Caught Between Too Little and Too Late
In the throes of distressed credit markets, lenders have had to take deep losses in their mortgage-backed securities (MBS) and asset-backed securities (ABS) portfolios. Lenders and investors alike have had to come to market for additional operating capital. According to Bloomberg News, banks raised $120 billion in capital from August 2007 to July 2008 to offset billions of dollars of writedowns and diminished earnings capacity.
The mortgage industry has seen businesses scaled back significantly since mid-
2007. Many businesses were no longer viable or posed significant market, credit or
operational risk. There just was not enough technology to cope with unresponsive and illiquid credit markets in the United States and abroad.
This is a technology column. So what is the technology angle in all of this? That
lenders are responding to this crisis by increasing the amount of money they are
investing in their risk-management technology.
What is surprising is that up until now most lenders have not had a technology
infrastructure for managing risk. Based on our MORTECH surveys, I would say that 70 percent of lenders had no protection against an adverse turn in mortgage market
conditions. They never installed automated risk-management systems.
The state of current models and systems for measuring risk management
Large financial institutions—and I would include not just commercial and investment
banks, but large hedge funds as well—evaluate the risk of their portfolios
on a daily basis. They use standard metrics such as value at risk, decompose their
exposures into tranches of maturity and credit exposure, and perform daily stress
tests on their derivative positions. The systems and models they employ for these
tasks are well developed; they are adequate for the risks they are designed to
measure.
The problem is that the systems are not designed to measure—and in the current
state of the world, perhaps cannot be designed to measure—the risks we care
the most about: the risks related to market crises. The best we can do at this
point is recognize, as my current firm does, that these risks can only be dealt
with through true market insight and experience. The final solution is to apply
common-sense rules that overlay the traditional risk metrics.
Subprime fallout
According to The Economist magazine, Credit Suisse Group, Zurich,
Switzerland, cannot pinpoint when in 2006 management became alerted
to signs of the subprime problems in America .
Culling data from the bank’s trading desks and from mortgage servicers ,
Credit Suisse began to reduce its exposure to the subprime market. At the
same time, it began to suffer a problem with the amount of risk-adjusted capital
allocated to its leveraged loan portfolio. It established hedges against its leveraged loan portfolio. But it was too little, too late.
Credit Suisse may be a good case in point. Conservative and tightly run, Credit
Suisse unexpectedly had to write down 5.3 billion Swiss francs in its investment banking businesses in the first quarter of 2008.
As others have as well, it lowered its exposure to residential finance by 37 percent
and to leveraged loans by 41 percent. The problems of the financial sector
are far from over, as the $2.8 billion second-quarter loss at Lehman Brothers Holdings Inc., New York, illustrated. There have been few bond defaults as yet, but Stephen Dulake, a credit strategist at JPMorgan Chase & Co., New York, reckons investors may be looking in the wrong place for trouble; there already have been 26 defaults in the American corporate loan market this year.
Condition yellow
It doesn’t seem that the economy is prone to bail out the financial sector. The economy grew at an anemic rate of 0.9 percent in the first quarter of 2008. Employment is soft, with non-farm payroll employment declines averaging 64,800 per month for the first five months of the year. Unemployment has been rising, and has reached 5.5 percent—closing in on the 30-year average of 6.1 percent.
The New York–based Conference Board Inc.’s broadest measurement of consumer confidence has been falling over the past 10 months. The Conference Board Consumer Confidence Index, which had declined in May, declined even further in June. The index now stands at 50.4 (1985=100), down from 58.1 in May. The Conference Board concluded that weakening business and job conditions have fed into growing pessimism about short-term economic conditions.
No relief in sight
The Federal Reserve Beige Book, released on June 11, 2008, reported for the New York district that bankers are seeing no growth in loan demand. That lack of demand held true for every category of lending, including refinancing activity.
Lenders continued credit tightening across all loan categories. The Beige Book cited no bankers easing standards for any type of loan.
Noticeably, rate spreads over cost of funds expanded in all loan categories. The contagion of tightened lending standards and increased spreads leapt from real estate lending to commercial and industrial loans.
Finally, delinquencies continued to rise in all loan categories—most notably on consumer loans. How did the industry get in such a tough spot? The Washington, D.C.–based Brookings Institution issued a discussion paper on May 16, 2008, “The Great Credit Squeeze: How It Happened, How to Prevent Another.” In the report, Brookings authors Martin Neil Baily, Douglas W. Elmendorf and Robert E. Litan conclude that the credit crisis was largely caused by three factors that could have been managed by bankers and regulators:
• Incentives in the mortgage brokerage “originate-to-distribute” model discourage credit-risk discovery.
• The erosion of mortgage lending standards was precipitated by gushing liquidity.
• The process of developing opaque derivatives of mortgage-backed securities progressed to the level of absurdity.
The factors that could prolong the crisis continue to deteriorate—home-price depreciation, illiquidity in the private mortgage-backed securities market, a weakening economy and softening job markets across the country. Uncertainties in the credit markets continue to affect the outlook for all asset classes.
Stresses in the credit market have yet to be relaxed by Federal Reserve Bank actions intended to moderate the housing market’s troubles and alleviate the credit crunch in the second half of the year.
Doing the right thing
Washington Mutual (WaMu), Seattle, probably is the most influential bank in the Pacific Northwest. It may become a classic business-school case demonstrating how difficult it is for even good managers to manage through a true financial crisis. Almost as if it had prior knowledge of the challenging times ahead, WaMu hired Stephen J. Rotella to be its president and chief operating officer.
Rotella had been a member of the JPMorgan Chase executive committee and served as the chief executive officer for Chase Home Finance as well as executive vice president for JPMorgan Chase. At JPMorgan Chase, he was known for his no-nonsense operating management style.
Since coming to WaMu, it seems Rotella has been doing exactly the right things—but will he be able to overcome the drag from a worldwide financial crisis? Here is a partial list of Rotella’s and WaMu management’s actions over the past three years:
• Raised $7 billion of capital to meet stress credit requirement.
• Reduced dividend to preserve capital.
• Positioned balance sheet defensively.
• Maintained solid sources of liquidity.
• Managed expenses aggressively.
• Reallocated capital to invest in its strong retail franchise.
Despite doing the right thing, WaMu expects that the cumulative remaining loss on residential loans will be approximately $12 billion to $19 billion over the next three to four years. Maybe the most frightening omen is how Wall Street is valuing Washington Mutual. The closing price of WaMu’s common stock on June 27, 2008, was $4.80. At that per-share price, investors are valuing WaMu at just 22 percent of its last reported book value ($21.74 on March 31, 2008).
As has been the case with most of the banks that issued new securities in recent months, shares have slid precipitously and investors now are far underwater.
Not doing much of anything
From our MORTECH series of surveys of lender use of technology, we discovered that two-thirds of lenders have no system for managing financial or operational risks. What is as startling from the data is that the implementation rates of risk-management technologies have not grown since 2001. Given the level of market and economic volatility, I should think that there will be a significant change in the pattern of lenders’ technology investment.
While the lack of risk-management technology has made the mortgage industry more vulnerable to sudden shifts in credit markets, it may open an opportunity for a few good vendors. As I made the case for investment in compliance-technology spending in my May column in Mortgage Banking Magazine, “Bad Times for Information Technology Spending,” I can say that the current credit crisis also creates a larger market for added spending on risk-management infrastructure—some good to come from a crippled credit market.
Automated risk-management technology may not have been enough to save the lenders that have left the business, but it might have afforded some protection—better than none at all.
Adapted from: M O RT E C H M u s i n g s By Jeff Lebowitz
