Lessons Learned From The Housing Crisis: Accumulate Reserves

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The MBA recently published a comprehensive study on the risk management practices of the mortgage industry that ultimately led to the mortgage meltdown. 

The study entitled Anatomy of Risk Management Practices in the Mortgage Industry was conducted by Professor Cliff Rossi of the University of Maryland and was sponsored by the MBA.  It is a well written academic piece that discusses the various underpinnings, management decisions and lack of risk management tools that helped create the worst case scenario for the mortgage business.  Most of us who worked through the housing market meltdown intuitively understand all the components that contributed to the crisis. To keep it simple: All the stars were misaligned at the same time.

I gleaned a few things from the piece...

  1. There was a proliferation of non fully documented loans offered by mortgage lenders and securitized by Wall Street firms.  As the market shifted to this product, more originators, lenders and investors moved to this product in order to compete and generate higher margins.
  2. There were  inadequate risk management tools at the time to assess the future performance of exotic loan program such as pay option ARMS, 100% CLTV piggy back loans and limited to no document loan programs.  There was no historical performance information to support the decisions of risk managers when launching these programs.  It was driven more by immediate profits than by risk.
  3. Secondary market investors lacked a complete understanding of the counterparty risk involved in originating these products. They also failed to forecast the risks associated with a shift in borrower sentiment as property values declined.  As borrowers defaulted on loans and investors looked to mitigate losses stemming from loan repurchase requests, many lenders “threw in the towel” simply because they lacked the capital and liquidity necessary to repurchase these loans. Thus investors such as FHLMC and FNMA were left owning all the risk as lenders closed their doors

The now constant threat of repurchases and the losses associated with them are a common denominator among mortgage operation owners.  Over the past three years I have visited over 120 small to medium sized mortgage banks, the one common denominator amongst them: They have all made major improvements in risk management and most understand to need to continue to grow the balance sheet either organically or through an infusion of capital to prepare for potential loan losses. 

Regardless of improved risk management tools and better credit quality, the need for capital to support current and previous origination activities will remain of topic of discussion among regulators and politicians.   $3M in reserves may be enough to support current production of $80M per month, but is $3M enough to support $3B of loans originated over the past 3 years?