Friday, July 31, 2009

The Financial Innovation That Wasn’t.

Posted on Rortybomb by Mike:

I need to set up the urgency over the past two years to get the mortgage-backed security refinancing question just right. So I’m going to start with two long blockquotes (forgive me) from Lewis Ranieri, who created the mortgage-backed security in the 1980s. In 2004 Newsweek gave him the title of one of the greatest innovators of the past 75 years. (Awards that year for top historical innovators included James Watson, Frank Lloyd Wright, and Jonas Salk. Mortgages bonds right up there with the cure for Polio – bet someone is regretting that call.)

It is April 2007. Everyone is starting to think there’s going to be a problem with subprime loans. The smartest people realize that traditionally mortgages could be written down easily by intermediaries on the ground – someone at your local bank who you could shake hands with – but that the mortgages packed into sieves of bonds held internationally couldn’t easily be modified. Here’s Lewis Ranieri speaking at the Milkin Institute Conference on financial innovation:

the real dilemma for me and I think the real issue . . . will be, we’ve never had to do substantial restructurings in housing in mortgage securities…

One of the accountants – you know, it will not be unusual, in some of these pools to have to restructure a third or more of the pool and we only have four [big accounting] firms and we had three of them in the room and one of them raised his hand and said, well you can’t do that. If you restructure that many loans, you’re going to taint the Q election and FAS 140 and what he was basically saying in English for the rest of [us] poor fools, was that there is a presumption when you – when a bank sells loans, into a securitization that it sold the loans . . . And what he was saying is wait a minute, if you guys can restructure all these loans without going back to bondholder, you obviously have control and you’ve just tainted 140 and Q election…

Well, wait a minute; we have to restructure the loans. The worst thing you can think of is freezing the pool and not being able to do what we need to do and I don’t know how long it would take us. I mean, you know you’ve just basically told us we now have a problem that we don’t quite exactly know how we’re going to fix – and another example of how crazy we can get is, when we restructured mortgage loans, in the past and we’ve done this many times, we actually really know what to do.

We restructured the loans and it was always better to negotiate around the borrower, assuming there was a borrower and for purposes of this conversation, we’re talking about homeowners, not speculative buyers, flipper and all the other guys playing games; we’re talking about people who bought a home and live in it and we, historically, structured those loans. We never send out a 1099.

We basically assume that was a renegotiation, end of story because it was in our best interest, as the lender, to do that but in a mortgage security, you don’t have that freedom because you’ve got get the outside accountants to sign off and the outside lawyers and the outside accountants and lawyers said, time out and I volunteered and said, well, wait a minute. I’ve been doing it this way all along and one of my friends [who is] now running one of the best of the combat servicing operations says, well, I’m doing that now, too and we were told, well you’re doing it wrong. You’ve got to send out a 1099.

That’s an incredibly dopey idea. We’re restructuring a loan around a borrower; he can’t afford the loan and now we’re going to take the NPV of the change and send him a tax bill so the IRS can chase him . . .?

Jump forward 1 year. May 2008. Milkin Institute Conference on financial innovation. Here is Lewis Ranieri with the same worry, however he believes we will be able to “innovate” our way out of it. Video from Mark Thoma’s page, my transcript (”…” indicates skipping on my part):

[24m19s] Narrator: Lou, how do we use financial innovation to go forward?…How bad do you think the markets could become if we get mired in a fear of using financial innovation?

Lewis Ranieri: Mortgages are real estate and all real estate is essentially local. The cardinal principle in the mortgage crisis is a very old one. You are almost always better off restructuring a loan in a crisis with a borrower than going to a foreclosure. In the past that was never at issue because the loan was always in the hands of someone acting as a fudiciary. The bank, or someone like a bank owned them, and they always exercised their best judgement and their interest. The problem now with the size of securitization and so many loans are not in the hands of a portfolio lender but in a security where structurally nobody is acting as the fiduciary. And part of our dilemma here is “who is going to make the decision on how to restructure around a credible borrower and is anybody paying that person to make that decision?” And what we need here is financial innovation in the first instance because you can’t do this loan by loan, you are going to have to scale this up to a bigger level and we are going to … have to cut the gordian knot of the securitization of these loans because otherwise if we keep letting these things go into foreclosure it’s a feedback loop where it will ultimately crush the consumer economy

Narrator: How optimistic are you Lou? You used crisis, you used Great Depression a few minutes ago. That’s a little strong…

Lou: It’s not strong. I believe we know what to do because it is not remarkably different than what we’ve done in the past in the context of the housing bubble. if we are allowed to do it. We know how to restructure loans. The process has not changed and technology has made it easier….it will work because of the financial technology and internet technology…I don’t think this is an issue of the government, in fact we’d be better left to do what it is we actually know how to do, we know how to deal with housing crisis…but the difference between a foreclosure and a restructuring is frequently over 30%and because of the feedbackloop that foreclosures create you keep taking a 30% loss on a smaller number. It doesn’t get to be fun. So no this isn’t a government issue, it is something the market needs to do…

And now it is end of July 2009.

loan-mod-chart

(source)

Where’s that innovation that will restructure the loans without needing foreclosures? The one thing we needed them to innovate, the one thing!, and they couldn’t pull it off. If it was a sneaky way to get 40-to-1 leverage, sure. Sell retail consumers put options hidden as bonds, all over it. Take care of the one information asymmetry and principle-agent problem in their instrument, nope. Nothing.

Instead we get this:

Many mortgage companies are reluctant to give strapped homeowners a break because the companies collect lucrative fees on delinquent loans.

Even when borrowers stop paying, mortgage companies that service the loans collect fees out of the proceeds when homes are ultimately sold in foreclosure. So the longer borrowers remain delinquent, the greater the opportunities for these mortgage companies to extract revenue — fees for insurance, appraisals, title searches and legal services.

Recall Lewis’ one problem for financial innovation to solve a year ago: “who is going to make the decision on how to restructure around a credible borrower and is anybody paying that person to make that decision?” Now notice that the solution we have in place, this innovation, is completely backwards. Someone is paying a person to not restructure loans. Lewis knew back in 2007 that this cycle would be incredibly destructive, and in 2008 look the world in the eye and said government intervention was not needed since the innovation was on the way.

Not only is it not here as they wanted, the exact opposite of it is here. Instead of incentives that line up with the investors, or even the households, the quants ended up with someone who makes the most money when both parties suffer. I knew a Russian equities finance quantish guy who said they he’d never need to know game theory since he’d never do corporate finance. Too bad those mathematicians didn’t know about the Principle-Agent problem and rent seeking sneaking into his equations; maybe he would have had a head’s up.

The one financial innovation that could have helped, finding a way to mass refinance failing mortgages, the one financial innovation people were calling for 2 years ago, hasn’t arrived, and I’m tired of waiting for a financial Godot. They have failed, the problem is growing, and the government needs to step in. Dean Baker’s Right-To-Rent should be a serious policy consideration, and I will give it coverage next week. I encourage you to do the same.

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