Ethan Penner's Misunderstanding of Mortgage Lending

Yesterday's Wall Street Journal featured an editorial by Ethan Penner, one-time head of Nomura's mortgage business, entitled "Of Markets and Mortgages."

Penner begins his defense of securitization, which is what his editorial really stresses, with this passage,

"Yet today we see the search for quick fixes and for villains, with securitization being identified as the chief culprit. Securitization is not the cause of the massive problems in our credit markets. The problems are due to basic mistakes that even the most unsophisticated among us can grasp. Lenders loaned too much money on too easy terms to borrowers who did not have the capacity to make their payments. No alchemy by even the brightest minds on Wall Street could turn bad loans into good assets. Sound simple? It really is."

What Penner writes is true. Unsound lending was and is at the core of the mortgage-related finance troubles. But he fails to note that much of the worst of the lending, the 'no money down' mortgages, were not intended to be held in portfolio, but securitized ASAP.

Penner continues in this vein a few paragraphs on, stating,

"The underwriting of risk in the past few years has, of course, not been so good, and securities backed by poorly underwritten loans are losing value daily. Yet the cry for systemic fixes from various constituencies has been dangerously off the mark. One common fix advocated is to abandon or de-emphasize mark-to-market accounting in favor of allowing companies to estimate an asset's "true" long-term intrinsic value. Another is to move away from securitization and return to a portfolio lending model -- where, for example, the bank originating a mortgage keeps it (in its own portfolio of assets), rather than selling it to a third party (as in securitization). Both fixes are tempting. Both are mistaken."

So Penner is about to disabuse us of the two major notions for repairing the current damage from bad lending and exotic structured finance instruments.

First, he deals with mark-to-market, opining,

"The desire to abandon or deemphasize the mark-to-market model is based upon the logic that, if the public didn't know how bad things were, then the all-important confidence in the system would not be at risk and we would be safer. The price to be paid -- the complete obfuscation of the truth -- is simply way too large."

That's it! Penner simply states, without any supporting statistical or other quantitative, descriptive evidence, that the reason we can't modify or adapt 'mark-to-market' is because it would result in 'complete obfuscation of the truth.'

But is that really true? What about the commercial bank investment account? We've lived with that for decades, and still do. Has that brought down our financial system? No.

Sometimes, when an instrument is truly held for income, to perpetuity, or for a long time, the current market value does not represent the value of the instrument to the holder. This could well be true for many institutional investors, especially pension funds, who hold structured finance instruments.

There are provisions for accounting for the value of such instruments by banks when the no longer perform, i.e., become delinquent or in default. But performing instruments thus benefit from a lack of pressure by markets to affect valuation decisions on performing instruments.

Penner then moves to defend his special co-contribution to our current finance system, the securitized mortgage,

"The argument in favor of portfolio lending is based upon the notion that, unlike securitization, portfolio lending incorporates the discipline of "skin in the game." Since, in the portfolio lending model, the loan's risk is not being transferred from the originator/lender, underwriters will therefore be more careful. But the anecdotal evidence just does not support this thesis. In the last major credit correction, it was portfolio lenders who violated prudent credit standards. And in this correction, many of the world's portfolio lenders are suffering the largest writedowns because of their bad credit decisions. Simply put, human nature exploits both models -- securitization and portfolio lending."

I believe Penner's 'analysis,' again, woefully devoid of any quantitative descriptions or statistics to support his weighty contentions, falls short on two counts.

First, I take issue with the 'fact' that 'many of the world's portfolio lenders are suffering the largest writedowns because of their bad credit decisions.' That rings false to me.

Merrill Lynch, Bear Stearns and Morgan Stanley took most of their write-offs from securities, not home loans. I don't recall specifically if Merrill's housing finance unit actually originated subprimes or not, but it clearly bought the unit to securitize the loans, not hold them. After all, Merrill could never use a commercial bank's 'investment account' approach to valuation, so it's unlikely they ever expected to hold any mortgage loans, as such. Even Citigroup's large SIV losses involved securitized mortgages, not the raw material.

Penner is simply deficient on this point. Without numbers to support his positions, I find them unbelievable.

His second error is less visible, but equally important. Penner glosses over why securitization is so much worse than experiencing the same dollar losses in portfolio lending.

The obvious first reason is that, with a bad bank portfolio, you know where the damage is. It's contained to a set amount within a known institution. Usually, FDIC-insured and Fed-supervised. Thus, arrangements to handle the losses and insulate the financial system, and depositors, from the fallout, are relatively easy and conventional.

When the mortgage losses bleed through countless tranches of countless CDOs scattered among investors worldwide, it's literally impossible to know the extent of the loss for each instrument and each (counter)party.

Thus, the uncertainty of the extent of loss for each participant becomes more important than the dollar value of the losses, because, with losses presumed to be resident somewhere, counterparty risk uncertainty skyrockets.

A useful, if unappetizing analogy, involves sewage systems. Which, sadly, appropriately represent much of the material 'pumped through' our financial system for the past few years.

Portfolio lenders essentially have individual septic systems. If they toss in the wrong material and or exceed the capacity of their own system, they suffer. But relevant regulatory and municipal officials can handle the damage and supervise remedies. Nobody else suffers very much, or for long.

Securitizing mortgages, especially suspect ones like subprimes, more closely resembles a situation in which each securitizer reaps a fee for pumping effluent into a common cesspool.

However, once the effluent leaves the securitizer's effluent outflow into the cesspool, the identity of its 'product' is masked. In fact, nobody knows exactly what, in total, is in the cesspool.

And since no one securitizer 'owns' the cesspool, none of them really care about its status. They are paid for pumping the maximum amount of effluent into the cesspool that they can, not for supervising the functioning of the cesspool.

Unless the operator, if there is one, of said cesspool charges an escrow fee by monitoring the effluent feeds into it, there's no negative consequence to the securitizer's if, one day, the cesspool closes, or otherwise becomes inoperable.

Penner ignores the greater motive of humans to misuse and abuse commonly-accessible resources, i.e., the cesspool-cum-financial markets, as opposed to at least trying to risk-manage their own asset portfolios.

Thus, prior mortgage-lending related bubbles and aftermaths have been relatively more easily cleaned up than this one has been.

Because we don't have 'owners' of markets, the cleanup is vastly different. In part, too, because investors may visit a market, buy some CDO, then leave, not being really 'in' the market anymore.

The insidious nature of distributed CDOs containing bad mortgages has had the most deleterious effect on our markets, not simply the size of the delinquencies or defaults.

This lack of knowledge of who might hold bad CDO paper is what has caused the credit market seizures- the implied or suspect counterparty risk.

None of this is evident, nor mentioned, in Penner's defense of the business he says he helped create.

No surprise there, eh?