If The Cook Leaves For Lunch

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A cook who is paid for quantity not quality and does not have to eat his own cooking will probably not follow the recipe all that carefully.  A mortgage lender in the same position will have little concern for the quality of the loans being made.  This was the situation during the last years of the US housing bubble of 2001 through 2005.

Anyone who has seen Frank Capra's Christmas classic, It's a Wonderful Life, knows how a bank operates.  Back then, if a person wanted to buy a house, he or she would go to the lending institution and apply for a mortgage loan.  The banker would carefully check the applicant's credit rating, job history and stability, get an appraisal of the property and decide whether to make the loan.  The bank lent money and expected to be repaid since the lent money came from the collective deposits of the bank's customers.  The bank recycled one person's savings into another person's home loan and made money on the spread between the interest rate it paid on the savings account and the interest rate it charged for the loan.  The bank had to be conservative in its lending practices since it still had to meet the daily withdrawals of its customers regardless of the borrower's repayment of the home loan.

In 1938, late in the Depression, the government established the Federal National Mortgage Association (Fannie Mae) to stimulate the moribund economy and to support the national policy of encouraging home ownership by making it easier to get a home mortgage.  The Federal Home Loan Mortgage Corporation (Freddie Mac) was chartered in 1970 to expand the government's efforts to provide funds for home loans. These agencies would purchase billions of dollars worth of mortgage loans from lenders across the country, repackage them into pools of securitized bonds which were then sold to debt investors.  The bond proceeds would then be used to buy yet more mortgage loans from the banks.  The theory was that the availability of this money would lower the cost of home loans.  

Wall Street copied the Fannie/Freddie models and got into the mortgage backed securities game during the housing bubble years in a big way.  Earlier, Congress had passed laws to make home loans affordable for many people whose credit was not strong enough to qualify them for a home loan.  These were referred to as subprime mortgage loans which provided very low "teaser" rates of interest for the first two years before the interest rate jumped to a market rate.  This increase would almost double the rate.  Mortgage lenders offered what were called "low doc" and "no doc" loans, i.e., loans made without credit checks or other traditional lending considerations and documents.  These loans were cynically called "liar loans" since the information on the credit applications was rarely, if ever, verified.  In an effort to keep them "honest," the mortgage brokers were required to keep a small percentage of their loans on their books. Despite this exposure, most brokers saw no reason to worry about repayment and creditworthiness.  

Repackaging subprime mortgages into bonds became a huge money machine for the investment banks.  In his book, The Big Short, Michael Lewis explains how billions of dollars in fees were earned by the mortgage companies and the investment banks by recycling money between American home buyers and bond investors worldwide.  The goal was booking loans, earning fees and converting the mortgage debt into bonds for sale around the world.  With those bonds went the risk of default.  Bond buyers were lulled by Triple A credit ratings for the bonds despite the subprime quality of the mortgages backing the bonds.  The poster child for this lending orgy, according to Lewis, was the California farm worker making $14,000 per year who received a home loan of over $700,000.  The underpinning of this debt debacle was the belief that home values would continue to rise, allowing otherwise unqualified borrowers to either refinance the debt or sell the property at a profit in less than the first two years.  When the teaser rates increased after the first two years, the loans became unaffordable.  Since the mortgage brokers and investment bankers had only a fractional interest in the loans and bonds or they had laid off the risk with credit default swaps, they did not believe they would suffer any loss.  What they failed to appreciate was the fact that a even a small fractional interest in hundreds of billions of dollars is still a large number.

The results of this played out when the housing bubble burst and an unexpectedly large percentage of the loans went into default.  The other part of this perfect storm was the rapid decline in home values.  Mortgage debt exceeded the value of the collateral with the obvious result - billions of dollars in losses for the holders of the mortgage backed bonds around the world.  As the music started to slow down in 2007, several very large publicly traded mortgage companies went out of business.

Two signs that the party was truly over were the failures of the venerable Wall Street firms, Bear Stearns and Lehman Brothers in 2008.  Lehman's September 15, 2008 bankruptcy filing, considered the largest in history, foretold the credit crisis to come.  The exposure of both Bear Stearns and Lehman to the subprime mortgage market played a significant role in their failures.

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