Mortgage securitization is drawing an increased amount of criticism after yet more research is completed in an effort to uncover the cause of the U.S. financial crisis. Emails between power brokers at Goldman Sachs, Morgan Stanley and Deutsche Bank that lambast mortgage securities as junk investment vehicles are leading many to believe that more people knew of the dangers than what was once thought. Mortgage securitization allowed banks to bundle mortgages and sell them to investors, which let them pass on risk while creating false profits that led to the eventual financial ruin of several large firms, including Bear Stearns and Lehman Brothers. For more on this continue reading the following article from TheStreet.
It appears that hundreds of people involved in securitizing mortgage loans heading into the real estate crisis, had no idea that the United States was in the midst of a housing bubble.
In the aftermath of the housing market collapse in 2008, there has been substantial research and press dedicated to analyzing the root causes of the crisis.
While some have blamed external factors such as a prolonged period of low interest rates and affordable housing policies, the popular view, especially among policymakers in Washington, has been that poorly designed incentives -- bonuses come to mind -- led Wall Street to take excessive risk in the mortgage market, leading to the collapse of the housing bubble and the demise of financial institutions including Bear Stearns and Lehman Brothers.
Recent research has increasingly suggested that securitization -- the process of packaging loans into securities that could be sold to investors -- may have been a major contributor to the bubble. Banks were arguably reckless in their lending, because they did not retain mortgages in their books and could pass on the risk to investors.
Investors also unwittingly believed that they were protected from the downside because they thought they held a diverse pool of mortgage-backed securities that received triple-A ratings from the rating agencies.
Still, lawsuits have alleged that many on Wall Street were fully aware of trouble in the housing market but chose to ignore it in their quest for more profit and higher bonuses. They point to emails deriding securitized mortgages as garbage or worse at investment banks such as Morgan Stanley (MS), Goldman Sachs (GS) and Deutsche Bank (DB).
Another hypothesis, that a distorted belief that housing prices would continue to rise, led to terrible choices all around, has also been floated, though it gets a lot less credit.
A new paper by Ing-Haw Cheng, Sahil Raina of the University of Michigan, and Wei Xiong of Princeton University, suggests that both poorly designed incentives and overly optimistic beliefs about housing prices among people involved with loan securitization, may have inflated the bubble. Preliminary findings from the report were first published in 2012, and the final results were published on March 12.
The researchers analyzed whether mid-level managers who were involved in issuing and investing in mortgage-backed securities - the very heart of the mortgage boom -- were actually aware of the housing bubble. Based on an analysis of the personal home purchase transactions of 400 mortgage securitizers, it looks like they weren't.
"Our analysis shows little evidence of securitization agents' awareness of a housing bubble and impending crash in their own home transactions," they concluded. "Securitization agents neither managed to time the market nor exhibited cautiousness in their home transactions. They increased, rather than decreased, their housing exposure during the boom period through second home purchases and swaps into more expensive homes. Our securitization agents' overall home portfolio performance was significantly worse than that of control groups."
The researchers stress that their conclusions "do not contradict the existing evidence that bad incentives caused loan officers and securitization agents to relax lending standards in the subprime borrower market."
The paper does suggest that Wall Street may have relaxed credit standards without expecting it to have an impact on the wider housing market.
The research suggests that these players were caught up in the bubble when making decision about their personal finances. "Our evidence suggests that certain groups of agents - those living in bubblier areas, working on the sell side, or at firms with greater exposure to subprime mortgages - may have been particularly subject to potential sources of belief distortions, such as job environments that foster group think, cognitive dissonance, or other sources of over-optimism. Changing the compensation contracts of Wall Street agents alone, for example through increased restricted stock holdings or more shareholder say on pay, may be insufficient to prevent the next financial market crisis," according to the paper.
This article was republished with permission from TheStreet.