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Of Markets and Mortgages

March 25, 2008; Page A23

It's been nearly 15 years since the beginning of the recovery from the last major credit-induced bear market. Like the early 1990s, it is time to re-evaluate and introduce some modifications. But it is certainly not the time to overreact and undermine the most fundamental aspects of our free-market system. We do need transparency, to learn from successes and failures. And we need rewards for winners and penalties for losers.

Yet today we see the search for quick fixes and for villains, with securitization being identified as the chief culprit. Securitization is not the cause of the massive problems in our credit markets. The problems are due to basic mistakes that even the most unsophisticated among us can grasp. Lenders loaned too much money on too easy terms to borrowers who did not have the capacity to make their payments. No alchemy by even the brightest minds on Wall Street could turn bad loans into good assets. Sound simple? It really is.

During the past three decades, securitization has become the dominant vehicle for raising debt capital to finance assets. That's because it efficiently matches borrowers with lenders. It gives individual borrowers access to the largest pool of capital in the world -- the AAA bond buyers, who make up the large majority of the investors in securitized asset finance.

The underwriting of risk in the past few years has, of course, not been so good, and securities backed by poorly underwritten loans are losing value daily. Yet the cry for systemic fixes from various constituencies has been dangerously off the mark. One common fix advocated is to abandon or de-emphasize mark-to-market accounting in favor of allowing companies to estimate an asset's "true" long-term intrinsic value. Another is to move away from securitization and return to a portfolio lending model -- where, for example, the bank originating a mortgage keeps it (in its own portfolio of assets), rather than selling it to a third party (as in securitization). Both fixes are tempting. Both are mistaken.

The desire to abandon or deemphasize the mark-to-market model is based upon the logic that, if the public didn't know how bad things were, then the all-important confidence in the system would not be at risk and we would be safer. The price to be paid -- the complete obfuscation of the truth -- is simply way too large.

The argument in favor of portfolio lending is based upon the notion that, unlike securitization, portfolio lending incorporates the discipline of "skin in the game." Since, in the portfolio lending model, the loan's risk is not being transferred from the originator/lender, underwriters will therefore be more careful. But the anecdotal evidence just does not support this thesis. In the last major credit correction, it was portfolio lenders who violated prudent credit standards. And in this correction, many of the world's portfolio lenders are suffering the largest writedowns because of their bad credit decisions. Simply put, human nature exploits both models -- securitization and portfolio lending.

Like many, I've wondered how our home mortgage finance system will rebuild itself, and how we will be able to contain problems in the financial system so they don't infect corporate America, lower profits, and lead to massive layoffs. The answer to these questions became much clearer to me on a recent Sunday when I drove to downtown Los Angeles and joined approximately 2,000 others in the Convention Center. They had come to participate in an open auction of 120 foreclosed homes from Los Angeles, Orange and San Diego counties. What I saw there reinforced to me that the only resolution to the crisis is to let the free market repair itself.

A number of lenders had foreclosed on and taken possession of the houses, with the objective of selling them to people at prices they could afford. They hired a company, National Home Auction, to run the show. Buyers all had to bring certified checks for $5,000 in order to participate. If they were successful in the auction, they had to post another $5,000 immediately, and then go upstairs where they were qualified for a mortgage. Once they were, the buyers moved to another room where the closing process was begun with the title and escrow company. Final closing was scheduled for 21 days later. Seventy-five percent of the homes auctioned that day have closed; would-be buyers and lender-sellers are still negotiating the rest.

I learned many things from observing this auction. One, there is indeed a market today for homes, no matter how ugly or poorly located. For lenders of the past few years, this market may clear at what appears to be at a 40%-50% discount to the values upon which they based their lending decisions. A difficult pill to swallow perhaps, but that is reality.

I also learned that there is mortgage money available for borrowers willing to put up cash, and that there is still in place a very efficient lending and closing system to service these borrowers. The U.S. home-finance system is still the best in the world. The problem is price discovery.

And for price discovery to happen, the government needs to get out of the way, encourage transparency, and let the market resolve this crisis. Lenders, financiers and their regulators need to let the market determine the value of these assets. Let us not forget that the only value of an asset is what someone will pay for it, not some theoretical value derived from a complex computer model.

Auctions such as the one I observed allow true prices to be discovered and honest valuations for lender portfolios. Lenders -- helped perhaps by a governmental agency like the Resolution Trust Corporation (RTC), which was formed in response to the last credit crisis -- can choose to continue to foreclose on borrowers in default and utilize auctioneers to sell the homes. Or they can choose instead to renegotiate their loans with existing borrowers, to mirror the levels of affordability reflected by these auctions.

In this scenario everyone gets to the right place. Surviving lenders pay the price for bad credit decisions. Borrowers, old or new, live in a home at a price and monthly payment they can afford. And the U.S. economy moves past this crisis with damage largely contained to the financial institutions.

The government needs only to take a few simple actions to facilitate this process. First, re-establish the RTC to dispose of the portfolios of those financial institutions that do not survive the massive writedowns. Second, impose real mark-to-market standards, which will give investors confidence to re-enter the market and will set the stage for the ultimate recovery. Third, soften the stance that is taken (particularly with regards to Fannie Mae and Fannie Mac underwriting standards) toward those who suffer from a foreclosure during the next 24 months, in order to allow them to continue to have access to the prime mortgage market.

There are a couple of changes worth considering as the market is being re-evaluated. One obvious one pertains to licensing. Everyone engaged in the business of selling securities must pass a test called the Series 7. But no test is required for investment managers who make investment decisions on behalf of investors. This doesn't make too much sense, especially with regards to those who are charged with making investment decisions on behalf of municipalities and pension funds. Perhaps the SEC should mandate that these individuals be tested, and perhaps retested regularly, and licensed to represent the investor -- particularly the more vulnerable among us.

But as to the future of the securitization market, I wouldn't worry too much about that. This market will discipline and repair itself. Bond buyers will surely require a larger risk premium, and will engage in a greater degree of due diligence regardless of the rating of their bonds. Perhaps the issuers of these bonds will have to retain a portion of the securities, i.e. "skin in the game." The rating agencies have already made numerous modifications to their model, and are highly motivated to self-police.

Mr. Penner helped pioneer the application of securitization technology to real-estate finance as CEO of Nomura Capital.

Bastian Gross

German Mathquant
March 25, 2008; Page A23
The U.S. home-finance system is still the best in the world. ....

And for price discovery to happen, the government needs to get out of the way, encourage transparency, and let the market resolve this crisis. ....

Is this so?