The meltdown of 2007 exposed the industry’s blind spots for risk, particularly as it ricocheted between the disparate and competing interests of lenders, servicers, traders and investors. The result was that many firms took on risk that far outweighed the rewards. Finding a path forward from the ashes of this debacle will require stronger leadership overseeing risk, a culture more respectful of interdependent risks and new technologies measuring them across the enterprise.
Vivek Mehra recalls his first “uh-oh” moment in the subprime mess. The Keane global financial-services director was discussing mortgage securitization in 2005 when a close industry source admitted the market made little sense to him. All types of imaginatively structured mortgages — 3/27 ARMs, no-interest balloon notes, income-stated “liar loans” — were jumbled throughout portfolios for the secondary market, usually packaged with prime loans that made it difficult to isolate any one piece for performance. In other words, understanding and measuring risk in these portfolios had become slippery. And if one can’t properly measure risk, how can it be properly priced?
The answer, of course, is one can’t. The fair reward for taking on that risk becomes unknowable. Mehra remembers the conversation so clearly because it was with an svp at Freddie Mac. And for those without a subprime-catastrophe scorecard, the GSE ended 2007 with expected credit writeoffs of $10 billion to 12 billion.
How deep the pain will go remains to be seen. But a late December admission by MBIA, the world’s largest bond insurer, that it had guaranteed $30.6 billion of complex mortgage securities—threatening its entire net worth—indicates the bottom could be a long way down. The troubles are so severe at Countrywide that in early January, it was forced to vigorously deny it was preparing to file bankruptcy—a move that drove its stock down 28 percent. The news worsened with Countrywide’s announcement that loans delinquent 30 days or more rose to 7.20 percent of the total principal outstanding in its mortgage servicing portfolio and pending foreclosures rose to 1.44 percent in December. Angelo Mozilo, CEO of Countrywide, isn’t the only one feeling the heat. Washington Mutual chief executive Kerry Killinger isn’t out of the woods. Both men could soon join a growing list of ousted executives brought down by the credit crisis.
Already more than $100 billion has been written off, but that could prove the thin wedge of the damage. After all, from 2004 to 2006 subprime originations rose from $300 billion to $600 billion. By 2006, these loans made up 21.8 percent of the market and the bulk of the $1 trillion in subprime mortgages in today’s collateralized debt obligations, according to Accenture.
Increasingly, it’s become clear that the market vastly mispriced the value of these risky assets and could have used a healthy dose of paranoia, though even many conservative investors did not include such a radical liquidity scenario in their models. However, it was exactly this kind of paranoia that prompted Goldman Sachs executives to insist the investment bank hedge its positions last spring, helping to save the white-shoe firm billions and making it the envy of the Street.
At far too many banks, however, the attitude was to let the good times roll when executives should have been nibbling their fingernails down to the quick. Christopher Hamilton, svp of financial services and leader for global risk and compliance at BearingPoint, says: “There’s a little bit of denial that goes on as you’re running up the money-making side of the curve.”
That’s being a bit too charitable. The party attitude has now changed. For some places and people, it’s too late; by yearend, more than 100 mortgage shops had closed and 140,000 had lost their jobs. For others, establishing a culture of paranoia is a much needed step in the right direction and will make their enterprise stronger (though it cannot be paranoia that paralyzes. Goldman Sachs, after all, acted and made tons of money). Critical to setting the tone in this new, more sober time will be chief risk officers. A high-level chief risk officer with strategic power can be a key backstop to help measure and influence corporate decisions.
Already, new faces are assuming chief risk roles. Both National City and Citigroup tapped new CROs from internal ranks (Dale Roskom and Jorge A. Bermudez, respectively), following mortgage-loss writedowns in the fourth quarter. Lehman Brothers and Merrill Lynch also have new risk executives in place. And JPMorgan Chase finally filled a year-long chief risk officer vacancy in November when it hired former Goldman Sachs executive Barry Zubrow. Analysts whispered that CEO James Dimon finally recognized—thanks to a $1.6 billion, third-quarter credit writedown — that CRO duties need more than his part-time attention.
Top of the to-do list for these CROs is fashioning a new enterprise view of risk that better assesses the interplay of risks across the institution; this view will allow an institution to understand if a certain risk has actually been hedged or whether to still lurks in another part of the organization. “Integrated risk management is one of the top initiatives that we see carrying on through 2008, and it’s definitely in full force in 2008,” says TowerGroup executive director and corporate strategy analyst Guillermo Kopp. “There are few banks that have a truly holistic platform.”
Kopp says there was a blind spot to the inter-relation of risk across practices that left organizations like Citigroup unaware of how the capital markets and alternative investments units were bilaterally exposed to subprime problems. “The fundamental mistake [was] failing to understand the interdependencies between risks,” says Kopp. “In particular, credit risk in subprime lending has a marginal impact on a credit portfolio, but has a multiplying affect of creating liquidity issues in a securitization portfolio.”
