Mortgage Meltdown: What Happened?

Our roundtable of experts sorts it out

The subprime mortgage industry began to fall apart rapidly in 2007 as the rate of defaults skyrocketed and lenders such as New Century began filing for bankruptcy. This resulted in the collapse of the subprime mortgage-backed securities market, threatening a broader crisis in the U.S and global economy. What were the underlying problems in our financial system that led to this crisis? Texas magazine invited four of the McCombs School’s top real estate and finance experts to sit down and discuss where to place the blame.

The participants were Greg Hallman, who teaches real estate finance and oversees the student-managed McCombs real estate investment trust (REIT) fund; Jay Hartzell, associate finance professor and director of the Real Estate Finance and Investment Center; Sandy Leeds, who teaches investments and serves as president of the MBA Investment Fund; and Lewis Spellman, finance professor, who studies capital markets and the banking industry. What follows is an edited version of the conversation.

HOW IT ALL BEGAN

Jay Hartzell: Just to start off, I can briefly define subprime mortgages and also how they were used as an investment vehicle. If you can imagine dividing up homebuyers into three buckets: In the first bucket, you’ve got people with prime credit. In the middle bucket are the Alt-A borrowers who might be a little more of a credit risk. Then the other end of the spectrum are the subprimes, people with poorer credit histories and lower credit scores that do not meet Fannie Mae or Freddie Mac guidelines. They would be offered subprime loans.

About five years ago, investment banks began “securitizing” these subprime loans, pooling them together and creating securities that could be bought and sold. It’s this secondary market for mortgagees that fueled the demand and led to a lot of the crisis.

Greg Hallman: Well, in my mind the seeds of the current crisis were planted in 2001 after the tech crash, when the Federal Reserve began lowering interest rates. Those low rates in the economy created very low mortgage rates and increased the demand for housing, and subsequently house prices started to go up dramatically. And as house prices appreciated year after year, housing started to appear to be a very safe asset. By 2004, as Jay mentioned, the big New York investment banks started securitizing high-rate subprime mortgages as a way to create high-rate subprime mortgage-backed securities. There was a huge demand from the fixed-income market for securities paying high rates in 2004, 2005 and 2006 because interest rates in general were very low, and fixed-income investors were yield hungry.

Hartzell: And just to add on to what Greg said, at the time, rates of return on traditional assets were low. So investment managers started looking for alternative assets. And if you look at the last several years, the big growth seemed to be in areas like private equity, real estate and hedge funds—asset classes that traditionally offer more return for more risk. Subprime was part of that.

Lewis Spellman: I don’t totally agree with respect to the source of the demand. Undoubtedly the Federal Reserve was easing monetary policy coming out of the tech bust in 2001. But the major portion of the demand was from foreign capital, particularly in the later years, 2005, 2006, 2007. There was a tsunami of capital coming from emerging nations like China. They were effectively taking their winnings in trade and turning around and investing 80 percent of it in U.S. assets. So to me the whole situation was driven by excess demand. Wall Street investments desks were sitting with multiple billion-dollar open orders for investment-grade U.S. fixed income, and given that kind of excess demand, the investment banks geared up to create the securities for the market.

Sandy Leeds: Well, you can talk about the huge increase in demand for this product, but I think the problem ultimately comes down to the fact that we were creating securities that were riskier than we thought. A significant part of this problem comes from the origination of the original mortgages. I look at this as an incentive and a compensation issue. Mortgage brokers were generating tremendous incomes and many were being paid more for subprime mortgages.

Hartzell: I agree. Of course, it’s not just the mortgage broker; it’s also the borrower. I was talking to one of our alumni who is involved in affordable housing in Texas. He said his tenants ask just two questions when they move in: “What’s the monthly rent?” and “What’s the late fee?” These are people who are not yet ready to own a house. And they were the ones leaving apartments to go take these subprime mortgages.

“NOT A FAIR FIGHT” FOR BORROWERS

Spellman: Well, I have a question. The brokers were always paid up front and were paid for volume and not risk bearing, so why did it suddenly come together at this point?

Hallman: I’d like to take this if I may. The difference is that the originator is no longer monitoring the borrower. If you think about the way these things were structured, you’ve got a bottom most risky piece, the first loss piece. The idea traditionally was that whoever owns that piece is the one monitoring the lending. But then all of a sudden you add in one more layer of securitization in the form of collateralized debt obligations (CDOs), for example, and these first-loss pieces are put into a new security and sold, and the monitoring incentive gets significantly diluted.

So, ultimately, the mortgage brokers were creating loans that they weren’t holding, and then the bankers were creating securities that they weren’t holding, and the first-loss piece buyers were pushing even those pieces into a new security called a CDO. We are very good in finance at spreading risk, and that’s a big benefit in the economy that the capital markets provide. On the other hand, the more you spread risk, the less incentive any one party has to monitor that risk.

Hartzell: It’s very easy to look at this securitization process and come to the conclusion that it was a bad idea after the fact. But the idea of taking a bunch of risky loans, putting them in another structure and re-securitizing, re-carving those up, and arguing that the very safest part of that new pool could be pretty safe is not crazy. Instead, I think the giant mistake was that people didn’t understand how highly correlated home prices and the underlying mortgages could be.

Leeds: I agree that everyone involved was acting rationally in the short term. They were trying to maximize income. Of course, saying that people were acting rationally doesn’t necessarily mean they were acting ethically or morally. Most mortgage brokers had done this enough to know when they were putting a borrower into a product that they were going to default on if home prices didn’t continue to increase.

