Thursday, February 28, 2008

Is The Other Shoe Dropping?

Since leaving the banking industry some years ago I have been active selling lending software applications. In the course of that I familiarized myself with the composition of each bank's loan portfolio. In the mid-nineties I began to notice the growth of construction and commercial real estate portfolios. Today it is common for community and even regional banks to have 40% to 60% of their portfolio in these two categories, double what one might have seen 15 years ago. With all of the focus on subprime lending, I have been wondering when it will dawn on folks that the traditional soft spots for bank during economic down cycles has always been in these two real estate categories. Well, yesterday that changed when the New York Times ran an article titled "Small and Midsize U.S. Banks Beginning to Struggle in Credit Crisis". (Click here to go the the article) In the article they express the exposure in terms of such loans in relations to capital with the ratio going from about 150% in 1990 to 285% today. Or, total capital is equal to 35% of such real estate exposure which will not provide much of a cushion if the economic down cycle becomes severe. Adding to this concern is Fed Chairman Bernanke's acknowledgement today that we are headed for an increase in bank failures.

Monday, February 25, 2008

A Subprime Legal Question

In my January 28 post I attempted to explain how credit scoring came about in the 1980's and eventually morphed its way to subprime lending twenty years later. In brief, the theory is that you grant credit to a broad group of borrowers with common characteristics and at a higher than normal interest rate. The belief was that in total such a portfolio would produce profits sufficient to cover losses and still yield an above normal return on investment.

The critical element here is that the lender did not attempt to underwrite each individual loan in terms of repayment risk. So, the legal question is, "does this failure to assess individual borrower risk change the lender's position in foreclosure?" To my knowledge this has never been tested in court. We have always had so called hard-money lenders that largely ignored the borrower's ability to repay. But, they protected their position by underwriting the loan against the value of the collateral. In the case of subprime we had lenders not just ignoring the borrowers ability to pay but also advancing 100% and often more than the value of the collateral.

So, could a borrower reasonably take the position that they were reassured by the bank's willingness to advance the money that the bank was satisfied with both their ability to handle the loan and the value of the collateral. I'm quite certain the lender NEVER told the borrower, "hey, we have no clue as to whether you will be able to pay this loan, and if you do not the house will not come close to covering the loan, so you will be left with a big deficiency".

Thursday, February 21, 2008

Legislating Good Sense?

There is an old expression that says you cannot legislate morality. To that I have always added that you also cannot legislate good sense. Well, I guess I have been wrong all this time.

Legislation is now pending in the US Senate that would mandate mortgage lenders to consider the ability of the borrower to repay the loan! Similar legislation, I understand, is pending in Oregon and other states. Back in December the Federal Reserve found it necessary to issue a 'rule' that banks had to have proof of the borrowers income when granting a mortgage.

All of this frankly boggles my mind. How did we arrive at a point where it is necessary to mandate banks to use good sense. Or, how did this chief credit officer;

Get replaced by this one?