Friday, March 23, 2007
Underwriting Technology To Blame?
Nice to see this mention of my former employer in the New York Times, in its reporting on underwriting technology in the mortgage market.
And here's my take on the NYT article:
The graphic (right, from NYTimes.com) shows an assembly line of homes stamped with "Approved." The implication is that underwriting technology helped to foster the current problems with subprime lending. You might as well say that automated switchboards fostered crank calling, e-mail fosters spam, and so on. It's true, but not the most useful starting point for fixing the problem. There's nothing particularly virtuous about a process that takes six weeks and a ton of paperwork, compared to a 30-second credit check that incorporates the same data to get to the same result.
The article quotes Professor Nicolas Retsinas of Harvard's Joint Center for Housing Studies: “Before there was A.U., down payment mattered a lot. Where we’ve crossed the line in recent years is to say, we don’t need down payment.”
Yes, it's true that down payments don't matter as much as they used to, and it was the underwriting model that made lenders comfortable enough to extend loans to people without down payments. But I'm not so sure that's where we "crossed the line."
In the old days, a lender would hold a mortgage loan on its own books. Accordingly, the lender was risk-averse as a counterweight to the borrower. Neither the borrower nor lender wanted the loan to default, but it was the lender who was singularly exposed if that were to happen. Thus, the lender would tend to put the brakes on the borrower's aspirations.
In the current environment, the lender’s incentive is to originate loans. They're not compensated on whether the loan carries through to maturity, but rather to whether they can get borrowers to sign the contract. Both sides get a short-term "win" when the deal goes through, but the borrower's the only one who has to live with the consequences. The mortgage itself is sold into the secondary market and then pooled into collateralized mortgage obligations (CMOs). The CMOs are then broken into tranches of varying risk profiles. The investors holding the high-risk tranches are compensated for the risks they take, and so they are risk-neutral.
This topic can be difficult to explain, but let me try an analogy:
Let's say there's a 26-mile marathon. Most entrants have trained for the event and will have no problem finishing. Some will finish quickly, some will limp through given enough time, and others will drop out.
Suppose you want to place a bet on whether a single runner completes the race. If you had your own money riding on the outcome, you’d be pretty careful about it – you'd have to know his or her training history, past results and current fitness level, and you’d want to know what the temperature and humidity would be on race day. You’d take a pair of calipers to measure the racer’s body fat. And you’d want to know if someone’s lying to you. If they say they’re running 70 miles per week, you’d ask the neighbors just to make sure.
Now, suppose the organizers said to you, "Why are you betting on a single racer? It’s too risky! Instead, I’ll pay you $x for every person you can convince to enter the race."
Why would the organizers make such an offer? Because they don’t need EVERYONE to finish in order to make the numbers. They just need, say, five-sixths of the entrants to get through the race in order to maintain credibility as race organizers. You see, the organizers also operate a special betting parlor, where big bettors can wager on how what percentage of runners will actually finish. They make enough from the betting action to cover the minimal costs of bringing exhausted and defeated runners to the medical tent.
Eventually, you’d start to use the same calipers, the same neighbors and the same weather report not to disqualify people who shouldn’t be racing, but instead to tell potential racers, "Hey, you’re in about the same shape as so-and-so down the street, who ran a great race last year! Go for it!"
Bottom line: The CMO market pooled the risk but not the responsibility. The diffusion of mortgage risk across the capital markets is where we "crossed the line," rather than as a consequence of the enabling technology. Lenders were risk-averse, but now they are risk-neutral. Therefore, if there are negative externalities stemming from foreclosures by risk-seeking borrowers and their mortgage agents, we may have an argument for regulation to promote risk-averse decision-making.
-----
Some of my earlier coverage on the mortgage market from Bank Systems & Technology.
“Without the technology, there is no way we would have been able to do the amount of business that we did and continue to do,” Scott Berry, executive vice president for artificial intelligence at Countrywide Financial, told a trade publication, Bank Systems & Technology, in the summer of 2004.Here's the original article by Judy Ward.
And here's my take on the NYT article:The graphic (right, from NYTimes.com) shows an assembly line of homes stamped with "Approved." The implication is that underwriting technology helped to foster the current problems with subprime lending. You might as well say that automated switchboards fostered crank calling, e-mail fosters spam, and so on. It's true, but not the most useful starting point for fixing the problem. There's nothing particularly virtuous about a process that takes six weeks and a ton of paperwork, compared to a 30-second credit check that incorporates the same data to get to the same result.
The article quotes Professor Nicolas Retsinas of Harvard's Joint Center for Housing Studies: “Before there was A.U., down payment mattered a lot. Where we’ve crossed the line in recent years is to say, we don’t need down payment.”
