Hamden Rice: Housing Bubble Lessons from 'It's a Wonderful Life'

by Hamden Rice

You can understand a lot about the current financial crisis surrounding the sub-prime mortgage market if you understand a premise of the movie, "It's a Wonderful Life."

And no, I'm not talking about the run on the bank scene, but it's a starting point on understanding what is going on. In one of my career guises, I used to draft mortgage backed security and credit card receivable security trust instruments for Wall Street investment banks.

In IAWL, you may recall, George Baily ran a small savings and loan, a kind of bank. George took in deposits from small depositors and lent the money to new homeowners as mortgage loans. There were two distinct banking sectors -- the thrift institutions (savings and loans associations, and savings banks) and commercial banks. Evil Mr. Potter ran the local commercial bank. Commercial banks dealt almost exclusively with business organizations, not with consumers. Many thrifts were so small, that, as in IAWL, they themselves deposited their money in commercial banks.

George Baily's problem was that he could only loan out as much money as he took in as deposits in his local community (actually, only a percentage of the deposits). So, during the New Deal, the Roosevelt administration created the Federal National Mortgage Association (affectionately known as Fannie Mae). The original system was designed to help George Baily if he found himself in this situation: that he had a bunch of homeowners paying their mortgages, but also had potential new borrowers, but had run out of deposits with which to make new loans.

Fannie Mae allowed George to sell his existing mortgages. In finance, this "paper" has value -- it is a promise by some homeowner to continue to make his monthly mortgage payments, and is backed by the right of the lender to seize the house if the payments stop, auction it off and use the sale to recoup his loan (that's foreclosure). It is easily valued using "discount to present value" calculations. The only thing that's hard to value is the risk that the homeowner will default and go into foreclosure. (There is also pre-payment risk -- banks don't like it when you pay off a loan early -- but that's a different and complicated story, and irrelevant to the crisis.) To eliminate this uncertainty, Fannie Mae guaranteed the mortgages.

So, Fannie Mae came up with this system. George would bundle his mortgages in convenient units, and send them to Fannie Mae. Fannie Mae would slap a guarantee on them (backed up by the credit of the US of A), and send them back to George. George could now sell the mortgages, and receive the money to make new loans. The homeowner wouldn't know the difference because George remained the "servicer" (ie collector) of the loan.

Fannie Mae was wildly successful. It financed a great deal of the explosive housing growth of the post war era. It helped little S&L's like George Baily's grow into very big banks, so that the difference between thrifts and commercial banks virtually disappeared.

Because of it's success, the government did two things: it created other similar organizations, while pushing them off the federal government's books. In other words, Fannie Mae became semi-private and although it continued to guarantee home loans, it did so by charging a fee, to originators, kind of like an insurance company.

By the 80s and 90s, some entrepreneurs realized that you didn't have to be a bank to act like a banker. You could really just skip the whole deposit side of the business. Developers were early alternative mortgage originators, for example. They would package their mortgages, get the guarantee and instead of selling them to banks, they would sell them to a trust or special purpose corporation that they themselves had created. This trust or spc would then sell trust certificates or shares that represented the right to receive a portion of the flow of mortgage payments from thousands of homeowners.

This was the birth of the "asset backed security" or "mortgage backed security" market. It was a process called "dis-intermediation," because it took banks out of the role of "mediation" between depositors (investors) and borrowers (homeowners).

The market for asset backed securities was vast -- almost unimaginable to the layman. A single tranche of asset backed securities was usually in the $500 million range in the 90s when I was doing this stuff.

All sorts of investors bought asset backed securities -- individuals, pension funds, insurance companies, commercial banks, thrift institutions, hedge funds, investment banks -- everyone and anyone.

Another thing that happened in the 90s is that mbs creators realized that they could reach new markets for home loan borrowers through "over-collateralization" and the use of derivatives. This was the "sub prime" market. In other words, keep in mind that whether it is a little George Baily operation or a billion dollar mbs trust, what makes the investment safe is that ultimately, behind every loan is a house. If the homeowner stops making payment, the bank (or mortgage holder) seizes the house, sells it and recoups the face value of the loan. There are delays and costs from foreclosure, but these are manageable. If it is a Fannie Mae guaranteed loan, there is also the guarantee, but the sub-prime market is largely un-guaranteed.

But if the borrowers are poor or have sketchy credit histories, the creators could allay their fears by putting more stuff into the trust than was being lent out ("overcollateralization" -- ie too much collateral, backing up the loan). (When the loans were all paid off, some lucky uber investor, usually the creator or an institutional investor, got all the extra stuff, and the trust bursted open with goodies like a Mexican pinata!)

The techniques of overcollateralization allowed banks and mbs creators to make loans to poorer people and people with poor credit histories, and allowed them to turn them into mortgage backed securities that investors felt comfortable buying.

Now, here is why there is a crisis.

Whether we are talking about George Baily, or a five billion dollar mbs trust, the thing that makes it work is that the value of the underlying property (someone's house) is always enough to recoup the loan if the homeowner defaults and goes into foreclosure.

But what if the value of the house is not enough? That sounds impossible and usually is, because real estate always goes up in price.

Until now.

When real estate prices decline, this puts banks (or mbs trust) "under water" -- that is, if they have to foreclose on a homeowner, and auction the homeowner's house, the value of the house will not be enough to cover the loan.

As more and more homeowners default, are foreclosed, and have their houses auctioned off, the price of houses in the area collapses even faster.

When this happens to banks, it causes bank failures -- eg during Bush I's S&L crisis.

When it happens to the fairly new, gigantic asset backed securities market, it causes something more grave. All those institutional investors may lose money. The uber investors who bought the "something extra" from the over-collateralizations are looking at being wiped out (no pinata goodies for you, my friend!).

This leads to an overall liquidity crisis. Institutions that thought they had money in the bank in the form of asset backed securities may have nothing, which causes them to sell other assets to get their balance sheets in order.

So, that's what's going on. So I guess in the end, it is a little like the run on George Baily's little savings and loan, except multiplied by a billion or so, and there is no beloved, trustworthy Jimmy Stewart character to explain that people can't get their money because it's in their neighbor's house, and there isn't a Clarence the angel making sure of a happy ending for all.

--Hamden Rice via Democratic Underground

It's a wonderful life

Often referred to as one of the best films ever made, this holiday classic is out of copyright and is available for everyone to enjoy again and again. Plot: George Bailey spends his entire life giving up his big dreams for the good of his town, Bedford Falls, as we see in flashback. But in the present, on Christmas Eve, he is broken and suicidal over the misplacing of a loan and the machinations of the evil millionaire, Mr. Potter. His guardian angel, Clarence, falls to Earth, literally, and shows him how his town, family, and friends would turn out if he had never been born. ~Tommy Peter(IMDB)

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