Roots of the CRE Crisis
The need for liquidity tempted banks to become conduits for subprime and other non-traditional home loans that Wall Street pooled and packaged as mortgage-backed securities. The rise in residential foreclosures, precipitous drop in real estate values and subsequent stock market losses made investors and consumers afraid to spend. That caused businesses to falter; many closed or downsized. Unemployment accelerated and vacancies in commercial and industrial buildings grew. Landlords began to struggle to make loan payments, and CRE defaults increased.
As late as the summer of 2008, CRE was considered a safe haven for lenders. Optimism faded quickly thereafter, but small and mid-sized U.S. banks had already developed credit concentrations secured by grossly overvalued commercial real estate accepted as collateral during the growing real estate “bubble.” The sizeable risk this represented in terms of LTV ratios was compounded by the fact that underwriters (often too young to have experienced the last real estate cycle) failed to consider the potential dangers such cycles represent.
Big Changes
Risk factors that were largely invisible during economic good times have loomed large during the current severe recession. An interagency Final Guidance on Concentrations in Commercial Real Estate Lending was published in late 2006, but some regulators did not seem to have totally grasped the enormity of the risk until the plummeting value of CRE collateral and proportionate rise in LTVs became the primary stressors of bank balance sheets. The FDIC published Managing Commercial Real Estate Concentrations in a Challenging Environment (FIL-22-2008) in March 2008. And by March 2009, the WSJ reported that “commercial real estate loans are going sour at an accelerating pace, threatening to cause tens of billions of dollars in losses to banks.”
There has been an abrupt (if necessary) change in the examiners’ approach. Examiners have ratcheted up criticisms to levels not previously seen (and not necessarily related to economic reality or the usual measures of credit quality). Profitable banks accustomed to positive regulatory reviews and CAMEL ratings of 1 or 2 have suddenly become subject to harsh criticism, leaving management in perplexed confusion. However, it is clear that they expect you to immediately apply extraordinary internal risk management efforts (monitoring systems, internal loan reviews, etc.) to loans secured by commercial real estate. Stress testing individual loans (for primary default triggers) is a recommended risk management tool. In addition, the regulators expect your internal risk assessments to be viewed in the context of changing local, regional, and national economic factors, as well as industry trends.
Exams are Significantly Tougher
We generally take a more conservative view of the loans we review than the examiners in their reviews of the same loans and portfolios. But starting in 2009, we found instances where loans have been criticized to a point beyond reason or justification. We are hardly alone in this observation. Testifying before the FCIC (1) on behalf of the Independent Community Bankers Association (“ICBA”), “Rusty” Cloutier, President and CEO, Midsouth Bank, N.A., Lafayette, LA, said on 1/13/2010: “Even though community banks did not cause the economic crisis, we have been affected by it through a shrinking asset base … and a suffocating examination environment. …We are hearing from community bankers… that the way they have conducted business in the past is no longer acceptable. In a recent (if unscientific) survey conducted by ICBA, 61 percent of respondents said that their most recent safety and soundness exam was “significantly tougher” than their last exam.”
Uncharted Waters
Let’s consider the regulators’ perspective: The head of the FDIC, Sheila Bair, said in a speech on January 20, 2010 (2) : “…while CRE price declines began well after the fall in home values, they have actually been larger on average ... with CRE price indices down by over 40 percent from their Fall 2007 peak…. FDIC-insured banks and thrifts still hold the largest share of commercial mortgage debt. Their dollar exposure to CRE loans stands at an historic high….”
“The annualized net charge-off rate of 6 percent on C&D loans in the third quarter significantly exceeds the highest rate seen in the last crisis, which was about 4 percent. ….Noncurrent CRE loans on income producing properties have risen by 250 percent over the past year to $44.8 billion.”
The regulators have been severely criticized by Congress and the press for failing to do their jobs properly. And the scope of the financial crisis is so huge and the extraordinary measures required to address it so unprecedented, that the regulatory community seems uncertain about how to proceed. Fed Vice Chairman Donald L. Kohn’s address in Atlanta on January 3, 2010, was telling in this respect “…it is well to remember that we are still in uncharted waters. We do not have any recent experience with financial disruptions of [this] breadth, persistence, and consequences…. And we have no experience with most of the sorts of actions the Federal Reserve has taken to counter the shock.” (3)
Shocking Statistics
The Congressional Oversight Panel’s (COP) report of February 10, 2010 points out that average CRE values have fallen more than 40% since January 2007. Vacancy rates for multifamily housing stand at 8%. Vacancies have increased to 18% for office buildings. Rents have declined 40% for office space and 33% for retail space. The report cites loans “…made carelessly” and borrowers’ inability to refinance maturing loans as the likely culprits for CRE defaults. Almost 3,000 banks have CRE concentrations of 40% or more. About $1.4 trillion in CRE loans will mature between 2010 and 2014 and nearly half of these are “underwater – that is, the borrower owes more than the underlying property is currently worth,” making these loans almost impossible to refinance and making foreclosures inevitable. The largest CRE losses, as high as $200-$300 billion, are projected for 2011 and beyond. The COP summarizes the consequences of these compelling problems as follows: “Commercial real estate loan failures…could jeopardize the stability of…the nation’s mid-size and smaller banks, and…contribute to prolonged weakness throughout the economy.”
Unprecedented Challenges with No Easy Solutions
There is no doubt that banks will face unprecedented challenges: increasing write-downs, charge-offs, and loan loss provisions – and for state-chartered branches, additional capital requirements. CRE lending tops the regulators’ watch list and the regulators will want documentary evidence that your staff is well trained and that your commercial portfolio is being monitored by a disciplined internal risk management system. The regulators have identified nearly one-in-eleven financial institutions as troubled in some fashion. Closures in 2010 could almost double the 140 institutions that failed last year. Thus, we don’t think that the new regulatory toughness will be a passing phenomenon; to the contrary, we believe that the new approach will become more stringent.
It won’t be easy. It may not always be possible, for example, to lessen risk by requiring additional collateral because added pressure could now push a previously credit-worthy customer into a death spiral, creating a lose-lose situation. Knowing this, the regulators assured those banks with meaningful risk avoidance programs that they will not be subject to adverse classifications “...solely because the value of the underlying collateral has declined to an amount that is less than the loan balance.”
The fact that the latest interagency issuance deals with Prudent Commercial Real Estate Loan Workouts is sobering. New CRE policies and procedures for underwriters and loan administration staff need to be taught and implemented. Risk management systems and workout programs designed to minimize losses have to be developed.
Effective Risk Management
Maximizing Loan Review Results. Without the requisite background, a loan reviewer may fail to identify control weaknesses and other important problems in a timely manner. Competent loan reviewers help to anticipate and ameliorate risk arising from both internal and external changes. For example, when the regulators published their guidance on CRE concentrations in 2006, we recognized the emerging CRE risk and immediately started to assess the “risk sensitivity” of real property collateral to troubled real estate sectors. Independent loan reviewers (internal or external) working as a team with management, can prevent problems from escalating.
Risk Prevention at Origination. The analyst’s responsibilities go beyond confirming the financial strength of the borrowers and guarantors. The analyst must determine whether the projections and/or goals for which the loan proceeds will be used are realistic. This may require an analysis of trends in the borrower’s industry and its growth and/or seasonal patterns, of demand for the borrower’s product or service, and of competition within the borrower’s market, etc.
Updating the Value of CRE Assets. Property valuations are critical to credit decisions in terms of risk, pricing, etc. Appraisers must be independent, qualified, and should have the specialized knowledge and experience required to evaluate the type of real estate securing the loan. Loan policy should require new appraisals based on loan/borrower status, type of real estate and locale, current trends, and the amount of time since the last appraisal.
The Benefits of Stress Testing. Stress testing can reliably predict the viability of an individual loan, or of a loan portfolio. It becomes a powerful tool when a bank faces unpredictable turns of internal or external events – whether it is a borrower’s inability to comply with loan covenants or a significant shift in the economy. Stress testing also can predict how changes in specific economic/market factors can impact a bank’s commercial loan portfolio, and can provide direction with respect to strategic planning and risk management. The sophistication of the process depends on the size, complexity and risk characteristics of the portfolio.
