The Myth of the Subprime Crisis

January 23, 2009

One of the most commonly misunderstood aspects of the current capital markets crisis is the sentiment, repeated ad nauseum by the mainstream media, that this is a crisis of ‘subprime lending’.  Or, it’s the ‘mortgage crisis’.  In reality, this crisis has little to do with mortgages and everything to do with mortgage-backed securities (MBS).  What many fail to understand is that the performance of the security may have only a scant relationship to the performance of the underlying asset.  If I serve you up a chicken salad sandwich that is in fact filled with chicken poop, you may complain about the sandwich.  But it’s not the sandwich’s fault.  The chicken poop is what it is.  I’m the one who served it up to you as chicken salad.  You could also blame the salad.  But the wise would hold me accountable for serving you up chicken poop disguised as chicken salad.  Similarly, if a security is created that is largely filled with subprime or ‘Alt-A’ mortgages, is fraudulently rated as a ‘AAA’ security and sold to pension funds, town councils and otherwise contractually conservative investors around the world, and the underlying assets perform the way one might expect them to – which is somewhat south of ‘AAA’ – we can blame subprime lenders and borrowers until the proverbial cows come home.  But it doesn’t change the fact that these assets were packaged into securities that were misrepresented to investors.  What is most astonishing about this crisis is the complete mainstream media blackout, let alone prosecutions, of ratings agency, investment bank, and hedge fund employees and executives without whom this fraud could not have been perpetrated.  And this doesn’t even touch on the CDO issues, the CDS issues, etc. 
 
It is now evident that these issues will never be intelligently presented in the mainstream media or debated in the public sphere.
 
But to bring this back down to the issue in the forefront of the popular consciousness, let’s look at subprime lending.  The popular position today is that banks should not be ‘making bad loans’.  Let’s pick this phrase apart for a moment:
 
‘making’ – Banks do not lend money, per se.  As discussed in prior posts, banks act in many ways as the middlemen between MBS investors and the borrowing consumer.  Yes, banks set guidelines and prices and execute the origination, underwriting and ultimately funding of these mortgages.  But the guidelines set and the operating procedures employed are simply a reflection of the appetites of the secondary market for the end product: the security.  During the mortgage and real estate boom, these appetites were voracious.  The velocity of credit, in the form of guidelines and overall business operations, therefore followed suit.
‘bad loans’ – In a credit-based economy, there is room for all different kinds of loans, on all different types of collateral, for all different types of borrowers.  But to say this is up to the appetites of the secondary market misses the major takeaway of the ‘mortgage crisis’: the misappropriation of the securitization model to subprime lending.
 
Subprime Portfolio Lending
 
The model for subprime lending is the much-maligned consumer finance company.  Finance companies, in their original forms, made subprime mortgage, auto, personal property and even unsecured loans for decades using a ‘full service’ business model where the loan was originated, underwritten, funded and serviced at the local consumer finance branch office.  In such a model, local management was empowered to make decisions regarding hardship modifications to the loan, up to and including waiving interest or payments, interest rate reductions, payment deferral and ultimately the write-off of the loan as uncollectable.  Local management could verify a hardship situation personally and make the appropriate decision based on the borrowers ability to repay some, all or none of the loan.  Within this model, localized economic conditions stayed local: a factory closing down or major employer going out of business in Tulsa, OK, may affect the book of business in the local branch, but the modern concept of ‘systemic risk’ was mitigated and prevented from spreading throughout the broader sector.
 
Funding was generally a function of raising money in the capital markets through the sale of bonds, utilizing standard business operating credit lines, and the like.  Loans were not securitized and sold to investors, but rather kept ‘on the books’.  The business model was then to manage the overall profitability of the business as well as breaking down P/Ls to the local level to keep check on the wisdom of individual decision-makers. 
 
This is a critical point because it speaks to the rapidity with which our current crisis has spread throughout the broader economy.  First, subprime mortgages performed like, well, subprime mortgages.  Differences in actual vs. predicted performance quickly manifested in the performance of the securities, sending panic throughout the sector.  Non-bank mortgage lending operations quickly began to fold, taking supply with them.  Remaining bank and non-bank lenders quickly began tightening guidelines, further restricting supply.  Because homeowners in overpriced, press-board McMansions could no longer refinance their adjusting mortgages at high loan-to-value ratios to pay off credit cards, make purchases or otherwise obtain cash, delinquencies and, soon afterwards, foreclosures increased.  As such, home values began to plateau and soon decrease.  This cycle continued until, due to further pressure on both supply and home value, the problems spilled over into ‘Alt-A’ and later even ‘prime’ borrowers.  The cycle continues to this day.  But it did not have to spiral out of control.  The problem has to do with applying traditional models of mortgage origination, funding, securitization and servicing to the subprime sector.
 
