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.
"The reporter can only report what she was told, but it's pretty clear that someone (or a number of people) didn't do the math," Hill said. "While it's true that subprime mortgages often did have lower fixed rates for the first two years, the lowest rates I heard of were around 7%, and the rate resets were capped at 2% or 3% on the first reset. That would mean that some people had their rates reset from 7% to 10%, not 4% to 11%."
While parts of the book repeat some instructional text Hill has written, it also contains many Wall Street and investors' "insider" anecdotes and gossip about that market culture and how it affected his personal and professional life that keep the read moving.
In a succession of early Wall Street interviews, Hill recounts how one of the people interviewing asked him to complete the following sentence for his would-be bosses, as if reflecting a year later: "It's too bad about Howard. He would have worked out, except....'
"After a pause, the answer came to me: '...except he was hit by a bus,'" Hill recounts in the book.
Hill, today an investor on his own behalf, candidly recounts how working long hours in a competitive environment on the sell-side took its toll on him and his marriage, and how he found some relief working on the buy side. He alternately critiques and sympathizes with both sides of the business in the lead-up to the downturn, depicting the sell-siders as short-sighted and cannibalistic but fiercely dedicated to their work, and the buy-siders as forced to buy deals without proper due diligence because the alternative was to be locked out of them entirely.
Ultimately, Hill concludes, securitizations such as pass-throughs and CMOs have their uses and should survive, but there are some related derivatives that shouldn't because of their destructive potential. Instruments such as credit-default swaps, for example, can endanger the financial system if they allow for potential bets on bonds that are decoupled from the bonds themselves and unlimited, potentially creating huge and unbalanced exposures that are hidden. These were what created the "finance monsters" of the downturn, he said.
"The finance monsters were the people who profited from creating all that risk and profited from putting it on anybody but themselves," Hill said.
But even CDS may have their uses if their risk is transparent, he said.
"Even the potentially destructive things like credit-default swaps, as long as all their positions and all their exposures are out in the open so everyone can see — and they are properly capitalized — are viable in certain circumstances," he said.
Investors need immediate access to detailed credit data to properly analyze and quantify their risk, not only in terms of an asset class as was the case with CDS that referenced certain vintages and tranches of subprime mortgage securities, but in terms of the individual companies involved in creating the loans and packaging them into securities, he said.
"I think it has to go down to an individual credit name on as close to a real-time basis as possible," said Hill.