The Regulators’ CRE Recommendations
The interagency Policy Statement of March 2008 reinforced the recommended risk management practices detailed in the interagency Guidance on CRE lending published December 2006. The ALLL Policy Statement issued in 2006, detailed board/management responsibilities, reviewed considerations for estimating the ALLL and the elements of effective loan review and sound credit grading systems. In both documents, the emphasis was (and it continues to be) on the maintenance of strong capital and loan loss allowance levels, together with robust credit risk-management practices.(4)
The 2006 CRE Guidance defines CRE concentrations as loans for land, construction, and land development representing 100% or more of Total Capital, or total CRE loans representing 300% or more of Total Capital where the outstanding balance of CRE has increased by 50% or more during the prior 36 months. Recommendations for navigating significant CRE concentrations in a deteriorating market conditions include:
1. Increasing capital and/or maintaining an already strong capital position to protect against unexpected losses in stressed markets.
2. Analyze the ALLL on a quarterly basis to ensure proper coverage of estimated credit losses on individually evaluated loans and in the remainder of the portfolio.
3. Enhancing risk management of construction and development and CRE loans by implementing prudent new lending policies, providing MIS reports sufficient to support informed credit decisions, and strengthening loan review and risk rating systems.
4. Maintaining updated financial information on borrowers/guarantors and relevant appraisals on real estate collateral.
5. Bolstering Special Assets with sufficient, appropriately-skilled staff.
Loan Workouts- Forbearance v. Hard Ball
Banks both large and small must convince the regulators of their capacity to reduce concentrations and/or quickly move troubled credits. Regulatory forbearance will allow community banks to give their solid borrowers more time to cure defaults if the bank has demonstrated an earnest effort to clean up its commercial portfolio. However, the current environment should inspire quick action on troubled credits, either “workout” or “work with.” (5)
Policy Decisions. Fair lending regulations require that they be uniformly applied. The established Fair lending policy criteria should cover: (6)
• Characteristics of financially-distressed borrowers based, for example, on changes in financial condition, increases in LTV ratios, reduction in DSCR, decreases in NOI, etc.
• Reasons for undertaking to negotiate a loan modification or refinance, i.e. the circumstances under which a distressed borrower will be considered creditworthy.
• Whether to proactively reach out to borrowers in trouble, or consider their plight only when they ask (which may have a higher risk of disparate impact).
• Circumstances deemed appropriate for providing benefits that would make a loan more affordable or cure a default.
• Changes in the borrower’s condition that would make restructuring a credit viable, as opposed to foreclosure, repossession, etc.
Designing a Workout Process. The bank’s workout process should identify the deficiencies which the bank must address, determine whether they can be fixed, and how the fix is to be implemented. Staff involved in this specialized process must have a solid understanding of how their jobs fit into the big picture. They must keep in mind that the ultimate goal is to limit the bank’s losses and, at the same time and whenever possible, help creditworthy borrowers survive a business environment that has created financial difficulties beyond their control. The workout procedures must establish a new set of underwriting protocols which include an immediate and thorough review of the borrower/guarantor’s current financial condition. Additional security may be required, including personal assets, e.g. of a sole proprietor or guarantor.
The regulators’ 2009 CRE Workout Guidance on prudent CRE workouts provides examples of analytical review processes designed to ensure that arrangements comply with all regulatory requirements, including reporting and accounting requirements.(7) Regulated institutions are assured that performing loans, including loans that are renewed or restructured on reasonable modified terms, will not be subject to adverse classification “...solely because the value of the underlying collateral has declined to an amount that is less than the loan balance.”
Review of “Work With” and “Workout” Decisions. Management decisions on troubled loans, whether related to work-with or workout situations, must be reviewed and approved by a senior staff individual before the decision is finalized. Similarly, the board or its loan committee should be able to assume that the borrower is eligible under bank policy when a refinanced or modified loan is submitted for approval. “Work-with” and “workout” agreements must be in writing. Loan files must reflect, document and justify approval of all exceptions to bank policies and procedures, whether part of the formal agreement or otherwise.
Amassing OREO in a Down Market. Borrowers and lenders seem to have been playing a consensual game of “extend and pretend.” In order to avoid accumulating distressed OREO, lenders have not foreclosed on financially stressed CRE owners who are defaulting on loan agreements. Instead, many of these loans have been renewed or extended, which is akin to “kicking the can down the street for awhile.” It passes the time but it does nothing to solve the problem.
Preparing for a Commercial Loan Exam
The regulators expect banks to have implemented comprehensive CRE risk management programs. The examiners expect that certain standard steps are being taken to ameliorate the enormous risk that large CRE concentrations represent. They are checking to see if banks are:
• Adhering to underwriting policy standards appropriate to current conditions in the financial sector.
• Segmenting the CRE portfolio into meaningful categories (e.g. geographies, industries, property types, etc.), and setting maximum threshold levels by dollar amount and percentage of Tier 1 capital.
• Minimizing (and tracking) exceptions to policy.
• Establishing the “credit-ability” (i.e. repayment capacity) of the borrower and guarantor(s) by performing ongoing cash flow analyses, verifying subordinated debt/contingent liabilities, requiring current financials, tax returns, etc. (and analyzing all such documents).
• Monitoring the depth and effectiveness of the bank’s cash flow analysis function.
• Insuring that file documentation is sufficient and current.
• Drafting loan agreements requiring the borrower to provide the data needed to determine whether contractual LTV and DSCR ratios are being met.
• Stress testing CRE loans/portfolios as appropriate to identify the key factors most likely to trigger defaults.
• Independently scrutinizing and tracking the status of CRE collateral by examining updated rent rolls, average daily rates, etc., and periodically comparing findings.
• Examining leases for expiration dates, rights upon default, etc., and checking lease provisions for options that could impact cash flow, such as the right of smaller businesses to terminate or reduce rent if a major tenant vacates.
• Maintaining updated appraisals that specify absorption rates and use a realistic capitalization rate together with a review/analysis of the appraisal.
• Implementing a centralized appraisal review process and assigning responsibility to one officer.
• Periodically reviewing appraisals on major credits (as such credits are defined in the policy) to ensure that there are no material changes in market conditions that would require a new appraisal for an existing loan.
• If risk exposure is high and deemed advisable by management, suspending internal valuations and using outside appraisers - even for loans under $250,000.
• Complying with the 2006 Interagency ALLL Policy Statement as reflected in related FAQs, which update the ALLL Policy Statements of July 2001 and March 2004.
• Amending loan policies to reflect the interagency guidance of October 2009 on CRE Workouts.
• Incorporating findings from stress test results in the loan loss reserve methodology, as well as capital and budget planning.
• Tracking total loan classifications to total capital (CRE in excess of 3xCapital).
• Tracking owner-occupied loans (despite the exclusion in the 2006 CRE exam guidance) because of recent slowing in the retail business sector.
All of the recommended steps that ensure a good loan examination should be applied equally to the bank’s efforts to minimize loan losses. In addition, it is prudent during the current unpredictable economy to require as a condition of, and prior to, approval of refinancing or extending an existing CRE loan:
• That the borrower provide additional collateral to offset an increase in the LTV ratio;
• That a new appraisal be performed;
• That the borrower agree to provide, as often as the Branch requests, additional cash flow and/or NOI documentation, including but not limited to rent rolls, ADR data, tax returns, financial statements etc.;
• That the banks compare new tax returns, financial statements, etc. to previous submissions, and perform an analysis which is documented in the file. The objective is to resolve all questions and concerns that are noted.
• That specific loans be stress-tested in a manner which isolates the factors most likely to trigger a default in order to sharpen the focus of oversight by the loan department.
