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How did Lenders Get it So Wrong?

posted by Mechele Dickerson

An economist, Professor Amir Sufi (University of Chicago), shifted our focus in the afternoon session from debtor, to lender, behavior. In discussing his paper, Lender Incentives, Credit Risk, and Securitization: Evidence from the Subprime Mortgage Crisis, Professor Sufi asks why lenders made such bad decisions when making subprime mortgages. He concludes that securitization reduced lender incentives to scrutinize borrowers, because lenders knew they would sell virtually all the subprime loans they originated and, thus, knew they would shed the credit risk associated with those loans. Professor Sufi argues that this is to be expected, since financial intermediaries overcome information frictions only if they have an incentive to properly screen and monitor borrowers.

Professor Sufi’s paper traces the increase in consumer mortgage debt relative to non-mortgage debt (it skyrocketed after 2002) and the increase in the number of securitized mortgage loans (skyrocketed after 2003). He examined differential securitized mortgage growth rates by zip codes and found that high securitization zip codes had riskier loans. Borrowers in these zip codes had lower incomes, were given more subprime loans, and the loans in these areas had a higher fraction of denied loan applications (all suggesting that the loans were riskier). While brokers should have been exercising greater caution in examining borrower information (income and employment) before approving these risky loans, the data show that lending in these areas increased but that lenders did not appear to consider whether these loans should have been made. This finding confirmed what many have suspected, .i.e., that the subprime lending boom was lender-based and was not created because of borrower demand.

Professor Sufi does not believe that securitization is always bad. He believes, however, that removing lender incentives to scrutinize borrower information coupled with the unrealistically optimistic ratings agencies gave mortgage-backed securities caused investors not to investigate the true risks associated with these mortgage investments. He also suggested that, because the collateral that backed the mortgages (houses, that is) was appreciating, investors also had no reason to consider the actual risks associated with the loans. He, like others, believe that the subprime lending itself caused much of the house price appreciation for the last several years. To fix the problem in the future, Professor Sufi suggests that securitization pools should require the loan originator/arranger to hold more of the credit risk.

Dr. Yuliya Demyanyk, an economist with the Federal Reserve Bank in St. Louis, disagreed that securitization distorted lender incentives. Instead, she argued that lenders had no incentive to screen borrowers because lenders were making the subprime loans specifically for securitization. Her research indicates that lenders understood that they were serving as an intermediary between Wall St. and the ultimate investors (she cites China as an example of an investor that was willing to purchase these high risk, but potentially high return loans). Dr. Demyanyk contends that Wall Street securitizers asked lenders to originate a certain number of loans over a certain period of time, that lenders made the loans and then sold them back to Wall Street. Thus, Dr. Demyanyk rejected the claim that lenders were surprised by the risks, arguing instead that they knew that the loans were risky.


Without having read Prof. Sufi's paper yet, I'm initially inclined to agree with Dr. Demyanyk and I would expound on the theory to say that EVERYONE in the industry knew what was going on. I base my reasoning for this statement on the fact that all of the major "third party" servicers are owned by all of the big originators and/or securitizers of loans. C-Bass had Litton - until it was sold to Goldman Sachs. Bear has EMC - for a little while longer at least. Ocwen - well that's a mystery to me at the moment because of their "de-banking". Credit Suisse owns Fairbanks/SPS. Merrill has Wilshire. I believe Morgan Stanley has Saxon...

All of the large originators/securitizers figured out that it was more profitable to keep the servicing in-house, have the servicing subsidiaries rack up the late fees - many of them being fraudulently manufactured - and just keep recycling loans through the foreclosure process.

Mortgage Servicing Fraud is more profitable than many realize. And the industry mantra that "lenders lose money on foreclosures" could not possibly be further from the truth. Especially if pmi is included in the loan.

Lenders got it wrong from simple greed. The secondary market implosion parallels the dotcom bust. Everyone got so greedy and was making so much money that they begin to ignore fundamentals. Remember during the dotcom boom no one was focused on profitability? P/E ratios were thrown out the window. All we kept hearing was "these are new business models! You can't use standard p/e ratios!" blah, blah, blah.

The same thing happened with mortgages. In effort to keep the money moving, lenders had to keep loosening up credit guidelines. They were egged on by Wall Street who was more than willing to buy the paper. As I mentioned, once the market got so saturated and the deadbeat subprime borrowers couldn't keep refinancing out of trouble did people finally realize that you can only make so many loans to people with 580 FICOs at 100% and two bit Carlton Sheets investors before the delinquincies start to show up.

Now we are at a point where banks aren't making loans to people with good credit. We are on the opposite end of the spectrum. We went from lending to deadbeats to not lending to solid credit worthy borrowers.

The other problem is that banks have gotten so big and efficient that they are actually inefficient. In effort to keep cost low, they went from actually underwriting files with common sense and a human touch to relying on FICO scores, automated underwriting tools, etc. There is only so much you can boil down to a statistical indicator. Banks need to get back to evaluting each indivudal file on its own merits instead of trying to fit square pegs into round holes which is the way it works now.

Nothing like explaining to a millionaire that the bank won't make a loan because "you are out of guidelines" while getting an automated approval on a borrower with maxed out credit cards, high debt ratios, and no down payment. The millionaire wants non-conforming jumbo that can't be sold to Fannie, but the borderline foreclosure waiting to happen within Fannie guidelines gets the best rates in the market. Go figure.

If anything, the situation seems likely to get worse.

Once they've worked through their (in)solvency issues, what motivation will banks have to make safer loans? Especially when they've just learned that banks that have made ludicrously irresponsible, risky loans will either be deemed too big to fail, meriting a tax-payer funded bail out, or that they'll be allowed to turn mortgage, auto and student loan crap into Treasury note gold at the Fed window?

It's the ultimate alchemists wet dream.

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