The current mortgage meltdown that everyone is reading about in the news media is a classic situation where form has dictated substance. In the 1990s a new mechanism in the field of financing became popular. The mechanism is “securitization”. The idea behind securitization is that you can generate loans and fund them by selling finance contracts into a trust. The trust raises funds from the public, including institutional investor such as pension funds by offering asset backed securities (“ABS”) or mortgage backed securities (“MBS”). The securitization theory provides that the risk associated with default is widely dispersed over a large pool of loans and therefore, the failure of some loans can be safely and easily absorbed by the performing assets of the trust. In theory it works great, however, the impact of the concept on the players involved in the process was not adequately considered. [ The use of securitization is not limited to home mortgages. It is used in every finance sector from car loans to credit cards. Ever wonder how a small Maryland bank (“MBNA”) became a powerhouse in the credit card world. MBNA jumped on the securitization bandwagon early to allow it to extend credit well in excess of its capital as a small bank.]

            Traditionally, a mortgage loan made by an institution must be carefully underwritten because if that loan goes bad, it will affect that institution negatively. But what if that same institution will immediately sell the loan to a trust and therefore, if the loan fails it will not be the institution’s problem but the trust’s problem. The institution makes money by selling the contract and its success is not dependent on the long term viability of the loan. The focus is no longer long term but short term and simple - what fees can be obtained at the time of the origination.

Add a public who is generally financially illiterate. First, the consumer, since he lacks the financial spohistication to determine his eligibility, employs the rule of thumb on the basic premise that since the institution will hold the loan, the institution would not make the loan unless they thought the consumer could afford it. The basic premise does not hold true in a securitization environment.  Second, the consumer does not question high fees because they are rolled into the loans. Based on these two factors, you have a path to riches for those originating the loans. Now add in an insatiable appetite for the loans as “products” for Wall St. firms to package and sell to trusts in return for commissions and fees. Again, like the institution, the Wall St. firms’ profits do not depend on the long term performance of the finance contract. Everyone is making money at the origination stage of these loans. The key to success for institutions and Wall St. firms is originating loans and before long the market adopts an anything goes standard. Take Lehman Bros’ decision to participate with a now defunct entity known as Fist Alliance as described by Mike Hudson in article appearing in the Wall St. Journal on June 27, 2007:

Twelve years ago, Lehman Brothers Holdings Inc. sent a vice president to California to check out First Alliance Mortgage Co. Lehman was thinking about tapping into First Alliance's lucrative business of making "subprime" home loans to consumers with sketchy credit.

The vice president, Eric Hibbert, wrote a memo describing First Alliance as a financial "sweat shop" specializing in "high pressure sales for people who are in a weak state." At First Alliance, he said, employees leave their "ethics at the door."

The big Wall Street investment bank decided First Alliance wasn't breaking any laws. Lehman went on to lend….

It is difficult, if not impossible, to motivate the originators to be concerned about long term performance when they will make money now and have no liability if the loan fails.

Of course, to keep the process moving, another necessary element is creating investor interest in the Trust’s Mortgage Backed Securities. Immediately after the dot.com bust in the stock market, investors were looking for the next great investment. They thought they found it in a booming real estate market. How do you create a booming real estate market? Create more potential buyers and give them ways to finance sums greater than they can afford. Since free flowing loans are the fuel for the boom market, underwriting of the loans becomes perfunctory and there is a need for new loan products that stretch buying capacity to allow the prices of real estate to rise rapidly.

            The 2 year arm is perhaps a perfect example of the new products. It sets an artificial low rate that gets the person in the house. As an added bonus, since the buyer cannot afford the loan once it adjusts in 2 years, it builds in an automatic repeat client who will need to refinance before the end of the 2 year below market rate.[ A 2 year arm can only lead to a need to refinance. Most loans adjust at least 2 points after the two year rate ends. A 2 point increase can increase the monthly payment by 20-40%. Given the average wage increase is less than 5% there is no way that person can handle the increased payments.  Interestingly, many lenders have now been announcing that they will discontinue sales of the 2 year arm product. See e.g., the report on Wells Fargo’s decision to stop selling 2 year arms at www.iht.com/articles/ap/2007/07/24/business/NA-FIN-US-Wells-Fargo-Subprime.php]

 It appears endless until it ends. With all mass delusions, the time comes when people suddenly realize that the emperor has no clothes. [ This is nothing new. See Extraordinary Popular Delusions and the Madness of Crowds written by Charles Mackay in 1841.]

Once the bubble bursts, the tumble begins. Many of the 2 year ARMS are now coming due and homeowners have no way to pay the new payments. It is predicated that a large number of the 2 year ARMS are due to adjust later this year and into early 2008. It must also be kept in mind that the market was not limited to 2 year arms but there are also 3-4-5 year arms. With the credit market drying up and the real estate market falling, the likelihood of extensive foreclosures is not unrealistic. For Marylanders, this will be harrowing under the current Rules applied to foreclosure proceedings. There is movement by the Governor and others in his administration to make changes to the foreclosure process and various task forces and working groups have been organized by the Governor and for lending issues overall by the State Attorney General.[ I am a member of the task force committees as well as the working group assembled by the State Attorney General. ]