There is no doubt that U.S. banks and more importantly, non-banks, have long been pursuing high risk practices in their approach to not only subprime, but also prime lending in the mortgage space. Loan structures that include low doc, no doc, I/O, low LTV, no down payment, etc. became rampant, particularly in more recent years leading up to the precipitous rise of interest rates and the onset of the “subprime crisis”. These were coupled with increased household debt and some of the same mortgage lenders also providing home equity lines and loans which further exacerbated the consolidated LTV (CLTV) of borrowers to levels never before seen in banking.
All of these have been a result of bad practices followed by worse practices. And there is no doubt that, predictably, a proportion of these portfolios (both prime and subprime) have and will go bad, and it is likely that this will be a higher number than we have normally associated with long run default rates of old.
HOWEVER, it is also true that up until the markets began to say “basta” and started a systematic devaluation of mortgage related players of all kind, relatively little of these bad practices were showing up in underlying mortgage portfolios through increased default rates or even a migration toward noticeably higher risk ratings. Many of the relatively cleaner lenders (both banks and non-banks) had long pulled out of I/Os, no doc, no down and many of the other more flagrant practices and had returned to more traditional structures and many of others would argue that they were never there to begin with.
Much of the market behavior has been targeted at anything with the word “mortgage” in the title, to the point where a growing number of very high quality funds and other players, all carrying pristine books, have been taken out, in some cases aggressively, by market devaluation, margin calls, and near predatory behavior on the part of certain notable investment banks. All of this has added fuel to the fire of market perception and generated rampant fear in many sectors. This, in turn, has led to a dive in the valuation of anything at all that is associated with mortgage (not just in equity prices) and has resulted in CDOs/SIVs/CMOs, etc. trading at distressed debt rates.
Once again, some of these instruments will no doubt have some portion of their underlying portfolios represented by the very bad practices mentioned above, but not all them and not all of their sub-portfolios. In fact, the percentage statistically would be less than 2.5% and less than that would actually default or become impaired. Many of the banks reporting significant capital constraints, write-downs, and negative earnings announcements are, in fact, riddled with these instruments, yet most are reporting that the overwhelming majority of these instruments are still performing, even today.
So, what has happened? Is it accurate to suggest that a pocketed group of players that have engaged in some very stupid lending practices have turned the tide for an entire industry? For these players, they certainly deserve what they get, as they were in the business of “high risk” and should have ensured adequate compensation, at least during good times. If they didn’t, then they deserve to go down. Likewise, markets should expect some of this and factor it into their analysis and pricing.
It is also true that a number of institutions have been overly concentrated in structured mortgage backed instruments, and a few have allowed their dependence on capital markets and the ability to securitize for funding and capital purposes to become so extreme as to run up loan to deposit ratios to an absurd extent (e.g. Northern Rock).
However, markets have potentially gotten it wrong as well. Not all of it is a disaster and not every one of these institutions, in fact, proportionally few, have been as flagrant as we have been lead to believe. Have the markets over-stated the case? Are the markets now causing a minor form of hysteria? Many companies have been undeservedly forced out of business, shareholders have lost billions, and housing valuations have plummeted along with demand and, in turn, so has the building construction industry. This, in turn, has further impacted jobless and default rates. Where does it stop? How do we keep markets in check?
Many of the recent responses revolve around broadening the role of the regulator and looking more closely at the mortgage industry. The value of this can be debated, but these responses only address the immediate problem at hand. Is there a rationale for better qualifications for market participation? Is it possible that, similar to the cases we saw emerge seven or more years ago post tech bubble, some institutions have engineered at least some of these outcomes? Is it ignorance or is it conspiracy?
My view: markets over-reacted against legitimate concerns over bad practices in some sub-sectors of the mortgage industry. Effectively, the pendulum swung from euphoria to nausea, driving what was likely an over-valuation of some players to a wild underestimation across the board. Markets ceased to distinguish the difference and panicked. There is no conspiracy theory, but as in every market event, someone is likely to emerge a winner: a few smart players have managed to turn strategy rapidly and take advantage of an opportunity. Both of these behaviors have served to deepen and prolong what might have otherwise been a more contained event. Market perception has managed to generate a self-fulfilling prophecy which has yet to fully play out.