Friday, May 02, 2008

To Solve the Subprime Mortgage and MBS problem for good...

...Supply the one essential ingredient that disappeared from the mortgage industry and thus produced the recent financial crisis, the one ingredient that can restrain even the greediest of the greedy: Cold Fear. The key fact that drove this disaster was that in many ways no-one was responsible. Make everyone in the picture responsible in some manner, really responsible, and the problem goes away.

Mortgage originators were in many cases among the most irresponsible. Too many foisted off adustable-rate mortgages (ARMs) or interest-only mortgages or no-means-test mortgages on naive homebuyers who were immediately in over the heads, but could carry the payments long enough for the originators to get them off their books, disguised as prime-quality mortgages, and onto the books of the next step in the food chain, the mortgage-backed securities (MBS) packagers. The bigger the principal amount of the loan, the better - bigger fees and profits from selling it on. They didn't care that many of the mortgages would eventually fail because the mortgages would be out of their hands when that happened; someone else would be holding the bag and the originators would have banked the profit. They would not be responsible. Doesn't sound like prime-quality, you say? That's where their friends, the real-estate appraisers came in. There was always someone who would pocket some baksheesh and in return put the value of the house serving as collateral so high it could back almost any conceivable mortgage.

What about those Wall Street wizards the MBS packagers? Didn't they perform due diligence? Sure they did: They read (or pretended to read) the crooked appraisals, took the assertions of the originators about creditworthiness at face value, folded the plague-carrier mortgages into fancy interest-bearing paper that could pay a high yield and get a double-or-triple-A rating because it was partly backed by those nice, juicy "prime-quality" mortgages and collateralized at least in part by all those houses shooting up in value. They weren't responsible either. Times were good, credit was easy, house values really were going up, after all; no problem getting the radioactive paper off their books too - by selling it to the ultimate, typically institutional investors. And what about the security-rating agencies? There's no accounting for them putting their multiple As on this stuff; I'll be kind and assume no malevolent intent, only staffs of blind clerks and bureaucrats who didn't care about the reality of what they rated as long as they could prove they followed their companies' internal rules well enough that their own butts were covered.

Well what about those ultimate investors? Didn't they ever hear of caveat emptor? Sure they did; they couldn't be expected to drive around checking up on all those individual houses themselves, could they? So they made sure everything they bought had ratings with multiple As stamped all over them - and wow, look at those juicy yields! Made their income statements look good. So everybody was happy until, inevitably, the roof fell in.


Suppose any originator who sells a mortgage has to guarantee it - for the life of the mortgage? Either back it himself or buy good mortgage insurance for it? Think they'll be so quick to shovel piles of road apples into bags marked "prime-quality", hold their noses, and pass them along? Suppose packagers of mortgage-backed securities had to do the same thing? Think those oh-so-ripe bags would go on up to ultimate investors - or ever be put on the financial conveyor belt in the first place?

There were irresponsible homebuyers too: Some speculators planning to flip their properties, others with no down payment invested in the property or a minuscule one, who were willing to walk away and abandon the property to foreclosure if things went wrong. Suppose they had to put up a good, old-fashioned 20% down payment into the property first? Think they'd be so ready to mail in the keys?

The ultimate investors - the banks and investment community at large - have had a collective near-death experience, and for some it passed beyond near-death to the real thing. The survivors will take care to protect themselves from a repetition - and those who don't will deserve to die. And the rating agencies? Perhaps the world needs new, hungrier ones willing to do the job right.

Will all this raise the cost of mortgage finance? Of course it will. But raised compared to what? How expensive is it compared to the financial disaster much of the developed world just went through? From society's point of view, it's got to be a bargain. Or would everyone really rather have a full-fledged financial panic and concomitant depression the next time?

Hopefully, the banking and investment world, who can find ways to impose discipline if they have the will, will see the importance of this self-government. They had better. If they don't, there are plenty of politicians, regulators, bureaucrats and big-government-anti-business ideologues ready and eager to force far worse solutions on them.