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Risk layering, oil and mortgages

By Holden Lewis ·
Monday, June 7, 2010
Posted: 12 pm ET

The mortgage meltdown and the oil disaster in the Gulf of Mexico have something in common: risk layering.

It's a self-explanatory concept: When you pile risk on top of risk, that's risk layering. Driving drunk is a risk. Speeding is a risk. Running red lights is a risk. Driving without a seat belt is a risk. Do some or all of those in combination, and the risk skyrockets.

My local newspaper carried a New York Times article yesterday that recounted the risk layering on the Deepwater Horizon. It was drilling in water a mile deep; more than 98 percent of rigs in the gulf are drilling in water that's 1,000 feet deep or less. The Deepwater Horizon project got an exemption from a rigorous environmental review, it used risky pipes and casings that deviated from BP's design and safety policies, it tested the blowout preventer at a lower pressure than was federally required, and the testing of the blowout preventer was delayed.

Risk was piled upon risk upon risk. Regulators condoned the risk layering and deferred to the private-sector geniuses who ultimately set the disaster in motion. Something similar happened in the mortgage business from 2002 to 2007.

With mortgages, it's risky to lend to borrowers who:

  • Are encouraged to lie about their incomes.
  • Don't make down payments.
  • Pay only interest and not principal.
  • Have trouble paying bills and thus have low credit scores.
  • Naively trust brokers and loan officers.
  • Borrow more than their houses are worth.
  • Do serial cash-out refinances to buy cars and boats and vacations.

Lenders layered the above risks with abandon. On top of that, risky loans were securitized, giving each party an incentive to pass problem loans on to the next guy.

Anyone could foresee the problems of risk layering. It was one of the most talked-about subjects at a daylong hearing about the mortgage industry that the Federal Trade Commission held in May 2006.

One of the speakers at the FTC hearing was Robert McKew, who was then senior vice president and general counsel for the American Financial Services Association.

Speaking nine months before the beginning of the subprime meltdown, McKew said: "I think as we sit here today, that the mortgage industry, the mortgage lending markets are probably in the best shape insofar as the government regulators, the industry participants, including the secondary market, and consumers basically all have their interests in alignment."

That mixture of optimism and incoherence is revealing, eh?

McKew added: "The emergence of the secondary market over the past 10, 15, 20 years is actually probably a more real-time implicit regulator of the industry as far as making sure that the right things are happening. If loans are being designed that are … inevitably going to fail or obviously are not going to have a good survivability rate, there will be no buyers for those loans in the secondary market. The secondary market acts as an effective regulator in addition to government regulation."

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1 Comment
Robert McKew
August 05, 2010 at 12:29 pm

As we look in the rear view mirror at the mortgage market snafu, it is clear that even those of us who were thought to be in the best position to know what was really going on, actually did not have a clue. And yes, that includes me.
We got caught up in the mania. We thought we were seeing something new and revolutionary---“mortgages for everybody!” and housing prices are going to infinity! In retrospect, yes, I was beyond naive about the situation. Everyone that I knew in the industry at the time believed what I did--that most of what was going on in the mortgage market between 2000-2006 was sustainable (we thought) and a positive thing overall (many of us were skeptical about option-ARMs and IO (interest-only) loans--for me, personally, the emergence of those produces signaled the beginning of the end, and I soon started looking for other work. I couldn’t defend these products).
Ultimately, we were wrong about just about everything. What most of us who were speaking for the retail side of the industry did not realize is that we really had NO IDEA what Wall Street was doing to leverage up the market to the absurd extreme that it did. Alan Greenspan knew or should have known--but now we are finding out that even he didn't know the extent to which the whole system had pyramided beyond all recognition.
If I knew then what I know now about what was really going on in terms of the hyper-leveraging of the mortgage market, I certainly would not have been as sanguine as I appeared to have been at that 2006 FTC Conference. I did believe at the time that Wall Street (the "secondary market") was allocating capital efficiently, and that it would scale back when it became clear that the retail market was getting ahead of itself. (Yes, this was thought to be a rational economic theory at the time).
Man, I was wrong! I had no idea that I was speaking for an industry that had become structurally and mechanically incomprehensible. Unwittingly, I had become a character in a modern day version of the old story concerning "The Blind Men and the Elephant". I could vouch for the part of the elephant that I was evaluating, but barely had a clue that other parts of which were only faintly aware to me would ultimately kill the elephant.
Like many others who were speaking on behalf of the industry at the time, I believed what I was talking about. I thought that I understood the industry, and, in fact, I did understand the origination side of the business. At the FTC conference, I expounded on something that I had come to believe—that the secondary market was effectively acting as a second regulator for the industry. Theoretically, it makes sense. In reality, as it turned out, nothing could hardly have been further from the truth.