COLUMN: Guarding against the Next Clever Idea

Article excerpt

Byline: Andrew Kahr

Successive spasms of legislative and regulatory actions followed the financial crisis of 2007-8 - accompanied by a chorus of assertions that these and more changes are needed to avert future crises.

To judge from the substance of the new laws and regulations, one might imagine that the crisis was caused by a whole host of exotic bank oversteps, such as arbitrary increases in credit card rates; banks buying and selling securities for their own accounts; and overdraft fees on debit cards. But although the purported cures to eliminate these supposed causes are doubtless less painful than another crisis would be, fact is that none of these putative forms of misconduct by banks caused or even contributed to the crisis.

Put forward more seriously at times is the notion that subprime consumer lending somehow ran amok. That's also wrong. Payday lenders didn't go broke. Subprime auto lenders remained in business. Pawnshops are flourishing.

The catastrophe started and will finish with residential mortgages. And it was by no means limited to "subprime mortgages" - unless we now expand our use of the term subprime to include poorly designed and underwritten mortgages that were marketed to people with high credit scores. Fannie Mae and Freddie Mac exhausted their capital primarily because of their guarantees of so-called conforming mortgages, not subprime mortgages.

Why were unsound products, such as payment option and 100% mortgages, so heavily marketed? Why were mortgages offered to consumers who failed to meet reasonable underwriting standards such as verification of income? During the same period, banks and non banks maintained a full range of other sane and profitable lending products, from boat loans to deposit advances. None of these suffered fulminating losses. What was different about mortgages?

Mortgages and no other type of consumer loan made possible securitizations in which, once the loans were sold, any perceived risk to the originating and pipeline institutions was tiny compared with their profits from the securitization activity. You couldn't do the same thing with auto loans or credit cards. When a credit card securitization fails because of high credit losses - a very rare event - the lender either makes good or is bankrupted.

If you expect to make money originating a mortgage irrespective of its ultimate performance, then you minimize origination time and cost - and quality. This is most obvious to a mortgage broker or correspondent bank. But it applies also to anyone who can profit by selling the mortgage into an impersonal and heedless market. …