By Lon S. Cohen
As the U.S. financial industry goes from high-flying tightrope walker into free fall, and the government struggles over how to intervene, the basic concepts of risk and value remain in place. A breathtaking cascade of events started with the government bailout of Fannie Mae, Freddie Mac and AIG, the dissembly of the investment baking system, and the $700 billion Treasury proposal to buy distressed assets to sell at a later date. But what taxpayers eventually recover depends in large part upon the worth of those assets at the time of sale. And the worth of those assets will be measured in large part by the proper assessment of risk.
Hidden Risk
In September, a landslide in credit resulted in major losses for large institutions. In a cascading effect, Lehman Brothers filed for bankruptcy after failing to find support in with the Feds or a potential buyer; Barclays will buy up Lehman’s pieces. Bank of America purchased struggling investment bank, Merrill Lynch. Goldman Sachs and Morgan Stanley applied to convert to traditional bank holding companies. The investment firms had debt to equity ratios two tothree times the level of Bank of America, JP Morgan Chase, and Citigroup. The FDIC, which is supposed to insure risk to the consumer by guaranteeing deposits in banks up to $100,000, may find itself in over its head if things don’t stop quickly heading south. Those insurance premiums the FDIC was collecting to hedge against bank failure were never meant to hold up under this much pressure.
All these complex systems were put in place and allowed to thrive for one reason: to mitigate risk and spread it around so that no one level of banking was left holding the liability bag.
Commenting before the September 20 Treasury proposal of the unofficially-named Troubled Asset Relief Program is Christopher S. Penn. He is CTO of the Student Loan Network, a ten-year-old student lending company. “Everyone’s asking what is next, what’s the next shoe to drop,” said Penn. “Right now, it’s not so much a shoe as an entire DSW warehouse about to fall out of the sky on your head.”
Penn suggested you keep an eye on commercial real estate since, “CRE lags residential by 5-8 quarters, typically.” He said that we’re poised to see “massive gluts of mall space, building loans go bad, and associated chain reactions in the commercial space.”
He also expects even more bank failures to come and predicts that the credit crunch isn’t going to get better by 2009. “It may last until the end of 2011,” he said, “when the remainder of the option ARM and Alt-A mortgages finally clear out.”
Frank McKenna, Chief Fraud Strategist of BasePoint Analytics, a company that provides statistical models to the lending industry. explained that Fannie and Freddie may have played an important role in the past as they created a secondary market for banks to sell loans that they originated, freeing up capital. “The agencies will continue to exist in the future,” he said, somewhat presciently, weeks before the agencies went into conservatorship. “However what they look like in the future may be very different than what we saw in the past.”
Risk vs Uncertainty
When the shouting on Capitol Hill is over, the basics of risk will remain where they were when the crisis began.
“The strict definition of risk is an expression of the probability of loss,” a numerical expression of the probability of a bad outcome, said Penn. “Risk is always a number.” The risk of being scalded is close to 100 percent if you stick your hand in a pot of boiling water, while the risk of being struck by lightning is .57142857 × 10^ -4 percent.
“Risk to a bank is the occurrence of a negative event,” said McKenna. “Typically those negative events are measured by financial impact since, of course, they are a bank and making money is their business.”
Of the many different kinds of risk, McKenna said, the main ones are risk as credit, fraud, compliance, internal and interest rate risks. (See sidebar, “Types of Risk” for an explanation of each type, page 18.)
Chris Penn has an additional definition of risk, to include uncertainty. Falling home prices are an uncertainty because we don’t know where the bottom is and there is no mathematical way to express it because we don’t have reliable numbers. Risk is quantifiable: uncertainty is not.
“Uncertainty can also come from unreliable information, he said. “For example, in the current financial crisis, a significant number of CDOs were rated by ratings agencies as AAA, but the quality of the loans in those CDOs is much worse, so we have uncertainty. We don’t know how bad those loans are.”
It’s an important point, Penn said, because people tend to confuse risk and uncertainty.
“They’re different,” he said. “And understanding the difference between known chance of loss and unknown chance of loss will guide your decisions.”
