Discussion Of “Credit Booms and Lending Standards: Evidence From the Subprime Mortgage Market”

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Discussion Of “Credit Booms and Lending Standards: Evidence From the Subprime Mortgage

Market”By

Edward J. Kane

Boston College

FDIC ConferenceSeptember 18, 2008

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• This paper shows that “lending standards” declined during the recent housing bubble and that the decline was sharper for loans that lenders chose to securitize.

• Not only did mortgage lending standards slip, standards got lower and lower in each year from 2005 to 2007. This is evidenced by shifts in the percentage of defaults occurring in the first (say) 15 months of loan life.

• Overlending is evidence of an Incentive Breakdown. But is it primarily a market or a political failure? To promote home ownership, Government subsidized leverage for borrowers and lenders alike.

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Subprime defaults have got worse each year

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TO FIX THINGS PROPERLY, AUTHORITIES MUST ANSWER ONE QUESTION

CORRECTLY:WHERE AND HOW DID SECURITIZATION

GO WRONG?

ANS. BY MARRYING BLIND TRUST IN REPUTATIONAL BONDING OF KEY FIRMS

TO GYPSY ETHICS OF THEIR EMPLOYEES: SHORT-CUTTING AND OUTSOURCING

DUE DILIGENCE IN SYNTHETIC CREDIT TRANSFERS

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RESEMBLANCE OF FINANCIAL-OVERENGINEERING CRISIS TO THE SIMPLER

S&L MESS

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Financial Engineering: Modern Credit-Risk Management Uses More Outside Information and

Entails Extra Dealmaking

ClientDeal-Maker

Credit Risk Mgt. Group•Counterparty evaluation•Credit limits•Concentration risk mgt.

CreditPortfolio

Risk Transfer The CreditMarket

CreditPricingSafety-Net

Supervisors

CRO Supervision

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TO ILLUSTRATE THE “SECURITIZATION MESS” OF 2007-2008, WE NEED MANY MORE DESKS.

1. The Fed and FHLB System helped Uncle Sam (Treasury).

2. Hit-and-run lenders came on the scene alongside the banks (State-Chartered Nonbank Mortgage “Brokers”).

3. A new layer of desks must be introduced between the lenders and the government supervisors. The occupants of these additional desks are “FINANCIAL ENGINEERS” who claimed as a group to have the magical powers to turn very RISKY mortgage loans into RISKLESS BONDS:

A. ACCOUNTING PROFESSION, APPRAISERSB. STATISTICAL MODELBUILDERSC. CROS: CREDIT RATING ORGANIZATIONSD. INVESTMENT BANKERS & DERIVATIVES DEALERSE. MONOLINE CREDIT INSURERSF. FINANCIAL SERVICERSG. GSEs and TRUSTEED INVESTORS

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COUNTERPARTIES AND SUPERVISORS SHOULD HAVE PERCEIVED OVERLEVERAGED

LOANS TO STINK IN MANY WAYS

• Badly underwritten

• Poorly collateralized

• Inadequately documented

• Important risks were hidden or misrepresented

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FINANCIAL ENGINEERING MAY BE VISUALIZED AS MANUFACTURING RISK EXPOSURES IN

FACTORY WORK STATIONS THAT ARE LOCATED ALONG A CONVEYOR BELT

• The different stations produce contracts that create, disguise, assess, assign, or insure overleveraged risk exposures.

• At each station, Product-Quality Inspectors (supervisors) were apt to use their computers to entertain themselves rather than to inspect the quality of the work that was passing by.

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Fannie and Freddie were the biggest buyers of garbage mortgage loans and securitizations: subprime & Alt-A mortgages and AAA tranches of private-label securitizations.

Especially from 2005 on, these purchases were driven by Congressional pressure on F and F to meet “affordable housing goals” administered and ratcheted upward each year by HUD. HUD could place F and F under a punitive consent agreement if GSEs did not meet these goals. F and F accepted these goals as the price paid to Congress for keeping the safety-net subsidies they captured from leveraged risk-taking from being regulated more effectively.

