk, manipulate its credit ratings, investors don’t have a say on this since it is impossible and too complicated to value them.

The only thing investors can do is to buy high and try to sell higher to the next suckers. This is why you see so many hedge funds are involved in this. At the end of the day, this whole thing is totally a pyramid scam now crumbling, as Bill Gross of PIMCO indicated.