Tag: banks

The Knee Bone’s Connected to the Shin Bone

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In simplest terms, the mortgage lending industry collects deposits to make loans possible.  As mortgage lending has grown increasingly complex, the checks and balances of a simpler time have been lost.  Like the proverbial frog boiled as the water temperature rose, bankers did not perceive the changes in systemic risks.  Like the subjects in Hofstadter’s “Escher, Gödel and Bach”, a strange loop has been formed that could not be predicted from its components.

http://en.wikipedia.org/wiki/G%C3%B6del,_Escher,_Bach

In place of the original triplet of depositor, banker and borrower, today we have no less than 14 actors to consider: borrower, mortgage broker, mortgage product, mortgage broker firm, mortgage lender, guarantor, consolidator, mortgage-backed security, securitized asset, credit default swap, credit rating agency, investment banker, investors, regulators and auditors.

In 1776, Adam Smith provided scientific, philosophical, ethical and political support for free markets of independent buyers and sellers. Academic economists from Alfred Marshall through the Chicago School provided sophisticated theoretical, historical and statistical support for free markets.  Ronald Reagan and Margaret Thatcher consolidated political support for free markets.  NONE of them had a 14 step conga line in mind.

http://www.youtube.com/watch?v=RKtPrOiMj3o

At every step, we have the risks of self-interest creating failure rather than an efficient market with optimal social welfare.

Borrowers have an incentive to lie to mortgage brokers about their income.

Mortgage brokers have an incentive to process as many successful mortgages as possible, coaching borrowers and appraisers.

Mortgage lenders and firms have an incentive to devise mortgage products that are most attractive to borrowers, including no money down, variable interest rates and negative amortization beauties. 

Mortgage broker firms have an incentive to generate volume, without regard to the risks that will be born by the lenders or investors.

Mortgage lenders have an incentive to book as much volume as possible; locking in profit spreads for 30 years.

Fannie Mae and Freddie Mac serve a pivotal role, consolidating and guaranteeing individual loans and collections of loans in support of the American ideal of home ownership.  As quasi-government agencies, they have an incentive to capture congressional support through campaign contributions.

http://www.diffen.com/difference/Fannie_Mae_vs_Freddie_Mac

Mortgage backed securities provide the key gap in the chain of responsibilities.  They allow the mortgage brokers and lenders to transfer liability for mortgage defaults to investors.  Theoretically, these financial instruments greatly increase the sources of funds and through the portfolio effect reduce risks for everyone.

http://en.wikipedia.org/wiki/Mortgage-backed_security

The most sophisticated financial engineering is used to transform a portfolio of mortgages into a new set of securities that separate risks into layers, theoretically allowing some investors to have low risks and returns while others assume moderate and higher risks and returns.  This financial alchemy also increases the pool of potential investors and fine-tunes the risks assumed.

http://en.wikipedia.org/wiki/Securitization

Investors in mortgaged backed securities and their derivatives are not fools.  They understand that risks accompay these innovative instruments and that there are inherent underlying risks.  As sophisticated investors, familiar with derivatives of all flavors, they seek ways to limit their risks.  Credit default swaps were created to provide them with additional security about the risks involved in investing in securitized mortgage based securities.

http://en.wikipedia.org/wiki/Credit_default_swap

Credit default swaps and mortgage-backed securities are evaluated by credit rating agencies.  The growing complexity of financial instruments greatly increased their business volume and relations with investment banks.  They provided overly positive ratings historically.  They were paid by the firms that created the securities.  No one should be surprised by the results.

http://en.wikipedia.org/wiki/Credit_rating_agency

Investment bankers have played a key role in the growth of the securitized mortgage industry. They collect fees as advisors in the creation of products and as advisors to mortgage brokers, mortgage lenders,  guarantors,  consolidators and investors.In their banking role, they have invested directly in these securities, provided funds for others to invest and developed derivatives to allow bets against the securities.  Investment bankers have supported both political parties.

The securitization of mortgages has allowed a wide variety of individuals and firms to invest in these assets, including banks and investment banks as part of their overall portfolios.

