[email protected]: Who's to blame for the mortgage meltdown?

When billions of dollars of asset value suddenly disappear and the world financial system is thrown into turmoil, it is natural to ask who's to blame.

Business ethics 88 (photo credit: )
Business ethics 88
(photo credit: )
When tens of billions of dollars of asset value suddenly disappear and the entire world financial system is thrown into turmoil, it is natural to ask who's to blame. That's what happened in the wake of the subprime mortgage crisis in the United States. The basic facts are as follows: In olden times, in order to get a mortgage on a house you had to be able to prove that you could pay it back. That meant that you had to show adequate income, as well as provide adequate collateral in the form of a significant down payment on your house. If there is no down payment, then a slight down-draft in housing prices will wipe out your collateral. Theoretically a high-risk borrower should be able to obtain credit at a higher interest rate, but in practice no single bank could afford the risk of lending to poor credit risks. Thus "subprime mortgages" were virtually non-existent, and people with bad credit histories were compelled to live in rented homes. This situation was rectified a few years ago when subprime mortgages were "securitized." In other words, bundles of thousands of such loans were converted into bonds and sold to the public at large. This has the effect of spreading the risk over a much larger number of borrowers. If the default risk on each mortgage is say 5 percent, then the bond will presumably lose about 5% of capital which is readily compensated for by an extra 5% of interest. This can't be done by an individual lender who has only a handful of such loans and who is exposed to a meaningful risk of a devastating loss. This had the beneficial effect of enabling millions of Americans to obtain mortgages, and indeed the rate of home ownership among disadvantaged communities soared. It also had the disadvantage of creating a division between the person approving the loan (a local bank) and the person bearing the risk of the loan (the bondholder). This creates an obvious incentive for the nominal lender (the bank) to approve unsound loans whose default cost will fall on someone else. The bank may fail to disclose known risks to the bondholders. It is hardly surprising that banks did indeed approve breathtakingly unsound loans. Huge loans were made to individuals who were terrible credit risks. Default was virtually encouraged by variable-rate loans in which higher rates kicked in after a period of years. Collateral was minimal as down payments were made nominal or optional. All this is not surprising. What is amazing is that willing buyers were found even though the lenders don't seem to have endeavored to hide this ugly picture. The mortgage bonds were a kind of "Picture of Dorian Gray" where the external appearance - high yields - remained attractive, while the hidden portrait - looming large-scale defaults - grew hideous. But unlike Oscar Wilde's story, here all the characters had access to the portrait, had they only cared to look. While the mortgages themselves were granted to America's most vulnerable and unsophisticated borrowers, the bonds were sold to the world's most stalwart and canny investors. This is nothing like the Enron scandal, in which the investment houses gave bogus advice to naïve private investors. Lately financial giants such as Citibank and UBS have written off tens of billions of dollars. Last week the crisis led to write-downs at one of Israel's largest banks. No one hid from Citibank how many mortgages had initial "teaser" rates; no one hid the extent of down payments; in fact, no aspect of the credit risk seems to have been hidden. It's true that the rating agencies gave exaggerated ratings to these bonds. The investment grade ratings were evidently based on the assumption that default risk is effectively filtered out by creating securities that combine huge numbers of borrowers. But this is true only if the default risk of each individual borrower is independent. If each borrower has an independent 5% risk of default and you have thousands of borrowers, the overall default rate will be 5%. But defaults are critically tied to housing prices, which are highly correlated. So when the housing bubble burst and housing prices declined throughout the US, the default rate went through the roof. But one would hardly expect a Citibank or UBS to be relying on rating agencies to guide their investment decisions. So here is my "hall of blame:" Many of the local lenders are at fault for predatory lending practices, including the "teaser" rates which create a huge default risk when the higher rates kick in. They are responsible for many families who lost their houses in the crunch. But they can't be blamed for the financial crisis, because these lending practices were known to bondholders. The rating agencies are at fault for giving investment-grade ratings to junk securities. But they can't be blamed for the crisis because the buyers were sophisticated investors who had no need to rely on these agencies for risk assessment. The large firms who lost tens of billions in this misadventure have no one to blame but themselves. Like the painting of Dorian, the ugly hidden portrait of these junk securities finally manifested itself in the outer appearance, and balance sheets, of these imprudent firms. [email protected] The author is research director at the Business Ethics Center of Jerusalem (www.best.org), an independent institute in the Jerusalem College of Technology.