Q & A

Did innovation cause the credit crisis?

Frank Fabozzi & William N. Goetzmann & Gary B. Gorton — October 2008

By 2006, the subprime market had grown to 20% of the total U.S. mortgage market, and 75% of these loans were securitized and sold off to investors around the world, facilitating an influx of capital. With credit easily available, more people than ever before were able to buy homes — but then the market seized up.

Q: Mortgage securitization has gotten a lot of attention lately, but how long has it been around?

Frank Fabozzi: Mortgage-backed securitization goes back about 40 years. The first Ginnie Mae securitization was 1970. When the first one was finally paid off, they had a big party down at Ginnie Mae. I was invited to that; that’s how I know it’s been a long time.

Will Goetzmann: There was an earlier period of securitization of real estate loans in the 1920s, and they were commercial loans. A lot of buildings in Manhattan were financed by bonds issued to the public that were backed by mortgages for these buildings.

The history of securitization more broadly goes back much further. The early securitizations, where portfolios of bonds were put together into a trust and then securities were issued against them, appear to have started in the 1700s in the Netherlands, as a way to bundle up securities that individually might be risky but collectively created a stable, reliable payoff. Some of those risky bonds were obligations of the early United States of America.

FF: What we’re talking about today is what’s called asset securitization. If you look at securitization in general, it’s really the use of public markets and avoiding the use of intermediaries. For example, common stock is an example of securitization, where instead of having private equity holders, you’re using public markets. 

In asset securitization, you’re using assets as collateral and you’re not looking at the credit risk of the issuer; you’re looking directly at the credit risk of the underlying pool of loans.

Q: What role has this kind of securitization played in the development of the current credit crisis?

FF: Here, I think I have a better perspective because I think I’m older than Gary and Will. I went to get my first mortgage in about 1974. And I could not get that mortgage until my local S&L had enough money to be able to provide me with funds.

Can you imagine telling people who want to buy homes today that, even though they have enough for the down payment and they also have good credit, they have to only rely on their local S&L to get funds? They have to wait until funds were available? Do you think that would be an acceptable market to America?

The question then becomes who was holding the mortgages? They were primarily held by S&Ls. And what did that lead to?

Gary Gorton: The S&L crisis.

FF: The S&L crisis. S&Ls, as well as banks, were basically lending long-term on a fixed-rate basis — because the government insisted that we have only fixed-rate mortgages at the time — and then borrowing short-term. Great market — until you started hitting double-digit interest rates.

Who in the world was going to hold all the debt of the U.S. mortgage market — the largest debt market in the world? If we’d wanted S&Ls to continue holding it, we’d have had a bigger crisis much sooner. So, we created this mortgage product.

What were the benefits of the mortgage securities market, holding aside what happened recently? You could say we had the best housing finance market in the world. Securitization, generically, has been a very successful product, both in the mortgage market and in non-mortgage assets. I mean, General Motors would have much more difficult problems if it wasn’t for the fact that GM can securitize its auto loans. We have governments that are able to raise money that way. 

What caused the problems with this market? It moved from a market in which the underwriting standards were very good to one where, in my opinion, credit standards dropped greatly. As a result, we have a lot of people who failed to meet their obligations. 

It was also overloaded. Remember, if I buy a $100,000 house and I put down $20,000, I’m leveraged five-to-one on the down payment. Now, a hedge fund goes out and buys that product on a leveraged basis, by borrowing money so they can get another five- or ten-to-one leverage on that. Look at the extreme leverage that creates.

The model that was used previously was, basically, create a loan, hold it in the institution, meaning a bank or an S&L’s portfolio. For example, my local S&L knew everything about the property I wanted to purchase. It was in their area. The manager responsible for providing the loan, the loan officer, would know about the underlying property. The manager would know trends in the community, and if the S&L put that loan in its portfolio and there were problems, the loan officer was accountable.

Now the concern with securitization in general is that issuers will reduce credit standards and, as a result, push the poor credit risk onto the market.

GG: I don’t think — I don’t agree with this, at all.

FF: You mean you don’t agree that that was the view?

GG: I think that’s the dominant view out in the world; I just think it’s wrong.

