The Pope and Ben Bernanke

The Pope and Ben Bernanke, the U.S. Federal Reserve Chairman, both rely on a higher force to motivate millions. The Pope relies on faith in the Resurrection, while poor Ben depends on the credibility of the bond market.

The latter, ultimately, rests on the integrity of investment banks and bond rating agencies — and those have proven faulty.

Back in the days of usury laws and regulated interest rates for savings accounts, the business of issuing mortgages was fairly straightforward. You went to a savings and loan, it checked your credit, purchased an independent appraisal — and gave you the money.

Either the bank held the note, or sold it to Fannie Mae or perhaps an insurance company. The bank serviced the loan — it collected the payments, administered the escrow account and foreclosed if things turned sour.

The bank loan officer, for his part, had a strong incentive to be certain that the loan application was accurate. If not, it would come back to him.

Today, loans go through complicated chains. Many more do not qualify to be sold to Fannie Mae, and many never pass through the granite confines of a community bank.

Often, an agent hanging around the real estate office takes an application, and forwards it to a mortgage company, who may or may not be his employer. The mortgage company processes the loan, and sells it to an investment bank, or similar entity, that bundles mortgages into bonds.

The investment bank sells those securities to hedge funds, pension funds, mutual funds and other investors. As mortgages vary significantly in quality, mortgage-backed bonds are rated by Standard and Poor and other rating agencies.

At each step along the way, information can be lost and temptations build up to understate the risk of default. The agent gets a big fee for writing the loan only if it is approved, so he puts the prospective homeowner in the best possible light — and finds an appraiser who aggressively values homes.

Mortgage companies get their cut from origination fees and are able to push off the risk of default onto the ultimate purchasers of the bonds. Hence, they are inclined to be lenient with agents.

Investment banks earn money on the spread between the interest rate charged borrowers and the interest rate on the bonds. The less risky bundles of mortgages that go into bonds appear, the lower the interest rates on the bonds and the more profits the mortgage bankers receive.

As we peel this onion, we are finding many purposeful compromises that look much like the insidious corruption that characterizes commerce in places like China. Just as China exports tainted toothpaste, Wall Street manufactures bad bonds.

But it gets worse. According to reports, large builders established mortgage-writing subsidiaries. When they built more houses than the market could absorb, those subsidiaries exaggerated the incomes and qualifications of buyers on loan applications, and pressed for exaggerated appraisals of their properties to move houses.

Those entities operated on lines of credit and resold the loans to investment banks who bundled them into bonds. Both the large builders and investment bankers had incentive to put lipstick on pigs.

Also, investment banks sought and received collaboration from bond rating agencies in bundling mortgages of differing quality into bonds. In the process, bond raters like Standard and Poor got compromised.

Subprime mortgages are hardly the whole credit market, but the meltdown of their bonds cast a spotlight on the decaying integrity of investment banks and bond rating agencies.

These institutions underwrite and rate all manner of credit, and if they could be corrupted in the subprime mortgage market then all commercial paper and bonds becomes suspect.

Over the last several weeks, creditors have increasingly sensed they cannot trust banks or bond rating agencies, and they have fled to short-term Treasury securities.

This was much worse than the collapse of mortgage companies that originated housing loans, because it caused all segments of the credit market to collapse.

Good businesses with sound cash flows couldn’t borrow operating capital, and good companies faced escalating interest rates for new bond offerings. Together, those threaten to throw the economy into recession.

For Ben Bernanke, the corruption of the investment banks and bond rating agencies is terrible news. It is akin to the Pope learning Easter morning was a hoax.