Best of Kass: Subprime Bracketology

He said this in February 2004 at a Credit Union National Association 2004 Governmental Affairs Conference:

"American consumers might benefit if lenders provided greater mortgage product alternatives to the traditional fixed-rate mortgage. To the degree that households are driven by fears of payment shocks but are willing to manage their own interest-rate risks, the traditional fixed-rate mortgage may be an expensive method of financing a home."

One year later Greenspan continued the same mantra and cited the social benefits of the financial industry's innovation as reflected in the proliferation of the subprime mortage market.

A brief look back at the evolution of the consumer finance market reveals that the financial services industry has long been competitive, innovative, and resilient. Innovation has brought about a multitude of new products, such as subprime loans and niche credit programs for immigrants. Such developments are representative of the market responses that have driven the financial services industry throughout the history of our country. With these advances in technology, lenders have taken advantage of credit-scoring models and other techniques for efficiently extending credit to a broader spectrum of consumers. The widespread adoption of these models has reduced the costs of evaluating the creditworthiness of borrowers, and in competitive markets cost reductions tend to be passed through to borrowers. Where once more-marginal applicants would simply have been denied credit, lenders are now able to quite efficiently judge the risk posed by individual applicants and to price that risk appropriately. These improvements have led to rapid growth in subprime mortgage lending; indeed, today subprime mortgages account for roughly 10% of the number of all mortgages outstanding, up from just 1% or 2% in the early 1990s...We must conclude that innovation and structural change in the financial services industry has been critical in providing expanded access to credit for the vast majority of consumers, including those of limited means. Without these forces, it would have been impossible for lower-income consumers to have the degree of access to credit markets that they now have. This fact underscores the importance of our roles as policymakers, researchers, bankers, and consumer advocates in fostering constructive innovation that is both responsive to market demand and beneficial to consumers.

But even as Greenspan was taking interest rates to levels that encouraged the egregious use of mortgage debt and exhorting the opportunities in creative and variable mortgage financing, there were some smart cookies out there who recognized the risks; here are quotes from two of the smartest who warned of the danger in the mortgage market.

When I took economics in World War II, and we were studying the Great Depression, one of the reasons given were all the interest-only loans that came due. They were an indication of an economy getting into unsound lending. Ever since then it's been a rule that when you go into interest-only loans, you're very substantially increasing the risk of default.

-- L. William Seidman. Former Chairman of the Federel Deposit Insurance Corporation and Chairman of the Resolution Trust Corporation

Our own Robert Marcin put it even more precisely (and vividly) in his prescient warning back in mid-2005.

If Greenspan had a clue (remember, he didn't have one in the tech bubble, or maybe he did), he would jawbone the banking industry to tighten or even strangle lending standards for residential real estate. He should not kill the entire economy to slow the real estate markets. Now that bag people can buy condos in Phoenix with no down payments, maybe the Fed should get involved. You can't expect mortgage bankers to do anything; they get paid to lend money. But like Greenspan's unwillingness to raise margin rates in 1999, I expect him to do nothing until the market declines. Then, the taxpayers will be on the hook for the stupidities of the real estate speculators. Remember, I expect a sequel to the RTC in the future.

-- Robert Marcin, Making Money Before Housing Crumbles.

Greenspan will go untouched and will continue to give speeches at $200,000 a pop.

Culprit #2: Irrational lenders like Novastar, New Century, Fremont General, Option One, Accredited Home, OwnIt Mortgage Solutions and others were no smarter than a sixth grader.

Many of these mono-line subprime lenders grew from nothing to originating billions of dollars of mortgage loans almost overnight. Their rush to lend and helter skelter growth relied on the candor of the mortgagees and not on common sense, prudent lending or reasonable underwriting standards.

The growth in subprime-only originators was irrational, but the industry will now be rationalized and the marginal lenders will go bankrupt. And, in the fullness of time, the more diversified lenders will benefit from their demise.

Culprit #3: Wall Street was no smarter than a seventh grader.

The role of the brokerage community in the packaging, warehousing and trading of mortgage securities is immense, with about a 60% share of the mortgage financing market. After tax shelter abuses in the early 1980s, junk(y) bonds in the late 1980s, overpriced technology stocks and ludicrous IPOs and disingenuous research reports in the late 1990s, one would think that Wall Street had learned its lesson.

It has not.

Defending the indefensible -- despite the "policing" of the SEC and Gov. Spitzer's initiatives -- remains Wall Street's credo. Time and time again, the major brokerage firms exist for the purpose of selling product (stocks and bonds), not for providing objective research or for the commitment to client's profitability. The higher a market surges, the easier it is for Wall Street to peddle, and package, junk.

