Monday, September 29, 2008

In Defense Of Banks

(Note: This post deals mostly with the mortgage lending industry. I know much, much less about the investment banking industry, and so will touch on it much more gingerly.)

I'm going to have to do something I never wanted to do: defend the banking system in America. My defense? Banks aren't stupid. They aren't. Look, I know that is hard to believe, what with the current banking crisis and all, and yes they are a little bit stupid and a lot myopic and short-sighted and all that jazz. But they aren't completely idiotic. Which is what we'd almost have to believe if we are going to place a majority of the blame (or even a good deal of the blame) on the people who took out the mortgages instead of on the banking institutions themselves. I know what you're thinking. Why should I pay attention to the crazy rantings of a literature major who never took a finance class in her life? I'll tell you why. It is because a big part of why I'm jobless right now is that I worked in the mortgage industry. Also, my mother works in the mortgage industry. All of her friends work in the mortgage industry. And I've gotten to hear a lot about banking and the rules and regulations and such both growing up and while I spent my summers working there along with working there after college. Plus, I got passed around from department to department, so I have a pretty good idea of how the mortgage industry works. I also kind of feel like Marisa Tomei with rattling all of that off, but I think it is important to note that I actually do know a bit about what I'm talking about.

First things first: the idea that some of this mortgage crisis was brought about by people lying on their applications is untrue. The main problem with this idea is that even if mass amounts of people were lying on their mortgage applications and getting mortgages anyway, the bank would still be at fault. The reason is simple; if one person manipulates the system, the system is not necessarily compromised and that person is responsible. If a large amount of people are able to manipulate the system, to the point where the system breaks, then there has been a systemic failure. Those people who screwed the system are still responsible, but the system is also to blame because it failed to work properly. I would contend that the system would be more to blame, because it disregarded the holes in the system and allowed itself to be compromised. It would mean that a majority of people working on that side of the bank, in departments like closing, post closing, and quality control, were complete idiots - along with the people who designed the mortgage approval process as well. It would mean that not one person in the whole system recognized that a great number of people were lying. It would mean that Quality Control should get a new name. It would mean that Post Closing failed in all of its duties. It would mean that Closing was approving files without even a cursory glance. Banks do not get all of their mortgage information from the customer. Banks also get access to credit reports and look at pay stubs and generally do a pretty thorough job. There are always going to be a few people who manage to beat the system, but for the most part the system runs fairly smoothly in this regard.

Second up in the blame game in many conversations are the people who bought houses they could not afford. This is ignoring a couple of salient points. There are very few people who could not, in that moment, afford to buy a house that got a mortgage anyway. Those people are out there; but if nothing else, the banking industry generally does catch these applicants and denies them. If a person (or couple) absolutely could not afford the mortgage or the home upon walking into a banking institution, they generally did not get the loan. Banks do not approve loans they know will fail. If too many of those loans were getting through, again, it is a situation where the blame is inequitably divided. The customer is to blame in part for applying for a loan s/he knew s/he could not afford. But the bank is more to blame because they are the institution with the stamp. The applicant's job is to apply for the loan. The banking institution's job is to verify whether or not this applicant could afford the loan, or if they were going to default. It would be like someone under 21 attempting to get served at a bar. The greater fault lies with the bartender who serves the underage patron than with the patron.

But the most important thing to recognize is that both of those scenarios make up a limited portion of the mortgage industry. The majority of the mortgage industry is not nearly as black and white. It deals with risk. If Will Smith were to walk into a bank and wish to take out a mortgage on a cozy little two bedroom cottage, the bank is in a relatively low risk situation. If I walked into a bank and wished to take out a mortgage on a cozy little two bedroom cottage, the risk attached to such a loan would be significantly higher. The act the banking industry attempted (and failed) to perform was by approving more and more high risk loans. These loans generated a good deal of income while the economy was good, allowing those banks to venture further beyond the border of the safe risk amount. It was a gamble that just kept paying off, and in many instances it was a gamble the industry as a whole encouraged banks to make. During the period of economic expansion, banks faced considerable risk of a take over by another financial institution. Bigger, more successful, banks were buying out smaller banks and banks that had less of a profit margin. Investors, stock holders, and CEOs of these mortgage institutions wanted to see significant growth each quarter in an industry that almost demands a longer view. Most loans are written to be paid off in 15 years or 30 years; the stress to grow exponentially when one's product requires longevity increases risky practices. In an eat or be eaten world, banks were more apt to make what seemed to be good short term decisions; the only problem with that is that those decisions were bad for the long term.

