A version of this paper first appeared on the author’s personal blog. A fully annotated version can be downloaded here (PDF).

The U.S. mortgage crisis lies at the heart of the financial recession: it was the point of first contact, the domino that began our initial descent into near-depression. How will the leaders of the free world deal with it? Mitt Romney’s proposal is simple, if not exacting: we ought to let the housing bubble bottom out — to let it run its course as a failed free-market enterprise. President Obama thinks otherwise: he believes government must step in and, despite its repeated failures, try again to save the day. Which of these views is more promising? This paper briefly retraces the credit history of the housing market, arguing that in order to avoid future bubbles, we ought to learn from past mistakes in credit extension. While Obama’s mortgage relief plan is well-intentioned, problems in scope, execution, and the realities of the credit and derivatives market advise against its implementation.

Stumping Along

Following a proposal outlined in his third State of the Union address, President Obama recently unveiled a new principal reduction plan allowing underwater mortgage holders (people whose home loan payments now exceed the value of the homes themselves) to refinance their mortgages. The plan offers lowered interest rate payments to borrowers and upfront cash payment to lenders as incentives to cooperate with the program.

The new plan (call it OMR, for “Obama’s Mortgage Relief”) is incredibly important in both its mechanics and in its broader philosophical implications, for it signals how the administration intends to handle the aftermath of the housing crisis. Unfortunately, most media outlets are focusing on how the plan plays out in the presidential campaign cycle – how it differs from Romney’s, what it says about Obama, what its rhetorical impact might be. This is a shame: not only are major media players like the New York Times displacing timely, substantive news with watered-down campaign commentary, but the displaced policies form important inflection points within the recession’s greater narrative – of our response to it, and of our ability to learn from it.

In order to understand the new plan, we need to understand the structure of the market it means to change. A brief analysis of this market shows how ineffective and in fact counter-productive OMR may be; like its analogue in the financial sector, the well-intentioned but ill-designed Dodd-Frank Act, OMR should not be implemented in its current form.

Federal Homeowner Financing

OMR seeks to redress a devastating cycle of default that begins, ironically, with the government, or more specifically, with government-sponsored enterprises (GSEs). GSEs are corporations created by Congress in order to inject credit into targeted sectors of the U.S. economy. They have been around for years – the first GSE was created in 1916 to help farmers build a viable trading infrastructure around the rural American Midwest. And while the means and methods by which GSEs work have become complex, their purpose is simple: when the government determines that a sector of the economy needs help, it sends a GSE in to plug the hole. For example, if the agriculture industry finds itself cash-strapped due to bad weather (e.g., crop yields fall and so farmers can’t get to market in time) or unattractive prices (e.g., cheap imports crowd out domestic wares), a GSE can step in and help farmers obtain extensions, favorable lines of credit, or better terms with lenders. From the government’s point of view, such assistance increases efficiency and liquidity while furthering federal priorities at the same time.

GSEs are thus economic intermediaries: they help connect borrowers with lenders, functioning as a tool used to strengthen industries such as agriculture, education, or small business. By far the largest GSE-influenced sector is housing, where GSEs currently hold around $5.4 trillion worth of mortgages. The principal GSEs in housing are the Federal National Mortgage Association (Fannie Mae) and Federal Home Loan Mortgage Corporation (Freddie Mac), corporations that, despite small differences, carry out the same broad functions. They are best known for buying and selling mortgages to third parties, thus creating packages of securities (the now-infamous mortgage-backed securities, or MBS) to trade with investors in the open market.

Importantly, GSEs are not government agencies. Until recently, both Fannie Mae and Freddie Mac were publically-traded, privately-owned companies, complete with stock and for-profit trading. However, Fannie and Freddie had a significant leg up on their competition: the mortgages they bought and pooled were backed, or insured, “with the full faith and credit” of the U.S. government. In other words, if the underlying borrowers defaulted on their loan payments, the government would pay off their debt, a risk it was willing to take because it wanted to further develop the mortgage market. This development was the key to increasing credit available to homeowners, ultimately allowing more people to own homes. Because Fannie and Freddie were backed by the government, the securities they sold would be more attractive to investors; because more investors would be willing to buy government-backed MBS, the demand for MBS would go up, incentivizing the underlying loan issuers to lend to would-be homeowners.

