Home mortgages and sub-prime crisis: some technical notes

Here is a graphical representation of the home mortgage system which has generated the sub-prime crisis. It is a free re-elaboration of a diagram circulated by Fred Moseley at the recent Historical Materialism conference in London on Nov 9-11.

homemortgages.jpg

Few observations. First, the main difference between the traditional mortgage system and the new one that came into place in the last 15 years of “financial innovation” in the US, is the complicated web of linkages away from the mortgage issuing bank. In the “old days”, mortgages were a simple affair between home buyers and banks. Banks had an incentive to minimise the risk of default and — possibly in certain conditions and to a limited degree– to re-negotiate mortgage terms if there was a risk of default. The mortgage deal was exhausted in the relation illustrated in the upper part of the diagram. The novel aspect of the mortgage market is the banks’ off loading of risk to the market through securitization, i.e. the repackaging of these mortgages (i.e. home buyers promises to pay back the loan with interests) into securities that combine a wide range of risks, securities that in turn were sold off to hedge funds, pension funds, and back to commercial banks themselves). This practice allowed to increase exposure hence prospect profit. Reports on Banks and mortgage agencies point out many fraudulent and “dodgy” practices to hook poor and middle class borrowers into a mortgage deals. But it would be a mistake to focus on these as the main cause of the crisis. The push to sell mortgages was also met by eager mortgage takers who, in condition of declining real wages and the prospect of house price increases, saw the possibility to capitalise on a booming house markets. But, as in a typical “Minsky moment” the boom turned into bust, mortgages foreclosures started to pile, commercial and investment banks run out of liquidity and faced huge losses.

Second, as it is becoming increasingly obvious, the crash and current crisis reveal that if it was true that “risk” was distributed to the market, it is also true that nobody knows exactly where “it” went. For example Paul Krugman makes the point that “Citigroup wasn’t supposed to have tens of billions of dollars in subprime exposure; it did. Florida’s Local Government Investment Pool, which acts as a bank for the state’s school districts, was supposed to be risk-free; it wasn’t (and now schools don’t have the money to pay teachers).” On the other hand, this “really undermined trust” . . .”the fact that nobody knows where the financial toxic waste is buried.” Trust is the crucial glue that makes daily business run. I am not sure to what extent this issue is something that government regulators could deal with . . .we will see.

Third, what is interesting is the system of incentives that different agents had in their attempt to maximise profit. First, mortgage lenders — or at least their agents — were interested in maximising the number of mortgage deals closed, as they received a fee for each deal closed, and therefore were not too much interested in minimising the risk of default involved. On the other hand, the rating agencies such as Goldman Sachs that were supposed to rate the securities mixing different types of mortgages, had an interest to rate securities high. Why? Because rating agencies have competitors, and if they fail too often to please their clients with good rating, these would go to ask their competitor’s rating agencies to rate their securities.

Now, this is a simple sketch of some of the issues at hand. The broad questions that interests me is this: what is the political meaning of all this? What is the role of the “working class” in all this? Prima facie a lot, actually, and not only in terms of “impact” . It is a role that takes us back in time to 1979, and in space to China, Africa and the Middle East. To 1979, because since the rise of interest rates by Fed chair Paul Volker back then — precipitating the global recession that ushered us into the neoliberal era –the American working class is the object of continuous restructuring that requires both stick and carrots, means of repression and cooption. And the latest of the carrots to compensate for declining real wages (See latest Bureau of Labour Statistics, and an earlier NYT commentary was the opportunity to catch a lift up on the wave of a house price boom through the “financial innovations” such as the ones that allowed the expansion of sub-prime mortgages. A boom that has by now turned into bust (to be continued).

Leave a Reply

You must be logged in to post a comment.