Who’s Responsible for the Subprime Mortgage Mess?
ATLANTA, Dec. 18 /PRNewswire/ — Editor’s Note: The following article was written by Thomas E. Quinn, chief executive officer and chief investment officer of Atlanta-based CornerCap Investment Counsel. It appeared in the firm’s quarterly newsletter which was published earlier this month.
Periodically, dramatic events happen in the market. Usually the event is real, perception causes the event to become dramatic, and we measure the magnitude of the drama in the marketplace. In July, a dramatic event began in the market.
The real event is the subprime mortgage mess into which our nation has gotten. And the mess was created by real people. Using the characters from the movie, It's a Wonderful Life, as our starting point, we will try to describe all of the modern-day characters who worked to get us into this mess.
The sad saga starts with us-we the people. The nice folks in Bedford Falls, USA, wanted more house than they could afford. They carelessly ratcheted up their lifestyle beyond their means. They assumed debt (mortgage) that was more complex and risky than they understood, and they assumed that the asset (house) would appreciate much faster than the cost of the debt.
Are we talking about greed here? Maybe, but we would rather reserve that term for Wall Street and not Main Street. We are talking about basic human nature. People can be enticed to buy something that they should not touch, be it a house down the street, swamp land in Florida, or a gold mine out West.
George Goes on Severance
Unfortunately, George Bailey is no longer at the Building & Loan (B&L) to protect the nice folks in Bedford Falls. The B&L has been acquired, and George has been fired. George has been replaced by a staff of mortgage brokers who are paid incentive compensation based on the mortgage transactions closed.
In fact, home buyers do not even have to go to the bank to get a mortgage. Approximately half of the subprime mortgages were originated with mortgage companies not affiliated with the banks, and therefore not subject to the bank regulators.
With George gone, Mr. Potter now has a staff of mortgage brokers transacting home loans for the townsfolk. Clearly, since Mr. Potter is a warped-minded, greedy, old man, he will ensure that the borrowers have sufficient credit and liquidity to pay back any loans that the bank might extend to them. Maybe not.
Unlike the old B&L days, the new bank in Bedford Falls no longer holds the mortgage and collects the payments. After the mortgage broker collects his transaction fee, the mortgages are securitized and sold to some large financial institution on Wall Street that is responsible for collecting the loan repayments. The new mortgage brokers' incentive is for short-term selling with no concern for long-term servicing.
The Village Goes Global
As you can see, there is a distancing taking place. The home buyer needing a mortgage is moving farther and farther away from the ultimate investor. This distancing and insertion of multiple intermediaries makes the process of balancing risk and return throughout the chain much more difficult. It gets worse.
The creative investment bankers decided to repackage the mortgage-backed securities noted above into more sophisticated instruments, such as the much talked about CDOs (Collateralized Debt Obligations). In order to sell these overly complex securities to the yield-hungry investors, the investment bankers hired the bond rating agencies to evaluate and rate the “packaged” instruments. With a wink and a nod, the bankers suggested that the agencies be optimistic in their ratings, and they were.
Go figure! This would be like CornerCap’s paying an independent consultant to rate its firm for one of the consultant’s clients.
The people in Bedford Falls knew and cared for each other. The incentives for doing the right thing emphasized character and reputation over making the most money. For better or worse, the village is going global.
This change is being forced by technology, mobility, leverage, and other opportunistic developments. We cannot go back. We should not want to go back. Even with all the mess that has been created, many millions of families are in homes now that they otherwise could not have afforded, and our standard of living keeps improving.
“Welcome” Back Potter
Since we cannot go back, how should we move forward? Mr. Potter’s greedy minions have replaced George Bailey. While we are not fans of overregulation, there need to be some federal regulations and controls. Like brokers in other industries, mortgage brokers need standards for the type of products that would be acceptable and unacceptable in a given situation.
There also needs to be some consequence realized by the loan originators when a default that they created takes place. Also, the ultimate investors have an “investors beware” problem with the enterprising investment bankers and rating agencies. If the rating agencies are going to be relied upon by the investors, then the agencies need to be paid and penalized by the ultimate investors.
No Bells for This “Bubble”
While the subprime mortgage problem is real, we believe that the significance to the economy is being over dramatized. Near term, everyone in the above chain, from homeowner, to broker, to banker, to regulator, to rater, to investor, will all suffer. When the boundaries of prudent risks are exceeded, there must be a painful consequence for real learning to take place.
We do not believe that we can label this as a bubble or even a quasi- bubble. At CornerCap, we have historically faired well in the bubbles, avoiding any direct hits. Fortunately, we were not heavy investors in the subprime mortgage market, only holding a few mortgage-market equities. After a notable subprime roller-coaster ride during the last half of the year, both the market and CornerCap look forward to moving on from what may be more of a media event than a market event.
Clarence, the wingless angel, taught George Bailey many things, and we can also learn from Clarence. He showed George how many lives he had touched by all of the wonderful things that he had done in his life and what the world would have been like without him.
We can see how many innocent homeowners’ lives were painfully touched by the uncontrolled greed shown by the numerous players in the subprime mortgage money-making machine. When George finally saw the light, the bell rang, and Clarence got his wings. However, with the subprime market blip, the only bell we hear ringing is the same old one at the end of each trading session on the floor of the exchange.
CornerCap is an independent investment counseling and management firm focused on providing quality investment decisions and the highest level of client service. The firm has been serving clients since 1989, providing investment management services to private clients, institutions, foundations, and endowments. CornerCap serves clients around the globe from its offices in Atlanta and Charlotte, N.C. For more information call 404-870-0700.
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