Those decisions were bad long term ones for a variety of reasons, but I think it is important to note that every mortgage lending institution I know of has a Construction Department. The Construction Department is in charge of, obviously, construction loans - loans that pay for the building of new structures. And those structures, during the housing boom, were valued for more than their worth much like many houses were. There came a point in the industry where the supply of these constructed houses far exceeded the demand, and that partially explains the collapse. It also clearly demonstrates a version of tulip bulb mania in which at one point in time houses were worth a certain amount because there were more people clamoring to own (and capable of owning) homes than there were homes (McMansions, mostly) they desired, but over the years the market had been flooded with those homes and thus devalued themselves while still attempting to sell at the same price when those homes were in a competitive market. The system corrected itself by devaluing homes (creating a buyer's market, if anyone had money with which to buy), which in turn made those high risk loans all the more risky. An additional problem is the fact that Lines of Credit are tied directly to the value of a homeowner's abode, so a person could have had $300,000 available on his LOC one day and $120,000 on that same LOC the next (those numbers are, of course, entirely hypothetical).

Due to the nature of the loan game, in which many take adjustable mortgages in the idea that in a couple of years the mortgager can refinance at a lower adjustable rate if the market is fair, the downswing was a disaster for the high risk loans that were so profitable merely a year earlier. In this way, the market kind of screwed itself, because it depended upon banks to be able to perform like other institutions and create consistent and large profit margins. Thus, my own personal "Biggest Blame" for this whole mess is not the mortgage lenders or the customers themselves but a financial system that demands short term success at the expense of long term success. In order for banks to maintain their independence, they engaged in risky business practices. As long as the economy was good, Wall Street rewarded those risky business practices. Once the economy shifted, those risky practices were not nearly as profitable, and now the mortgage industry is in a fairly stupendously bad free fall. Obviously, there are many different solutions that need to be put in place over the next months and years, and there is the necessity of a bail out. But one thing we need to take heed of is what happens when short term profits come at the expense of long term stability, especially in an industry that supplies long term products. We need to come up with a different way of analyzing their success and failure on the global markets; we need to recognize that we should not expect large profit margins each quarter due to the nature of the product itself. If we hadn't focused so much on short term profit, then banks would not have had to engage so many high risk mortgages to ensure their survival from financial quarter to financial quarter when the market was good. And if banks had been more picky and less "eat or be eaten", then less of them would be in financial straits now.


mikhailbakunin said...

1) I don't think you have any idea how wide-spread mortgage fraud is. It's one of the most common white collar crimes.

We'll probably have a better concept of how much of this mess was caused by mortgage fraud and/or deceptive lending after the FBI completes its investigation. But right now, I think it's pretty presumptuous to pretend that you know that fraud wasn't a contributing factor here.

2) Arguing that "the system" is responsible for the financial crisis (rather than those who choose to defraud it) is like arguing that weak homeland security regulations are responsible for terrorist attacks. The people who commit crimes are culpable, not the system that failed to prevent those crimes.

petpluto said...

"I think it's pretty presumptuous to pretend that you know that fraud wasn't a contributing factor here."

I didn't say that it wasn't a contributing factor. I'm saying that in the spread of news, some organizations are blaming fraud and those who couldn't afford mortgages in the crisis and ignoring the culpability of the banking institutions and the financial sector themselves.

And you know what? I consider myself a pretty smart cookie who, having worked in the mortgage industry (and in this section of it, no less) and actually researched it a bit in the meantime, may actually have an informed opinion about this particular financial issue. That doesn't mean I am necessarily right, but I'm at least knowledgeable enough to write about it. Call it presumptuous if you will, but I think that is more than a little dismissive.

And if fraud was as big an issue as you seem to feel it was, then yes, the banking institutions shoulder some of the blame for creating a flawed system that was easily manipulated.

Thirdly, when most people talk about mortgage fraud, and I'm not implicating you but in the other conversations I have had, white collar crime has not been the basis. Instead, it has been the CRA -and the people in that income bracket- that have been the scapegoat of the industry.

"Arguing that "the system" is responsible for the financial crisis (rather than those who choose to defraud it) is like arguing that weak homeland security regulations are responsible for terrorist attacks."

Weak homeland security would possibly be to blame for allowing the attacks to take place. Sept. 11, for instance. There was plenty of intel that was ignored before that attack. Were those people who ignored the intel to blame for the attack? No. Were they culpable for ignoring intelligence that could have potentially prevented the attack? Yes. Which is why Homeland Security was formed.