In the runup to the crisis, lenders tended to confuse the two, issuing dangerous no-documentation mortgages because it was assumed that uncertainty and risk were interchangeable. “They clearly are not,” Penn stated.
As government policy develops, uncertainty is still the watchword.
How We Got Here
A bank may know less about the borrower’s true condition than the borrower does. Historically, banks have reduced the asymmetry of information by cultivating long-term relationships with their clients. But what happens when an institution doesn’t have that long-term relationship, and passes the borrower’s loan onto the secondary market?
Before the current crisis, a low interest rate environment encouraged the expansion of some banks into areas that they had never thought of servicing before in order to get a good return on investment. Coupled with ever rising house prices, the risk number seemed to approach zero.
That environment lent itself to excessive risk-taking by lenders in order to chase higher rewards, said Robert Madden, a sales representative for a large New York-based mutual fund family. Prior to his current role, he spent 4 years in the high grade fixed income markets as a sales trader catering to credit unions and community banks.
“[Lenders] forcibly moved on to a market that typically doesn’t get any lending consideration – the subprime market,” said Madden. “And though this is more of a cause and effect reason, the ‘tightness’ of credit spreads made for easy implementation of new derivative products that fell in to the category of ‘credit tranching’.”
Collateralized Debt Obligations or CDO’s would be the most prominent type of product that falls into this “credit tranching” derivative. Essentially, a pool of low credit quality investments made up of either high yield corporate bonds or subprime mortgages is created, then ‘cut up’ in to credit tranches. “This allows for an investment with an overall credit rating of BB or lower to be made into tranches that include AAA through the use of an insurance wrapper from a mono-line insurance company like AMBAC or MBIA,” Madden explained.
This may be how we got to where we are today. “The problem with that statement, though, is no one is truly sure where we really are today,” Madden said as the financial crisis unfolded.
An Overreaction
But is that really the end of the story? For banks, the most dreaded occurrence is loan default, which makes up most of the risk assessment.
“Credit spreads are now historically very wide and the reward for investing in lower quality bonds would seemingly outweigh the risk,” said Madden. “But the markets are not concurring at this point.” In fact, based on evidence from various market factors, people may be overreacting to the occurrence of default, Madden says
“With the depletion of stock prices of the monoline insurers, the equity hit to companies like Fannie Mae and Freddie Mac over the last few months, the bankruptcy of IndyMac, the dislocation of the municipal market because many of those bonds are insured by the same companies that insured the supposed high-grade credit tranches of CDO’s – one would think the market is actually pricing in 100 percent defaults,” said Madden.
But default rates are not 100 percent – not yet, at least. Remember the 100 percent chance of scalding your hand versus the minuscule possibility of being struck by lightning? Doesn’t the default rate on subprime loans lie somewhere comfortably between a certainty and improbable? Will every subprime borrower eventually default?
No, says Madden. “Defaults may very well be higher historically because of the increased lending in the subprime arena, but to assume defaults will be double or triple their historic subprime averages is unrealistic.”
A Quick Cascade
Frank McKenna said that from his perspective, compliance, fraud and credit risk are converging right now. “Lenders that were traditionally more sales and production focused find themselves being much more focused on those three risk factors in today’s market.”
On the other hand, Steven Drake, a regulatory compliance consultant and principal at the firm, Drake/Lockhart/MacKenzie Consultants said that risk is defined differently at each institution depending upon its portfolio, risk tolerance and philosophy. One type of risk, when it fails, can lead to other types of risk needing to be addressed; each occurrence is not independent in and of itself.
“Poor credit decisions can create regulatory risk, that can create institutional risk that can create reputational risk,” Drake said. “As we’ve already seen in this environment, it becomes a quick cascade of one type to another for many firms.”
Fear-Based Selling
Data intended to help analyze and manage risk, from the Federal Reserve’s reports to surveys of consumer confidence, is feeding perceptions of the financial marketplace.
“More money than ever is sitting in cash and bank certificates of deposit,” said Madden. “There is fear-based selling by concerned investors who see mark-to-market prices deteriorating daily on what they would consider their ‘safe’ investments.”
