Subprime Mortgage Mess - Whose Fault Is it Anyway?

By: Andy_Sutton

A few weeks back I did a special edition of my radio program 'Beat the Street' during which I discussed the recent problems in the subprime mortgage markets and the credit arena in general. The broadcast lasted nearly 30 minutes and covered maybe half of what I wanted to talk about, and left unanswered was my opinion of the culprit in the subprime mortgage mess.

To really get at the answer, we have to look at, challenge and either uphold or repudiate some of our assumptions about the roles of the various players and where their motivation comes from.

Where does credit come from?

In the bygone days of more sound credit policy, Mr. and Mrs. Smith would take a drive to their local bank and apply for a mortgage. During this process they were poked, prodded and maneuvered into giving up every nugget of info about their financial lives. If all was well and they had a modest down payment, the loan would be written. The loan itself came from the savings of the depositors of the bank. In other words, the bank acted in its given role as a financial intermediary between the real lender (the depositors) and the borrower. The bank, while holding the note on its books, was not the real lender. This is an important distinction to make. Banks had to be very careful because if a loan went bad, then the bank had to make its depositors whole again. So banks were very careful to focus on the borrower's ability to pay and exercised proper due diligence. Certainly, there were cases where the bank would get burned and a borrower would default, but the property could often be sold to close the gap and keep losses to a minimum. It worked very well.

Guaranteed Loans guarantee trouble

However, in typical fashion, Big Government decided that everyone had some sort of inborn 'right' to own a home and created GSE's (Government Sponsored Enterprises) to 'guarantee' certain types of loans. This served to shift the risk to the GSE from the originator. So the bank which previously had a very good reason to be diligent now had less of a reason to do so knowing that the loan could be dumped on the GSE's. This was the beginning of the moral hazard in lending. The only saving grace was that the GSE's were throttled by their charters and regulators in terms of the types of loans they could buy, the total amount of their holdings, and similar restrictions.

In recent weeks we have seen a continuation of the entitlement mentality as the Federal Reserve and government have now decided that the people who made these poor decisions need to be absconded of their responsibility at the expense of the rest of us, our kids, and future generations. It would seem that the only group of people who are not entitled to anything are those of us who work, behave and act responsibly. Oh wait I forgot; we're entitled to pay for the profligate ways of others, government included.

Wall Street steps in

Then another layer was added: securitization. Loans were sold by originators and chopped up and packaged into pools of CDO/CMO/CLO's and sold to Wall Street firms who then performed acts of magic that would make David Copperfield blush. Fancy computer models were used to 'distribute' the risk and spread it out (sarcasm mine). At the end of all of this, the aforementioned Wall Street bigshots would run to their rating agency buddies who slapped a higher than deserved credit rating on the pools and the shuck and jive was complete.

It is pretty easy to see what the role of the originator had become. Due to loose monetary policy on the part of the Fed, the markets were sloshing with money and the demand for asset-backed securities was voracious. It became as simple as selling as many loans as possible and do it as quickly as possible. The loans never stayed with the originator for more than a few months so who really cared if the borrower could make the payments? If they didn't, the originator didn't have to make anyone whole again. The moral hazard reached fever pitch. Originators no longer worried about the borrower's ability to pay, instead opting to focus on their own ability to sell the resulting loans.

Where does buck stop?

Since the beginning of the year, cries have come out from consumer advocacy groups, watchdog organizations and political action committees decrying the exploitation of the defenseless victims in the mortgage mess. There has been talk of a bailout of consumers unlucky enough to put their signature on something they never bothered to learn about. Where is our sense of personal responsibility? I am not going to advocate or try to justify the unethical business practices of those involved from the originators to Wall Street and the rating agencies. There need to be indictments; and quickly. Some folks need to go to jail for this. Some of the big boys need to be allowed to fail if that is their destiny.

The Fed facilitated this mess with too much easy money and it is asinine to believe that they'll be able to fix it with more of the same. All that being said, at the end of the day none of this would have happened if there weren't people who for whatever reason were willing to sign on the dotted line. Maybe it was greed. Maybe they assumed that the other counterparties were looking out for them. Maybe it was naivete. Maybe it was a lack of education. Maybe it was our new national attitude: buy now worry later. Well, the buying has been done. Now it's time to worry. We do not live in a vacuum. There are immense resources for anyone inclined to exercise due diligence. I just don't buy the exploitation line. The seeds for this mess may have been sown in Washington and on Wall Street, but the blame ultimately lives on Main Street.

By Andy Sutton
http://www.my2centsonline.com

Andy Sutton holds a MBA with Honors in Economics from Moravian College and is a member of Omicron Delta Epsilon International Honor Society in Economics. He currently provides financial planning services to a growing book of clients using a conservative approach aimed at accumulating high quality, income producing assets while providing protection against a falling dollar.

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