This essay is about how the securitization of mortgage loans by the big banks created the US housing bubble. The bubble eventually burst in 2008, and precipitated a worldwide recession.
Of all the material investments, which one is considered the safest? Most people will point to real estate. Besides providing shelter, a house tends to preserve its value if not appreciate. After all, the world’s population is rising. The land available cannot increase. Countries with large populations are industrializing. When people get richer, they switch to bigger houses and likely buy a second home. Even wars and natural disasters cannot stop housing demand. A housing boom will follow as people start to rebuild afterwards.
In America, the big housing bubble that burst in 2008 seems unlikely in retrospect because land is relatively plentiful, and personal incomes have not risen much to fuel it. Then how could it have occurred? The irresponsible financial creativity of the big banks is to blame, which eventually came back to haunt them. As a consequence, the big banks almost went bust in 2008, their reputation tarnished, and their assets and stock prices plummeted. Five years later as of now, they are still struggling to recover from the big bubble burst of their creation.
America’s housing bubble was caused by a fake demand like pie in the sky. How can you create a fake demand? The banks created it by offering mortgage loans that were almost impossible to resist. At the peak of the housing craze, the only requirement to secure a mortgage was your signature. The sweet deal included: no upfront fees, no employment and income verification, no credit checks, a very small down payment, and a very low interest rate for the first three to five years after purchase. Given these requirements, who did not want to buy a house? Moreover, as prices kept rising fast, who worried about a few years hence? You could sell your house and make a good profit within a couple of years. Housing became a seller’s market where multiple buyers lined up to bid for a house, which would usually be sold within a week.
You may wonder how the banks could afford to lend so much mortgage money to create a bubble. In fact, they couldn’t due to limited cash holdings. This is where their devious creativity came in. It’s known as securitization of loans. It simply involved bundling various mortgage loans together in packages called financial securities, persuading rating agencies to give them a good grade, and selling the securities to other banks and investors to replenish the cash. Since any investment related to real estate seemed safer, there was a big demand coming from all circles including stock and mutual funds, retirement funds, college endowment funds, even foreign banks and governments. So the US banks that issued the real estate securities could easily find willing buyers at home and abroad. The securitization is a cash-generating design that has a multiplier effect in creating fake housing demand.
Without securitization, a US bank having issued a mortgage loan can only replenish the cash by selling it to another bank, investor, or semi-government agencies like Fanny Mae or Freddie Mac. It is done on an individual loan basis. That is, the potential buyer reviews the mortgage payment history, the location of the house, its conditions, and the liquidity in it. If satisfied, the potential buyer purchases the mortgage and becomes the new lender. The bank that initially issued the mortgage continues to service the loan, but replenishes the cash and lends it to another homebuyer again. The homeowner does not need to know that the lender has changed hands because everything else stays the same.
What is wrong with securitization? The following specifies:
*Bad mortgages are bundled with good ones.
*Potential security buyers cannot review individual mortgages for comparison. They buy according to the good grades given by the rating agencies.
*A mortgage can also be chopped up into parts and bundled into different securities, making it impossible to be reviewed individually as a whole.
*The original mortgage with its history is destroyed as a result, making it impossible to tell whether it’s a good or bad one.
*Real estate securities are sold all over the world in speculative markets, thus transforming the relatively safe real estate into objects of speculation same as stocks, foreign currencies and commodities.
Given all the negative things in real estate securities, why were investors so stupid to buy them? This is where the rating agencies come in, the top three being Standard & Poor’s, Moody’s and Fitch Group, which are supposed to be independent and objective assessors of securities. Due to the huge amounts of money and profits involved, greed persuaded them to give good ratings to real estate securities, thus encouraging innocent investors to buy more. In so doing, the rating agencies were colluding with the big banks to push the real estate securities, thereby inflating the bubble even more. It all sounds like a big scam to me, don’t you agree?
As you know, anything fake cannot stand for long. By 2007, things began to unravel:
*The easy mortgage loans had been issued to too many unqualified homebuyers.
*The initial low interest rates of the easy mortgages began to expire after three years, to be replaced by much higher rates. This caused many homeowners to default.
*The banks had to re-possess those houses with default mortgage. They ended up poisoning their own assets with millions of mortgages that turned sour.
*People finally began to see that things were not that rosy. They started to sell, causing real estate prices to plummet.
*As of now, we still have millions of houses under water, meaning the mortgage owed at time of purchase is greater than the present value of the house.
In recent months, housing prices seem to be recovering. Buyers are coming back although getting a loan is much harder now. The banks have cleaned up part of the sour mortgages in their assets. Will a housing bubble repeat itself? You can bet on it. Why? The devious design of securitization is still here, although not as active as before. The government has not clamped down on securitization and the rating agencies. It has barely begun the tough job of Wall Street reform against the rich and powerful, who have many friends in the US Congress ready to oppose reform.
Securitization does not end with real estate. You can securitize almost anything: mortgages, car loans, and college student loans for instance. These are some of the tenets of the American Dream: a house, a car, and a college education. The big banks have irresponsibly securitized the mortgage by turning part of the American Dream into a speculative object. The next potential target is probably college student loans that have recently surpassed one trillion dollars, bigger than all consumer loans combined. Creativity is good, but irresponsible creativity in finance can easily ruin the entire economy as seen through the burst of the housing bubble in 2008.
Therefore, all I can say to the innocent public is: Greed has no limit. Only conscience and responsibility can put a lid on it. If you don’t want to push the government for banking reform, at least be on guard with respect to your money. It’s a jungle out there despite all the laws.