Underwrite This

In continuing with the regulation theme, I wanted to consider one way in which regulation advocates might believe the crisis could have been prevented: a more highly regulated mortgage industry. What if those evil/negligent/stupid mortgage brokers hadn't been allowed to originate wacky subprime mortgages? What if a regulation had been there to stop it? If you believe that regulation should be put in place to prevent a subprime housing bubble in the future, then this idea probably seems attractive.

But how would the government go about telling mortgage originators how to write mortgages? They've already got truth-in-lending disclosures, so borrowers know what they're getting into. You'd have to go further and have specific requirements about the basic underwriting standards.

For example, maybe some government regulator could step in and say, for a $100,000 mortgage, you have to prove an income of at least $30,000.

But what if this person also had a loan for a $50,000 automobile? Suddenly, it seems less plausible that he can afford the same mortgage, given his income. So maybe the regulator should take all debt into account.

Oh, this person also has a terrible track record of paying his bills, so his credit score is only 550. Maybe he won't qualify, and the regulator should make the cut-off 650.

If this seems complicated, welcome to the life of the underwriters in a mortgage company. Their job is to look at as many as a dozen or more characteristics and predict if each person requesting a loan can actually pay it back. They've got all sorts of tools at their disposal too, like loan term and interest rate. They develop complicated models where they can plug in lots of variables and out pops a decision, or probably a few scenarios, under which they think it would be profitable to underwrite the loan.

Mortgage originators are very protective of their underwriting models. They consider them to be highly sensitive, proprietary information. Some require outside consultants to sign a non-disclosure agreement before seeing them; others won't allow outsiders to see them under any circumstances. That's because good underwriting models can provide a strategic advantage to finance companies.

The evidence seems to indicate that they did a pretty poor job of this the past few years. If their models had correct predicted borrower performance, then we wouldn't be in this mess.

In order to remedy their inability to properly assess the creditworthiness of their customers, the government could step in and regulate underwriting standards. For example, they could say that, in order to qualify for a mortgage, you need a credit score of at least 720. That would certainly prevent many defaults, but it would also be pretty bad news for someone making $250,000 per year with no other debt but a credit score of 719.

How do government regulators hope to succeed where decades of experience has led mortgage bankers to fail? Underwriting is more an art than a science, and even the most brilliant of experts didn't know things would be this bad.

Another problem is also lurking: if the government steps in and standardizes underwriting, then those underwriters will all be going after the same people, offering them the same deals and ignoring those who don't fit into the government mandated mold. That leaves no room for strategy or innovation, and also means the credit market can never be broadened.

That's why it seems like the best solution is to have mortgage originators compete and create their own underwriting models. That way they can determine under which circumstances groups of people with similar characteristics might be less likely to default. They then price mortgages to mitigate risk accordingly.

So why did the market fail?

I would argue that it was not so much lax underwriting standards, but faulty market assumptions. If houses in Florida and California had continued to increase 5% to 10% per year forever, then the vast majority of those subprime loans would have been okay. And even the ones that weren't okay might have been forced to sell their houses, but ultimately have come out ahead, since those houses would have increased in value.

The error, of course, is in assuming that real estate would continue to appreciate in a historically unprecedented manner. But having visited many mortgage companies in 2004-2005 who were making these subprime loans, I can attest, they believed this bad assumption was perfectly reasonable. Otherwise, they would never have allowed those subprime borrowers to pass their underwriting standards.

So really, the best solution would be to somehow regulate out stupid market assumptions. I'm not sure how the government does that. The government fell for it too -- just ask Fannie Mae or Freddie Mac. But if their proxy is to regulate underwriting standards and constrain the ability of banks to responsibly broaden the credit market, then I'm not sure that gets us to a much better outcome.