Today’s Crisis: It’s Not the S&L Crisis Again

At the start of 2007, my commentary for this magazine was titled, u00e2u20acu0153A Time for Being Very Careful.u00e2u20ac The subtitle was u00e2u20acu0153It is important to proceed with caution to help ensure the safety and soundness of the U.S. banking system.u00e2u20ac

At the time of that writing, (December 2006), banking profits were at record levels, inflation and unemployment were at historic lows, and most folks seemed to think my words of caution came from a combination of old age and profound pessimism.

Well, now we know I was wrong, but only to the extent that I didnu00e2u20acu2122t title my piece u00e2u20acu0153Watch Out, Disaster Ahead!u00e2u20ac

I wrote about how lending standards were weakening, how real estate prices were too high, and how major banks were putting themselves at great risk with option derivatives and other new financial creations.

What I didnu00e2u20acu2122t know was that large banks were using huge off-balance-sheet structured investment vehicles (SIVs) to package subprime mortgages, putting them in trusts for worldwide distribution. The SIVs held enormous amounts of subprime and other nontraditional mortgages in securitizable trusts, or collaterized debt obligations (CDOs)u00e2u20ac”up to 80 billion in Citibanku00e2u20acu2122s case. They were then distributed by investment bankers to buyers all over the world. Unbelievably, almost a trillion dollars of these new financial instruments were created and sold in about three yearsu00e2u20acu2122 time. The mortgages were not only subprime credit, but usually contained a teaser interest rate that rose after a set period.

Why did the good people in Dusseldorf and Spitsbergen buy these new financial instruments? Because they had credit ratings AAA, BB, etc., from the accredited rating agencies.

Now reality has set inu00e2u20ac”the mortgagees canu00e2u20acu2122t pay the new higher rates and defaults have begun at record rate.

The worst feature of this mess is that those lenders (i.e., the purchasers of the CDOs) have no direct contact with the borrowers except through mortgage servicers who, by contract with the CDO, are directed to collect interest and foreclose on the mortgage if the mortgagee canu00e2u20acu2122t make their payments. Few have any provisions allowing for adjusting the mortgage debt to prevent foreclosure and all experienced lenders know that foreclosure is the most costly way to deal with nonperforming loans.

This is not the same situation we had with the failures of the S&L industry in the late 1980s. In the present case, we have created a mess that is far more convoluted and very difficult for the government to fix.

Today the bad loans are in the private sector and held by many thousands of different owners, whereas in the late u00e2u20acu212280s, the RTC and FDIC owned the loans that were taken over from failed banks and S&Ls.

This explains why the government actions so far, moratoriums on collections by lenders, have all been voluntary programs. It is not at all clear that government can decree new terms between private parties. Of course, it could create a new program to give money to borrowers as a means of assistance, or create an agency to buy up loans and redirect the payment to the borrower as a loan holder.

Under such a program, the name of the game often becomes how to push the losses on overpriced securities off on the government. Many programs under consideration (using FHA, Fannie and Freddie, etc.) hope to avoid putting the government at risk, but my past experience is not optimistic in this respect.

In fact, we should consider who the real losers and winners are in this situation.

The mortgagees (borrowers), by and large, have scant financial interest in their home, since under the relaxed lending standards, they made little or no down payment and paid mortgage payments that were lower than rent. The losers are the owners of the CDO, etc., who comprise a thousand different kinds of investors ranging from such entities as Fannie and Freddie and large endowment funds at major universities to church funds in Grand Rapids.

One alternative is to let the private sector sort the problem out by a combination of foreclosures and loan reductions. Given the government aid to investment banks and the recent Bear Stearns rescue, politics will require the government to provide aid to the subprime mortgage market. My opinion is, letu00e2u20acu2122s try to do it by reducing the mortgages so the lenders, not the government, take the loss.