How Retirees Teamed With Banks To Cause the Mortgage Crack-Up

High risk mortgages that should never have been made fueled the decade-long real estate bubble that eventually burst in 2006 and 2007, beginning the 2007-2009 recession. These high risk mortgages were made for three reasons: originators made money regardless of the outcome of the mortgages, the models used by the banks suggested that risky mortgages were more profitable than safe ones, and pension funds needed high risk, high return investments that were rated as relatively safe to keep up with rising life expectancy and low funding formulas. We have only addressed one of these causes, so we are at risk of another similar meltdown if we do not change course.

Mortgage originators contributed to the problem because they make their entire profit upon the closing of a mortgage. Thus, they have no skin in the game and no reason to care if the borrower can repay the loan. All their incentives are to find a way to qualify every borrower they can even if they suspect the borrower is borrowing more than he should or committing outright fraud.

Banks contributed due to a serious error in their risk management models. Essentially, after banks were forced by the government to enter the business of subprime loans (thanks to the Community Reinvestment Act), the banks discovered that the business was wildly profitable. For example, a low-risk, prime loan might carry an interest rate of 4 percent and have a 99 percent chance of repayment. That means the expected return on the loan is 3.96 percent (0.99 x 0.04). Risky subprime loans, in contrast, might carry an interest rate of 7 percent and were thought to have a 96 percent chance of repayment.

Thus, according to the banks' models, the risky loans were expected to earn them 6.72 percent, a much higher figure than the return on the safer loans. The banks thought the non-payment rate on these riskier loans was considerably higher than on safe loans, but that the losses would be manageable. The most mistaken assumption in the banks' model was that banks would recover all or most of their money if forced to foreclose on houses on which they were making these risky loans because they did not factor in much of a probability of home prices declining.

These risky and intemperate behaviors by the banks and mortgage originators were aided by an indispensible ally: pension funds. Pension funds, particularly public pension funds, arrange to make low annual contributions look acceptable by predicting high future returns on their investments. The most common return assumption according to the National Association of State Retirement Administrators is 8 percent per year with 40 percent of plans assuming 8 percent or higher and 63 percent of plans assuming they will earn an average of 7.5 percent or more.

While the 25 year historical average return for public pension funds has been 8.6 percent, the average over the past 10 years is only 7.1 percent. Private funds are governed by different rules that mean they assume future returns of closer to 4 percent. The difference is non-trivial. According to the future returns assumed by the public pension fund managers, the funds are 73 percent funded. If the assumptions which private funds are forced to use were required of public funds, the public pension funds are only 39 percent funded.

Public pension funds make high future return assumptions because otherwise they need their government or government employees to make larger pension contributions, and neither one wants to do that. Yet as people live longer and longer, pension funds face larger and larger future payouts to the average retiree. The easy solution is to assume a high future investment return to keep the required contributions nice and low. It is this need to maintain high returns that sent pension fund managers searching for higher yielding investments that were still rated as safe enough to be eligible to be placed in their portfolios. They found collateralized debt obligations (CDOs), mainly mortgage backed securities.

As reported as early as June 2007 by David Evans of Bloomberg, public pension funds were heavy buyers of the riskiest tranches of many CDOs. They did this with a small portion of their assets in hopes of boosting their overall average return. We all know now that the story did not turn out the way the asset managers hoped and instead the fund managers lost money and were left with a steeper hill to climb than before.

Still, the lesson to learn here is that the lengthening life spans of pension recipients combined with political pressure to keep the burdens on government budgets low led pension fund managers to search for higher returns. Banks were happy to provide such investments in the form of CDOs. The demand for these high risk investments by pension funds encouraged bankers, with the help of mortgage originators, to increase the supply of such securities. This in turn made it easier for borrowers with poor credit or no financial documentation to secure mortgages. After all, why reject a prospective borrower when a certain buyer is waiting for such a product?

The steps to avoiding a repeat of the last recession seem obvious. All pension funds, not just private ones, should have to meet the same standards for assuming future investment returns. Future and current retirees should band together with taxpayers to ensure their funds are well-managed, thus avoiding future tax increases, benefit reductions, or both. Mortgage originators should get paid annually based on whether each borrower is still current on his loan, not receive full payment at closing.

A little courage could greatly reduce the risk of repeating the financial meltdown of 2008. Without it, we should expect the growing elderly population to feed more risky investment schemes leading to more financial crises when some risky investments inevitably suffer losses. The choice is to be fiscally realistic or to experience a continuing cycle of bubbles and busts.

These changes are not complicated. They require some sacrifice by taxpayers and public employees who will each have to pay more to fund their retirements if lower returns are assumed on pension fund investments. A price would be paid, but the gains in retirement security would be significant. In a time when more and more retirees are seeing their benefits reduced, such changes are becoming rapidly more political possible.