“The financial crisis that began in August 2007 had relatively little to do with traditional bank lending…Its prime cause was the rise and fall of ’securitized lending,’ which allowed banks to originate loans but then repackage and sell them out.”

 

                                                            - Niall Ferguson, The Ascent Of Money (2008)

 

I am often asked to point to the root of the current financial and economic crisis.  My answer increasingly is the extreme dependence that the American and global financial system grew to have on something known as securitization.

Securitization, in short, is the process of taking future claims on an income stream (like mortgage payments, credit card payments, and car payments), bundling them into a large group (say 4,000 mortgages), turning them into an asset or security (a security is just a written claim of ownership), and then selling them to a third party.

Securitization allows an investor to ‘own’ future principal and interest payments.

Again, securitization is the process of  pooling the revenue or cash flow of productive properties and assets and transforming them into new securities, or ownership claims that can be marketed and sold to others. 

This practice has spread throughout the American and global economy and can even be found in the music industry, where securities have been created out of the royalties of popular musicians.  The best known example are ‘Bowie Bonds,’ created by Wall Street financier David Pullman which allowed investors to ‘own’ the current and future royalties of artist David Bowie by investing in bonds backed by his music-related income.

In 1997, in exchange for sellling the current and future income stream of his first 25 albums, David Bowie received over $50 million up front by Prudential Insurance Company.

In the case of mortgage backed-securities, an investor ‘owns’ the sum of principal and interest rate payments from a bundle of mortgages.  At that point, the role of the bank is only to collect the interest and principal payments, and ‘pass them through’ (pay them out) to the third party who now ‘owns’ them.

Here’s an example of how it works - from a Wall Street Journal article from July of 1983, “Home Economics: Big Secondary Market In Mortgaes Smooths Flow of Housing Funds” by Christopher Conte and Timothy D. Schellhardt:

“Matthew and Marianne Metcalf, without even knowing it, are part of a fast-emerging revolution in housing finance.

Last fall, when the couple bought a new town house in a Maryland suburb, they followed custom and went to a savings and loan association for a loan. But the money really came from a circuitous route from an unusual source - the Maryland state employees’ pension fund.

Baltimore’s Loyola Federal Savings & Loan Association initially provided the $80,000 that the couple needed. But the S&L, instead of keeping the loan, promptly sold it and some 350 others to the Federal National Mortgage Association. And Fannie Mae, as the privately owned mortgage corporation is known, immediately melded the mortgages into securities that were sold to the giant pension system.

Across the country, organizations such as Fannie Mae are rapidly building such bridges between home buyers and investors. The link, known as the secondary mortgage market, is supplanting the old system in which local lenders provided most of the nation’s housing money. In the secondary market, the likely players will be pension funds, insurance companies, banks and investment companies, plus, perhaps, individuals and foreign buyers. And the mortgage originators increasingly will probably include - besides S&Ls - mortgage bankers, home builders, real-estate firms and others.”

The creation or utilization of a security in and of itself is not problematic or necessarily evil, but when taken to an extreme, and when greed and inordinate self-interest in the financial system is not checked, this efficient form of trade and commerce develops a serpent-like grip on the real economy, effectively interfering with its circulatory system - the flow of money and finance.

The basic truth that the Obama administration has not made clear to the American public is that due to securitization - the majority of loans made in the American economy are not owned by the bank, credit card company or even car financing company that originated them.

The real, untold reason why commercial banks have not made loans again, as expected, even after receiving bailout money from the American taxpayer - through programs like the $700 billion TARP (Troubled Asset Relief Program) - is because they are generally no longer able to bundle these loans and sell them to investors on Wall Street - pension funds, insurance companies and investment banks, for instance.

In short, prior to this current crisis, many banks were making millions and billions of loans to consumers, and businesses, and homebuyers, not primarily to make money from that initial transaction, but rather, in order to make a second transaction - bundling these loans and selling them to investors.  When this secondary market - which grew in the trillions - for securities collapsed, so did loan-making to the public.

The story of mortgage securitization can be told in three parts.

