“Mortgage Credit Risk #2: Mortgage underwriting (the activity of underwriting a mortgage loan to ensure it meets an investor’s loan program guidelines) defect rates and mortgage fraud DID NOT cause the U.S. mortgage crisis, so what did?…

…1) Macroeconomic events (e.g. asset bubbles/busts, including housing, trade deficits, monetary policies, and reduced economic activity and increased unemployment, etc.) beyond the control of any bank or mortgage lender, which I have discussed at length on my blog and others have written about. and 2) A gradual deterioration of mortgage lending program guidelines over many years. Government and private mortgage lenders, investors, guarantors, and insurers all established riskier mortgage loan programs over time. This posting is all about #2. Don’t believe me, that it’s the primary cause of the U.S. mortgage crisis (within our control)? You don’t have to believe me. See the excerpt just below from Elizabeth Warren’s Consumer Financial Protection Bureau (CFPB). They agree with me. There is no mention of mortgage defect rates or mortgage fraud is there (and there isn’t in the full document either)? (And by the way, for my final blog posting on mortgage credit risk, I will prove the government and others claims of high pre-crisis mortgage underwriting defect rates are bogus, a Red Herring.) The CFPB only mentions “ability to repay” (a mortgage loan program guideline) and “the gradual deterioration of underwriting standards” (again, that’s not the activity of mortgage underwriting, “mortgage underwriting standards” is another term for “mortgage lending guidelines”). Also, I have attached an excerpt from former FCIC Commissioner and AEI Scholar Peter Wallison’s 2016 writings, where he shows a table from Fannie Mae’s 2nd Quarter 2009, 10-Q, that discloses credit losses by product feature (another term for loan program guidelines). The increased losses are directly related to the riskiness of the lending guidelines and not to mortgage underwriting defects or fraud (which while present were minor and non-systemic and so weren’t disclosed anywhere by Fannie or anyone else). Could it be any clearer? So, how did this happen and who is responsible? First, I want to dispose of another related falsehood. In particular as it relates to private MBS issued pre-crisis, many have made roughly the following claim: “mortgage lenders and/or mortgages securities issuers and underwriters (Wall Street) misled investors into buying MBS backed by shoddy mortgages”. That is a LIE. Every single one of these transactions disclosed upfront all key lending guidelines for each mortgage loan (Fannie Mae’s “product features” below), underlying each MBS. These disclosures, on an electronic “tape”, were available to everyone involved in the transaction, and included borrower name, property address, loan amount, whether it was a 1st lien or 2nd lien/HELOC,  appraised value of the home, loan-to-value ratio, FICO score, whether income was documented or not and how much, debt-to-income ratios if applicable, whether other assets were verified and how much, etc…and this data was audited, in our case by a major U.S. auditing firm, who issued a “comfort letter” in each securitization that the data on the “tape” matched the data in the loan files. So the securities issuer, the underwriter, the insurer, the rating agencies, and most importantly the investor, understood clearly the key risk parameters of the underlying mortgage loans in every single transaction. (This is why I said in an earlier blog posting re. the movie The Big Short, “They used the securities’ prospectuses and the individual loan data on the tapes to make their decision to short, the disclosures worked!”) So back to, “Who is responsible for deteriorating mortgage lending guidelines/standards over many years?” I think Peter Wallison makes a strong case that well-intended government policies/mandates to expand home ownership in America, was a key cause (and I have documented his work in this area extensively on this blog). I have also mentioned less prominently numerous times on this blog two other key issues both related to The Federal Reserve: Our Central Bank: 1) As a result of the Fed’s dual-mandate (stable prices and low unemployment), I and others believe their monetary policies led to a smoothing-out of economic cycles. Greenspan and Bernanke even bragged about this, calling it “The Great Moderation” period. However, there was an important, negative unintended consequence of this that is not discussed much. During times of stable and growing economic activity, it is well-known that credit expands, both as a result of more economic activity and lending standards loosen/deteriorate, because the good economy masks lending risks. In other words, if as a result of the Fed’s distortions, you don’t have the ups and downs of normal economic/business cycles, you won’t have a normal credit cycle either, with a normal correction in credit standards, when the economic downturn hits. Some have used the analogy of the U.S. Forest Service not allowing smaller natural fires to burn and so putting us at risk for much larger, highly destructive ones. And 2) Because the Federal Reserve, pre-crisis and now again post-crisis, in its mis-guided attempt to fulfill its dual mandate, distorted interest rates far lower than normal for long periods of time, they forced investors, both pre-crisis and again now, to seek out riskier assets (like riskier private MBS pre-crisis) resulting in massive mal-investment. In other words, The Fed’s monetary policies created more demand, than the free market would otherwise, for risky mortgage securities and other risky investments. Many now believe that The Fed is a key cause of asset bubbles and busts and our financial instability. Bankers and mortgage lenders, as financial intermediaries between borrowers and investors, were just responding to the economic incentives created by these well-intended government distortions of the marketplace. Who is the real control point? Isn’t it the investors? As soon as investors stopped buying private MBS, riskier mortgage loans stopped being made, except those risky mortgages that are still being insured and/or guaranteed by the government: FHA, VA, Fannie Mae, and Freddie Mac!”, Mike Perry, former Chairman and CEO, IndyMac Bank

