NOW BATTING FOR AMERICA: THE OCC
"The lending system has run amok and real people are going to get hurt."[1] That was said, in an unguarded moment, by the lead author of BusinessWeek’s current cover story [3] on the human impact of toxic mortgages. She has evidently spent months with industry insiders, and these people aren’t just concerned, they’re emotional.
This episode will look at what people are saying now, and what smart people were saying months or years ago, about the "suicide loans" that proliferated during the great Millenium housing bubble. As well, we’ll be looking at what they plan to do about them. When the vital interests of U.S. borrowers are threatened, the go-to guys are the Office of the Comptroller of the Currency (OCC). All signs now point to them being ready to rock and roll on toxics. Here’s hoping the rest of the Administration and Congress stands aside and lets them do their thing.
It goes without saying that the bubblehead community has been warning on suicide loans for years. However, as it became obvious to anyone willing to look that the bubble was about to peak, economic and central banking interests began to take note. An example is this extract from a March 2006 report [2] for the Bank for International Settlements written by analyst Allen Frankel. Notice the typically mild way he points out the problem. It’s a bit like the Australian tour guide quietly informing the foreign tourist that the reptile he is approaching might possibly be less harmless than it appears.
"There are signs that the US housing market is cooling. As house price appreciation slows, mortgage defaults become more likely and, at the same time, voluntary prepayments become less likely. To the extent that some investors may have failed to recognise the degree of sensitivity of their MBS investments to housing market developments, they may be exposed to losses in excess of what they had anticipated."
Here at Doom we were lucky enough to capture some of the moment, on Tuesday night, August 15, when the mainstream media suddenly "got it" about the bubble bursting and house prices going down. BusinessWeek seems to have been ahead of the curve on this, though, as it’s now obvious that they had long been working on a major article exploring how the burst was going to effect toxics. Last Friday they released a comprehensive cover story [3] investigating serious problems with certain classes of these exotic mortgages.
"Banks that hold lots of option ARMs on their books will surely be hit by loan defaults in coming years. ‘It’s certainly reasonable to expect to see some excesses wrung out,’ says Brad A. Morrice, president and CEO of New Century Financial Corp. But even here the damage will likely be limited. Banks use insurance [4] and other financial instruments to protect their portfolios, and they hold real assets — homes — as collateral. …
Most of the pain will be born by ordinary people. And it’s already happening. More than a fifth of option ARM loans in 2004 and 2005 are upside down — meaning borrowers’ homes are worth less than their debt. If home prices fall 10%, that number would double. ‘The number of houses for sale is tripling in some markets, so people are not going to get out of their debt,’ says the Ford Foundation’s McCarthy. ‘A lot are going to walk.’
…
Public policy has yet to catch up with the new complexities of the lending industry. Comptroller of the Currency John C. Dugan, the banking industry’s main regulator, wants banks to clean up their act. A source inside the federal Office of the Comptroller says Dugan intends to raise lending standards, as he did last year on credit cards, where super-low minimum payments made it improbable that cardholders would ever pay down debts. New guidelines are expected this fall."
Lead author Mara Der Hovanesian, who I quoted at the head of this piece, expanded on the story during a revealingly candid 19 minute long podcast.[5] I have transcribed the following passage that occurred at time 07:55 – 08:33 on the MP3 version.
"We don’t know exactly what [option-ARM mortgage loans] they [the lenders] have on the books because they haven’t been required to disclose it. Now that is slowly changing. We’re getting little glimpses now because the regulator is mad. And they’re looking at their audits, and they’ve seen and they’ve talked to the banks and they’ve said, ‘you know, you have to get this stuff off your books, you’ve got to raise your standards and things have got to change.’ And so we’re expecting, in fact, new guidelines from the banking industry’s main watchdog, the Office of the Controller of the Currency, to come out with something."
Much of the OCC’s strategy appears to revolve around telling the lenders something like "we won’t tell you what to try, but you’d better know just what you’re doing." This would serve to make the lenders specifically responsible for the results of their actions. Supporting this idea is the output of a recent OCC sponsored study. DSNews summarized [6] the results in part as follows.
"A recent study by the Office of the Comptroller of the Currency examined the role of predatory lending practices in the increase among subprime mortgage foreclosures and found that tightened underwriting framework is a better way to curb foreclosures than restricting certain lending practices."
The abstract from the study itself [7] seems to support this assessment.
"Policies that encourage subprime lenders to review and tighten loan underwriting and pricing procedures to ensure that borrowers’ abilities to repay their loans are fully reflected in lending decisions and terms may be more effective than prohibitions on specific lending practices. This approach is consistent with the approach taken in the recently proposed Interagency Guidance on Nontraditional Mortgage Products, which emphasizes prudent loan terms and underwriting standards rather than restricting particular loan features."
