The Risk Problem…

Being a finance geek, I can’t help myself from making a few comments…

E.D. Kain writes

Here we see another rather conservative approach to Government involvement in home ownership.  Rather than subsidize home owners, the Canadian Government is approaching home ownership as a responsibility that the individual needs to bear, rather than the state.  And, as Havers says above, if a mortgage goes belly up in Canada, it’s the mortgage-owners responsibility, not the bank’s.  This changes the central risk involved in home-buying and forces Canadians to be more prudent in their purchases.  This and the lack of tax breaks has lead to far fewer bad mortgages changing hands in Canada than in the United States.

Although I may agree that the deductability of mortgage interest has distorted the incentives of homeownership, I am not completely satisfied with this explanation.  Banks have been making residential mortgage loans on a non-recourse basis for decades.  Setting aside the insanity that was the subprime mortgage market and what happened with lending standards over the past five years in certain sectors, banks require a substantial down payment (20% of the cost) and certain other things from the borrower.  Borrower imprudence was minimized (at least in theory) based on the willingness of the banks to take risk, and as balance sheet lenders tend to be conservative, not a lot of that took place.  Furthermore, both parties had risk.   While the bank had principal at risk, the borrower had a sizable downpayment that he/she would lose in the event of a default.   Like with any financial arrangment, be it between borrower and lender or between two equity partners via a joint venture agreement, a goal of these arrangement is to have the interests of all parties aligned as best as possible. 

My opinion on the financial crisis is that one of the causes was a complete misalignment of interests between just about all parties involved in the originate-to-securitize lending process that drove subprime and Alt-A loan volume to record levels (and much of the housing boom).   In a sense, it was a kind of Hayekian knowledge problem in that the investors that ultimately bore the risk in the underlying mortgages (hedge funds, pension funds, mutual funds, other institutional investors) had no knowledge of how much risk they were really taking on.  Making matters much worse was that any of the internal controls that were supposed to accurately assess risk, from loan officers verifying the ability of borrowers to repay to appraisers who were writing up “made as instructed” appraisals to the due diligence firms hired by Wall Street to evaluate the quality of the loan pools they were purchasing to the gross negligence of ratings agencies that, at the behest of their clients (the investment banks) used woefully inaccurate models and slapped AAA ratings on anything it possibly could (by law, many institutional investors are forbidden to purchase bonds with less than a AAA rating).   As the risk was shifted from one party to the next, the true nature of it was obscured.  It was in this environment where the worst-of-the-worst lending practices were taking place.  

While the commercial real estate lending environment was nothing like what we saw in residential mortgages, one can at least observe this difference in action.  Those who were able to shift the risk to investors via mortgage-backed securities were lending far more aggressively than those lenders who were keeping that risk on their balance sheets (i.e. life companies and commercial banks).  Balance sheet lenders were not competitive on pricing or on the amount of proceeds they were willing to lend.  Not surprisingly, they are the only lenders left standing in this environment.

Therefore, I respectfully disagree.  It is not an issue of banks taking the risk as much as it is whoever ends up taking the risk understanding what risks are being taken.  This is where the breakdown occurred.

* I highly recommend Roger Lowenstein’s Triple A Failure.

** Generally, when Wall St. firms bought packaged loans from originators, there were provisions that forced loan originators to buy back bad loans that triggered some default or non-payment provision within the first 90 days or so (the term could have been longer).

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