Cembalest changes his mind on the subprime crisis | FT Alphaville

Cembalest changes his mind on the subprime crisis

Here’s something you might have missed during last week’s (UK) holiday.

Michael Cembalest has made a retraction. JPMorgan’s private banking chief investment officer (and reportedly the only JPM-er who refused to do business with Ponzi-schemer Bernard Madoff, according to Forbes) has a new view on the roots of the US subprime debacle.

From a note sent last week:

(And a big thanks to professor Anthony Sanders for sending it in)

Retractions: US earnings growth, the Euro, and the primary catalyst for the US housing crisis

Agencies played a larger role in the housing crisis than we first reported. In January 2009, I wrote that the housing crisis was mostly a consequence of the private sector. Why? US Agencies appeared to be responsible for only 20% of all subprime, Alt A and other mortgage exotica. However, over the last 2 years, analysts have dissected the housing crisis in greater detail. What emerges from new research is something quite different: government agencies now look to have guaranteed, originated or underwritten 60% of all “non-traditional” mortgages, which totaled $4.6 trillion in June 2008. What’s more, this research asserts that housing policies instituted in the early 1990s were explicitly designed to require US Agencies to make much riskier loans, with the ultimate goal of pushing private sector banks to adopt the same standards. To be sure, private sector banks and investors are responsible for taking the bait, and made terrible mistakes. Overall, what emerges is an object lesson in well-meaning public policy gone spectacularly wrong.

For [Edward] Pinto and [Peter] Wallison [authors of two recent reports on the subprime crisis] this quote from the Department of Housing and Urban Development in 2000 is a smoking gun of sorts, and lays out a blueprint for the housing crisis:

‘Because the GSEs have a funding advantage over other market participants, they have the ability to under price their competitors and increase their market share. This advantage, as has been the case in the prime market, could allow the GSEs to eventually play a significant role in the subprime market. As the GSEs become more comfortable with subprime lending, the line between what today is considered a subprime loan versus a prime loan will likely deteriorate, making expansion by the GSEs look more like an increase in the prime market. Since, as explained earlier in this chapter, one could define a prime loan as one that the GSEs will purchase, the difference between the prime and subprime markets will become less clear. This melding of markets could occur even if many of the underlying characteristics of subprime borrowers and the market’s (i.e., non-GSE participants) evaluation of the risks posed by these borrowers remain unchanged.’ (HUD Affordable Lending goals for Freddie Mac/Fannie Mae, Oct 2000).

The strategy worked, as shown in the chart: the Agencies took the lead in the 1990s and early 2000’s in both subprime and high [loan-to-value] (>=95%) loans, acquiring over $700 billion in non-traditional mortgages before private markets had even reached $100 billion. Then in 2002-2003, private sector banks took the bait and jumped in with both feet. According to Wallison, the distortion of the housing bubble from 1997 onward obscured what would otherwise have been rising delinquencies and losses. As a result, when investors, banks and rating agencies finally got involved in a substantial way, they ended up looking at understated default statistics on subprime, Alt A and high LTV borrowers.

… The Wallison/Pinto research appears to be a well-reasoned addition to the body of work dissecting the worst housing crisis in the post-war era. It is convincing enough to retract what we wrote in 2009. As regulators and politicians consider actions designed to stabilize the financial system and the housing/mortgage markets, reflection on the role that policy played in the collapse would seem like a critical part of the process.

Links to Pinto and Wallison’s reports are here and here.

If you’re wondering why it took Cembalest and Co so long to figure this out after the housing collapse, the JPMorgan analyst blames nothing less than “creative reporting” that masked the agencies’ real subprime lending. Fannie Mae classified a mortgage as subprime only if the loan was originated by a lender specialising in subprime, or by the subprime units of the big banks. They didn’t use things like credit, or Fico, scores to report all subprime exposure, thus reducing its reported subprime loan count.

And if you’re thinking private sector banks and brokers still made much worse loans than the government agencies on a dollar-per-dollar basis, well, Cembalest has a response for you too:

… Wallison and Pinto are not trying to find out who made the worst loans. They’re trying to figure out why underwriting standards collapsed across the board; how policy objectives were designed to have private sector banks follow the Agencies off the cliff; and why Agency losses to taxpayers are estimated to be so large ($250-$350 billion). It’s a hollow victory for Agency supporters to claim that their version of Alt A and Subprime was not as bad as private sector ones: the Agencies had almost no capital to absorb losses in the first place, given what their mandate was. According to the Financial Crisis Inquiry Commission, “by the end of 2007, Fannie Mae and Freddie Mac combined leverage ratios, including loans they owned and guaranteed, stood at 75 to 1.” After factoring out tax-loss carry-forwards, Agency capital ratios were probably below 1% on over $5 trillion of aggressively underwritten exposure.


Related links:
All the devils are here – Amazon
The skeletons (or mortgage audits) in Deutsche Bank’s closet – FT Alphaville