In continuing with the regulation theme, I wanted to consider one way in which regulation advocates might believe the crisis could have been prevented: a more highly regulated mortgage industry. What if those evil/negligent/stupid mortgage brokers hadn't been allowed to originate wacky subprime mortgages? What if a regulation had been there to stop it? If you believe that regulation should be put in place to prevent a subprime housing bubble in the future, then this idea probably seems attractive.
But how would the government go about telling mortgage originators how to write mortgages? They've already got truth-in-lending disclosures, so borrowers know what they're getting into. You'd have to go further and have specific requirements about the basic underwriting standards.
For example, maybe some government regulator could step in and say, for a $100,000 mortgage, you have to prove an income of at least $30,000.
But what if this person also had a loan for a $50,000 automobile? Suddenly, it seems less plausible that he can afford the same mortgage, given his income. So maybe the regulator should take all debt into account.
Oh, this person also has a terrible track record of paying his bills, so his credit score is only 550. Maybe he won't qualify, and the regulator should make the cut-off 650.
If this seems complicated, welcome to the life of the underwriters in a mortgage company. Their job is to look at as many as a dozen or more characteristics and predict if each person requesting a loan can actually pay it back. They've got all sorts of tools at their disposal too, like loan term and interest rate. They develop complicated models where they can plug in lots of variables and out pops a decision, or probably a few scenarios, under which they think it would be profitable to underwrite the loan.
Mortgage originators are very protective of their underwriting models. They consider them to be highly sensitive, proprietary information. Some require outside consultants to sign a non-disclosure agreement before seeing them; others won't allow outsiders to see them under any circumstances. That's because good underwriting models can provide a strategic advantage to finance companies.
The evidence seems to indicate that they did a pretty poor job of this the past few years. If their models had correct predicted borrower performance, then we wouldn't be in this mess.
In order to remedy their inability to properly assess the creditworthiness of their customers, the government could step in and regulate underwriting standards. For example, they could say that, in order to qualify for a mortgage, you need a credit score of at least 720. That would certainly prevent many defaults, but it would also be pretty bad news for someone making $250,000 per year with no other debt but a credit score of 719.
How do government regulators hope to succeed where decades of experience has led mortgage bankers to fail? Underwriting is more an art than a science, and even the most brilliant of experts didn't know things would be this bad.
Another problem is also lurking: if the government steps in and standardizes underwriting, then those underwriters will all be going after the same people, offering them the same deals and ignoring those who don't fit into the government mandated mold. That leaves no room for strategy or innovation, and also means the credit market can never be broadened.
That's why it seems like the best solution is to have mortgage originators compete and create their own underwriting models. That way they can determine under which circumstances groups of people with similar characteristics might be less likely to default. They then price mortgages to mitigate risk accordingly.
So why did the market fail?
I would argue that it was not so much lax underwriting standards, but faulty market assumptions. If houses in Florida and California had continued to increase 5% to 10% per year forever, then the vast majority of those subprime loans would have been okay. And even the ones that weren't okay might have been forced to sell their houses, but ultimately have come out ahead, since those houses would have increased in value.
The error, of course, is in assuming that real estate would continue to appreciate in a historically unprecedented manner. But having visited many mortgage companies in 2004-2005 who were making these subprime loans, I can attest, they believed this bad assumption was perfectly reasonable. Otherwise, they would never have allowed those subprime borrowers to pass their underwriting standards.
So really, the best solution would be to somehow regulate out stupid market assumptions. I'm not sure how the government does that. The government fell for it too -- just ask Fannie Mae or Freddie Mac. But if their proxy is to regulate underwriting standards and constrain the ability of banks to responsibly broaden the credit market, then I'm not sure that gets us to a much better outcome.
The lenders that use "lax" underwriting standards will always fail because the loans they originate will never be repaid.
The Value at Risk models that you refer to as "faulty market assumptions" are just that, faulty. Anyone with a more than basic knowledge of mathematics would tell you that any model based on assumptions has, at the root of the assumptions, faulty logic. No one can predict the future and those that tell you they can, lie.
That is what happened, in part, with the "subprime crisis". The Value at Risk (VaR) models that were used contained within the formulas assumptions that could not be proven. By accepting these models without the necessary skepticism and betting billions of dollars on the faulty assumptions, many lenders effectively "shot themselves in the foot" when making loans. (This assumes that there was no level of greed regarding compensation).
Lending is an art. It does require a knowledge and measurement of people and their capacity to repay loans. It also requires an aversion to risk by the lender. What the models provided was risk mitigation in a very lax lending environment. No one bothered to check anyone else's work, and therein lay the beginning of the "subprime crisis" and indeed the "Great Recession".
True, VaR is garbage, but that was not the only risk management model used. Over-used, yes, but default models are more complicated, although as you mentioned, any model is only as good as the assumptions underlying it, GiGo, as it were.
Also this article is confusing. When the Govt's "unofficial" policies were to cram home ownership to everyone, why would they want to make it harder to get a mortgage? If we're gonna get more regulation, it has to start at the top with policy change, and understanding that home ownership for everyone is not an outcome the gov't should be encouraging.
Another issue was not that instead of building a robust model and then plugging in data to get the result, sometimes models were built in order to produce a desired outcome or set thereof.
One more thing, in addition to assumptions about ever-increasing real estate values, I spoke to a friend a while back on a large bank's CDO desk, who told me something I couldn't have possibly imagined: No one on the structuring/buying side ever imagined how badly borrowers/brokers lied on mortgage apps/underwriting. Unfortunately, there was plenty of lying and fraud, and I think to a not insignificant extent, that issue needs to be discussed more.
wow that was very poorly-written, apologize for the multitasking fail
The solution is simpler. Require that all the parties in the mortgage creation chain have some skin in the game, that is they have to put some of their own money at risk. All the other problems would solve themselves.
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I agree that these kinds of regulations would be counterproductive. The government already enforces a sort of regulation on mortgage quality via Fannie/Freddie's purchases of loans, creating a tier of qualifying 'prime' mortgages.
My feeling (and correct me if I'm wrong) is the problem was faulty assumption on the part of the financial companies buying the loans from the originators, since the purchasers would buy basically whatever originators put out, then there was no pressure to be careful with the loans as-written, so the standards were lowered in order to keep the fees coming in.
Should we assume that since everyone got burned this won't happen again? Should we regulate the stable door closed and locked now, or is there a regulatory principle to mitigate the damage? I don't know what one would be. Requiring originators to hold a percentage of the loans they sell would be something. Maybe some regulations on securitization would be worthwhile (not ending it, just creating some incentives to manage them better).
Requiring the orginators to hold a percentage would be a great start to regulatory reform by creating a "dis"incentive for passing off bad loans for securitization.
Your point was correct, that in the rush to book fee income, both originators and the purchasers in the secondary market lost sight of underwriting standards. This was done in part becuase the loans were sold to the securities market, bundled, and then sold again - purportedly diversifying the risk.
I think another good way forward is to tie the orignators compensation to the 80% of the life of the loan. In the insurance industry, our agents receive a portion of you premiums of the course of the policy. This disincentive prevents the haphazard writing of policies. I think a policy shaped after that fashion would require mortgage orginators, to look less at the initial fee income and more at the earning potential over the life of the loan.