Greed and fear are the two great motivators. However, if greed dominates fear, then we become blind to some obvious dangers.
Recently, something went badly wrong with the US mortgage market. Somehow, people forgot fear and focused on greed. Banks started to give out loans without considering whether people could pay the money back.
Normally, bankers should treat all potential borrowers with the utmost fear. Borrowers can destroy banks. Borrowers can default on loans, delay payment and provide fraudulent information. If I may paraphrase Mad-Eye Moody from Harry Potter, Banks need "constant vigilence" when confronting those nasty potential defaulters and defrauders that go under the name of borrowers.
Here is an article from Bankrate.com. It sheds some light on how banks stopped fearing borrowers and just handed out cash without any serious consideration of the risks. The answer appears to be straightfoward. Incentives changed. Origination volumes became more important than long term profitability.
Soon, the pendulum will swing the other way; greed will stand aside and fear will take over. Banks will tighten credit, risk premia will again become important, and as credit becomes more expensive, both consumption and investment will fall. When that happens, an old ghost will return to haunt America – recession.
The nonprime mortgage business is in a mess because during the boom years, hardly anyone had an incentive to say no.
The people who take applications, the companies that lend the money, the appraisers who check property values, the investment banks that sell mortgages to investors and the investors themselves -- all had millions of reasons to keep mortgages flowing to borrowers who couldn't afford them. Each reason had a dollar sign attached to it. As long as each participant kept saying yes to risky borrowers, everyone made money.
"It's like we were originating willy-nilly, with abandon, and the consequences be damned," says Christopher Cruise, who trains brokers and loan officers. "As Americans, we're accustomed to not being told no. ... If we want to have a mortgage loan and we want it now, we don't want to hear about the potential consequences down the road."
That goes for borrowers and also for the players throughout the mortgage industry. The siren song of bountiful paychecks drowned out the murmurings of conscience.
"Are there individuals and folks in the supply chain here and there that don't care, or don't necessarily have the borrower's best interest at heart?" asks Jim Svinth, chief economist for LendingTree.com. "Yes. But that can be said about just about any industry where people are paid on commission."
Make the deal, dump the risk
Recently, something went badly wrong with the US mortgage market. Somehow, people forgot fear and focused on greed. Banks started to give out loans without considering whether people could pay the money back.
Normally, bankers should treat all potential borrowers with the utmost fear. Borrowers can destroy banks. Borrowers can default on loans, delay payment and provide fraudulent information. If I may paraphrase Mad-Eye Moody from Harry Potter, Banks need "constant vigilence" when confronting those nasty potential defaulters and defrauders that go under the name of borrowers.
Here is an article from Bankrate.com. It sheds some light on how banks stopped fearing borrowers and just handed out cash without any serious consideration of the risks. The answer appears to be straightfoward. Incentives changed. Origination volumes became more important than long term profitability.
Soon, the pendulum will swing the other way; greed will stand aside and fear will take over. Banks will tighten credit, risk premia will again become important, and as credit becomes more expensive, both consumption and investment will fall. When that happens, an old ghost will return to haunt America – recession.
The nonprime mortgage business is in a mess because during the boom years, hardly anyone had an incentive to say no.
The people who take applications, the companies that lend the money, the appraisers who check property values, the investment banks that sell mortgages to investors and the investors themselves -- all had millions of reasons to keep mortgages flowing to borrowers who couldn't afford them. Each reason had a dollar sign attached to it. As long as each participant kept saying yes to risky borrowers, everyone made money.
"It's like we were originating willy-nilly, with abandon, and the consequences be damned," says Christopher Cruise, who trains brokers and loan officers. "As Americans, we're accustomed to not being told no. ... If we want to have a mortgage loan and we want it now, we don't want to hear about the potential consequences down the road."
That goes for borrowers and also for the players throughout the mortgage industry. The siren song of bountiful paychecks drowned out the murmurings of conscience.
"Are there individuals and folks in the supply chain here and there that don't care, or don't necessarily have the borrower's best interest at heart?" asks Jim Svinth, chief economist for LendingTree.com. "Yes. But that can be said about just about any industry where people are paid on commission."
