Photo Credit: woodleywonderworksRemember when “junk bond” was a dirty word? People and companies bought these newfangled high-interest rate bonds without fully appreciating that the interest rates were high because the borrowers were shaky. Investors lost their shirts, Michael Milken did hard time, and the economy stumbled. Today, meretriciously renamed “high-yield” bonds, junk bonds are an important cog in our economy’s machinery and a key component in many investors’ portfolios.
What changed? Sunlight and common sense were applied. A better system evolved for evaluating the creditworthiness of high-yield borrowers. Today buyers of junk bonds, by and large, know exactly what they’re getting. For many, the higher risk/reward character of junk bonds is exactly what they need to round out a diversified portfolio. And many worthy companies that would have been cash-starved in earlier times have access to the capital markets.
Today the dirty word du jour is “subprime mortgage.” The problems caused by the subprime mortgage mess dwarf those caused by the junk bond scandal. Banks and financial markets around the globe are reeling from the slow but seemingly endless unveiling of rotten paper in their portfolios of mortgage-backed securities (“MBSs”). Billions in losses are turning up every week. The top experts admit they don’t know how far this is going to go.
How did this happen? And can we prevent it from happening again? The answer to both questions is surprisingly simple. The key is to appreciate how mortgage lending has changed in recent years, and to shed a little sunshine and common sense on the whole process.
The Brave New World of Mortgage Brokers and Mortgage-Backed Securities
When my Dad took out a mortgage fifty years ago the only lender in town was the local bank. The bank intended to collect payments from my Dad over the entire life of the loan, so it took a long hard look at his financial soundness. The last thing the bank wanted was to lend to someone who might default; foreclosing and managing real estate is not what banks like to do�it’s expensive and outside their core competence.
When I took out a mortgage fifteen years ago, and when I refinanced twice since, the world had changed. Like almost everyone else, I dealt with a “mortgage broker” (or with a bank that was effectively acting as a mortgage broker). As soon as the ink was dry on the loan, the lender sold the mortgage to someone else � typically a bank, or a government agency. Often the buyer bundles the mortgage with hundreds of others, and sells commercial paper that represents an ownership interest in the whole bundle. That paper is a MBS.
Consider how profoundly this changes the process. First, the seller of the loan � the broker � doesn’t care one bit if I’m likely to default two years down the road. As long as he can sell the loan, my creditworthiness has no consequence for him.
Second, it’s almost impossible for buyers of MBS’s to know what portion of the loan “bundle” they’re buying is sound. They can’t analyze the hundreds, or even thousands, of underlying mortgages. Because home mortgages traditionally were carefully vetted by the lending banks, MBS’s were presumed safe. Needless to say, that presumption is now out the window.
Ideology or Pragmatism: Who Has the Answer?
So what can we do to make sure this doesn’t happen again? First, let’s consider the ideological responses. The left-wing, paternalistic response might involve creating new laws imposing liability on lenders who let borrowers take out imprudent mortgages. Some might even want to criminalize such behavior. The result? Lots of litigation, lots more CYA paperwork, and considerably higher transaction costs.
The libertarian response would be that we shouldn’t do anything. It’s a free country, after all, and if a bunch of chuckleheads want to take out mortgages they can’t afford, let them live with the consequences. There are three reasons why this is not the answer, either.
First, it’s tough on the economy. Over the coming years thousands of homeowners will default. Many will simply abandon their homes, putting an enormous burden on the banks holding the mortgages, on those holding the MBS’s, and on municipal governments whose tax revenues will plummet. Global stock markets have already lost trillions in value, and the continuing credit crunch has us tottering on the brink of recession. This is not exactly something we want to go through on a regular basis.
Second, it’s tough on the borrowers. There is a huge information gap between mortgage brokers and their customers. I have been practicing law for over 20 years, and even I find a mortgage contract � 20 pages or so of fine print and technical jargon � pretty daunting. And often a borrower doesn’t really know the terms of the mortgage until the closing. Consider: You go to your closing, only to learn that the interest rate on your loan will be higher than you thought. You would like to tell the lender to stuff it, but you’ve already contracted to sell your condo and the movers have picked up your furniture. Not an easy situation.