The multiplier impact ended up forcing new Citigroup CEO Vikram Pandit to rescue seven of the bank’s struggling structured-investment vehicles in December by shifting $49 billion in assets back onto Citi’s books. Citi is now the subject of speculation as to whether it should just sell off its investment-banking group. And in early January, Goldman predicted Citi would write down $18.7 billion in fourth quarter tied to CDOs. That’s on top of a $5.9 billion writedown in the third quarter. Investors are rightly leery of the situation in the U.S., says Kopp. “They see the risk at Citi. Why would they put their money with Citi?” Kopp thinks it may take a year before Citi’s brand damage begins to heal in the markets.
Adding to the challenge around developing an enterprise view of risk is coping with the evolving role and views around risk. For instance, mortgage risk evolved over the past 10 years into a commodity that was sliced and diced and packaged in any way a financial engineer could imagine—as if mortgage risk was as interchangeable as barrels of light, sweet crude.
“We evolved a system that completely separated the borrower from the ultimate lender,” says Bill Seidman, the former Federal Deposit Insurance Corp. chairman who is now CNBC’s chief economic commentator. “We had a system where the incentives were all wrong … nobody had an incentive to see that the loan got paid.”
The reckoning came this fall as delinquencies and foreclosures poured in, creating junk bonds out of once highly rated mortgage securities and dumping $1.25 trillion worth of mortgages into real-estate owned assets of institutions. Senior executive departures like Citigroup CEO Charles Prince, Merrill Lynch chief Stanley O’Neal, Bear Stearns CEO James Cayne and Morgan Stanley co-president Zoe Cruz attest to the severity of the problem—with more heads likely to roll.
The good news for banks that weather this crisis: The mortgage business is not going away. Lending will remain a profitable business for those companies that adapt quickly by putting in place better oversight (risk officers), healthier culture (paranoia) and stronger controls (integrated risk-management).
Prior to the meltdown, banks were already aiming to improve their risk-mitigation strategies by opening their wallets wide for technology investments. A recent TowerGroup survey of consumer-lending professionals showed that market volatility and regulatory compliance had shifted to a top priorities for 2008. Sixty-four percent said they planned to spend $100 million or more on technology in 2008, while 18 percent put their IT initiatives’ price tag in the “staggering” range of $1.5 to $5 billion each. Chartis Research in May pegged a nine percent annual growth in operational risk-management expenditures alone in financial services. The firm expects spending to increase to $1.55 billion by 2011.
Some observers say that mortgage operators, CFOs and chief risk officers can’t afford to cut back now. If anything, spending per institution may rise to cope with the onslaught of trouble.
Ironically, the need to position for growth in the mortgage arena and generate income after a dismal year of losses will force banks to spend on technology as much as the need to implement technologies to help clean up the mess. TowerGroup estimates that business-line leaders are still under pressure to deliver 10 percent growth rates annually, and institutions have plenty of lost profits to recover.
As far as coping with the current credit crisis, technology vendors like ISGN, IBM and Fidelity National Information Services are fast-tracking new default and loss-protection automation tools. It’s vital that the industry get these technologies in place quickly, given how fast the market is unraveling. The prospect that consumer-lending platforms and workout teams could be overwhelmed and not able to save otherwise salvageable loans is a real risk.
Ron Morgan, managing director of default-mitigation vendor ISGN, has institutional clients that will see as many as 25,000 loan requests this winter. With REO numbers exploding and 20 percent delinquency rates reported in the portfolios of troubled lenders like Washington Mutual and Countrywide, “I see that number doubling or tripling over the next two or three years,” says Morgan.
Earlier this year, ISGN bought the loss-mitigation platform from Fair Isaac with plans to pool it next year with its existing foreclosure/REO/claims products, including its MortgageHub subsidiary, for a “next-gen” default-handling platform for servicer, wholesale- and retail-mortgage operations. ISGN also launched a Home Retention Alliance, a MortgageHub alliance with the former U.S. Foreclosure Network, which tries to bring lenders together with borrowers and attorneys to work out foreclosure alternatives.
Institutions are also taking matters into their own hands. Jeff Mouhalis, evp at mortgage-technology provider Fidelity NIS, says institutions’ mortgage units are “speeding up” their risk investments and process outsourcing in back-office technology for loss mitigation and foreclosure prevention. Fidelity launched a Web-based workout platform for clients allowing their qualified mortgage customers to “self-serve” their loan-term changes. The backlog problem is not something mortgage companies and banks can hire themselves out of, because default specialists aren’t just warm bodies wearing headsets—they perform a job requiring plenty of experience and seasoning. “Just like underwriters, you don’t grow loss mitigation experts overnight,” says Mouhalis.