First, the modern form of securitization began in 1970 when the Government National Mortgage Association (GNMA), “Ginnie Mae,” created the model for a pass-through mortgage-backed security.  Ginnie Mae allowed private financial institutions to gather a group of GNMA-guaranteed mortgages into a bundle and then sell this bundle - as a security - to a third party, such as a pension fund. When individuals made their mortgage payments, the financial institution would then pass all payments through to the owner of the security.

Second, came the investment bank, Salomon Brothers who created the first private issue of mortgage backed securities in 1977 when it persuaded Bank of America to sell the mortgages that it orignated to homebuyers. It was Salomon Brothers who formed Wall St.’s first mortgage security department in 1978 and who, in 1983, created a new kind of mortgage-backed security - a collateralized mortgage obligation (CMO) - which not only bundled thousands of mortgages together, and further categorized them, but also subdivided the interest payments on them into different ‘tranches’ or slices, according to the length of maturity and the risk associated with it.  The development of the CMO is very significant because it helped to attract enormous pools of capital to the mortgage securities market. For example, by the Summer of 1983, pension funds held nearly $700 billion in assets, with virtually none of it in mortgages. Three years later, they owned $30 billion worth of CMOs. There is also an important connection to note between Salomon, the current financial crisis and the last major one - the Savings and Loan (S&L) problem of the 1980s. It was desperate and insolvent Savings and Loan associations which sold their mortgages at bargain basement prices to Salomon Brothers, enabling the New York investment bank to bundle them and later create CMOs. Another important element to the Salomon legacy is that, in 1985, it issued $1 billion in mortgage-backed securities simultaneously in three different markets: the U.S., Europe, and Japan, effectively globalizing the securitization of mortgages and spreading the risk associated with this market beyond America. Salamon’s pioneering work of internationalizing mortgage-backed securities provides an important historical context and sets the stage for the kind of losses that European and Australian investors, for example, experienced, in 2007 and 2008.

Third, came the little-known role of the Resolution Trust Corporation (RTC), created by the U.S. government in 1989 to take over the troubled thrifts (as S&Ls were known) and hold and sell their assets.  The RTC’s role in the current crisis was publicly acknowledged by its first chairman, Bill Seidman, who in a October 9, 2008 speech at Grand Valley State University in Michigan said: “The sub prime mortgage market grew in a way that is almost impossible to believe.  There were almost two million sub prime mortgages written in a year in a half.  That means somebody had to finance a couple million homes, almost, of sub prime mortgages.  So, why did anybody put their money in this? Sub prime means that they are not prime.  Well, the genesis of that goes back to something called securitization and something called tranched credit rated securitization.  Now that was invented by one of the people who were operating in the RTC.  And namely it was invented by me and our group.  So you can start with saying that the vehicle that was used to market the sub prime mortgages was this kind of securitization”.

Mortgage securitization expanded rapidly.  By 1992 two-thirds of all residential mortgages were securitized to the tune of $1 trillion.  Today it is estimated that 80% of all mortgages are securitized. There are an estimated $8 trillion of securitized mortgages outstanding.

As most of us know by now, the subprime and housing market of the past decade was filled with excesses and marked by greed.  The longer housing prices rose, the weaker lending standards became, with individuals qualifying for sub prime loans with no job and no income, and others able to borrow 100 percent of an inflated home’s price, with no money down.

This all came to an end in 2006 when housing prices stopped rising throughout the United States, and the first signs of economic downturn appeared, with individuals unable to make mortgage payments.  This was followed by mortage lenders going bankrupt by March of 2007.

Understanding the relationship between securitization and mortgage loans is essential to understanding why credit markets and bank lending are currently described as ‘frozen.’

The real reason why banks and mortgage services companies are not really able to halt foreclosures, adjust mortgages payments, and assist delinquent homeowners as expected, is because the bulk of mortgages serviced by these institutions have been securitized to third-party investors.  Therefore the banks can’t modify what they don’t own.

No program instituted by the administration by President Barack Obama can get around this harsh reality, and therefore will have a limited impact on the housing crisis.

And because securitization is not confined to the housing market, and three-fourths of all lending is now made outside of the banking system through securitization markets, the entire economy has become dependent upon this sophisticated form of finance.

