Monday, January 28, 2008

The Mortgage Mess

John Stumpf the CEO of Wells Fargo Bank recently said in a speech that “I don’t understand why bankers have to come up with new ways to loose money when the old ways were working just fine”. What a great way to summarize the mess we are now in.

I was witness to the train wreck that was the savings and loan debacle of the 1980’s. It was not difficult then to recognize the problem as it rose to the level of a crisis. And, it has not been difficult more recently to recognize the problem developing in the real estate sector, specifically in mortgage loans. And just like in the 1980’s the government agencies responsible for oversight, namely the Federal Reserve, did nothing but watch.

Mortgage lending for banks has always been about as staid and boring as any business can be. Mortgage loan losses were rarely big enough to even comment on in the bank’s financial reports. So just how did the industry come up with this new way to loose money and in mortgages of all things? To answer that question we have to look at several of the moving parts that came together to create something of a perfect storm.

The first component, oddly enough, I believe to be credit scoring. Without going into the boring minutia, credit scores are today being used in a manner for which they were never intended. Credit scoring came about in the 1980’s as a means of improving the profitability of loan portfolios. The scoring algorithms had to be validated for each lending institution and for each loan type within that institution. Individual applications were given scores for the sole purpose of managing the portfolio’s aggregate profitability. What is important to understand is that the bank for the first time was abandoning the notion of underwriting a specific application. In effect they said we have no idea who will fail to repay us; we just know our scoring model says that in the end we will make more money. This naturally caused no small amount of angst among traditional bankers and also gave rise to all those stories like twice bankrupt, crazy Uncle Fred getting yet another credit card offer. But love it or hate it, it has worked reasonable well for credit cards, auto, and similar such loans. Somehow this whole scoring notion morphed itself into you the individual having ONE credit score as something of a badge of general credit wothyness. I’m not sure how this happened but the fact that the folks behind it were the same ones that said crazy Uncle Fred should get a credit card, should have been a clue!

The second component leading to the mortgage mess is that somehow this notion of credit scoring portfolios instead of underwriting individual loans escaped their confinement to general consumer loans and made their way into mortgage lending. Remember, the purpose of the credit score is to allow the bank to extend credit to riskier borrowers and still grow their profit. Suddenly, sub-prime loans were born. I’m certain that the scoring companies, of which there are only several in the nation, were able to develop statistical models showing how these more risky loans in total will perform in a manner that is profitable. What a great day it must have been when crazy Uncle Fred got a mortgage on that big new house of his! While I am certain I could find more than a few flaws if allowed to examine these models, what is more important is what eventually transpired in the industry. In short, if only one or a handful, of lenders persisted in making these sub-prime loans the portfolios may have performed reasonably close to their models. But, when such lending became widespread it began to alter the very reality within which the models were created. Sub-prime loans created enough additional demand to turn a cyclical upturn in the market to a genuine asset bubble. As in any bubble, during its early stages owners could sell at any time and take a profit which served to obscure those borrowers who were selling because they could not make the payment. The scoring folks could then point with pride to their models as working perfectly. But hey, crazy Uncle Fred was now a move-up buyer hotly pursued by real estate agents and mortgage brokers alike.

The third component added to this witches brew was the investment bankers. (Why is it whenever a financial train wreck occurs you see investment bankers walking away with only scratches but their wallets stuffed with cash?) Investment bankers, who in recent years have become adept at creating exotic trading instruments, just couldn’t resist getting involved with this new sub-prime market. After all, they had been successfully packaging conventionally underwritten mortgages into marketable bonds for years, so why not sub-prime loans as well. In the low rate environment of recent years there was no shortage of demand from investment managers looking to improve yields. No doubt they had the reassurance of the credit scoring agencies that their models show the portfolios will perform just fine. So mortgages became just another trading instrument. It reminds me of the story of the young man learning the ropes at the Chicago Board of Trade. One day he asked his mentor, “just who eats all these pork bellies anyway?” To which his mentor responded, “You don’t understand son, pork bellies ain’t for eat’n’ they’s for 'trad’n”. So too it became for mortgages, they were not for financing homes they were for trad’n. And trade they did. Seemingly just to make things interesting, the same loan was sometimes used to back multiple bonds which were sold to separate buyers. They call these tranches which is French for slices. Hey, nobody would buy a slice, but a tranche, now that is a different thing all together! So, this time when Uncle Fred defaults on his mortgage he can’t sell his house, and he has two, three or more folks that come collecting. One wants the interest, one a portion of the principle, etc, etc. You can see how, on the face of it, it is virtually impossible to restructure this loan into something that makes sense to every party involved.

So how will all of this work itself out? Painfully and slowly I am afraid. Like all asset bubbles, it is ending badly; meaning even innocent people are and will get hurt. Foreclosures are skyrocketing and home values declining. While no one can predict how long this will continue, it does appear that we are still very early in the process. Unfortunately, it seems to be like a bad cold. About all you can do is tough-it-out. The steps taken recently by the federal government are about all that they can do but their effect will be minimal.

Over the holidays, I watched the classic movie “It’s a Wonderful Life”. How quaint! A local bank making loans to local citizens to finance their homes.

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