“I’m in the trenches every day watching AA+ short duration funds with tons of Agency paper get hammered as spreads widen more and more while treasuries overall have rallied,” said Madden in early September. “I used to sell CEOs and CFOs of credit unions on the benefits of [Fannie Mae and Freddie Mac] paper.” Madden sees the difference between actual losses and market perceived losses as “almost absurd.”
He cites the example of Centrix, third-party subprime auto lender, marketing mostly through credit unions. Centrix, which filed for Chapter 11 Reorganization in September 2006, charges 18 percent and expects 20 percent of its loans to default, he says.
In an unfortunate risk assessment at the height of the subprime lending craze, the credit unions saw a benefit because they were able to recruit new members through the lending programs. But when the risky subprime borrowers began defaulting, the credit unions had little initial contact with these clients or information about them.
When Centrix exited bankruptcy this year, there was practically nothing left of the company after attorney fees and administration costs were paid, although Centrix still services a large chunk of its remaining loans under a different company name.
“Sub-prime mortgage holders are paying less than 18 percent, which is going to translate to less than 20 percent defaults to me,” Madden said, “because the 18 percent is strapping them for cash and making defaults higher, but at least the risk/reward ratio is in place.”
Madden argues that despite higher default rates in mortgages, it’s nowhere near 100 percent, so the market is overreacting to the risk of subprime mortgages by everyone from the GSE’s to the banks. Plus there is one big difference between auto loans and mortgages. And that’s depreciation. Unlike autos, homes don’t totally depreciate – there’s always intrinsic value. “Subprime borrowers also don’t own million-dollar homes. They own $100,000 homes,” Madden said. “Are those homes going to $50,000? Such absurd speculation, in my view.”
“There is a lack of faith in investment banks because they are very much responsible for the credit tranching derivatives that are playing such a role in this problem,” said Madden.
Some want to let the marketplace play things out to their eventual end. Others fear what will happen if they fail and think that could be based not on real numbers, historical precedent or faith in the free market.
“As the largest holders of these types of assets [Fannie and Freddie] were going to get hit the hardest by the housing crisis,” said McKenna. “Homes are depreciating at a rapid rate and many of the loans are upside down [meaning that the value of the loan exceeds the value of the underlying collateral]. Many loans are foreclosing. All that spelled real trouble for the agencies.”
Risk Is Real
“Real risk, risk of loss, is much, much higher now,” said Penn. “There’s been a lot of media sensationalism, to be sure, but there’s also a tremendous pile of debt in our financial system that is decaying rapidly.”
The subprime mess has brought out some serious flaws in our financial system. “This crisis exposed very significant problems in the financial systems of the United States and some other major economies,” said Timothy F. Geithner, President and Chief Executive Officer of the New York Federal Reserve Bank, during remarks at The Economic Club of New York, New York City. “Innovation got too far out in front of the knowledge of risk.”
No matter what, risk is a factor of life in a bank. In one simplistic view, a bank’s function is to processes information and manage risk by relying relies on assessing the information available and making informed judgments based on that information.
“Traditionally risk addressed loan policy, and perhaps physical security,” said Steve Coen, former Chief Technology Officer of a New York based regional bank. “Today it is broadly viewed across many areas. There are compliance issues related to privacy, fiscal policy, loan policy, and security both physical and information based.”
With all this information to manage and protect, risk is a fulltime job. “Many enlightened institutions have established Chief Risk Officer positions and regular high level reporting made to the management committee and board,” said Coen.
Does that mean that risk will soon be mitigated by datamining? “Computers can quickly crunch numbers and run models,” said Drake. “But it’s up to the user to appropriately use them and crunch all the right numbers and use forecasting models to spot trends in their markets and portfolios, and not enough did that.” They crunched profit numbers but not risk numbers, he said.
So will use of data now be used to prevent some future crisis? “The unfortunate answer is that banks are more reactionary than precautionary,” said Matthew Gluck, owner of LMS Strategies Inc., a company that implements software solutions for large investment banks. “Every time a crisis occurs banks start putting in all these controls that would have helped us previously.”