Dugan’s "Number 2" at OCC is Ms. Julie L. Williams. A year and a half ago she delivered a remarkable speech [8] to an audience of loan officers. Half a dozen passages of this text deserve to be written in letters of fire, and I heartily recommend you read the whole thing. But for now I’ll just quote two paragraphs. The first summarizes the problem, and the second sketches the solution. Although she is actually addressing more the credit card industry (which the OCC cleaned up last year), the lessons are for the most part directly applicable to mortgages. Remember this was written in March of 2005, when the bubble was still going full blast.
"The practices associated with the new philosophy of retail lending – higher credit limits and loan-to-values, lower minimum payments, more revolving debt, less documentation and verification, and lengthening amortizations – have certainly introduced risk elements not previously present in the banking system. Combine those elements with current macroeconomic trends, including high levels of consumer leverage, sluggish job and wage growth, and a rising interest rate environment, and all signs point to considerably more credit risk embedded in the retail loan portfolios of banks than the current performance measures would indicate.
…
What that entails is zeroing in on those particular loans that have the highest probability of default. It means identifying particularly risky borrowers: those with unusually high debt levels and utilization of their credit card lines, and declining credit scores. It means singling out high LTV loans, loans with extensions, renewals, and rewrites; and loans in work-out programs. It means testing transactions to ensure compliance with policies and procedures. It means evaluating whether collection practices are effective, loan reserves are appropriate, and losses are recognized in a timely manner. And it means doing this consistently, constantly."
I for one would very much like to hear Ms. Williams’ thoughts today on option-ARMs.
[1]: The sentence is recorded at time 12:10 – 12:18 of [5].
[2]: "Prime or not so prime? An exploration of US housing finance in the new century" (PDF), by Allen Frankel, BIS Quarterly Review, March 2006, pp 67-78. The emphasis in all the quotes is mine. I am indebted to commenter "MaxedOutMama" in the Piggington discussion 60 Days to Tighter Lending? for the link to this paper.
[3]: "Nightmare Mortgages – They promise the American Dream: A home of your own — with ultra-low rates and payments anyone can afford. Now, the trap has sprung", Cover Story, lead author Mara Der Hovanesian, BusinessWeek, posted September 1, 2006, September 11, 2006 edition.
[4]: In an August 22nd post I pointed out that the private mortgage insurance group the Mortgage Industry Companies of America (MICA) was seriously worried about the prospect of holding the bag for these losses, and was frantically asking for help from the regulators.
[5]: "Is Your Mortgage Toxic? Deceptive loans. Phantom profits. And coming soon: A wave of defaults", Podcast, interview with Mara Der Hovanesian, BusinessWeek, released September 1, 2006.
[6]: "OCC: Stringent Lending Best Defense Against Subprime Foreclosures", by Kristin Campbell, DSNews – Default Servicing Online, September 1, 2006.
[7]: Morgan Rose, "Foreclosures of Subprime Mortgages in Chicago: Analyzing the Role of Predatory Lending Practices," Office of the Comptroller of the Currency, Economics Working Paper 2006-1, August 2006.
[8]: "Remarks" (PDF), by Julie L. Williams, Acting Comptroller of the Currency, Before the BAI National Loan Review Conference, New Orleans, LA, March 21, 2005.
The bond market continues to have an insatiable appetite for less-than-prime paper, it would seem. This from a story [1] today in Realty Times.
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[1]: “Lenders, Analysts Don’t See Risk In ‘Risky’ Loans”, by Broderick Perkins, Realty Times, September 5, 2006.
Very great information on your blog. Most people are leveraged to the sky and are living paycheck to paycheck. They are pushing the limits to keep up w/ the jones. Consumerism is out of control and we need to have some people help us get back to helping thy neighbor.