If we ask, was the systemic financial crisis caused by a lowering of credit standards? I think the answer is no, that’s not the problem. Not only is there no econometric evidence that supports that view, but it has a couple of other problems.

One problem is that you have a whole variety of asset classes that have been securitized, and those markets are 20, 25 years old: credit card receivables, automobile loans, tobacco settlements — there are about 30 asset classes. And somehow, according to this view, in one of these asset classes, for some unknown reason, the credit standards went down. That just doesn’t intuitively make any sense, in addition to not having any particular evidence.

My view of what is happening is that this particular asset class, which is subprime mortgages, is a new product. So, 20 years ago, the four of us would be having a discussion like this, and the subject would be why banks don’t lend to poor people, the riskier borrowers.

The problem for banks and mortgage originators was and is that poor people are, in fact, riskier. And they’re riskier partly because their income is just more volatile but also because they have other attributes that are riskier. They don’t necessarily have income they can document, for example. They may be illegal aliens. So the question was how can you possibly lend to them? And the short answer is you don’t lend to them for 30 years because they’re just way too risky. But what you do is you take advantage of one thing that we know pretty well, which is that for most people, including probably the four of us, a large part of our net worth is tied up in our home equity. So, if you can create home equity for these people over a short horizon, then they may change their incentives and work harder and be more likely to repay.

So, a bank is willing to say, “I’ll take a risk that for two years, if you can build up some home equity over that period, then we’ll give you another loan for two years. And maybe eventually we’ll give you a long-term loan.” That’s what some of the loans that reset after two years essentially did. Now building up equity requires house prices to rise, so this product is extremely sensitive to house prices. And not only is the mortgage extremely sensitive to house prices but so is the actual structure of the securitization.

Securitized products are very complicated. Frank’s written a lot about this. For subprime securitization, the structure is very different than other securitized products, and it inherits the sensitivity to house prices. And so what happened was that there was a very long, complicated set of structures — not only securitization products but other structured products, CDOs [collateralized debt obligations], SIVs [structured investment vehicles], all sorts of products — and this sensitivity to house price risk was spread through all these products in a way which became very opaque. Everybody saw that it was a problem when we finally had a market open that revealed it, which was a synthetic index related to subprime, the ABX index. And then the whole house of cards came tumbling down because we saw that house prices weren’t going up, and that was affecting the value of these products.

This is a very special case of securitization. But the wider world, including all the bank regulators and central bankers, have this view that the problem is all of securitization. Hopefully they won’t destroy all of securitization. But I think it’s very important to stress that this is a rather unique set of circumstances.

FF: Let me go back and address two points. First is what I was saying about the issue of holding versus transmitting risk to the marketplace. That was intended to describe what the general view has been as a criticism of securitization. It wasn’t my position, obviously, because I’m positive toward securitization.

The second point is that it’s true that you have a situation where you’re basically making a bet on real estate prices when you attempt to build up equity for someone who has a blemished credit record or insufficient funds to put down a suitable down payment. But certainly there were other issues as follows: If you look at the worst mortgage-backed deal that was done, they packaged together mortgages that were second-lien mortgages on properties that basically had loan-to-value [LTV] ratios of 100%. How could something like that pass muster—

GG: Wait a minute, wait a minute. That in itself doesn’t make it a bad deal. If you look at 100% cumulative LTVs with second liens, and you’re only securitizing the second lien, you’ll see that the structure of the securitized bonds are a lot different than if you’re securitizing first lien.

FF: But it doesn’t make any difference. It’s still a bad deal. The structure was rated AAA at the time, but that bond went under probably within one year.

GG: But, Frank, I don’t see what that’s evidence of. There’s a lot of stuff around the fringes here. Did some guys just neglect their lending standards? Probably. Were some brokers getting kickbacks? Yeah, probably. Were some people put into mortgages they shouldn’t have gotten into? Yeah, probably. But if you’re going to redesign regulation for financial institutions, what’s the central issue?

At the end of the day, if you ask what caused this crisis, I don’t think the evidence is there that there was a decline in lending standards. I don’t think the evidence is there that the incentives were not aligned all along this chain. I think you had a product, which was designed to address this particular clientele. It happened to be, unfortunately, linked to house prices and it almost had to be.

