At this time of year in particular, many indulge in a certain amount of nostalgia that includes watching It’s a Wonderful Life. And indeed, that account of a bygone era offers valuable lessons in the context of the recent financial turmoil. At that time, mortgages were held on the books of banks, so it was in the interest of the lender to make sure the borrower could repay the loan. Like George Bailey, the banker and the borrower’s interests were often aligned. That is not the case today, in the era of securitization. Today, instead, the mortgage originator provides a mortgage product, and immediately sells this mortgage on to an entity specializing in the packaging of loans into tradable securities. The advantage, we were told, is that risk would be more easily diversified and loans would become cheaper and more accessible. What happened instead is that usury raised its ugly head.
In a recent article in the Wall Street Journal, Rick Brooks and Ruth Simon look at recent developments in mortgage lending. The present some interesting findings. In 2005, the peak year of the subprime boom, 55 percent of subprime mortgages went to people with credit scores high enough to qualify for conventional loans on better terms. By 2006, this rose to 61 percent. For sure, not all borrowers are innocent. Some knowingly took out highly risky loans, hoping to make a quick profit by flipping a house in an environment where house prices increased forever. But there is a darker side to the story. As Brooks and Simon show, “lenders or brokers aggressively marketed the loans, offering easier and faster approvals — and playing down or hiding the onerous price paid over the long haul in higher interest rates or stricter repayment terms .” Mortgage agents were compensated for persuading borrowers to take loans with higher interest rate. They frequently persuading borrowers to spend more than they could afford, or take out exceptionally risky and completely non-transparent loans.
It was the profit motive, pure and simple. Mortgage brokers collected 1.88% of the loan amount for originating a subprime loan, and only 1.48% for conforming loans. And especially since they no longer held the loan on the books, and would not be exposed to default, it was in their interest to push subprime loans that exposed customers to high interest rates and greater financial risk. When the default came, they could wash their hands.
But the game does not stop there. The loans that were originated by the mortgage lenders were turned into asset-backed securities and combined into massive CDOs. These CDOs had three tranches, based on risk. In the event of default, the holders of the top tranche would get their money first, and so forth. Hence the bottom tranche was inherently risky, and was bought by hedge funds and others seeking high returns. But remember: these high returns come from the fact that borrowers were saddled with mortgages with higher interest rates than warranted and all kinds of non-transparent penalties. I believe that used to be called usury.
It is worth recalling what the Church has said about usury in the past. From the Second Lateran Council (1139):
“We condemn that practice accounted despicable and blameworthy by divine and human laws, denounced by Scripture in the Old and New Testaments, namely, the ferocious greed of usurers; and we sever them from every comfort of the Church, forbidding any archbishop or bishop, or an abbot of any order whatever or anyone in clerical orders, to dare to receive usurers, unless they do so with extreme caution; but let them be held infamous throughout their whole lives and, unless they repent, be deprived of a Christian burial”
Pretty harsh.
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