John, An informative posting but don’t you think many lenders, and responsible consumers, are merely being set up to be the fall guys for irresponsible borrowers? In the last 10 years political types of both stripes have hammered on the need to make housing “affordable” either to promote an ownership society agenda(the Rs) or to pander to low income and public empolyee groups (the Ds). To make a profit in a very low interest rate environment and hedge rate increase risk by sharing it with the borrower, loans with adjustable rates and other new features were more widely deployed. Regardless, the lending institutions and their regulators responded with a whole variety of exotic products, stimulating unsound home purchasing demand across ALL income groups… with a predictable contribution to a price bubble. Ironically, and predicably, this resulted in housing being less affordable in both nominal and real terms. Today we need to remember that many people with so-called toxic loans can afford to continue paying them (for now) with spending restraint in other areas (really need that new cell phone and bass boat bubba?). Many are people who used these mortgage products with knowledge of the risks and hope for reward. How many people really didn’t understand that a adjustable rate mortgage could adjust upward? The number of loans “upside down” is not a proper proxy for those that can, should or will default in the housing business any more than with loans on autos or boats. Truly “predatory loans” or lending practices have remedies, but I suspect that only a tiny fraction of recent loans are actually of that class. In a nation where obesity is a major health problem, even for those on public assistance, we need to be careful about urging citizens to “walk away” from upside down loans. Lending cannot be a heads we win, tails you lose proposition in favor of the borrower. We can blame McDonalds for obesity and the banks for so-called “predatory loans” but it would be interesting to know what percentage of borrowers “fudged” their income even without urging from a mortgage broker. In one of your prior postings on this topic you used an analogy to “slavery” of the “middle class” in discussing the effects of such lending. Are any consumers coerced into taking that next loan or buying that next double cheeseburger? Slavery is an evil and coercive practice, so far removed from even the most eggregious lending practice that such hyperbole is not helpful. Now a question: As a macro-guy, do you believe the inverted long yield has cushioned the effects on these borrowers to date and resulted in a strange situation whereby fear of a recession makes these loans more viable for a longer period of time?
[for what it’s worth, Igor thought this effort was spam, so be warned]
Mike -Here’s a rough draft of a response to the questions and points you’ve raised. I’m not really happy with how I dealt with your taking me to task on slavery (see below). I may try a seperate post on that if things come together and twist can fit it in. With luck that would be a tighter presentation than these first thoughts. It might not even be this week.First of all, I have few of the usual qualifications for standard macro analysis, so can’t really comment on the inverted yield curve. I never really “got” statistics, calculus, diff equations, and so on although I pursued (with some futility) undergraduate measure theory and the calculus stream as far as early graduate level functional analysis. My better intuitive feel is for discrete subjects like graph theory and baby algebra. My macro analysis, such as it is, derives from extrapolating human “group dynamics”, in the near-pop-psychology sense, into emergent behavior in the large. Basically, all I’m doing is randomly reading a lot of odd internet news stories and rants and detecting trends using a sense of “smell” informed by some funny diagrams I discovered. My posts contain a lot of links because I suspect the reader can often get more benefit following them than reading my opinions!That being said, the inverted yield curve per se wouldn’t be helping borrowers, but the historic low yields on the 10 year treasury bond certainly would. The inversion appears to be a factor in the complete pandemonium engulfing the mortgage banking industry today. Mortgage lenders lend long and borrow short, so the inversion clearly impacts their profits. Combine this with the natural shrinkage in the loan business as the bubble winds down (as noted by Roubini in a post yesterday) and you have some people talking about a “perfect storm”. I hope to talk about this a bit in episode IX, with a dose of our current favorites, the appraisers, thrown in for good measure. But once again, I haven’t a clue how the inversion would flow through the other parts of the macro economy.In Harper’s for 01May06 there was a feature: “The New Road to Serfdom – An Illustrated Guide to the Coming Real Estate Collapse”, by Michael Hudson. Here’s the cover image (JPG). That didn’t have much content but was one of the very first alarmist articles in the MSM. They did note that the Japanese bubble and burst were symmetric, and we can count on something like that happening here, too. The bottom line is that we are looking at a lot of losses. Clearly the interested parties will try to make past present and future lenders, consumers, taxpayers, borrowers, and anyone else that comes to hand the fall guy. Equitably sharing out the pain is going to be difficult. Morality will be a critical driver, but so will be the practical limits of what each group can stand (not to mention how well they can defend themselves). Doom’s primary purpose now that the bubble has burst will likely be to find some, in fact any, humane and practical way out of this mess.I understand that the new 2005 US Bankruptcy Act makes it quite a bit harder for borrowers to shed their debts. My concern is that post-bubble, many middle class Americans will be over their heads and in danger of falling into debt bondage. From vague things I’ve heard and read, I suspect that your average Joe Sixgoats early 19th century Ukrainian farmer might not share your opinion about the moral high ground occupied by his friendly neighborhood financial services guy relative to, say, an SC planter from the same era.
A technical note:
Mike, I see what your problem is now with the editor. It doesn’t respect paragraphing like it should when you compose directly in the comments window. I’ll pass the problem to our tech support. Usually I compose offline with HTML using P, BR, BLOCKQUOTE, etc. labels and apply HTML source to the window. The comments window clearly doesn’t do the right thing with plain old text.