Risk is Reaction
The credit crunch has impacted industries far beyond housing, McKenna said. Card issuers are being impacted since mortgages and home equity lines were what borrowers in trouble used to pay off their debts. “Auto loans are experiencing higher repo’s than ever, student loans are harder to get and, of course, lines of credit are harder to get as well.”
The first people to be refused credit are those with poor credit scores or no borrowing history, the very same customers who started the subprime crisis, as lenders bet that the reward was worth the risk and didn’t think about the uncertainty. Looking forward, banks are adjusting to the new realities.
“Today, banks and lenders are looking to conserve capital, which means lending only to the highest quality borrowers, especially in non-government student loans, or private student loans,” said Penn. “The losses due to writedowns of bad mortgage pools are escalating so badly that banks need as much cash as possible, and that’s constraining all forms of lending, including student loans. FICO requirements are significantly higher, on the order of 100+ points more, this year.”
That’s a big change from the days when people with a FICO score around 600 still used to be able to secure no-documentation loans. “Risk is being evaluated much more broadly now,” agreed McKenna. “Policies are eliminating whole segments of lending such as non-prime.”
But it can’t last forever. In the coming years, as lenders understand that risk has to be evaluated on a case by case basis, those segments may come back, McKenna went on to explain. “Not every loan with a FICO score greater than 790 will pay, not every loan with a FICO score of 620 will default. There are other factors that need to be taking into account.”
But when that change comes around and how we’ll get there is still open for debate. “We’ve gotten a good percentage of the subprime resets out of the way, but inflation is running super hot right now and the FOMC is likely going to need to raise rates – just as the crop of Alt-A and Option ARMs begin to reset,” said Penn. “If the first wave of subprime was the perfect storm, batten down the hatches, because there’s plenty more to come.”
But won’t regulation eventually take hold and help reverse the market’s course, mitigating the severe risk of lending? “Risk can be regulated, absolutely,” Penn said. “Uncertainty can never be regulated. Risk is a known quantity – we can prohibit any activity that carries a risk of, say, 78 percent of loss, for example. The problem is uncertainty. How can you regulate ‘I don’t know’?”
“We’re not going to see a V bottom,” said Gluck. “It’s more of a W. We’ll hit bottom two or three times before it goes back up.”
Many banks have pulled back lending, raised rates and even restructured their loan programs to service only pristine borrowers. In reaction to their own past mistakes banks may be leaving some qualified borrowers out in the cold, which only leads to extending the crisis even further.
Despite it all, some say that the credit crunch has yet to really hit. “The reality is that we’re probably in the 3rd inning of a 9-inning game,” said Penn.
The Turning Point
A free market says risk is essential and profitable. Once banks are finished reacting to the crisis they can get back to the business of lending, expanding their portfolio out past just A+ borrowers and into the general lending market. But to get the rewards of higher risk, banks need to address uncertainty and operate from a position of strength.
“It will definitely prolong the period of economic duress, but banks aren’t withholding credit from consumers by choice,” said Penn. “They must, absolutely must, conserve capital to deal with still looming write-downs coming.”
Hard decisions still remain to be made. McKenna says lenders “have done a lot of very tough things and are implementing lots of processes, policies and tools to help them assess risk. I view these changes as the turning point for the industry.”
Once loan quality improves and the housing market comes back to life, the industry should see an uptick in volume and they need to be ready for the positive as well as the negative.
Advice comes from all sides. Chris Penn suggests vigilance.
“For anyone looking for a strategy in this, it’s simple –but not easy – de-leverage and raise capital,” suggests Penn. “If you don’t have mortgage debt on your books, congratulations and be vigilant about other forms of lending.”
Madden sees a point where investors need to take those cash reserves and start putting them back into the market, in order to surmount today’s market problems. “Enjoy the yield spread on Agency debentures right now. If you are a high yield investor, enjoy the historically wide credit spread environment and take on some of the supposed risk because your reward is currently making it a worthwhile investment.”
Madden has some other advice for the powers-that-be in the industry:
“Realize that owning a home is and always will be one of the great undertakings of any American family or individual.”
Lon S. Cohen is a freelance writer based in New York. He has over seven years’ experience working in and writing about the banking industry. You can reach him at lon@lonscohen.com.