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Saturday, July 14, 2012 4:01 PM

Reader Questions on "Credit-Worthiness": Did Banks Give Mortgages to Non-Creditworthy Borrowers?

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I received several emails from readers regarding Can Bernanke Force Banks to Lend by Halting Interest on Excess Reserves?

Here are the specific sentences in question:

Banks lend if and only if both of the following are true.

  1. They are not capital impaired
  2. They have credit-worthy borrowers willing to borrow.

Reader Gil writes ....
Hello Mish
I must take exception to #2.

Did the banks not lend to anyone that walked through their doors just a few years ago without asking questions and without income to repay the loans?

Yes, I know the Fed “forced” them to do it, but ....
Any thoughts on that?

Thanks, Gil
Meaning of "Credit-Worthy"

For starters let's quickly discard the notion the Fed forced banks to lend. The Fed has no such power. If the Fed did, there would be more lending now.

My statement of lending conditions above are accurate. It all depends on the meaning of "Credit-Worthy".

All I meant is banks thought they would be repaid. More accurately, banks extend credit if they think loans will result in profits.

Did Banks Give Mortgages to Non-Creditworthy Borrowers?

Certainly banks do not lend if they expect losses.

Recall that banks did not believe that people would walk-away! It had never happened before. People historically paid their mortgage before paying credit card bills. There was much discussion of this before it happened.

I predicted mass "walk-aways", banks certainly didn't.

Five Reasons Banks Extended Credit in Housing Bubble Years

  1. [Banks thought] People would pay mortgage loans because they always did
  2. [Banks thought] Housing prices would rise sufficiently to cover defaults
  3. [Banks thought] Mortgage interest rates to subprime borrowers were high enough to cover risk 
  4. [Banks thought] Defaults would happen over a long period of time, not quickly concentrated
  5. Banks could pass the trash to Fannie Mae and Freddie Mac (without clawbacks for non-performance), and/or loans could be sliced and diced in tranches to investors

If any of those conditions were true, then banks were indeed making loans to "credit-worthy" borrowers. Subprime borrowers did pay a huge penalty rate. Multiple combinations of the above five points are likely.

Huge Mistakes Coupled With Greed

Banks made huge mistakes because all five conditions above failed, far sooner than banks or the Fed expected. Recall that Bernanke did not believe there was a housing bubble at all!

Thus, at the time, banks thought they were making creditworthy loans.

They thought wrong, in a big way, and they were very greedy as well. Greed coupled with poor thinking is a very bad combination.

What About Now?

Banks are not lending now for three reasons

  1. Banks are capital impaired
  2. Banks are worried about being repaid
  3. The relatively small pool of credit-worthy borrowers who banks would lend to right now, do not want credit

Stunning Change in Attitudes

Another way of looking at the five points pertaining to the "housing bubble years" is there has been a stunning change in attitudes regarding how banks perceive "credit-worthiness" as well as a stunning change in willingness of consumers to go deeper in debt.

Conclusion: Then as now, banks only lend to customers they think are credit-worthy.

However, Attitudes on what it takes to be "credit-worthy" have changed.

Attitudes are the key to understanding this apparent conundrum.


Reader David wants to emphasize point number 5 ...
Hello Mish

Please emphasize that in the mortgage bubble, banks did not lend for the most part, they originated. Thus creditworthiness was not a factor since the agents who would face most of the losses were not banks, they were instead Fannie/Freddie, investors of MBS paper and especially investors of structured MBS paper and CDO's.

The banks themselves only held inventory of super-senior paper which they expected had enough cushion to absorb any losses. Moreover, the banks held this paper off-balance sheet in SIV's and other conduits which technically were separate from the bank.

Thus the loan-origination process asked not whether the borrower was credit-worthy, it asked only whether that loan could be sold on for a profit.
Point of note: For purpose of clarification I added the words [Banks thought] to the above five points.

David is clearly correct.

So I wish to reiterate ... If banks think they will make enough profit to compensate for the risks they take, then they make loans.

If they think they will make adequate profit on the loans, then by definition, they think they are making credit-worthy loans.

Of course, as I pointed out, what banks thought would happen and what actually happened are two different things. Regardless of what did happen, banks thought they were making credit-worthy loans.

Banks did originate tons of garbage (on purpose), but only with the intent to immediately pass the trash, not to hold the loan. The distinction is extremely important.

Mike "Mish" Shedlock
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