Yes, it's true that down payments don't matter as much as they used to, and it was the underwriting model that made lenders comfortable enough to extend loans to people without down payments. But I'm not so sure that's where we "crossed the line."
In the old days, a lender would hold a mortgage loan on its own books. Accordingly, the lender was risk-averse as a counterweight to the borrower. Neither the borrower nor lender wanted the loan to default, but it was the lender who was singularly exposed if that were to happen. Thus, the lender would tend to put the brakes on the borrower's aspirations.
In the current environment, the lender’s incentive is to originate loans. They're not compensated on whether the loan carries through to maturity, but rather to whether they can get borrowers to sign the contract. Both sides get a short-term "win" when the deal goes through, but the borrower's the only one who has to live with the consequences. The mortgage itself is sold into the secondary market and then pooled into collateralized mortgage obligations (CMOs). The CMOs are then broken into tranches of varying risk profiles. The investors holding the high-risk tranches are compensated for the risks they take, and so they are risk-neutral.
This topic can be difficult to explain, but let me try an analogy:
Let's say there's a 26-mile marathon. Most entrants have trained for the event and will have no problem finishing. Some will finish quickly, some will limp through given enough time, and others will drop out.
Suppose you want to place a bet on whether a single runner completes the race. If you had your own money riding on the outcome, you’d be pretty careful about it – you'd have to know his or her training history, past results and current fitness level, and you’d want to know what the temperature and humidity would be on race day. You’d take a pair of calipers to measure the racer’s body fat. And you’d want to know if someone’s lying to you. If they say they’re running 70 miles per week, you’d ask the neighbors just to make sure.
Now, suppose the organizers said to you, "Why are you betting on a single racer? It’s too risky! Instead, I’ll pay you $x for every person you can convince to enter the race."
Why would the organizers make such an offer? Because they don’t need EVERYONE to finish in order to make the numbers. They just need, say, five-sixths of the entrants to get through the race in order to maintain credibility as race organizers. You see, the organizers also operate a special betting parlor, where big bettors can wager on how what percentage of runners will actually finish. They make enough from the betting action to cover the minimal costs of bringing exhausted and defeated runners to the medical tent.
Eventually, you’d start to use the same calipers, the same neighbors and the same weather report not to disqualify people who shouldn’t be racing, but instead to tell potential racers, "Hey, you’re in about the same shape as so-and-so down the street, who ran a great race last year! Go for it!"
Bottom line: The CMO market pooled the risk but not the responsibility. The diffusion of mortgage risk across the capital markets is where we "crossed the line," rather than as a consequence of the enabling technology. Lenders were risk-averse, but now they are risk-neutral. Therefore, if there are negative externalities stemming from foreclosures by risk-seeking borrowers and their mortgage agents, we may have an argument for regulation to promote risk-averse decision-making.
-----
Some of my earlier coverage on the mortgage market from Bank Systems & Technology.
- Regulators Warn on Home Equity Lending – You can't say that the regulators were asleep at the switch. The current raft of problems was anticipated and expected.
In a guidance issued by the OCC, the Federal Reserve, the FDIC, the OTS and the NCUA, the regulators found that "in many cases, institutions' credit risk management practices for home equity lending have not kept pace with the product's rapid growth and easing of underwriting standards."
- Online Advantage – Whatever happened to RESPA reform and the Guaranteed Mortgage Package? If regulators really want to clean up the incentive structure, this is the place to start. Put the incentives out there in the open, so that borrowers can better understand how everyone in the chain is being compensated.
- Open Skies – One of my first cover stories about the mortgage industry, containing an overblown comparison to airlines and a glossary of terms. It also talks about loan-level pricing, which will become more prominent in the emerging environment.
Labels: finance, mortgage, NYT, wall street
Wednesday, March 14, 2007
Year of the Pig
The New York Times has been standing up for the little pig:
Now, there are 60 million pigs and approximately the same number of pet dogs in the United States. The pigs live in metal boxes until killed for food, while the dogs generally live in safety and comfort.
And they say pigs are as smart as dogs? Not if you judge by recent results.
My advice to the dogs: Be careful. Free-range puppy may seem a shocking idea today, but human tastes are notoriously fickle.
- Today, an editorial describes the horror of hog confinement operations for over 95 percent of the 60 million pigs in the United States.
- Yesterday, a science article pointed out the irony of the "unclean" pig in Judaism and Islam, since "it was humans who infected pigs with tapeworm, not the other way around." One species of tapeworm thus transmitted may have been "acquired either by [humans] eating each other or by eating dogs."
