MUNICH — Once upon a time, stocks were risky and collateralized securities were safe. That time is over, as the breakdown of the American mortgage securitization market has shown.
For years, hundreds of billions of new mortgage-backed securities (MBSs) and collateralized debt obligations (CDOs) generated from them were sold to the world to compensate for the lack of savings in the United States and to finance American housing investment.
Now virtually the entire market for new issues of such securities — all except 3 percent of the original market volume — has vanished.
To compensate for the disappearance of that market, and for the simultaneous disappearance of nonsecuritized bank lending to American homeowners, 95 percent of U.S. mortgages today are channeled through the state institutions Fannie Mae, Freddie Mac and Ginnie Mae. Just as there was a time when collateralized securities were safe, there was a time when economies with so much state intervention were called socialist.
Most of these private securities were sold to oil-exporting countries and Europe, in particular Germany, Britain, the Benelux countries, Switzerland and Ireland. China and Japan shied away from buying such paper.
As a result, European banks have suffered from massive write-offs on toxic American securities. According to the International Monetary Fund, more than 50 percent of the precrisis equity capital of Western Europe’s national banking systems, or $1.6 trillion, will have been destroyed by the end of this year, with the lion’s share of losses of U.S. origin.
Thus the resource transfer from Europe to the U.S. is similar in size to what the U.S. has spent on the Iraq war ($750 billion) and the Afghanistan war ($300 billion) together.
Americans now claim caveat emptor: Europeans should have known how risky these securities were when they bought them. Even AAA-rated CDOs, which the U.S. ratings agencies had called equivalent in safety to government bonds, are now only worth one-third of their nominal value. Europeans trusted a system that was untrustworthy.
Two years ago, Ben Bernanke, chairman of the U.S. Federal Reserve, argued that foreigners were buying U.S. securities because they trusted America’s financial supervisory system and wanted to participate in the dynamism of its economy. Now we know that this was propaganda intended to keep the foreign money flowing, so that U.S. households could continue to finance their lifestyles. The propaganda was successful. Even in 2008, the U.S. was able to attract net capital inflows of $808 billion. Preliminary statistics suggest that this figure has now fallen by half.
For years, the U.S. had a so-called return privilege. It earned a rate of return on its foreign assets that was nearly twice as high as the rate it paid foreigners on U.S. assets.
One hypothesis is that this reflected better choices by U.S. investment bankers. Another is that U.S. ratings agencies helped fool the world by giving triple-A ratings to their American clients, while aggressively downgrading foreign borrowers. This enabled U.S. banks to profit by offering low rates of return to foreign lenders while forcing foreign borrowers to accept high interest rates.
Indeed, it is clear that ratings were ridiculously distorted. While a big U.S. rating agency gave European companies, on average, only a triple-B rating in recent years, CDOs based on MBSs easily obtained triple A-ratings. According to the IMF, 80 percent of CDOs were in this category. And according to an NBER working paper by Efraim Benmelech and Jennifer Dlugosz, 70 percent of the CDOs received a triple-A rating even though the MBSs from which they were constructed had just a B+ rating, on average, which would have made them unmarketable.
The authors therefore called the process of constructing CDOs “alchemy,” the art of turning lead into gold.
The main problem with U.S. mortgage-based securities is that they are nonrecourse. A CDO is a claim against a chain of claims that ends at U.S. homeowners. None of the financial institutions that structure CDOs is directly liable for the repayments they promise; nor are the banks and brokers that originate the mortgages or create MBSs based on them.
Only the homeowners are liable. However, the holder of a CDO or MBS would be unable to take these homeowners to court. And even if he succeeded, homeowners could simply return their house keys, as they, too, enjoy the protection of nonrecourse.
As home prices declined and one-third of American mortgage loans went under water — that is, the property’s market value sank below the amount of the loan — 3 million American homeowners lost their homes, unable to meet their payment obligations, making the CDOs and MBSs empty shells.
The problem was exacerbated by fraudulent, or at least dubious, evaluation practices. For example, homeowners signed cash-back contracts with builders to feign a higher home value and receive bigger loans, and brokers’ fees were added to mortgages and the reported values of homes. Low-income people who could not be expected ever to repay their loans were given so-called NINJA credits: “No income, no job, no assets.” Such reckless and irresponsible behavior abounded.
The U.S. will have to reinvent its system of mortgage finance in order to escape the socialist trap into which it has fallen. A minimal reform would be to force banks to retain on their balance sheets a certain proportion of the securities that they issue. That way, they would share the pain if the securities are not serviced — and thus gain a powerful incentive to maintain tight mortgage-lending standards.
An even better solution would be to go the European way: Get rid of nonrecourse loans and develop a system of finance based on covered bonds, such as the German Pfandbrief. If a Pfandbrief is not serviced, one can take the issuing bank to court. If the bank goes bankrupt, the holder of the covered bond has a direct claim against the homeowner, who cannot escape payment by simply returning his house key. And if the homeowner goes bankrupt, the home can be sold to service the debt.
Since their creation in Prussia in 1769 under Frederick the Great, not a single Pfandbrief has defaulted. Unlike the financial junk pouring out of the U.S. in recent years, covered bonds are a security that is worthy of the name.
Hans-Werner Sinn is professor of economics and public finance, University of Munich, and president of the Ifo Institute. © 2010 Project Syndicate (www.project-syndicate.org)
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