Ben Lorica, our senior research analyst, wrote in email recently: “How out of control was the subprime loan market? Steve Pearlstein had a great column about the subprime loan market a few weeks ago, where he summarized some of the “innovations” that were marketed heavily until recently. My personal favorite is the NINJA loan: No Income, No Job, No Assets!” Other “how could they?” loans include the “liar loan” in which the borrower needs to provide no documentation on claimed income or assets, and the “teaser loan”, which gives an artificially low rate for two years, before dropping the hammer on someone who will never be able to make the real payments.
The article provides good insight into the evolution of financial instruments from someone’s creative money-making hack to wild speculation and eventual collapse:
It began years ago when Lewis Ranieri, an investment banker at the old Salomon Brothers, dreamed up the idea of buying mortgages from bank lenders, bundling them and issuing bonds with the bundles as collateral. The monthly payments from homeowners were used to pay interest on the bonds, and principal was repaid once all the mortgages had been paid down or refinanced.
Thanks to Ranieri and his successors, almost anyone can originate a mortgage loan — not just banks and big mortgage lenders, but any mortgage broker with a Web site and a phone. Some banks still keep the mortgages they write. But most other originators sell them to investment banks that package and “securitize” them. And because the originators make their money from fees and from selling the loans, they don’t have much at risk if borrowers can’t keep up with their payments.
And therein lies the problem: an incentive structure that encourages originators to write risky loans, collect the big fees and let someone else suffer the consequences.
This “moral hazard,” as economists call it, has been magnified by another innovation in the capital markets. Instead of packaging entire mortgages, Wall Street came up with the idea of dividing them into “tranches.” The safest tranche, which offers investors a relatively low interest rate, will be the first to be paid off if too many borrowers default and their houses are sold at foreclosure auction. The owners of the riskiest tranche, in contrast, will be the last to be paid, and thus have the biggest risk if too many houses are auctioned for less than the value of their loans. In return for this risk, their bonds offer the highest yield.
It was this ability to chop packages of mortgages into different risk tranches that really enabled the mortgage industry to rush headlong into all those new products and new markets — in particular, the subprime market for borrowers with sketchy credit histories. Selling the safe tranches was easy, while the riskiest tranches appealed to the booming hedge-fund industry and other investors like pension funds desperate for anything offering a higher yield. So eager were global investors for these securities that when the housing market began to slow, they practically invited the mortgage bankers to keep generating new loans even if it meant they were riskier. The mortgage bankers were only too happy to oblige.
I’ve been thinking a bit about the parallels between the Web 2.0 economy and financial markets. I’m mostly looking at positive developments, but it’s not out of the question that as the current mini-bubble continues, we could see “innovations” in the Web 2.0 economy that have similar destructive market potential as we’ve seen in the mortgage market. If you see any crazy business models that could run out of control and turn destructive, we’d love to hear about them.
Update: I just picked up yesterday’s paper and noticed that the New York Times ran a story entitled The Subprime Loan Machine that is very relevant to this entry, but also to my recent entry on the troubles at the Chronicle:
“The rise and fall of the subprime market has been told as a story of a flood of Wall Street money and the desire of Americans desperate to be part of a housing boom. But it was the little-noticed tool of automated underwriting software that made that boom possible….Automated underwriting is now used to generate as much as 40 percent of all subprime loans.
The point, I think, is that in many ways the financial markets prefigure much of what is to come in Web 2.0. As trading has become automated, the differences between a hedge fund or an automated mortgage lender and a Google may narrow, both relying increasingly on systems that have the potential to run wildly out of control. One of Google’s secret weapons may be the power that their search quality team wields — they really do think hard about the implications of their changes — while many companies let loose a genie without thinking about the consequences. But even Google’s attention to consequences tends to be limited to consequences within their own search engine economy, and not necessarily to the wider economy. More on that tomorrow.