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Beating Zippy

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Friday, Mar 28, 2008

Sorry for the hiatus—was busy moving. But it’s been business as usual in the lending industry: This story from The Oregonian, details the tricks used to circumvent Chase’s automated underwriting system, Zippy. It lays bare through one particular example how we have ended up in this full-blown credit crisis.


Chase, the nation’s second-largest bank, originates mortgage loans itself but also operates a wholesale arm that underwrites and funds loans brought to them by a network of mortgage brokers. The “Cheats & Tricks” memo was instructing those brokers how to get difficult loans approved by Zippy.
“Never fear,” the memo states. “Zippy can be adjusted (just ever so slightly.)”
The Chase memo deals specifically with so-called stated-income asset loans, one of the most dangerous of the mortgage industry’s innovations of recent years. Known as “liar loans” in some circles because lenders made little effort to verify information in the borrowers’ loan application, they have defaulted in large number since the housing bust began in 2007.


The story is always the same. No one—not the borrowers (who wanted a house), the mortgage brokers (who wanted their cut for getting the loan made), the banks who supplied the money (who wanted to sell the loans to Wall Street), or the Wall Street firms who repackaged the loans (who wanted more-enticing yields for the securities they made out of them)—wanted to interfere with the subprime lending, despite the obvious skepticism about the ability of the borrowers to repay. They were like tobacconists facing down the medical studies linking smoking to cancer. As Barry Ritholtz argues, “Anyone with even a modicum of experience in the mortgage industry will confirm the rampant disregard for lending standards and the corner cutting and shortcuts that were all but official corporate policy during the boom years. There was headlong rush to originate, process and securitize mortgages—and the ability to repay the loans be damned. (Predatory Borrowing my ass!)”


Martin Wolf, in an FT column, noted what Bernanke has come around to saying about subprime lending:


Ben Bernanke, Fed chairman, famously understated, described much of the subprime mortgage lending of recent years as “neither responsible nor prudent” in a speech whose details make one’s hair stand on end. This is Fed-speak for “criminal and crazy”.


Everyone seemed to countenance fraud, perhaps figuring that the fraudsters would come up with new frauds to keep payments coming in or that rising house prices would allow refinancing to keep up payments. Or maybe they wishfully believed that the fraud risks would be spread thin enough across the many, many securities derived from mortgages that they wouldn’t matter in the end. They would be lost in the shuffle. But it hasn’t worked out that way, because eventually everyone caught on to the counterparty risks because everyone knew all the tricks that everyone else was pulling because they were pulling them too—so banks stopped feeling comfortable about lending to other banks on the collateral they knew to be dodgy. Tyler Cowen asked the relevant questions last week:


Does herd behavior, combined with agency problems, make things worse?
Is it the standard story that everyone is afraid of the other trader’s knowledge?  Or can liquidity crises become more acute in a hyper-informed world?  We like to think: “market—trade—liquidity—good, etc.”, forgetting the Glosten-Milgrom point that liquidity often rests upon the presence of fools.  Informing the fools eliminates one business cycle problem but creates another.


It’s hard to fool people when everyone is trying to do the fooling.

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