The Brief: Law School News and Events

Misuse of Mortgage-Backed Securities Brought Economy Down, Panelists Say

As Congress deliberated over a $700 billion bailout package for Wall Street, Penn Law and Wharton professors analyzed the causes of the financial crisis, government responses and solutions at a “teach-in” last October.

Fannie Mae and Freddie Mac did not cause the housing market crisis but they contributed to it by buying Alt-A loans, said Wharton Professor Susan Wachter. Fannie and Freddie lost 40 percent of their value by purchasing Alt-A loans, which are considered less risky than subprime loans because the borrowers are generally in better financial shape. Their losses, however, did not constitute the majority of the losses in the Alt-A market, said Wachter, a subprime mortgage expert.

Bad loans, which had been bundled into pools and sold off to investors through mortgage-backed securities, caused the housing market crisis to cascade into a global financial crisis, said Penn Law professor Jill Fisch, who co-directs the Institute for Law and Economics.

Mortgage-backed securities as a concept make a lot of sense, said Fisch, because they free up capital and allow investors to enter the mortgage debt market without having to hold the mortgages themselves. The problem started when parties began issuing securities based on mortgages that deviated from the norm: 30-year fixed rate loans under $417,000 to creditworthy borrowers. Investors who bought these mortgage-backed securities insured their debts by buying credit default swaps from counterparties who had invested billions in collateralized debt obligations also based on subprime mortgage-backed securities. When these fell in value, counterparties could not sell them to pay the investors. As a result, credit markets dried up because “all of a sudden people couldn’t trust the financial system,” said Fisch. Wharton Professor Richard Herring agreed with Fisch that securitization is one of the most useful innovations in finance, but he said that it was carried too far.

Policy interventions after the failure of Bear Stearns, he said, have appeared increasingly ad hoc and desperate, and the markets have reacted sharply to the uncertainty. The decision to bailout Bear Stearns and not Lehman Brothers was a mistake because it was “in every way more connected, larger and more likely to be a systemic problem,” and the miscalculation is evident in the “huge outflows from institutional money market mutual funds that are thought to be the next safest thing to treasury bills,” said Herring.

In the future, he predicted, the economy will see a return to a “simpler style of securitization which is essential for the system to go forward.”

David Skeel, a bankruptcy expert at Penn Law, noted that the two most striking things about the financial crisis are that significant legislative intervention has taken a long time and that the legislation doesn’t include significant regulatory reform. The Bear Stearns bailout, he said, caused a delay in reform, because historically reforms have only come about after major banks were allowed to collapse. It’s wrong to assume that our bankruptcy process can’t handle investment bank failures like Bear Stearns, said Skeel, who pointed to the Chapter 11 filing of Lehman as an example.