“Why don’t banks just refuse to lend to subprime borrowers?  Then you have no problem.”
 
This question ignores two realities.  First, it is rhetorical.  These loans are already out there and, in case you’ve been following the news, play a major role (in the form of the securities composed thereof) in this unfolding drama.  Second, the reality is that the demand for such loans exists, and will continue to exist.  There will be actors entering the marketplace to match supply to this demand.  The question, then, is how best to do it.  I suggest the consumer finance business model was the way. 
 
One of the biggest problems with the securitize-and-service business model applied to subprime over the past 10-15 years has to do with the actual servicing, or more specifically, collections activities on such loans.  Large, centralized servicing models suffer from two challenges in this regard:
1) Subprime borrowers are going to have more problems and issues, generally, than prime borrowers.  This should be obvious.  But the long-distance, impersonal servicing model has proven ineffective in appropriately handling such borrowers.  First, they are limited to making phone calls and sending letters.  This puts the model at a significant disadvantage relative to the old-line finance companies that could simply drive out to a borrower’s home and knock on the door. 
2) Perhaps most important are the limitations of the large servicer to make modification decisions.  A centralized business model generally means it is harder to reach a decision-maker.  This is true of any business.  Decentralized business must have empowered managers in many field locations to make local decisions.  Centralized business models have legions of minions managed by a small number of decision-makers.  More specifically, the large servicing model is contractually obligated to investor who owns the security a given loan is attached to.  This is priority one.  The problem is that, by nature of incentive and distance, large servicing models are incapable of assessing risk at the loan-by-loan level and making decisions on whether, when or how to modify the loan.  They are also very limited in their modification options.  In a local, decentralized, portfolio model, a manager would have many options at their disposal, among them rate reduction, principal reduction, payment and/or interest deferral or even opting to write off the balance completely.  On the other hand, there would be a number of collection options that could be performed at the local level if it was determined the borrower could in fact afford repayment.  As for centralized servicing models, as the old saying goes: “When all you’ve got is a hammer, every problem starts looking like a nail.”
 
Unfortunately, as the subprime securitization model was taking off on Wall Street and thereby facilitating the rise of subprime ‘mortgage companies’ (many subsidiaries of the same banks now receiving TARP money – Citi, Wells Fargo, Chase, etc), consumer finance companies began running into problems.  For one thing, consumer finance companies priced risk appropriately.  If a borrower was in fact ‘subprime’, they could expect to pay a true subprime rate of interest to offset the risk the company was taking to make the loan.  Pay to play.  It was not uncommon for finance companies to charge rates in the low to mid teens on mortgages and into the 20’s or even 30’s on unsecured loans.  With the influx of investor money from Wall Street, the new subprime mortgage companies were charging near-prime rates on these higher loan-to-value, higher debt-to-income ratio, lower credit score loans.  The consumer finance companies eventually had to succumb to competitive pressures and, in the mid-90’s, began to change their business models to mirror the competing mortgage companies.  Out of full service lending businesses came sales offices and centralized servicing operations.  There remain a few hold-outs, but they do very little mortgage lending and may well not survive the current crisis.
 
Today, and the future
 
As long as we operate within a fractional reserve lending, fiat currency, central banked economy, there will be demand for credit.  In the imperfect world in which we live and function, there will be accidents, mistakes and choices – some good, some bad.  There will, therefore, be subprime borrowers.  Given the reality of this demand, there will be an enterprising company figuring out a way to profitably meet it with supply.  It is highly unlikely, however, that the prime lending securitize-and-service model will be applied to subprime in the future.  There is simply no private money chasing subprime MBS.  This is as it should be.
 
But leave it to government to be slightly behind on the up-take.  The securitize-and-service model for subprime lending still exists.  In fact it is enjoying a boom the likes of which rivals that of previous years.  That last remaining hold-out is the taxpayer, as spoken for by government, and as delivered by the FHA and GSEs – Fannie Mae and Freddie Mac.  Specifically as it regards FHA, the new subprime lender of choice, the exact same disastrous model of origination, underwriting and servicing is not only still occurring but has increased dramatically, all underwritten by the taxpayer. 
 
-Third party origination?  Check.
 
-Centralized, computer-based underwriting?  Check.
 
-Reliance on third-party credit score models?  Check.
 
-Securitization of mortgages and sale to secondary market investors?  Check.
 
-Large, centralized servicing model?  Check.
 
-Inability to head off localized delinquency trends with creative modification solutions?  Check.          
 
How is government able to find investors for this failed mortgage business model?  Simple – the securities are backed by your tax dollars.

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4 Responses to “The Myth of the Subprime Crisis”

  1. Loan-holder Says:

    I have looked over your blog a few times and I love it.

  2. Forex news Says:

    Nice post! Keep it real.


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