Modest Proposals for Financial Reform: Abolish Mortgage-Backed Securities
Guest post by Dr. Manhattan, a lawyer in New York City who represents, among others, clients in the investment management industry.
Thanks to Megan for the kind introduction. Anyone interested in additional biographical information can access that, along with my prior Atlantic posts, here. (My old blog is defunct, but Internet archeologists can access it here.)
If given the opportunity to pick one financial regulatory reform, I'd pick one which allowed us to pay regulators lots and lots of money, competitive with the worst excesses of the private sector if need be -- up to and including signing them up for the Porsche-of-the-Month Club. (Another way of saying the foregoing is that, notwithstanding all the attention paid to income inequality, we need much, much more if it in the public sector.) However, other people have made the same argument and it doesn't seem to have helped much. So maybe it's time to start thinking of some other exceedingly modest proposals which haven't gotten as much play: Some impractical ideas which nonetheless might point us towards actions which -- with apologies to Lena Dunham -- may not be "the solution to the problem, but a solution to a problem."
Here's my first such idea:
Abolish Mortgage-Backed Securities (and Offspring)
CDOs and credit default swaps don't kill financial systems, mortgages kill financial systems.
There has been altogether too much opproprium directed at CDOs, credit default swaps and other structuring techniques that spread financial contagion, and not enough directed at the underlying collateral. The record seems to be, however, that Dick Pratt was correct when he called the mortgage "the neutron bomb of financial products."
Don't believe it? Ask the foremost experts in credit derivatives, such as:
1) The inventors of credit default swaps and CDOs at JPMorgan: As Gillian Tett describes in Fool's Gold, while they truly believed in the CDO structure, they did not believe that the credit risk could be accurately measured on underlying mortgages. Other banks felt...differently, and this classic Felix Salmon post is the best synopsis of what happened.
2) The long-time heads of AIG Financial Products: no that was not a typo. For most of the history of AIG FP, they absolutely refused to enter into any transactions, CDOs included, backed by real estate. It is worth excerpting the following from Roddy Boyd's definitive Fatal Risk, referring to Joe Cassano's predecessor as head of AIG FP:
[A]nything mortgage related left [Tom Savage] cold. He took a literal view of the issue: any security backed by a house or building was verboten. His colleagues saw it as a quirk of his personality...It was anything but that. As a groundbreaking modeler in the mortgage departments at First Boston and Drexel, he had come to see that all of mortgage trading was just a way to make money until the next unanticipated blow up. Time after time, the same thing happened: rates changed and entire trading desks, whole fixed income divisions were blown out of the water because of one or two mortgage trading positions. Savage had a litany of reasons why: hedges -- if they were even available -- always underperformed because the securities were too leveraged to interest rates. In turn, brokers and hedge funds, trying to squeeze every last dime of profit out of a trade, used too much leverage in positioning the bonds, so when the market reversed, they were always forced to sell in a panic.
Savage saw his former specialty, modeling mortgages, as little more than folly. The models the bank touted assumed that rates would move in sequential, orderly patterns and that market prices would follow. The opposite happened, of course, with panic, greed and liquidity flowing into or out of the market at a second's notice. Somehow those inputs never seemed to make it into the models.
Similarly, the founder of AIG FP, Howard Sosin, refused to allow FP to invest in anything mortgage-related, believing that they would always be subject to risks they could neither analyze nor quantify.
And the subsequent history of AIG FP demonstrates that the problem was the underlying collateral, not the structure: AIG FP's portfolio of credit default swaps on corporate and bank debt, despite always being much larger than its portfolio of swaps on "asset-backed" CDOs, did not cause the losses which destroyed the company in 2008: those were all concentrated in the smaller, latter portfolio (together, that is, with the losses in AIG's securities lending program, which is a similar story for another day).
Perhaps the best argument in favor of getting rid of MBS entirely is that -- as is happening with the regulatory dispute over money market funds -- the market is already doing the job. As this Sober Look post describes in great detail, other securitizations are getting done and performing just fine: auto loans, credit-card receivables, etc. -- but home equity-based securitizations are barely visible.
(Yes, killing MBS will likely kill the 30-year fixed-rate mortgage with no prepayment penalty, which, in the words of Raj Date, "does not flourish in the state of nature." And right now very few people can get one of those anyway, which is not a coincidence.)
In short, if we are to focus our regulatory ire on instruments which are per se dangerous, CDOs and credit default swaps are not the place to look: start with the humble mortgage-backed security and its offspring.