As a matter of politics, the process sounds well and good: government helps more people buy and own their own homes, while encouraging financial institutions to fund these projects and turn a small profit at the same time. As a matter of practice, however, the process was suspended on a high-wire strung together by two fundamental assumptions: (a) that MBS would reliably retain their value over time and across the country; (b) that the underlying loans would be reliably serviced. The financial crisis, of course, proved both these assumptions false.

What do Californian Farmers and Floridian Nurses Have in Common?

Imagine you are a farmer in California. You have a wife, three kids, and an unsteady income that floats at around $15,000 on a good year. Your wife is pregnant, and you need a bigger home. So you take out a loan for a $750,000 house – no down payment, no questions asked.

If that’s not your cup of tea, instead imagine yourself a nurse at a retirement home, living with three sisters in a townhouse in Tampa, financed with an adjustable-rate mortgage. The value of your townhouse goes up, so instead of selling, or building equity, you refinance the property, take out $250,000 against the mortgage, and use it to buy a second townhouse. A few months later, the second property’s value rises as well, so you rinse and repeat. Soon, you’ve bought three townhouses, and now you’re the king of the hill.

Imprudent? Probably. Implausible? Not even close. The last decade is full of such stories; they are the bedrock upon which the financial crisis is built. The problem with each scenario, as you can probably guess, is that sooner or later, prices will plateau and then start falling. And now our Californian farmers and Floridian nurses (let’s call them Borrowers) have a problem. Their income cannot match their expenses (indeed, for many, it was never steady to begin with). They’ve got multiple mortgage payments and rising interest rates. They accepted mortgages with “teaser” rates (where payments are small for the first few years and then sky-rocket for the balance of the loan), and now they’re really in a bind. What’s worse, they’re not the only ones in this boat: because the loans are government-insured, all of their holders, everywhere, must be paid back.

This pattern of subprime borrowing, lending, and subsequent default began a domino effect as early as in 2007. As of now, around 12 million homeowners are underwater on their mortgages, 20% of all mortgages have negative equity, and in states with the highest overall housing price declines – states such as Florida, California, Nevada and Arizona – roughly half of all mortgage borrowers are underwater. Of course, because these borrowers are typically subprime, they cannot easily refinance: their only possessions of value (against which they can obtain credit) are the mortgaged homes themselves, effectively putting them in negative equity.

How did we get here? How was any of this possible? The short answer revolves around the mechanics of credit, or, as the MBS-shorting extraordinaire Michael Burry puts it, the extension of credit by instrument. Home loan applicants (our Borrowers) are awarded loans based on their credit rating, which is usually determined by their FICO scores. The scores themselves are determined by the respective Borrower’s credit history – how creditworthy he is – but the process was, until recently, comically simplistic. The score calculations didn’t take the Borrower’s income into account, or look into his past borrowing habits (thus, an immigrant with no previous borrowing history might seem more creditworthy simply because he had no outstanding debt at the time of a loan application); a Borrower could raise his score by taking out a credit card and immediately paying it back. This gave him an artificially high FICO score, made him appear creditworthy, and allowed him, for example, to take out a $750,000 loan on a $15,000 salary.

Of course, this explanation is incomplete. What kinds of lenders extend credit like this? Didn’t they realize they were just throwing their money away? The long answer is rooted in the policies that encouraged such lending, and that, too, begins with GSEs.

Up until the 1990s, Fannie and Freddie retained what most analysts describe as conservative underwriting standards. They required down payments on home loans and did not offer much flexibility for deferred-payment options. This began to change in the 1990s, when affordable housing became a popular social policy objective among Democrats in Congress. Together with lobbyists and community groups, Democrats pushed legislation in 1992 that stripped underwriting regulations of much of their previous standards. By 1995, Bill Clinton’s National Homeownership Strategy eliminated the down payment requirement, encouraged “flexible and innovative” underwriting, and ushered in a new process of loan applications with lax standards and minimal review.