The problem is that the strength of that link was not common knowledge in the market until the ABX index crashed four times in a row. Everything else, like beating up on the rating agencies, is just not the central issue.

WG: This observation that the housing price is the fundamental variable that underlies a lot of the turmoil is an interesting one. I think that we have in the United States a fairly short history of home price data. It’s only been in the last, say, 15 years, through the efforts of people like Bob Shiller and Karl Case, who created these repeat-sales housing indices, that we really felt like we could put the forecast of housing prices into models so that we could have some estimate of recovery in the event of a default on a mortgage.

In some sense, I think that the statistical foundations for including the home prices into valuation models are a driver of the current set of events. What we got was fabulous information about how housing has trended, since about 1980. But it really only shows a couple of dips and rises historically. 

You can take these housing indices — and I’ve done this myself — and use them to make forecasts. And the econometrician feels pretty comfortable about using these forecasts because they have a lot of inertia in them. So if you go back to, let’s say, 2004, you put in the various housing indices for the various cities, what you see is that they were all forecasting increasing rises in home prices. And the confidence levels of those forecasts were pretty high.

I don’t find it surprising that lenders would be willing to make a mortgage to people with low credit scores, because, if they were going to get the house back in three years, the models would be telling them that the house would be worth something.

FF: But when you securitize, in the securitization, you shouldn’t be looking for appreciation in the collateral’s value.

GG: That’s why this is different.

FF: Lending on an asset which you’re relying on appreciating is a mistake. Even when you look at CDO deals, for example, you see very few market-value CDO deals—

GG: They all died.

FF: Shiller called the housing crash two years before it happened. But we didn’t have data, and the rating agencies didn’t have sufficient data, to be able to properly assess what the risks were. And a point that I’ve made many times is before you decide you want to securitize a new asset class, and this was a new asset class, you should have a good history.

GG: But you never do when it’s an innovation. One of the things that happened was the house prices went up in zip codes that had a lot of subprime mortgages, right? You can get the zip codes of the mortgages and go look at the house price changes in those zip codes. And it looks like those zip codes had latent demand for mortgages, which appeared to cause the house prices to go up. But, more generally, with a lot of innovation, you just don’t have the data that we would like as academics, but that doesn’t stop the market from creating products. I mean, you can’t wait. You try to make money.

FF: That’s true. But this was extreme. I was involved in the first mortgage securitizations in Denmark. This was an innovation there. Before the first deal came out there was a tremendous amount of work that was done looking at historical databases. In subprime, I think there was insufficient data to be able to generate a market of this size. And whether you attribute it to just housing prices alone, or housing prices combined with inadequate data and lower credit standards...

WG: Well, I think it’s a little subtler than that. What happened was, for the first time, we had these historical indices, city by city and in many cases zip code by zip code, that provided some comfort to an underwriter that they might not have had before. And that led to a willingness to extend credit into areas and to people who very well might not be able to pay off their loans. 

The big problem in all of this is that 20, 30 years worth of housing data, under lending conditions that were unlike the ones we’ve now created, just doesn’t give you any information about what will happen in a crisis. So the crash that we’re seeing in housing prices, we don’t see that in all those historical indices. And, as Gary pointed out, the availability of credit itself affected housing prices. So, as economists we’d like to say ceteris paribus, hold everything else equal, but the ability for the first time of poorer people to buy houses in their neighborhood actually pushed prices up. And then lenders cheerfully forecasted a continued increase in prices. And so you could say it was a virtuous or an evil spiral, whichever way you look at it. It meant a lot of poor people owned houses they couldn’t own before, but it also led to conditions under which eventually the price level would drop.

FF: Now remember, there were also new mortgage designs that were permitting this. The fact that you allowed borrowers options as to whether to pay — that was something we had no information about. 

I think we have views that are similar on why the crisis occurred. I put a lot more emphasis on credit, and Gary puts more emphasis on housing prices. Is that fair?

GG: Yes.

Q: You’ve focused on the subprime market. Why have the problems spread outside of that area?