Regulatory Concerns about Safety and Soundness
A majority of enforcement actions are currently focused on safety and soundness issues. Enforcement actions most frequently cite a need for increased capital (77 percent) and address asset quality (83 percent). Provisions aimed at asset quality have included directives to reduce problem assets and to improve lending policies/procedures, and/or compliance with related laws and regulations. Reference is often made to appraisal requirements and OREO accounting. More than three-quarters of enforcement actions cite factors related to management, such as mandates to improve board oversight of risk management, and specific requirements pertaining to the knowledge and experience of the individuals serving on the board or as part of the management team.
Other significant issues that are currently being addressed in enforcement actions are: required policy revisions (87 percent); correction of examination findings (75 percent); and development of additional controls (72 percent). Enforcement actions also point to deficiencies in training (45 percent), the need for additional MIS reporting (50 percent) and/or enhancement of the internal audit function (44 percent)
Footnotes
(1) The Financial Crisis Inquiry Commission was created by Section 5 of the Fraud and Recovery Act of 2009
(2) See http://www.fcic.gov/hearings/pdfs/2010-0113-Cloutier.pdf
(3) See https://www.federalreserve.gov/newsevents/speech/kohn20100103a.htm
(4) The SEC took action against SunTrust Bank in 1999, alleging that it was manipulating earnings by setting aside excessive loan loss reserves, an action which undoubtedly had a negative effect on bank reserves through the early 2000s. Lower reserves resulted in increased earnings, and increased earnings allowed banks to pay out more capital and expand their balance sheets.
(5) Steve Cocheo (Executive Director), “Digging in for a Long Stretch of Workouts,” ABA Banking Journal October 2009.
(6) Carl G. Pry, CRCM, “To Modify or Not,” ABA Bank Compliance November/December 2009
(7) FIL-61-2009 published October 30, 2009, replaces the Interagency Policy Statement on the Review and Classification of CRE Loans (November 1991)
Thursday, April 1, 2010
Wednesday, February 10, 2010
AIG Hearings Run by the Gang That Couldn’t Shoot Straight
I watched Treasury Secretary Geithner on January 27th testify today before the House Committee on Oversight and Government Reform about the bailout of the insurance giant AIG and two aphorisms came to mind: No good deed goes unpunished and who promised you fair?
To put it politely… Geithner was skewered.
Congress acted like the surviving recipient of CPR who lives to sue his rescuer for breaking a few ribs in the process. Congress should be fixing a broken financial system, not posturing for posterity. It should have considered that Geithner, and a few others, saved the world’s financial system from a breakdown of unprecedented scale. They did not act perfectly, but they acted quickly, decisively, and effectively. With no oversight responsibilities for AIG, the Fed was a little busy dealing with:
• a run on a series of commercial financial institutions which ultimately failed (Wachovia, Washington Mutual, etc.),
• a systemic loss of confidence in the investment banking system and its four largest participants (in order of their problems: Lehman Bros, Merrill Lynch, Morgan Stanley, and Goldman Sachs),
• a systemic liquidity shortfall in the commercial paper market, and the money market funds, and
• the onset of the worst economy since the Great Depression.
Then, on Friday, September 12th, AIG came to the New York Fed, hat in hand, and announced that it was running out of cash and needed help. Mind you, AIG’s systems were so antiquated and inadequate to the informational needs of its global operations, that it did not know exactly how much cash it had on hand, did not know at what rate it was losing cash, did not know what exposure it had from the issuance of credit default swaps by its London operation, could not provide a list of its counterparties, nor its exposure to them, and had no one available who could answer these questions.
Over that weekend, then New York Fed President Geithner, while trying to find a private-market solution for AIG, was instrumental in:
• arranging the merger of Merrill Lynch with Bank of America,
• overseeing the failure of a private-market solution for Lehman Bros that resulted in its being required to file for bankruptcy in early Monday morning,
• substantially beefing up the Primary Dealer Credit Facility and the Term Securities Lending Facility by very broadly expanding the types of collateral that could be used under them, and
• arranging temporary exceptions to Section 23a of the Federal Reserve Act to allow insured depository institutions to provide liquidity to their affiliates struggling in the chaos.
The sleep-deprived team of regulators watched on Monday as AIG was downgraded by the credit rating agencies. The Dow fell some 500 points. The commercial paper market continued to fall apart.
The best estimate of the team working on the AIG problem was that the liquidity hole was $80 billion, not the $20 billion estimated by the company’s management. The firm’s exposure to the derivative and swap markets exceeded a trillion dollars. The firm was deeply interwoven into the world’s financial system.
At that point, Geithner and his team crafted an $85 billion secured loan that represented the first step in the rescue for AIG which was announced on the following day, September 16th.
If instead of Geithner, we citizens had Congress on the hot seat, here are the Q & A’s I would have liked to have seen:
• What government body oversaw a substantial reduction in the scope and power of the various entities regulating the financial industry?
• What government body created a regulatory scheme that incorporated such a disparate group of competing and uncoordinated regulators?
• What group of people preached that the free-market was self-regulating and safe while simultaneously accepting over $2 billion in campaign contributions from the financial industry in the last decade?
The answer to all three of these important questions is, of course, Congress.
On behalf of one citizen, Secretary Geithner, please accept my thanks for your role in crafting an extraordinary series of measures that took us on a path well away from Armageddon, even if it is a trail none of us would choose to be on.
One final aphorism comes to mind: don’t let the %$#@!@^ grind you down.
To put it politely… Geithner was skewered.
Congress acted like the surviving recipient of CPR who lives to sue his rescuer for breaking a few ribs in the process. Congress should be fixing a broken financial system, not posturing for posterity. It should have considered that Geithner, and a few others, saved the world’s financial system from a breakdown of unprecedented scale. They did not act perfectly, but they acted quickly, decisively, and effectively. With no oversight responsibilities for AIG, the Fed was a little busy dealing with:
• a run on a series of commercial financial institutions which ultimately failed (Wachovia, Washington Mutual, etc.),
• a systemic loss of confidence in the investment banking system and its four largest participants (in order of their problems: Lehman Bros, Merrill Lynch, Morgan Stanley, and Goldman Sachs),
• a systemic liquidity shortfall in the commercial paper market, and the money market funds, and
• the onset of the worst economy since the Great Depression.
Then, on Friday, September 12th, AIG came to the New York Fed, hat in hand, and announced that it was running out of cash and needed help. Mind you, AIG’s systems were so antiquated and inadequate to the informational needs of its global operations, that it did not know exactly how much cash it had on hand, did not know at what rate it was losing cash, did not know what exposure it had from the issuance of credit default swaps by its London operation, could not provide a list of its counterparties, nor its exposure to them, and had no one available who could answer these questions.
Over that weekend, then New York Fed President Geithner, while trying to find a private-market solution for AIG, was instrumental in:
• arranging the merger of Merrill Lynch with Bank of America,
• overseeing the failure of a private-market solution for Lehman Bros that resulted in its being required to file for bankruptcy in early Monday morning,
• substantially beefing up the Primary Dealer Credit Facility and the Term Securities Lending Facility by very broadly expanding the types of collateral that could be used under them, and
• arranging temporary exceptions to Section 23a of the Federal Reserve Act to allow insured depository institutions to provide liquidity to their affiliates struggling in the chaos.
The sleep-deprived team of regulators watched on Monday as AIG was downgraded by the credit rating agencies. The Dow fell some 500 points. The commercial paper market continued to fall apart.
The best estimate of the team working on the AIG problem was that the liquidity hole was $80 billion, not the $20 billion estimated by the company’s management. The firm’s exposure to the derivative and swap markets exceeded a trillion dollars. The firm was deeply interwoven into the world’s financial system.
At that point, Geithner and his team crafted an $85 billion secured loan that represented the first step in the rescue for AIG which was announced on the following day, September 16th.
If instead of Geithner, we citizens had Congress on the hot seat, here are the Q & A’s I would have liked to have seen:
• What government body oversaw a substantial reduction in the scope and power of the various entities regulating the financial industry?
• What government body created a regulatory scheme that incorporated such a disparate group of competing and uncoordinated regulators?
• What group of people preached that the free-market was self-regulating and safe while simultaneously accepting over $2 billion in campaign contributions from the financial industry in the last decade?
