Disconnect: The cause of the mortgage debacle

When I went to the bank in 1967 to apply for a mortgage on the house I wanted to buy, the bank required me to make a 20 percent equity down payment. It also asked for proof of my income, it checked my credit rating, and it asked me to pay for an independent appraisal of its choosing. The bank did all this because it was itself going to hold the 30-year, 6-percent mortgage, which it finally extended to me.

That mortgage truly warranted a Triple-A rating because I had a real significant personal investment in that house, a good job that promised to cover the monthly payments more than adequately, and a conservative appraisal of the real value of the house. But perhaps most importantly, single-family homes in the U.S. had never declined anywhere near 20 percent; the bank was as sure as it is ever possible to be that, in the event I ever defaulted, it could surely recover the 80 percent of the value of the house its mortgage represented.

So the major debt rating agencies likewise understood that that kind of debt justified a Triple-A rating. In fact, that same kind of appropriate conservative requirement to obtain a mortgage prevailed right through the first few years of the 21st century.

In recent years, however, a significant change took place. The major Wall Street investment firms, Merrill Lynch, Bear Stearns and Lehman Brothers, developed a new debt instrument product. They would acquire a bunch of mortgages, package them (they called it securitizing them) and thus turn this bundle of mortgages into a kind of bond that they would then sell to a vast variety of investors.

Because the major rating agencies put a Triple-A rating on these securities, and because they could offer them at a higher yield than that prevailing for other Triple-A debt, issuers found that there was an enormous demand for this “attractive” product. As they sought to meet the growing appetite for this debt they pushed the mortgage brokers and banks to provide them with an ever greater volume of mortgages.

As a result, the providers of mortgages became more aggressive in writing and filling the mortgage applications brought to them so that they could enjoy the fruits of this “easy” lucrative business. Because mortgage originators themselves were not taking any of the risk of holding this paper and were being well paid for providing mortgages to the Wall Street banks that were packaging them, they became more aggressive, less demanding of the conditions traditionally required to attain a mortgage on a house, and ever less careful.  

The mortgage brokers and banks introduced a whole series of criteria that made it easier to obtain a mortgage.

They introduced “nothing down” (no equity) mortgages, interest-only mortgages and “ninjo” (no income, no job) as sufficient basis to receive a mortgage.

They pressured appraisers whom they themselves hired to inflate the estimated value of the houses so as to help the real estate agent and/or the mortgage broker “close” the deal. The exaggerated appraisal led to many cases in which the mortgage provided exceeded the “true” value of the home such that at the very time the mortgage was issued it already exceeded the total value of the house.  This meant that in the event of default by the homeowner on the mortgage, the mortgage holder could not even recover the loan it had arranged if it had to sell the house.

Indeed, there was a kind of automatic built-in loss at the very outset unless the value of the home appreciated dramatically. Many justified this approach in their own mind as reasonable since the price of housing was rising so fast that they felt assured that in six months to a year the house would be worth a lot more and thus the mortgage based on the “exaggerated appraisal” would be safe.

Because there was such irrational exuberance for this product and it was so profitable, no one bothered to look at the immense change that these newly written mortgages encompassed. Notwithstanding all this, the major rating agencies mindlessly continued their Triple-A ratings that continued fueling the demand for these seemingly attractive high-grade, higher-yield debt instruments.

The changes in lending practices actually transformed what were solid, safe, secure mortgage loans into instruments that were inferior even to subprime mortgages. The cause of this can be traced to the simple fact that the providers of these mortgages did not end up holding the paper and thus were far less concerned about the quality of the loan. This was utterly unlike the practice of the bank that provided me with my mortgage and held the mortgage itself and assumed whatever risk that might have entailed, and accordingly made demands on me that were necessary to ensure the safety of its investment.

Because the ultimate buyers and holders of these packaged mortgages were not themselves evaluating the portfolio of mortgages they were buying, but rather relying entirely on the super excellent ratings provided by the rating agencies and the leading investment banks Merrill, Bear and Lehman, they were confident that the paper they were buying was indeed Triple-A and risk-free.

Because of this disconnect between the types of mortgages provided by my bank back in 1967 and the “new” mortgages issued in recent years, buyers throughout the world bought possibly as much as $6 trillion worth of junk paper.

Because nobody bothered to look at or take issue with the enormously changed quality of these underlying mortgages — not the Federal Reserve, not the Securities and Exchange Commission, not the rating agencies who surely should have been more responsible and accountable, and not the many Wall Street banks that were coining money (just as they did in the mad Internet craze of the late 1990s) — the whole world is now suffering the pain, the outsized losses and the damage to its banking systems and economies.

That’s what happens when there is a disconnect between the aggressive writers of mortgages and the holders who actually assume the risk. To ensure that we never suffer a recurrence of such a devastating debacle, the relevant oversight agencies need to stay alert to any new derivative securities that Wall Street, in its aggressive pursuit of profits, may package. And then, if these new securities embody anything like the kind of risks the securitizing of mortgages entailed, the agencies need to address it early and aggressively.

Davis, a shareholder in The Hill’s parent company, is an economist, an MBA graduate (with distinction) from Harvard Business School and author of From Hard Knocks to Hot Stocks (William Morrow and Co.) and Making America Work Again (Crown).