When financial managers first contemplated selling off bundles of mortgages or other loans to investors, their goal was to bring in additional cash on to their books to make more loans. So they would create loans, based on the ability of the borrower to pay and the value of the asset being lent against, and, when they had sufficient volume of loans to entice an investor group, the banks would sell off this group of loans in the form of a “mortgage-backed” security, having made an interest mark-up in the process, and the new investors would benefit from the remaining interest rate.
These were, for the most part, good loans made to good people for good assets. They were sold to good investors at a fair price. They were the early-stage “derivatives” that wound up blossoming into bundles of debt instruments that leapt far beyond mere mortgages into every form of credit instrument imaginable (like the “corporate loan default insurance” derivative – the credit default swap).
Let’s take this model one little step further. Let’s assume that the buyer of these bundles of joy can borrow money at a very favorable rate, so instead of using equity cash to buy the bundle, they would borrow the whole or a substantial part of the cost of buying that bundle, effectively keeping as pure cash flow the difference between the average interest rate yield of that bundle and the interest cost that the investor had to pay. Sounds good, huh? So good that the buyers of these bundles of loans wanted more; they were developing a heroin addiction to the difference between the interest they were earning and the interest they were paying. They told the banks they needed more, even when the banks told them that they had lent to all the qualified buyers they could.
Enter the credit rating agencies and the theory of blended risk. As banks and real estate brokers complained that the good borrowers were gone, the statistical “experts” from the financial world told them that since they were blending so many borrowers into each bundle of joy, they would factor in an “expected average default rate” and price the bundles accordingly. The volume of loans would absorb these riskier new borrowers (the new unqualified borrowers that we have euphemistically labeled as “sub prime”), and the process could continue. Since the folks creating the bundles and trading in them got to pick the credit agency that would put its stamp on the deal – thus making the bundles marketable – they tended to pick credit rating agencies that were overly generous in their ratings.
But if the ratings on the new bundles of sub prime loans really were too high (the actual average default rate significantly exceeded what they predicted), and real sub prime defaults occurred way above expectations (late 2006 and beyond), then the bundles of loans wouldn’t generate the interest rate that the investors needed to pay the loans they took out to buy the derivatives in the first place (read: Bear Stearns, Lehman Bros, etc.).
So the question is whether we should simply ban all derivatives. Matthew Wurtzel writing for the February 26th the Deal.com: “Securitization is a tool banks and other financial services firms use to generate liquidity, which allows them to lend. If we simply outlawed it, we'd be rolling back the availability of credit by decades, just as the government is spending huge sums to restart student lending, credit cards and mortgages, and of course to save the car companies. Bernie Madoff was a crooked money manager. That doesn't mean we should ban money management… Outlawing securitization would mean an end to the American middle-class lifestyle. We should be careful what we wish for. ”
The answer may not be to ban the entire practice, but instead to tighten the regulatory process and the standards that credit ratings must apply, require that the originating banks keep some of the original loans on their books so that they are incentivized to vet borrowers and assets thoroughly and severely limit how much leverage (borrowing) is permitted to those who buy derivatives. We also need to clamp down on home buyers who don’t put enough down (except when they are taking distressed and otherwise unsellable properties off banks’ hands) and don’t have the necessary earning power to pay a real mortgage.
I’m Peter Dekom, and I approve this message.
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