# Presentation: 559842

## Discussion Of “Credit Booms and Lending Standards: Evidence From the Subprime Mortgage Market”

- By
- Edward J. Kane
- _Boston College_

- FDIC Conference
- September 18, 2008

## This paper shows that “lending standards” declined during the recent housing bubble and that the decline was sharper for loans that lenders chose to securitize.
Not only did mortgage lending standards slip, standards got lower and lower in each year from 2005 to 2007. This is evidenced by shifts in the percentage of defaults occurring in the first (say) 15 months of loan life. 
Overlending is evidence of an Incentive Breakdown.  But is it primarily a market or a political failure? To promote home ownership, Government subsidized leverage for borrowers and lenders alike.

- Not only did mortgage lending standards slip, standards got lower and lower in each year from 2005 to 2007. This is evidenced by shifts in the percentage of defaults occurring in the first (say) 15 months of loan life.
- Overlending is evidence of an Incentive Breakdown.  But is it primarily a market or a political failure? To promote home ownership, Government subsidized leverage for borrowers and lenders alike.

## Subprime defaults have got worse each year

**Subprime defaults have got worse each year**

## TO FIX THINGS PROPERLY, AUTHORITIES MUST ANSWER ONE QUESTION CORRECTLY:WHERE AND HOW DID SECURITIZATION GO WRONG? ANS. BY MARRYING BLIND TRUST IN REPUTATIONAL BONDING OF KEY FIRMS TO GYPSY ETHICS OF THEIR EMPLOYEES: SHORT-CUTTING AND OUTSOURCING DUE DILIGENCE IN SYNTHETIC CREDIT TRANSFERS 

## RESEMBLANCE OF FINANCIAL-OVERENGINEERING CRISIS TO THE SIMPLER S&L MESS

## Financial Engineering: Modern Credit-Risk Management Uses More Outside Information and  Entails Extra Dealmaking

- Client

- Deal-Maker

- Credit Risk Mgt. Group
- Counterparty evaluation
- Credit limits
- Concentration risk mgt.

- Credit
- Portfolio

- Risk Transfer

- The Credit
- Market

- Credit
- Pricing

- Safety-Net
- Supervisors

- CRO Supervision

## TO ILLUSTRATE THE “SECURITIZATION MESS” OF 2007-2008, WE NEED MANY MORE DESKS.

- The Fed and FHLB System helped Uncle Sam (Treasury).
- Hit-and-run lenders came on the scene alongside the banks (State-Chartered Nonbank Mortgage “Brokers”).
**A new layer of desks** must be introduced between the lenders and the government supervisors. The occupants of these additional desks are “**FINANCIAL ENGINEERS**” who claimed as a group to have the magical powers to turn very **RISKY **mortgage loans into **RISKLESS BONDS**:
- ACCOUNTING PROFESSION, APPRAISERS
- STATISTICAL MODELBUILDERS
**CROS: CREDIT RATING ORGANIZATIONS**
**INVESTMENT BANKERS & DERIVATIVES DEALERS**
- MONOLINE CREDIT INSURERS
- FINANCIAL SERVICERS
- GSEs and TRUSTEED INVESTORS

## COUNTERPARTIES AND SUPERVISORS SHOULD HAVE PERCEIVED OVERLEVERAGED LOANS TO STINK IN MANY WAYS

- Badly underwritten
- Poorly collateralized
- Inadequately documented
- Important risks were hidden or misrepresented

## FINANCIAL ENGINEERING MAY BE VISUALIZED AS MANUFACTURING RISK EXPOSURES IN FACTORY WORK STATIONS THAT ARE LOCATED ALONG A CONVEYOR BELT

- The different stations produce **contracts** that create, disguise, assess, assign, or insure overleveraged risk exposures.
- At each station, Product-Quality Inspectors (supervisors) were apt to use their computers to entertain themselves rather than to inspect the quality of the work that was passing by.

## Fannie and Freddie were the biggest buyers of garbage mortgage loans and securitizations: subprime & Alt-A mortgages and AAA tranches of private-label securitizations.

Especially from 2005 on, these purchases were driven by Congressional pressure on F and F to meet “affordable housing goals” administered and ratcheted upward each year by HUD. HUD could place F and F under a punitive consent agreement if GSEs did not meet these goals.  F and F accepted these goals as the price paid to Congress for keeping the safety-net subsidies they captured from leveraged risk-taking from being regulated more effectively.