Now, this isn’t the stuff global recessions are made of. Loose government financing translates into deficiencies in federal oversight, the worst consequences of which are subprime lending and default, in which case the government loses some money because it has to cover defaults for borrowers who fail to service their debts. Contagion threatened – and the financial crisis was made possible – because the government didn’t just want to make it easier for people to get home loans: it wanted to create and foster an entire mortgage market, a market into which banks, hedge funds, and other non-financial institutional investors would be incentivized to pour money so that everyone could have access to cheap credit.

Spurred by aspirations to level the playing field for disadvantaged demographics and mitigate the effects of income inequality, standards in the mortgage industry – encouraged by GSE underwriting – dropped lower and lower, until by the 2000s, borrowers were offered products like the “pay-option negatively-amortizing adjustable-rate mortgage,” a devious creature that allowed borrowers to vary how much they paid in interest per month, even letting them defer monthly interest and tack it on to the balance of the loan.

The flexibility of this payment method is obvious: for borrowers with volatile earning schedules or commission-based pay, the option to choose how much to pay and when to pay it can often mean the difference between securing or failing to qualify. But this flexibility can also be a means of deception, for if borrowers choose the negative amortization that comes with deferred interest payment, their balance down the road becomes larger and larger. The future balance cannot be inflated indefinitely; sooner or later, the mortgage’s monthly payment will have to be recalculated (for it runs its course in a finite amount of time), and then the borrower is up against the wall: his monthly payment has ballooned out to several times its initial amount, and he’s used up all of his means of delay or deferment.

More important than this accumulation effect, however, is what these adjustable-rate mortgages represent: the ability to secure mortgages by the most subprime of borrowers. For who would choose to keep increasing future balances (and risk the added interest) rather than stick to a regular payment schedule? The answer is simple: someone with no real or reliable income – someone just like our Californian farmer or Floridian nurse.

Down the Rabbit Hole

It takes two to tango — you can’t secure a loan without someone on the other side, willing to give it to you. So who exactly was reckless enough to extend millions of dollars to subprime borrowers with low credit scores and unreliable income? Now we’re moving from the primary mortgage market to the murky waters of the secondary MBS market, and from there to the even darker, tertiary world of collateralized debt obligations (CDOs).

In order to understand how these markets work, we can go back to Borrowers and bring in some new friends, Lender and Banker. Lender is the original mortgage originator: he runs his own shop, finds the Borrowers, and offers them “great deals” like the pay-option negatively-amortizing adjustable-rate mortgage. He tells them not to worry about things like steady income or the notion of living within one’s means — he can get them cheap credit! And so, for a fee, Lender gets the Borrowers their mortgages.

How is he able to do this? Because, ultimately, he’s not on the hook if they can’t service the mortgages: remember, Fannie and Freddie are backing the loans, and what’s more, Lender’s not going to sit on them. Instead, he will pool together a hundred of them and sell them as a bundle to Banker. The logic behind the sale is simple: Lender receives payment for the bundle; Banker receives interest payment proceeds for the relatively low risk that all of the underlying loans will go bad together.

In fact, however, Banker isn’t buying the bundled loans because he thinks it unlikely that most of them will go bad at the same time (though he might have). He knows all about FICO scores. He knows not only how subprime borrowers can secure all sorts of crazy loans, but how these loans can be categorized and securitized. For example, at the very start of the process, when credit rating agencies such as Moody’s or Fitch receive pools of loans from originators like Lender, they rate them according to their average FICO score. But a pure mathematical average, by itself, can be misleading: a pool of 100 loans with an average score of 615 (the minimum needed for a AAA-rated bond) can consist of 100 scores that all hit 615, or it can alternatively consist of 50 loans rated at 550 and another 50 at 680. The first set will be much less likely to suffer losses (that is, the underlying loans have a lower chance of defaulting) than the second.

At the end of the day, as long as a subprime borrower with a score of 500 can be offset with a strong borrower with a score of 730, the bond built from their loans is given a AAA-rating – and therein lies the rub. Banker sees this, and now all he needs is a way to exploit the game. He buys loans from Lender that average 615 or higher, bundles them together into a bond (the MBS), and gets his AAA-rating. He know the loans underlying the security are crappy, but never mind that: they’ve got the official, sterling, AAA stamp of approval, and now he’s got a brand new, attractive product on his hands.

