THE MORTGAGE TAIL THAT WAGS THE ECONOMIC DOG

June 2, 2009

Evan M. Drutman

Partner

View profile

Evan M. Drutman discusses securitization as a financing technique and how mortgage-backed securities came to play a role in the financial crisis because of poor credit underwriting and inadequate risk management.

New Yorkers who work in finance, at least those who still do, may recall the old joke about Jews proclaiming to be God’s “chosen people” while, in light of persecution, wishing that He would choose someone else once in a while.

Here, less than a decade after being at “ground zero” of what figured to be the most consequential event of our generation, we are again at the epicenter of a calamity that, without the immediate human tragedy, may prove just as historic. Consider recent events.

When Bear Stearns collapsed in March 2008 people were horrified and incredulous that real estate investments and subprime mortgages had taken so major a victim. Yet, at the same time, some took comfort in the notion that every big downturn in a market seemed to end with one spectacular bankruptcy. Think Arthur Andersen. For many, Bear was presumed to be that single bankruptcy. Boy, was that mistaken.

Not six months after our fifth largest investment bank failed, we had Lehman. Even prior to Lehman, in early September, the federal government nationalized Fannie Mae and Freddie Mac, which was considered appropriate and even inevitable in that these companies, although technically private enterprises, were presumed to have governmental support. That is how their securities traded and how they acted out Washington’s mission to support middle-class home ownership.

Whether inevitable or not, the seizure of these “government-sponsored entities,” like the shotgun wedding between Bear Stearns and JPMorgan for what now seems like a bargain at just $30 billion, was intended to comfort the market. Did it ever not.

The list of major American institutions that have been lost following the nationalizing of the GSEs and the bankruptcy of Lehman — not to mention the lost jobs, careers, fortunes and even lives — is too painful to recount. And that’s not to mention the impact overseas, already extreme and gaining momentum.

The focal point of this destruction has been one industry, the mortgage market, and one product of that industry, the excoriated subprime mortgage. It’s fair to ask, after the previous Congress appropriated $700 billion in relief spending, and the current one is considering well over $1 trillion more, why we can’t just restructure the toxic mortgages or otherwise buy them off lenders’ balance sheets. Why? Because so many of the mortgages have been sold into investment securities. They’ve been securitized.

Securitization

Mortgage-backed securities are debt instruments that are collateralized by mortgages, that is, they pay investors interest and repay principal from collections on a pool of mortgages. The securities may be divided into several classes, each having a different payment priority, with the interest rate for each class being based on the credit risk associated with that class, and with that credit risk often being delineated by a credit rating.

The industry adopted the euphemism “subprime” to describe a mortgage to a borrower with less than optimal credit, making the risk of default more likely than for a borrower with good credit history. One paradox of the mortgage boom was the popularity of subprime mortgages: They were coveted by investors since they paid higher interest rates, and they were thought to extend the benefits of home ownership to the lower and middle classes, thereby fulfilling a policy objective.

Most lenders did not retain the loans they originated but instead sold the mortgages (and the legal right to receive the related monthly payments) in the secondary market, often to an investment bank. The investment bank would combine the mortgages with others and sell interests in that pool to investors.

It effected this sale through the use of a securitization vehicle. The vehicle, typically a trust or some other newly created special-purpose entity, would receive a transfer of title to the pool of mortgages and, in turn, would create and sell mortgage-backed securities representing a beneficial interest in the pool.

From the proceeds of the sale of these securities, the original lender would be paid for its sale of the mortgages to the securitization, so the lender thereafter had no further interest in the mortgages or in their long-term health (other than for certain legal defaults). Without a long-term interest in the viability of the mortgages, those lenders did not have the same incentive to ensure the creditworthiness of borrowers. However, an appreciating real estate environment made a lender’s underwriting criteria less relevant.

Mortgaged-backed securities, as well as other structured finance investments, have been popular with investors since their inception. They can be structured in ways to accommodate the diversified interests of purchasers. For risk-averse investors, securities can be created with an excess of protection (and a correspondingly lower return), either by prioritizing their payments over other securities, or by using derivative instruments or reserve funds or “excess cash.” At the opposite end of the spectrum, subordinated securities would be in a first-loss position, in exchange for yielding a higher interest rate.

Mortgaged-backed securities also enabled investors, including foreign investors, to buy into American real estate, an historically safe and reliable (and appreciating!) asset. Structured securities soon became an attractive alternative for investors seeking products bearing a higher yield. The height of the securitization market coincided with a period of low interest rates in western economies; therefore, highly rated debt was not offering attractive yields. “AAA” rated structured finance bonds, on the other hand, yielded interest rates that were higher than government securities, and were (mistakenly) considered the equivalent risk.

The difference in yield was attributable to the different risk borne by the structured products — risk that at the “AAA” level was considered inconsequential. When plotted on a graph this risk is reflected at the extremities, or “tail,” of an investment curve. Investor and rating-agency models, based on market performance over the past 30 years, did not (arguably, could not) account for the unprecedented confluence of factors we currently confront. Basically, investors and the rating agencies (by their own admission) did not properly account for the tail risk.

Participants in the securitization market, together with those in the ancillary markets that enable it, share the blame for the collapse of these investments. Structured products were rushed to the market to satisfy a voracious investor appetite, mortgages with increasingly creative components were marketed to borrowers who would not have qualified for more traditional loans, the structure of investment vehicles were so complex that investors would rely exclusively on the credit rating of the securities, and disclosure documents that purported to describe the investments and their risks were so long and laden with jargon that even industry professionals struggled to understand them.

Now, the industry has the challenge to restore credibility to lending standards, integrity to the rating process, and clarity and legal certainty to the market. However consequential the government initiatives may be, the industry must attract a return of private capital. Structured products are currently trading at deep discounts (those that are even trading), which is not a function of their credit quality, but of the volatility, illiquidity and uncertainty of asset values.

Conclusion

It is simple and convenient to blame the collapse of our financial systems and the devastating performance of structured investments on greed, as if people were greedier in 2006 and 2007 than they were in previous years. Or to attribute the collapse to deregulation, when commercial banks and insurance companies, who have suffered the greatest, are two of our most heavily regulated industries. Even the securitization industry was subject to sweeping new regulation in 2006, known as Regulation AB and Securities Offering Reform, whereas hedge funds and private equity, heretofore unregulated (though that’s about to change), weathered the initial mortgage crisis more successfully.

The problems of excessive leverage, poor credit underwriting and inadequate risk management are not the fault of securitization as a financing technique. Nor are securitized products “esoteric” or inherently “risky” when, in recent years, securitization has funded the majority of consumer assets, including mortgages, credit cards, student loans and more.

In today’s capital-constrained environment, where bank balance sheets are under enormous pressure, commercial banks are unlikely to have sufficient capital to fund current and future demand. For the sake of our financial future and economic growth and stability, we must restore a secondary market for the sale of mortgages and other assets to enable private capital to share in or, in fact, lead the lending responsibility.

Without securitization and the ability to sell assets into structured vehicles, our economy will be set back much further than the 700-point decline in the stock market.