GG: One thing to keep in mind is that subprimes were not just securitized once. So, you take the mortgages, you put them in a portfolio, you create securities out of that portfolio, and you sell the securities. But when you sell them, you don’t necessarily just sell them all directly to investors. Many of them were sold into other structured products. And then those structured products were, in turn, tied to derivatives. And/or those other structured products ended up in the portfolios of still other structured vehicles.

You have this very, very complicated chain of the movement of the risk, which made it very opaque about where the risk finally resided. And it ended up residing in many places. So the whole infrastructure of the financial market became kind of infected, because nobody knew exactly where the risk was. So the monoline insurers had some of it, and big banks had some of it. And monoline insurers happened to back municipal bonds, and so it spread there.

Then because banks were forced to write down billions of dollars, there were fears about liquidity in the market, so everybody stopped lending and nobody would do repo. The effects of this were magnified, and it was already a pretty big number to start with, because the amount of subprime in 2006 and 2007 was $1.2 trillion. You take $1.2 trillion and you don’t know where that is, it’s easy to have a whole financial system be at risk.

FF: If you recall newspaper articles coming out at that time, we just got pieces of information. At one time, the report was the losses to financial institutions would be x. Then all of a sudden it increased by a multiple of that. Did you see the latest numbers, Gary?

GG: You can’t even keep up with it.

FF: Right.

GG: The critical thing is that the press has only recently started to distinguish between losses and write-downs. So most of the stuff is not really losses, it’s write-downs. 

A write-down is an accounting event. The accounting profession has bought into the finance profession’s idea of efficient markets. So if the price of something goes down, the idea is that the value of it actually went down. And that’s a problem when you’re in a panic or a crisis like we’re in today where there are no prices. And to the extent that there are prices, they’re fire-sale prices.

So you’re writing things down under GAAP accounting using prices that we know are not exactly what they should be. And the problem is that GAAP accounting has real effects because the measured capital ratios for regulated financial institutions go down, and then those institutions have to raise capital at very punitive rates.

At first they got sovereign wealth funds to invest, but now they’re having to sell things. And the obvious thing to sell is all these bonds that were marked down. So, now you sell them and you’ve crystallized the loss, which happened because of the write-down. And so the whole thing is a sort of vicious circle where you can’t distinguish between what’s really a reflection of a future realized loss that we’re predicting with these market prices, and to what extent the market prices are just a reflection of the fact that there’s no liquidity. The way the accounting works made everything much, much worse. 

FF: It’d be interesting to get a response from the accountants who read this. [Editor’s note: You can read responses from SOM accounting faculty. Rick Antle addressed the comments directly. Shyam Sunder had an editorial in the Financial Times touching on the issues.] 

Q: Given the problems with data around the subprime market and how unclear the prospects were for some of these products, who was actually buying them?

FF: The driver was highly leveraged investors who saw attractive spreads available on the product. We’re not talking about the AAA-rated pieces but some of the real risky pieces offering very wide spreads. When Wall Street saw that there were entities such as hedge funds and CDOs that were willing to buy this product, they found a great desire to create it. 

The hedge funds and CDO managers were able to buy them on a leveraged basis, and that’s why who got stuck holding them at the end, to our surprise, was the banks. Banks were taking them in as collateral in repo transactions, and when collateral calls were requested they didn’t have the ability to dispose of them.

If the end result was that the investor group holding the product was hedge funds, I see no problem with that. That’s what hedge funds are in business to do: take on great risk, and with great risk come potentially greater losses.

WG: I would like to go back to the theory of securitization for a moment, because it helps you understand what was envisioned by this new market. The notion of securitization is that you take a lot of assets that may not have liquidity, and you create liquidity by bundling them and parsing them. By parsing them, you create securities that have characteristics that some people would like to own. For example, you take a pool of mortgages, and you split them up so that one part is a very safe set of payments and another part is very risky. In a world where everybody’s different, and some people have a greater taste for risk, there is a price at which somebody, a speculator or just somebody with a tolerance for risk, is willing to hold the risky part. You kind of match the risk characteristics of the assets to the risk attitudes of the purchasers. Thereby you have an efficient allocation of risk across the economy. The notion is that once you’ve done that, that risk is broadly diffused throughout the economy. Not that it disappears, but it’s residing with those entities that feel comfortable in holding that risk.

