Federal Meddling Will Only Delay and Increase Inevitable Mortgage Industry Losses
Mortgage-backed securities have collapsed in value, and aren’t worth as much as once thought. That’s becoming clear as increasing numbers of homeowners default on their mortgages as interest rates rise.
The ratings agencies like Moody’s and Standard and Poor’s were foolish to give mortgage-backed securities high ratings based partly on the false assumption that the risks of individual mortgages cancel each other out, when they in fact much of mortgages’ risk is shared, systemic, and heavily-correlated.
But rather than write down the rapidly declining value of the mortgage-backed securities they possess, Wall Street firms are now pretending that their value remains the same, with some of them using shenanigans that would make Enron proud.
They’re doing their best to hide their losses by holding onto their mortgage-backed securities and not selling them for the lower price they would receive from selling them today (assuming they could be sold — it’s not even clear if there’s much of a market for the most risky mortgage-backed securities). If they sell some securities at a price less than they paid for them, then they would have to record a loss. And any securities remaining in their possession would have to be written down to reflect the falling market value of those securities. They want to hide the fact that they are close to broke.
Now the government is getting into the act, encouraging financial institutions to hold onto their mortgage-backed securities rather than sell them for their true value by creating a pool to prop up the prices of mortgage-backed securities. The Treasury Department also is hinting at a bailout of the mortgage industry. There’s talk of federal agencies buying up junk mortgages, reducing the mortgage payments of irresponsible borrowers who borrowed more than they could afford, and giving them special exemptions from taxes for the amount of their mortgage that is written-off when they can’t pay their mortgage.
This is pointless meddling in the market. It’s just delaying the inevitable market correction that is going to happen sooner or later when Wall Street has to admit the fall in value of mortgage-backed securities. That’s going to happen when people with adjustable rate mortgages can’t make their increased mortgage payments after introductory teaser rates expire. (I was offered an adjustable rate mortgage when I bought a home. I knew rates would go up, so I got a fixed rate mortgage instead — at a 5% interest rate, which is a lower interest rate than I now receive on my internet savings accounts).
It’s better to have a soft economic landing now than a steep recession later. Federal meddling just delays the inevitable.
When the stock market collapsed in 1929, Herbert Hoover meddled in the market, pressuring employers not to lay off employees or cut wages. All that did was prolong the Great Depression. The Great Depression started out milder than the short but severe post-World-War I recession. But while the Post-World War I recession ended after a couple years, thanks to the government not meddling in the economy, and gave way to an economic boom, the Great Depression, thanks to government meddling, ravaged the economy with a vengeance for many years. Thanks to Hoover and Roosevelt, who insisted on meddling in the economy rather than letting the market correct itself, the Great Depression did not end until World War II came along and stimulated the economy.
In addition to holding onto overvalued mortgage-backed securities to avoid recognizing losses, some Wall Street firms are selling them in ways that artificially inflate their price, such as by selling them to purchasers who agree to purchase them for a high price only on the condition that the purchaser will be able to sell them back later on for a price that is at least as high as the purchase price. The seller then claims that that inflated price is the true value of the mortgage-backed securities that remain on its balance sheet.
Other examples exist of how ratings agencies like Moody’s and Standard and Poor’s view the world through rose-colored glasses. They gave puzzlingly high-ratings to the Municipal Bond Insurance Association (known as MBI or MBIA), which branched out from its original focus on insuring municipal bonds to engage in risky financial insurance of junky mortgage bonds and subprime CDO tranches (which the ratings agencies gave unjustifiably high ratings).
The ability to resell junky mortgage loans to Wall Street at high prices made many risky loans possible, since the companies making the mortgages knew they would resell those mortgages before homebuyers defaulted, selling those mortgages to Wall Street in the form of mortgage-backed securities. The high prices of risky mortgage-backed securities were made possible by ratings agencies, such as Moody’s, which gave the mortgage-backed securities high ratings that they didn’t deserve, by failing to recognize that they were risky, and thus made those mortgage-backed securities seem like attractive investments even when they weren’t.
Banks that couldn’t resell their loans, by contrast, were much more careful in lending, and the mortgages they made were less likely to default. For example, loans to illegal aliens have a surprisingly low default rate, even though many illegals have incomes in the range typical of risky subprime loans. The reason isn’t that illegals are especially trustworthy, since they are often transient and have modest incomes (and are here illegally to begin with). The reason is that it’s hard to sell a mortgage loan to an illegal alien to Wall Street (through securitization), and thus shift the risk of the loan defaulting to someone else. So before lending to illegals, banks often vigorously vetted them and demanded everything but X-rays to document their loan, weeding out a great many unreliable borrowers. As a result, loans to illegals were often made only to the most reliable borrowers, and only after their assets and income were confirmed to be exactly what the borrower claimed, thus preventing fraud by the borrower and keeping borrowers from taking on more debt than they could handle.