The answer to all three of these important questions is, of course, Congress.
On behalf of one citizen, Secretary Geithner, please accept my thanks for your role in crafting an extraordinary series of measures that took us on a path well away from Armageddon, even if it is a trail none of us would choose to be on.
One final aphorism comes to mind: don’t let the %$#@!@^ grind you down.
Thursday, October 15, 2009
Effective Enterprise Risk Oversight - The Role of the Board of Directors
Effective Enterprise Risk Oversight: The Role of the Board of Directors
Enterprise risk management is a process, effected by the entity’s board of directors, management, and other personnel, applied in strategy setting and across the enterprise, designed to identify potential events that may affect the entity, and manage risk to be within the risk appetite, to provide reasonable assurance regarding the achievement of objectives
COSO’s Enterprise Risk Management – Integrated Framework (2004)
The challenge facing Boards is how to effectively oversee the organization’s enterprise-wide risk management in a way that balances managing risks while adding value to the organization. Although some organizations have employed sophisticated risk management processes, others have managed risks informally or on an ad hoc basis. In the aftermath of the financial crisis, executives and their boards realize that ad hoc risk management is no longer tolerable and that current processes may be inadequate in today’s rapidly evolving business world. Boards, along with other parties, are under increased focus due to the widely-held perception that organizations encountered risks during the crisis for which they were not adequately prepared.
Increasingly, boards and management teams are embracing the concept of enterprise risk management (ERM) to better connect their risk oversight with the creation and protection of stakeholder value. ERM is a process that provides a robust and holistic top-down view of key risks facing an organization. To help boards and management understand the critical elements of an enterprise-wide approach to risk management, COSO issued in 2004 its Enterprise Risk Management – Integrated Framework. That framework defines ERM as follows:
In today’s environment, the adoption of ERM may be the most effective and attractive way to meet ever increasing demands for effective board risk oversight. If positioned correctly within the organization to support the achievement of organizational objectives, including strategic objectives, effective ERM can be a value-added process that improves long-term organizational performance. Proponents of ERM stress that the goal of effective ERM is not solely to lower risk, but to more effectively manage risks on an enterprise-wide, holistic basis so that stakeholder value is preserved and grows over time. Said differently, ERM can assist management and the board in making better, more risk-informed, strategic decisions.
An entity’s board of directors plays a critical role in overseeing an enterprise-wide approach to risk management. Because management is accountable to the board of directors, the board’s focus on effective risk oversight is critical to setting the tone and culture towards effective risk management through strategy setting, formulating high level objectives, and approving broad-based resource allocations.
COSO’s Enterprise Risk Management – Integrated Framework highlights four areas that contribute to board oversight with regard to enterprise risk management:
Understand the entity’s risk philosophy and concur with the entity’s risk appetite. Risk appetite is the amount of risk, on a broad level, an organization is willing to accept in pursuit of stakeholder value. Because boards represent the views and desires of the organization’s key stakeholders, management should have an active discussion with the board to establish a mutual understanding of the organization’s overall appetite for risks.
Know the extent to which management has established effective enterprise risk management of the organization. Boards should inquire of management about existing risk management processes and challenge management to demonstrate the effectiveness of those processes in identifying, assessing, and managing the organization’s most significant enterprise-wide risk exposures.
www.coso.org Effective Enterprise Risk Oversight: The Role of the Board of Directors www.coso.org
Review the entity’s portfolio of risk and consider it against the entity’s risk appetite. Effective board oversight of risks is contingent on the ability of the board to understand and assess an organization’s strategies with risk exposures. Board agenda time and information packets that integrate strategy and operational initiatives with enterprise-wide risk exposures strengthen the ability of boards to ensure risk exposures are consistent with overall appetite for risk.
Be apprised of the most significant risks and whether management is responding appropriately. Risks are constantly evolving and the need for robust information is of high demand. Regular updating by management to boards of key risk indicators is critical to effective board oversight of key risk exposures for preservation and enhancement of stakeholder value.
Boards of directors often use board committees in carrying out certain of their risk oversight duties. The use and focus of committees vary from one entity to another, although common committees are the audit committee, nominating/governance committees, compensation committees, with each focusing attention on elements of enterprise risk management. While risk oversight, like strategy, is a full board responsibility, some companies may choose to start the process by asking the relevant committees to address risk oversight in their areas while focusing on strategic risk issues in the full board discussion.
While ERM is not a panacea for all the turmoil experienced in the markets in recent years, robust engagement by the board in enterprise risk oversight strengthens an organization’s resilience to significant risk exposures. ERM can help provide a path of greater awareness of the risks the organization faces and their inter-related nature, more proactive management of those risks, and more transparent decision making around risk/reward trade-offs, which can contribute toward greater likelihood of the achievement of objectives.
An executive summary of COSO’s Enterprise Risk Management – Integrated Framework provides an overview of the key principles for effective enterprise risk management and is available for free download at www.coso.org. More detailed guidance, including examples about effective implementation of the key principles, is contained in the full document. COSO’s objectives are to improve organizational performance through better integration of strategy, risk, control, and governance. Our Frameworks are based on identified best practices and the development of consistent terminology and approaches that can be used by many organizations in meeting their objectives. We hope that our ERM Framework will help you in that journey to enhancing long-term stakeholder value.
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The Committee of Sponsoring Organizations of the Treadway Commission (COSO) is a voluntary private-sector organization comprised of the following organizations dedicated to guiding executive management and governance participants towards the establishment of more effective, efficient, and ethical business operations on a global basis. It sponsors and disseminates frameworks and guidance based on in-depth research, analysis, and best practices.
American Accounting Association Institute of Management Accountants
American Institute of Certified Public Accountants The Institute of Internal Auditors
Financial Executives International
__________________________
U.S. Securities and Exchange Commission, Speech by SEC Chairman: Address to the Council of Institutional Investors, 2009 (www.sec.gov/news/speech/2009/spch040609.html).
Committee of Sponsoring Organizations of the Treadway Commission (COSO), Enterprise Risk Management – Integrated Framework, September 2004, www.coso.org, New York, NY.
Enterprise risk management is a process, effected by the entity’s board of directors, management, and other personnel, applied in strategy setting and across the enterprise, designed to identify potential events that may affect the entity, and manage risk to be within the risk appetite, to provide reasonable assurance regarding the achievement of objectives
COSO’s Enterprise Risk Management – Integrated Framework (2004)
The challenge facing Boards is how to effectively oversee the organization’s enterprise-wide risk management in a way that balances managing risks while adding value to the organization. Although some organizations have employed sophisticated risk management processes, others have managed risks informally or on an ad hoc basis. In the aftermath of the financial crisis, executives and their boards realize that ad hoc risk management is no longer tolerable and that current processes may be inadequate in today’s rapidly evolving business world. Boards, along with other parties, are under increased focus due to the widely-held perception that organizations encountered risks during the crisis for which they were not adequately prepared.
Increasingly, boards and management teams are embracing the concept of enterprise risk management (ERM) to better connect their risk oversight with the creation and protection of stakeholder value. ERM is a process that provides a robust and holistic top-down view of key risks facing an organization. To help boards and management understand the critical elements of an enterprise-wide approach to risk management, COSO issued in 2004 its Enterprise Risk Management – Integrated Framework. That framework defines ERM as follows:
In today’s environment, the adoption of ERM may be the most effective and attractive way to meet ever increasing demands for effective board risk oversight. If positioned correctly within the organization to support the achievement of organizational objectives, including strategic objectives, effective ERM can be a value-added process that improves long-term organizational performance. Proponents of ERM stress that the goal of effective ERM is not solely to lower risk, but to more effectively manage risks on an enterprise-wide, holistic basis so that stakeholder value is preserved and grows over time. Said differently, ERM can assist management and the board in making better, more risk-informed, strategic decisions.
An entity’s board of directors plays a critical role in overseeing an enterprise-wide approach to risk management. Because management is accountable to the board of directors, the board’s focus on effective risk oversight is critical to setting the tone and culture towards effective risk management through strategy setting, formulating high level objectives, and approving broad-based resource allocations.
