For a couple of years now I’ve been whining about chronicling my sporadic and unsuccessful attempts at understanding exactly what caused our ongoing Great Recession. I’ve sworn off economics books because I just can’t get past the problems arising from the fantasy of infinite growth, and besides, they weren’t much help in answering the one question I kept coming back to: How can the simple lumping together and packaging and reselling of home mortgages bring the entire world’s financial system to it’s knees?
I’ve just finished reading a fascinating book by Michael W. Hudson that answers that question. The Monster: How a Gang of Predatory Lenders and Wall Street Bankers Fleeced America — and Spawned a Global Crisis tells the whole sad and sordid tale of the subprime mortgage debacle. It reads like a mystery novel, except, of course, the whole world already knows how it ends.
When I think of a mortgage, I think of my own conventional home loan; a fixed number of payments over a fixed amount of time at a fixed rate of interest. Borrowers with a decent credit score and a steady income get this type of mortgage and a lower — prime — interest rate because they present less risk of default to the lender. The subprime mortgage is an altogether different and much less desirable loan. As the name implies, the interest rate is subordinate to (higher than) prime and often not fixed, but in addition, subprime mortgages usually contain extra fees and closing costs for the borrower. The whole mess stems from those high fees, but ultimately it was simple greed at the center of the implosion.
Contrary to what Glenn and Rush and the rest of the right-wing noise machine would have you believe, millions of inner-city black people didn’t somehow band together to use their combined magic negro powers to force lenders to grant them loans they could not afford, thus bankrupting Amurka. The problems did sort of begin in the ‘hood, though. In The Monster, Hudson details how some of the survivors of our last big financial disaster — the Savings and Loan crisis of the 1980s — arose from the rubble and began looking around for a new way to make (as in manufacture) money, and began marketing high interest loans in low income, largely minority neighborhoods.
The subprime mortgage machine billed itself as extending credit to borrowers who would otherwise not have access to the credit market thereby “helping” them achieve the American dream of home ownership, or renovate an existing home, or just get out from under credit card debt. The reality was boiler rooms full of young, aggressive salesmen using high-pressure sales tactics to dupe the elderly, the ignorant and the trusting with bait and switch interest rates, exorbitant hidden fees, balloon payments and early repayment penalties. And since there is probably no more unscrupulous creature on the face of the earth than a salesman working on commission, fraud in the form of phony documents, forged signatures and inflated appraisals was the norm from the start, and things only got worse with success.
And they were successful. Here’s Hudson, writing about the early days at Long Beach Savings and Loan, which later became the top player in the subprime game as Ameriquest:
The second-mortgage business took off. It performed so well that the S&L ran out of cash to bankroll its home loans. The nest egg created by customers’ savings deposits simply wasn’t big enough. There was only one thing to do: go to Wall Street.
Successful, indeed. Individual lenders were generating these loans in such volume that they created a very profitable income stream from the fees alone, so the loans were bundled together — securitized — and sold to investors, which allowed the lenders to further increase their volume of lending and collect still more fees. Profit from borrowers’ monthly payments on long-term, high interest loans was no longer the purpose of making the loans in the first place. When Wall Street money relieved lenders of the burden of holding the loans they generated, it simultaneously removed any motivation to act responsibly in generating those loans. The fraud grew like a cancer and a two decade long financial train wreck was under way.
But, you ask, what about due diligence from Wall Street? Why would investors put their money into the shady loan business? The simple answer is greed. More Hudson:
The attraction for investors was twofold. First, pooling thousands of loans into a mortgage-backed securities deal provided a cushion against the impact of borrower defaults. If some borrowers didn’t pay, the income stream from other loans in the pool would cover the losses from the loans that had gone bad.
Even with a lot of bad loans in the mix, the return on investment for a shitload (technical jargon) of 15 to 18 percent (or even higher) loans was still substantially better than investors could get from Treasury securities or other safer, more mundane investments. Hudson continues:
Second, securitization decreased information costs for investors. By pooling mortgages an having ratings agencies affix a grade to the securities, investors could get a prediction of expected returns without having to investigate whether each borrower or each lender was on the up-and-up.
This is what is known as “dumb money.” Investors are just as lazy and incurious as us proles. They don’t really want to understand what they are investing in, they just want to make more money, so they line up to buy securities based on a rating agency’s “prediction of expected returns.” But that prediction is essentially purchased by the seller of the securities:
None of this alchemy would make any difference if Moody’s and other credit rating agencies weren’t willing to give their seal of approval to the deal. Moody’s, S&P, and Fitch played a crucial role in putting together securitizations. The veneer of propriety they provided helped assure pension funds, insurers, and other major investors that the securitizers were indeed turning high-risk assets subprime mortgages into the safest investments money can buy. The fees that the ratings agencies collected buoyed their profits; just as subprime mortgages were more profitable for the lenders than A-credit mortgages, the agencies made three times as much money rating complex securitizations than they made rating traditional corporate bonds. The pressure to play ball and give good ratings to mortgage-backed securities was enormous.
At the height of the subprime feeding frenzy, these fraudulent ratings kept increasing demand for mortgage-backed securities from investors all over the world. This, of course, created demand for ever more subprime mortgages, which in turn led to ever more relaxed lending standards and ever increasing fraud, to the point where outrageous amounts of money were being lent via “stated income” loans on fraudulently appraised or even non-existent homes. Since the whole enterprise had always hinged on keeping the overall percentage of “questionable” loans down by constantly increasing the total volume of loans, it was only a matter of time before the bubble burst.
It seems I’ve circled back to my problems with the economics of infinite growth. The bubble metaphor is particularly apt for the subprime mortgage crisis; there was an appearance of industry on the surface, but underneath there was no genuine economic activity. The only real “profits” made were by the now defunct lenders at the bottom of the food chain, and those profits were mostly just a pillaging of the largest, and often only, asset many Americans possess: the equity in their homes.
The subprime mortgage crisis is not over yet. Banks are dragging their feet in taking the inevitable write-downs on millions of over-appraised, foreclosed properties. Eventually, the rest of us, all the homeowners of America, will be taking that write-down too. Until then, we can’t know exactly where the bottom is, or exactly how much of our “wealth” is a facade built on over-indebtedness.