Automobile loans, commercial real estate loans, business loans, computer and equipment leases, credit card receivables, have all been securitized in the trillions of dollars.  Any credible effort to get credit and loans circulating to the American economy would have to involve an unfreezing of the securitization markets (The creation of asset-backed and mortgage-backed securities is currently down 91%, with just $4.6 billion issued this year) which really control finance in the American and global economy today. 

This fact, which the Obama administration has failed to explain to the American public, exposes the reality that it is shadowy and virtually unregulated institutions like hedge funds that may have more influence over finance in America than either the government or the commercial banking industry.

How?

While the American public has been left in the dark, the Treasury department has just turned to the privately owned Federal Reserve to do what it has not been able to - make credit and loans flow again in the economy.

A lesser-known program designed to do what the Treasury Department’s TARP program has not been able to, was just modified over a week ago by the Federal Reserve.  It is called TALF (Term Asset-backed Securities Loan Facility) and was first established last November.  The Fed’s TALF program - now expanded to $1 trillion - will provide financing to investors who buy securities backed by consumer loans, small business loans, car loans, student loans, credit card debt, and commercial real estate loans. 

The most interested investors likely to get their hands on these securities are hedge funds - in the dozens.  While hedge funds have not in the past been interested in asset backed securities, because those institutions which traditionally have made such investments (insurance companies and pension funds) are no longer doing so, in an act of desperation (or perhaps even by secret, pre-arranged agreement) the government is turning to completely unregulated entities.

With the privately-owned Fed running TALF; and with the Treasury Department providing $100 billion of taxpayer money to protect the Fed from any losses associated with TALF; and with TALF representing a subsidy to the unregulated hedge fund industry it is hard not to have concerns that the government, and therefore American taxpayer won’t be taken advantage of by the most wealthy investors - the few institutions that actually understand securitization and are in a position to profit from it.

However, any concerns over TALF alone, miss the more important truth - American consumers, students, businesses, automobile companies, commercial banks, and mortgage lenders are all ultimately dependent upon securitization to ensure the flow of liquidity, credit and loans to (or through) them.

While President Obama has briefly mentioned the problem of derivatives - of which securitization is a form - he has not directly explained the problem to the American people, in a sobering manner that will identify the root of the problem, the individuals and institutions most responsible, and the vice-like grip this financial process has on the American economy.

In a little-reported speech - made in December 17, 2007 in Fredericksburg, Virginia - President George W. Bush exposed the root of the financial crisis - extreme securitization - when he said, “And the issue-the housing issue has changed. I can remember the first home I bought in Midland, Texas. I remember going down to the savings and loan and sitting down with the savings and loan officer and negotiating with the savings and loan officer. Well, this day and age you’re going to use mortgages that have been bundled, so the savings and loan doesn’t own the mortgage anymore, or the bank doesn’t loan [sic] the mortgage anymore, the local lending institute doesn’t loan [sic] the mortgage anymore: it’s owned by some international group, perhaps, or it’s been bundled into an asset. And so there’s hardly anybody to negotiate with.”

Although he did nothing about it, President Bush seemed to understand that because the institutions that originate loans - banks - increasingly lack ownership of those loans, a relationship of mutual accountability does not exist between the borrower and the institution that purchases the securitized loan.  A possible solution to this problem would be to make loan originators responsible for the loans they repackage and sell to others, by mandating they maintain a certain ownership stake in them.

Another truth leading to a solution would be for the highest economic officials of the United States government to acknowledge that the American economy, over the last 30 years, became too dependent upon financial services, and must place greater emphasis on manufacturing, technology, service, and agricultural industries.

If the greatest orator ever to become President - Barack Obama - were to pick up where his predecessor left off, and go deeper - with the American people and international community - into the truth of securitization, and the impact of America’s extreme dependence upon it, the realistic and radical solutions necessary to save and revive the global economy may become clear.

Nothing creates stimulus like the right form of truth.

 
Cedric Muhammad is President and Chief Economist of CM Cap (http://www.cmcap.com/).  He is also Publisher of Blackelectorate.com (http://www.blackelectorate.com/).  His blog ‘The Eclectic Economist’ can be found regularly at (http://www.cedricmuhammad.com/).

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