By James R. Hagerty and Nick Timiraos
Home-mortgage defaults have soared in recent years partly because lenders relied on flawed risk models during the housing boom and allowed themselves to be lulled by a strong economy into a false sense of security, a new study concludes.
The study–“Anatomy of Risk Management Practices in the Mortgage Industry: Lessons for the Future”–was prepared by a research arm of the Mortgage Bankers Association, a trade group.
The author, Clifford Rossi, a former banker who is now a finance professor at the University of Maryland, argues that the reasons for excessive risk taking go well beyond the popular notion that mortgage lenders typically sold most of their loans to investors and thus didn’t retain “skin in the game.” Many of the lenders that got into trouble retained large amounts of loans on their books and held interests in mortgage securities, he notes.
Among other reasons for the debacle, a long period of strong economic growth and rapidly rising house prices pushed defaults down to unusually low levels and created a “mirage” of adequate risk management, the paper says. Because defaults were so low, lenders grew more willing to accept risk as they pursued market share and sought to please investors with rapid earnings growth.
Lenders also found they could make bigger profit margins on racier types of loans–including ones that didn’t require full documentation of income and allowed borrowers to make minimal initial payments–than they could on standard fixed-rate loans.
Amid the drive for bigger profits, managers in loan-production departments were able to shout down risk managers, the paper says. That was partly because business managers had lots of hard data on current profitability of mortgages, while risk managers could offer only a fuzzy range of uncertain outcomes.
Mortgage lenders also were less equipped than they believed to gauge the risks of looser mortgage standards amid a housing bubble. Riskier types of loans that became popular near the top of the housing boom had never been tested on a broad scale by a crash in home prices. As lenders “began expanding the risk envelope,” the historical data used for predicting defaults were based on conditions that no longer existed, the paper says.
Further undermining the data was the increasing use of loans that allowed borrowers to simply state– rather than verify–their incomes. That meant the information about borrowers’ financial health, plugged into risk models, was unreliable. Credit scores also became less “predictive” as people learned how to “game” the system to improve their numbers, the report says. Fraud aggravated the data problems; for example, many home buyers who declared themselves to be owner-occupants were really investors with little attachment to the property.
The complexity of many statistical models offered “analytical elegance” but contributed to the false sense of security, the paper says. Reliance on these flawed models also may have led lenders to “under-invest” in more traditional risk-management processes, including quality control, appraisals and staff to work with struggling borrowers.
Some lenders also allowed themselves to become overly concentrated on the hottest markets, including California and Florida.
During a discussion of the paper at a Mortgage Bankers Association conference in New York Wednesday, Teresa Bryce, president of Radian Guaranty Inc., a mortgage insurer, said the industry “lost the art of underwriting” during the boom. “It became a checklist mentality,” she said, and underwriters were “not actually looking at those documents…or making sure what’s in those files makes sense.”
Borrowers have also shown a greater propensity in recent years to pay credit cards and auto loans ahead of mortgages, reversing long-standing behavior. That raises another question: are those changes a temporary phenomenon or do they represent a permanent shift in borrower behavior, said Ms. Bryce.
One risk-modeling challenge that hasn’t been addressed is the use of so-called “silent” second mortgages that are added to properties without the knowledge of the first-lien holder. “How are you going to get equilibrium back if you don’t address the silent-second issue?” asked Mr. Rossi, the study’s author.