COSO’s Enterprise Risk Management – Integrated Framework highlights four areas that contribute to board oversight with regard to enterprise risk management:
Understand the entity’s risk philosophy and concur with the entity’s risk appetite. Risk appetite is the amount of risk, on a broad level, an organization is willing to accept in pursuit of stakeholder value. Because boards represent the views and desires of the organization’s key stakeholders, management should have an active discussion with the board to establish a mutual understanding of the organization’s overall appetite for risks.
Know the extent to which management has established effective enterprise risk management of the organization. Boards should inquire of management about existing risk management processes and challenge management to demonstrate the effectiveness of those processes in identifying, assessing, and managing the organization’s most significant enterprise-wide risk exposures.
www.coso.org Effective Enterprise Risk Oversight: The Role of the Board of Directors www.coso.org
Review the entity’s portfolio of risk and consider it against the entity’s risk appetite. Effective board oversight of risks is contingent on the ability of the board to understand and assess an organization’s strategies with risk exposures. Board agenda time and information packets that integrate strategy and operational initiatives with enterprise-wide risk exposures strengthen the ability of boards to ensure risk exposures are consistent with overall appetite for risk.
Be apprised of the most significant risks and whether management is responding appropriately. Risks are constantly evolving and the need for robust information is of high demand. Regular updating by management to boards of key risk indicators is critical to effective board oversight of key risk exposures for preservation and enhancement of stakeholder value.
Boards of directors often use board committees in carrying out certain of their risk oversight duties. The use and focus of committees vary from one entity to another, although common committees are the audit committee, nominating/governance committees, compensation committees, with each focusing attention on elements of enterprise risk management. While risk oversight, like strategy, is a full board responsibility, some companies may choose to start the process by asking the relevant committees to address risk oversight in their areas while focusing on strategic risk issues in the full board discussion.
While ERM is not a panacea for all the turmoil experienced in the markets in recent years, robust engagement by the board in enterprise risk oversight strengthens an organization’s resilience to significant risk exposures. ERM can help provide a path of greater awareness of the risks the organization faces and their inter-related nature, more proactive management of those risks, and more transparent decision making around risk/reward trade-offs, which can contribute toward greater likelihood of the achievement of objectives.
An executive summary of COSO’s Enterprise Risk Management – Integrated Framework provides an overview of the key principles for effective enterprise risk management and is available for free download at www.coso.org. More detailed guidance, including examples about effective implementation of the key principles, is contained in the full document. COSO’s objectives are to improve organizational performance through better integration of strategy, risk, control, and governance. Our Frameworks are based on identified best practices and the development of consistent terminology and approaches that can be used by many organizations in meeting their objectives. We hope that our ERM Framework will help you in that journey to enhancing long-term stakeholder value.
*********
The Committee of Sponsoring Organizations of the Treadway Commission (COSO) is a voluntary private-sector organization comprised of the following organizations dedicated to guiding executive management and governance participants towards the establishment of more effective, efficient, and ethical business operations on a global basis. It sponsors and disseminates frameworks and guidance based on in-depth research, analysis, and best practices.
American Accounting Association Institute of Management Accountants
American Institute of Certified Public Accountants The Institute of Internal Auditors
Financial Executives International
__________________________
U.S. Securities and Exchange Commission, Speech by SEC Chairman: Address to the Council of Institutional Investors, 2009 (www.sec.gov/news/speech/2009/spch040609.html).
Committee of Sponsoring Organizations of the Treadway Commission (COSO), Enterprise Risk Management – Integrated Framework, September 2004, www.coso.org, New York, NY.
Wednesday, July 15, 2009
The 6% solution to the Housing Crisis
By Jon Hainer
It doesn’t take a Sherlock Holmes to deduce that our lawmakers are focused on the wrong element of the housing crisis. Congress has just created a massive bailout package the details of which are still fuzzy. If only it had included the right provisions. Instead, it did nothing for the consumer, nothing for the individual homeowner, and it did nothing to put a floor under the value of homes which continue to drop nationwide. The bailout package focused on the concerns of those with the most political leverage that have precious little to do with the national emergency as it effects most of us. Rather than worrying about whether top financial executives have earned their golden parachutes, or whether Nancy Pelosi was right about the role of deregulation in this crisis, the Congress, the Administration, and the Fed should have spent time and energy worrying about the little guy. Here’s one modest proposal they could have considered.
Let’s make it a condition of any financial institution accepting government assistance with their illiquid mortgages, or mortgage-backed securities (“MBS”), that it will be required to lower the rates on all of its mortgages to not more than 6% and to fix them there. The problems that individual borrowers have with rates resetting at unaffordable levels would be considerably reduced. For the family with a $300 thousand mortgage that faced a rate-reset to, say 10%, the savings would make a world of difference. The principal and interest portion of their payment would be reduced by $834.06 per month. If their percentage of take-home pay were 50% with the 10% mortgage, it would drop to a much more manageable 34% with the 6% mortgage. Let’s call it the 6% solution.
Not only would this idea help the little guy, it would have a beneficial impact on the entire residential real estate market. Prices would tend to stabilize. Defaults would tend to decline. The supply of new homes coming on to the market through foreclosure would tend to drop. Illiquid MBS do not now trade because no one knows what the flow of funds into the mortgage pools will be will. As the 6% solution stabilizes the payment streams at known levels, those MBS will become increasingly saleable, and the banking system increasingly liquid. The 6% solution would not be a panacea, but it could make a considerable difference just at the cusp, or tipping point, at which I suspect we now find ourselves.
Interestingly, the cost of this little guy bailout would probably be about what the cost of the big bailout that is underway. Bank of America / Countrywide just announced a $8.5 billion dollar package for 400 thousand homeowners. If the bailout were for 40 million homeowners at the same rate the cost would be $850 billion – or almost exactly what the bailout we got is projected to cost. In addition, the Bank of America plan would lower borrower rates to as low as 2.5% and provides assistance to those who are going to loose their homes no matter what the rate.
There are problems with this 6% solution, of course. Owning an undivided interest in a pool of mortgages (i.e. owning part of an issue of a MBS) is not the same as controlling the terms of each individual mortgage. This proposal would tend to hurt holders of the lower-rated MBS disproportionately as less money would come into the mortgage pools. Moral hazard – rewarding risky behavior with public funds – exists with this idea. But isn’t that why we pay those guys in Washington, to figure out the details to such things and craft a workable solution? Tell your Congressman to stop worrying about political posturing and limiting the payout to a handful and to start worrying about putting a hand out to help millions. Even Dr. Watson could recognize this as a more promising avenue of investigation. Can’t anyone think outside of the box anymore? Sherlock, are you there?
………………………………………………………………………………….
Jon Hainer is a principal with Stern & Associates, a bank compliance firm, and co-author of the book Commercial Loan Review and Audit Manual published by Sheshunoff. He also heads the Economic Strategy Group at the downtown LA law firm of Hicks Park LLP. He may be reached at jhainer@sternassociatesllc.com
It doesn’t take a Sherlock Holmes to deduce that our lawmakers are focused on the wrong element of the housing crisis. Congress has just created a massive bailout package the details of which are still fuzzy. If only it had included the right provisions. Instead, it did nothing for the consumer, nothing for the individual homeowner, and it did nothing to put a floor under the value of homes which continue to drop nationwide. The bailout package focused on the concerns of those with the most political leverage that have precious little to do with the national emergency as it effects most of us. Rather than worrying about whether top financial executives have earned their golden parachutes, or whether Nancy Pelosi was right about the role of deregulation in this crisis, the Congress, the Administration, and the Fed should have spent time and energy worrying about the little guy. Here’s one modest proposal they could have considered.
