'Toxic' MBS Were Unfairly Blamed for Crisis, an Ex-Quant Argues
17 March2015
Many believe securitized mortgages caused the 2008 crisis, but author Howard Hill argues that derivatives that amplified their performance woes should bear more of the blame.
Structures such as credit-default swaps, which essentially allowed investors to place unlimited bets on the performance of mortgage bonds without direct ties to the bonds, were the bigger problem, he wrote in his recent book, "Finance Monsters."
Hill, who helped create the collateralized mortgage obligation, criticizes those who described all securitized mortgages as toxic. He said the label exaggerated investors' panic over performance woes and led to greater runs on the market than there otherwise would have been.
Consumers often used the term without understanding it, and investors who had bet against the class through financial instruments used it manipulatively to help benefit their positions in the market, he said. Hill also said larger patterns of leverage and risk, more than lenders' loans, are what caused concerns to escalate beyond direct investments in mortgages into larger, global markets.
"A lot of the horrors that followed the meltdown weren't really predatory loans," he said in an interview, noting that while there was unprecedented underperformance the mortgage market reaction to it was much more extreme. "A lot of people don't realize how well things performed. From 2009 to 2012, the single sector that performed the best in the universe of U.S. dollar bonds were seasoned private-label [mortgage-backed securities]."
That may be true for investors who bought the bonds at a discount during that period, when new issuance was largely nonexistent or historically low. However, the bonds were "toxic" for investors who bought them at full price during their heyday, Hill acknowledged. He also does blame lenders who allowed stated income and no-documentation loans in the alt-A sector between 2005 and 2007 — and fraudulent borrowers who exploited the practice — for loan-quality problems.
"When there was misrepresentation as to the borrower's status, that makes the mortgages toxic," he said.
The concern would have been more limited if the secondary market had not leveraged mortgages as much as they did, Hill said.
"There was definitely more and layered risk being taken in the mortgage market all based on the assumption that house prices will never go down. That amplified it," Hill said.
The originate-to-securitize model was problematic in that respect and because it let every party except the end-investor off the hook for the risk, he said. However, putting the "toxic" label on mortgage securitizations kicked the panic and the losses in the market up an extra notch in his opinion. It also overlooks the fact that securitization has not been all bad, Hill said.
"Securitization itself is this great technology for bundling risk and diversifying and channeling funding," he said. Without it, mortgage rates would have been roughly 2 percentage points higher on average than they have been since the early 1970s, when securitization began, Hill said.
The book, which reads like a series of related essays on the downturn, is not only retrospective but looks at how the collapse is shaping the future of the single-family rental market and other important changes in the business.
"Many of yesterday's investor-owned houses bought for resale have appeared on the rental market and many former homeowners are now renters again," he noted in the book, comparing the looser financing standards available then for investor and homeowner properties to the tighter standards today.
Hill started in the business as a "quant," a mathematician involved in modeling structures and performance that some say overlooked new risks that developed during the downturn, notably failing to anticipate the extent of potential depreciation in home prices. His first job involved modeling CMOs as a system manager for the mortgage department at A.G. Becker, a company that subsequently merged with a French bank and then Merrill Lynch, which today is part of Bank of America.
He explains in the book why market participants generally underestimated home price depreciation potential, saying there was too much reliance on historical models. Hill also notes how the different roles and competing dog-eat-dog cultures on Wall Street distorted trading beyond what was mathematically justified. He depicts "a little help from some very savvy traders" as contributing to the market correction in 2008.
In one account, Hill describes how a trader once said to him, "I have 20 minutes before my limo gets here. Explain the CMO business to me."
"It was one of the few times I was completely speechless," he said. "I was thinking of telling her that it generally took six months to a year to teach a Wharton associate professor enough to be a useful member of my CMO team."
However, he acknowledges that this is somewhat a function of the job traders have to perform.
"Members of the Trading Tribe need the unique ability to forget what happened ten minutes ago and be completely sure right now," he wrote in the book. "That's not to say they don't know history or pay attention to details. But what they do need to do is forget the last trade as soon as it's over. If they can't, they'll second-guess themselves into a kind of paralysis."
Hill believes oversimplification that resulted in misinformation contributed to market price distortion during the downturn, and journalists were sometimes the culprits — although he gives them credit for exposing risks such as derivatives' amplification of mortgage risks as well.
"When something is inherently complicated, simplifying the explanation too much can have the same effect as intentionally misleading," he said in the book.
Hill takes writers to task for this and exposes incidents of other writers' "innumeracy" in which public perceptions based on incorrect math contributed to hysteria that depressed market prices beyond what is quantitatively justified.
He references a "Pulitzer Prize-winning financial reporter" who said she had talked to many people whose mortgages had reset from 4% to 11% in one year as one example