But margins are so thin for mortgages—net income per loan may dip below $250 next year, according to a report from WNS Global Services—that even a self-service Web platform isn’t cost-efficient enough. Fidelity is finding takers for a new lockbox-type payment-notification system that informs institutions when a bar-coded payment envelope is dropped off at a post office location—and eliminates an agent’s collection call.
In the back office, Fidelity has new systems that are automating purchase-agent payoffs, credit-bureau file refreshes, closing streams and loan-document management, and is also responding to requests from institutions to improve delinquency analytics.
An example of the industry’s new approach to risk is how lenders now view high-yield home-equity lines of credit. Institutions have historically kept HELOCs in-house, while sending the lower-rate, first-lien products out into the secondary market. The variable rates brought in good income, with relatively lower collateralized risk. “For [banks], it was a win-win,” says TowerGroup research director Craig Focardi.
That is, until the rising prime rate eventually pushed HELOC rates from a low of four percent in 2003-04 to 8.25 percent in 2006, effectively doubling consumer payments and mushrooming delinquencies. Banks have grown fearful of HELOC exposure in bankruptcy proceedings, since second-lien creditor positions are disadvantaged; many began shifting their HELOC servicing from consumer-lending platforms to the higher-end real-estate systems. The real-estate platforms add the ability to handle pre-petition delinquency tracking and track tax-sale information if necessary, says Mouhalis. In addition, “more and more people are saying HELOCS are getting big enough that maybe we need to securitize those,” he says. “Consumer-loan systems won’t give you that.”
Much of these new technology investments aren’t just for handling the problem loans, either, but for building the mortgage business in general and for reaching for that industry standard of 10 percent growth. More paper than ever is involved in approving loans for the 700-plus FICO crowd. “People with very good credit standing are having to produce a lot of documentation that is going to bog down the origination process,” says Ted Landis, a senior financial-services group executive with Accenture.
In the secondary market, investors are looking for technologies that gather more details about the amount of ARMs in a portfolio, or the geographic concentration of subprime collections. The risk issues for the secondary market involve not just fixing mistakes, but making better calls beforehand, according to Sandeep Vishnu, BearingPoint’s managing director for financial services. “How do banks manage all of that data so that it actually yields insight in the form of leading indicators, rather than forensics,” he says.
A new payment-default system introduced this fall by BasePoint Analytics gives investment banks insight into problem loans with early default warning signs. Using data gathered from its historical entrenchment in mortgage-fraud monitoring, BasePoint can identify up to 52 percent of loans that will produce late payments. Early default warnings can force a buyback for any loan that goes bad within 90 days. “Investment banks will have to recalibrate the higher default rates and loss severity rates into their loan purchase models, as well as their models for creating CDOs,” says TowerGroup’s Focardi.
And it is worth noting that revitalizing the securitization market will require banks to find new ways to package and value portfolios beyond the standard review from the ratings agencies, whose reputations have been battered.
Meanwhile, another driver of technology spending is compliance. The GSEs and FHA, for example, are requiring more default data, forcing servicers to build up new data-management and reporting capabilities. Indeed, it’s critical the industry implement strong improvements on its own or the regulatory hammer will come down hard. Some new rules seems inevitable, but the industry would be wise to do what it can to forestall further policing.
Recently, the Federal Reserve unanimously proposed new rules to protect would-be homebuyers from unscrupulous lenders and “higher-priced mortgage loans.” Somewhat ominously, however, the rules also seem intended to protect lenders from making bad business decisions. The four key protections are that creditors would be barred from lending without documenting a borrower’s ability to repay the loan; creditors would have to verify a borrower’s income and assets; prepayment penalties would be restricted; and creditors would have to establish escrow accounts for taxes and insurance.
Although, the challenges posed by the mortgage meltdown are great and demand swift and decisive action by institutions, it’s important to put the current crisis in perspective. The crisis so far is mostly about performance and trust—not soundness. William Isaac, former chairman of the FDIC, looks across the damaged landscape from the subprime credit crisis and shrugs. A seven percent jump in banks’ reserves, an 18-year high? In his day, he says with venerable authority, there were real problems facing banks. “Most of the people who are talking about this being a financial crisis haven’t lived through one,” he says.
Banks that were on the problem lists in 1991 had about 20 percent of America’s assets, versus one percent today, says Isaac, who now is a managing director with expert-services consultant LECG. “If you look at the banking system, even the [banks] that are taking pretty big lumps, it’s not threatening,” says Isaac. “It might be painful; they might fire a CEO over it, and might even reduce their dividend. But we’re not talking about banks teetering on the brink of actual failure.”
The subprime mess has, though, exposed how fragile banks are today to market pressures, and how much can fall on the shoulders of risk officers. Even more, expansion within local markets and beyond borders in international finance makes money-center institutions exposed to unique business-continuity challenges in supply chains or even political unrest in a key market. Says Kopp, “There needs to be a shift from being worried about compliance and cost to leading through times of change, where integration, value creation, creation of business volume and coordination of all the moving parts becomes a factor.”
