Borrowing Short and Lending Long Poses Problem
What's more dangerous: originating a 30-year fixed-rate mortgage using short-term deposits and then holding that note in portfolio - or gathering subprime loans through a loan broker who's using a wholesaler that intends to securitize through a Wall Street firm that eventually will create a CDO and then hedge that investment using credit default swaps?
Three years ago the answer to that question would have been simple. Even folks without a Wharton MBA know that "borrowing short and lending long" is a recipe for disaster. But for 150 years savings and loans (a k a building and loans or thrifts) did just that: they borrowed short and lent long. And it worked until inflation reared its ugly head during the Carter administration and money market deposit accounts sucked savings accounts out of thrifts, which by law, were only allowed to offer 5.5% on their deposits.
Up until federal deregulation, circa 1982, federally charted S&Ls were not allowed to originate and hold ARMs, which would've given them some degree of protection against interest rate moves. But then again, having your liabilities capped at 5.5% can be problematic when all your depositors are fleeing for 12% MMDAs at Wall Street firms and banks.
Of course, the spike in MMDA yields eventually came down, as did inflation. And thrifts were de-regulated on the state level and then both state and federal thrifts were later re-regulated back into being mostly home mortgage lenders and investors. By this time the deposit-gathering playing field had been leveled along with the FRMs vs. ARMs conundrum. Also, securitization of conventional loans made assets quite liquid.
It can be argued that the post-FIRREA (Financial Institutions Reform Recovery and Enforcement Act) model worked the best. S&Ls could securitize their loans, sell them to the GSEs, or hold ARMs in portfolio. To remain profitable they would need to hedge their interest rate exposure.
Yes, borrowing short and lending long can only, eventually, lead to trouble. But let's, for argument's sake, say that a thrift or bank did just that over the past 10 years. A thrift could fund mortgage production using low-cost checking and savings accounts and then hold those loans in portfolio, making a return on the difference between the assets and liabilities. Let's face it: the yield on savings and checking accounts has been in the basement the past decade. How do I know? I have an "interest bearing" checking account with Citibank. The yield has never risen higher than 1%. (Whoopee.) Yep, 1%. Mortgage rates have averaged between 5% and 7%.
Of course, checking and savings accounts only make up a portion of a depository's liabilities. CD rates tend to be much higher but when an institution mingles its liabilities the average cost of funds can still be quite cheap, allowing for a decent interest rate profit margin.
But really, no depository wants to hold whole mortgage loans in portfolio anymore, especially fixed-rate notes that have an average life of eight years. If you fund a fixed-rate asset that could stick around for eight years with a checking account that could disappear tomorrow you're asking for trouble. Right?
So went wrong with our nation's home lending industry? It wasn't a mismatch on deposit and asset yields. We all know the chief cause of the current morass. In two words: Wall Street. The Street discovered that securitizing subprime mortgages (without doing much underwriting on them) was a brilliant idea especially since none of the parties involved - the loan brokers, wholesalers and Street firms - had any "skin in the game."
Remember that phrase: skin in the game. Going forward - as our elected officials and regulators contemplate the future of housing finance in this nation - we're going to hear more about the "originate to hold" strategy. But just how, exactly, a bank, thrift or credit union can do this successfully without borrowing short and lending long will be crucial. At the very least, whether we're talking about a conventional or nonprime loan, the first step is to thoroughly underwrite the mortgage - and the borrower. Get out of your office and kick the tires. Just like George Bailey used to. The days of Wall Street firms securitizing stated-income lending are over. Good riddance.
Paul Muolo is executive editor of both National Mortgage News and Mortgage Servicing News.