My Theory: F and F insistent demand for loans and highly rated securitized claims on low-income households undermined due-diligence all along the securitization chain: Acted as garbage collectors of last resort

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US regulatory framework is destabilizing. Disruptive elements subsidize creative forms of borrower and lender leverage in housing loans

1. Politically-Directed Subsidies to Selected Bank Borrowers: The policy framework either explicitly requires—or implicitly rewards—banks and GSEs for making credit available to selected classes of risky borrowers at a subsidized interest rate;

2. Subsidies to Bank and GSE Risk-Taking: The policy framework commits government officials to providing on subsidized terms emergency loans and explicit or implicit conjectural guarantees of repayment to depositors and other bank & GSE creditors;

3. Defective Monitoring and Control of the Subsidies: The contracting and accounting frameworks used by banks and government officials fail to make anyone directly accountable for reporting or controlling the size of either subsidy in a conscientious or timely fashion.

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Insufficient Reputational Damage to Officials from Unraveling of

Affordable-Housing Pressure

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Credit-Rating Organizations Over-Rated the Highest-Quality Tranches of

Structured-Finance Obligations• Process of Rating Securitized Debt is a Negotiation that starts

with Issuer specifying its desired rating. The CROs compete by specifying structure and level of credit support needed to obtain it.

• Severe Conflict of Interest Between Reputation and Revenues exists in Rating Structured Securitizations (more than 40% of Moody’s 2005-06 Ratings Revenue came from such deals)

• CRO’s aggressive judgment that an adequately documented “true sale” of loan pool has taken place (necessary to spin pool off originator’s balance sheet) has no legal standing and is undermined by CRO claims that it is “unreasonable” to rely on their “mere opinions” which are not “investment advice”.

• CROs should have discounted their ratings on Complex Securitizations for modeling, legal and documentation risks.

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The major incentive weakness faced by federal supervisors is the political and practical difficulty of establishing and maintaining vision and deterrency for what is going on at CROs, at monoline insurers, at GSEs, and at major derivatives-trading institutions. The FDIC and Bank of England are at a disadvantage because:

1) CROs and Derivatives-trading institutions’ principal supervisors are housed in other agencies that have clientele incentives to treat them as Too Important to Discipline Adequately.

2) Such firms and major CROs are too big, too complex, and too politically well-connected to fail and unwind (TDTFU).

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No One Wanted to Catch or Be Caught

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Three counterincentives interfere with pursuing a market-mimicking approach to rescue and support underinvestment in disaster planning & prevention.

• Decision-making horizons of incumbent top regulators are seldom more than a few years in length (need for deferred compensation and fair-value budgeting for implicit subsidies)

• Mercy and Nonescalation Norms extend the life of zombie firms

• Disaster myopia (Guttentag & Herring) undermines timely prevention:

Definition: Disaster myopia exists when authorities systematically underestimate the frequency of crisis pressures and long-term incentive effects of implicit bailouts.

Incentives Drive Zombie Preservation

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The US needs to Reform the incentives of Supervisors, not the Structure of Regulation. Goal must be to enforce duties of loyalty, competence, and care that agents and principals

owe one another.

In firms and in government, Supervisors five specific duties to their principals:

1. A duty of vision: They should continually adapt their surveillance systems to counter regulatee efforts to disguise their rulebreaking;

2. A duty of prompt corrective action: They should stand ready to discipline rulebreakers whenever a violation is observed;

3. A duty of efficient operation: They should produce their services at minimum cost;

4. A duty of conscientious representation: They should be prepared to put the interest of the community they serve ahead of their own.

5. A duty of accountability: They should make themselves answerable for neglecting or botching their duties. (Issue for CROs and monoline insurers is to bond the quality of their performance in a meaningful way.)

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The major incentive weakness faced by federal supervisors is the political and practical difficulty of establishing and maintaining vision and deterrency for regulation-induced innovation going on at GSEs, CROs and at major derivatives-trading institutions. The FDIC is at a disadvantage because:

1) Derivatives-trading institutions’ principal supervisors are housed in other federal agencies that have incentives to treat them as Too Big to Discipline Adequately.

2) Such firms and major CROs are too big, too complex, and too politically well-connected to fail and unwind (TBTFU).

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SOME SPECIFIC REFORMS

1. Safety-Net subsidies must be estimated both by beneficiary institutions and by politically accountable supervisory officials (≠ only the Fed)

2. No government regulation should rely on CRO ratings: Sin of Simony

3. CROs must disclose information used and bond against negligent construction of models and data samples; should report ratings in 2 dimensions

4. Securitizers should report monthly balance sheets and income statements for underlying asset pools.