Mortgage Fraud
Risky Subprime Market

Subprime Loans Send Ripples Through Financial World

PBS News Hour with Jim Lehrer
April 30, 2008

The volatility of the financial markets this summer has stemmed from weaknesses within the mortgage industry and other risky loan operations.

Economics correspondent Paul Solman explains what is behind the subprime market and how it has impacted the financial world.

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Interview:

Paul Solman: With so much in the news about the subprime mortgage crisis, foreclosures and even threats to the global financial system, people are asking one simple question, among many: How could so much money the world over have financed such seemingly lousy loans?

There are lots of reasons, of course. But the one we'll focus on, with the help of some low-rent toys from around the house, is a technique without which the globalization of the subprime housing boom would probably have been impossible.

It's called securitization. We'll explain it in a bit, but first a reminder of how home lending used to work.

A buyer bought a house by putting down maybe 20 percent of the price, borrowing the rest of the money from a bank, which had taken in the money as deposits mainly from people in the local area.

The bank took a cut by charging the borrower a little more in interest than it paid the depositors. This is the system whose virtues Jimmy Stewart so classically extolled to his Bedford Falls bank depositors in It's a Wonderful Life movie.

JIMMY STEWART, Actor: Your money is in Joe's house. That's right next to yours, and in the Kennedy house and Mrs. Macklin's house and a hundred others. You're lending them the money to build, and then they're going to pay it back to you as best they can.

PAUL SOLMAN: With Stewart's bank in between.

ACTRESS: How much do you need?

PAUL SOLMAN: That's pretty much how it was right up through the savings and loan crisis of the late '80s, the last time we used Jimmy Stewart on the NewsHour to explain the way banking used to be.

So what was new this time around? Well, with the end of communism, the globalization of China, India, and the like, continuing prosperity in the U.S. and Europe, there was way more wealth in the world to be invested.

Why not lend some of it for mortgages in the United States, where housing is the collateral, continually rising in price, and the interest rates are pretty high? But you don't do that through Jimmy Stewart's bank.

Instead of banks like the Bailey Building and Loan, the main way to get money from lenders to borrowers has become securitization. To help us explain it, Wellesley economist Karl Case.

Securitization, what's that?

KARL CASE, Professor of Economics, Wellesley College: It used to be that when you signed a mortgage and borrowed money, the bank put the paper in its vault and held it.

Now, almost all mortgages are sold in the secondary market. Wall Street firms package these mortgages up and then issue what are called mortgage-backed securities against them.

Other countries assume risk

PAUL SOLMAN: So if I'm a conservative investor, I take a low rate of return, but I'm the last guy standing after all these foreclosures and defaults?

KARL CASE: That's exactly right. So there are layers of risk being passed all around, presumably to people who want to take that risk in exchange for a higher return.

PAUL SOLMAN: But what risk? It was a virtuous circle, ever rising prices, ever more home buyers, ever more investors, from U.S. hedge funds and European banks, says Case, to...

KARL CASE: ... the Chinese, and the Russians, and people from all over the world.

PAUL SOLMAN: But why would the Chinese, say, invest in something as risky as a subprime American mortgage?

KARL CASE: Well, we didn't perceive it to be so risky a few years ago. Right? In a rising housing market, there are no losses on these things. You get the impression from looking at the performance over the last 10 years that you're getting a good return for a level of risk that's quite low.

PAUL SOLMAN: Indeed, hardly anyone appeared to think this stuff risky. Consider the hype on cable TV, where one could watch folks flip this house on A&E, flip that house on the Learning Channel, buy and sell on House and Garden TV. Even PBS got into the act with pledge specials around the country featuring financial gurus like Robert Kiyosaki, here on his own Web site pushing real estate investment where you don't even live in the home you're buying.

COMMERCIAL NARRATOR: "Homeowners, want to refinance and get cash?"

PAUL SOLMAN: Meanwhile, the explosion of mortgage-backed securities made home buying and refinancing more affordable for everyone, including unsophisticated first-time buyers, easy prey for brokers who'd often lend them more than the house was worth, with little or no down payment and low so-called teaser rates for two years that would then readjust dramatically upward, the monthly payments ballooning.

The brokers would slip in all sorts of fees, then sell the mortgages, more and more of them subprime, to Wall Street to securitize.

Now, the teaser rates have expired, mortgage payments are ballooning, and homeowners across the country are being squeezed, their houses snatched away from them. Many of the brokers, meanwhile, have taken the money and, in some cases, run.

Is this securitization's fault, though? Doesn't it just transfer risk to those willing to take it?

KARL CASE: Well, there's nothing wrong with securitization. It's a good tool, and it's been used for a long time. What's different now is the subprime end of the mortgage market is being tested by a down housing market and the fact that we extended a lot more credit than we probably should have.

More risk for more payoff

PAUL SOLMAN: When Wall Street securitized, repackaging the mortgages and selling them to investors the world over, that was unregulated, too. So what's new is the global, unregulated market for U.S. mortgages, made feasible by securitization.

What's old is the end of the virtuous circle, the inevitable unwinding, because markets are built on trust. It's often been said that the word credit comes from the "credere," "to believe." When belief collapses, investors panic and global markets can spin out of control.

ACTOR: Better to get half than nothing.

JIMMY STEWART: Randall, now, wait a minute, wait. Now listen, now listen to me. I beg of you not to do this thing.

PAUL SOLMAN: Bank runs were the fear in Frank Capra's 1946 world, which still remembered the Great Depression and FDR's declaration of a bank holiday.

Today, the fear is of runs on markets, as we've seen recently, which reminds some of perhaps the most durable rule of finance: For every extra bit of reward you get, you take that much more risk.

KARL CASE: It is true that the more risk you took, the harder you're going to get hit this time around. So it's the higher you fly, the further you fall.

PAUL SOLMAN: With investors here and abroad buying mortgage-backed securities and thus providing the financing for iffy U.S. mortgages, the flying was high.

The fall? Well, the U.S. housing boom has certainly been turned on its head. Mortgages harder to come by, lenders suddenly less willing to take risks.

That's why there's talk of a credit crunch, much less money available to be borrowed, except at high interest rates, for anything.

That could lead to slower economic growth, even a recession, which is why the Fed has been pushing money into the economy to prop up the housing market and to prevent a situation which could be messy for us all.

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