Discussion Of 'Credit Booms and Lending Standards: Evidenc

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Discussion Of Credit Booms and Lending
Standards Evidence From the Subprime Mortgage
Market
FDIC Conference September 18, 2008

• By
• Edward J. Kane
• Boston College

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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 CORRECTLYWHERE 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 SL MESS
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Financial Engineering Modern Credit-Risk
Management Uses More Outside Information and
Entails Extra Dealmaking
Deal-Maker
Client
Credit Pricing

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

Safety-Net Supervisors
Credit Portfolio
The Credit Market
Risk Transfer
CRO Supervision
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• TO ILLUSTRATE THE SECURITIZATION MESS OF
  2007-2008, WE NEED MANY MORE DESKS.

• The Fed and FHLB System helped Uncle Sam
  (Treasury).
• Hit-and-run lenders came on the scene alongside
  the banks (State-Chartered Nonbank Mortgage
  Brokers).
• 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
• ACCOUNTING PROFESSION, APPRAISERS
• STATISTICAL MODELBUILDERS
• CROS CREDIT RATING ORGANIZATIONS
• INVESTMENT BANKERS DERIVATIVES DEALERS
• MONOLINE CREDIT INSURERS
• FINANCIAL SERVICERS
• 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

• Politically-Directed Subsidies to Selected Bank
  Borrowers The policy framework either
  explicitly requiresor implicitly rewardsbanks
  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 Moodys 2005-06
  Ratings Revenue came from such deals)
• CROs aggressive judgment that an adequately
  documented true sale of loan pool has taken
  place (necessary to spin pool off originators
  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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Incentives Drive Zombie Preservation

• 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.

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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

• Safety-Net subsidies must be estimated both by
  beneficiary institutions and by politically
  accountable supervisory officials (? only the
  Fed)
• No government regulation should rely on CRO
  ratings Sin of Simony
• CROs must disclose information used and bond
  against negligent construction of models and data
  samples should report ratings in 2 dimensions
• Securitizers should report monthly balance sheets
  and income statements for underlying asset pools.