Stock Prices At Heart Of Mortgage Crash
A new and revealing study by the Mortgage Bankers Association argues that the introduction of risky loan products during the past few years was caused in large measure by efforts to pump up lender stock prices.
Written by Clifford V. Rossi, a business professor at the University of Maryland, Anatomy of Risk Management Practices in the Mortgage Industry: Lessons for the Future “contends that expansion into riskier products by mortgage firms that subsequently suffered large credit losses was a strategy intended to grow the franchise and along with it the attractiveness of the firm to investors.”
The goal was to increase the “attractiveness of the firm to investors.” In other words, company stock. “If executives could not earn a higher return on invested capital,” explains Rossi, “they would be replaced through a takeover by executives who could. This message was consistently and convincingly hammered home by Wall Street analysts to every increasingly anxious CEO and CFO.”
The report says that new loan formats were developed in an environment where the true extent of lender risk was not understood.
Multiple Causes
Rossi says “no single factor was responsible for the significant expansion of credit and mortgage products during the period leading up to the mortgage crisis. However, there are indications that greater risk-taking could be attributed to the following factors:
- “An over-reliance on performance metrics not adjusted for risk which would lead management toward riskier products
- “Data and analytical limitations and blind spots that led risk managers to grossly underestimate credit losses
- “Cognitive biases among senior business managers that over time led them to take greater risks, and in the process reduced the effectiveness of risk management practices
- “Incentive problems leading to regulatory actions that wound up not being in the best interest of the taxpayer.”
Bad Timing
Rossi says non-traditional mortgage products were introduced during a period when home appreciation was strong and interest rates were near historic lows.
“This favorable economic environment,” says Rossi, “contributed to a period in which mortgage default rates were very low by historical standards. As a result, the economic environment tended to bias loss estimates downward in a real
sense. This contributed to further mortgage expansion and vast understatement of potential losses due to risk layering and the expansion of nontraditional mortgage products such as option ARMs and piggyback HELOCs. The development of new products and the expansion of risk parameters on existing products came at perhaps the worst time. With virtually no historical experience with these new risk combinations and that which existed largely coming from a benign economic environment, risk models would have little hope to accurately reflect expected loss, let alone loss levels during an extreme event such as the financial crisis.”
Translation: Industry leaders should have listened to stock brokers who always remind us that past performance does not guarantee future results.
No Doc Loans
Another interesting point made by Rossi concerns the increased use of no-doc and low-doc mortgage applications.
“As underwriting standards on income documentation and LTV loosened, allowing for both limited or no income verification and low equity stakes in the property, traditional borrower sentiment toward home ownership changed. Renters were increasingly able to become homeowners with little downpayment and with creative cash flow structures that provided short-term payment capacity. As long as home prices continued to rise, a borrower in such a situation could refinance out of one loan and into another, or sell the property without loss. But once home prices peaked, particularly for those purchasing their home at or near the top of the cycle and possessing limited equity in the property, borrowers became stranded in the home with few alternatives. In such cases, borrowers ruthlessly exercised their default option as historically important ties to the home were outweighed by excessive payment burdens coupled with negative equity in the home. At the same time, widespread lapses in controls of counterparties as evidenced by a spike in mortgage fraud aggravated a growing credit problem.”
This is an area where I disagree with Rossi. While there was surely a lot of mortgage fraud, there was also a lot of predatory lending where — for example — borrowers who qualified for better financing were sold high-cost subprime mortgages. Unfortunately, the term “predatory” does not appear in the report. Also among the missing is the word “fiduciary,” as in the lack of an obligation under federal rules by lenders to get the best possible rates and terms for borrowers.
That said, the Rossi report is unusually well-done and should be read by anyone who wants a better understanding of the motivations which led to the mortgage meltdown. It’s a step forward, helpful and insightful.
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