Let’s make it a condition of any financial institution accepting government assistance with their illiquid mortgages, or mortgage-backed securities (“MBS”), that it will be required to lower the rates on all of its mortgages to not more than 6% and to fix them there. The problems that individual borrowers have with rates resetting at unaffordable levels would be considerably reduced. For the family with a $300 thousand mortgage that faced a rate-reset to, say 10%, the savings would make a world of difference. The principal and interest portion of their payment would be reduced by $834.06 per month. If their percentage of take-home pay were 50% with the 10% mortgage, it would drop to a much more manageable 34% with the 6% mortgage. Let’s call it the 6% solution.
Not only would this idea help the little guy, it would have a beneficial impact on the entire residential real estate market. Prices would tend to stabilize. Defaults would tend to decline. The supply of new homes coming on to the market through foreclosure would tend to drop. Illiquid MBS do not now trade because no one knows what the flow of funds into the mortgage pools will be will. As the 6% solution stabilizes the payment streams at known levels, those MBS will become increasingly saleable, and the banking system increasingly liquid. The 6% solution would not be a panacea, but it could make a considerable difference just at the cusp, or tipping point, at which I suspect we now find ourselves.
Interestingly, the cost of this little guy bailout would probably be about what the cost of the big bailout that is underway. Bank of America / Countrywide just announced a $8.5 billion dollar package for 400 thousand homeowners. If the bailout were for 40 million homeowners at the same rate the cost would be $850 billion – or almost exactly what the bailout we got is projected to cost. In addition, the Bank of America plan would lower borrower rates to as low as 2.5% and provides assistance to those who are going to loose their homes no matter what the rate.
There are problems with this 6% solution, of course. Owning an undivided interest in a pool of mortgages (i.e. owning part of an issue of a MBS) is not the same as controlling the terms of each individual mortgage. This proposal would tend to hurt holders of the lower-rated MBS disproportionately as less money would come into the mortgage pools. Moral hazard – rewarding risky behavior with public funds – exists with this idea. But isn’t that why we pay those guys in Washington, to figure out the details to such things and craft a workable solution? Tell your Congressman to stop worrying about political posturing and limiting the payout to a handful and to start worrying about putting a hand out to help millions. Even Dr. Watson could recognize this as a more promising avenue of investigation. Can’t anyone think outside of the box anymore? Sherlock, are you there?
………………………………………………………………………………….
Jon Hainer is a principal with Stern & Associates, a bank compliance firm, and co-author of the book Commercial Loan Review and Audit Manual published by Sheshunoff. He also heads the Economic Strategy Group at the downtown LA law firm of Hicks Park LLP. He may be reached at jhainer@sternassociatesllc.com
What is to blame for the mortgage crisis?
By Jon Hainer
Good question.
As a student of economics, I was taught to be very careful when designing incentives to affect any element of human behavior because you tend to get more of the behavior that you actually reward. This is often not the same thing as the behavior that you intended to reward. Unfortunately in real life, there is no professor standing on the sidelines ringing a bell and intoning “beware the incentives” at the crucial moment.
Two dozen years ago, I was involved in one of the first securitizations of retail automotive receivables cutely called CARS for collateralized automotive receivables. (Loans grouped to provide the security for a bond are said to be “securitized”). It was perhaps the very first securitization effort that targeted “B” and “C” borrowers (car buyers). “A” borrowers were the people with good credit and/or large down payments. The transaction involved multiple originators (automobile dealerships), a loan broker, a loan servicing company, and an investment bank. My commercial bank provided the funding to accumulate the loans into a large enough pool to be efficiently securitized.
Auto dealers had difficulty selling cars to people with uneven or bad credit histories because few lenders wanted to hold such loans. By gathering these loans into pools and securitizing them, we provided funding for an under-served market. CARS helped struggling borrowers to finance the cars they needed to get to work and promoted the sales of cars for auto dealers. It transferred risk to those who were willing to bear those higher risks in exchange for stellar returns and an absence of paperwork. Everyone benefited.
Can you hear a bell ringing? Perhaps you can if you have been paying attention to the mortgage crisis of the last year or two.
With CARS we created some perverse incentives. The auto dealer did not have to be as careful as it once was in arranging financing for marginal buyers because it no longer had a meaningful stake in whether the loan was repaid. The loan broker did not worry because it would only be holding the loans for a matter of days. The loan servicing company did not worry because its fees were paid from the very first dollars coming from borrower payments into the loan pool. The commercial banker did not worry because the exposure was short term and hedged. The investment banker (think bond salesman) did not worry because it never owned the loans but rather packaged them for the end-buyers. The end-buyers made the relatively subtle error of assuming that things were staying the same, and that they were buying into a pool of collateralized loans underwritten to very exacting specifications – high risk, but high return and carefully scrutinized. They should have worried.
The truth was that no one was carefully watching. By changing the system from a one-step process (borrower and lender) to a five-step process, lines became blurred, responsibilities vague, and self-interest paramount. Borrowers promised more than they could deliver. Auto dealers generated worse and worse quality loans because that meant they could sell more and more cars. The rest of us just passed on whatever came through the pipeline blithely unconcerned because we were not bearing the ultimate risk. The system did not reward being careful; it rewarded volume with large short-term profits. So we generated fleets of loans. Before long, however, there were too many defaults and too many repossessed cars gathering dust in a lot in the desert. Does any of this sound familiar?
The underwrite-to-hold model (traditional lending) is successful precisely because it requires the financial entity generating a loan to depend upon its repayment. The underwrite-to-sell model (securitization) is not only successful, but superior in many ways because, if everything is done right, everyone benefits. But with underwrite-to-sell, moral hazard is built-in. Without very careful financial engineering, perverse incentives will undermine even those with the noblest of motives, much less the characters (like me and you) who operate out of strict self-interest.
As the current mortgage crisis developed, it looked quite familiar to those who remembered the ill-fated CARS. The moral hazard of the underwrite-to-sell system wreaked its havoc as it is wont to do. To solve the current financial crisis, we have to realign the system’s incentives so that all participants are rewarded for success at every stage and all are punished for failure at any stage. It is easier said than done; but in the end, it is just a question of creating proper incentives. Economics 101.
Good question.
As a student of economics, I was taught to be very careful when designing incentives to affect any element of human behavior because you tend to get more of the behavior that you actually reward. This is often not the same thing as the behavior that you intended to reward. Unfortunately in real life, there is no professor standing on the sidelines ringing a bell and intoning “beware the incentives” at the crucial moment.
Two dozen years ago, I was involved in one of the first securitizations of retail automotive receivables cutely called CARS for collateralized automotive receivables. (Loans grouped to provide the security for a bond are said to be “securitized”). It was perhaps the very first securitization effort that targeted “B” and “C” borrowers (car buyers). “A” borrowers were the people with good credit and/or large down payments. The transaction involved multiple originators (automobile dealerships), a loan broker, a loan servicing company, and an investment bank. My commercial bank provided the funding to accumulate the loans into a large enough pool to be efficiently securitized.
Auto dealers had difficulty selling cars to people with uneven or bad credit histories because few lenders wanted to hold such loans. By gathering these loans into pools and securitizing them, we provided funding for an under-served market. CARS helped struggling borrowers to finance the cars they needed to get to work and promoted the sales of cars for auto dealers. It transferred risk to those who were willing to bear those higher risks in exchange for stellar returns and an absence of paperwork. Everyone benefited.
Can you hear a bell ringing? Perhaps you can if you have been paying attention to the mortgage crisis of the last year or two.
With CARS we created some perverse incentives. The auto dealer did not have to be as careful as it once was in arranging financing for marginal buyers because it no longer had a meaningful stake in whether the loan was repaid. The loan broker did not worry because it would only be holding the loans for a matter of days. The loan servicing company did not worry because its fees were paid from the very first dollars coming from borrower payments into the loan pool. The commercial banker did not worry because the exposure was short term and hedged. The investment banker (think bond salesman) did not worry because it never owned the loans but rather packaged them for the end-buyers. The end-buyers made the relatively subtle error of assuming that things were staying the same, and that they were buying into a pool of collateralized loans underwritten to very exacting specifications – high risk, but high return and carefully scrutinized. They should have worried.