So, what went wrong, or how come that vision didn’t play itself out? How come we didn’t simply have a case where a bunch of hedge funds that wanted to hold risky product got hurt?

What we didn’t quite envision in the theory is the extent to which holding all of these different pieces of paper had to be done through the medium of financial institutions of some sort. Intermediaries like, let’s say, Bear Stearns were fundamental to the process of holding and trading these securities. And in some sense, the institutional framework was the weakest link in this chain.

You might have had hedge funds that said, “We can accept this risk.” What you didn’t have was a sign-off by the financial system that said, “If something goes wrong in one part of this, we can wall it off from the other part of the system.”

So, that’s what we had. We had a propagation of the consequences of a relatively small part of the housing market, that is, the extreme tranches of these subprime mortgages, impact the financial system because of the leverage extended by intermediaries, like the investment banks. And once you start shaking the foundations of the institutions, everything rattles. That’s something that may not have been envisioned by the pure theory of securitization.

FF: Will makes a good point. The theory of securitization would say that the risk should be out of the banking system, into the hands of a broader base. But the exact opposite happened.

Q: What steps might decrease the panic in the market now?

GG: I think Bernanke’s been doing a fabulous job. I think he’s really the only one who’s done anything. But the problem is that I don’t think we’re anywhere near the end of this. One thing you have to remember is that you have millions and millions of mortgages now that have nowhere to go to be refinanced. They probably can’t be refinanced. Many of them are going to fail.

The reality of the situation is pretty bleakbecause things that could’ve been done weren’t done. Now with a lame duck president, things are not really going to be done. Some new president’s going to come in and won’t do anything for six months. By then it’ll really be too late. So we’re going to muddle our way through this, and it’s going to be extremely painful.

Q: Will, do you see historical parallels between current events and any 
previous financial crises?

WG: The most extreme example might be the Bubble Act of 1720. In England there was a proliferation of corporations that followed the financial revolution of 1688, which actually was a “glorious revolution.” And there was a period of wonderful financial activity that could have started the Industrial Revolution a century earlier. But Parliament decided that there was too much speculation, and they basically suspended the ability of companies to register as limited liability firms in 1720. And that set the financial world back a century.

I think we’ve seen hints of this with things like Sarbanes-Oxley where politicians feel the need to do something. And what results is a regulatory framework that is not developed organically by the markets but sort of a heavy-handed response that doesn’t set things right. We’re seeing this loom on the horizon. Actually, it’s not on the horizon; it’s on the tables of Congress. Every congressman who wants to brag that he did something about the crisis has some new constraint or new regulatory entity — limits to short selling or God only knows what. 

I’m concerned that there is going to be a permanent, or at least a decades-long, setback in the ability of the financial markets to create wealth and to finance innovation and to help people at lower income levels. That’s the scary part about this crisis. We can weather things like bailouts of Fannie and Freddie, and hedge funds losing a lot of money, and even large banks going under. But what we really have to be concerned with is well-intentioned but poorly designed solutions.

Q: Frank, do you see any potential solutions arising from the market, as Will said he’d like to see?

FF: It may be too early. We see more and more talk about using a different structure called covered bonds. It’s been around in Europe.

GG: I think that’s probably a good idea, Frank.

FF: I agree. But they’re still working it out.

GG: I agree with everything both of you just said. There’s a danger that government will overreact, but there are going to be millions of Americans who get chucked out of their houses. And there’s a huge social cost associated with that. It’s just massive.

You’re going to have boarded-up neighborhoods and people aren’t necessarily going to have places to go. That is something that ought to be addressed. It’s very difficult for the government to do anything about that because the natural entities to do that would be Freddie and Fannie. But you can’t in the current political environment, given their difficulties, expand their criteria. It would be perceived as bailing out Wall Street.

WG: The role of government at this point is to figure out how to extend a helping hand to reduce the grave social effects of what we’re confronting. That would be a more productive thing for Congress to be focusing on, as opposed to creating new oversight and new rules.

Interview conducted and edited by Jonathan T. F. Weisberg