The current mortgage crisis was not caused by one group of individuals, one class of society, one company or one industry. It was caused by mismanagement coupled with excessive greed, and, in some cases, the lack of regulatory oversight. The basis of capitalism, and economics, is the theory that each individual, acting for his own benefit, will make decisions that ultimately benefit society as a whole. However, when individuals and companies are not held accountable for their actions, then society, as a whole, must ultimately end up paying the bill - which in this case will be the $700 billion provided for in the Emergency Economic Stabilization Act of 2008.
Home ownership is a wonderful joy, and has historically provided a source of wealth and a safe investment for individuals. However, there are certain characteristics that are common to all homes - - they are very expensive, illiquid assets.
Similarly, mortgage loans are also illiquid assets to the entities that originate them. This fact was a significant cause of the Savings and Loan Crisis of the 1990s, which was actually a foreshadowing of today's problems as mortgage loans were the predominate assets of Savings and Loans. Mortgages are illiquid assets that require extensive due diligence to properly underwrite. Due diligence consists of taking a loan application, verifying income, completing an appraisal, obtaining a title opinion and preparing the actual mortgage documents. This extensive origination process makes a mortgage loan even more illiquid.
Furthermore, mortgage loans expose lending institutions to high levels of interest rate risk. Because of the high cost of a house, most borrowers desire long repayment terms, such as 20 or 30 years. However, bank liabilities are very short and generally do not have maturities past five years. This creates a repricing imbalance for the bank when rates increase. Their liabilities cost more; however, the 20- or 30-year fixed rate mortgage loan does not reprice or generate additional income to offset the higher borrowing cost.
In an effort to make mortgage loans more liquid and minimize the interest rate risk, "Wall Street" developed the Collateralized Mortgage Obligation, or CMO, which essentially turned trillions of dollars of home mortgages into supposedly liquid bonds. This was an attempt to mitigate the illiquid nature of the mortgage loan, to diversify credit risks and to address the interest rate risk concerns that toppled the savings and loan industry. So what happened?
Mortgage lending and securitization is highly dependent upon volume. The more loans that are originated, the more money everyone makes. This is where mismanagement and greed had a devastating impact on the economy: 1) Individual home owners wanted the largest house possible, regardless of their ability to pay the mortgage or manage their own personal finances; 2) Loan originators became addicted to the $2,500 to $10,000 fees generated from each mortgage loan originated; 3) Wall Street firms were raking in enormous fees from securitization activities (just look at the compensation packages of Fannie Mae, Freddie Mac and Lehman Brothers); and 4) Investors were ignoring the correlation between risk and return. Compounding all of this was the assumption that credit risk was either non-existent or disbursed among the large volume of CMO bonds originated. In fact, the credit risk was disbursed, but it was not eliminated.
As already noted, for mortgage lending and securitization to be successful you must have high volume. When the supply of sound, qualified borrowers dwindled, alternative solutions were developed and proper due diligence was ignored. Thus, alternative financing methods became prevalent: subprime (which is NOT synonymous with low- and moderate-income); Alt-A (or very limited documentation); teaser interest rates (very low initial rates, that significantly increased within 12 months); reverse mortgages; and 100 percent plus financing. To keep a steady flow of mortgages, originators required almost no documentation and performed almost no verification of the information provided. All of this culminated in a number of borrowers purchasing houses and obtaining mortgages that put pressure on their capacity to pay. This created a false level of demand, which in turn led to inflated home values. At the peak, home values were 20-30 percent above the statistical trend line, resulting in the so-called mortgage bubble and subsequent burst.
Well, what about the regulators? Ten years ago, an FBI agent was teaching a fraud class I attended, and he predicted that mortgage lending would be the next major economic crisis in the United States. Was he a genius or clairvoyant? No! He simply understood that a tremendous amount of money was flowing through the mortgage market, and this would eventually lead to bad decisions, fraud, abuse and predatory lending. Regulatory bodies have seen the enormous risks associated with these "alternative" mortgages for years, and several high risk CMOs have exhibited excessive levels of credit risk for years. So why wasn't anything done to stop it? Because the mortgage industry was too "profitable."
The Emergency Economic Stabilization Act will bring about extensive new regulations. Some regulatory changes will be good, and will help prevent these types of staggering losses in the future. Governor Beshear's administration and the Kentucky Legislature were very proactive in dealing with the underlying causes of the problems when HB 552 was passed and signed into law on April 24, 2008. The Web site www.ProtectMyKYHome.org offers resources to homeowners who are experiencing difficulties. In addition, the DFI is diligently working with financial institutions to ensure Kentucky's banking industry remains strong.
However, it all comes back to how corporations and private citizens react to this wake up call. Learning from our past mistakes is crucial to not repeating them in the future. We all must be accountable for the successful re-emergence of a stable and viable mortgage market. If we are not successful, the recent actions by Congress will have been futile.
Charles Vice is Commissioner, Kentucky Department of Financial Institutions (DFI).