Make the deal, dump the risk
Much ink has been spilled on the meltdown going on in subprime mortgages, which are home loans for people with flawed credit histories. Analysts believe problems will show up in Alt-A mortgages, which go to borrowers who have so-so or even good credit, but who don't document their income or assets. A lot of interest-only loans can be lumped into the Alt-A category, too. Together, subprime and Alt-A are known as nonprime.
The mortgage industry is set up in such a way that the participants chase after profits while dumping the risks onto someone else. The chain of buck-grabbing and buck-passing starts with mortgage brokers and loan officers -- the men and women who work face-to-face with borrowers.
Brokers and loan officers make their livings by persuading people to get mortgages. There's no profit in telling an applicant that he has no business buying a house. Except in cases of flagrant fraud, brokers and loan officers don't suffer consequences if their customers later fall behind on their house payments.
'We don't really care'
"For us, as frontline originators, there isn't a direct correlation between loan performance and compensation, so we're disconnected from these failures so long as there's no fraud. In a way, we really don't care that much," Cruise says.
If that sounds harsh, here's what two other mortgage men have to say:
"They have no skin in the game. They'll do anything to get a commission," says Bob Walters, chief economist for Quicken Loans.
"The loan officer's incentives are not aligned with the consumer or the lender," says Jeff Lazerson, president of Mortgage Grader, a flat-fee mortgage brokerage where brokers don't draw commissions.
Behind the brokers and loan officers are the companies that do the actual lending. During the nonprime boom years of 2003 to the middle of 2006, lenders had an incentive to approve mortgages to uncreditworthy borrowers because lenders don't hang onto loans for long. They sell most home loans to investors. Lenders thought they were in the clear after selling loans: If the borrower fell behind on the payments, the investor -- not the lender -- would face the consequences.
Hey! You've won a ride back to the top
5 comments:
Anonymous said...
Didn't mad-eye moody turn out to be a death eater high on pollyjuice potion?
Markus Arelius said...
But fear in a market is sort of like matter. It cannot be completely destroyed. It just gets shuffled around from one market participant to another.
The problem with this scenario is that the banks lost the "fear" you eloquently described when they re-packaged these loans and flogged them on the exchanges. When banks realized that they could commercialize these debts and sell them to the wider market, their fear of destruction sloughed off. That fear (with more precise information, loan classifications, and disclosure) should have transfered and made itself evident to investors in these packaged debts, but it was not. Now banks are fearful - and should be - because ultimately they are responsible to adhere to lending standards. Clearly, this was not the case - and the consequences won't be a light slap on the wrist for banks, investors and homedebtors. The fear is going to turn into anger. The stories are only now resurfacing with little detail. What happens when families who lose their life savings and their homes start to name the realtors, mortgage lenders and appraisers who were complicit in the unstustainable run up and sales pumping of already overvalued real estate?
To say this will all end badly is an understatement, because it will affect multiple layers of the real estate industry and the US economy as a whole. The crisis will be magnified by the fact that we Americans are the largest consumers and the absolute worst savers on the planet.
Economic Despair said...
Risk can be repackaged and sold on to others. It can be diversified and spread around. However, it can not reduced.
Risk diversification gave banks a false sense of security. Itled then to take on more risk that was prudent. As I said, they forgot about the fear that borrowers could default and just focussed on making money.
How bad will it be: I reckon things will happen in this order. Increasing bank defaults, followed by higher risk premia, a credit contraction followed by a slowdown investment and consumption. Unemployment rises, GDP falls, the US current account contracts and sends a powerful negative shock to the rest of the world. East Asia takes the hardest hit, followed by Russia + the middle east (via a collapse in oil prices). Continental Europe gets off due to better balance sheets, but the UK goes the way of the of the US.
Anonymous said...
bank do not fear because they are selling default loans. increasing due amount of borrower.
Anonymous said...
In places like where I live, the recession never did much beyond settle into stagnation.
What I'm hearing from nearly everywhere else suggest (to me, at least) that a recession for real has already begun. The stock market may be shooting up, but the dollars doing the shooting aren't worth near as much as they used to be.