This new MBS can be bought or sold on a secondary market, and indeed many were, often to investors who saw only the AAA-rating and never looked through it to determine its composition. But Banker doesn’t stop here. Now he does what bankers do best: he slides, dices, mixes and matches the various bonds to create new securities from them, composed, for example, of the fourth year payments of 30 different loans, or the first and last year’s payments of another 25. These securities all have different values, and are organized into a tower type structure based on their risk of default, correlated with their prices and returns. In so structuring these towers, Banker has created an entirely new product, the synthetic subprime mortgage bond-backed collateralized debt obligation, or CDO.

In cutting up and re-packaging individual mortgages, CDOs redistribute the risk of default not merely of specific Borrowers, but of variable payment periods such as, say, the second year of a 30-year loan (which is presumably less likely to be missed, and thus will be at the top of the debt tower, where it is safe) or the second-to-last year (which, assuming the loan’s low teaser rate has morphed into the higher, permanent interest rate, is much more likely to be missed and thus sits at the bottom of the tower). Returns on the lower tower floors (or tranches) will be higher because the risk is greater; returns on the higher tranches will be lower but will also be safer. So how do you market the riskier bets? By putting together a CDO that cuts horizontally across multiple debt towers, pooling the lower tranches into a new security. And how exactly did this mitigate risk? Because the new CDO comprised tranches from mortgages taken out in California and Texas and Nevada and Arizona – and presto, a diversified portfolio of assets! No one at the credit rating agencies thought to ask why the last-year payments of subprime borrowers across the country would be any different from one another, and none of the large-scale investors seemed to notice.

Banks thus designed and sold these CDOs because they could make a profit for doing nothing more than manipulating rows and columns on an Excel spreadsheet; their counterparties felt safe buying the securities because, first, the securities are so opaque as to be completely misunderstood (it becomes increasingly difficult to price the bonds in a CDO when they are so intricately packaged and pooled with different rates, years, risk, and return chances, not to mention the contextual differences that arise from geographic and demographic disparities); two, because the counterparties are cowboys, willing to take risks with huge sums of money in order to pocket what could potentially be even huger sums of money; and three, because the underlying loans are backed by the full faith and the credit of the United States government – and the government wouldn’t fully insure just any bundle of mortgages, would it?

Once this machine started spinning in the mid-2000s, it quickly became a monster. Congressional complacence lowered lending standards; credit rating incompetence allowed subprime borrowing; bold but risky banking practices created complex financial products that incentivized the entire crew to keep digging into the mortgage market, finding newer and more inappropriate borrowers whose mortgages could be manipulated to spread risk and return through the entire financial industry as investors such as pension plans, insurance giants and hedge funds lined up to get their share of MBS.

By 2010, this translated into an $11 trillion residential debt market, in which GSEs were leveraged at around $80:$1 in their debt-to-capital ratio. Fannie and Freddie were involved with more than half of all U.S. mortgages (estimated to be around $10-$15 trillion), and financed 45% of consolidated residential mortgage debt, further incentivizing investors otherwise leery of such credit risk by guaranteeing the securities and holding small amounts of capital as cushions against default.

In this way, the MBS and CDO markets piggy-backed off the broken credit rating system to create a complex, grossly distorted risk-reward scenario the systemic nature of which crisscrossed the global economy, connecting institutional investors in Germany with rural farmers in Georgia, binding them together with a single bet: that someone, somewhere, would take their chips and walk away from the table. In the end, of course, no one did: the farmer lost his house, the lender lost his principal, the banker – well, the banker didn’t really lose anything (he had hedged his bets, a sneaky little move we won’t get into here) – and the government lost its credibility. Why, now, should we trust any of them again?

OMR: Once More into the Breach?