- Sunday, there was an article about a dishware set showing butcher's diagrams of cows, pigs, and (to put the carving up of those animals into context) dogs. (Link, third row from bottom.)
Now, there are 60 million pigs and approximately the same number of pet dogs in the United States. The pigs live in metal boxes until killed for food, while the dogs generally live in safety and comfort.
And they say pigs are as smart as dogs? Not if you judge by recent results.
My advice to the dogs: Be careful. Free-range puppy may seem a shocking idea today, but human tastes are notoriously fickle.
Labels: NYT, talking dogs
Saturday, March 10, 2007
New York Times Insults Worms
Like worms that surface after a torrential rain, revelations that emerge when an asset bubble bursts are often unattractive, involving dubious industry practices and even fraud. In the coming weeks, some mortgage market participants predict, investors will learn not only how lax real estate lending standards became, but also how hard to value these opaque securities are and how easy their values are to prop up.Interesting comparison, but I'm not sure it's the most appropriate given the circumstances. Sure, the worms appear "unattractive" to you and me, but most people don't eat worms outside of reality television. If we were birds, the worms would be a wonderful treat after having perched outside on a tree branch for hours during the torrential rain. Worms are also good for the soil, and you can't say that about irresponsible subprime lenders, ineffective regulators, or anyone else responsible for the unfolding fiscal nightmare.
In fact, one could say that America's worms bore the brunt of the housing boom. Overinflated property values led to over-allocation of investment in the real-estate sector, which contributed to an excess number of housing starts, higher utilization of earthmoving equipment, and the greatest destruction of worm habitat this country has ever seen.
The worms deserve a better analogy. The rusty nails stuck in the blown-out tire. Loaded dice found at a raided underground casino. Politicians' names discovered in a madame's little black book. The dead body in the trunk of the speeding motorist. Sickness, disease or rot. Leave the worms out of it.
Labels: economics, finance, mortgage, NYT
Thursday, March 08, 2007
Weekly Roundup
When I first read the New York Times article about the death of Captain America, my first reaction was to write a satirical open letter to the Public Editor of the New York Times:
But then I realized that it would just be another in a string of recent blog posts attempting to wring humor out of a narrative heedlessly combining fiction and reality. For instance, just yesterday, I wrote about the auction of Star Wars and Dr. Who memorabilia as if those items had more than simply iconic power for film buffs, under the conceit that the fictional characters existed outside of the imagination. A variant of this idea overlays fictional constructs on real-life figures, such as the suggestion that Warren Buffett should create a Willy Wonka-style contest to pick a successor. Even the mention of the obituary of Arthur Schlesinger, Jr. contained a gratuitous pop-culture reference to a fictional country from a Dilbert cartoon.
At best, these quips are good for a quick chuckle, but the approach has already begun to wear thin. Were I to go ahead with the Captain America post as originally conceived, it would cement the impression of this blog as a lightweight diversion with a formulaic approach. Considering the death of Jean Baudrillard, who "argued that mass media and modern consumerist society had built up such a complex structure of symbols and simulated experience that it was no longer possible to comprehend reality as it might actually exist" (Reuters, 3/8/07), I should consider at least a temporary moratorium on such blog posts as a sign of respect and to make a tiny contribution to the idea of regaining some semblance of authenticity in communications.
At least the suggestion that Microsoft operates a windowless private jet works slightly better on the level of both parody and critique, by creating a conceptual blend between the intuitive action of flying and the theoretical aspects of a software program. While it's sometimes hard to describe what's wrong with software, putting it into concrete terms can serve to illuminate the original idea.
Finally, in what was perhaps the most controversial blog entry of the week, I made an oblique connection between the increased risk of schizophrenia by the children of older fathers and the advanced age of the Biblical patriarch Abraham. This carries the unfortunate implication of an increased risk of mental illness in the families of both Hagar and Isaac, which by ignoring the basic theology of an all-powerful G-d, risks offending adherents of the world's major religions. Nor does the theology-based suggestion advance the rational discussion of the treatment and prevention of mental illness from a scientific perspective. In fact, the post could have negative clinical repercussions if it were to convince a male reader to father children at an advanced age in emulation of the Patriarchs, despite the empirical evidence concerning the all-too-real risks. In short, the blog entry was ill-consided and potentially damaging to public health. Although I respect the author's right to publish such nonsense about schizophrenia, it is my fundamental right as a reader to protest its inclusion in a family blog and to voice my strenuous objections.