John, to me the limits of slavery run from the african experience (both inside and outside Africa) to the Irish experience escaping from British genocidal policy. Modern asian sex trade slavery falls somewhere in between, but all are far more serious and coercive than Mr. and Mrs. American Six Pack having to pay back upside down loans they took out to support a lifestyyle that would be the envy of most Ukranians past and present. I do not buy the argument that borrowers in America require much more than the self descipline exhibited by their grandparents and 90% of the world to escape a “bondage” that vast numbers of our southern and carribean neighbors would gladly accept in exchange for 18 hour work days and grinding poverty. The more we spread the costs seeking a “humane’ solution, the more we enable the behavior.
“Irresponsible Consumerism” is a misnomer. With wages stagnant, benefits like health insurance disappearing, and cost of living constantly rising, people are overborrowing as a last ditch effort to tread water. Of course, bait and switch on the part of the real estate industry, no, make that con artists called “Real Estate Professionals” are the primary culprit.
WHEN THE HOUSEHOLD EXPENDITURES ON CELL PHONES, LOTTO TICKETS, BEER,COSMETICS, HBO AND CALL WAITING ARE ELIMINATED LETS TALK ABOUT HEATH INSURANCE,UNTIL THEN PAY THE MORTGAGE!
For the poor in this country, yes their expenditures are almost 100% living expenses. But for the middle class, you can pretty much classify everything as consumerism or greed.
My wife and I (and our 10 month old son) live in San Francisco. We rent a condo in the SOMA district — the hottest and trendiest housing market. (Although this is changing rapidly — the new 45-unit condo just built across the street from me has about 4 occupied from looking at the lights that are on during the evenings.) Because we rent, we’re not saddled with a psychotic mortgage payment. We don’t have iPods or plasma TVs or whatever. Toys/clothes/car seats/furniture for our son are hand-me-downs or loaners. (Why buy when the stuff is outgrown in 3 months?) Our car is a MINI Cooper. (While there are more gas efficient cars, you can’t beat the discipline it forces on you — if you can’t fit it in the car, you can’t buy it.) Not that gas efficient matters much when you walk to work.
We make average professional salaries for our age (35+30). And of our combined post-tax income, we currently salt away 59%! (This is after paying for a nanny who looks after our son during the daytime and also cooks for us.)
So if an average middle class family living in the #2 most expensive place in the U.S. can put 59% of our post-tax income into savings and investments while raising a kid, the idea that middle class Americans are being forced to take out suicide loans to tread water is ludicrous. They’ve been taking out these loans to finance lifestyles beyond their means — vacations, SUVs, bigger houses, whatever. Now the bill is due — my only concern is there’ll probably be taxpayer bailouts and stock market downturns due to the bubble bursting.
William -
Congratulations to you and your wife on being savers. The Fed could use another 10 million or so households like yours about now! Just pray everyone stays healthy and your child(ren) win(s) scholarships at university.
The middle class need vs middle class greed debate is almost unanswerable. Sometimes you really need to consume overpriced/inflating healthcare and education for family members. Sometimes you even need to keep up with the Joneses just to stay in the middle class. Ugh.
Today is a reminder that it’s even worse to be poor. A report is out showing that the use of nonprime (more expensive) mortgages jumped sharply in 2005, with the lion’s share of the burden falling on minorities.
Your comments about education is telling about keeping up appearances because I don’t remember it costing a lot during my school days. I went to public schools K-12. And I went to the 2nd-tier CA university system after 3 years of picking up credits at the community college. $250 a year the first 3 at CCSF, $2000 the next 3 at SFSU. Even if I assume psychotic 10% inflation every year, that means my kid’s total college bills will be $35K. If I can work part-time during the mid-90’s and earn $10K a year, I don’t see why my kid won’t be able to do $20K part-time just due to minimum wage increases.
But of course, being frugal for college means going to — GASP! — community/state colleges. Where a student gets the same education as a private school costing 40 times more — because in the end, it’s the effort the student puts in that controls what he learns.
I think education is yet another poorly thought out decision for most people. For very specific jobs, the name of the school might count — you want to join NASA/JPL, you’re best shot is going to one of the top tech schools. You want to be a CEO, you need a Harvard or Stanford MBA. People continually repeat the mantra that education is an investment. Then why aren’t they applying cost/benefit analysis that befits an investment? Will getting Harvard on your degree increase your earning power and will it be enough to pay for $200K in student loans?
(There’s plenty of online college cost calculators available — what we now need is a reality check calculator that determines what the value of your education will be on your earning power.)
William, i would like to move to California and vote for you. You and your wife are an example of what may save this nation and help fund my social security.