The Mortgage Crisis: A ‘Failure of Leadership’

By Heide B. Malhotra
Heide B. Malhotra
Heide B. Malhotra
July 20, 2008 Updated: October 1, 2015

A �Public Auction� sign is posted in front of a foreclosed home for sale in Richmond, Calif. (Justin Sullivan/Getty Images)
A �Public Auction� sign is posted in front of a foreclosed home for sale in Richmond, Calif. (Justin Sullivan/Getty Images)
WASHINGTON—More regulatory action is not the answer to the ongoing subprime mortgage mess, according to industry experts and academia.

The mortgage market will rebound once market confidence returns, and when transparency and rational decision making overtake greed and speculation.

For years, many investors—even seasoned institutional investors—bought into mortgage securitization. Government-sponsored lenders such as Fanny Mae and Freddie Mac bought mortgages and packaged them into derivative instruments, with varying degrees of returns and risk profiles.

However, the formerly foolproof investments began to falter last year, as many loans went sour resulting in mounting losses for investors and businesses.

“Indeed, default rates were so low in the mortgage-based securities market that banks and other private financial institutions were eager to take a piece of the residential business,” according to a series of reports and interviews from Knowledge@ Wharton (KW) discussing weaknesses, strengths and presumed regulatory changes in the mortgage industry.

A Perfect Storm

Industry experts and academia agree that free market forces reacted to booming real estate prices and escalating interest rates. Imperfections and vulnerabilities slow surfaced, but were largely dismissed by banks and market watchers at first.

The bursting of the housing bubble began in earnest in 2006, when some loans defaulted due to increases in adjustable interest rates.

However, those warning signs became obstructed by increasingly larger dollar signs.

Credit rating agencies, responsible for assigning credit ratings to individual and packaged loans, were often the only measurement of quality available to investors. But during the height of the real estate boom some rating agencies relaxed their due diligence, and as gatekeepers of the industry, neglected their fiduciary responsibility.

Many issuers and Wall Street brokers also had cozy relationships with the rating agencies, some of the largest being Moody’s Investor Services, Fitch Ratings Ltd. and Standard & Poor’s. As a result, securities with “AAA” ratings—the highest credit rating possible—became commonplace.

“It seemed like an elegant market-based solution that served everyone. People got mortgages. Mortgage originators and Wall Street firms earned high fees. Investors got top-rated securities. Builders sold more homes, and home prices soared,” KW concluded.

“Monoline” insurers, or insurance companies that specialize in insuring bonds, gave an additional stamp of approval. But as defaults skyrocketed, some “Monoline” insurers have recently filed for bankruptcy protection.

Complex models developed by investment banks to track returns proved faulty—causing billions in write downs and losses, dismissals of CEOs, collapses of major institutions (New Century Mortgage and Bear Stearns), and massive layoffs on Wall Street.

The Blame Game

In the wake of an economic downturn and rising housing foreclosures, there is plenty of blame to go around.

Analysts believe a combination of Federal Reserve officials’ inability to assess market forces, incompetent regulators, greedy lenders and Wall Street executives, naïve homeowners, and irresponsible speculators dragged the United States into its current economic turmoil.

In the eyes of Russell Palmer, former dean of Wharton School at the University of Pennsylvania, greed was a fundamental cause of the mortgage mess.

“Wall Street, hedge funds and others [were] looking for any financial machination that they can find to hype their financial returns,” Palmer said in the KW report.

Palmer called the mortgage plight a “failure of leadership” by the so-called experts, who ignored the signs of a bubble ready to burst. Artificially inflated prices—created by hype in the mortgage industry—were obvious to financial experts, but went ignored because of high returns.

At first sight, rising interest rates leading to loan defaults were the culprit.

In addition, shoddy underwriting standards and reactive behaviors that led to lenders undercutting interest rates and eliminating down payments further expanded the real estate bubble.

“Although the growing risks were clear to people who understood the mortgage and housing markets, lenders kept lending because they could earn big up-front fees. They were not terribly concerned if homeowners defaulted later, because the loans were converted into securities that passed the risk onto investors,” explained Susan Wachter, professor of finance at Wharton, according to a KW interview.

Lessons Learned?

Wharton professors suggest that unless the underlying causes that created the subprime market crisis come out into the open, any regulatory or market effort would only provide a band-aid solution instead of a long-term recovery.

One of the reasons for the current crisis is that many parties involved simply ignored the potential risks because they could always push the losses to another party.

Borrowers, lenders and those along the line must retain an interest in the process to assure that on default, they would absorb some of the losses.

“If there is nothing on the other side about what the consequence is of these fee-driven returns, then you are going to have a race to the bottom,” Wachter said.