Originally published in the August 2011 issue of Asset Securitization Report (www.sourcemedia.com)
I
recently completed the book Reckless
Endangerment, a widely discussed and heavily promoted perspective on the
mortgage and financial crisis. While the book is quite interesting and
illuminating at times, it is a poorly written, incomplete and flawed analysis
of recent events.
The
book's strength is its description of how the fixation on affordable housing
was allowed to morph into a goal that eclipsed other issues such as loan
quality and institutional safety and soundness. It also describes how Fannie
Mae, Freddie Mac and the lending industry exploited this to dominate housing
finance and, for many years, defeat all attempts to circumscribe their
activities. (Full disclosure: I worked
for Countrywide Securities from 1996 to 2008.)
However,
I thought the book was the weakest of the works I've read on the activities and
events leading to the mortgage and MBS collapse. The writing is poor; its
annoying and condescending tone is combined with an inability to explain
relatively simple concepts without indulging in caricatures. While it's common for writing to be tailored
to a non-technical audience, describing the Glass-Steagall Act as a measure
that "protected consumers and individual investors from rapacious bankers" is
ludicrous. (As the authors must surely know, it essentially protected one set
of bankers from another.) It also has a
strange pace, as if the authors were rushing to meet a deadline. One of the
book's better sections discussed the GSEs' accounting scandals in depth, while
the subsequent events leading to their being placed into conservatorship were
crammed into a few paragraphs.
The
authors are clearly trying to stoke anger and outrage at the various players
that they view as being responsible for the financial crisis. However, their
arguments and credibility are undermined by a large number of errors and
misconceptions that betray a limited grasp of the mortgage market and
securitization practices. Among these
mistakes:
-
They repeatedly confuse different types of loan
products. They describe the subprime market as the issuance of "nonconforming"
loans, although huge amounts of non-agency securities backed by prime loans
were issued over the same period of time. They also incorrectly categorize all
adjustable-rate loans as subprime in nature, with interest rates "...that adjust
to sky-high levels in a few years." In
fact, the bulk of ARMs issued during the period were prime hybrid ARMs with 225-basis-point
gross margins, and many prime ARM borrowers have recently seen their rates
decline. (Only subprime products had
gross margins in the 400-700 basis point area.)
-
They write that the rating agencies defended
themselves from legal liability by arguing for First Amendment protection. ("A more important defense was their
insistence that investment ratings were simply opinions. This meant that the
agencies should be shielded from lawsuits just as a journalist's views are
protected by the First Amendment.") In
fact, the rating agencies had an exemption from liability that was included in
the Securities Act of 1933. Moreover,
the removal of this protection by the Dodd-Frank Act has hindered the recovery
of the non-agency MBS market, since the rating agencies subsequently stopped
allowing their ratings to be included in deal documents. (The SEC has issued a
series of no-action letters that allow non-mortgage ABS to be issued without
ratings.)
-
Their statement that by 2002 "the vast majority
of mortgages were cash-out refinancings" is incorrect. The majority of refinancings involved taking out cash, according to industry
figures.
-
The authors follow a discussion of affordability
products such as interest-only and negative amortization loans (which they
correctly pinpoint as a major factor in skyrocketing home prices) by
incorrectly asserting that "(b)y creating these loans..., Wall Street's bankers
had allowed institutions extending credit to consumers in the form of a second
mortgage to share in the collateral backing all the loans without asking for
permission from lenders..." These two
issues are completely unrelated. They
also assert that bankers "were careful to bundle them with more traditional
mortgages in the securities they were selling to investors." While interest-only and amortizing loans were
typically securitized together, option ARMs were securitized in separate
transactions.
-
They claim that "by the summer of 2005, almost
40% of subprime mortgage originations were for amounts exceeding the value of
the underlying properties." In fact, the
market for loans with original LTVs greater than 100% was very small.
-
More than once, the authors state that
"prevailing rates" were at 1% in 2003, leaving "little room for further
declines." While short interest rates
(i.e., Fed Funds and LIBOR) were at or around 1% at that time, mortgage rates
were much higher - the lowest rate for the Freddie Mac survey rate in 2003 was
around 5.25% in June.
In addition, the
book makes a number of dubious and unsupported claims. For example, the authors state that
"(b)orrowers who could prove that their incomes and assets were ample were
pushed into more expensive loans that required no documentation...These and other
tricks hurt borrowers." Without some
elaboration, this contention is highly questionable: Why would rational borrowers take
unnecessarily expensive loans?
The
apparently weak and unsophisticated understanding of market practices exhibited
by the authors also contributes to one of the book's glaring deficiencies -
their unwillingness to examine critical issues in anything but superficial
terms. For example, they write that
investors bought securities backed by subprime loans (in this case, originated
by Fremont)
"because they offered a higher income stream than more conservative mortgages
backed by Fannie Mae or Freddie Mac."
This statement overlooks the fact that the largest tranches in subprime
deals (about 75%, in most cases) were generally LIBOR-based floaters with reset
margins of 20-25 basis points. (The
large amounts of interest thrown off by the loans were primarily utilized as
credit support for the senior bonds.
Only the more junior tranches and interests in subprime ABS received
relatively large income streams.) This
begs a series of questions, the most important of which is why large numbers of
institutional investors found the senior securities attractive and continued to
purchase them even as collateral performance noticeably weakened in 2006. (An ABS trader once told me that he was asked
the same two questions at every client meeting: 1) "When's your next deal?" and 2) "How can I
get my full allocation?") The notion
that ostensibly sophisticated investors were simply "stuffed" with securities,
as the book relates, is at best highly simplistic and ignores the different
clienteles that were active in the MBS market.
There are numerous
other examples of the book's superficial treatment of complex issues. For example, what were the actual
ramifications of the repeal of Glass-Steagall on the financial system? (I'd argue that it ratified a reality that
had evolved over the previous 20 years.)
Is the securitization process itself inherently corrupt? Can it be policed successfully, and how? Anyone seeking an intelligent discussion of
these issues will need to look elsewhere.
Finally, the authors
are unwilling or unable to forthrightly address the roles that borrowers and
home buyers played in the mortgage debacle.
These actions included massive amounts of speculation on real estate,
income misrepresentation, overleveraging (through both the cash-out
refinancings cited by the authors and loans taken with absurdly high DTIs), and
the pervasive mishandling of personal finances.
Economists and financial advisors have been warning for decades about
Americans' low savings rate, dependence on debt, and irrational activities
(such as utilization of expensive credit card debt). Unfortunately, Americans have exhibited a
short-sighted propensity to buy the things they want (whether they are houses
or consumer items such as cars and vacations) whether or not they can
realistically afford them.
An alternative to
the look-what-those-evil-people-did-to-us narrative advanced by books like Reckless Endangerment is to view the
mortgage debacle as an economic disaster that resulted when the home financing
industry (which includes both lenders and Wall Street firms) figured out how to
make enormous amounts of money by helping borrowers carry over their dangerous
financial practices into their residential real estate under the guise of
expanding home ownership opportunities.
However, the exceedingly complex web of activities leading to the
mortgage crisis defies any single explanation.
Books
such as Reckless Endangerment
represent the zenith of the finger-pointing game that, in my mind, is dangerous
and delusional. At this point, the right
approach is to work toward restructuring and rehabilitating the mortgage and
housing markets. A good first step would
be to implement Dodd-Frank without destroying the mortgage market, as the
recent interagency proposals on risk retention would do.