Why Lending Standards Matter

[David Farber <dave () farber net>]

Begin forwarded message:

From: Barry Ritholtz <ritholtz () optonline net>
Date: October 21, 2008 7:25:16 AM EDT
To: dave () farber net
Cc: huitema () windows microsoft com
Subject: Why Lending Standards Matter

Dave,
There is a general lack of understanding as to how the Housing boom  
and bust occurred, and why it led to the subsequent credit freeze. The  
situation is complex, and that is why we are still explaining this 3  
years into the housing bust.

Let me take another shot at clarifying this:

Underlying EVERYTHING -- housing boom and bust, derivative explosion,  
credit crisis -- is the enormous change in lending standards that  
occurred. I am not sure many people understand the massive change that  
took place during the 2002-07 period. It was more than a subtle shift  
-- it was an abdication of the traditional lending standards that had  
existed for decades, if not centuries.

Its the key to the current situation.

After the Greenspan Fed slashed rates, home prices began to levitate.  
More and more mortgage were being securitized -- purchased by Wall  
Street, and repackaged into other forms of bond-like paper. The low  
rates spurred demand for these higher yielding, triple AAA rated,  
asset-backed paper.

In this ultra-low rate environment, where prices are appreciating, and  
most mortgages were being securitized, all that mattered to the  
mortgage originator was that a BORROWER NOT DEFAULT FOR 90 DAYS (some  
contracts were 6 Months). The contracts between the firms that  
originated mortgages and the Wall Street firms that  securitized them  
had explicit warranties. The mortgage seller guaranteed to the  
mortgage bundle buyer (underwriter) that payments were current, the  
mortgage holders were valid, and that the loan would not default for  
90 or 180 days

So long as the mortgage did not default in that period of time, it  
could not be "put back" to the originator. A salesman or mortgage  
business would only lose their fee if the borrower defaults within  
that 3 or 6 month contractually specified period. Indeed, a default  
gave the buyer the right to return the mortgage and charge back the  
lender the full purchase price.

What do rational, profit-maximizers do? They put people in houses that  
would not default in 90 days -- and the easiest way to do that were  
the 2/28 ARM mortgages. Cheap teaser rates for 24 months, then the big  
reset. Once the reset occurred 24 months later, it was long off the  
books of the mortgage originators -- by then, it was Wall Street's  
problem.

This was a monumental change in lending standards. It created millions  
of mew potential home buyers.  Why? Instead of making sure that  
borrowers could pay back a loan, and not default over the course of a  
30 YEAR FIXED MORTGAGE, originators only had to find people who could  
afford the teaser rate for a few months.

This was a simply unprecedented shift in lending standards.

And, its why 293 mortgage lenders have imploded -- all of these bad  
loans were put back to them. Note that the fear of this occurring is  
what was supposed to keep the lenders in line. The repercussions of  
this is why Greenspan believed the free market could self-regulate.  
(After all, people are rational, right?) One of the many odd lessons  
of this era is that, under certain circumstances, companies and  
salespeople will pursue short term profits to the point where it  
literally destroys the firm.

If you want to point to the single most important element of the  
Housing boom and bust, this is it. Ultimately, these defaulting  
mortgages underlie the entire credit freeze. And, it would not have  
been possible without the Greenspan ultra-low rates, which made the  
teaser portion (the "2" of the 2/28) of these mortgages so attractive.



Barry Ritholtz
The Big Picture
~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~
Macro perspectives on the Capital Markets, Economy, Geopolitics,  
Technology and Digital Media
http://bigpicture.typepad.com/comments



On Oct 21, 2008, at 3:42 AM, David Farber wrote:

> Begin forwarded message:
>
> From: Christian Huitema <huitema () windows microsoft com>
> Date: October 20, 2008 10:36:40 PM EDT
> To: "dave () farber net" <dave () farber net>
> Subject: RE: [IP] Credit Default Swap (CDS) question and answer
>
> > Despite their apparent
> > sophistication, almost everyone seems to have underestimated the
> > volatility in the mortgage market.
>
> Volatility? It hardly has anything to do with volatility. In theory,  
> aggregation uses the law of big numbers to deal with volatility. If  
> you aggregate a large enough number of anything, you reduce the  
> standard deviation, thus reduce volatility. However, the problem  
> with the dubious mortgage was with the first moment, not the second  
> one. If every mortgage in a lot is actually worth 50 or 60% of the  
> nominal amount, aggregation does not guarantees that the average  
> converges to 100%. The more you aggregate, the more likely you are  
> to converge on the underlying 50 or 60%, or whatever the actual  
> value is.
>
>
> -- Christian Huitema











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