Interesting session on the Mortgage Crisis next, subtitled “Implications for a Global Economy”. Joe Breeden of Strategic Analytics and Daniel Melo of Fair Isaac. Joe started by saying that this is the 3rd time this has happened in the last 16 years. And, as before, it’s not just about mortgage and it’s not just about the US.
The 2007 mortgage collapse was his first topic.
- Before the event, consumer interest and loan originations were balanced (hypothetically).
- As interest rates fall, consumer demand rises both for refinancing and people looking to get into homes.
- This is good demand – the right kinds of loans – so lenders gear up to provide the loans and a new balance is reached with high demand, high supply.
- Interest rates now rise as do house prices and these “good” consumers pull back and wait. But lenders have all this capacity and continue to issue large targets. Risk takers now move in, attracted by this loan capacity, and these borrowers may not LOOK that different in terms of scores or history but they are taking a risk to be part of rising house prices. Consumers and brokers participate in this.
- The bubble bursts because it is not sustainable and the number of loans dries up but, meanwhile, lots of new loans are on the books and don’t immediately fail but eventually they do and things crash.
- Eventually demand begins to rebuild as interest rates fall and house prices fall and “good” consumers start to return. This is where we are and losses will continue to grow as these bad loans work through in the next few years but the demand/supply curve will start to balance again.
Interesting question if house price falls or interest rate changes were the biggest driver and Joe felt that the interest rate changes probably matter more as they impact everyone’s ability to pay where falling house prices tend to be balanced by both a desire not to leave one’s home and by the psychological investment people have in their house.
Joe also made the point that, while this happens periodically, securitization and other issues did make this cycle worse. Portfolio performance has a number of components:
- Vintage life cycle – each year has a delinquency curve as time passes
- Credit quality varies because scores change, consumer interest changes and product definitions change
- Seasonality
- Management actions creates noise like bankruptcy law changes or process errors, database conversions
- Macroeconomic and competitive environment
All of these things interact in a complex way so it is hard to make assessments of how a given vintage will pan out. This leads to some patented techniques Strategic Analytics have for comparing vintages in terms of how it moves month to month relative to median curve and how origination quality varies once the economic trends have been removed. They develop what they call an “Exogenous Curve” that shows the relative impact of economic factors on a portfolio, with everything else removed.
When this approach is applied to the US mortgage industry it is clear that there was a boom in originations as interest rates fell. After this boom both delinquency and foreclosure rates tend to climb. But graphs of this are combinations of many different things and hard to use because all lenders, for instance, tend to behave similarly and compete. When the techniques he described are applied, the economy is not the major cause. However, the quality of loans is an issue and deteriorating quality shows up three times (1996,2000,now) and these correlate with lending booms. Each time there is a boom in lending it ends and then loan quality deteriorates rapidly.
He pointed out that this is not inevitable – some mortgage lenders resisted and kept the quality of their loans high. He also showed that the quality is improving rapidly after being terrible in 2006/2007 – this will not show in blended rates for a while but lenders have clearly responded. All this may be moot, however, as the broad economic trends (the recession) may overwhelm the improved quality. Losses may stay high but there is an opportunity for growth if lenders are careful about the recession.
Joe also pointed out that it is not just mortgage – auto and card are hurting too because volumes rose there too and created the same adverse selection problem that mortgage experienced. Various explanations are put forward but in the end it was about good consumers did not take out these loans.
None of this is about bad products but about the way cycles and interest rates move and how that causes adverse selection. You must make more dynamic decisions about portfolios – volume must rise and fall as the cycles go because if you keep volumes up at the wrong time then you will end up in this mess. Whenever interest rates fall then good consumers will flood in and as the environment changes, driving them out, you MUST change. Agility is critical to respond well as things change.
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Another aspect to the Credit Crisis is the ability of the Mortgage Servicing industry to handle the significant increase in customers who cannot make their normal mortgage payments. Trillions of dollars in mortgage loans are outstanding in the U.S. An unprecedented level of defaults is sweeping the nation, creating staggering losses for mortgage note holders, credit underwriters, and other investors in Mortgage Backed Securities.
In 2007, of all the foreclosures completed on behalf of the Government Sponsored Enterprises (Federal National Mortgage Association and Federal Home Loan Mortgage Corporation) by Mortgage Servicers, over 50% had absolutely no borrower contact prior to the foreclosure action being completed. Investors receive foreclosed properties back from Mortgage Servicers and must refurbish and re-sell these homes. The expense for investors and underwriters of Mortgage Backed Securities is soaring into the billions of dollars annually. As a result:
Homeowners are not given a fair chance to stay in their homes.
Work-out options to avoid foreclosure are not explored, let alone exhausted.
Mortgage Servicers are not incented to work loans out, but rather to liquidate them as quickly as possible.
BearingPoint and our partners have worked on a number of projects for Mortgage Servicers both large and small. Our work confirms that servicers need assistance with:
Deployment of advanced analytics that provide detail on performing loans likely to transition to a different state and recommended resolutions thereof
Assistance with process improvements, restructuring and toolsets to back the outcome of the analysis with high performance operations
Institution of performance measurement and predictive models to enable continuous, proactive loss mitigation efforts
We believe that by applying advanced loss mitigation techniques, the great majority of customers will be able to work effectively with their Mortgage Servicer to resolve their delinquency and become current with their mortgage. It is time to rethink and reengineer how Mortgage Servicers deal with customers in default in order to deal with the credit crisis.
Chuck
Thanks for the comments. The whole tangled web of servicers and sold-on loans is certainly making it harder as is a lack of analytics in determining who could and will use a work out program.
JT