Banks Are Flirting With Bonds That Burned Them Before

SMITH BRAIN TRUST – Nostalgia can be a worrying thing.

That’s what Maryland Smith’s Clifford Rossi has been feeling.

He’s been watching as large U.S. banks have once again begun cozying up to the business of building and selling mortgage bonds, the very securities that helped plunge them into financial crisis a decade ago. In the past year, Goldman Sachs, Wells Fargo, JPMorgan Chase and Citigroup have relaunched or expanded the business of parcelling mortgages into securities.

“All too familiar,” he says.

The underlying collateral of the securities at this point aren’t as toxic as the ones that began to crater the financial sector in 2006 and 2007, says Rossi, Executive-in-Residence and Professor of the Practice at the University of Maryland’s Robert H. Smith School of Business. “But what I am most concerned about is this: We are just over 10 years from the crisis, and here we are in a situation where we are thinking that private-label mortgage-backed securities that are not GSE- or FHA- or VA-eligible are somehow a good investment.”

That mortgage-market alphabet soup refers to the kinds of loans that are insured by the federal government, either through GSEs (Government Sponsored Enterprises such as Fannie Mae and Freddie Mac), FHA (the Federal Housing Administration) or VA (Veterans Affairs). By insuring the loans, those entities encourage financial institutions to lend money to home buyers.

A decade ago, Rossi had a front row to the financial crisis, as Managing Director and Chief Risk Officer for Citigroup’s Consumer Lending Group. In that role, he was responsible for overseeing the risk of a global portfolio of mortgage, home equity, student loans and auto loans valued in excess of $300 billion.

He recalls how the crisis’ mortgage-backed securities entered the mainstream market, surged in popularity, and multiplied to meet a seemingly insatiable demand with riskier loans approved without proper documentation or oversight for borrowers who would ultimately default.

“What happened was that mortgage products morphed into something unlike what they started off as,” he says. “And it could happen again.”

The market for mortgage-backed bonds right now is relatively small, but it’s been growing. Last year, about $70 billion in loans ended up in private-label mortgage securities, a high not seen since 2007, according to a recent report. In pre-crisis years, the market peaked around $1 trillion.

“I am concerned,” Rossi says. “In the grand scheme of the residential mortgage-backed securitization market, $70 billlion is a drop in the bucket. But already, you’ve got non-bank originators in the marketplace putting product out there, some of the banks are buying them up and packaging them as mortgage-backed securities. And, well, here we go.”

The risks of the underlying collateral – those loans – could expand equally quickly, he says. If that happens, he says, he worries about the integrity of the loan manufacturing process – the infrastructure used to originate the mortgages, particularly by today’s non-bank institutions. What would stop non-bank institutions from cutting corners and compromising on quality if demand outstrips supply for mortgage-backed securities?

Non-bank entities don’t face the same level of regulation and oversight imposed on commercial banks and traditional savings and loans institutions, he warns.

“This is an interesting phenomenon and it reminds me of a place we were at some 15 years ago,” says Rossi. “And if we go back 15 years, I was saying the same thing.”

Banks, he says, must be “very careful” and scrutinize the nature of how the loans are being underwritten and appraised.

“If we had done those two things then, we probably would have avoided a lot of the mess that we ended up getting into,” he says.