Virtuality and the Financial Crisis: Part 1

The financial crisis that began in 2007 and reached fever pitch in the past few months is generally believed to be a consequence of the securitization of subprime mortgages and more generally of the over extension of credit. Participants in this tragic drama include actors in the real estate and financial services industries as well as home buyers.

The process of purchasing a house consists of a long chain of transactions starting with a ‘meeting of the minds’ of buyer and seller, usually mediated by a real estate agent representing the seller. Once an agreement has been reached, the buyer must arrange financing. Here is where the trouble starts.

Let’s say the buyer uses the services of a mortgage broker to find a bank or other lender willing to issue a mortgage on the house. Having no responsibility for the future behavior of the buyer, and receiving a fee for its services, the mortgage broker’s interest is to place as many mortgages as possible. Real estate agents and property appraisers have a similar interest. Both work on fees or commissions based on sales, so their aim is to generate as many sales as possible.

In the ‘old’ days – before the housing bubble of the past decade – the bank or mortgage company issuing a mortgage on a given property would generally hold the paper until the debt was discharged. This relationship between home buyer and lender changed as mortgages were bundled into pools of financial assets to be securitized and sold. With securitization the lenders’ interests became aligned with those of realtors, appraisers and mortgage brokers.

Commercial banks and other mortgage originators realized they could increase their profits through securitization. By using pools of mortgages as assets for new classes of securities, and selling these securities to investors, additional funds could be made available for yet more lending. Investment banks entered at the end of the chain to package, underwrite and sell the mortgage-based securities to investors.

None of the actors in this chain was overly concerned about the borrower’s ability to repay a loan. Borrowers’ equity increases when house prices rise. Under these conditions even subprime borrowers could cope with adjustable rate mortgage resets by using the additional equity to refinance their loans. Alas, all good things must come to an end, and house prices cannot rise forever. When prices ceased to rise, and adjustable rate mortgages reset higher, many subprime borrowers could neither make their payments nor refinance their loans.

Mortgage holders started a wave of foreclosures that eventually depressed house prices by increasing the inventory of houses on the market. The wave of defaults and foreclosures led to price declines for mortgage backed securities, and suddenly major financial institutions had to take write downs on billions of dollars worth of securities on their balance sheets. This led to the collapse of major financial institutions and necessitated intervention by the Federal government.

A vast amount of ink has already been spilled on this issue, so why retell the story here? Missing from the picture painted by the media is the underlying cause of the debacle. No doubt greedy and unscrupulous lenders, real estate agents, property appraisers, mortgage brokers, commercial and investment bankers and rating agencies, together with irresponsible borrowers are the villains of the piece. But greed and irresponsibility have always been with us and these human traits are not likely to disappear any time soon. It is necessary to identify the greedy, unscrupulous and irresponsible parties, but such identification is not sufficient to prevent a recurrence of similar behavior in the future.

To be continued in Part 2 …