Also, here's a bit of advice: Be careful about lying to the reader. The post about the "lying game" may serve to demonstrate what was good about the movie "Breach," but it nonetheless sows doubt in the mind of the reader as to whether you're a trustworthy source. In their economic model of the blogosphere (see InformationWeek coverage), Yale researchers Dina Mayzlin and Hema Yoganarasimhan write: "We assume that a blogger must be truth-telling in its posting of a news story. That is, a blogger who simply manufactures a story or makes up a sale will be severely punished by other bloggers and the audience."
Ivan, you've already admitted to lying to your audience at least once. Who's to say that you're not going to do it again? Keep it up, and people will most certainly go elsewhere for small-business consulting tips, sporadic coverage of the financial services market, and links to other references about blogging. My advice is that you stick to writing about your résumé. Or talking dogs. That dog "Ratt" you keep mentioning seems to have a good head on her shoulders. Let's hear what she has to say, and stop monopolizing the conversation with your readers.
Sincerely,
Ivan Schneider
Dear Mr. Calame,In the fictional letter, I would complain about the paper's bias in covering the superhero registration act, as well as paper's unwillingness to address the question of why Captain America was never promoted to the rank of Major despite decades of faithful service.
While I am pleased that The New York Times has finally woken up to the biggest story of the year – government registration requirements for superheroes – I am nevertheless extremely disappointed with several aspects of the paper's coverage.
...
But then I realized that it would just be another in a string of recent blog posts attempting to wring humor out of a narrative heedlessly combining fiction and reality. For instance, just yesterday, I wrote about the auction of Star Wars and Dr. Who memorabilia as if those items had more than simply iconic power for film buffs, under the conceit that the fictional characters existed outside of the imagination. A variant of this idea overlays fictional constructs on real-life figures, such as the suggestion that Warren Buffett should create a Willy Wonka-style contest to pick a successor. Even the mention of the obituary of Arthur Schlesinger, Jr. contained a gratuitous pop-culture reference to a fictional country from a Dilbert cartoon.
At best, these quips are good for a quick chuckle, but the approach has already begun to wear thin. Were I to go ahead with the Captain America post as originally conceived, it would cement the impression of this blog as a lightweight diversion with a formulaic approach. Considering the death of Jean Baudrillard, who "argued that mass media and modern consumerist society had built up such a complex structure of symbols and simulated experience that it was no longer possible to comprehend reality as it might actually exist" (Reuters, 3/8/07), I should consider at least a temporary moratorium on such blog posts as a sign of respect and to make a tiny contribution to the idea of regaining some semblance of authenticity in communications.
At least the suggestion that Microsoft operates a windowless private jet works slightly better on the level of both parody and critique, by creating a conceptual blend between the intuitive action of flying and the theoretical aspects of a software program. While it's sometimes hard to describe what's wrong with software, putting it into concrete terms can serve to illuminate the original idea.
Finally, in what was perhaps the most controversial blog entry of the week, I made an oblique connection between the increased risk of schizophrenia by the children of older fathers and the advanced age of the Biblical patriarch Abraham. This carries the unfortunate implication of an increased risk of mental illness in the families of both Hagar and Isaac, which by ignoring the basic theology of an all-powerful G-d, risks offending adherents of the world's major religions. Nor does the theology-based suggestion advance the rational discussion of the treatment and prevention of mental illness from a scientific perspective. In fact, the post could have negative clinical repercussions if it were to convince a male reader to father children at an advanced age in emulation of the Patriarchs, despite the empirical evidence concerning the all-too-real risks. In short, the blog entry was ill-consided and potentially damaging to public health. Although I respect the author's right to publish such nonsense about schizophrenia, it is my fundamental right as a reader to protest its inclusion in a family blog and to voice my strenuous objections.
Also, here's a bit of advice: Be careful about lying to the reader. The post about the "lying game" may serve to demonstrate what was good about the movie "Breach," but it nonetheless sows doubt in the mind of the reader as to whether you're a trustworthy source. In their economic model of the blogosphere (see InformationWeek coverage), Yale researchers Dina Mayzlin and Hema Yoganarasimhan write: "We assume that a blogger must be truth-telling in its posting of a news story. That is, a blogger who simply manufactures a story or makes up a sale will be severely punished by other bloggers and the audience."
Ivan, you've already admitted to lying to your audience at least once. Who's to say that you're not going to do it again? Keep it up, and people will most certainly go elsewhere for small-business consulting tips, sporadic coverage of the financial services market, and links to other references about blogging. My advice is that you stick to writing about your résumé. Or talking dogs. That dog "Ratt" you keep mentioning seems to have a good head on her shoulders. Let's hear what she has to say, and stop monopolizing the conversation with your readers.
Sincerely,
Ivan Schneider
Labels: NYT, talking dogs, weekly roundup
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