Regulators have tried to keep pace with these innovations, but failed.

Auditors have invested their resources complying with the details of the Sarbanes-Oxley legislation, but missed the change in risks in this complex system.

The mortgage world has become very complex in the last 30 years.  The proponents of “financial reform” in both parties need to closely review the reality of a 14 actor system.  There is a trade-off between the benefits of financial innovation and the regulatory costs of financial complexity.  We have clearly crossed the line where the costs of complexity (regulatory and risk) have exceeded the benefits of innovations (funding and reduced risks).

Banking in Bedford Falls

tomkapostasy1 Comment

As the Great Recession moves along into its third calendar year, the focus in Washington is on “Financial Reform”.   The backlash at Democrats and Republicans alike over the “bank bailout” continues to grow.  The politicians are posturing to allocate credit for the so-called reforms, but seem destined to “give the people what they want”.  It might help the politicians and the people if there was a shared understanding of the inherent factors universally at play in the home lending market.

I propose that everyone take an evening off and watch the classic 1946 film “It’s a Wonderful Life”, starring James Stewart as George Bailey, the initially reluctant but eventually heroic, manager of the Bailey Building & Loan Association in Bedford Falls.

http://en.wikipedia.org/wiki/It’s_a_Wonderful_Life

The essentials of banking are exhibited in this film.  Bedford Falls is the whole universe.  All of the actors know one another.  The cast is composed of depositors, owners, board members, bankers, borrowers, regulators and landlords. 

There are inherent conflicts between the roles.  Depositors don’t really trust the bank as shown by the bank run.  Landlords would like to see lending restricted to boost rents.  The owners are motivated by self-interest (enlightened or not) and set policy accordingly.  The board seeks a trustworthy banker to be its agent, and provides incentives to attract and retain him.  The banker has fiduciary and personal motives.  The regulators enforce the laws, unaware of all key facts.  The borrowers want loans, even if they can not afford them, in order to escape the costs of the landlords.  People act out of self-interest.  They respond to incentives.  There are trade-offs to be evaluated and decisions to be made.

A bank fills a valuable social role, attracting deposits in order to lend money.  A bank profits by the spread.  A bank is in business to lend money whenever it sees a profitable opportunity, irrespective of the moral concerns of owners, depositors or borrowers.  Banking is subject to real risks such as bank runs.  Banks are subject to poor decisions by bankers, mistakes by employees and fraud by anyone involved in any transaction. 

Historically, banks have operated by the 4 C’s of credit: capacity/cash flow, capital/collateral, conditions and character.  This is especially effective in a small town such as Bedford Falls.  Although George and the audience might hope that every citizen should qualify for a loan, some may not have the earnings to cover the principle, interest, insurance and maintenance of a home.  Some may not be able to save for a down payment to create adequate collateral.  As business conditions change, the income of the citizens is at risk and the ability of the bank to manage its affairs fluctuates.  A banker with a long-term perspective and proper incentives adjusts lending accordingly.  Finally, character counts.  Past financial and personal performance are good predictors of future performance.  Character is part objective and part subjective.

Even in this simplified setting, risks abound.  Public pressure for universal home ownership can result in too many loans.  Regulators can enforce laws mechanically while missing larger problems.  Institutional knowledge can be lost through staff turnover.  A single fraudulent act can threaten a bank.  Changing external business conditions can disrupt the bank.  Lending policies can be too loose or too tight.  Business judgments can be wrong.

The film delivers an escapist, idealist, overly simplistic view of life.  Mr. Potter is the evil bank owner and plotting, fraudulent landlord.  George Bailey is the selfless hero.  Yet, behind the scenes, we have a social institution performing a social function.  We need banks to provide the social function of collecting deposits, allocating credit and collecting from borrowers.  In spite of the vastly more complex institutional structures today, the role of a “building & loan association” is essentially the same.  As a society, we allow these institutions to connect savers and borrowers across varied time frames because this is a necessary function.  Our laws and regulations should be based on this real-world understanding, not upon the simplistic dualism of “good and evil”.