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Your Bank > Education and Advice > CNB University

Lessons in Lending - One Year Later: The Financial Crisis

October 6, 2009

Reprinted with permission of The Daily Record ©2009

You may recall that, a year ago, the newspapers were filled with startling information as large institution after large institution reported severe financial news and, in some cases, closed their doors.

Mortgages were identified as the main culprit, and Freddie Mac and Fannie Mae virtually were taken over by the federal government because they could no longer function in their roles without large bushels of fresh new money.

Lehman Brothers, a once-admired investment house, actually closed its doors, out of money and with no help. That after their boss only a few days earlier had said in reference to the financial crisis, as quoted in The Economist: "We have a long track record of pulling together when times are tough."

Five days later, Lehman was bankrupt. A good deal of the information contained in my column comes from a very well written article by Sue Allon, published by Mortgage Banking magazine.

Things got worse before they got better as the government took a controversial role, creating mountains of new debt to bail out institutions feared "too big to fail."

The news media did everything in its power to raise the public's awareness about this previously unheard of tool. What about medium and smaller banks? Yes, there have been 95 or so failures so far this year nationally, but that it is a small percentage - slightly more than 1 percent - of the 8,000 commercial banks still out there. In many instances, the FDIC has been able to arrange acquisitions of failed banks by larger and better capitalized banks, with little to minimal loss to the fund.

Treasury Secretary Henry Paulson went before the Senate Banking committee in October 2008 and said the housing valuation correction was the primary cause of the problem. Pools of underwater loans, many poorly underwritten, no longer could be sold because buyers were concerned about their quality - in spite of acceptable ratings by third-party firms. That contributed to a freeze on the flow of money, the mainstream of many businesses' operating funds. Even large banks that regularly borrow and sell cash daily were unwilling to lend to each other out of fear the buyer might become the next Wachovia, about to go broke thanks to toxic assets.

All of that proves to me the government took the right course of action by pumping money and guarantees into the economy. It is beyond imagination what would have happened with no access to cash and no ability to trade assets.

Some people call the government's "socialistic." I prefer to consider the action a necessary, short-term infusion by our central bank, designed to keep balance in our economic model. We certainly would not want it to become a standard operating model, but by the same token we cannot ignore the need for intervention during crises such as the current one.

The Troubled Asset Relief Program was one of the first tools the government used in an attempt to restore order to the markets. TARP is a grossly misunderstood concept, which is the fault of the Treasury because, upon announcing the program, Washington quickly switched gears. Funds originally intended for the purchase of toxic assets - classified non-performing commercial and residential mortgage loans - actually were invested as capital into banks of all shapes and sizes, based on the idea that stronger banks would be willing and able to lend money or even purchase weaker banks.

The first $350 billion of TARP funding was given to prop up the largest financial institutions, such as Goldman Sachs, which actually declined the offer but was forced to take it anyway. So-called toxic assets remained on the books of the originating banks or were charged-off. Unfortunately, the confusion hurt more than it helped. A market for loans always existed, even for troubled assets either directly or as a part of a mortgage-backed security, but that market froze quickly as values suddenly were questioned on all fronts. As a result, TARP's scorecard is not good: While it did provide needed liquidity, it did not get trades going and assets remained frozen.

In March, the government announced the first detailed plan for getting distressed assets trading again. The Public-Private Investment Plan brought the Federal Reserve, the Treasury and the FDIC together with private investors. The new partnership would combine private investment with government funds and guarantees to purchase either loans or bonds secured by loans, including toxic loans.

The private capital leveraged by $50 or even $100 billion of government money would get trading going again by removing fears and actually increasing the values of the securities. That, once again, was thought to be the impetus needed to get the markets moving. It took the government several months to work out the details, however, and by that time investors lost their enthusiasm and the markets continued to languish.

The government's next attempt was called the Legacy Loan and Securities Program, which was met with great enthusiasm. Immediately, 24 investment firms stepped up to apply to become fund managers. Ultimately, nine securities firms were selected, and were challenged to raise $500 million each, which the government would match. Of the $500 million raised, $20 million had to be from their own capital. Those assets would be pooled and sold over time in newly-structured transactions. The plan actually is happening now, so it is too early to say how successful it may be although the Legacy securities are showing very good market acceptance. The Legacy Loan program, while not as popular initially as the securities plan, also shows signs of market acceptance. The irony is that many investors, including those from the mortgage sector, have cash accumulating on the sidelines and need programs like these to increase values and move the markets. While not yet robust by any means, the program looks as though it has great prospects. Combined with the signs of new life being felt in the markets generally and one almost could be optimistic.

"PPIP opens up a whole new world of possibilities and investors know it" Allon's article states.

While that is good news for investors, it is even better news for small loan servicers with excess capacity who will purchase, at a significant discount in some cases, loans from the larger institutions. In turn, they will reach out to underwater borrowers offering loan modifications, which in turn will get properties and loans moving again since market prices will be adjusted. Allon also points out that investors are driven by the economics behind loan modifications, realizing the loss taken through a principal write down, interest rate reduction or term extension in all likelihood will be far less than the loss they could take by foreclosing and having to invest in repairs or remodeling, then marketing, for sale.

The Helping Families Save Their Homes Act and the Making Home Affordable program provided incentives for lenders to work with borrowers to keep them in their homes. Combined with private sector initiatives, we see renewed optimism in real estate community and a light at the end of the tunnel. The programs are not designed to bail out those who cannot or will not pay, but rather allow those who have, proved that they can and want to pay, the chance to save their homes.

What does all of this prove? First of all, we all need to look under the rocks when looking at investment, even in a home. Nothing can be taken for granted and no one is exempt from scrutiny. It also proves the government believes its actions have saved our economy from near disaster, even at an incredible price.

There are many dissenters, and only time will really tell who is right. The industry, particularly on the securitization side, needs proper regulation in order to ensure we don't go through it again. Will that happen, or will we be subjected to mountains of mindless disclosure and compliance challenges?

When was the last time you borrowed to purchase a home? I challenge anyone who claims they have read, and understood, all of the papers. Even attorneys who have borrowed admit it is impossible, and therefore is not true reform. Many other reforms are still necessary - starting with due-diligence standards for the rating agencies and the removal of incentive compensation that make people cheat.

We also must understand that not everyone should own a home. Homeowner counseling is available through banks and housing agencies and is contributing to the growth of eligible borrowers, but it will never achieve the goal of home ownership for all. Lenders need to ensure borrowers qualify, that they have income, and are willing to pay, as evidenced by their credit, and that they understand all of the responsibilities of home ownership. It is clear not all households want those responsibilities, which is why there always will be housing owned by investors who will provide those services for a price.

Robert G. Sheridan is the executive vice president of Canandaigua National Bank and Trust and the president of CNB Mortgage Co. He can be reached via e-mail or at (585) 394-4260, ext. 36097.