Regulatory Reality

Jul 12 2010   6:31PM GMT

The banking crisis gets another dose of common sense

David Schneier David Schneier Profile: David Schneier

Summertime often means vacation time and while I’m not sure I’ll take a true vacation ever again, my wife imposes her will upon me and makes me at least try.  I try and circumvent the process a bit by using the downtime to catch up on some of my reading and this year the book of choice is Michael Lewis’s “The Big Short,” which is all about the real estate bubble and how Wall Street fed it with hot air before it was blown to pieces.  Right at the onset of my reading the book, I received an email from the FDIC regarding a speech recently given by its chairman, Sheila Bair.  Her subject of choice is coincidentally all about the collapse of the real estate market, its impact on the banking industry, and what needs to be done in order to prevent the same thing from ever happening again.

Now I’m not sure if everyone enjoys reading Michael Lewis’ books the way that I do, but his approach to framing a story and providing seemingly unrelated perspectives so that you gain a much fuller understanding of the situation is perhaps the best I’ve ever encountered.  And in detailing the mess on Wall Street, he has provided me with more to think about than anything previously.

I recall when I purchased my last house in the New York market, I was concerned that the lenders were willing to finance deals in which houses were selling for more than double what they had sold for just a few years earlier.  I couldn’t figure out what the banks were thinking by entering into those deals.  The day I moved into that house I started forming predictions regarding when the real estate bubble would burst, how it would impact me personally and what it would mean to the economy at large (I was right more than wrong but not all results have been reported as of yet).  I’ve since sold out of that market, moved to another part of the country where financially everything made a bit more sense to me and have watched as events have continued to unfold.

But there’s that one question that has been stuck in my mind for nearly eight years: what were the banks thinking?  The short answer is that they weren’t.  They were along for the ride like most of us and  in order to keep pace with the market, shed solid lending practices that had always provided some measure of sanity to the process.

Now I have a new  question that’s knocked the older older one from its place of prominence: What are we going to do in order to make sure this doesn’t happen ever again ( a question perhaps only a regulatory compliance professional such as myself could be consumed by)?

Enter Chairman Bair. As most of my readers know, I’m a longtime, big time fan of hers and she’s done nothing to disappoint me this time around either.  In her speech, she said that the “pervasive breakdown in financial practices at the peak of the housing bubble points to the need for fundamental reforms in mortgage finance.”

She continued: “While regulation is necessary to set the ground rules and protect consumers, excessively proscriptive rules are likely to either stifle the initiative of the market or be circumvented by new practices. Instead, we need a whole new set of basic ground rules that go from origination to securitization to the servicing of the loans. These rules should create the transparency and incentives needed for this market to do what competitive markets do best – efficiently allocate resources and price risks.”  I like her thinking is because it’s all encompassing.  One of the most glaring problems in obtaining a mortgage based on my own experiences is the origination process.  The first time I practically had to submit DNA samples and waited for weeks to get a decision, the second time I was pre-approved for both the primary loan and a home equity line-of-credit after barely more than a 15-minute conversation. The third time, I didn’t have a clue what was going on until a week before the closing despite multiple attempts to get someone, anyone, to return a phone call.  Shouldn’t there be a consistent process that’s followed and perhaps even required by law?

Chairman Bair added: “We need to have some basic underwriting guidelines that apply to mortgages originated not just by FDIC-insured depository institutions, which are already heavily regulated, but also for the thousands of mortgage brokers who fall outside the rules for banks and thrifts. Basic limits on loan-to-value and debt-to-income ratios, and consistent documentation requirements should be set for any loans held by a depository institution or sold to a securitization trust.”  Do you think the real estate bubble would have grown so large if loan-to-value and debt-to-income ratios had been in place, required by law and enforced?  In “The Big Short,” Michael Lewis writes about a farm worker earning $14k per year  securing a mortgage for a house worth over $700k.  If there had been a way to prevent such deals, it’s not likely we’d be in this mess.  And regarding those lenders who fall outside of the banking industry, there definitely needs to be a new set of rules to govern what they do.  I recall talking with a mortgage broker when purchasing my first home who said, “Don’t worry about your credit score or income, I’ll find you a deal somewhere”.   Well if there were enforceable rules in place governing the various formulas used to assess an applicant, that would no longer be possible.

And lastly, for those who rail against the idea of new legislation and insist that the market can manage itself and that government should stay out of it, I offer Chairman Bair’s closing comments: “We need to get back to a world where our financial sector supports the functioning of our economy, and not the other way around. And we need to fix what caused the crisis by reforming our mortgage lending and securitization practices. Only by getting back to basics in these most fundamental areas of our financial system can we begin to restore balance to our broader economy and confidence in our economic future.”

Let’s face it folks: Left up to their own devices, the lending markets will repeat these mistakes at some point in the future.  Without a set of enforceable rules that ensure some measure of sanity and sensibility, a future generation who didn’t really feel the pain of the experience will figure out they can make a boatload of money in the short run, enough so that they won’t have to worry about the potential (and inevitable) collapse that’s sure to follow and do this all over again.  The bigger mistake would be to let that happen again.

I sure hope Chairman Bair has a fan or two up on Capitol Hill who finds her words and ideas as refreshing and relevant as I do.

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