Four Reasons for the 2007-08 Financial Crisis

A recent Bank Think post by ConnectOne Bank CEO Frank Sorrentino regarding restoring Glass-Steagall got me thinking about how far the debate has drifted from the root causes of the 2007-08 financial crisis.

There have been quite a number of research pieces offered as to the root causes (read a good one here by University of North Carolina). In researching this post, I sifted through some interesting, and some not so interesting opinions. Which reminds me that the old axiom "figures don't lie, but liars figure" may be closer to accurate than we would like.

Here is what I think caused the financial crisis based on what I read, what I experienced, common sense, and my interpretation of the facts.

1.  People borrowed more than they could repay if they experienced a modest financial setback.

If you know me personally, I will always put more weight on personal responsibility than the boogeyman. Yes there was some degree of fraud perpetuated on the borrowing public. But, by and large, people knew how much they were borrowing, what their payments were, and that some of their mortgage payments would rise if rates rose. 

In 1974, household debt stood at approximately 60% of annual disposable personal income. In 2007, that number climbed to 127%. It should be noted that in 2006, 40% of purchase mortgages were for investment or vacation property. But you won't see the real estate investor losing his/her shirt on 20/20.

Absolving people of personal responsibility is a problem in our society. As one of my Navy lieutenants once told me: "Be careful pointing the finger, because the other fingers are pointing back at you". Words to live by.

So, in my opinion, number one exceeds all others. It will not get me personal kudos in the news media.

2.  Credit risk was too far removed from the loan closing table.

This is the moral hazard argument, where the people that have the relationship with the customer, that stare the customer in the face and say "yes" or "no" to the loan, were not the same people assuming the risk should the customer default, in most cases. The shoulders where credit risk ultimately came to rest, investors, were placated by insurance and bond ratings. 

Community financial institutions make their debut here, as they purchased bonds, typically highly rated, backed by mortgages that also had insurance applied to them.

3.  There was a lot of money looking for investments, and Wall Street met the demand. Mortgage-Backed Securities (MBS) almost tripled between 1996 and 2007, to $7.3 trillion, as investors lined up to participate in the US housing market. This led to creative means to take a risky mortgage at the closing table, to a perceived "safe" investment in the bond market after it was combined with hundreds of other mortgages, parsed into traunches, insured by a bond insurer, and rated by a ratings agency. What could go wrong?

See the list of top 10 sub prime mortgage lenders from 2007. Note the absence of anything resembling a community bank. BNC was owned by Lehman Bros. EMC-Bear Stearns. First Franklin, a JV between National City Bank (emergency sale to PNC) and Merrill Lynch (emergency sale to BofA). Option One was sold to shark investor Wilbur Ross for its servicing rights. Ameriquest was purchased by Citi, and its origination arm shut down. The table indicates that loans were closed in these banks'/entities' names. A community financial institution that sells its loans in the secondary market would typically close the loan in its own name, and then sell it. So the absence of community financial institutions implies that these loans were originated by mortgage brokers or the listed banks themselves, and not a community FI. This is consistent with my experience. 

The MBS bond-creation engine was a well oiled, end-to-end machine designed to satisfy the appetite of investors.

4.  Government's participation in the mortgage market. Way back to the Great Depression, when mortgages were typically five-year balloons, the Federal Government has intervened in mortgage lending. When the five years were up, the government didn't want people tossed from their homes because they couldn't refinance due to economic hardships. A respectable goal. But this intervention played a role in what we have today, a separation between the borrower and the ultimate lender. 

Note that Presidents Reagan, Bush, Clinton, Bush, and even Obama openly encourage home ownership because it has a causal relationship with household wealth creation.

But the reason why community financial institutions shy from putting 30-year, fixed rate mortgages on their books is because there is no 30-year, fixed rate funding instrument. It creates unpalatable interest rate risk. 

If interest rate risk drives the wedge between borrower (i.e. homeowner), and the desired lender (i.e. local bank that retains the credit on their books), then perhaps a 5/1 mortgage should be the norm. This answers the interest rate risk problem, while allowing borrowers to keep their mortgage and therefore their home if they befall some economic setback after five years.

And note, a local financial institution has more flexibility to alter the terms of the loan if it is on their books, rather than owned by an investor.

Back to my original point regarding re-instating Glass-Steagall. What does this have to do with the four points above? We should ask the same question about every article within Dodd-Frank.

~ Jeff 

Bankers: How Should It Be?

I have been sitting on an airport tarmac for 45 minutes. Twenty-first in line. Waiting for a re-route from the tower to avoid the rain drops. Such is the way that it is.

But how should it be?

In banking, do we ask ourselves how it should be?

My firm analyzes bank processes to identify how it is, versus how it should be. But the question goes deeper than how a wire is done versus how it should be done. Answers are typically “it depends”. And what it depends on is in the eye of the beholder. Is the beholder the employee? The customer? The regulator? The shareholder?

