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10/28/2011 12:49
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The Mortgage Crisis: Some Inside Views

 

Emails show that risk managers at Freddie Mac warned about lower underwriting standards—in vain, and with lessons for today.

 

By CHARLES W. CALOMIRIS   

 

 

Occupy Wall Street is denouncing banks and Wall Street for "selling toxic mortgages" while "screwing investors and homeowners." And the federal government recently announced it will be suing mortgage originators whose low-quality underwriting standards produced ballooning losses for Fannie Mae and Freddie Mac.

 

Have they fingered the right culprits?

 

 

 

 

There is no doubt that reductions in mortgage-underwriting standards were at the heart of the subprime crisis, and Fannie and Freddie's losses reflect those declining standards. Yet the decline in underwriting standards was largely a response to mandates, beginning in the Clinton administration, that required Fannie Mae and Freddie Mac to steadily increase their mortgages or mortgage-backed securities that targeted low-income or minority borrowers and "underserved" locations.

 

The turning point was the spring and summer of 2004. Fannie and Freddie had kept their exposures low to loans made with little or no documentation (no-doc and low-doc loans), owing to their internal risk-management guidelines that limited such lending. In early 2004, however, senior management realized that the only way to meet the political mandates was to massively cut underwriting standards.

 

 

 

The risk managers complained, especially at Freddie Mac, as their emails to senior management show. They refused to endorse the move to no-docs and battled unsuccessfully against the reduced underwriting standards from April to September 2004. Here are some highlights:

 

On April 1, 2004, Freddie Mac risk manager David Andrukonis wrote to Tracy Mooney, a vice president, that "while you, Don [Bisenius, a senior vice president] and I will make the case for sound credit, it's not the theme coming from the top of the company and inevitably people down the line play follow the leader."

 

Risk managers had already experimented with lower lending standards and knew the dangers. In another email that day, Mr. Bisenius wrote to Michael May (another senior vice president), "we did no-doc lending before, took inordinate losses and generated significant fraud cases. I'm not sure what makes us think we're so much smarter this time around."

 

On April 5, Mr. Andrukonis wrote to Chief Operating Officer Paul Peterson, "In 1990 we called this product 'dangerous' and eliminated it from the marketplace." He also argued that housing prices were already high and unlikely to rise further: "We are less likely to get the house price appreciation we've had in the past 10 years to bail this program out if there's a hole in it."

 

Donna Cogswell, a colleague of Mr. Andrukonis, warned that Fannie and Freddie's decisions to debase underwriting standards would have widespread ramifications for the mortgage market. In a Sept. 7 email to Freddie Mac CEO Dick Syron and others, she specifically described the ramifications of Freddie Mac's continuing participation in the market as effectively "mak[ing] a market" in no-doc mortgages.

 

Ms. Cogswell's Sept. 4 email to Mr. Syron and others also anticipated the potential human costs of the mortgage crisis. She tried to sway management by appealing to their decency: "[W]hat better way to highlight our sense of mission than to walk away from profitable business because it hurts the borrowers we are trying to serve?"

 

Politics—not shortsightedness or incompetent risk managers—drove Freddie Mac to eliminate its previous limits on no-doc lending. Commenting on what others referred to as the "push to do more affordable [lending] business," Senior Vice President Robert Tsien wrote to Dick Syron on July 14, 2004: "Tipping the scale in favor of no cap [on no-doc lending] at this time was the pragmatic consideration that, under the current circumstances, a cap would be interpreted by external critics as additional proof we are not really committed to affordable lending."

 

Sensing that his warnings were being ignored, Mr. Andrukonis wrote to Michael May on Sept. 8: "At last week's risk management meeting I mentioned that I had reached my own conclusion on this product from a reputation risk perspective. I said that I thought you and or Bob Tsien had the responsibility to bring the business recommendation to Dick [Syron], who was going to make the decision. . . . What I want Dick to know is that he can approve of us doing these loans, but it will be against my recommendation."

 

 

The decision by Fannie and Freddie to embrace no-doc lending in 2004 opened the floodgates of bad credit. In 2003, for example, total subprime and Alt-A mortgage originations were $395 billion. In 2004, they rose to $715 billion. By 2006, they were more than $1 trillion.

 

In a painstaking forensic analysis of the sources of increased mortgage risk during the 2000s, "The Failure of Models that Predict Failure," Uday Rajan of the University of Michigan, Amit Seru of the University of Chicago and Vikrant Vig of London Business School show that more than half of the mortgage losses that occurred in excess of the rosy forecasts of expected loss at the time of mortgage origination reflected the predictable consequences of low-doc and no-doc lending. In other words, if the mortgage-underwriting standards at Fannie and Freddie circa 2003 had remained in place, nothing like the magnitude of the subprime crisis would have occurred.

 

Taxpayer losses at Fannie and Freddie alone may exceed $300 billion. The costs of the financial collapse and recession brought on by the mortgage bust are immeasurably higher. Unfortunately, the Obama administration has perpetuated the low underwriting standards that gave us the crisis and encouraged the postponement of foreclosures by lending support to various states' efforts to sue originators for robo-signing violations.

 

Now they are trying to deflect blame from Fannie and Freddie by suing the originators who fulfilled the politically motivated demands of the government-sponsored agencies that drove the mortgage crisis. If successful, all of those efforts will further postpone the ability of banks to grow the supply of credit, and they will sow the seeds of the next mortgage bust.

 

Mr. Calomiris is a professor of finance at the Columbia Business School and a research associate of the National Bureau of Economic Research.

 

 

 

 

 

 

 

Eureka's View:

 

 

                                               Ponzi Scheme                             Goldman Scheme

 

Vehicle                               Esoteric Investment tools                 Hedge Funds (Mortgages, Bonds, etc.)