Finally, its too easy on the scoundrels. Again, many will say there are no scoundrels in this story; just chuckleheads who borrowed beyond their means. But it is easy to see that that isn’t the real story.
The borrowers who are in trouble today took out adjustable rate mortgages (“ARMs”) two or three years ago (ARMs typically hold their introductory “teaser” rate for 2-3 years, then the rate starts adjusting). Two to three years ago home mortgage interest rates were at historic lows. We hadn’t seen mortgage rates at 6% since my Dad was using Burma Shave fifty years ago. Now ask yourself � why on earth would anyone take out an ARM when rates are at historic lows?! With the rare exception of someone who knows for certain that they are going to resell the house, and pay off the mortgage, within a year or two, it makes absolutely no sense to take out an ARM when rates are already at bargain basement levels. Think about it: When the rates adjust, which way are they going to go? There’s only one way they can go. Up.
So what happened is this: hundreds of thousands of people were sold ARMs when (a) they couldn’t afford the payments if interest rates adjusted upwards, and (b) interest rates were virtually guaranteed to adjust upwards. There is something very wrong with this picture.
One of two things is true. Either the average homebuyer in America has suddenly gotten a lot dumber in recent years, or mortgage lenders became much more willing to issue loans to people who probably couldn’t afford them. I don’t think Americans have suddenly gotten stupid. And as we have seen, it is a fact of the new world of mortgage brokering that initial lenders, as often as not, couldn’t care less whether the borrower can handle his payments. Defaults will be somebody else’s problem.
A Model for The Solution
So how do we prevent this from continuing? My Dad was neither left-wing nor libertarian. In fact, he was fond of saying that America has only one philosophy � Pragmatism. We don’t need any other philosophy, he’d say, because “Pragmatism works.”
In fact, my Dad’s kinder, simpler world has the solution to the subprime mortgage problem. After World War II, home ownership skyrocketed in America, and homes became a lot more complex. Houses had basements; they were wired for electricity; gas or oil furnaces were installed; plumbing became standard; and roofs became complex multi-layered affairs. My Dad was a smart guy, but when he bought his first home he didn’t have the knowledge to evaluate any of this. For all he could tell the roof would need replacing, the basement was subject to flooding, the electrical system was a huge fire hazard, and the furnace was about to blow. In the modern home, much that is critical is also invisible to the untrained eye.
So what did we do? The economy rose to the need with a new professional � the home inspector. Today States require that any homebuyer get a house inspection before signing on the dotted line. In one hour, for a couple hundred bucks, a trained eye can see any and all of the serious house defects that you and I would never notice. Presto, problem solved. No need for lots of lawsuits. Pragmatism: common sense and sunshine.
We need the same pragmatic common sense today, in the form of mortgage advisors. Typically, today, the only person advising a would-be homebuyer about the terms of a proposed mortgage is the person trying to sell the mortgage. That, as we’ve seen, is a formula for disaster. A knowledgeable and disinterested advisor could easily assess whether a given mortgage is prudent for a given borrower. The paperwork is already assembled (you know, the endless tax returns, pay stubs, utility bills, and laundry lists that lenders require with a mortgage application). The mortgage advisor could easily and quickly determine the borrower’s ability to service the mortgage. Just as in the case of home inspectors, requiring review by a mortgage advisor would ensure that borrowers know what they’re getting into. Some people will still borrow more than they can handle, but most will do the common sense thing, and cascading defaults like those we’re seeing today will be a thing of the past. And as in the case of the home inspector, the cost will be trivial.
Like junk bonds, MBS’s were a great financial innovation. They have made the entire global pool of capital available to would-be homeowners in towns large and small. And I doubt that many will deny that home plumbing and electricity have made our lives vastly more comfortable. But as with junk bonds and the modern home, the securitizing of home mortgages has created hidden hazards for all involved. Disinterested and knowledgeable mortgage advisors could shed sunlight and common sense to dispel the mystery and eliminate most of the hazards.