EYE ON AMERICA Putting lipstick on pigs
By Peter Morici
The pope and US Federal Reserve chairman Ben Bernanke both rely on a higher
force to motivate millions. The pope relies on faith in the Resurrection; poor
Ben depends on the credibility of the bond market. The latter, ultimately,
rests on the integrity of investment banks and bond-rating agencies, and those
have proved faulty.
In the days of usury laws and regulated interest rates for savings accounts,
mortgages in the United States were fairly straightforward. You went to a
savings and loan association, it checked your credit, purchased an independent
appraisal, and
gave you the money. The bank either held the note or sold it to the Federal
National Mortgage Association (popularly known as Fannie Mae) or perhaps an
insurance company. The bank serviced the loan - it collected the payments,
administered the escrow account and foreclosed if things turned sour. The bank
loan officer had a strong incentive to be certain that the loan application was
accurate. If not, it would come back to him.
Today, US loans go through complicated chains. Many more do not qualify to be
sold to Fannie Mae, and many never pass through the granite confines of a
community bank. Often an agent hanging around the real-estate office takes an
application and forwards it to a mortgage company, which may or may not be his
employer. The mortgage company processes the loan, and sells it to an
investment bank, or similar entity, that bundles mortgages into bonds. The
investment bank sells those securities to hedge funds, pension funds, mutual
funds and other investors. As mortgages vary significantly in quality,
mortgage-backed bonds are rated by Standard and Poor's and other rating
agencies.
At each step along the way, information can be lost and temptations build up to
understate the risk of default. The agent gets a big fee for writing the loan
only if it is approved, so he puts the prospective homeowner in the best
possible light and finds an appraiser who aggressively values homes.
Mortgage companies get their cut from origination fees and are able to push off
the risk of default on to the ultimate purchasers of the bonds. Hence they are
inclined to be lenient with agents.
Investment banks earn money on the spread between the interest rate charged
borrowers and the interest rate on the bonds. The less risky bundles of
mortgages that go into bonds appear, the lower the interest rates on the bonds
and the more profits the mortgage bankers receive.
As we peel this onion, we are finding many purposeful compromises that look
much like the insidious corruption that characterizes commerce in some
countries. In essence, Wall Street manufactures bad bonds.
But it gets worse. Large builders established mortgage-writing subsidiaries.
When they built more houses than the market could absorb, those subsidiaries
exaggerated the incomes and qualifications of buyers on loan applications, and
pressed for exaggerated appraisals of their properties to move houses. Those
entities operated on lines of credit and resold the loans to investment banks,
which bundled them into bonds. Both the large builders and investment bankers
had incentive to put lipstick on pigs.
Also, investment banks sought and received collaboration from bond-rating
agencies in bundling mortgages of differing quality into bonds. In the process,
bond raters such as Standard and Poor's were compromised.
Subprime mortgages are hardly the whole credit market, but the meltdown of
their bonds cast a spotlight on the decaying integrity of investment banks and
bond-rating agencies. These institutions underwrite and rate all manner of
credit, and if they could be corrupted in the subprime-mortgage market, then
all commercial paper and bonds become suspect.
Over the past several weeks, creditors have increasingly sensed they can't
trust banks or bond-rating agencies, and they have fled to short-term Treasury
securities. This was much worse than the collapse of mortgage companies that
originated housing loans, because it caused all segments of the credit market
to collapse.
Good businesses with sound cash flows couldn't borrow operating capital, and
good companies faced escalating interest rates for new bond offerings.
Together, those threaten to throw the US economy into recession.
For Bernanke, the corruption of the investment banks and bond-rating agencies
is terrible news. It is akin to the pope learning Easter morning was a hoax.
Peter Morici is a professor at the University of Maryland School of
Business and former chief economist at the US International Trade Commission.
Head
Office: Unit B, 16/F, Li Dong Building, No. 9 Li Yuen Street East,
Central, Hong Kong Thailand Bureau:
11/13 Petchkasem Road, Hua Hin, Prachuab Kirikhan, Thailand 77110
