Not Just My Opinion October 22, 2007
Posted by robzel in Business, financial companies, New York Times.Tags: auction, lending. subprime, Mortgage, mortgage crisis, New York Times, Paul Krugman
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Paul Krugman’s editorial in today’s NY Times echos what I wrote about the economy last week (http://www.nytimes.com/2007/10/22/opinion/22krugman.html?_r=1&ref=opinion&oref=slogin). I do admit, I like his explanation better, but he has been writing a lot longer than I have.
On the front page of the Times is a related story about how the lending crisis has created an aggressive real estate auction market. As the article points out, “It’s a symptom of the foreclosure crisis…and it’s cause for concern that …areas that are already hit by investors who are buying up properties to rent them out, which makes neighborhoods less stable than owner-occupied housing”. (http://www.nytimes.com/2007/10/22/us/22auction.html?ref=us)
It seems this mortgage crisis may have some legs. Of course the contrarian in me has to point out that some buying opportunities may present themselves once the dust settles.
The Future of the US Economy October 17, 2007
Posted by robzel in Business, financial companies, Housing, Mortgage.Tags: economic cycle, economy, Housing, lending, Mortgage, mortgage market
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Like ripples in a pond, the downturn in the US mortgage market will have effects that expand into other areas of the US economy. This holiday season will likely be especially brutal as the ability to use increasing home values and therefore home equity to fuel consumer spending has all but disappeared. It seems we should have seen this coming; the reality is many people did. The issue was not that a slump in housing would occur, but rather the timing. Most economist using tools developed for the analysis of past housing cycles did not anticipate the impact of the secondary and derivative markets in supporting the continued growth in mortgage lending. There was no way to predict these impacts, because much of these derivative products never existed until recently.
To understand the impacts these secondary markets had on the mortgage industry is illustrative to follow the path of a typical mortgage: The process typically starts with a mortgage broker. The broker gathers information from the borrower including personal information, income, and property information. Since the property is used as collateral, an appraisal is typically ordered and is incorporated into the underwriting process. Based upon the information gathered, loan terms are generated which include not just income and property information, but also includes an evaluation of the applicants credit bureau. Many lenders choose not to keep these loans on their books, but instead sell them to Wall Street companies. The advantage to selling these loans is the ability to generate cash more quickly than gathering payments from customers over time. The amount received for a loan is based upon many factors such as the type of loan (fixed vs. variable rate), duration of the loan, credit quality, etc. By selling these loans, the selling company frees up more cash and thereby the ability to go out and generate more loans. As long as a buyer exists for an originated loan, a selling company has almost unlimited potential to continue to generate loans.
The process still continues on: Firms buying loans strip them into components for sale to investors. Some examples are selling principle and interest payments as separate products, selling future originations, etc. Underlying all of this are rating agencies that were supposed to give some estimate of the probability that the derivative products created might default. If you have been following this story in the press, you know that the rating agencies have missed the mark.
To summarize, the secondary markets did what they were supposed to do in one sense; they created liquidity which enabled the housing boom to occur. However, in another very important sense these same markets created an extreme distortion in the mortgage market. The underlying principle in any efficient market is having good information. In the case of the derivative mortgage market information was extremely distorted, kind of like smearing Vaseline over some thick coke bottle eyeglasses. In the ‘old days’, when a bank actually underwrote and managed a mortgage loan the credit quality of an applicant and the asset quality of their home were the primary concern. Secondary markets refocused this view to originating as many saleable loans as possible. Over time, underwriting became less of a concern as there were buyers in the secondary markets for almost any type of loan originated. Again these buyers were less concerned about asset values or credit quality but rather returns and income streams which supposedly were factored into the rating of each derivative product. In this market cycle products began to be created where an applicant did not even have to provide proof of income and other information. This type of lending was unheard of in previous mortgage cycles. In latest cycle there were buyers for these ‘no document’ loans and other types of non-traditional mortgage products.
Irrational exuberance was the term used to define the Internet stock bubble. The lesson from the fall internet stocks was a loss of sight of investment fundamentals. Investors were not interested in whether a company had any real intrinsic value or even much future potential. Instead a heard mentality prevailed with everyone scrambling to trade on the latest rumor or a tip from a friend. The fall of the mortgage market has many parallels to the fall of Internet stocks. The real question is whether lessons will be learned or will history repeat itself.
The Decipline of Managing Risk October 3, 2007
Posted by robzel in financial companies, New York Times, Risk Management, Zelcom Group.Tags: American Banker, banking, Citi, finance, financial companies, lending, quantitative, Risk, Risk Management, subprime, Zelcom
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There was a recent editorial by Joe Rizzi in American Banker titled the “The Mismanagement of Risk Management” (www.americanbanker.com). Unfortunately, you need a subscription to view the editorial. To summarize, the opinion piece describes how risk management has progressed from a judgmental “collection of ad-hoc practitioner rules of thumb into a bona fide discipline”. I would agree with this statement. However, Mr. Rizzi goes on to say that, “Risk Management has become a hyper-technical, specialist control activity with limited linkage to management or shareholders…A reliance on (statistical) models may encourage us to become lax and to amplify market volatility.” Mr. Rizzi goes on to argue that over-reliance on risk management techniques can lead to overconfidence by business managers which in turn can cause companies to take on too much risk.
While I think Mr. Rizzi makes some good points, he fails to point out that at least in some cases, business leaders fail to heed the advice given to them by their risk managers. Any seasoned risk manager knows that models or other statistical tools can start to break down in periods of rapid economic changes such as we are experiencing in the housing market. Further, these changes are not parallel across the credit spectrum, but tend to impact sub-prime groups more than prime groups. What tends to drive deaf ears are the high yields of subprime accounts coupled the ease of acquiring these account relative to prime accounts. The typical business manager is always facing the challenge of getting the most bang for each marketing dollar spent and subprime accounts always seem to be an easy way to boost a revenue number. In a economic downturn such as we are currently experiencing funding rates can begin to climb which pushes margins down. This again tends to push business managers to focus more on higher yielding subprime accounts to gain back some margin. In the end, this only exacerbates to problem.
There have been regulatory efforts such as Sorbanes-Oxley and Basel II that require better reporting and analysis of risk. While these regulations may have some mitigating effect, they do not necessarily prevent some of the blow ups that have occurred recently. I agree with Mr. Rizzi that, “…regulatory requirements can become a ceiling rather than a floor, which slows the development of risk management”.
Finally, Mr Rizzi argues that there should be less focus on quantitative risk management and more focus on including risk in “strategic planning, capital management, and performance measurement.” While I disagree that there should be less focus on quantitative risk management, I do agree that risk management should be viewed not as single cost avoidance strategy, but as a holistic quantitative way to evaluate business opportunities.
Many companies have moved in the direction of creating enterprise risk management type functions that focus not just on loss avoidance, but rather on creating profit. Unlike Mr. Rizzi, I do believe that while all employees should be focused on maximizing profit, it is necessary to create an organization with the proper checks and balances. In this regard, risk management or enterprise risk management functions need to have the ability to say “no”. At the same time, successful risk managers will also recognize they need to develop creative solutions that solve the collective business goals and objectives rather than just preventing business from happening. It is this constructive tension that tends to lead to effective business decisions and ultimately successful companies.
