It may seem too soon to talk about the next financial crisis since we are hardly through this one. To be sure, no two financial crises are ever the same. History, like ocean waves pounding the shore, repeats itself in general patterns, even as each occurrence differs in every detail. It took many mistakes to create our current situation, some of which, like allowing excess leverage, were known to be dangerous because of their contribution to the crash of 1929. Nonetheless, we are far enough removed, and close enough, to make some important observations-observations that may prove useful in averting a future crisis.
Certainty is not a fact, it is a warning. It was frequently said that housing prices had never fallen nationwide since the 1930s. Until the present financial crisis, this was a cornerstone argument for discounting the risk associated with lower quality mortgage-backed securities. This statement went from being understood as an assumption to being understood as a fact-from housing prices never having fallen nationwide to housing prices not being able to fall nationwide.
If it doesn't make sense, it doesn't mean it doesn't make sense; it means the incentives are unclear. Wall Street's insatiable desire to create pools backed by residential mortgages led to the development of "no doc mortgages," sometimes called a "liar's mortgage." These mortgages required little if any documentation of the borrower's income and/or credit history. Since each party expected to sell these securities as soon as it could, there was no reason to remember the words, "Trust, but verify."
Who loses if the transaction does not work as intended? "Not me," said the borrower to the mortgage originator. "Not me," said the mortgage originator to the bank. "Not me," said the bank to the underwriter. "Not me," said the rating agency to the underwriter. "Not me," said the underwriter to the bank. "Not me," said the banks to the federal government. Then, when everything went sour, all of them said in unison, "You are," and the American taxpayer covered the loss. There is no free lunch; someone must always take the risk of loss. If no one has that responsibility, then it is the American taxpayer who will be responsible.
Regulating the system. Like a car engine, every system requires a governor, or it will spin out of control. The regulator's role, while not to obstruct creativity and risk-taking, is to contain reckless and illegal behavior.
From 1980 to 2004, Congress, with the complete support of both Democratic and Republican administrations, systematically weakened regulations that had been put in place in the wake of the Great Depression. By removing these regulations, an environment was created eerily reminiscent of the financial markets before the crash of 1929. In 2004, the SEC allowed five investment banks (Bear Stearns, Merrill Lynch, Lehman Brothers, Goldman Sachs, and Morgan Stanley) to go from 12-to-1 leverage to as high as 35-to-1 leverage. Without adequate regulation and restraint, the financial system, like any system, will, and did, spin out of control.
Assessing risk. The rating agencies (Standard & Poor's, Moody's, etc.) are paid to rate the credit quality of a transaction.
The more transactions they rate, the more money the rating agency earns. If they are too conservative, consistently rating transactions lower than their competitors, then they will not be asked to rate additional transactions. This creates an incentive for ratings to "drift" upward. Given these incentives and conflicts, it is no mystery that the system produced inaccurate credit ratings.
The O'Neal Effect. Stanley O'Neal, the former chairman of Merrill Lynch, made $22,410,000 in 2006 (according to Wikipedia). In 2008, the year Merrill Lynch almost went bankrupt and was sold to Bank of America, O'Neal made $161,500,000 (according to Fortune). Merrill's success or failure did not matter; reward was forthcoming regardless of the outcome. He was better rewarded for failing than most non-Wall Street CEOs are for succeeding. Over the long run, this type of compensation must inevitably lead to excessive risk-taking.
Where in the economy the next crisis will occur is hard to say, but based on the above observations reverse mortgages seem a prime candidate (see the September edition of Consumer Reports for more on this). They are not, in and of themselves, a bad idea. After all, allowing seniors to remain in their homes while tapping the illiquid equity of their houses can be the right choice.
On the other hand, origination and other fees can be as much as $30,000 on an $182,541 reverse mortgage. Fees alone can amount to one-sixth of the loan value. Although counseling sessions are required in order to explain the product, the product is complex, and hard for many people to understand. More importantly, the financial incentives are not structured appropriately. Any defaults or shortfalls, beyond mortgage insurance, are paid by the federal government, not by the originator or the bank making the loan. The lender has little incentive to make sure the borrower is creditworthy, since insurance, but ultimately the federal government, picks up the loss. There is extensive documentation required, but that has never made up for misaligned financial incentives. The only party ultimately responsible for losses is the American taxpayer. This seems eerily familiar and an accident waiting to happen.
Seth Becker, RFC, is a managing director of Oakstone Financial Management in Columbus, Ohio, and a registered representative of Cadaret, Grant & Co. Inc. He can be reached at [email protected]