Legal_Landscape

A commentary on law and current affairs

Sub prime mortgage crisis and data governance

Sub prime mortgage crisis

The sub prime mortgage crisis in the USA resulted in the loss of billions of dollars for banks, caused hundreds and thousands of foreclosures, rendered millions homeless and in short, caused a severe economic downturn in the USA. The ripple effect of the crisis is felt all over the globe as all major banks and financial institutions have branches world wide and since the US Dollar is the main currency for trade in many international markets.

In a traditional mortgage, there is a direct involvement of the bank in checking the data submitted by the borrower and on the valuation of the house mortgaged to the bank, as the objective is to be risk averse. There is no such involvement of the bank in a sub prime mortgage, where the bank’s objective is not risk averseness in lending but the increase of revenue through investments. The statutes enacted in the USA during the 70’s and 80’s[1] liberalizing regulations in lending operations expanded the mortgage portfolio of lenders and induced them to engage in riskier operations such as the sub prime model. Under this method, checks and assessments in the lending process is performed by independent individuals rather than the lender itself.

Mortgage Brokers, securing borrowers for Banks acting in an independent capacity, are motivated by the Commission from the transaction and collect data to meet their targeted objective. Such a process, without bank supervision, has a lot of room for errors.

In a de-regularized environment, the lender focuses in lending its excess funds as much as possible and would not take the trouble to comb through loan applications in search of errors. This includes lending to all types of borrowers – prime borrowers (i.e. those who have the capacity to pay back the loan and who may give a deposit for the loan apart from the house mortgaged as collateral) and sub prime borrowers (i.e. those who cannot substantiate through documents their ability repay the loan and who do not have any funds to deposit as an advance against repayment.) In the case of sub-prime borrowers, the collateral of the mortgaged house is the only asset the bank can rely on if the borrower defaults. In bank parlance, this is called a “bad mortgage”. The bank thus has both good mortgages and bad mortgages in its portfolio.

Borrowers who cannot show proof of their ability to repay the loan, such as low income sub-prime borrowers, are considered “high risk” and the interest payable on their loans are fixed according to a risk based pricing method[2]. Generally a low fixed interest rate of 8% for 2 to 3 years and thereafter a ballooning interest rate going up to as much as 40%.  In the sub-prime crisis, most sub-prime borrowers were not aware of their exposure to excessive interest rates. Sub prime borrowers also pay other banking charges, which made this category of borrowers the generators of an attractive return for the lender.

Ballooning interest rates on loans after the initial fixed interest period and the ability to transfer sub prime risk by selling both good and bad mortgages packaged together as asset backed or collateralized documents, seems to have been two significant factors which prompted lenders to enter into the sub prime model of lending. The increasing housing prices corresponding with the rising demand for real estate, lulled the lenders to give scant attention to the aspect of risk.

These asset backed securities (ABS) or collateralized debt obligations (CDO) are rated by independent rating agencies, based on historical data and the ability of the issuing Bank to honor interest payments and not by considering the risk embedded within them. The “high risk” element of the bad mortgages are thus, not visible to the buyer investing in bonds. When sub prime borrowers could not meet their loan obligations and Banks started on foreclosures, the interest payments assured on the bonds could not be delivered by the Banks, leading to investors’ lack of confidence in the secondary bond market.

Culture on data governance at the time of the sub prime crisis

An interesting revelation is the culture on data governance that existed in banks at the time of the sub-prime crisis which may have lead to some of the causes highlighted. There was no doubt about strict controls as the Sarbanes Oxley and Basel II imposed tighter control and greater disclosure requirements on banks. But the focus of banks seems to have been more on data breaches[3] as the most serious threat to banking. The TJX breach, where data of millions of bank customers were lost, is a case in point. Banks therefore had a greater bias towards tightening controls to prevent data breaches from hackers, viruses, loss of laptops, etc., rather than maintaining the quality and integrity of data.

Another reason for the lack of focus on data quality was the increasing levels of electronic transactions and business complexity which lead to higher volumes and duplication of data. When the same bank opens in different geographical locations, data on similar matters are viewed in a manner distinct to that location. All of these issues caused ‘duplicative and inconsistent data, spilling over to associate business processes’[4].

Taking into account the banking models and the culture which prevailed, we can identify the following as causes for the sub-prime mortgage crisis:

  1. Statutory and federal regulations broad basing home ownership without stressing on systems of control.
  2. Banks’ failure to self-regulate.
  3. Inadequate implementation of Data Governance Programs or the failure to constantly monitor and update policies, guidelines, rules and procedures to meet the changing needs of the organization.
  4. External independent processes without bank supervision.
  5. Entering of inconsistent and low quality data into the banking system undetected.
  6. Increase in electronic transactions and duplication of data.
  7. Rating agencies considering the liquidity and stability of the service provider rather than the quality of the product sold for rating purposes (i.e. Rating of Bonds by only assessing the issuer of the Bonds rather than the Bond per se)

The above is an extract from my e-book “Preventing a sub-prime mortgage crisis” http://www.lulu.com/content/5279040

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[1] The Community Reinvestment Act of 1977, Tax Reform Act of 1986, Deregulation and Monetary Control Act of 1980

[2] Risk-based mortgage pricing has expanded the types of mortgages lenders offer and increased the number of borrowers that can generally qualify for a mortgage. Alt-A and subprime mortgages, the types of mortgages generally subject to risk-based pricing, are frequently sold by the mortgage originator into the secondary mortgage market, where they typically become part of collateralized mortgage obligations (CMO), asset backed securities (ABS) and collateralized debt obligations (CDO). Risk-based pricing plays a large part in the structuring of CMO, ABS and CDO, enhancing their overall credit rating and making them attractive to wide range of investors (Investopedia)

[3] In 2007, 30% of banks reported data breaches (2007 Deloitte and Touche Tomatsu Global Financial Security Industry Geographical Survey)

[4] Data Governance: Banks bid for Organic Growth (Guillermo Kopp-Tower Group June2006)

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December 7, 2009 Posted by | data governance | , , , , , , , | Leave a comment