The truth was that no one was carefully watching. By changing the system from a one-step process (borrower and lender) to a five-step process, lines became blurred, responsibilities vague, and self-interest paramount. Borrowers promised more than they could deliver. Auto dealers generated worse and worse quality loans because that meant they could sell more and more cars. The rest of us just passed on whatever came through the pipeline blithely unconcerned because we were not bearing the ultimate risk. The system did not reward being careful; it rewarded volume with large short-term profits. So we generated fleets of loans. Before long, however, there were too many defaults and too many repossessed cars gathering dust in a lot in the desert. Does any of this sound familiar?
The underwrite-to-hold model (traditional lending) is successful precisely because it requires the financial entity generating a loan to depend upon its repayment. The underwrite-to-sell model (securitization) is not only successful, but superior in many ways because, if everything is done right, everyone benefits. But with underwrite-to-sell, moral hazard is built-in. Without very careful financial engineering, perverse incentives will undermine even those with the noblest of motives, much less the characters (like me and you) who operate out of strict self-interest.
As the current mortgage crisis developed, it looked quite familiar to those who remembered the ill-fated CARS. The moral hazard of the underwrite-to-sell system wreaked its havoc as it is wont to do. To solve the current financial crisis, we have to realign the system’s incentives so that all participants are rewarded for success at every stage and all are punished for failure at any stage. It is easier said than done; but in the end, it is just a question of creating proper incentives. Economics 101.
Buying Back Public Confidence - What Will It Take?
By Jon Hainer
On the one hand, the Treasury Department’s so-called economic “Bailout” plan is on the wrong track. On the other hand, Shiela Bair, Chairman of the Federal Deposit Insurance Corporation (the FDIC that insurance bank deposits) is on the right track. Yes, it is the Main Street v. Wall Street argument that is raging right now, with an added consideration, the increase in public confidence that would attend to a focus on the needs of American taxpayers.
It is clear that, in general, the public does not understand the difference between commercial banks and so-called “investment banks” i.e. Wall Street brokerage houses. As a result, banks in general are getting a bad rap which erodes public confidence in our financial institutions. At the same time, giving financial giants billions of dollars without conditions is a big factor in the erosion of public confidence: billions in government funds used to acquire “failing banks” and create bigger monopolies with which community banks have to compete; the multi-billion dollar tax breaks provided to the financial giants acquiring failing institutions; few caps on multi-million dollar salaries and bonuses to executives of the corporate giants receiving bailout money. How about the story in the Wall Street Journal of the $7+ billion purchase by Citi of a toll road in Europe? Banks should get “capital injections” not only when withholding help from them would create havoc on Main Street – but also as a reward for direct assistance to homeowners. Further, there should be a mandate that “Bailout” money be used to ease the credit crunch by increasing the availability of credit.
The current economic crisis was driven by a growing number of foreclosures at the bottom of the economic structure and the primary solution should start there. Subprime borrowers (those with poor credit) got subprime loans - higher points, fees and interest to offset the added risk of making such loans. Consequently, subprime borrowers who could least afford a high-priced loan got the least affordable mortgages. Most home loans had been fixed-rate mortgages, but most subprime loans were “non-traditional,” something that unsophisticated subprime borrowers often failed to understand. Examples were adjustable rate mortgages (low interest to start, but periodically resetting to higher interest and higher monthly payments). Hybrid mortgages (starting with a fixed rate and switching to an ARM loan after a couple of years), loans with payments of “interest only” that later converted to payments of principal and interest, often doubling or tripling the monthly payments, etc. The resulting monthly payments were unaffordable and triggered defaults and foreclosures, which created a backlog of unsold homes that caused home values to plummet. The public in general is unaware that lenders who are basically unregulated by any governmental authority, state or federal, such as loan brokers and mortgage companies, were responsible for originating a large percentage of the subprime loans that were sold to banks and subsequently pooled and resold to Wall Street.
When a home is worth less than the principal amount owed on a promissory note representing the mortgage loan, discouraged homeowners often hand the bank the keys and walk away. In the foreclosure process, the borrowers lose their homes and, on average, the lender loses 40% of the outstanding balance owed on the note. The FDIC Chair, Sheila Bair leans toward restructuring all viable loans. One option to help homeowners currently struggling to stay in their homes and cut losses by banks, would be for:
¨ The bank (or other regulated lender) to reduce the balance owed by the homeowner to the current value of the residential property, but not more (for example) than 20%.
¨ Treasury to reimburse the lender for half of the reduction on the homeowner’s promissory note, and also to guarantee repayment of the note as reward for the lender’s portion of the reduction.
¨ Treasury to place a lien on the property in the amount of its reimbursement to the lender (paperwork to be handled by the lender.)
¨ Loan terms to be extended up to 40 years and interest to be fixed at 6-7% as required to keep monthly payments under 35% of the homeowner’s gross monthly income.
¨ Treasury’s lien to reimburse the federal government (and the taxpayers) upon the sale of the property.
Some side issues would have to be considered: The lender would have to provide proof of the reduction in the amount owed by a homeowner, and 50% would have to be reimbursed to the lender by an authorized government agency (possibly the IRS with a temporary extension of manpower – which would help unemployment). However, collection on the government’s lien should be relatively automatic and should not require much, if any, paperwork.
How such a program could apply to mortgages that were pooled as the underlying collateral for “mortgage-backed securities” is unclear. The fact that writing down the principal owed on a mortgage affects the interests of those who invested in mortgage-backed securities is something that must be resolved at the federal level, perhaps by the Justice Department. However, the government has never insured stocks, bonds and similar investments, and investors should readily recognize that a small loss is better than a big loss.
On the one hand, the Treasury Department’s so-called economic “Bailout” plan is on the wrong track. On the other hand, Shiela Bair, Chairman of the Federal Deposit Insurance Corporation (the FDIC that insurance bank deposits) is on the right track. Yes, it is the Main Street v. Wall Street argument that is raging right now, with an added consideration, the increase in public confidence that would attend to a focus on the needs of American taxpayers.
It is clear that, in general, the public does not understand the difference between commercial banks and so-called “investment banks” i.e. Wall Street brokerage houses. As a result, banks in general are getting a bad rap which erodes public confidence in our financial institutions. At the same time, giving financial giants billions of dollars without conditions is a big factor in the erosion of public confidence: billions in government funds used to acquire “failing banks” and create bigger monopolies with which community banks have to compete; the multi-billion dollar tax breaks provided to the financial giants acquiring failing institutions; few caps on multi-million dollar salaries and bonuses to executives of the corporate giants receiving bailout money. How about the story in the Wall Street Journal of the $7+ billion purchase by Citi of a toll road in Europe? Banks should get “capital injections” not only when withholding help from them would create havoc on Main Street – but also as a reward for direct assistance to homeowners. Further, there should be a mandate that “Bailout” money be used to ease the credit crunch by increasing the availability of credit.
The current economic crisis was driven by a growing number of foreclosures at the bottom of the economic structure and the primary solution should start there. Subprime borrowers (those with poor credit) got subprime loans - higher points, fees and interest to offset the added risk of making such loans. Consequently, subprime borrowers who could least afford a high-priced loan got the least affordable mortgages. Most home loans had been fixed-rate mortgages, but most subprime loans were “non-traditional,” something that unsophisticated subprime borrowers often failed to understand. Examples were adjustable rate mortgages (low interest to start, but periodically resetting to higher interest and higher monthly payments). Hybrid mortgages (starting with a fixed rate and switching to an ARM loan after a couple of years), loans with payments of “interest only” that later converted to payments of principal and interest, often doubling or tripling the monthly payments, etc. The resulting monthly payments were unaffordable and triggered defaults and foreclosures, which created a backlog of unsold homes that caused home values to plummet. The public in general is unaware that lenders who are basically unregulated by any governmental authority, state or federal, such as loan brokers and mortgage companies, were responsible for originating a large percentage of the subprime loans that were sold to banks and subsequently pooled and resold to Wall Street.
