FICO's Decline (& Fall?)

Credit Rating Agencies, Writ Small

As a long-time lender, I would always trade off fico for equity.

--email from Angelo Mozilo, Countrywide CEO (now charged with civil fraud), to a lieutenant

What exactly is Mozilo talking about?

Sub-prime lenders' growing concerns, circa 2006, that the size of a borrower's down payment was a much better predictor of their loan quality than their credit score as calculated by the Fair Isaac Corp. (now called "FICO").

As the housing boom wore on, such scores came to loom increasingly large in mortgage origination decisions -- much like the Triple-A ratings parceled out by Standard & Poor's and Moody's effectively became the "Good Housekeeping Seal of Approval" for trillions in mortgage-backed securities.

Unfortunately, the calculations made by both FICO and the credit rating agencies rested on the same, fatally flawed -- and for a time, very lucrative -- assumption: namely, just because something had never defaulted in mass numbers, it never would.

Un-unhh.

With respect to mortgage-backed securities, the prevailing mindset was that the risk of default to investors, always historically negligible, could be reduced even further by segregating the highest risk securities into discrete groupings or "tranches."

In FICO's case, the decision-making was at the level of the individual mortgagor (or borrower).

The fatal assumption? That consumers who had never defaulted on their debts, never would.

As now seems obvious, there's a big difference between paying your utility bills on time and owing, say, a couple grand on a few credit cards, and owing several hundred thousand (and perhaps much, much more) on a mortgage. On a house that's worth less than you owe. That you've got no equity in (and indeed, never did). When you've maybe lost your job, or are afraid you might. You get the idea . . .

Not surprisingly, the foregoing proved to be an especially combustible mix.

Lenders: 'Show me the money' (downpayment)

So now what?

At least at the moment, everyone's "back to basics":

--Only lend against good collateral, conservatively valued;
--Require borrowers to have some "skin in the game" (a sizable down payment);
--Carefully vet the borrowers' income and assets.

As Mozilo and other long-time bankers know -- and always knew, deep down -- it is those principles that are the foundation for high-quality mortgages -- not a third party's flawed, seal of approval such as FICO scores.

Mozilo's been called lots of things, but "dummy" isn't one of them (unless you count leaving behind incriminating emails).

Countrywide's Angelo Mozilo

Personal Fortune, Economic Disaster

I don't follow pro sports very closely these days, but growing up, I remember a statistic in basketball and hockey called the "plus/minus ratio."

The goal was to filter out individual statistics like goals scored or baskets made, and instead, focus on each player's net contribution to their team.

The result was something called the player's "plus/minus" ratio.

To calculate it, you added the total points scored by the player's team while he or she was on the ice (or court), then subtracted the total points scored by the opposing team.

So, a player who didn't score much, but was great on defense, would have a deceptively high plus/minus ratio.

So would a consummate team player, who unselfishly aided his or her teammates' point-scoring.

Net Minus

What makes me think of this is Angelo Mozilo, former CEO of subprime lender Countrywide, who now stands accused of (civil) fraud.

Leaving aside the particulars of the subprime business, what's clear is that Mozilo's total compensation over the last decade or so was several hundred million dollars.

Compare that to the carnage caused by the the toxic loans his company made: hundreds of thousands -- if not millions -- of foreclosures. Conservatively, say the number is 500,000.

Assuming each foreclosure costs $50,000, Mozilo's conduct arguably could be said to have cost the economy $25 billion. And that's before taking into account the human suffering, dislocation, etc. caused by all those foreclosures.

That makes Mozilo's "plus/minus" ratio a rather lopsided negative $24.5 billion. Not quite up there with Bernie Madoff (minus $50 billion), or the senior management of AIG, Merrill Lynch, or Goldman Sachs -- but a pretty staggering sum, nonetheless.

Compare that to the contributions made by a teacher, a fireman, or a talented doctor, whose pay may be nominal, but whose efforts add real wealth to the economy, and society generally.

Unlike the Angelo Mozilo's of the world, they would all score very high on the social "plus/minus" scale.

Not to mention the "financial" Hippocratic oath: 'first, do no harm.'

