The Bankwatch

Tracking the consumer evolution of financial services

Global Financial Turmoil and the responsibility of social lending

Nice crisp explanation of the cause of the sub prime crisis by Governor Frederic S. Mishkin of the US Federal Reserve. In particular I liked this quote “a global margin call on virtually all leveraged positions”. Later on I offer an observation on how social lending has a responsibility, and a role to play in all this.

FRB: Speech–Mishkin, Global Financial Turmoil and the World Economy–July 2, 2008

The subprime crisis exposed problems with the securitization of mortgages. In particular, it became painfully clear how poor the underwriting and credit-risk analysis were for a wide range of products. Some appraisers, brokers, and investment banks were motivated by transaction fees and had little stake in the ultimate performance of the loans they helped to arrange. Many securitized products were complex, and the ownership structure of the underlying assets was opaque. Investors relied heavily on credit ratings instead of conducting due diligence themselves, and credit rating agencies failed to fulfill their raison d’etre. The result has been rising defaults, particularly in the subprime mortgage markets, with losses to both investors and financial institutions.

The ultimate losses from the recent residential mortgage-market meltdown have been estimated by Wall Street analysts at about $500 billion–less than 3 percent of the outstanding $22 trillion in U.S. equities.2 Why did a relatively small amount of losses on subprime mortgage loans lead to such broad-based financial disruption? After all, a 3 percent decline in stock market prices sometimes happens on a daily basis with hardly a ripple in the U.S. economy.

In part, the outsized impact of mortgage losses on broader financial markets probably stems from the fact that they exposed a more extensive set of problems in financial intermediation that were not limited to the original subprime loans. The liquidity shock that hit us in August has been described by one of my colleagues as a global margin call on virtually all leveraged positions.3 The liquidity shock quickly brought an end to the credit boom that preceded it, as a striking loss of confidence in credit ratings and an accompanying revaluation of risks led investors to pull back from a wide range of securities, especially structured credit products. Along the way, the inadequacies of the business models of many large financial institutions were exposed, and these models are now in the process of significant re-examination and rehabilitation.

However this statement, when the Governor spokeof the future, caught my eye. The agency problem he refers to, is the reliance on mortgage brokers, appraisers, and all catch points for mortgages. He explained earlier those agents had been motivated by mortgage volume, took their commissions, and ran. There was no incentive for those agents to offer quality, and in fact they were incented to offer volume, with poor or fictitious quality.

Although some of the most complex structured-finance products may be gone for good, securitization will only recover fully when new business models solve the agency problems that were inadequately dealt with in recent years

This highlights a market opportunity, where social lending can bring significant leverage to bear. In the speech, the Governor spoke of credit ratings failing, and he spoke there of the Moodys etc rating on the ABCP (Asset Backed Commercial Paper) market. There is another rating that becomes essential in all this, and that is the rating on the end borrower, the person who takes out the mortgage to purchase a home. The rating on that person must be complete, accurate, and transferrable. By transferrable, I mean it must be available for inspection, and due diligence up stream as the collaterisation process disseminates the mortgage into pieces that become CDO’s and other ABCP. Social Lending is not just about people lending to people. That is a great beginning, and offers the valuable inspection from the wisdom of crowds.

In the future the market may well see additional markets appear, and social lending must at a minimum outperform the old way of doing things.

Written by Colin Henderson

July 6, 2008 at 03:17

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