Wednesday, March 28, 2007

Braunstein Testimony on Subprime: Supply or Demand?

by Tanta on 3/28/2007 12:00:00 PM

There was some outrage in the comments recently about Sandra Braunstein’s recent testimony on subprime lending. Braunstein is the Director of the Division of Consumer and Community Affairs for the Federal Reserve.

There are many things one can say about Braunstein’s testimony. I want to drive a few little conceptual wedges into her nice smooth characterization of the current mortgage market in general and subprime lending in particular.

It starts early, in the fourth paragraph of the written statement:

Today, the mortgage lending business has changed dramatically with the development of national markets for mortgages, technological changes, and the advent of securitization. The traditional book-and-hold model of mortgage lending has shifted to an originate-to-distribute model.

So far, so good, except something important seems to be missing from the “national, technological, and securitized” holy trinity of major market forces. Braunstein continues:

While commercial banks still have a significant role in the mortgage origination and distribution process, they are no longer the leading originators or holders of residential mortgages. Securitization has allowed many financial institutions to use increasingly sophisticated strategies to package and resell home mortgages to investors. This has resulted in increased competition and a wide variety of mortgage products and choices for consumers, in a market in which mortgage brokers and mortgage finance companies compete aggressively with traditional banks to offer new products to would-be homeowners. [My emphasis]

In what strange world are mortgage brokers “competitors” of banks? Let us remember what a broker is: not a lender. A broker brings a borrower and a lender together, and pockets a commission of some sort for so doing. The broker has no capital to lend. The “competitors” of brokers are direct retail lenders, meaning those lenders with loan officer employees who offer loans directly to consumers without requiring the services of brokers.

But for any bank with a wholesale origination model (which could, you know, be related to its “securitization” model in some fashion), brokers are not competitors, they’re sources of business. The wholesaler’s competition is other wholesalers, some of which are not depositories. Why am I making such a big deal about this? Because brokers have no “new products” to “offer” to “would-be homeowners.” They go out and find products offered by wholesalers to offer to would-be homeowners. Is this an unimportant distinction? I don’t think so.

Two paragraphs later, the lurking problem gets even worse:

One of the products of this new mortgage market is subprime lending. Subprime lending has grown rapidly in recent years. In 1994, fewer than 5 percent of mortgage originations were subprime, but by 2005 about 20 percent of new mortgage loans were subprime. The expanded access to subprime mortgage credit has helped fuel growth in homeownership.

It’s certainly questionable that subprime has really directly fueled homeownership to the extent Braunstein here assumes. As commenters have pointed out, there is evidence that subprime is still mostly a refinance business, not a purchase money business. To say, for instance, that record numbers of new home purchases have been made with subprime loans is not to say that most subprime loans are for purchases. Subprime on the whole, as far as I can see, has been fueling the MEW machine, and only indirectly the ownership machine. It is hard to build a MEW market with a bunch of renters.

But that aside, I am puzzled by the phrase “expanded access to subprime mortgage credit.” This assumes that “access” is a question of borrowers having access to creditors, rather than, perhaps, a question of creditors having access to borrowers. The whole idea of “predatory lending,” which is a subset of subprime lending, is that there are lenders who want to lend going after borrowers who may not have supplied the “demand” until someone fast-talked them into it. Even in the more “respectable” parts of the subprime and Alt-A business, I would argue, the "disintermediation" of “national markets, technology, and securitization,” which rely to a large extent on the “intermediation” of brokers, can function as much as supply creating demand than the other way around.

Those who wish to throw the Econ 101 textbooks at me will have to explain to me just how, exactly, borrower demand for loans they obviously do not understand, and that are not anywhere close to being in their best interest, gets created. Are we talking about a demand for credit or a demand for income-substitutes? And those who want to say that it’s all a matter of borrowers substituting short-term interest for long-term interest need to explain this EPD epidemic to me. Either those EPD loans were 100% fraudulent—borrowers who never intended to own the property or make the payments—or some of them were borrowers who never stood a chance of receiving even short-term benefit from the loan. I’m not sure which case is more comforting, but I surely can’t see here unambiguous evidence for pent-up demand that simmered for years until the “new mortgage market” Braunstein discusses suddenly offered the product everyone had been waiting for. Next thing you know, someone is going to tell me about the invention of advertising.

Quite honestly, after the first couple of paragraphs I just lost interest in anything else Braunstein had to say. It isn’t even, in my view, that her other testimony is wrong or worthless. It’s simply that I no longer care to hear anyone, and especially regulators, continue to talk about the mortgage “market” without talking about the mortgage business. I’m not interested in people talking about securitization and other forms of “disintermediation” until they address wholesale and correspondent originations and telemarketers and other kinds of “intermediation.” At some point these regulators are going to have to quit with the executive summaries and get into the UberNerd weeds with the rest of us, or else we’re going to keep getting this "disclosure" regulation (you can do pretty much anything as long as you slip in a disclosure that says so in the mice type) that works nicely in Econ 101 and doesn’t do diddly when the Borg adapts. Until they’re willing to recognize that a demand “bubble” exists, and that intermediation is not "competition," nothing they come up with in the name of “consumer access” is going to help much.