Excerpt from The Consumer Financial Protection Bureau’s 2016: Policy priorities over the next two years:

“With a market size of approximately $10 trillion, the mortgage market is far and away the largest consumer credit market. For most consumers, a mortgage is a necessary step in the path to home ownership….The CFPB envisions a mortgage market where lenders serve the entire array of credit-worthy borrowers fairly and in a non-discriminatory manner, servicers’ processes result in fair and efficient outcomes for consumers, and new mortgage rules are implemented in a manner that supports a sustainable mortgage market…Why is this a near-term policy goal? Leading up to the mortgage crisis, certain lenders originated mortgages to consumers without considering their ability to repay the loans. The gradual deterioration in underwriting standards led to dramatic increases in mortgage delinquencies and foreclosure rates….As required by the Dodd-Frank Act, the CFPB issued several rules to address the issues that helped cause the crisis. The Bureau is now responsible for implement those rules. This includes requiring that lenders assess a borrowers ability to repay a mortgage before making the loan.”, 

From former FCIC Commissioner and AEI Scholar Peter Wallison’s 2016 writings about the mortgage crisis:

“Perhaps the most telling exclusion from the report were data published with Fannie’s 10-Q report for the second quarter of 2009 – after the firm was taken over by the government but almost two years before the FCIC issued its report. Table 2 includes an excerpt from the 10-Q that shows all the NTMs they held at that time. These amounted to $838 billion, less than a third of Fannie’s $2.8 trillion book of business, but they were responsible for 81 percent of its 2008 credit losses.

TABLE 2: FANNIE MAE CREDIT PROFILE BY KEY PRODUCT FEATURES                                    (AS OF JUNE 30, 2009)

Product feature Unpaid principle ($B) Percent of credit losses (%)
Negative-amortizing loans 13.7 2.9
Interest-only loans 183.2 34.2
Loans with FICO < 620 109.3 11.8
Loans with FICO ≥ 620 and <660 230.4 17.4
Loans with original LTV ration     > 90% 262.6 21.3
Loans with FICO < 620 and original LTV > 90% 24 5.4
Alt-A loans 248.3 45.6
Subprime loans 7.4 2.0
Subtotal of key product features 837.8 81.3
Overall book 2,796.5 100.0

SOURCE: Fannie Mae[1]

The FCIC majority thus seemed to have made up its analysis for why Fannie and Freddie bought all these risky NTMs in order to fit the conclusion it wanted to reach: that insufficient regulation and Wall Street greed — and not government housing policy — caused the financial crisis.”

Posted on May 27, 2016, in Postings. Bookmark the permalink. Leave a comment.

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