Wall Street banks have spent the past five years recovering from massive wounds they inflicted on themselves and the country at large. The banks bet they could build a housing doomsday machine, feed it criminally flawed mortgages, and have the story end with fat bonuses and smiles, rather than recession and grief. Now Wall Street is at it again, with bankers dusting off their doomsday machine. If they get their way, the housing market will become even more susceptible to catastrophic meltdown than it was before the 2008 crash.
During the housing boom, Wall Street banks made piles of money selling allegedly safe mortgage instruments called residential mortgage-backed securities. This business was hugely lucrative — so good, in fact, that banks poisoned the mortgages they sold their customers just to keep business flowing.
These mortgage instruments have all but disappeared over the last five years. But now JP Morgan is trying to open the spigot to these easy profits again by resuming sales of mortgage-backed bonds. The bank is also trying to rewrite the rulebook that accompanies these once-ubiquitous investments to reduce its financial liabilty if the bonds again go sour. It looks like the only lesson JP Morgan learned concerned the importance of protecting oneself from one’s own terrible decisions.
Big banks brought down the economy by pushing worthless home mortgages onto investors. They pooled mortgages together into bonds and then sold slices of the bonds to investors. These securities were supposed to be stable investments; the bonds would only sour in the event that huge chunks of mortgages across the country defaulted.
Wall Street’s thirst for easy fees meant the banks didn’t care what kind of doomed loans they stuffed into these bonds. The mortgages inside these bonds wound up being the worst loans the housing bubble produced, precisely because Wall Street never intended to keep them. Banks sold subprime trash downstream, to their customers, and got paid handsomely for the effort.
JP Morgan is trying to open the spigot to easy profits again.
In theory, bonds are important for housing finance because they let private banks compete with government-backed mortgage companies. In practice, the mortgage-bond machine allowed big banks to make enormous profits without assuming any risk. One would think the solution for driving private dollars into the mortgage market would lie in giving the banks the incentive to traffic in good loans, not bad ones. Instead, JP Morgan’s attempt to restart the mortgage-bond machine weakens the few remaining incentives for honest behavior.
When banks sell a mortgage bond, they file a booklet with regulators detailing how the bond works and what’s in it. They also assure investors that the bond’s contents meet certain quality benchmarks. They sell mortgages under warranty, and if investors discover they’ve bought bad loans, they can make their bankers buy the loans back.
These warranties were routinely made during the housing boom, but they’ve become a flashpoint since the crash. Scores of burned investors, including the federal government, have sued for false guarantees and breached warranties in bubble-era mortgage bonds. JP Morgan has bought back $6 billion worth of warrantied loans over the past four years, and the bank is in court fighting to avoid paying billions more.
The $616 million mortgage bond JP Morgan is currently shopping makes an end-run around these commonplace assurances: It wants to put a short expiration date on the guarantees investors receive. That shouldn’t be a problem in this particular case, since JP Morgan is currently shopping high-quality, fully documented loans. The danger is that JP Morgan writes new rules for residential mortgage-backed securities on Wall Street, and a system that encourages banks to pass risk to their customers loses the modicum of consumer protection it still enjoys.
A lawsuit the federal government filed against JP Morgan in late 2011 alleged the bank consistently overstated the quality of the loans it packaged into mortgage bonds; that it inflated home values to make mortgages seem safer than they were; and that JP Morgan and its brokers didn’t adhere to their own underwriting standards. Federal lawsuits against other Wall Street banks made similar claims. Post-crisis investigations have revealed that outside auditors told banks that they were handling bad mortgages, but the banks stuffed them into bonds and sold them off anyway. The banks did all this while knowing they would have to own any mortgage fraud that investors discovered. Just imagine what they’ll be tempted to pull once they let themselves off that hook.
Paul McMorrow is an associate editor at CommonWealth Magazine. His column appears regularly in the Globe.