Holy you know what, GonzoBankers, by the time this article goes to Web on October 3, 2008, who knows what financial, economic or other calamity will have befallen this great nation of ours. I have to tell you, though, that I am angry, upset, perturbed and miffed about the state of affairs this country is in stemming from easy Fed money, unregulated mortgage originators, non-existent underwriting standards, and complex mortgage-backed instruments. All of this leading to a proposed bailout package nearing $1 trillion of taxpayer money.
Hmmph! How did we get here? What can we do to make the future a little brighter? I’ll try and answer all of this and more in the span of a 3 ½ minute read.
The problem we find ourselves in now isn’t subprime loans going bad. Sure, NINJA (No Income, No Job, and no Assets) mortgage loan defaults are a big issue but we live in a $14.2 trillion dollar economy. Current estimates are that there are about $1 trillion in subprime loans in total and only a fraction of those are in default. No, the real problem is the derivative contracts tied to subprime and other potentially bad debt. These contracts are meant to act as insurance against possible default, which is where we get the name “credit default swaps.” These swaps are traded in unregulated markets across the world by any institution, fund or person that wants to gamble on how mortgage-backed bonds, student loan bonds, credit card paper, etc. will perform. Current estimates put the total of credit default swap derivatives at $62 TRILLION, a staggering amount that led my good friend Warren (Buffett that is) to proclaim these as “weapons of financial mass destruction.” A small ripple one way or the other in their value can create a financial tidal wave across global markets.
What led us to this predicament? I would argue that the government’s role in promoting “home ownership” through Fannie and Freddie has trumped strong underwriting, fiscal discipline and plain ol’ common sense. The truly sad part of this entire situation is that turning loans into mortgages, into mortgage-backed securities, into CDOs (which themselves are sliced and diced into even narrower debt instruments) with a massive gamble in credit default swaps backing it all up hasn’t created one new bridge, school or highway in this country of ours where infrastructure is deteriorating on a daily basis. Instead, Wall Street, abetted by federal policies, created an environment where passing the “mortgage risk buck” created outsized “financial” profits for bankers and investors in the short term leaving the rest of us with the long term mess we’re in now.
Did it have to be this way? Are other countries suffering the way we are? Could we have done something to avert this catastrophe? I believe there are two things that have influenced where we are now:
While our European colleagues have by no means been immune to the housing crisis roiling the U.S., their mortgage market can provide some instructive lessons for Hank, Ben and the rest of the pin-striped crowd in Washington.
Over 200 years ago in Germany the first Pfandbriefe was created. Today this asset-backed instrument is more commonly known as a “covered bond” – a more mellifluous name that doesn’t sound quite so much like a sneeze. Covered bonds are securities created from a dedicated group of mortgage loans (and sometimes public sector loans) known as a “cover pool.” Their historical double and triple A ratings in Europe symbolize the high quality of the loans in the cover pool. Covered bonds are in many respects similar to mortgage-backed securities but differ in significant ways:
The second factor contributing to our current debacle (among 200 other factors) that I want to touch on briefly is the type of mortgage products U.S. banks bring to market. Now don’t count me as un-American on this one, GonzoBankers, but bankers need to break their addiction to the 30-year fixed mortgage. We are practically the only country in the world that has this product with volumes that make it #1. Why is this? Why do U.S. banks offer a product that leaves them with the interest rate risk? Your bank makes a 30-year fixed loan at 6.5%. If interest rates go up, you’re stuck with a below market earning asset potentially for 30 years. That’s why you are all so anxious to sell these loans. If interest rates go down, your borrower refinances – and probably with another institution.
If one looks at the mortgage products offered by our friends in England, the most popular are 2, 3 and 5 year fixed rate deals. In Canada the 5 year fixed amortized over 25 years is the most popular, with short term variables coming in a close second. This theme runs true through Europe, Australia and other developed countries. Much of Europe is struggling right now as well, but it’s not because there are mass mortgage defaults. It’s because of their involvement with our mortgage-backed products that are imploding.
I understand that covered bonds are not the balm to salve all of America’s mortgage wounds, especially in a market with 8,400 banks and 8,200 credit unions, most of which are offering mortgage loans. And I also understand that we can’t get rid of 30-year fixed mortgages anytime soon since they are up there with Mom and apple pie. However, a mortgage financing system that keeps risk where it should be, while allowing an issuing bank to raise more capital to make more mortgage loans is something that U.S. markets should take a long hard look at Hank Paulson announced in July that Treasury would attempt to kick-start a market for covered bonds with four of the largest banks. Hank’s a lot smarter than I am, especially if he can push this $700 billion (wink, wink) “rescue” package through the House tomorrow. If he can do that, I’ll line up behind in support of building out our Pfandbriefe Market.
All for now.
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