Warranty Fix for Mortgage Securitization Problems

This is not nearly as wonky as it sounds — see if you can follow the thought process to the end.

I continue to be surprised at the general criticism and misunderstanding of the securitization process. Some have blamed the repackaging of these debt instruments as an underlying cause of the housing boom and collapse. By extension, goes the thinking, we therefore should blame Fannie Mae (and Freddie Mac) for the collapse.

There are several problems with this explanation:

1) Fannie Mae has been securitizing mortgages for nearly three quarters of a century; If after 70 years of well functioning securitizations, how did this process suddenly cause a collapse? The short answer is it didn’t, something else was the cause;

2) Many parts of the globe where there is no Fannie Mae — from the UK to Spain to South Korea to Australia — had their own boom and bust. Where there is little or no  securitization, but the same boom/bust cycle took place, there must obviously be another explanation for the root cause; As I made clear in Bailout Nation, it was ultra-low rates and an abdication of lending standards that were the causes — not securitization;

3) Securitization has, like all systems, a GIGO problem — garbage in, garbage out.

There have been several attempts to address this last issue. One of the fixes proposed is to require originators who sell mortgages to Wall Street securitizers to retain a portion of the mortgages:

“Lenders would be required to retain at least 5 percent of the risk of losses on each package of loan pieces, known as an asset-backed security. The employees and contractors who originate loans would be paid gradually, and they could get less if borrowers started to default.”

I don’t have a problem with that approach, but I would point out an even more egregious GIGO flaw in the securitization process: The absurd default warranties that the mortgages underwriters used. when selling these debt instruments to WallStreet.  This is one of the ways we concentrated, rather than disbursed lending risks.

Let’s go to a book excerpt comparing the old securitization model with the 2002-07 version:

“This was very different from the way traditional banks operated. To your local banker, a mortgage is a reliable and secured for m of lending. With few notable exceptions, lending standards by banks had always been rigorous. When a traditional depository bank originated a mortgage, it assumed it would hold on to the loan for the full 15- or 30-year term; depository banks felt no compulsion to resell them. Guarding against default over the life of that loan was the key to not only being profitable, but staying in business.

That wasn’t how the newfangled lend-to-securitize originators worked. In one of many examples of misplaced compensation schemes we have seen, they were paid on the volume, not the quality, of their loans. Besides, they didn’t need to find a buyer who was a good risk for 30 years—they needed only to find someone who wouldn’t default before the securitization process was complete. Thus, they had very different standards from the traditional lenders. The sellers of these mortgages made warranties to the Wall Street buyers of this paper that the borrowers would not default for 90 days—enough time for the loans to be sold off and repackaged as residential mortgage-backed securities (RMBSs).

This was a radical change in lending standards.”

– Bailout Nation, The Machinery of Subprime,

Sure, we can make the originators retain 5% of what they have underwritten, but I have a simpler idea is to simply require a warranty that is mor ein line with the term of the loan.

A default warranty of 3 or 6 months on 30 year mortgages is utterly absurd; Instead, we should mandate a 5 year warranty on 15 year mortgages, and a 7-10 year warranty on 30 years. This way, we align the interest of the underwriter with the securitizer and the ultimate buyer of that structured product.

Garbage in, garbage out problem fixed!

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Previously:
Paul Krugman is Wrong About Securitization (March 28th, 2009)
http://www.ritholtz.com/blog/2009/03/krugman-is-wrong-about-securitization/

Can There Be Market Solutions With No Real Markets? (March 30th, 2009)
http://www.ritholtz.com/blog/2009/03/can-there-be-market-solutions-with-no-real-markets/

Sources:
Regulatory Revamp Targets Securities at Heart of Crisis
Sellers of Mortgage Loans to Share In Losses Under White House Plan
Binyamin Appelbaum
Washington Post  June 16, 2009
http://www.washingtonpost.com/wp-dyn/content/article/2009/06/15/AR2009061502523.html

Understanding the Securitization of Subprime Mortgage Credit
Adam B. Ashcraft, Til Schuermann, Staff Report no. 318
Federal Reserve Bank of New York, March 2008
http://www.newyorkfed.org/research/staff_reports/sr318.pdf

Securitisation and financial stability
Hyun Song Shin
18 March 2009
http://www.voxeu.org/index.php?q=node/3287