President Obama’s new mortgage plan is designed to help homeowners with underwater mortgages by letting them refinance into lower-cost loans backed by the Federal Housing Administration (FHA), the federal agency under which the GSEs were originally run. The plan will allow qualifying borrowers to either reduce their principal payments or modify the loans so that monthly payments are capped at 30%-35% of the individual borrower’s monthly income for a 3-6 month period. Obama’s administration says about 3.5 million borrowers will likely qualify for OMR, which requires that borrowers have not had more than one late payment in the past six months. The proposal will cost between $5-$10 billion, paid with a tax on large banks (that, it is worth nothing, Republicans in Congress have rejected twice in the past two years).

Unfortunately, as well-intentioned as the plan is, OMR does not promise to be particularly effective, or even executable. Its weaknesses lay on two fronts, concerning execution and implication. In terms of execution, a number of questions have yet to be answered: How exactly do we determine how much to reduce principal by? Who will be determining these figures? The same agencies whose policies made the housing bubble possible in the first place? More importantly, what happens if borrowers experience further declines in their home values? How can speculators hoping to flip houses on the cheap be identified and excluded from the program? Why not let foreclosures commence and then encourage low-income or rental offerings?

These worries are not partisan or political. They are grounded in what the government has proved for decades now to be incompetent at: jumping into the market and effectively, efficiently moving it without blunder or mishap. Previous attempts to ease borrower burdens were ineffective and, because they did not work, ended up costing taxpayer money. The coordinating government bodies do not adequately understand the mortgage market, as their actions run counter to the realities of that market. For example, initiatives such as “shared appreciation mortgage” (where lenders and borrowers share housing appreciation in exchange for immediate principal reduction) make little sense because MBS holders (linked together as, functionally, lenders) are wary of large upticks in loan prepayments, an unattractive feature of MBS products because they cut out the predictability of interest payments (that is, if you cannot control when you will be paid back, you cannot tell how much interest you will receive, disincentivizing you from extending the initial loan at a possible opportunity cost). The history of government agencies and GSEs are riddled with similar examples.

On the second front, OMR represents an ad hoc solution to a systematic problem. As this article argues, we landed in a recession because we were too eager to extend loans to borrowers who should never have received them. OMR has the potential to duplicate the problem, extending loan revisions and reductions for property that should be foreclosed or sold and thus delaying the inevitable, letting borrowers in over their heads limp along with loans they have almost no chance servicing. The resolution in this situation should be natural default – a band-aid is not a solution where stitches are required.

Finally, making large investment banks pay for borrower principal reduction is a pretty large interest rate risk, one many banks cannot yet take. Assuming interest rates on typical 30-year mortgages increase to 7% (which is merely a modest level), investors parking cash in banks will deploy it, seeking to take advantage of relatively high rates of return. From the banks’ point of view, this is a deployment that represents lost capital, against which MBS holdings total approximately $1.5 trillion. With OMR in effect, these holdings, yielding a return of around 4%, will have to be written down by a couple of billion dollars, a loss that mark-to-market requirements (that is, collateral posting) will have to recognize. The upshot is a significant hit on bank capital, an impact with potentially devastating consequences in an economy just beginning to recover.

Conclusion

The collapse of the housing market can rightfully be blamed on a series of different players. But the entire process of lending, pooling, inflating, and leveraging would not have been possible without over-eager government interference in the market. The lesson we ought to learn from the Democrats’ 1990s push to liberalize home-loan standards and amplify GSE power is not that we need to return to strict regulation: that merely represents a cyclical overcompensation, swinging too far to one side after an unsuccessful sojourn on the other. Instead, we ought to examine what exactly OMR entails, and with a firm understanding of how we fell into the recession, determine whether the proposal leads us out or ropes us back in.

The twin execution and implication problems OMR confronts, at least in its present form, do not advise us to support it. History shows us that eager lending and credit extension to subprime borrowers leads to more problems rather than less, and at any rate, massive, bureaucratic government-run agencies are not exactly well-placed to facilitate such programs. With bank settlement/foreclosure litigation intensifying and the uncertainty of credit default swaps still looming, now is not the time to take another risk on big government meddling in the country’s precarious structured financial markets.

 

A fully annotated version of this post can be downloaded here (PDF).

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