Blown Mortgage

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On Tuesday, March 27th members of the Federal Reserve Board testified in front of Congress regarding the current crisis in the subprime market.  Below I’ve excerpted and commented on the testimony of Sandra F. Braunstein, Director, Division of Consumer and Community Affairs.  You can read her full testimony here.

Securitization has allowed many financial institutions to use increasingly sophisticated strategies to package and resell home mortgages to investors. This has resulted in increased competition and a wide variety of mortgage products and choices for consumers, in a market in which mortgage brokers and mortgage finance companies compete aggressively with traditional banks to offer new products to would-be homeowners.

Just a point of order here, mortgage brokers are not developing, offering, or securitizing any new mortgage products.  All brokers are doing is selling what the banks and lenders are giving them to sell.  It would be more comforting if members of the Federal Reserve Board clearly understood that distinction.

The expanded access to subprime mortgage credit has helped fuel growth in homeownership.

Ms. Braunstein then goes on to report that an additional 3 million Americans enjoy homeownership than did 10 years ago.  To me, this number seems very small.  I would argue that subprime credit was used more for mortgage equity withdrawal (MEW) refinances than with home purchases, but I don’t have the data or time to back up that statement.

Subprime borrowers with ARMs have experienced the largest recent increase in delinquency and foreclosure rates, while prime borrowers experienced almost no increase in delinquencies and foreclosures.

If you check out any of the other excellent housing bubble blogs, such as the California Housing Forecast, I think you’ll see that clearly, exotic and ARM-type mortgages are experiencing faster default rates than traditional products, regardless if they have yet to break traditional levels.  CHF even has reproduced a graph from the Credit Suisse mortgage liquidity report that shows steep differences in delinquency trajectories for the different prime product types.

While the testimony may be factually true, it ignores some compelling evidence that point to possible future problems in the prime market.

Because of the rapid expansion of subprime lending in recent years, lenders, investors, and ratings agencies had limited data with which to model credit risk posed by new borrowers or novel mortgage types and so may have underestimated the risk involved.

…

(re: supervisory activities) In addition, examiners review stress testing, economic capital methods, and other quantitative risk-management techniques to ensure that banks are assessing the level and nature of these risks appropriately; asset securitization activity to ensure appropriate risk management and capital treatment; residential lending appraisal practices to ensure appropriate collateral valuation processes; and new product review processes to ensure that disciplined approaches are being brought to new lending products and programs.

So in one paragraph there wasn’t enough data to properly asses risk of the new products, but in a latter statement the fed examiners are "ensur[ing] appropriate risk management [and] that disciplined approaches are being brought to new lending products and programs."  This seems rather impossible.  If the risks are not known how can the Fed properly examine and comment on "appropriate" actions?  They can’t. 

…we have a full range of powerful enforcement tools at our disposal to compel corrective action.

This is the part of the puzzle that is needed.  Enforcement staffs are tiny, she used the word "cadre" which is defined by Webster’s as "a nucleus or core group".  What the Fed needs is an army, not a cadre.  As I’ve argued before, the answer is not in new laws, its in the enforcement of existing laws.

She then discusses the various regulatory actions of the Fed starting with guidance releases by the Fed on lending including the 1993 Interagency Guidelines for Real Estate Lending and the 1999 Interagency Guidance on Subprime Lending.

(From the 1993 document) A key point in this document is that prudently underwritten real estate loans should reflect all relevant credit factors, including the capacity of the borrower to adequately service the debt.

Hello?  So where did we miss the boat here?  How are tons of stated income loans floating around (perhaps 50% of total originations) and where was the Fed while this was happening?  How is automated underwriting giving undue weight to FICO scores instead of "all relevant credit factors"? If the Fed has guidance on it why did they turn their backs to the surge in these types of products?

(Re: revisions in 2001 to the 1999 document) The agencies recognized three common characteristics of predatory lending, including making unaffordable loans based on the assets of the borrower rather than on the borrower’s ability to repay an obligation…The guidance also states that loans to borrowers who do not demonstrate the capacity to repay the loan, as structured, from sources other than the collateral pledged are generally considered unsafe and unsound.

Stated income loans, by the above definition are (90% of the time) predatory loans, where is the enforcement of this guidance?  Did economic euphoria get the best of everyone?

The main point I wish to make here is that the guidance was in place, the laws are present, the enforcement teams are out in the field supposedly to carry out the implementation of this guidance, how did the guidance get thrown out the window?  Where was the checks and balances that said "wait a second, we’ve got guidance to the contrary on this, lets tighten up x,y and z"?  It was non-existent.  The regulators have to take some of the blame, when clearly the industry went against clear guidance and were allowed to get away with it.

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