Reforming our credit markets

The U.S. financial system, as we all know, is in serious trouble; and its troubles may be pushing us into a recession.

How did we get into this pickle? Though our media have given some partial answers, they have largely ignored one critical problem: new, harmful, incentives in our credit markets.

To explain, I’ll begin with a story. Suppose I want to buy a house, but I have a very weak credit record – I don’t pay my apartment rent and other bills on time. You own one of the banks in town, and I come to you asking for a mortgage loan.

Let’s say that this happened in 1990. At that time, banks commonly held on to mortgages until they were paid off, a practice called “originate and hold.” So banks had an incentive not to make risky loans to applicants with weak credit records – “subprime” applicants – because they were likely to default on the loans. Your bank would likely turn down my application.

Now let’s fast-forward to, say, 2002. By this time, important financial innovations had been introduced: the “originate and hold” practice largely had been replaced by “originate and distribute.” Most mortgages were not held by the originating banks, but were sold to other financial institutions – a second tier of institutions. Millions of mortgages – including almost all subprime mortgages – were sold by banks to bigger banks and to other financial companies.

“Originate and distribute” changed banks’ incentives. By 2002, banks could profitably issue a mortgage loan to poor credit risks like me: they could sell the mortgage at a profit to another bank; get rid of the risk; and get cash from the other bank. By 2002, banks had an incentive to make loans to borrowers with lousy credit records.

In fact, banks had an incentive to do this again and again. The originating bank could take the cash received from the second-tier bank and loan it to a new subprime borrower – for an additional profit. Banks in fact did this, according to a recent study by two University of Chicago economists. And all these new loans drove up the demand for houses, adding to the housing price inflation of the early 2000s.

The last thing we needed in the early 2000s was additional housing inflation.

Wait, there is more. The second-tier banks introduced another innovation: they bundled many mortgages together into “pools,” which they then used as backing for brand new securities. These were called “mortgage-backed securities.” The second-tier institutions sold these new MBS to a third tier – including other big commercial banks and investment banks.

These third-tier companies were in a risky situation. They were bearing the risk that the original loans would not be repaid – and for subprime mortgages this was a big risk. But they had little information about the original borrowers, who were now three tiers away. The link had been severed between the borrowers and those who would take the hit if the borrowers defaulted. True, the financial innovations brought important benefits: better ways to manage some types of risks and greater ability to extend credit to low-income borrowers. But these benefits did not offset the dangerous separation of responsibility and information.

The third-tier institutions apparently did not worry much about their new risks. They believed that because housing prices were rising rapidly, houses must be worth much more than the unpaid balances remaining on their mortgages. So here was another set of harmful incentives: third-tier financial institutions, keen to make a profit, eagerly bought, sold and held MBS without realizing that they were very risky.

The spectacular rise in housing prices from 1999 to 2006 was fueled partly by the very easy money policies of the Federal Reserve, but also by the burgeoning demand for new housing loans created by the new detrimental incentives.

You know what happened next. The sky-high housing prices could not be sustained, and starting in 2006 they fell as spectacularly as they had risen. Prices are now 11 percent below the 2006 peak. And these slumping housing prices of course drove down the housing values that served as backing for the new MBS.

Suddenly, housing values were too low to back up many of the MBS, so the MBS prices also fell. Big, smart financial institutions – Merrill Lynch and Citigroup, along with many others – had to write down the value of billions of dollars’ worth of these securities; several institutions reported huge financial losses for the fourth quarter of 2007. Total write-downs of securities related to subprime mortgages have amounted – so far – to $160 billion, according to The Economist magazine. These credit market problems are pushing us toward recession.

Clearly we must reform our credit markets. But those responsible for reform – Congress, the Federal Reserve and the Securities and Exchange Commission – face a tricky dilemma. They should preserve the important benefits of the recent financial innovations, yet eliminate the harmful incentives that have come with them.

Meanwhile, we don’t know whether we are headed for a full-blown recession. Stay tuned. My best guess is that we’ll get by with a couple years of painful economic stagnation.

Edwin Dean, an economist and seasonal resident of Vinalhaven, writes monthly about economic issues.