In the aftermath of the financial crisis, market commentators have scrambled to identify a cause: deregulation, lax regulation, predatory lenders, naïve borrowers, cheap or free credit, and all the parties involved in financial securities linked to mortgages.
While all these elements contributed to the crisis, there is a simpler root cause that can provide lessons for the future: key players lost sight of, or simply ignored, the fundamental economic reality that underlies mortgages: people and homes.
Mortgage-backed securities are a good idea in theory and were, at first, a good idea in practice. It makes perfect sense to seek the risk-sharing benefits that result from combining many individual payment and risk streams. For one thousand standard mortgages made to borrowers with relatively high credit scores who make down payments of about 20 percent in a so-called normal real-estate market, the risk of all those loans going bad simultaneously is extremely small. In principle, collateralized debt or mortgage obligations (CDOs) facilitated more efficient distribution of risk-and-return cost for both suppliers of capital and borrowers. The rating agencies recognized this by giving each tranche, or portfolio, of mortgage payments a rating based on its underlying fundamental risks.
But not all products are created equal. Subprime mortgages have riskier fundamentals: a pool of mortgages in which home values were based on a frothy housing market, down payments were minuscule and credit ratings of borrowers were low should have been expected to have a reasonably high probability of default.
Assume that credit-rating agencies (CRAs) gave a low rating (BBB) to a pool of mortgages for which investors would take a loss if 7 to 10 percent of the original group of mortgages defaulted. Would we expect that any subset of this 7- to 10-percent pool should be as highly rated as the part of the pool for which investors would not take a loss until 40 to 50 percent of the original group of mortgages defaulted (the AAA tranche)? Yet this is precisely what occurred when a second CDO was created for the low-rated, high-risk tranches, and from this pool a new security was created that was branded as a low-risk (AAA) security by the CRAs. (For more detail on this, see related links at right.)
Meanwhile, homebuyers were borrowing against the future, rather than the current, value of their homes, without the financial means — or even potential wealth — to support those mortgages if home prices stopped rising. They even borrowed against their homes to pay off credit-card debt and auto loans. All the parties to these securities — lenders, mortgage brokers and banks, securities firms who created or traded in these securities and, of course, the homeowners (borrowers) — were making a bet on constantly rising home prices, while disregarding the real people and real homes on top of which these products were precariously built. Much like a Ponzi scheme, everyone lent to everyone else, creating a bubble and then compounding it. Returns could only continue while new money kept flowing into the system. When the money stopped, the whole system started unraveling.
Profits and returns were presumed to be more sustainable than they really were because so many parties to the products did not understand how the money was being made or how much risk was underlying these profits. Many homebuyers anticipated, often wrongly, that they would be able to sell their home at a higher price or, in the worst case, refinance at another low rate when it came time to reset their adjustable-rate mortgages. Analogously, lenders borrowed for very short periods to reduce their costs, even though the mortgages were for longer terms, and then assumed they could just keep rolling over their own financing.
Some loan originators often sold the mortgage to the firms creating the CDOs, quickly obscuring the trail to the original homeowner. The CRAs and those who issued the securities knew the constituent mortgages, but too often these were just numbers put into complex quantitative models to package the risks. Given the size and complexity of these packages, it is likely that the purchasers of the securities found it too complex to spend time tracking the homes and individual mortgage owners. Cash flows were being traded from spreadsheet to spreadsheet rather than from person to person.
Further, the securities were also insured by many companies that argued they did not need much capital because the probability of default was so small. But how much did — or could — insurers look at the people and homes they were guaranteeing? Similarly, there was little likelihood that a CEO from any of the large banks had information available on his balance sheet that reflected the underlying numbers or a profile or the credit scores and home value ratios that constituted the portfolios for the product his company sold. Fannie Mae and Freddie Mac gave quite a lot of aggregate information about the average scores — at least in the last six months — which to a degree revealed the scope of the problem. But this detailed information does not show up on balance sheets, so the problems were not easily tied to mortgage portfolios or the guarantees.
There is no explicit restriction on what internal reporting shows (other than a manager’s ability to deal with hordes of information), but most internal reports still focus on point estimates, such as earnings, assets and liabilities, and they use leverage ratios as if all liabilities are debt-like securities, relative to equity, with equivalent claims against all the assets. Despite that the reality is more subtle and complex, good and bad competitors are treated the same, without reflecting the actual risk distribution. The financial-reporting system aims to determine a number, e.g. earnings or equity, at the particular point in time — a number that is itself subject to many assumptions — and does not attempt to reflect expected market behavior or distribution of outcomes. But no requirement demands that internal reports have the same constraints and ignore the underlying fundamentals. People often say it is too hard or impractical to show the detailed fundamentals, but if that’s true, how can managers argue they are managing their businesses appropriately?
In September 2008, some firms were selling mortgage loans at 22 cents on the dollar, while others were still marking theirs at 70 cents on the dollar. In no instance did the latter companies provide a rationale for those numbers: Were those mortgages marked at 70 cents prime mortgages whose borrowers had high credit scores? Subprime? Both? Under what circumstances would the values be lower or higher? Instead of trying to manage the growing problem, everyone hid from it; CEOs apparently kept refusing to believe just how bad some of the outcomes were.
To provide a more comprehensive picture of the economic fundamentals and risks, regulators need to start thinking about how to bring transparency into the underlying fundamentals and risk characteristics of a business. Otherwise, we get a huge uncertainty premium that is discounted in the market, as we see today. At the School’s Annual Dinner in May, Fed Chairman Ben Bernanke presented heat maps of the United States, showing how much double leverage there was on homes. You could see huge, deep red pockets in Florida and California. There were a lot of details behind this but the message was clear. Presenting financial reporting information in such a way would go a long way toward highlighting real problems and preventing some of the more egregious situations we have seen lately.
The ultimate result of neglecting fundamentals has been tremendous risk and uncertainty in the system, a lot of unregulated money, many rumors and many parties taking advantage of the ensuing tumult.
Crucially, in its failure to foster transparency, the market — as well as the financial press, which must accept a large share of the responsibility — further encourages the creation of rumors and fans inflammatory presumptions that feed on themselves and create volatility. Some of these problems can be rectified through better oversight and transparency, and that is where we should concentrate a rethinking of regulation; rules without transparency will fail to prevent the next crisis. Ultimately, much of the fallout we continue to see comes primarily from a failure to think about fundamentals in the right way — which is to say, first.
Trevor S. Harris is professor of professional practice in the Accounting Division and codirector of the Center for Excellence in Accounting and Security Analysis (CEASA) at Columbia Business School. Before returning to the School in July 2008, Professor Harris was vice chairman and managing director at Morgan Stanley.