Prelude to a Crisis | Feb 13th at 9:47am
The next panel is a meaty one, on the structure of the mortgage products that helped to fuel a housing bubble and then turned the crash into a financial crisis. Moderator Joseph Tracey introduces the first speaker, Lewis Ranieri, as the inventor of the mortgage-backed security. Ranieri opens with the line, “Hi, I’m Dr. Frankenstein.”
Ranieri notes that MBS were created to help meet the increased expected demand for mortgage capital from the Baby Boomers. To make the securitization of loans work, financiers had to make the bonds “safe.” This meant getting a nice rating slapped on the MBS. It also meant convincing lenders, or purchasers of MBS, that they’d be paid back. These lenders were not in a position to know whether originators were doing an adequate enough job of “looking borrowers in the eye,” and determining whether they were a good credit risk. So, to reassure lenders, MBS took advantage of pooling (combining hundreds or thousands of mortgages together into a security), so that if some small percentage of borrowers defaulted, the MBS would still be ok. They also took advantage of government guarantees, and of the use of tranches (that is, breaking MBS up into riskier and less risky bundles) so that lenders could feel safe getting into the market.
The obvious stumbling block here is that nothing was done to ensure that originators would act in good faith. This set up a problem. Suddenly originators had access to new capital without an increased incentive to maintain high standards. This fundamentally changed the dynamic of mortgage markets and created a nationwide housing boom, which set the stage for epic failure; the vulnerability of MBS was that pooling wouldn’t work—that all housing markets and borrowers would suffer at once. That, of course, is exactly what happened.
It’s wild to listen to this, like listening to the designers of the Titanic. You want to yell, “But didn’t you think about icebergs?”
Ryan Avent is an economics writer living in Washington, DC. He authors The Economist's economics blog, Free Exchange, and covers environmental and urban policy issues for Grist.