                                                                                                                                                     

 

Victims                               Investors                                             Taxpayers, Sovereign States

 

 

Insured                               No                                                        Yes by AIG, Banks, etc.

 

 

Imprisonment                 Yes; up to 150 years                            Protected by Frank & Dodd

 

 

Magnitude                        Bankrupts Investors                            Bankrupts Nations

 

 

AAA Rating                        No                                                        Yes

 

 

Culprits                             Typically  Greedy Criminals                Greedy Investment Bankers &

 

 

                                                                                                           Corrupt  politicians 

 

 

 

 

 

 

 

 

Commenters:

 

Excellent Essay!

This is the truth that most of the nitwits occupying Wall STreet don't know. Of course the banks and lenders wrote "no doc" loans. Why wouldn't they when the Federal Government was buying them up. What will it take to get the American Public to realize that the real culprits here are Barney Frank, Countrywide Chris Dodd and the democrats and republicans that signed on to this insane plan.

 

They are the ones that should be on trial!

 

 

 

 

An interesting read on the history of one facet of a multi-faceted story. What is now needed is an equally in-depth history of all the other facets and players. Then it will easier to appropriately see who else is guilty in this fiasco.

 

Certainly Fannie & Freddie behaved abhorrently, but they paid for their mistakes, and unfortunately made us pay as well, as seen by their negative earnings between 2007-2010. Meanwhile back at the Goldman ranch (just one example), earnings between 2000-2005 averaged 3.4 billion, then jumped to 9.02 billion in 2006-2010, and that includes an outlying mere 2.3 billion in 2008. So the taxpayer gets screwed, left holding the bag and the yahoos @ Goldman are basking in the sun on their yachts, or wherever. Now THAT's class warfare.

 

 

 

A WS broker named Wang won a Nobel for creating the "Gaussian Copula" formula whereby the sub-prime mortgages were bundled up with AAA debt, given approval by the Ratings agencies and then sold off to the world as AA debt.

 

What's less apparent is why the government encouraged them do it... unless, of course, the government viewed the outcome (free houses for its deadbeat constituents) as favorable.

 

Barney "Elmer Fudd" Frank should be tarred and feathered and it's not too late...

 

 

 

These changes in underwriting standards, which are simply tools to assess the credit quality of the borrower, would not have been problematic if the rating agencies hadn't changed their rating standards to allow mortgage pools to obtain AAA ratings without subordinated equity interests supporting the debt (i.e. allowing 100% of the face value of the mortgage pool to be securitized). This change in credit rating standards allowed originators to sell mortgages for face value to the pool and have no continuing exposure to the credit. When I worked in structured finance in the early '90s, to get a AAA rating originators were required to keep "skin in the game" by servicing the mortgages and there was a mandatory equity interest supporting the sold pool (usually 20%, just like what mortgage originators require on the mortgages themselves), both of which were subordinated to the P&I payments on the bonds supported by the sold mortgage pool. The originator's profit on the pool was thus tied to the continuing creditworthiness of the pool, leaving the originator with a vested interest in ensuring that the credits were good, regardless of the level of documentation used to validate that perspective. When credit rating agencies no longer required subordinated equity interests or other methods of continuing risk exposure by the originator, then a moral hazard was created that encouraged originators to go originate as much as they could without regard for the credit quality of the loans originated. The changes in the documentation or underwriting standards didn't cause the problem - they just took away an objective method for MBS underwriters to reject mortgages. The change in the ratings structure, allowing for AAA ratings on mortgage pools when there was no underlying equity interest to take some of the losses and no servicing fee stream to the originator that put its profit at risk (both of which would encourage effective underwriting and appropriate allocation of losses), that's what caused the problem.

 

 

 

 

The Fannie / Freddie problem is a result of their muddled ownership and charter origins. Both are Congressionally chartered which means they are the maifestation of the nation's puiblic housing mandates and priorities. However, they are also stockholder owned, which assures that the enterprises will earn a competitive ROE. These are mutually exclusive constituents: public policy is rarely profitable.

 

A mistake that is often made in regards to Fannie/Freddie is that their affordable income programs were at the heart of their problems. This is false. The typical affordable housing program was a fullly documented loan that met every other underwriting guide except that the borrower need assistance in making a down payment on the purchase of their owner occupied home. Their incomes were documented and met similar tests for adequacy as non-affordable borrowers.

 

The real issue is that Fannie/Freddie were allowed to grow their retained portfolios to enormous proportions AND that these portfolios had securities that were collateralized by subprime mortgages. The irony is that they could buy securities backed by the very loans that they were prohibited to originate. Their participation was limited to the investment rated securities, but as was mentioned by another commenter, the ratings were bogus.

 

Fannie/Freddie grew their retained portfolios to compete for equity investment dollars because their metrics were often compared against Countrywide and other mortgage originators. In order to be competative and generate attractive returns, the agencies ballooned their balance sheets with senior bonds securitized from mortgages that were practically worthless.

 

Because they were not adequately regulated in terms of their capital requirements against the risk of owning these assets, when the bubble burst, it set in motion a tsunami of catastrophic credit issues throughout the housing and general credit markets.

 

 

 

 

One can look at all the inter-related causes, but at the end of the day, isn't the reason there was a bubble is that more people were "qualified" for mortgages under lower underwriting standards (causing asset prices to increase) and then those people could not meet their obligations? In other words, if the government had not pushed Fannie and Freddie to lower the bar (and put taxpayer dollars at risk, despite numerous warnings), then there would be no aggressive mortgage marketing companies (like Countrywide), no ratings agency issues, and no assets to hedge (Wall Street). One is cause, the other is effect. Our government wanted to spread the "dream" of home ownership and it backfired

 

 

 

 

 

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