Liar Loans Were Not The Problem: Don't Worry About Re-Sets...Just A Scare Like Y-2K
Housing-Market / US Housing Aug 21, 2009 - 01:15 PM GMTBy: Andrew_Butter
Years ago I got a project building a credit scoring system for a bank that did auto loans in Dubai, it was a lot of fun, I got hold of tons of data, did a multivariate regression analysis, and the result was absolutely useless.
About the only thing that really worked was if the borrower owned a dog; owning a dog and paying your debts on time are incredibly well correlated. Now that's an idea, how about instead of "cash for clunkers"..."cash for puppies?"
The reason was that everyone lied on the applications, we did some audit trails it was a disaster. In the last meeting I ever had with that client I suggested that perhaps it might be a good idea to hook the borrowers up to a lie detector when they filled out their forms. That marked one of the low points in my otherwise (broadly) un-tarnished career of "exceeding customer expectations".
I remembered that incident when I saw all the press about "Liar Loans".
Apparently the credit crunch was not caused by incompetent and crooked bankers, it was caused by liars, presumably therefore if a way can be found to stop people lying then the world can be saved and we can all live happily ever after. Q.E.D.
There is another explanation:
In the olden days everyone assumed that everyone else was lying, and a lot of the time they were. In those days what the smart bankers used to look at very hard was the "pound of flesh".
The point of course which was conveniently forgotten in the mad rush to load up as much money out of bonuses as possible, is that it's not what the collateral could have sold for yesterday that matters (mark-to-market on the day the loan was written), it's what you can sell it for when the realization hits that the guy you handed over a bunch of money to a year or two ago never had any intention of paying it back (and didn't).
Prove it!!
One wouldn't have thought that after thousands of years of bankers finding out by painful trial and error that (a) many people lie, and (b) if you can't sell the collateral for more than you advanced you lose money (or more precisely the people who own the bank that foolishly agreed to employ you looses money, (and these days so do the taxpayers); but you don't care because you got your bonus. That's of course the secret of any bank robbery, be long-gone before anyone finds out).
Be that as it may, I was looking at the results of a study done by a team from Columbia University led by Dr. Wei Jiang which as far as I know represents the most coherent study of the mortgage market in USA (http://www.columbia.edu/~wj2006/liars_loan.pdf).
But I don't agree with the conclusion (which was that Liar Loans were what caused the credit crunch (and implicitly there is a lot more trouble to come). That's an over-simplification but...round numbers.
Where I think they went wrong (and I'm trying to persuade them to run my numbers, which they might, perhaps); was that they didn't put the value of "pound of flesh" (at the point in time you might want to sell it, in other words what International Valuation Standards calls "Other-Than-Market-Value"), into the pot.
Which I suppose is understandable since only 17,000 people read the article I wrote on this last September, and Market Oracle is hardly "mainstream". Anyway with Dr. Wei's kind permission I have done some rough analysis.
This is one of the charts they published (the dotted lines are mine).
Then I did something very "un-scientific", I extrapolated the chart they published (those are the dotted lines), to get an estimate of the delinquency after 48 months for all the data of the various times of when the loan was written except Jan/Feb 08 since that was not half a year (if you eyeball the chart you can see that there is typically a sort of leveling off after the initial flurry, and I used the slope of 2004 2nd quarter as a template).
Then I plotted that against the estimate of market mispricing of the US housing market which I published in September 2008 (http://www.marketoracle.co.uk/Article6250.html), and I explained a bit in a piece on Bubble Economics recently (http://www.marketoracle.co.uk/Article12114.html).
Just for reference the mispricing is the difference between "mark-to-market" value and the "other than market" value worked out using International Valuation Standards.
Anyway, this is how it looked (I put in the 28 month data as was shown just as a comparison, the problem with that is (a) it's less data and (b) the dynamics of all the lines hadn't stabilized; but the picture looks pretty much the same):
Well that works for me better than any story about the credit crunch being the fault of liars.
What that says is that 98% of the delinquency rate can be predicted from knowing what the level of mispricing of the housing market was at the time of writing the loan (and that algorithm predicts the delinquency 8% at the 95% confidence level).
OK so we can attribute the remaining 2% of the credit crunch to liars. Big Deal (actually it doesn't work like that but I think it is highly unlikely that "Liar Loan" as a variable would trump mispricing and I strongly suspect there would be an auto-correlation).
So what's Liar Loans got to do with it?
In my opinion it's co-incidental.
The reason why there were so many liar loans at the end of that sad saga was that was when they were "scraping the barrel", and they reached a point where (a) anyone could get a loan and (b) the dumb bankers didn't care a toss about the probable value of the collateral in 48 months time (and by the way you could work out other than market value then, just the idiot bankers were too focused on their bonuses to bother, or perhaps they didn't know how? (That wouldn't surprise me either)).
CONCLUSION
I know everyone is in a mad funk about what happens when the "Re-sets" start kicking in, but I don't buy that.
What matters is how much people paid for their house compared to what it's worth now, or more precisely what it will be worth in two years time.
And that's not going to get much worse, no-one will be selling now unless they are forced to, and remember that people fool themselves that their houses are worth more than they actually are...the line goes like this..."hey honey are we in negative equity?".
To which the only sensible answer (if you want to sleep), is "don't worry your pretty little head about that sweetheart, of course we aren't". And if you can lie to your sweetheart why can't you lie to that jerk in a suit?
The resets are going to come and go like Y-2K, house prices will stabilize at about 40% peak to trough average (10% to go or so (http://seekingalpha.com/article/153182-u-s-housing-one-dead-cat-bounce-two-sucker-rallies-to-go)), then after a while they will start to pick up, and the world will go on.
And people will still lie to each other.
By Andrew Butter
Andrew Butter is managing partner of ABMC, an investment advisory firm, based in Dubai ( hbutter@eim.ae ), that he setup in 1999, and is has been involved advising on large scale real estate investments, mainly in Dubai.
© 2009 Copyright Andrew Butter- All Rights Reserved
Disclaimer: The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. Information and analysis above are derived from sources and utilising methods believed to be reliable, but we cannot accept responsibility for any losses you may incur as a result of this analysis. Individuals should consult with their personal financial advisors.
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