In today’s Wall Street Journal, Alex J. Pollock a former President and Chief Executive Officer of the Federal Home Loan Bank of Chicago wrote a piece on the subprime industry, I wrote to the Journal’s editor, the following letter:

“In his “Credit Crack-Up” (March 12, 2007), Alex J. Pollock offers a perceptive summary of the current malaise in the subprime mortgage industry. Some of his comments however call for qualification.

1. The risk of “punishing of the innocent along with the guilty”

Some segment of the subprime industry falls unfortunately under the category of “predatory lending” where the lender seeks his profit not, as in normal circumstances, in the interest being charged but in the equity locked in the property and attempts in fact to force repossession. In a speech he made in 2004, Edward M. Gramlich, a Governor of the Federal Reserve, complained that “despite […] actions by the Fed and other bank regulators, we still have no obvious way to monitor the lending behavior of independent mortgage companies” (*), which at the time represented 12% of originations in that sector.

2. “How could all these problems arise […] given our massive computer power manipulating mortgage data with sophisticated models built by mathematical experts?”

No amount of computer power and mathematical expertise will ever allow to bridge safely from observations of the past to prediction of the future. A majority of the mortgage products currently offered to the consumer are of recent invention and have only a short track-record from which to extrapolate. The FICO score has shown a remarkable efficacy at predicting borrower default. Its power derives from assuming that consumers’ past credit behavior along with the current servicing of their debt predicts accurately their future credit behavior. This simple assumption neglects however that the wider economic context, such as the current level of interest rates or of unemployment, has an influence on consumer creditworthiness and the fact remains that the FICO score has never been tested over a full business-cycle including a recession. The “traditional” threshold of 620 FICO points that the industry had adopted as marking the border between subprime and prime has in the past few weeks been raised by lenders to 660; the move is no doubt prudent but it is not based on any objective measurement: new developments only will eventually reveal if the new value was too conservative or still too low.

3. “The belief that the economy has changed in some fundamental way, and that a ‘new era’ is beginning”

The single true danger lies here precisely. Because it has no choice but to extrapolate from historical data, the mortgage industry is bound to develop new scenarios whenever new circumstances dictate. If we keep in mind that what we see now may only reflect the favorable part of the business cycle, we will envisage consumer behavior within that context and remember that a downside remains possible in the future. If on the contrary we assume that a “new era” has opened where business cycles are a thing of the past or, which amounts to the same, that the favorable part will last forever, then we haven’t seen the end of our troubles.
But are we justified to blame mortgage bankers for having trumpeted the arrival of a “new era” in consumer credit? In its most recent guise, the “new era” theme was once again reborn from its ashes as the “optimal allocation of financial risk,” where risk migrates automatically to those parties ideally suited to take it. Its advocate was of course no less an authority on these matters than the former Chairman of the Federal Reserve, Alan Greenspan.”

(*) Edward M. Gramlich, “Subprime Mortgage Lending: Benefits, Costs, and Challenges”, May 21, 2004