What Happened in The Mortgage Market

At the very least, Fannie and Freddie were accomplices and victims.. Wall Street and our beloved federal government played the key roles.

Wall street created the bomb, sub-prime loans. The government failed to fulfill one of its principle responsibilities; assuring that private enterprises and markets are conducting business in an honest manner that protects the citizens of this country.

I have extensive experience in the residential mortgage industry. In 1998 I left that industry to concentrate on commercial real estate loans. In 2005 a life-long friend of mine asked me to do some consulting work for him on a residential mortgage company that he started in 2004. One of the first actions I took was to review some loan files to check the "quality" of the loans that they were making. After reviewing a half-dozen files I went into his office and said he had a huge problem. The loans that his company was processing were of very poor quality and either he was wasting allot of time and effort on deals that were not going to fly, or his "buyers" of these loans were going to pull his right to sell them anymore loans.

He summoned the head of operations into his office to hear what I had to say. After 20-minutes of reviewing what I found out, the operations head laughed and said things have change. What changed was Wall Streets creation of the sub-prime loan. This new product would never have gotten off the ground if Wall Street could not find a buyer for their new innovation. This would never have happened if Wall Street was not able to get the credit rating agencies, Fitch, Standard & Poor's and Moody's, to give a very high credit rating. Guess what; they did.

As a result, the mortgage broker on the street was able to offer poorly underwritten loans to the consumer so he could buy a house that he could not afford. (If a mortgage broker refused to participate in sub-prime originations he probably went out of business because his competitors were happy to do so.)

The mortgage company sold these loans to Wall Street so he was able to earn a fee and dump the risk onto the wall street firm. The wall street firm in turn bought off the credit rating agency to get a AA rating on his new product. This in turn allowed Wall Street to sell the bonds to clients who relied heavily on the credit rating agencies. These rating agencies were making big money for giving high ratings to these sub-prime loans. No one cared or was concerned that the rating agencies were being paid by the wall street firms.

So far I have not mentioned the fault of the federal government. The governments fault is simple to state, and ended up to be very costly. They failed to protect the citizens of this country by not performing their responsibility of being the rule maker and umpire for wall street and the rating agencies. It was like two NFL football teams playing a game without umpires.

The trouble that Fannie and Freddie is in has more to do with the amount of debt they are allowed to carry on their books relative to equity. The debt to equity ratio allowed was 30:1.When the sub-prime market crashed, the entire residential mortgage market crashed; including the more traditionally underwritten loans held by the two lending agencies. Once again the government implemented poor regulations relating to Fannie and Freddie.

Adam Smith when he discussed “rational self interest” and competitive markets in his book Wealth of Nations, envisioned many consumers buying goods and services from many producers with everyone looking out for their self-interest. By keeping markets “free”, producers pursue their rational self-interest and this best meets the needs of the consumers and the citizens of our country, who are also looking out for their self-interest. Under this system, what is in the producers self interest is to provide the best product possible to the consumer, while striving to be a low cost producer for their niche.

We lost track of a key ingredient that Adam Smith identified as necessary in order for “rational self interest” to work. There must be many producers. In too many industries, the number of producers has shrunk and the ones remaining have gotten “too big to fail”. This is not the case in the mortgage industry, however it certainly is on Wall Street.