Same thing with the bartender. Is he responsible for the underage kid asking for a drink? No. Is he culpable if he serves the kid? Yes. If there is that much fraud, then the banking system is flawed and they are culpable for that flaw in their system. Fraud is a known part of the industry. I myself worked in fraud prevention. If I let a bad check go, I would be culpable and would have been if not fired then warned and placed on suspension. If the industry was so unprepared that fraud was a large enough that it could greatly and negatively affect the market, then the industry is indeed culpable -just like the bartender and just like the CIA and the FBI.

The bank's job is to verify loans. If they suck at that and can't figure out how to combat fraud, then they aren't a very good bank.

mikhailbakunin said...

Well, mortgage fraud is a form of white collar crime, whether it's income fraud, appraisal fraud, etc.

If the bank was negligent, that's one thing. But sometimes lots of people just beat the system. My problem is that you seem to be placing more of the blame on the institutions that were defrauded than on the actual perpetrators.

I think the CRA may have contributed to the crisis. The study you cited (Traiger & Hinckley) didn't find that CRA borrowers weren't defaulting, just that they were defaulting at a lower rate than regular sub-prime borrowers.

There are lots of economists who have contradicted this. I don't know who's correct, but I'm certainly not going to trust one study by a law firm whose primary purpose is to advocate for low-income CRA mortgage holders.

petpluto said...

"The study you cited (Traiger & Hinckley) didn't find that CRA borrowers weren't defaulting, just that they were defaulting at a lower rate than regular sub-prime borrowers."

There are always going to be loans that default. That isn't fraud. That is the banking industry. That is why banks have Collection Departments. As I said in the post, banking is a game of risk; and even in a good economic environment, some loans don't get paid. In bad economic environments, more loans don't get paid. To say that the CRA is partially responsible, when in the current bad economic climate they are defaulting at a lower rate, is ignoring that fact.

"If the bank was negligent, that's one thing. But sometimes lots of people just beat the system."

Surely you can agree that if lots of people are beating the system, then there is something wrong with the system.

"My problem is that you seem to be placing more of the blame on the institutions that were defrauded than on the actual perpetrators."

The institution is responsible for putting into effect methods and criteria to stop fraud. If they fail to live up to a certain level of success in that area, then they are culpable for the flaws in their system.

Those who screwed the system are to blame for their own crime. The bank didn't make them do it; nor did I suggest that the bank is more to blame for the actual fraud. What I am suggesting is that the bank is more to blame than those who perpetrate fraud for the economic downturn.

One person who commits fraud is an anomaly. He beat the system. Up to a certain percentage, fraud is not a bank system issue, because like loans that default banks have a cushion. But at a certain point, the number of people getting away with fraud exceeds that cushion. Then the banking institution shoulders some of the blame for the outcome, because they failed in their duty to protect their institution; and since their institution's well-being also affects society's well-being, they are more to blame for their own flaw in the system.

That doesn't make the fraud perpetrator any more or less guilty of the crime they have committed. They are still fully to blame for the individual crime. But on a systemic level -and that is what I'm talking about, what went wrong on a systemic level- the banks shoulder more of the burden if the cases of fraud were so rampant as to undermine the very structure. Because it is the bank's JOB to maintain that structure.

John said...

Based on both sides of your argument, it seems to me that to say either side is completely guiltless in this equation is deluded. The perpetrators of mortgage fraud are obviously guilty of the crimes that they committed, and (hopefully) they will be investigated and made to answer for their actions in court. The banks failed to diligently investigate their applicants' records, and should be forced to answer for their negligence (whether it was willful negligence or simply gross incompetence I cannot say for certain.)
Here's an interesting example: Remember Aqua Dots? People found out that the active ingredient was GHB, which meant you could turn them into a date rape drug. Anyone who would use them to commit date rape is a rapist and should be charged as such, but the makers of Aqua Dots should be (and were, if I recall) forced to account for putting an unsafe product on the market. Banks may not have committed mortgage fraud, but they should be made to answer for their failed quality control and fraud investigation measures. Otherwise the message we're sending is that it's okay to knowingly invest our money insecurely.

petpluto said...

Exactly, John. Thank you for being so clear and concise!

mikhailbakunin said...

There are a few separate issues here. One is mortgage fraud, which is not the same thing as predatory lending or corporate negligence. The people who commit mortgage fraud - whether they be the borrowers, the brokers, or clerks processing the loan - are solely responsible for their actions.

The other issue is systematic negligence or deception on the part of the lender. I think you're both arguing that widespread fraud somehow proves negligence or deception on the part of the lender, but it doesn't.

Lenders only have to comply with federal and state regulations. They aren't doing anything wrong if they don't take additional preventative measure in trying to combat fraud. It's much easier for a borrowers to lie on stated loans, for example, but it's also legal for lenders to issue these loans. So, who's responsible? The lender or the regulator? How can the lender be responsible when he's in full compliance with the law?