When a home is worth less than the principal amount owed on a promissory note representing the mortgage loan, discouraged homeowners often hand the bank the keys and walk away. In the foreclosure process, the borrowers lose their homes and, on average, the lender loses 40% of the outstanding balance owed on the note. The FDIC Chair, Sheila Bair leans toward restructuring all viable loans. One option to help homeowners currently struggling to stay in their homes and cut losses by banks, would be for:
¨ The bank (or other regulated lender) to reduce the balance owed by the homeowner to the current value of the residential property, but not more (for example) than 20%.
¨ Treasury to reimburse the lender for half of the reduction on the homeowner’s promissory note, and also to guarantee repayment of the note as reward for the lender’s portion of the reduction.
¨ Treasury to place a lien on the property in the amount of its reimbursement to the lender (paperwork to be handled by the lender.)
¨ Loan terms to be extended up to 40 years and interest to be fixed at 6-7% as required to keep monthly payments under 35% of the homeowner’s gross monthly income.
¨ Treasury’s lien to reimburse the federal government (and the taxpayers) upon the sale of the property.
Some side issues would have to be considered: The lender would have to provide proof of the reduction in the amount owed by a homeowner, and 50% would have to be reimbursed to the lender by an authorized government agency (possibly the IRS with a temporary extension of manpower – which would help unemployment). However, collection on the government’s lien should be relatively automatic and should not require much, if any, paperwork.
How such a program could apply to mortgages that were pooled as the underlying collateral for “mortgage-backed securities” is unclear. The fact that writing down the principal owed on a mortgage affects the interests of those who invested in mortgage-backed securities is something that must be resolved at the federal level, perhaps by the Justice Department. However, the government has never insured stocks, bonds and similar investments, and investors should readily recognize that a small loss is better than a big loss.
How Did It All Happen
By Jon Hainer
In the financial industry, the word “bank” is generally used to refer to a “commercial bank,” a financial institution chartered by state or federal government that accepts deposits and makes a lot of different kinds of loans to consumers and businesses. Savings and loans, now called savings banks, accept deposits but focus primarily on making residential loans. Both kinds of “banks” are subject to stringent regulatory supervision by federal agencies; their examiners visit, audit and rate these banks on a regular basis. However, the media often uses the word “bank” to refer to financial entities that don’t accept deposits and are subject to very little government regulation or oversight. These include mortgages companies and brokers that make home loans and finance companies, as well as Wall Street’s investment banks which are primarily in the business of buying and selling stocks and bonds. Wall Street banks created and “mortgage-backed-securities” (MBS) that were backed by sub-prime home loans; they were snapped up worldwide by small investors and corporate investors including banks, mutual funds, retirement funds, etc. Defaults on sub-prime mortgages and a growing flood of foreclosures, followed by a sharp decline in home prices, caused huge losses slashed the value of MBS supported by sub-prime mortgages. Losses suffered by investors and banks around the globe triggered the current worldwide financial crisis.
The problem arose when unregulated mortgage lenders made home loans to people with questionable credit at unfavorable terms meant to offset the added “risk” to the lender. Often, the loans were for more than the sub-prime borrowers could afford and the terms were “predatory” in that the amount of periodic “resets” to a interest rate resulted in an unexpected and excessive increase in monthly payments Unregulated mortgage lenders sometimes made huge profits for making risky loans which were immediately sold to banks that frequently failed to analyze the credit quality of the loans, which were immediately resold to greedy unregulated Wall Street investment banks. Wall Street created securities which were backed by “pools” of sub-prime mortgages on residential real estate - which was going up in value. The securities were sold to domestic and foreign consumers and investors.
When the value of residential real estate plummeted, the value of the mortgage-backed securities sold by Wall Street tanked. Big investors and ordinary people suffered enormous losses and stopped buying mortgage-backed securities, and Wall Street stopped buying loans from commercial banks. Commercial and savings banks lost one of their primary sources of income (used to make new loans) and had to limit the funds they lend. Naturally, they also stopped buying loans from mortgage lenders. At the same time, but to varying degrees, commercial banks suffered deepening losses from defaulting sub-prime loans, often forcing a foreclosure which usually caused banks to lose about 40% of their investment in the loan (asset). As the value of residential properties have fallen below the amount that homeowners owe on their mortgages, increasing numbers are returning house keys to lenders and “walking away.” More than a few are consumers who bought property to re-sell it at a profit but received terms less profitable to the bank by fraudulently claiming that they would be resident owners of the property. Developers, also, have walked away from unfinished projects. Consequently, the requirements for approval of both commercial and consumer loans are more rigorous and loans to residential real estate developers are scarce.
While the implementation processes relative to the current $700 billion “bailout” bill passed by Congress have yet to be clarified, it is clear that the government is funding Wall Street by buying their mortgage-backed securities at more than their current value on the theory that they will be re-sold at a profit at some future time to pay taxpayers back. Something further may have to be done to increase the liquidity of cash-poor commercial banks that are limited in the number of community-based loans they can make to consumers and small businesses.
In the financial industry, the word “bank” is generally used to refer to a “commercial bank,” a financial institution chartered by state or federal government that accepts deposits and makes a lot of different kinds of loans to consumers and businesses. Savings and loans, now called savings banks, accept deposits but focus primarily on making residential loans. Both kinds of “banks” are subject to stringent regulatory supervision by federal agencies; their examiners visit, audit and rate these banks on a regular basis. However, the media often uses the word “bank” to refer to financial entities that don’t accept deposits and are subject to very little government regulation or oversight. These include mortgages companies and brokers that make home loans and finance companies, as well as Wall Street’s investment banks which are primarily in the business of buying and selling stocks and bonds. Wall Street banks created and “mortgage-backed-securities” (MBS) that were backed by sub-prime home loans; they were snapped up worldwide by small investors and corporate investors including banks, mutual funds, retirement funds, etc. Defaults on sub-prime mortgages and a growing flood of foreclosures, followed by a sharp decline in home prices, caused huge losses slashed the value of MBS supported by sub-prime mortgages. Losses suffered by investors and banks around the globe triggered the current worldwide financial crisis.
The problem arose when unregulated mortgage lenders made home loans to people with questionable credit at unfavorable terms meant to offset the added “risk” to the lender. Often, the loans were for more than the sub-prime borrowers could afford and the terms were “predatory” in that the amount of periodic “resets” to a interest rate resulted in an unexpected and excessive increase in monthly payments Unregulated mortgage lenders sometimes made huge profits for making risky loans which were immediately sold to banks that frequently failed to analyze the credit quality of the loans, which were immediately resold to greedy unregulated Wall Street investment banks. Wall Street created securities which were backed by “pools” of sub-prime mortgages on residential real estate - which was going up in value. The securities were sold to domestic and foreign consumers and investors.
When the value of residential real estate plummeted, the value of the mortgage-backed securities sold by Wall Street tanked. Big investors and ordinary people suffered enormous losses and stopped buying mortgage-backed securities, and Wall Street stopped buying loans from commercial banks. Commercial and savings banks lost one of their primary sources of income (used to make new loans) and had to limit the funds they lend. Naturally, they also stopped buying loans from mortgage lenders. At the same time, but to varying degrees, commercial banks suffered deepening losses from defaulting sub-prime loans, often forcing a foreclosure which usually caused banks to lose about 40% of their investment in the loan (asset). As the value of residential properties have fallen below the amount that homeowners owe on their mortgages, increasing numbers are returning house keys to lenders and “walking away.” More than a few are consumers who bought property to re-sell it at a profit but received terms less profitable to the bank by fraudulently claiming that they would be resident owners of the property. Developers, also, have walked away from unfinished projects. Consequently, the requirements for approval of both commercial and consumer loans are more rigorous and loans to residential real estate developers are scarce.
While the implementation processes relative to the current $700 billion “bailout” bill passed by Congress have yet to be clarified, it is clear that the government is funding Wall Street by buying their mortgage-backed securities at more than their current value on the theory that they will be re-sold at a profit at some future time to pay taxpayers back. Something further may have to be done to increase the liquidity of cash-poor commercial banks that are limited in the number of community-based loans they can make to consumers and small businesses.
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