The magnitude of the potential gains are always too attractive and tempting particularly as product demand swells into another cycle excess, as it did in subprime. Astonishingly, even the obligatory emergency conference calls intended to persuade investors that all is well were superficial and failed to disclose the inherent conflicts that each and every multiline brokerage has.

The major brokerages will be litigated against -- again. They will pay large fines but will proceed in business until the next bubble -- which they will also capitalize on.

Culprit #4: The rating agencies were no smarter than an eighth grader.

The little-known secret in the subprime market is that the principal ratings agencies have been lax in their downgrades of subprime paper and securitizations. This should not be considered a surprise, because like their Wall Street brethren, they prosper from the rising tide of credit issuances. In doing so, like a teacher who has turned his back on a boisterous and disobedient class, those recalcitrant agencies -- Moody's, Fitch and S&P -- have ignored the erosion in credit quality and abetted the rush and market share taking of subprime lending.

According to Jim Grant's Interest Rate Observer, downgrades at Moody's were even with upgrades in 2005. In 2006, downgrades/upgrades rose slightly to 1.19 to 1; this compares to the historical downgrade/upgrade ratio of 2.5 to 1. Importantly, until downgrades are issued by the agencies, investors routinely carry their investments at cost, or par -- downgrades force investments to mark to market ... and sell.

The rating agencies will likely go unscathed because they always do.

Programming note: I discussed the "four culprits" and my broader view of the subprime debacle on Aaron Task's Real Story podcast last night.

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Fed Is No Savior in Subprime Slide
Originally published on 3/15/2007 8:17 a.m. ET

Bullish observers have increasingly been making the case that the growing fungus of subprime credit problems will force the Federal Reserve into a loosening of monetary conditions sooner rather than later.

These days, the private-equity put doesn't seem to be working, so it appears that the struggling bulls now must hold on to the notion of a Bernanke put to counter the currently troubling and tenuous stock market conditions.

After all, lower interest rates always reverse investor sentiment and adverse financial conditions, right?

My view is that with the level of inflation remaining stubbornly high, coming to the aid of a bunch of reckless and overly aggressive mortgage bankers is not necessarily seen by Chairman Ben Bernanke & Co. as an immediate responsibility of the Federal Reserve.

They might deem it too early in the crisis, or think there is no crisis at all.

In fact, consider the cheerleading of Treasury Secretary Henry Paulson in Tokyo last week and remarks made recently by Federal Reserve Governor Susan Bies, both of whom have downplayed the subprime problems:

"Credit issues are there, but they are contained. I don't think it (subprime) has, at this point, implications for the aggregate economy in terms of the ongoing expansion."
-- U.S. Treasury Secretary Henry Paulson

"Based on some recent observations, mortgage lending certainly is an area in which we believe financial institutions and supervisors have learned some key lessons about risk management."
-- Federal Reserve Governor Susan Schmidt Bies

Also, consider this quote from another Fed official on what he sees as the Fed's true role.

Ultimately, though, ex ante judgments about leverage, concentrations and liquidity risk will continue to prove elusive. Our principal focus should therefore be not in the search for the capacity to preemptively diffuse conditions of excess leverage or liquidity, but in improving the capacity of the core of the financial system to withstand shocks and on mitigating the impact of those shocks.

And, as always, central banks need to stand prepared to make appropriate monetary policy adjustments if changes in financial conditions would otherwise threaten the achievement of the goals of price stability and sustainable economic growth. - Timothy Geithner, president of the New York Federal Reserve Bank, Feb. 28, 2007.

Now even if the Federal Reserve did lower interest rates in March or April, the markets could interpret the move more negatively than the bulls realize by calling attention to the magnitude of the mortgage crisis and by fueling inflationary fears, serving to pull the capital markets into a tailspin.

As we move into the summer or fall (at the latest), there will be better visibility of the subprime problems. By that time, it will be abundantly clear to even the bulls that an inventory-swollen housing market is back on the sick bed as the two most important marginal buyers -- the first time and trade-up buyers -- have lost access to home-financing. And, by then, the multiplier effect of the housing downturn should be in full force, causing the economy to sputter and for corporate profit expectations to fall to more realistic levels.

The upheaval in the subprime mortgage industry is in its middle stages, but the broad impact on the U.S. economy is in its infancy. To paraphrase, Frankenstein's Dr. Waldman, the credit markets and Wall Street have created a monster -- subprime -- and it will destroy the economy.