(If the lender isn't in compliance with the law, that's a different story.)

CRA loans are a totally different story. No one's claiming fraud here. Critics are saying that the government was making unsafe loans, just like other subprime lenders. These loans may have been a bit saver than other subprime loans (because they offered lower interest rates), but that doesn't make them safe . . . and it certainly doesn't mean that the CRA wasn't part of the problem.

Many CRA borrowers were still huge credit risks, many still defaulted, and some critics charge that the CRA paved the way for widespread subprime lending.

petpluto said...

"Lenders only have to comply with federal and state regulations. They aren't doing anything wrong if they don't take additional preventative measure in trying to combat fraud."

It is irresponsible to only comply with federal and state regulations if there has been rampant fraud. It is bad business practice to not combat something that is weakening one's financial power and standing -which fraud does. To say that just because they didn't break the law, they are somehow completely without responsibility for not protecting their own financial institutions is not holding them accountable for their own negligence.

I don't think John is arguing that they should be punished for breaking the law, since they clearly haven't. Nor is it what I am arguing. But I think they should be held responsible for poor business practices. They should not be completely without blame for systemic cracks they could have done something about.

"I think you're both arguing that widespread fraud somehow proves negligence or deception on the part of the lender, but it doesn't."

Not deception; but negligence, yes. Because as I said, there is a certain amount of fraud that will get through. There is no system that is impenetrable. But when enough people can subvert the system to partially bring about a collapse, then obviously not enough was done to circumvent those who would seek to permeate the system itself.

"Many CRA borrowers were still huge credit risks, many still defaulted, and some critics charge that the CRA paved the way for widespread subprime lending."

1) The CRA was substantially weakened in 2005.

2) I don't know what you hope to accomplish with the "some critics" fork of your argument. Please tell me why you agree with them or what validity their points have, because "some critics" (though not universally the same ones) can always be found to attack any legislation (democratic or republican) and any social movement. Sometimes their criticisms are correct, and sometimes they are bunk. But without at least understanding where the critics stand, what they gain and lose by their analysis, and what basis they are attributing the CRA's responsibility for the subprime mortgage lending bust is, I don't find that aspect of the argument to be a logical one to necessarily believe or lend credence to.

"and it certainly doesn't mean that the CRA wasn't part of the problem."

You know what? Almost every aspect of the mortgage industry and the investment banking industry is part of the overall problem now. The major fissures of the system put an inordinate pressure on other weak aspects of the system, and thus all parts of the system contributed to the collapse. The issue now is fixing the system, and figuring out which parts of the system were the integral points without which other bearings could not maintain the integrity of the financial system. And I happen to suspect that the CRA is one of the bearings that could not maintain the structure once the primary structures crumbled.

mikhailbakunin said...

What does accountability mean if it's not legal accountability? Should I wag my finger at banks and tell them to straighten up?

petpluto said...

Yes. That's exactly what it means.

How about banks are partially to blame for their own system failures. How about we recognize that those who did not secure their systems can't wash their hands and say, "Did what the government asked me to do, I'm good"? How about we hold banks accountable, in terms of future regulatory practices and how much individual CEOs can take home this time around for falling asleep at the wheel? How about we recognize that at points throughout history, the industry in question may have met federal standard but was still well below par in terms of actual performance and this is one of those times?

Because they are not criminally negligent, but that does not limit their actual negligence. If their practices and lax programs led to a swelling in the amount of fraud committed, then some of that is at their feet. And that means that maybe Wallstreet has to allow for the possibility that they don't get their severance packages, that they don't get their bonuses, and that none of them get to be Carly Fiorina this time around. They have to sacrifice as well for the good of the bailout. They have to contribute to their own rescue plan. Because from where I'm standing, that doesn't seem like a hell of a lot to ask.

And since, even without them being asleep at the wheel in regard to fraud, the lending industry is deeply responsible for the current economic crisis, what with irresponsible use of credit default swaps and the like, I'm pretty sure I don't want to be giving them $700 billion dollars without any caveats or conditions stemming from their colossal failure.

But if you think wagging a finger at them and telling them not to do it again is enough, I best not presume otherwise.

John said...

Maybe it's not legally enforced, but I would think these institutions (at least the incorporated ones) would have accountability to their investors. Did they make it clear to them exactly how much of a risk was involved in this trade-off between fraud protection and volume of loans/mortgages issued? Perhaps some of them would not have demanded such a high annual growth rate had the risks involved been made clear to them, but then again, this is still a "let the buyer beware" environment. No one wants to spell out how risky their ventures are (and the short-term gains vs. long-term costs of inferior fraud protection) in their annual report, after all.