Imagine you’re shopping for a new high-definition television. You’re looking around the store for the television with the best picture from a brand you trust. You pick the one you like, not the least expensive model but not the most expensive, either. You take it home, plug it in, and all the television can display is an image that’s been painted on. You open a panel in the bank, and where you expected to see electronics, there’s only crumpled-up newspapers. You were sold a dud, and didn’t know it until you had taken the “television” home. Furthermore, there’s no return policy.
No one should allow a company to sell a product whose components are drastically different than what’s advertised, particularly if the opportunity to evaluate the components doesn’t rise until after the product is sold. This is similar to the reason the Federal Housing Finance Agency is suing Bank of America, JP Morgan Chase, Goldman Sachs, Deutsche Bank, and other banks. The products were mortgage-backed securities. Banks sold these securities to investors as if they were low-risk investments. For a while, there wasn’t a problem. Eventually, the banks had trouble finding qualified borrowers to bundle into securities and extended loans to riskier home buyers.
Selling the mortgages as securities meant that every investment would be somewhat diversified across a wide selection of mortgages, and this diversification should have kept risk low, but the banks — and most likely the investors, as well — continued these transactions because everyone was profiting.
The banks were complicit in making the mortgages appear better by falsifying borrower income statements. Perhaps other parties were aware that the securities were riskier than advertised, but no company, not the investors nor the companies providing insurance for these investments, stepped in to bring attention to the risk. Every company was making too much money to stop and consider the downstream effects.
The FHFA is making the allegations and will file a suit in federal court within the next few days, according to the New York Times and the Wall Street Journal. The banking industry’s position is that a downturn in the economy caused the loss of value on mortgage-backed securities, not that mortgages offered to people who couldn’t afford them caused the downturn in the economy. Now the industry is concerned that a suit in which banks are required to buy back the investments would put the economy back on this ice.
For many years, the government (and the real estate industry and the banking industry) promoted home ownership in the United States. Owning a home became the new definition of the “American Dream.” Owning your own property is the only way to be free, and this philosophy stemmed from feudalism in England. Those who owned land ruled over others. It’s not quite the same in the United States; homeowners are still subject to their local governments, but the feeling of freedom that accompanies home ownership has persisted. Land ownership in feudalism was for the aristocracy, and unlike feudal times when there was little socioeconomic mobility, the promise of America meant that anyone could be a land owner — anyone could be in the upper class.
This drive to live a better life and increase social status led to the market finding ways for more people to afford to be homeowners, from the proliferation and expectation of bank-financed purchases through mortgages to creative ways for increasing supply like condominiums, home ownership without land. The business of home ownership is profitable, so there was no need to slow down. With incentives from the government and a stigma attached to renting, potential homeowners would do anything to qualify for mortgages so they could buy a home quickly rather than saving money first, and potential lenders would do anything to find more borrowers, bundle the mortgages into securities somewhat masking the risk, and sell them to investors.
Now society is paying the price. The economy crashed after the housing bubble became uncontrollable. Homeowners lost their homes. Investors in the mortgage-backed securities and the banks that sold them are jockeying for who will be held responsible. Should the banks be required to buy back the mortgage-backed securities?
Published or updated September 2, 2011.