Why Did Underwriting Standards Deteriorate?

Three reasons: 1. Lazy, new investors 2. The *perceived* reduction of risk brought on by financial complexity / precision and engineering 3. Fragmentation of the value chain.

The first coherent explanation of this is at: Calculated Risk, halfway down the page

Probably the big innovation that the GSEs had on the market for mortgage-backed securities, back in the day, was their process of selecting homogenous and uniform loans for their security pools. If you can create a set of rules—underwriting guidelines, product features, appraisal rules, all the way down to very detailed requirements for legal documents, property and title insurance, etc.—and make sure all loans fall within those rules, you can build a security with a fairly high degree of confidence in the assumptions about delinquency, default, prepayment, enforceability of legal rights in the event of foreclosure, and so on. This allowed the agencies to create reliable calculations for the guarantee fee they would need to charge the lenders in order to cover the credit risks of the pools; it also made it possible for various kinds of institutional and depository investors to buy those securities in a market that could establish apples-to-apples prices for them. The regulators of depository institutions had already reviewed the GSE guidelines, as it were, and given their general approval to such standards; the depository didn’t have to wade through a 400-page prospectus for each deal. GSE loans became the vanilla ice cream of the mortgage world.

Of course no one ever claimed that only GSE-style loans were worth making. First, of course, the GSEs by charter were limited to moderately-sized loans, and so there was always a segment of the market—the jumbo market—that was simply outside the GSE sandbox for charter reasons. Also, there have always been all sorts of near misses, one-offs, unique deals, and so on, that are certainly loans worth making, but that just can’t go to the GSEs; banks generally held these in their investment portfolios. Again, although it’s possible that such loans are of weaker credit quality than the GSE standards, it’s also possible that they’re more or less equivalent, if you go to all the trouble of wading through all the variables and risk layers and coming up with a total. The idea of GSE MBS was simply that neither investors nor the GSE’s buy side staff would have to do any “wading,” as an efficiency issue as much as anything else, and that prices for those securities could be set with a lot less fuss. There is of course a huge value to efficiency, if you’re trying to run a trillion-dollar securities market, but it was never intended to be the last word in credit quality.

So the big problem with “Alt-A,” from the beginning to right at the moment, was and is that you have to wade into the weeds. A lot. Much of the cries of outraged innocence we’re hearing lately from some investors stems from the fact that they didn’t wade very deeply into the loans underlying the securities they bought. There are lots of reasons for this; to my mind, the biggest one is that a bunch of people seemed to think that one could invest in Alt-A pools at the same operational cost as GSE MBS. But, of course, that’s missing the whole point. In any case, investors became more and more reliant on the rating agencies, whose job was largely to build models that would take these risk-layered loans and end up slapping some overall credit designation on the pool or the security or a tranche thereof. Many folks, right about now, are taking the rating agencies to the woodshed over some of the assumptions in those models and the rating agencies’ apparent inability to react (downgrade) fast enough when new data on performance catches up with some of these loan products underlying these pools. I can’t argue with the critics of the rating agencies in the specifics. On the other hand, I find myself chuckling a little—in a cynical way—over the underlying problem here. For the rating agencies to become fully effective modelers and predictors of credit risk for Alt-A is, at some level, for them to reinvent a certain wheel that the GSEs invented a generation or more ago on the “conforming” side. In other words, we’re expecting the rating agencies to homogenize the heterogeneous so that bond buyers can trade RMBS without doing all that wading and paying all those analysts and complicating all those VaR models. We want mocha java praline mango on a sugar cone at vanilla levels of efficiency.

Theoretically, that can be done—one can build guidelines and other requirements that standardize the Alt-A world fairly reliably, or at least break it down further into somewhat more homogeneous sub-classes—but I confess to being surprised that anyone thinks the rating agencies are the parties to do it. The GSEs were not simply standardizing other people’s loans: they were the buyer, the one on the hook for the credit guarantees, the party of the big risk kahuna. (So were/are the mortgage insurers, which is why you see a whole lot of overlap between MI and GSE credit guidelines.) I’m not sure what other people expect by asking fee-based rating agencies who are not owners of the risk to get in there and standardize the Alt-A market, but what I expect is not very much. My own view is that being on the hook in the event of default tends to concentrate the mind in ways that making fees off of the volume of securities issued does not. Call me cynical if you want, but I think I’m just making a pretty obvious point about how risk works.

So why, you ask, are not the real risk-owners—the buy-side Wall Street firms and big originators who invest in or securitize Alt-A—making it an efficient and standardized market? Well, because it’s a competitive market. Those who like to complain about the GSEs being “monopolies” like to imply that the more competition in the mortgage marketplace, the better things will be. I have my doubts about some of that for lots of reasons, but I will note that the other side of “monopoly” is homogeneity, efficiency, and transparency to the investor (at least as far as the underlying loans are concerned; I’m not talking about GSE accounting practices here. In fact I have no objection to FASB holding a “monopoly” on accounting standards, to make a related point.) Once “competing” products or loans or security issues enter the marketplace, by definition the things can’t just be more of the same. In a marketplace unprepared to do the analysis, due diligence, and complex price-modeling on these “competing products,” it became, after the dust settled, a fairly predictable question of the highest apparent yield getting the most bids. Anyway, one reliable sign that there’s a bubble going on is not so much the repeated statement that “it’s different this time,” but the repeated habit of using “the same” analytical or due diligence or pricing tools on what is clearly not “the same” precisely because it was marketed to you in the first place as “not the same old same old.” I cannot help offering a general “duh” here to certain institutional investors who have just discovered something that was hidden in plain sight.

Posted on March 14, 2007 and filed under Finance.