Saturday, March 24, 2007
Ratings Agencies To Blame?
Another potential culprit for the subprime mess: the ratings agencies.
Fortune's Bethany McLean writes:
So I don't blame the ratings agencies. Just like they should be able to rate corporate bonds based on their financial reports and stated sales figures, they should be able to rate CDOs and CMOs under the assumption that the underlying commodity meets a certain standard. The responsibility for making sure that mortgages meet that standard should be assigned to the originators and to the banks buying the loans.
Perhaps what the industry needs is an eBay-style rating system for originators. If an originator or lender ends up putting a more-than-average number of people into loans that fail, the secondary market may want to know about it. More public information and more transparency would be the right move.
Fortune's Bethany McLean writes:
Janet Tavakoli, who runs Tavakoli Structured Finance, points out that AA-rated tranches of CDOs backed by subprime mortgage paper now yield far more than AA-rated debt backed by other assets - a sign that the market doesn't trust the ratings. "No one believes the ratings have any value," she says. Opined Grant's Interest Rate Observer: "We are willing to bet that the agencies assigned too little weight to greed, ignorance, and soft criminality."The ratings agencies have the unenviable job of double-checking the work of an army of mortgage originators. If the incentives were appropriately set at the point of origination, ratings could be set on the macro level, based on economic factors such as the number of housing starts, interest rate trends and other wonky stuff. But now, they have to add another unpredictable variable into their economic models – the extent to which the pipeline has been stuffed with unsustainable mortgages.
So I don't blame the ratings agencies. Just like they should be able to rate corporate bonds based on their financial reports and stated sales figures, they should be able to rate CDOs and CMOs under the assumption that the underlying commodity meets a certain standard. The responsibility for making sure that mortgages meet that standard should be assigned to the originators and to the banks buying the loans.
Perhaps what the industry needs is an eBay-style rating system for originators. If an originator or lender ends up putting a more-than-average number of people into loans that fail, the secondary market may want to know about it. More public information and more transparency would be the right move.
Labels: finance, mortgage, wall street
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
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
Tuesday, March 06, 2007
Warren Buffett's Replacement
Still wondering how Warren Buffett's going to pick his replacement at Berkshire Hathaway?
Despite this headline from TheStreet.com (Stockpickr: Seeking Buffett's Apprentice), he's probably not going to pull a Donald Trump by getting a bunch of photogenic twentysomethings to compete on challenges, with the winners sleeping on Buffett's couch and the losing team sleeping in the parking lot at Gorat's.
But maybe he should.
Personally, I think Buffett should aim even younger. No way the #2 billionaire in the world doesn't have a team of doctors making giving him at least another 20 to 25 years left to live. That's just about enough time to turn a street urchin into a world-class investor. He could put "golden tickets" inside of chocolate bar wrappers to find a random sample of youngsters, and then take the finalists inside of the Berkshire Hathaway factory. In turn, all but one of the children would be eliminated from consideration, say, by suggesting that executive compensation should be tied to company performance instead of personal performance, which would cause a bunch of Geico lizards to break into song. The last kid standing will get a full education in the Graham and Dodd school of value investing and eventually run the business when Buffett flies off in his great glass elevator.
That's the way I see it happening.
Despite this headline from TheStreet.com (Stockpickr: Seeking Buffett's Apprentice), he's probably not going to pull a Donald Trump by getting a bunch of photogenic twentysomethings to compete on challenges, with the winners sleeping on Buffett's couch and the losing team sleeping in the parking lot at Gorat's.
But maybe he should.
Personally, I think Buffett should aim even younger. No way the #2 billionaire in the world doesn't have a team of doctors making giving him at least another 20 to 25 years left to live. That's just about enough time to turn a street urchin into a world-class investor. He could put "golden tickets" inside of chocolate bar wrappers to find a random sample of youngsters, and then take the finalists inside of the Berkshire Hathaway factory. In turn, all but one of the children would be eliminated from consideration, say, by suggesting that executive compensation should be tied to company performance instead of personal performance, which would cause a bunch of Geico lizards to break into song. The last kid standing will get a full education in the Graham and Dodd school of value investing and eventually run the business when Buffett flies off in his great glass elevator.
That's the way I see it happening.
Labels: finance, insurance, wall street
Monday, March 05, 2007
From Boom to Bust to Boom
Here's a nice pairing of articles from the New York Times. The first is about the collapse of the latest boom market, and another about the start of what might be the next boom market.
Just as the technology boom of the late 1990s turned twenty-something programmers into dot-com billionaires, and leveraged buyouts a decade earlier turned Wall Street bankers into Masters of the Universe, the explosive growth in subprime lending turned mortgage bankers and brokers into multimillionaires seemingly overnight.Party's over. Where's the next one? How about insuring coastal areas?
...
Weakening home prices and rising default rates have rocked the subprime business.
As most big insurers are cutting back coverage in Florida and other coastal states after a string of catastrophic hurricanes, Mr. Buchmueller has started a company offering policies that hardly anyone else wants to sell — and at as little as half the going rates.Buchmueller only insures homes worth over $1 million, cherry-picking homes in the market that should hold up better in a storm. Shouldn't be long before others follow the lead.
...[And] recent start-ups have been structured to yield high profits as quickly as possible.
Labels: finance, insurance, mortgage, wall street
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