Unreliable Securities

There was a time when stocks were risky and collateral securities were safe. That time is over and the collapse of the United States mortgage securitization market clearly has demonstrated this.

For years, hundreds of billions of new Mortgage-Backed Securities (MBS) and the ones from Collateralized Debt Obligations (CDOs) were sold all over the world to compensate for the lack of savings in the U.S. and to finance American real estate investment. Now, almost the entire market that issues those securities — all but 3 percent of the original market volume — has completely disappeared.

To compensate for the disappearance of the market and the simultaneous vanishing of bank loans without warranties to U.S. real estate owners, 95 percent of the mortgages in the U.S. are now channeled through state institutions like Fannie Mae, Freddie Mac and Ginnie Mae. Just as there was a time when CDOs were safe, there was also a time when economies with too much state intervention were called socialist.

Most of these private securities were sold to oil-exporting countries and to Europe, particularly Germany, the UK, Benelux countries, Switzerland and Ireland. China and Japan refrained from buying those securities.

As a result, European banks were penalized by the massive depreciation of those toxic U.S. securities. According to the International Monetary Fund (IMF), more than 50 percent of equity capital held by the national banks of Western Europe before the global crisis — $1.6 trillion — will have disappeared by the end of 2010, with the lion’s share of losses coming from the U.S. Thus, the transfer of resources from Europe to the U.S. is similar in size to the total U.S. spending on wars in Iraq and Afghanistan ($750 and $300 billion, respectively).

Americans are now calling it “caveat emptor” (Latin for “let the buyer beware”): Europeans should have known these kinds of risks when buying these securities. But even CDOs with AAA ratings assigned by North American credit-rating agencies, which considered them as safe as government bonds, are now worth only a third of their nominal value. The Europeans trusted a system that was not worth being trusted.

Two years ago, Ben Bernanke, chairman of the Federal Reserve, argued that foreigners were buying U.S. securities, because they trusted the U.S. system of financial supervision and wanted to participate in its dynamic economy. We now know that this was only propaganda with the objective to keep capital flowing, which allowed American families to continue to finance their lifestyles. The propaganda worked well. Even in 2008, the U.S. was able to attract net capital inflows worth $808 billion. Preliminary statistics show that this number is now down to half.

For years, the U.S. had at its disposal the so-called return privilege. The U.S. received a rate of return on its foreign assets that was twice as high as the rate it paid foreigners on U.S. assets. One hypothesis is that this reflected the fact that U.S. investment bankers made better choices. Another is that American “rating” agencies contributed to deluding the world by assigning triple-A ratings to their American clients, while progressively lowering “ratings” of foreign loan borrowers. This allowed U.S. banks to benefit by offering low rates of return to foreign credit-granting entities, while forcing loan borrowers to accept higher interest rates.

In fact, it is clear that the “ratings” were absurdly distorted. Although a big North American credit-rating agency gave, on average, only triple-B ratings to European agencies over the past few years, the MBS-based CDOs easily had triple A-ratings. According to the IMF, 80 percent of the CDOs were in that category. And, according to a National Bureau of Economic Research work document by Efraim Benmelech and Jennifer Dlugosz, 70 percent of the CDOs received “AAA” ratings even if the MBS from which they were created had only a medium “rating” of “B+,” which would have made them unmarketable. Thus, the authors of this document called this process of creating CDOs “alchemy,” the art of transforming lead into gold.

The main problem is that the securities endorsed to mortgage credits are non-recourse. A CDO is a claim against a chain of claims where the last link is the North American real-estate owner. None of the financial institutions that structure those CDOs is directly responsible for the reimbursements they promise, nor are the banks or intermediaries that create mortgages and the MBS based on those same mortgages.

Only the homeowners are responsible. At the same time, the owner of a CDO or an MBS would not be able to take these owners to court. And even if he could, the homeowners would simply return their house keys once they benefited from the protection of non-recourse. Once the house prices dropped, and a third of mortgage loans in the U.S. were flushed down the toilet — meaning that the market value of the houses fell to below the amount of the loan — three million real estate owners lost their new houses when they failed to pay the benefits, turning the CDO and MBS into empty shells.

The problem was aggravated by fraudulent practices of evaluation — or at least doubtful ones. For example, many of the real estate owners signed contracts with constructors to pretend that their house values were higher, thus receiving higher loans, and brokers’ fees were added to the mortgages and to the declared house value. People with low incomes, who couldn’t expect to be able to completely amortize their loans, received the so-called NINJA assets (“No income, no job, no assets”). These imprudent and irresponsible behaviors were common practice.

The U.S. will have to reinvent their financial mortgage system in order to escape the socialist threat they fell into. One elemental reform would be to force banks to retain in their balances a certain proportion of the securities that they issue. This way, they would take part of the losses if the securities weren’t honored — and, once again, that would constitute a powerful incentive to maintain rigorous patterns of mortgage lending.

An even better solution would be to adopt the European method: Get rid of non-recourse loans and develop a financial system based on assured obligations, like the German “Pfandbrief.” If a “Pfandbrief” is not honored, it is possible to take the issuing bank to court. And if the bank goes bankrupt, the owner of the assured obligation can claim his money directly to the owner of the house, who cannot escape the payment by simply returning his house keys. And if the homeowner goes bankrupt, the same home can be sold to pay the debt.

Since its creation in Prussia in 1769 during the rein of Frederic the Great, not one “Pfandbrief” has defaulted. Unlike all the financial garbage from the U.S. in the last years, assured obligations offer a security worthy of its name.

Hans-Werner Sinn is a professor of Economy and Public Finance at the University of Munich and president of the Ifo Institute.