The 2007 Financial Debacle- It Could Have Been Much Worse

As bad as the mortgage-related travails of 2997 have been for the financial services sector, particularly the commercial banks, it could have been so much worse.

For instance, as I wrote here, in August, commenting on a Wall Street Journal article tracing one family's mortgage,

"What I saw in this article is an example of people who should have waited until they actually had the money for a reasonable down payment, and then should have been more sanguine about their prospects of affording the mortgage they chose. Additionally, they seem gullible, in that they simply believed a mortgage broker's promise that they could refinance the mortgage. Perhaps they should have planned on affording the one for which they applied?

The broker, of course, hardly did anyone a favor by putting the Monteses into a barely-affordable mortgage. The institution which lent the money for the house didn't seem to have done a very careful job stress testing the Montes' ability to afford the mortgage.Then the loan was likely bundled up into a security. I don't know what the 'seasoning' period is nowadays, but years ago, lenders typically had to hold their mortgage loans for a year, if I'm not mistaken, before other investors would buy them in CMOs.

This story displays a shocking tale of greed and overreaching on everyone's part, including the Monteses. They should never have expected, in their financial position, with other loans to service, to be paying as much as 42% of their income for housing, before taxes and insurance.It's no wonder that this is the last year of the housing expansion. With loans like these, to borrowers like these, it was clearly time for mortgage merry-go-round to stop. I can't honestly express any sympathy for investors who purchased instruments backed by loans like those of the Montes.'

This was a total lending, underwriting and investing system failure. But it's not a banking failure, per se. Those who bought these loans, packaged as whatever, deserve the losses they take, just as if they had made unwise equity or currency investments."

The current structure of the mortgage finance system should have been a signal to institutional investors that times have changed. As I further observed in this October post,

"The passage in Wednesday's Journal article citing the importance of the SIV sector, "at its peak....about 30 funds....$400 billion in assets," causes me to ponder how the three largest commercial banks- Citigroup, Chase, and BofA- and perhaps a few more, would have managed the mortgage assets on their own balance sheets a decade ago.

Back then, the largest banks built or bought large mortgage origination businesses, feeding into the banks' own large lending portfolios. The rise of securitization, with its liquidity and market-based risk pricing, made it economically feasible and sensible for the commercial banks to cede the portfolio lending business to a market of CMOs and, now, CDOs.

If the commercial banks had remained portfolio lenders, would this current SIV sector have reached $400B in assets? Or would the risk management functions of the banks have slowed as the mortgages began to decline in quality, hitting the sub-prime market? For example, one-time high-flying manufactured housing lender Green Tree Financial was rescued by an Indiana-based insurer, not a commercial bank.

As inept and stodgy as commercial banks can be, including their own prior mortgage lending problems which helped lead to the RTC creation to clean up the last housing finance mess, I think they perhaps exercise a bit more focused risk oversight than a widespread free market in CDOs."

My own belief is that we should be thankful that securitization has prevented the largest US commercial banks from taking more losses than they already have. Rather than being in the tens of billions of dollars, I believe we would have seen at least one, and probably two of the largest five US banks collapse.

As it was, the banks' formations of SIVs in which to ostensibly park mortgage-backed securities at arms' length from the commercial banks' own balance sheets should have given pause to the institutional investors who bought the notes backing them.

Portfolio lending, while worse than financial markets at correctly pricing risk, does, on the other hand, tend to exert an attenuating effect on a commercial bank's risk positions. A mortgage lending unit can afford to underwrite riskier loans when it knows they will be securitized and sold to investors.

This is simply common sense. That commercial banks have experienced severe losses from CDO tranches they kept tells you they would have experienced even worse losses, had they kept everything they underwrote.

As I see it, the various players in the financial services sector have all gotten what they deserved from playing a form of 'hot potato' with risky mortgage lending.

Mortgage brokers will probably become heavily regulated. Commercial banks are now exercising the kind of credit judgment that they used to when they held most of their mortgages in portfolio. Investors and traders have sustained losses by failing to recognize the new risks inherent in buying structured mortgage-backed instruments that weren't retained by the firms which underwrote the original loans.

What has become clearer over the past few months, including this Christmas season, is that the losses and effects felt in the US financial sector isn't spreading to the rest of the economy's sectors, as so many pundits have predicted since August. Recent consumer spending data, and continuing job and incomes growth would seem to testify to a healthy economy, outside of the self-inflicted damage of the financial sector.

Yes, I think things could have been much, much worse. If not for securitization, much of the risky mortgage loan volumes, though perhaps less in the aggregate, would have remained on commercial bank balance sheets, causing a few total failures.

Thanks to our sophisticated financial markets, those investors and traders who believed they knew how to assess and price risk have borne most of the losses. As such, the few hundreds of billions of dollars of ultimate losses from these bad mortgage loans will appear as simply more investment losses, rather than economy-crippling contractions in bank credit markets.