With the meltdown in credit markets over the past several weeks I thought it may be insightful to look beyond the typical cries of mutual greed on the part of lenders and borrowers alike to some of the lesser-known underpinnings associated with this debacle. I’m not disputing for a second that many lenders have pushed the razor’s edge with aggressive, perhaps even in some cases predatory lending, and that many borrowers were (and still are) all too willing to accept potentially disastrous loan terms in an attempt to create a short-cut in the wealth-building process. However, my suspicion is that most of you reading this post don’t have clear visibility to the fact that there is a third head to the greed monster which I’ll reveal in today’s post…
The sad reality is that mercenary investors and rating agencies (their co-conspirators) will always be willing to make a market and arbitrage the greed factor exhibited by lenders and borrowers. As I mentioned above, it is really only the lender and borrower sides of the three-headed greed monster that make it into the mainstream media, and as such constitute the public veneer on what is actually a much deeper trough of gluttony.
Those reading this post not familiar with capital markets need to be aware of the behind the scenes conflict of interests and greed mongering that takes place in the form of the roles played by investors and rating agencies in order to have the third head revealed and possess a full picture of what caused this most recent meltdown.
The three primary global rating agencies are Standard and Poors, Moody’s, and Fitch Ratings. These three rating agencies and a hand full of lesser-known agencies (A.M. Best, Baycorp, Dominion, UK Data, etc.) assign credit ratings for issuers of debt obligations which allow them to be placed into securitized pools and sold into secondary markets transferring the balance sheet risk from the original lender to the institution purchasing the structured credit product in the form of asset-backed security.
In order to further explain and expand on the above paragraph let’s start with a bit of history…If we roll back the clock we can easily point to a time when loans were underwritten by the institution that was going administer and service the debt for the life of the loan, which means that all risk associated with loan performance was born 100% by the institution that originated the debt. You see all lenders were once upon a time portfolio lenders holding all credit obligations on their own balance sheet. This meant that lenders tended to be more conservative in their underwriting guidelines because it was them, and only them, that stood to suffer in the event of a default.
Okay, so you may be asking what do investors and credit agencies have to do risky loans? The answer is virtually everything. In today’s era of modern lending which came on the scenes in the late 1970s and early 1980s, and whose proliferation has only gained momentum since then lending practices have shifted focus from portfolio lending to off-balance-sheet loans, the main profit center in lending has shifted from the retail side of the table to the wholesale side. In today’s market loans are rarely structured to be held on the balance sheets by lenders. As opposed to the old-school lending practices described above, most lenders now sell a majority of their debt to third party investors. By creating a secondary market for lenders to sell into, they are able to improve liquidity, increase loan production, and transfer risk. It all sounds quite reasonable on the surface, doesn’t it?
The problem in my opinion begins when lenders begin to underwrite to a different standard (aided by the rating agencies) with the sole intention of moving their loans off-balance sheet. You see when lenders sell their loans into secondary markets they are transferring default risk by selling the future value income stream for net present value fees. When this process of transferring risk to investors in exchange for a fee occurs, lenders are really no longer lenders, but in fact, become little more than brokers as they have no long-term qualitative incentive inherent in their lending practice. When a chief credit officer becomes a chief investment officer the emphasis is clearly on making markets not quality underwriting.
The bottom line is that loans don’t stand on their own merit today. Rather they are propped-up by a broad array of financially engineered synthetic derivatives and credit enhancement techniques which should never substitute for sound underwriting. Artificial market-making run amuck for fee generation does have the impact of boosting short-term revenue and profit. This is all well and good until the tires come off due to poor underwriting standards. The plot has only thickened of late as the Federal Reserve seems to have expanded its domain from fiscal oversight to financing private M&A transactions, and underwriting and making markets in the purchase of the very asset-backed securities that started this problem, to begin with…
If there is a bright side to this debacle it is that this most recent shake-up is really nothing new as we experienced something similar during the last credit downturn…does anyone remember the Resolution Trust Corp? As memories have faded, financial engineering has evolved, and the role of rating agencies has not been properly governed, the problem we experienced in the 1980s has just manifested itself on a grander scale and on a global stage. A major difference between underwriting debt for a securitized mortgage pool and underwriting a loan to be held in the lender’s own portfolio is that, in the former case, the emphasis is on cash flow whereas in the latter case the emphasis is more on value. The reason for this is that the capital markets require above all certainty of cash flow to service securitized debt. The failure to pay debt service on time will immediately impact the value of the securities in the secondary market, causing loss to investors selling prior to maturity (i.e. the recent collapse of Bear Stearns). By contrast, traditional balance sheet lenders normally do not continually adjust the values of their portfolio loans but rely on their initial underwriting to assure the loan will be repaid either by the borrower or through a foreclosure.
From the retail borrower’s perspective, along with securitized lending comes a total lack of accountability in mortgage servicing. Because the originating lender no longer services the loan post-closing, borrowers are now forced to navigate a complex world of master servicers, sub servicers, and special servicers when they have an issue with their loan. Borrowers facing a challenge often cannot even determine who it is that they should contact about their loan. Making matters only worse is the fact that many of these agencies won’t even speak to a borrower unless the loan is in default.
So what’s the answer? It all begins with regulating the rating agencies. I’m clearly not against the many intended benefits that secondary markets afford which have been described above, but I vehemently oppose the manner in which these markets are governed. I made earlier mention of rating agencies being co-conspirators with lenders, and until the rating agencies become something more than a codified self-regulation scheme then problems will continue to exist. A great first step in this process was the Rating Reform Act of 2006 signed into law by President Bush, however, the operative phrase here is “the first step”.
Until the rating agencies set underwriting guidelines based upon managing default risk and prevention of predatory lending, as opposed to participating in a pay to play environment bent on maximizing value, we are going to continue to run into problems. Moreover don’t think that this problem only exists in the sub-prime lending market. We are quite likely to see the further proliferation of the credit crisis as these same problems spill over into traditional mortgage, commercial mortgage, and business lending arenas. Our capital markets are very fluid and very sophisticated, but they are nonetheless very scary as a result of flawed logic, a lack of accountability, and a system that places profit incentives above sound risk management. Get prepared for the meltdown ahead…
