There has been a lot of discussion lately about homeowners walking away from their homes and mortgages, breaking their contracts and disavowing their obligations. Such talk often is punctuated by finger wagging, scowls and recriminations: the only ethical thing for homeowners to do is to live up to their obligations and keep current with their mortgage payments, regardless of whether the most rational economic thing to do in such a situation is to walk away. But this criticism is apparently reserved only for homeowners and not the businesses and banks that did their best to get us into the current financial mess. Both Daniel Gross of Slate/Newsweek and Roger Lowenstein, writing for the New York Times Magazine, have pointed out the hypocrisy of these criticisms. Indeed, many financial institutions and large economic actors have done--without hesitation or compunction--just what borrowers are being told they cannot do: walk away from their contractual obligations. Examples include investment banks defaulting on commercial properties they lease and the real estate investment group that purchased Stuyvesant Town and Peter Cooper Village in New York City planning to default on its own mortgage on the properties. This is called a "strategic default" in the business parlance, but rarely considered evidence of a deeper moral failing. But these institutions aren't the only ones with business models that went bust and that decided to walk away from their contractual obligations. In fact, when we look at the root causes of the financial crisis, we see that strategic default--not by borrowers, but by lenders--was a central feature of the crisis, and the Financial Crisis Inquiry Commission should make sure to probe this phenomenon in its work.
When financial wizards developed the concept of mortgage securitization roughly 40 years ago, they believed they had found a way to spread the risk of default of a single mortgage over a wide number of mortgages. Through securitization, one could create a risk-sharing pool that provided a cushion against a small number of defaulting mortgages in a portfolio causing widespread harm to that portfolio. What it also did was provide a ready supply of capital to an industry that normally had its funds tied up in long- term investments. A mortgage lender that could package and sell off its mortgages would be able to realize a quick return on its investment when it sold its mortgages to investors. This freed up capital to make more loans. It also generated fees for the lenders whenever they packaged such loans for resale through securitization. Finally, securitization helped to lure investors into the U.S. housing market--typically viewed as a pretty solid investment--without having to get involved in the messy business of mortgage lending.
What securitization also did was pass the risk of default on to investors and away from the lenders: i.e., the ones responsible for assessing the credit worthiness of borrowers. For lenders, this was a coup. Because they could package and sell their loans to the investors clamoring for investment opportunities in the mortgage market, lenders could make loans regardless of the creditworthiness of the borrowers, and then hand those loans--and the risk of default--off to the investors. Two things were supposed to have protected the investors. First, credit ratings agencies were supposed to assess the viability of the underlying mortgages. Second, lenders were often obligated--by the terms of the securitization agreements--to buy back underperforming loans from the investors.
We all know that the credit rating agencies rubber stamped many of these deals, taking one or more of the following views: a particular lender generally made good loans; a sample of the loans looked good to the agency; the lender had represented that the loans were good; and/or that since the lender had agreed to buy back non-performing loans, there was little risk. Well, all of those assumptions were flawed. And the most disastrous of all, perhaps, was the faith in the buyback provisions, which returns us to the concept of strategic default.
Subprime lenders, literally hundreds of them, have gone belly up since 2007. And one of the first signs of trouble in the subprime market was when lenders failed to buy back the underperforming loans in accordance with their contracts. And why didn't they? It was in their business plan: all of their money was tied up in making more loans and paying the salaries of their employees and executives so they did not have the capital to honor their contractual obligations. Such contractual obligations were supposed to have served as a firewall to protect investment banks and investors from the risk that underperforming, securitized loans would infect the pools of loans held in loan portfolios. Investors counted on the buyback provisions of those contracts, as did ratings agencies when they rated those investments. If lenders had held funds in reserve in the event their mortgages went sour, the ripple effects that were caused by investment bank write-downs and the collapse of the credit default swap market--which insured against the risk that lenders would not be able to make good on their buyback obligations--might never have occurred. Without those trillion dollar disasters, the contagion of the subprime mortgage market might never have spread to the broader economy, at least not with the force or impact that it did.
Given this recent history, the following are questions the financial crisis commission could ask of failed lenders that generated many of the subprime loans that have performed so poorly:
- Did your business model contemplate any level of default on the mortgages you were selling? If it did, why didn't you keep money in reserve to provide for such default? If your business model did not contemplate some level of default, why didn't it? Isn't it true that at the height of the subprime mortgage market, you were making no documentation loans and not verifying borrower income or assets, steering prime borrowers into subprime loans when they qualified for standard mortgage terms, and targeting vulnerable populations in your marketing? If all this was true, wasn't there a great deal of risk that these loans were troubled from the start and were risky investments?