"They're B-a-a-a-c-k . . ."

Return of the Sub-Prime Lenders

One of the surprises -- at least to me -- wading through all the foreclosures in Minneapolis neighborhoods like Phillips, Camden, and Powderhorn Park is the identity of the banks who now have title (i.e., they're the owners).

It's a veritable "who's who" of the most aggressive -- and least ethical -- subprime lenders: entities like Countrywide, Indymac, Washington Mutual, etc.

At least to my knowledge, none of these lenders had a major presence in the Twin Cities at the peak of the market. Of course, today they're folded into other banks that bought them at fire sale prices after they collapsed or outright failed.

So what gives?

The explanation has to do with how the mortgage market works.

Borrowers can either apply for a mortgage directly from a lender, or, go through a broker who does the shopping for them in exchange for a commission.

Guess which lenders dangled the fattest commissions in front of Twin Cities brokers (and presumably, mortgage brokers nationally) when the market was frothiest??

Unfortunately, as far as the subprime lenders are concerned, it's not so much that "they're b-a-a-a-c-k," as, "they never really went away."

P.S.: Foreclosure Feeding Frenzies

(More) Market Manipulation?

In my last post, "Banks Price Low to Elicit Multiple Offers," I discussed the increasingly popular tactic of foreclosure Sellers pricing low to precipitate bidding wars.

What I left out was the identity of the banks who appear to be behind many of them: notorious, sub-prime lenders such as Countrywide and Indymac.

Just to refresh your memory, these are the same folks at the epicenter of the real estate market melt-down in places like Southern California and Florida.

While credit was free-flowing, they handed out such exotic fare as option-ARM's (the borrower decides how much to pay, with any interest shortfall added to the principal); mortgages with initial teaser rates on loans that later "explode"; and various other, negative amortizing products.

When people refer to "Liar Loans" (no documentation of any kind required), these are the lenders who handed them out. Big surprise: such lenders made their money originating such loans and re-selling them.

So nice to see how far we've come . . . not.

Proposal: Financial "Son of Sam" Law

Look Who's Cashing in on the Mortgage Mess

Fairly or not, Countrywide Financial and its top executives would be on most lists of those who share blame for the nation’s economic crisis. After all, the banking behemoth made risky loans to tens of thousands of Americans, helping set off a chain of events that has the economy staggering. So it may come as a surprise that a dozen former top Countrywide executives now stand to make millions from the home mortgage mess. Stanford L. Kurland, Countrywide’s former president, and his team have been buying up delinquent home mortgages that the government took over from other failed banks, sometimes for pennies on the dollar. They get a piece of what they can collect.

--Eric Lipton, "Ex-Leaders of Countrywide Profit From Bad Loans"; The New York Times (3/3/09)

Let me see if I've got this right.

Bank executives at subprime lenders made hundreds of millions originating toxic loans that helped blow up the housing market. In turn, that helped blow up the banking system, which -- surprise! -- is now tanking the general economy.

Nothing has happened to them.

On the contrary, they are now using their toxic loan wealth and banking connections to make money a second time on toxic loans -- this time, by buying them for pennies on the dollar.

To paraphrase the government attorney who admonished Joseph McCarthy: "Have you no sense of decency sir(s), at long last? Have you left no sense of decency?"

And what kind of financial and legal system stands by and watches this happen??

Proposal: Financial "Son of Sam" Law

After serial killer David Berkowitz reportedly received lucrative offers to sell his story to publishers, New York state passed a law preventing such a travesty.

Known as the Son of Sam law, it authorizes the state to seize money earned from such a deal and use it to compensate the criminal's victims. The rationale, which hardly seems to require explanation, is that no one should financially profit from crimes that they've committed. Since then, 39 states have passed similar laws.

Such an approach seems tailor-made for today's housing and financial crisis, and the "economy killers" at the root of it.

The best thing for public confidence would be a healthy economy generating lots of well-paying jobs.

In the meantime, the next best thing would be sending the people most responsible for the financial crisis to prison -- or at least pulling them away from the trough ("A-I-G" is starting to look and smell a lot like P-I-G).