The new President of the Federal Reserve of Boston called on banks to support subprime lending as mortgage rates reset to higher levels following the binge of the first part of this decade. Selections from Market Watch:

Banks must step up and provide loans during times of financial market distress and also help homeowners who find themselves behind in their payments of unfavorable mortgages, said Eric Rosengren, the new president of the Boston Federal Reserve Bank.

Rosengren said the recent market turmoil was not a wholesale reassessment of risk by investors.

Instead, the central issue was a lack of liquidity, as relatively low-risk financial assets traded between large financial institutions experienced the most difficulty.

Bank balance sheets expanded in August and September as securitization of subprime mortgages and other asset-backed commercial paper declined.

Rosengren said that “conservatively underwritten securitizations and asset-backed commercial paper will find acceptance by investors” but said this will take some time.

We certainly have worked ourselves in to a pickle here haven’t we? Let’s take a quick look at the problem. The loans that are resetting now (and in to ‘08 & ‘09) were written during 2005 (and in to ‘06/’07) which has been determined is the worst performing of the loan vintages during the subprime boom. In fact, now-defunct lenders such as New Century and Fremont drove the loosening of underwriting guidelines to the extent necessary to keep production (and profit) levels at unsustainable levels.

As just one example of the reckless underwriting guidelines at these banks to sustain this volume Fremont used to take 3 letters of reference for self-employed borrowers in lieu of any additional documentation for their income derived from the business. This was a stated income loan that didn’t require the borrower to provide anything other than 3 letters of reference! No business license, business tax returns, CPA letters, nothing.

I am not singling out Fremont, all subprime banks had these ridiculous lending standards. It’s these loans that are resetting higher that Rosengren wants rescued. The problem, of course, is that “conservative” underwriting guidelines do not include help for these people. A person who is self-employed who can’t even produce bank statements showing enough income to support a home loan is not going to get financing at this point in the game. And it’s not up to the banks to decide that either.

In the world we live in banks are often nothing more than big brokers, securitizing and selling loans off to end investors. If investors decide that they don’t want to buy self-employed stated income loans from people that have 550 FICO scores the loans aren’t getting done. Trust me, I am sure that if end investors suddenly say we’ll buy this stuff, banks would oblige in a heart beat; but they aren’t and so banks are in no position to offer those types of programs that they simply cannot sell.

Rosengren argues that credit isn’t the issue, that liquidity is. The simple fact is that the two are inexorably linked; they can’t be unwound easily from one another.

Further, banks have little room to take additional files on their balance sheets. Balance sheets have swelled unexpectedly from loan pools that haven’t found favorable bids in the secondary markets. In addition, banks rarely keep a ton of cash on hand to portfolio a large amount of loans. For the most part, the banking system is not setup that way in its current configuration.

Banks can’t be expected to make loans they can’t sell; and investors can’t be made to buy assets that don’t have a return commensurate the risk associated with the asset. No matter the Fed “hope” this situation will not change unless a major stimulus comes along to shift the existing paradigm. The Fed can’t do it alone, but the government/Fed/OFHEO/GSEs could do that through several means, including backing certain assets (a la FDIC), opening up Fannie and Freddie loan limits and portfolio caps, easing underwriting and loan limit guidance in FHA, etc. Is that a good idea? I don’t think so. What do you think?

Share This

Share This

This entry was posted on Wednesday, October 10th, 2007 at 4:19 pm and is filed under mortgage industry. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.