Subprime Editorials

Two NY Times items today deal with subprime lending. Both miss the mark in some important respects.

A Catastrophe Foretold, an Op-Ed column by Paul Krugman, bemoans the lack of regulation, despite government foreknowledge, as subprime loans were offered to the poor, who could not evaluate them, and disproportionately offered to minorities who would have qualified in many cases for cheaper conventional loans. With the wisdom of hindsight, the fact that some lenders were overzealous in promoting subprime loans to borrowers who could not really afford them is pretty well established. The fact that the poor and minorities cannot be effective consumers seems considerably less well established to As Good As News. The fact that some government officials understood the problem years ago is interesting, but doesn't really make the case for greater regulation.

Not so long ago the NY Times, and many others, decried redlining - a practice banks used to limit the mortgage financing available to residents of minority neighborhoods who, but for their address, were creditworthy borrowers. Before jumping on the regulation bandwagon, it would be interesting to understand what happened to reverse this situation. Why would any lender push to market adjustable rate loans to bad credits when the loan would turn into a big loss as soon as interest rates rose, home prices fell and the borrower defaulted? Wouldn't it be nice to understand why the market failed and consider how the market might work before deciding we must regulate more.

Banished by the Big Banks, Risk Finds its Way Back Home tells us that the answer to why the markets failed is complicated. Kudos to Floyd Norris for even trying to cover this and providing a reasonably clear explanation of one example. Unfortunately, Mr. Norris got caught up in the holy grail of all NY Times reporters and columnists, the quest for irony, and missed the real point. His glee that some of the same banks who packaged and sold mortgage loans with one hand bought back the credit risk with the other hand (their derivative trading desks) is an interesting, even pleasant distraction, but the legal claim Mr. Norris covers almost as an aside goes to the heart of the matter.

First, some background to the example presented by Mr. Norris. Recall that the people originating subprime mortgage loans were getting high fees when the loans were made. They had credit evaluation procedures and standards to follow, but there was lots of pressure to approve credit, collect the high fees and book the profits today. Default was next year's problem. Second, the loans were bundled together in packages and sold. A mortgage originator like American Home Mortgage Holdings (the Norris example) would sell bundles of mortgage loans to special purpose entities (SPEs) it created. The SPEs would borrow money in the commercial paper market to finance the cost of buying these loans. The SPEs had limited net worth, borrowing almost all the money they needed to buy mortgage loans. The value of these bundles of mortgage loans would fall if the anticipated default rate went up, so the highly leveraged SPE's looked like a questionable credit risk, and normally only the most creditworthy of borrowers can tap the commercial paper markets. The SPE's dealt with this problem by entering into risk shifting contracts (derivatives) with Big Banks. The contracts basically specified: if the SPE can't continue to borrow money in the commercial paper market and is forced to sell its bundles of mortgage loans to cover costs then Big Bank will pay to SPE the difference between the face value of the bundled mortgage loans and the market value of the bundled mortgages at the time of sale. With these risk shifting contracts in place the SPE was now creditworthy, and thus able to borrow at low interest rates in the commercial paper market and use that money to buy high interest paying bundles of mortgage loans from American Home Mortgage Holdings.

When the shit hit the fan this Spring, the SPE's did have to sell mortgage loans at less than face value and they did turn to Big Bank to collect on the risk shifting contracts. One Big Bank, Bank of America, has refused to pay a claim by American Home Mortgage and its SPEs, and refused to comment. All Mr. Norris tells us about the pleadings in the resulting law suit is that Bank of America alleges some of the loans should not have been made. American Home Mortgage responds that this is irrelevant, noting other Big Banks have paid on the same type of risk shifting contract. What are the terms of the risk shifting contract - is "market value" based on the actual sales price of the bundled mortgages sold by the American Home Mortgage SPEs or by an index price reflecting the general market price for that type of mortgage bundle? Use of an index price is more typical in a derivative contract generally and more likely here given the fact that other Big Banks paid American Home without squawking. If the index price is effected by the fact that many mortgage lenders did a lousy job evaluating the borrower's credit can Bank of America assert that the contract is unenforceable just because American Home Mortgage may have been one of several sloppy lenders?

This is an interesting claim. If I wasn't so busy with important things like writing comedy, rowing, tennis and golf I would find the pleadings and the confirmation on the derivative and really look into it. Instead I will assert the blogger's privilege of assuming my own provisional analysis of the facts is accurate. If the market price used in computing the payment required under the derivative is in fact an index price then the simplest, and probably best, analysis is that Bank of America should pay. The possibility that American Home Mortgage might have engaged in some sloppy loan practices really is irrelevant. Derivative contracts look to indexes of all kinds. One point of using an index is that it allows the party accepting a transferred risk to do so without controlling, or even investigating, the operations of the party shedding the risk. Bank of America may be able to kick up some dust before a judge or jury that does not understand derivatives - sloppy lending practices effected the index of mortgage prices, American Home Mortgage was one of the sloppy lenders, it shouldn't benefit from its own fraud, negligence, etc. , neither party understood or contemplated the unforseeable circumstance that mortgage index prices could be effected by sloppy lending practices, blah, blah blah. Sounds almost like a real argument, and it might persuade a judge, but anyone in the business would tell you that none of it is relevant if the contract refers to an index price.

Mr. Norris includes none of this, even though a copy of a typical derivative contract is probably available in the pleadings. It would tell us quite a bit about how the Big Banks writing these derivative contracts may have ended up swallowing a risk they did not understand completely. Aside from the wrinkle that agressive lending practices may have "unforseeably" effected an index price, the problem is all about credit risk. Banks and other financial institutions know how to deal with credit risk. If they are forced to take their losses they will learn any necessary lessons and self correct, including better identifcation of where the risks are in securitized lending and related derivatives, which will back up into more careful credit evaluation on loan origination. If "bailout" regulation is needed to avert a foreclosure crisis it should be consumer oriented and assist only those subprime borrowers who can actually make the mortgage payments with a shift to a fixed rate, very slightly above the fixed rate that a prime borrower would pay.

Whatever mistakes mortgage lenders, mortgage buyers and derivatives (risk shifting contracts in the example) writers were making, they can now fix with two simple steps. Allocate the risk clearly in the relevant contract, evaluate the credit on a mass default scenario basis once you know where the risk lies. Mortgage lenders and Big Banks (writers and repurchasers of this type of risk shifting or derivative contract actually include investment banks and hedge funds, not just commercial banks, as Mr. Norris notes) can all take care of themselves, and they will do so without any help from the government. Cases like American Home Mortgage v. Bank of America will resolve any problems in the old contracts in time and the parties have probably been addressing this with extraordinary clarity in any contracts written lately.