Last year I did a blog post Build Your Own Small Business Loan Platform. In it I described having a series of options to fund small businesses. Some options were on the bank’s balance sheet, some not. What the post does not say is just because you could advance a loan to the customer, doesn’t mean you should.

Take the following example:

Suppose Jane and John Doe, owners of J&J Bikes, come into your bank for a mortgage loan. The bike shop has been doing well the past couple of years and the Doe’s want to upgrade their lifestyle into a bigger house.

So they find one. And come to your bank to finance it.

Your bank has a robust menu of mortgage loan programs. And the Doe’s are pushing their limit on loan-to-value, and debt-to-income. But based on the last two bumper years at the bike shop, they are feeling pretty good about their future and moving to a new, tony neighborhood.

You recognize that the Doe’s business is cyclical, and suffers revenue setbacks during recessions. Their ability to service the mortgage payments on their dream home would be significantly impaired if their revenue dropped as little as 20%.

But they would qualify for the mortgage with one of your loan programs. Since your bank sells the mortgage to investors, and you would meet the investor’s underwriting criteria, the risk of the Doe’s defaulting would fall on the investor. And your mortgage originators only get paid on closed loans.

Do you do the loan?

How it should be…

A relationship driven bank would be concerned about more than the risk of the investor putting back the loan to the bank. It should be concerned about the potential downward spiral of the Doe’s should the bike shop befall hard times and they can no longer service the mortgage.

The Doe’s are not the financial experts that know what would happen if they can’t make the mortgage payments. You are.

So you counsel them on the pitfalls of pushing their financial limits to live in a large home. Values of larger homes fall more in recessions because buyers become scarce. So if they can’t make payments due to a recession impacting their bike shop, they may not be able to sell their home at its current value either.

You tell them to look at past recessions, and the bike shop’s decline in revenue. And look at homes where they can sustain the mortgage in hard times.

I’m not suggesting telling them no, you won’t do it. But be the financial counselor your strategic plan wants you to be. The Doe’s may not appreciate your advice initially. But you would be their trusted advisor for a long, long time.

Or you can put them in that new high LTV loan program from your aggressive investor so you can pay your originator and hit the budget.

How should it be?

~ Jeff

Uncle Sam: Get out of my house!

Freddie Mac posted a $4.5 billion fourth quarter profit. Fannie Mae did not yet report but made $1.8 billion in the third quarter. So our Government Sponsored Enterprises (GSEs) are minting over $25 billion to their owners... Uncle Sam. Folks, revenue to the government is like crack. Congress won't be taking up GSE reform anytime soon.

This poses a challenge for bankers. Twenty five percent of our loans are in residential mortgages (see chart). Eighty percent of mortgage originations currently pass through the GSEs. In other words, Uncle Sam owns the mortgage market and dictates its terms. Ever heard of a QM (qualified mortgage)? I would not call myself a libertarian because there are legitimate reasons for the government to participate in free markets. When the payoff is long term, such as drug research, comes to mind.

But residential mortgages are not the same as the cure for pleuropulmonary blastoma. The market is fairly mature. FHFA (regulator for the GSEs) Director Edward DeMarco recognizes this and is working on developing a sustainable mortgage trading platform that can eventually be in private hands. Mortgages can be done by banks, credit unions, and the shadow banking system, without Uncle Sam's assistance.

If you believe what I say is true, and perhaps our Congress finds religion to make it so, there will be changes. Some of these changes will not benefit consumers in the short term. Mainly, we are likely to see a decline in the number of 30-year mortgages.

Now, I have a 30-year mortgage. Who wouldn't with rates so low? But, truth be told, there is no way a financial institution (FI) can find 30-year funding. I understand that the "average" mortgage loan lasts seven or eight years because people move. And that there is some cash flow to the FI because the loan amortizes. But there is no seven year funding FIs can tap either. 

If the mortgage market became more private, the 5-1 or 7-1 ARM would assume a higher perch. This is more palatable to FI risk managers and would allow for them to put more of these loans on their books. If booking the loans, they don't have to worry about the tail risk and all of the other bad things that can happen as a result of government intervention and QMs.

I don't believe 30-year mortgages would go away. Their would still be a secondary market with private investors to purchase pools of mortgages. Additionally, FIs may determine to book some 30-years, and to accept the interest rate risk or hedge it. But the 30-year will begin to be priced to market, instead of artificially low because of all the government interference.

The end result will be a resurgence of local FIs willing to lend and book their customers residential mortgages. There will be more choices for borrowers. And yes, borrowers will more frequently have to accept interest rate resets sooner than 30 years out.

How do you think FIs can more fully participate in residential mortgage lending?

~ Jeff