My Theory: F and F insistent demand for loans and highly rated securitized claims on low-income households undermined due-diligence all along the securitization chain: Acted as garbage collectors of last resort 

- Especially from 2005 on, these purchases were driven by Congressional pressure on F and F to meet “affordable housing goals” administered and ratcheted upward each year by HUD. HUD could place F and F under a punitive consent agreement if GSEs did not meet these goals.  F and F accepted these goals as the price paid to Congress for keeping the safety-net subsidies they captured from leveraged risk-taking from being regulated more effectively.
- My Theory: F and F insistent demand for loans and highly rated securitized claims on low-income households undermined due-diligence all along the securitization chain: Acted as garbage collectors of last resort

## US regulatory framework is destabilizing. Disruptive elements subsidize creative forms of borrower and lender leverage in housing loans

- _Politically-Directed Subsidies to Selected Bank Borrowers_:  The policy framework either **explicitly requires**—or **implicitly rewards**—banks and GSEs for making credit available to selected classes of risky borrowers at a subsidized interest rate;
- 2. _Subsidies to Bank and GSE Risk-Taking_: The policy framework commits government officials to providing on **subsidized** terms **emergency loans** and **explicit or implicit conjectural guarantees** of repayment to depositors and other bank & GSE creditors;
- 3. _Defective Monitoring and Control of the Subsidies_: The contracting and accounting frameworks used by banks and government officials fail to make anyone **directly accountable** for reporting or controlling the **size** of either subsidy in a **conscientious** or **timely** fashion.

## Insufficient Reputational Damage to Officials from Unraveling of Affordable-Housing Pressure

## Credit-Rating Organizations Over-Rated the Highest-Quality Tranches of Structured-Finance Obligations

- Process of Rating Securitized Debt is a **Negotiation** that starts with **Issuer** specifying its desired rating. The CROs compete by specifying _structure and level of credit support_ needed to obtain it.
- Severe Conflict of Interest Between **Reputation** and **Revenues** exists in Rating Structured Securitizations (more than 40% of Moody’s 2005-06 Ratings Revenue came from such deals)
- CRO’s aggressive judgment that an adequately documented “true sale” of loan pool has taken place (necessary to spin pool off originator’s balance sheet) has _no legal standing_ and is **undermined** by CRO claims that it is _“unreasonable”_ to rely on their “mere opinions” which are not “investment advice”.
- CROs should have discounted their ratings on Complex Securitizations for modeling, legal and documentation risks.

## The major incentive weakness faced by federal supervisors is the political and practical difficulty of establishing and maintaining vision and deterrency for what is going on at CROs, at monoline insurers, at GSEs, and at major derivatives-trading institutions. The FDIC and Bank of England are at a disadvantage because: 

- 1) CROs and Derivatives-trading institutions’ principal supervisors are **housed in other agencies** that have clientele incentives to treat them as Too Important to Discipline Adequately.
- 2) Such firms and major CROs are too big, too complex, and too politically well-connected to fail and unwind (TDTFU).

## No One Wanted to Catch or Be Caught

## Incentives Drive Zombie Preservation

-  Decision-making **horizons** of incumbent top regulators are seldom more than a few years in length (need for deferred compensation and fair-value budgeting for implicit subsidies)
-  Mercy and Nonescalation Norms extend the life of zombie firms
-  Disaster myopia (Guttentag & Herring) undermines timely prevention:
- 	Definition:  Disaster myopia exists when authorities 	systematically underestimate the frequency of crisis 	pressures and long-term incentive effects of implicit bailouts.

**Incentives Drive Zombie Preservation**

## The US needs to Reform the incentives of Supervisors, not the Structure of Regulation.  Goal must be to enforce duties of loyalty, competence, and care that agents and principals owe one another.

- In firms and in government, Supervisors five specific duties to their principals:
- 	1. _A duty of vision_: They should continually adapt their surveillance systems to counter regulatee efforts to disguise their rulebreaking;
- 	2. _A duty of prompt corrective action_: They should stand ready to discipline rulebreakers whenever a violation is observed;
- 	3. _A duty of efficient operation_: They should produce their services at minimum cost;
- 	4. _A duty of conscientious representation_: They should be prepared to put the interest of the community they serve ahead of their own.
- 	5. _A duty of accountability_: They should make themselves answerable for neglecting or botching their duties.  (Issue for CROs and monoline insurers is to bond the quality of their performance in a meaningful way.)

## 1) Derivatives-trading institutions’ principal supervisors are housed in other federal agencies that have incentives to treat them as Too Big to Discipline Adequately.
2) Such firms and major CROs are too big, too complex, and too politically well-connected to fail and unwind (TBTFU).

- 1) Derivatives-trading institutions’ principal supervisors are housed in other federal agencies that have incentives to treat them as Too Big to Discipline Adequately.
- 2) Such firms and major CROs are too big, too complex, and too politically well-connected to fail and unwind (TBTFU).

## SOME SPECIFIC REFORMS

- Safety-Net subsidies must be estimated both by beneficiary institutions and by politically accountable supervisory officials (≠ only the Fed)
- No government regulation should rely on CRO ratings: Sin of Simony
- CROs must disclose information used and bond against negligent construction of models and data samples; should report ratings in 2 dimensions
- Securitizers should report monthly balance sheets and income statements for underlying asset pools.