Those arguing for less regulation should remember subprime meltdown
Mortgage-backed securitisation was a good idea, tragically corrupted
The Big Short hit Hong Kong cinemas last week, just in time to provide some comic relief in the unfolding tragedy of recent global markets performance.
The film, which chronicles the blind greed and systemic rot that allowed the subprime loan crisis to occur in the United States, is getting attention for its use of a “fourth wall” cinematic technique to explain how complex financial products work. In one such scene, the storyline cuts away to actress Margot Robbie sitting in a bubble bath. “Whenever you hear subprime, think sh*t,” she says between sips of champagne.
In fact, subprime bonds do not blow up world economies; people do. Even the famously explosive adjusted-rate mortgages (ARMs) could have been a force for good. But products this complex and risky need tight and comprehensive regulation. We didn’t get that. What we got instead is spelled out literally in a scene in the film – when a US Securities and Exchange Commission employee goes to bed with an investment banker.
The Big Short, based on Michael Lewis’ fantastic book of the same name, covers the period when the subprime market was already thoroughly corrupted, so much so that those shorting the relevant derivatives kept sinking deeper in the hole, even after the underlying mortgages were already defaulting at alarming rates. This is the axis on which the drama revolves: the short-sellers are right, but no one believes them, and for a long time they bleed.
It didn’t have to be this way, as one of the story’s anti-heroes points out near the end of the film. The original idea of mortgage-backed securitisation was a good one. It just became tragically corrupted.
And there’s the rub. Even those subprime products that seem the most insane had potential to solve everyday financing problems. This includes the ARMs, famous for transforming from low-interest into punitively usurious default loans. Yet as the Yale finance professor Gary Gorton pointed out in a 2008 paper, “The Panic of 2007”, ARMs had been helping poorer customers buy homes since the mid-1990s with a structure that was undoubtedly risky but also, if properly managed, kind of brilliant.
Here’s how ARMs were supposed to work: the banks would provide a housing loan to a higher-risk customer (i.e. poorer customer), even with zero money down, but only on condition that the borrower agreed to refinance after two or three years. The hope was that the value of the house increased in that time, boosting the borrowers’ equity and thus allowing for a new loan at reasonable rates. Otherwise, the loan terms would have to be reset at higher rates to cover the risks of an uncollateralised loan.
In short, options on the property market are embedded in these loans. As Gorton put it in his paper: “Lenders are long real estate, and are only safe if they believe that house prices will go up.”
Based on historical house price trajectories in the US, banks going long on housing was not as wacky as it seems. But should less-sophisticated loan customers have been taking such punts?
Why not? Remember that many such borrowers did not have much skin in the game, in the sense that they had not coughed up cash for a down payment. They paid their monthly mortgage, but got a roof over their head in that period, and presumably would have otherwise been paying rent. If the gamble doesn’t work out, they walk.
If properly and thoroughly informed of the risks, why can’t a waitress from Wyoming give it a go? Her odds of otherwise owning a house might be next to nil.
A game like this is only feasible however, in a closely watched market. In the absence of vigilant oversight, banks gave loans to anyone and everyone, pushing up the underlying property market. They then offloaded these loans to the global bond market, in collusion with credit-rating agencies who stamped them with top ratings in exchange for fees.
In the wake of the disaster that came, some bankers are warning that the subsequent regulatory backlash is killing financial innovation. But lax regulation is worse. Subprime once had potential – now it will be forever associated with a four-letter word delivered by a naked actress in a bubble bath.
Cathy Holcombe is a Hong Kong-based financial writer