And if you look at the repercussions of someone defaulting on their mortgage, someone who has saved all they can to put 5 percent down rather than 20 percent down, the result is that they’re going to not only lose all of their savings but their family is going to have to move and have the possibility of tremendous turmoil.

Hartzell: But it’s tough when you are in a competitive situation. As a broker, am I going to go out on a limb and lose business to you because I’m going to take a stand on some sort of principle that may or may not happen in the future?

Hallman: Just to argue with Sandy’s proposition that there might be something morally or ethically wrong with what the brokers were doing. You could say, yes, this person may run into trouble. But there was a strong feeling at the time—2004, 2005, 2006—that home prices only go up, and so they could always sell the house and pay off the loan if they got in trouble—there would always be an out. That brings us to what Jay mentioned about nobody realizing how highly correlated housing prices had become across the country. Nobody ever thought housing prices could go down everywhere at the same time, because it had never happened before. When we looked at these pools of mortgages underlying the mortgage-backed securities and CDOs, we thought we were looking at much more independence across geographic regions of the country, and it turned out that they were correlated. I think in a large part they were very correlated by 2007, and the commonality was the lax lending standards that existed in almost every market in the country.

Leeds: I’d like to get back to the borrowers for a minute. When I complain about some of the mortgage brokers, I’m not saying the borrowers can’t be blamed. But I think some of these borrowers were uneducated.

Hallman: I agree with Sandy on that. It was not a fair fight.

Leeds: It’s not a fair discussion between an experienced mortgage broker and a person who has never bought a house. Have you guys read your home-mortgage loan?

Hartzell: No.

Hallman: I have.

Spellman: No.

Leeds: I mean, it’s too long.

THE ROLE OF RATINGS AGENCIES

Hallman: We can also talk about the ratings agencies—they were closer to the securities than the original borrower. The rating agencies like Moody’s, Standard & Poor’s, and Fitch will certainly take their share of the blame. I think it will be very interesting to see how the ratings industry changes or is made to change as a result.

Hartzell: The way the securities were packaged, they were acting like bonds, and therefore they came across the ratings agencies’ desks. And then they got traded based on that rating, which are paid for up front by the investment banks.

Hallman: And it appears now that one mistake the rating agencies made is that they did not realize the degree of correlation in the pools, and this likely contributed to the significant number of downgrades we’ve seen, especially in the mortgage-backed securities created in 2006 and 2007.

Hartzell: Their position now seems to be that they relied on the data and the models that were provided to them from the banks.

Leeds: But that means that the ratings agencies were not doing independent due diligence on the underlying credits, but simply looking at the pool in the aggregate. I mean, that’s a scary world if you’ve got a rating agency that’s not doing any due diligence. And there’s no independence. The bank is paying the rating agency and asking the ratings agency for the rating and then the rating agency asks the bank for the information about the securities. Then you stamp your approval and get paid. It sounds insane.

Hartzell: So if someone asks what happened to really spur the crisis, it’s just like anything else, it’s maybe not an event, but a combination of circumstances and an issue of confidence.

Leeds: I agree. The securities were essentially created as instruments based on the rating. And so now you can’t trust the one person who told you it was okay, the rating agency. So the market stops in large part from indecision.

Hallman: And as soon as house prices stopped going up, then the market says, “Boy, now I have to count on the borrower paying because I can’t count on rising housing prices to bail them out.” So once housing prices stopped going up, nobody wanted to buy these securities. The bids went on the floor almost completely. And then everything started to tumble. And I think that the complexity of these securities—especially the CDOs constructed with the lower-rated subprime paper—also contributed to the extent to which the markets froze. If you as an investor hear that those securities might be in trouble and you go back to your documents and you start reading them, those are complicated documents.

WHAT HAPPENS NEXT?

Spellman: The bank write-offs worldwide so far are about $300 billion from subprimes. But the bigger relevance is not the $300 billion, but the fact that these banks are regulated in terms of minimum capital. So now the banks are short of capital. When you’re short of capital you can’t lend any further, and so you go into the next stage which is recession.

The fallout will be that there’s going to be re-regulations and there’s going to be penalties, and we’re going to go through rounds of litigation. Part of the re-regulation is going to come about because the Fed bailouts extended not just to commercial banks but to investment banks, which are not regulated by the Fed. They are going to become regulated. This really is not so much a source of comfort, because the government will come out with rules based on fighting the last war, and then the market will engineer around that. Wall Street is going to be very sorry that this happened, because the value of their franchises are going to decline. Probably the biggest way that this is going to be held in check for at least this generation is they won’t forget it.

Leeds: I completely agree that we always regulate sort of in the rearview mirror. But I would say this: I would like to see mortgages with a plain-English disclosure that is limited to one or two pages with all the key terms. There has to be a way to do that where we make something understandable so that not only can people understand it, but then people can’t deny understanding it.

Spellman: If you want to sum it up, the brokers were paid up front to produce the loans, the investment bankers were paid up front to package and sell them, and the rating agencies understood the value of an investment-grade rating. And there were literally hundreds of billions of dollars of institutional buyers with an excess demand for that kind of product, and so they had an incentive to look the other way.

You know, Sandy was saying he was amazed that the mortgage brokers continued to originate these loans and they were the closest to the end borrower. But what amazes me is that the investment bankers were willing to look the other way while taking incredible franchise risk. Obviously Bear Stearns is one franchise so far that’s gone down. But they were all willing to look the other way because of the incredible amount of money being made by all those involved in the building blocks between the borrower and the end holder. They had to have a sense that there would be a day of reckoning.