Arnold Kling hits the creation of the secondary market for mortgage loans as the major factor -- 50 percent — causing the current financial crisis. As Kling wrote:
In hindsight, I think that the crisis was caused by a) creation of the secondary mortgage market (50 percent) b) low down payment mortgages (30 percent) c) the "suits vs. geeks" divide (15 percent) d) other (5 percent)
The more I think about the secondary mortgage market, the less I like it. Any widespread benefits, such as lower mortgage interest rates, are microscopic. On the other hand, several times (not just recently), the market has been used to create or enhance regulatory loopholes that undermined the safety of the financial system as a whole.
I am surprised that Kling so lightly dismisses the benefits as “microscopic” of one of the most positive innovations in the mortgage market. Just think about it. Financial institutions — primarily savings and loans -- prior to the creation of the secondary market, took in short-term deposits and made long-term, fixed-rate loans (30 years). Until the early 1980s, Regulation Q set the limit on the interest rates that could be paid on deposits.
That spread between the interest paid to depositors and the interest charged on the mortgages was what formed the bulk of the financial institution's profits. In periods of high inflation where the Reg Q ceilings on deposits were significantly lower than other investments, institutions experienced massive “disintermediation,” a technical term meaning that people withdrew their money from banks and savings and loans. Besides causing liquidity crises for financial institutions, this also meant that banks didn't have the funds to lend, so people were unable to get mortgage loans very readily. And, if they did, the new mortgage rates were very high.
When the Reg Q ceilings were phased out, institutions began to offer higher and competitive rates to attract depositors, yet they still held lower-rate, long-term mortgages. The fact that the financial institutions had to hold and service the long-term portfolio of mortgages increased their risk, as the spread between their assets (loans) and their liabilities (deposits) widened. In addition, since the mortgages were not diversified, but were from only the financial institution's lending area, if there was a local or regional economic downturn, the mortgage portfolio would be at risk. The savings and loan crisis of the late 1980s resulted from this and other factors.
What were some of the results of the lack of a secondary market?
· In many cases, inability to get a mortgage loan, even for very credit-worthy borrowers.
· High mortgage rates for those borrowers who could get a loan
· Increased risk to financial institutions which had to hold long-term mortgages on their books even in periods when those mortgage interest rates were much lower than they were paying for deposits.
· Increased risk to financial institutions because of the geographic homogeneity of their mortgage portfolios
With the secondary mortgage market, lenders sell their loans — the principal and interest payments -- to an entity that pools the loans according to varied risk strategies and issues securities backed by those loans. The lender continues to service the loan and is responsible for keeping the mortgage current. The pooled mortgages can decrease risk through diversification — e.g., combining loans with different maturities, from different geographical areas, at different interest rates, etc. Through such diversification, the risk can be spread.
However, issuers of securities based on these mortgages (and on up the line of pools and tranches) must continue to evaluate the risk of the underlying assets and any changes that may heighten the upstream risks.
The secondary mortgage market as almost completely dominated by government-sponsored entities (GSEs) is unfortunate and has been an important contributory factor in the current financial meltdown. The creation of Fannie Mae and Freddie Mac has led to a political moral hazard problem of enterprises backed by the government and believed to be operating with the full faith and credit of the government behind them. The implied government backing not only may lead to the GSEs not providing due diligence in their pooling of mortgages — not properly evaluating the risk of the pooled mortgages -- but also may have caused investors to be less than diligent themselves. Also, the GSEs' government backing forced out competitors and created a virtual monopoly.
Despite the distortions that the GSEs created, secondary markets provide important benefits for both borrowers and lenders:
· Increases the availability of mortgages
· Reduces the borrowing costs
· Improves financial institutions' liquidity by moving assets off the books
· Lowers lenders' risk re both interest rates and diversification
The GSEs helped create the current problems, but secondary markets are vital in today's world, not only for mortgages, but also for other asset-based securities, such as those for credit card receivables, auto loans, etc.