It has been nearly a year and a half now since the rot in the subprime mortgage market became apparent to the rest of the world. When two Bear Stearns hedge funds collapsed in the summer of 2007 due to overexposure to risk in these types of home loans, the economy’s house of cards began to collapse. Writing now in February of 2009, the collapses do not even seem to be letting up, with entire industries on the brink of failure and even nations defaulting on debt payments.
What went wrong with the mortgage markets to cause a disaster? A number of factors played a role in the collapse of the housing bubble, the large increase in the home foreclosure rate, and the ensuing recession. We should all take time periodically to review the collapse, examine what led institutions to take on so much risk, and what we can learn from it to prevent another destructive bubble from being created.
One main problem was a creation of Wall Street called securitization, the bundling of similar types of loans into one instrument and the slicing and dicing of this debt instrument. Investors could buy into a package of hundreds of mortgages and, as long as the homeowners kept up on their payments, expect a portion of the proceeds every month. This financial creativity had the effect of spreading risk of American mortgage defaults throughout the world as investors bought the securitized loans.
The theory was that even if a few loans defaulted and the mortgage servicer had to foreclose, most of the loans would be paid as agreed. And for the property owners that did default, there was an even greater reward for the banks and investors and home values were on the rise. While an on-time homeowner could generate a few percentage points of interest for an investor, a default on a house that had increased by 20% in value from the time of origination of the loan to foreclosure was a gold mine.
Riskier and riskier loans were bundled into these mortgage securities, from prime loans to Alt-A mortgages to, finally, subprime loans. During the boom years, it seemed anyone could get a mortgage no matter how little money they made, and everyone could stop foreclosure simply by selling and cashing out the new equity or refinancing into a new subprime loan. And a large percentage of these subprime mortgages were securitized and sold to pension funds and hedge funds worldwide.
No one buying the mortgage securities tracked the risk because no one really knew how much risk was involved in their portion of the bundled loans. Mark Zandi, in his book Financial Shock, puts it succinctly when he states that, “The mortgage lender counted on the Wall Street investment banker who counted on the regulator or the ratings analyst, who had assumed global investors were doing their own due diligence. As the process went badly awry, everybody assumed someone else was in control.”
In control of what, is the question. In fact, it is still the question. No one, from bankers to politicians and everyone in between, can adequately explain who was in control of what during the real estate and mortgage securitization boom. But now it is too late, as the risk has been spread around the country and throughout the world by Wall Street bankers offloading risky assets onto anyone who was gullible enough to believe the marketing pitches of these loans being non-risky.
And when regulators finally began to issue warnings and take action on the subprime industry, it had already collapsed. Subprime mortgages lenders went out of business by the hundreds. Some were forced to buy back loans that immediately defaulted. Some could no longer secure money from Wall Street to keep funding mortgages. Others knew the jig was up, the regulators were on the scent, were never properly licensed anyway, and just left the industry before being shut down or bankrupted.
All that anyone knows now is that the money is gone. It has all been erased. Once it became known that people were given loans with no regard to their ability to pay them back, the mortgage securities instantly became impossible to value, at best, and worthless, at worst. Without a large number of people without jobs or incomes being given mortgages, the housing market collapsed and property values have sharply fallen. Homeowners are underwater on their artificially inflated real estate assets.
The bankers, though, realizing that the goose has stopped laying golden eggs in the mortgage market, is now trying (and being successful) to get the goose in Washington, DC to lay golden eggs. But homeowners and foreclosure victims are taxpayers, too, and each new bailout and Congressional hearing exhibiting feigned outrage at the banks increases the animosity people have towards their lenders and the government itself. Even state governments are fighting with counties and the feds.
Congress, in response to the disaster caused by mortgage securitization, has thus far proposed numerous subsidies of securitization. If you subsidize something, you get more of it. The $700 billion Troubled Assets Relief Program (TARP) was originally designed to allow the Treasury Department to buy up bad mortgage assets. While it was co-opted into a giant unaccountable corporate welfare program instead, Congress is now discussing a so-called “bad bank” to buy up toxic securities.
The more the banks and the government proposes to fix the economy, the more apparent it seems that they have learned nothing from the subprime mortgage collapse. Using taxpayer money to buy up worthless assets can not end well, even if the program is not helplessly corrupted. The most that can be hoped is that Americans themselves learn their lesson and do not rely on borrowed money to finance the vast majorities of their lives any longer.
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