What is remarkable about the crisis in housing finance is that even in the face of continuing bad news, the economy is proving resilient. We added 94,000 new jobs in November, according to the U.S. Labor Department, keeping the unemployment rate at a respectable 4.7 percent. The global economy, too, is showing signs of weathering the crisis.
There is even some good news in the housing sector. Thirty-five percent of Americans own their own homes debt-free. Of the remaining 65 percent, more than 19 in 20 are paying off their mortgages on time. At 3.5 percent, the national mortgage foreclosure rate is high, but manageable.
"We have a very strong global economy. We have a strong U.S. economy," U.S. Treasury Secretary Henry Paulson told business leaders in late October in India. He also cautioned: "Six months ago people were more optimistic that in the housing market we have hit the bottom. We haven't hit the bottom yet."
But whether the current crisis ends in the near term or well into 2008, the compelling questions are: What have we learned? What, if anything, should we do differently next time?
Changes in the structure of the mortgage industry in recent years – especially the securitization of many kinds of mortgages, including subprime – disconnected many borrowers from their lenders. Cheaper credit created a booming market in lending and fed higher housing prices. Competition accelerated between mortgage lenders. Delinquencies rose and the quality of loan portfolios deteriorated. The resetting of subprime mortgage rates – and in some cases prime mortgages – and the cooling of the housing market caused a perfect storm that spread from one asset class to another, as well as from country to country.
Regulators have not lost sight of the global implications; in fact, they have their work cut out for them. The subprime crisis has forced them to reexamine the effectiveness of their compliance and regulatory models, determine the extent to which central banks should be more engaged and find ways to cooperate more closely.
One factor that led to the crisis in credit markets was the uncertainty of individual bank investments and positions in mortgage-backed securities and their value in a market that had suddenly lost its liquidity. Fair value accounting (FVA) will help significantly in providing the transparency the market needs to make decisions and help a clearing mechanism emerge for transactions at the end of each business day. Even with FVA, though, the practical problem for banks and regulators remains how to deal with the market consequences of sudden changes in the value of substantial transactions, which at one minute might be worth 95 cents on the dollar and at another worth practically nothing.
We know that FVA is important for long-term market stability, but how do we achieve that end without short-term market disruption? And when markets cease to function, what are the rules that we should apply? These are issues for regulators, market makers and bank chief financial officers that must be addressed.
So what should we do differently? First we need a new and more transparent mortgage-banking model. Banks that sold mortgage-backed securities to hedge funds financed by bank loans often found they had simply substituted one asset class for another. The underlying source of repayment remained the same, namely the pool of subprime mortgages they sought to divest. Banks will need to be significantly more involved in mortgage origination, risk management, deal structuring, servicing and distribution.
Securitization must be tightly managed and more transparent. Bankers must work closely with the broader investment community to determine that returns are appropriate to the risks involved. The recent effort by major banks and investors to create a “Super SIV” fund, to help prevent bank losses on structured investment vehicles, seems to be an intended step in that direction.
But bankers also need to upgrade their risk management capabilities and assign greater priority to enterprisewide risk management systems. Deloitte has found that a properly staffed and funded enterprise risk management program can be central to improving a bank’s operations, notably in the costly and growing area of compliance. Our new integrated compliance risk management tool is showing promise for improving operational efficiencies at banks.
Investors likewise will need to take a much more hands-on approach to understanding their risk assets, placing less reliance on rating agencies and other investment managers and improving their own risk management capabilities. Rating agencies, after all, are a guide to risk management, not a substitute.
If the subprime crisis taught us anything – both those who profited and those who suffered – it is that everyone is in the risk management business now. The marketplace of the future will reward our increased diligence.
In that marketplace, bankers should play a more active leadership role in ensuring that customers actually get the products they need. This “trusted partner” approach will further demonstrate to regulators that bankers are serious about looking out for the welfare of their customers and making the mortgage marketplace a safer environment for all borrowers.
Out of the debris of the subprime collapse, it is possible to see the beginnings of new opportunities for banks, a demonstration of industry leadership, the restoration of trust in the mortgage finance business and an evolution toward a new kind of mortgage business model. The best run banks are already taking steps to strengthen every aspect of their mortgage-lending and securitization businesses. When all is said and done, it will be the restoration of customer trust and the renewal of bank credibility with investors and regulators that move the industry beyond this lending crisis and help prevent another down the road.
Don Ogilvie – who served as president and chief executive officer of the American Bankers Association for two decades – is the independent chairman of the Deloitte Center for Banking Solutions, which provides insight and strategies to address the complex issues that affect the competitiveness of banks operating in the United States.
View the article below that appeared in American Banker
