“It’s become a freelance business, in essence—that’s what it is.”

The U.S. housing market suffers from multiple personality nondisorder. The 2008 housing crisis was largely caused by the proliferation of mortgage backed securities (MBS) This crisis exposed the existence and inherent clashes between several of these personalities. MBS were created, as many alternate personalities are, as a response to a major trauma: The Great Depression. The U.S. government created these assets through a government-sponsored entity (GSE) known as Fannie Mae. By buying loans from loan originators, Fannie Mae was able to stimulate the market for mortgages by increasing the overall liquidity and size of the lending market. A larger mortgage market was beneficial for many of the economy’s different personalities: buyers had more money to purchase new homes, lenders could sell their newly created loans to GSE, and investors could buy the new GSE created MBS. GSE only purchased and bundled low-risk, fixed-rate loans where the homebuyers were unlikely to default or foreclose because the GSEs retained some of the risk underlying the loans they bundled. Under this system, GSE, buyers, and loan originators all held a united interest in producing as many responsible loans as possible.

(Excuse the bluntness, but I think you are incorrect in your historical interpretation. The FHA, Fannie, and Freddie were created as a response to the Great Depression. Surely this is where the story should begin, rather than after the WWII, no?)

In the 70’s, the united interest of these multiple personalities began to disintegrate when private entities began bundling MBS. This shadow banking system, made up of private MBS creators, lacked the regulation of the GSE. They were able to create assets without the mandated risk retention of the GSE. This created a situation where the interests of the buyers, a large home lending market for high quality, low-risk loans, became decoupled from the desires of loan originators, investors, and the financial sector, to create, bundle, and sell high-quantity loans regardless of quality. Because private MBS creators were willing to buy subprime mortgages, a category of loan GSE wouldn’t touch, loan originators were willing to make more subprime mortgages with the knowledge that the risk could soon be spread to a private MBS creator. This caffeinated investing created short-term benefits for the economies many personalities (buyers, loan originators, investors, and even the government) but set the stage for the 2008 crash when the decoupled interests of these personalities came to the fore.

“Complexity so intricate no one can fathom it. Large things within small things, small things within large things—things encompassing things which would seem to be beyond them. Chaos.”

The moment when the economy’s personalities were forced to face each other was delayed by the increasing distance and complexity of the relationship. Private MBS were split apart and formed into collateralized debt obligations (CDO). A subsidiary insurance market began to develop in the form of credit default swaps (CDS). These CDS were themselves bundled to create synthetic CDO. MBS, created as a tool to improve responsible lending to new homeowners, morphed into a system that hurt homeowners. The housing market continued to grow by constantly developing new coping mechanisms in the form of more intricate assets and investment tools. These complex instruments created the illusion of a great distance between the divergent personalities of the housing market for a time but when the defaults and foreclosures of regular buyers led to the meltdown of financial institutions the true interconnectivity of the system was on display.

Kathryn Judge, an Associate Professor at Columbia, refers to these intertwining levels of ownership as “fragmentation nodes.” Judge argues that as each the number of stakeholders increases, information is lost at each node, and the distance between parties increases further limiting communication. This information loss combined with the relatively small stake each holder holds in any one asset is part of what allowed the market to bubble without notice.

“Federal troops. The eighty-second airborne. The paratroopers. On every corner. And camps. Work camps. Put them all in work camps…But wouldn’t the presence of federal troops depreciate property values?”

Much like a lawyer drinking heavily to avoid acknowledging a midlife crisis, the government avoided a total collapse with an immediate, aggressive bailout. TARP, Dodd-Frank, and other immediate legislative responses saved most, but not all, of the financial institutions who were the final recipients of the risk of MBS transactions. These regulations prevented a total crisis, but did nothing to reduce the systemic complexity and distance that created the environment where the mortgage market forgot its founding purpose of supporting a healthy housing market. The government’s response did succeed in the short-term in keeping the entire economic system afloat, but without addressing and acknowledging the dissonance between the market’s personalities the recovery did not address the long-term, systemic conflict that remains.

“That precise point when consciousness is heightened and everything glows.”

The U.S. housing market inherently has multiple personalities. Punishing investors by banning MBS entirely would be equally harmful to buyers as the pool of loans would shrink. Likewise, leaving investors unfettered to create new securities could create another crisis. Like anybody dealing with multiple personality nondisorder, the key to staying in control is ensuring all personalities have room to exist, none become too dominant, and all are satisfied in their own way. By regulating all MBS creators in the manner BSE are regulated the many personalities of the housing market would face the same risks and have the same goals. Investors would be able to purchase MBS with confidence knowing they are composed of quality loans, MBS creators would face more risk and their market would shrink (sorry guys, we all have parts of our personality that we try to suppress), loan originators would have both a securitization market to sell their loans in as well as buyers willing to create mortgages, and buyers who are unlikely to default would be able to receive loans and become homeowners—a sip of espresso here, a sip of wine there, and some Volvic at the end for good measure.

Lawrence Joseph's Lawyerland
Judge, Kathryn, Fragmentation Nodes: A Study in Financial Innovation, Complexity and Systemic Risk (January 24, 2012). Stanford Law Review, Forthcoming; Columbia Law and Economics Working Paper No. 406. Available at SSRN: http://ssrn.com/abstract=1894105
Background information drawn from conversations with Prof. Thomas Merrill