Who Did It? The Subprime Crime

There is a considerable search on by Congress, the press, the politicians, etc., to tag someone or something as the villain who caused the current financial system problems, aka the subprime home mortgages mess. (Theyu00e2u20acu2122re called subprime because the debtor has less than a prime credit rating.)

Among the suspects are financial institutions, mortgage brokers, securitizersu00e2u20acu2122 rating agencies, and various types of defrauding individuals.

It is with some concern that I am duty bound to report that the Resolution Trust Company (the RTC) and its first chairman (thatu00e2u20acu2122s me) must shoulder a good bit of the blame for the costly losses that have rather suddenly appeared. Of course, the losses are caused by these poor credit debtors being unable to meet their mortgage payment. Usually this is the result of teaser rates expiring, although it is equally likely to result from the fact that these customersu00e2u20acu2122 financial condition never justified their having such a mortgage in the first place. A large percentage of subprime mortgages really should be classified as substandard lending practices, i.e., putting people into mortgages where default is almost a certainty.

Why would lenders want to fund mortgages where the likelihood of default is high? The answer is quite simple: Those selling the deal donu00e2u20acu2122t expect to be involved when the default takes place because they will have sold the mortgage on a no-recourse basis.

But who would want to put their money in buying a mortgage with a high likelihood of default? Here is where the old RTC comes in, so bear with me.

The RTC, of course, had huge numbers of nonperforming or substandard mortgages from insolvent banks and S&Ls. I figured out that selling these, even at a million a day, would require hundreds of years. My staff, with the Wall Street bankers, proposed a system of tiered securitization as the way to dispose of large numbers of mortgages in one sale. This involved putting many mortgages in a trust, which would then sell securities to investors in the debt market. But, why would investors buy such a u00e2u20acu0153pig in a poke?u00e2u20ac Because the holders of the securities were able to persuade rating agencies to rate them.

When this idea was first suggested at the RTC, the staff said if we had a million dollars of mortgage value (worth a million) in a bulk sale, we could get one and quarter million if we securitized. I remember saying that it was incontrovertibly proven that one could not turn u00e2u20acu0153lead to goldu00e2u20ac with financial schemes. My staff explained that the increased value came from the packaging of the product through the tiered securitization. The top tranches of securities get the first coverage of all the mortgages (AAA), then BBB gets the next coverage, etc. So a new, large, tiered securitized mortgage market was accepted as a sound financial mechanism.

Under this scenario, the lender (the buyer of the security of the securitization) has nothing to do with making the loan, he must rely on the credit rating in deciding whether to invest. Moreover, the actual party (mortgage broker or financial institution) selling the mortgage to the homeowner, does not have an economic interest in its repayment. The result is that loans are made that are pretty sure to go bad, and the holders of the securities (the lender) take the hit.

Obviously the credit ratings were wrong (too high) and as a result, huge losses are now appearing.

So, as I said, you could blame the old chairman and his RTC for helping to start reliance on the system of tiered securitization as a way to ultimately finance mortgages.

But one group, by and large, you canu00e2u20acu2122t blame, are the community banks. They were much more likely to make and hold loans and thus the loans were much more likely to be good ones. Plus bankers have it in their DNA to make sure they are repaid.

Congress is now considering many actions to deal with the subprime problem. The last thing they should do is bail out the mortgage holder because that really allows those who made bad loans to pass their losses on to the government. One thing we didnu00e2u20acu2122t do at the RTC-FDIC was let those who made the bad loans profit by their actions.

The bottom line is, when the fundamental incentives in the debt financial systems are geared to sales, rather than repayment, the result is what we have today: a real mess.