Villains in the Mortgage Mess? Start at Wall Street. Keep Going.

By Kathleen Day
Sunday, June 1, 2008

Yes, the executives at Countrywide Financial Corp. planned a top-dollar shindig at a ski resort earlier this year, just after the bank's multibillion dollar losses on subprime mortgages required a shotgun marriage to Bank of America. (A Wall Street Journal story forced them to cancel the party.) And sure, Bear Stearns chief executive James E. Cayne was off playing golf last summer as two of his investment bank's hedge funds collapsed under gargantuan subprime losses. (He's been dumped.)

But so far, the current mortgage meltdown hasn't featured the crasser displays of the 1980s savings and loan fiasco, when executives partied hearty -- one banker famously dressed up as a king and served lion meat to his guests -- as they created a mortgage industry mess that cost taxpayers more than $500 billion.

As a reporter for this newspaper, I covered the savings and loan debacle in depth and later wrote a book about it. Watching the current crisis unfold, I see much of the same behavior that led to the "S&L Hell" of two decades ago. Indeed, some of the fixes for the last problem led directly to this one. Once again, too many people had access to other people's money with too little oversight. Once again, the White House, Congress and federal bank regulators failed to police the financial services industry because they mistook deregulation for a system without any reasonable rules. And now as then, our saga is chock-a-block with people and institutions deserving special mention in the Suprime Hall of Slime.

But make no mistake: Today's crisis dwarfs the S&L fiasco. The eventual cost to taxpayers of this scandal is likely to make yesteryear's culprits look like pikers.

The short version of how we got here: Lenders, fat with money made cheap by the federal government, aggressively coaxed millions of borrowers to take out unaffordable mortgages. They lent this money without assessing whether borrowers could repay it. They assumed, in fact, that most wouldn't be able to and would have to refinance into new, equally unaffordable loans. This process would produce an endless cycle of fees for the lenders -- but only if home prices rose, fairy-tale-like, forever.

On what planet would that be an acceptable business plan?

Here's a longer version of how this happened, with a nod of recognition to the many actors who made it possible.

First and foremost: Wall Street. In the 1990s, after the S&L blowout -- and bailout -- an innovation called securitization took hold on Wall Street to spread risk among many investments and investors. The idea was to insulate mortgage lenders from the ravages of sharp interest-rate spikes that could catch them holding low-interest mortgages even as depositors demanded high-interest returns on savings -- the very thing that had sparked the savings and loan industry's turmoil.

By the end of the millennium, securitization in the housing market was a huge, well-greased mass production line. Mortgage finance giants Fannie Mae and Freddie Mac -- companies chartered by Congress to finance home lending -- bought home loans from banks, then bundled hundreds of them together to secure a bond, called a mortgage-backed security. Wall Street investment bankers bought the securities, which then traded freely in the bond market. For a fee, Fannie and Freddie guaranteed the mortgages behind every security against default, so they required lenders to assess each borrower's ability to repay a loan -- a prudent practice known as underwriting.

Fannie and Freddie's underwriting rules are the gold standard by which lenders evaluate the creditworthiness of "prime" borrowers, people whose strong credit histories make them a low risk and therefore eligible for the lowest borrowing charges.

Fannie and Freddie competed fiercely with each other to create these bonds at the best price, paying less and less for the loans they bought from banks. Securitization became so efficient that it shaved profits in the prime market paper-thin. In response, by 2000, a market had sprouted to lend to "subprime," or higher-risk, borrowers, who could be charged more for loans. Many of these individuals had been denied access to credit for decades because of their skin color or the neighborhoods they lived in -- a process known as redlining for the magic-marker boundaries lenders drew on maps to show which areas were off limits. (Subprime didn't turn out to be a boon to minority home ownership, however; many minority families have ended up as the biggest victims in this mortgage mess.)

Wall Street firms were also eyeing the subprime market. They began buying and bundling subprime mortgages into "private-label" mortgage-backed securities. But Wall Street didn't guarantee the loans it bought, so it had no financial stake in assessing borrowers' creditworthiness. Which meant that lenders didn't have to care, either.

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