Mortgage Lessons From 'It's a Wonderful Life'

It's traditional during the holiday season to watch the great Frank Capra movie "It's a Wonderful Life," and this year, the film is particularly relevant—it can help us to better understand our current economic malaise and the mortgage credit problem that is at the center of the crisis.

In one of the most famous scenes, there's a run on the Bailey Building and Loan, a small bank owned by George Bailey, the tortured character played by Jimmy Stewart. As depositors clamor to get their money back, Stewart tells them, "You're thinking of this place all wrong, as if I had the money back in the safe. The money's not here. Your money's in Joe's house, that's right next to yours. And in the Kennedy house and Mrs. Macklin's house and a hundred others. Why, you're lending them the money to build. … Give us 60 days."

In the language of finance, Bailey is explaining that the Bailey Building and Loan made and held "whole loans," mortgages that have not been securitized. Its liabilities are the deposits the bank's depositors have come to withdraw, and its assets are the highly illiquid mortgages that it holds as a result of lending money to the town's residents to build their homes in Bedford Falls.

If the movie were remade today (and let's hope it's not), here's what would happen in Bedford Falls. A different George Bailey—played, say, by Brad Pitt—would have "originated" home loans in Bedford Falls. Pitt would have then sold those loans to Freddie Mac or to Fannie Mae or to another loan aggregator. Each of those loans would then ultimately have been "securitized" into one of many "tranches": cut up into many slices based on the risk of repayment of each chunk of the loan. The various slices from thousands of loans all over the United States would then be pooled, again by potential risk of default, and that pool would issue a mortgage-backed security that was "rated" by one or more of the federally sanctioned ratings agencies: Moody's, Standard & Poor's and Fitch. (In the current crisis, those investments had cryptic names like "GSAMP 2006-S5 A2" and "WAMU 2007-HY6 2B1.") The idea behind the pooling of loan slices is a powerful one—by sorting the payments to those supplying capital into specific risk categories, it is possible to lower the cost of capital to borrowers.

Now, what would the Bailey Building and Loan do with the proceeds it receives from selling the loans that it originated? It would buy securities that would be held as assets on its balance sheet and, depending on the risk and value of those securities, it would continue to originate more loans. So far, this all seems well and good. The securitization has lowered the cost to borrowers and made the assets held by the Bailey Building and Loan appear to be more liquid—instead of lumpy whole loans, its new assets are securities that, at least in theory, can be sold and that are priced in the market.

The problem is that while the Building and Loan would buy securities such as treasury bonds, it would also likely buy small amounts of a lot of mortgage-backed securities, such as the above-mentioned GSAMP 2006-S5 A2 and hundreds of other such securities. These securities aren't heavily traded in markets, but the top category of these offerings typically was treated by bank regulators as extremely safe—likely to return the full value of the investment made in them with interest—because of their very high investment grade ratings. When housing declined in value throughout the United States, many mortgage-backed securities became imperiled, and as a result, many of the nation's banks became insolvent.

So in the presence of a run, in our remake, Brad Pitt might say this: "Why, don't ask for your money back right now when the housing market is in decline. You know that money isn't in the safe; it's invested in GSAMP 2006-S5 A2 and WAMU 2007-HY6 2B1 and the like. I can't give you your money back unless and until those multiyear-duration securities get repaid (if they ever do) or if they somehow revert back toward par value and I can sell them. Since they're trading at cents on the dollar, they have a long way to go. Just give me 60 days, and maybe the Treasury will bail me out."

Jimmy Stewart told his depositors that he knew that their investment in the Bailey Building and Loan was "good," even though its assets were not liquid. This is because he knew the location of each home held as collateral, the occupant-borrower, the prospects for repayment and more. All that Brad Pitt's George Bailey could ever know is that he bought securities rated highly by each and every one of the three government-endorsed rating agencies, and that the investment banks that underwrote them thought those securities were sound investments. Nothing more. He'd have no idea who the borrowers are, where the homes are located, what their condition is or whether they are even occupied, much less the likelihood that a particular borrower could weather the storm.

The contrast is what makes a new viewing of "It's a Wonderful Life" compelling this holiday season—it's a reminder of a simpler time, and simultaneously a stark reflection of what went wrong in the current crisis.