The 2008 mortgage crisis was preceded by a series of missteps and unfortunate circumstances, culminating in a perfect storm that triggered the worst financial meltdown since the Great Depression. After experiencing an 87% increase in average home prices between January 2002 and mid-2006, the mortgage market steadily declined and the housing boom began to subside. Unfortunately, the boom soon became a bust, and by the end of 2008, housing prices were about 25 percent below the peak level achieved in 2006. As a result, liquidity and capital disappeared from the market.
There are several factors that contributed to the mortgage crisis including weak underwriting standards, relaxed regulatory oversight, introduction and endorsement of risky products, and deficient compliance enforcement. Credit underwriting standards were imperfect, as less stringent guidelines permitted subprime borrowers—who would not qualify in stricter underwriting climates—to receive loan approvals. Non-agency loans increased substantially in the five years leading up to 2007 and the bulk of subprime mortgages were delivered to the market through unregulated private capital that did not require underwriting quality restrictions.
In addition to the lax underwriting standards, the market experienced an increase in new, non-traditional mortgage products. These riskier products, which were characterized by high loan-to-value ratios and were often coupled with variable rate features resulting in payment shock, prepayment penalties, and potential negative amortization, quickly infiltrated the market. Overall, regulatory oversight to identify and control risky products and underwriting standards was weak, or hindered by a lack of oversight authority in many areas.
These historical missteps not only provide a source of insight into the events that triggered the crisis, but a great opportunity to learn from faulty practices. So, what has the market learned from these challenges in the wake of the crisis?
Lesson #1 Lenders must considered layered risk when evaluating loan quality
During the subprime boom, lenders and underwriters did not account for compounded risk on the loan transaction. High loan to value loans, some in excess of 100%, were considered safe because housing values were increasing to record highs. In many cases, high LTV’s were coupled with stated income and asset loans or no verification loans, These low- and no-doc loans were then coupled with unstable loan products that carried payment shock and/or negative amortization. To top it off, home values were often determined by a drive-by appraisal or AVM. These risky loans were then offered to already at-risk borrowers with marginal credit scores. Layered risk tipped the scales in favor of default and misrepresentation.
Lesson #2 - Underwriting is important and underwriting standards should be robust
Banks and lending institutions have increased lending standards, although some would argue these standards have become too strict. With the more stringent guidelines set forth for credit standards, institutions are steadfast in determining borrower credit-worthiness. In fact, federal regulators have provided guidance on how to manage riskier mortgage borrowers for qualification purposes. These federal regulations have been supported by state bank regulators and are considered by Fannie Mae and Freddie Mac in reviewing riskier mortgages that are presented for purchase.
Lesson #3 Risk governance and reporting needs to be developed and enforced
After the housing crisis, it became evident risk management governance and reporting needed improvement, as the existing risk management requirements were either lacking the appropriate governance and enterprise-wide risk view or were non-existent. Risk Management did not fully evaluate the future performance of the imprudent lending programs offered. . Additionally, institutions recognized that their risk management systems needed upgrades to ensure risks are properly accounted for.
Lesson #4 Improved processes enhanced by precise controls are critical
Well-defined, comprehensive procedures combined with rigorous control standards are fundamental components for successful operations. This combination provides a structured fulfillment process fortified by an exact quality assurance and quality control foundation. While well-documented procedures allow transparency into the process, thorough quality controls reassure the integrity of the process.
Lesson #5 Development of, and adherence to, compliance guidelines are key
In addition to the assemblage of comprehensive procedures and rigorous control benchmarks required to ensure safe and sound practices, these procedures should be grounded in policy guidelines that affirm compliance to regulatory requirements. Timely monitoring and reporting will verify internal compliance against external regulatory requirements.
Given the severe global impact attributable to the mortgage crisis, as well as the enormity of the losses, careful thought regarding the leading risk factors is valuable. Hindsight affords the industry the ability to learn from the mistakes of the past and avoid potential downfalls that detract from the achievement of worthwhile future goals.
