Christopher Pang

In my previous entry, we have seen how the public sector encouraged the hazardous behaviour in modern banking through central banking, bailouts and deposit insurance. In part 2, we will take a closer look at the hazardous behaviour in the private sector of modern banking that led to the subprime crisis, i.e. mortgage broking, securitization and credit rating.

The American Dream was first expressed during the Great Depression by James Truslow Adams as attaining prosperity though living a “better and richer life”. This dream of prosperity gradually transformed into home ownership during the subprime bubble, touted by mortgage brokers with liquidity provided by accomplice in form of investment banks. Home ownership was very much seen as a status symbol distinguishing the middle class from the poor.

This American Dream subsequently turned into a mortgage nightmare when housing prices started to decline. Gone were the days when home owners could extract equity to spurge on plasma televisions, automobiles or Iphones. With housing prices much lower than the mortgage owed to the banks, home owners were left in a situation where they could default on their mortgage payments and leave the bill to the financial institutions.

Mortgage Broking

Why was mortgage broking a huge moral hazard during this financial crisis? Unlike a loan approval officer, mortgage brokers have an incentive to help new home owners secure the mortgage with disregard about the creditability of the home owner as they are being paid a commission based on the amount of the mortgage. Falsifying the income of the home owner will boost the chances of the lending institution in providing these funds. The lending institutions also do not bother doing a proper credit evaluation on the home owner as they do not have an interest in the mortgages either. These funds would soon be recovered through the securitization process as explained later in this article.

Mortgage brokers had convinced home owners that real estate was the investment option as housing prices appreciated more than 10% yearly after the dot com bubble in 2000 with low interest rate policies, very similar to the current situation. As financial institutions made it easy for home owners to realize this appreciation though reverse mortgages, home owners could finally live a live of prosperity by lavishing themselves with their every desire.

Adjustable rate mortgages (ARMs) were also introduced to homeowner wannabes and speculators to realize their “American Dream” with the minimum required payment for a ARM so low that it is not even sufficient to cover the interest on the mortgage. No downpayment was required in many of these mortgages. The GDP growth was seemingly aligned with the housing bubble as spending peaked as people believed they had owned a goose that kept laying golden eggs. Nobody wanted to sell their homes and home builders continue to enter the property market with new condominium projects everywhere even in deserts.

When bubble finally popped, home owners could not sustain the mortgage payments as they did not earn that level of income in the first place or were laid off during the downturn. Many home owners had defaulted on their mortgages strategically as they were unwilling to use good money to chase after bad money any further. Up till now financial institutions, e.g. Bank of America, are still sitting on a portfolio of houses declining in prices monthly.

With a supply of housing that need years to work off, prices should continue to decline(*if Federal Reserve does not continue its expansionary policy). It is time financial institutions return to traditional loan and appraisal procedures.

Securitization

Securitization is a structured finance process that distributes risk by pooling assets together, forming a structured product. After which, different investors owning this structured product would be receiving cash flows based on the tranches they were in. The senior tranches would get a lower return for a lower risk of default and the junior tranches would get a higher return for assuming higher credit risk. It was designed to reduce risk of bankruptcy and obtain lower rate of financing from lenders.

Under a normal mortgage process, a bank lends money to a home owner, books it under its balance sheet as a long term loan with a cash outflow and earns interest income based on balance of principal amount remaining. The risk ultimately belongs to the bank who lends out the money.

Under a securitization process, a bank lends money to a home owner, then securitizes it under a mortgage backed security (MBS), and sells this security to investors overseas (mainly Asia) who are in search of yields because Asian central banks persistently kept interest rates aligned with the Fed. In a securitization process, the main source of income to the banks would be the underwriting and sales of the MBS as contrary to the loan interest income. This disconnect between risk and reward manifests itself as a moral hazard.

The banks which sold the mortgages had access to liquidity from securitization and reduced their exposure significantly. Given that the risk no longer lies on the banks’ balance sheet and the income they generate from mortgages no longer ties up the liquidity for 20 years, the quick realization of income from securitization process enables investment bankers to book record bonuses for themselves. It was also obvious why banks would accept zero down payments and provide teaser rates to entice consumers to take up the mortgages at extreme overvaluations.

The only losers were the men and women on Main Street, who lost their money as a retail investor in structured investments, who paid for the bailouts to the banks from their taxes, and those who lost their homes by overpaying for the speculative prices during the peak of the market.

Rating Agencies

It is inconceivable that the Mortgage Backed Securities (MBS) that were rated triple “A” by rating agencies such as Moody’s, Standards and Poor’s and Fitch could lose over 90% of their value in less than a year. The time that was taken to unravel this house of cards suggests this credit rating system was flawed to a large extent.

Moody’s, the only credit rating agency that is publicly listed, reported outstanding results during the peak of subprime mortgage bubble coincidentally. It announced record operating income of US$1.26 billion in 2006 and record revenue of US$2.26 billion in 2007. Moody’s share price subsequently plunged 78% from the peak in 2007 to the lows in March 2009 after profits declined more than 65% in 2008.

There is an obvious agency problem in which investment banks securitizing the mortgages could shop and decide on which rating agency will be hired to determine the creditability of these securities. As the main objective of the investment banks was to sell these securities and to compete with other credit rating agencies for credit rating assignments, these agencies have to satisfy their customers (investment banks) with good credit ratings so that these securities could be sold.

After the unfolding of events during this crisis, rating agencies are using the defense that ratings are a form of free speech and companies that issue them cannot be sued even if these ratings turn out to be ridiculously wrong. These credit ratings were definitely material in some investors’ decision making process because a triple “A” rating would induce one to invest and a junk status would otherwise result in the potential investor shunning the investment. The incompetency demonstrated by the rating agencies during this current financial crisis has increased the need for investors to do due diligence on their own or hire independent firms to rate these securities when they are considering investment decisions.

Moral hazards in the financial industry are aplenty and unavoidable if you are a retail investor. It is therefore important to make any prudent investment decisions with a level of skepticism and to do enough due diligence even if it cost you some time/money.