Trust but Verify (Part 1)

During President Ronald Reagan’s terms as our President, he used the phrase “trust but verify” quite often in his foreign policy discussions concerning the Soviet Union. Soviet Premier Mikhail Gorbachev noted Reagan’s use of the term while they were signing the INF Treaty in 1987. While President Reagan’s use of the term to describe our future engagement with the former USSR made it famous in modern political terminology, Russian revolutionary Vladimir Lenin is also credited with using the term frequently as well. How interesting it is that the modern leaders of the free and communist worlds would both find favor with this phrase.

You might wonder why I’m discussing nuclear arms and international politics on a blog focused on mortgage collateral. Well, bear with me as I certainly hope to get there.

Leading up to the downfall of the mortgage industry, you read where Warren Buffett referred to certain mortgage-related derivative investments as thermonuclear devices. Today, in hindsight, we understand more about his fear. Without getting into great detail, our marketplace bet heavily on subprime and Alt-A mortgage (first, second and HELOC) instruments. These loans were eventually bundled after closing into residential mortgage-backed securities (RMBS), collateralized debt obligations (CDO) and a number of other synthetic investment vehicles.

As we know now, many of the funds used to invest in these obligations were highly leveraged, as were many of the underlying assets. The investors in these vehicles also lacked clear transparency into what they were actually buying. They couldn’t really see the underlying collateral. Once the market headed south and people stopped paying their mortgage obligations, the risky funds began to collapse right along with the mortgages, sending shockwaves and fear throughout the marketplace.

While much of the country and world didn’t see the beginning of the market collapse until the summer of 2008, there was clear evidence it was coming in 2007 when many mono-line mortgage originators began losing their credit lines and closing up shop. So what have we learned in the nearly four years since this all began to snowball? Most people clearly believe that our industry was a bit better off with clean separation between commercial banking (where mortgages are typically originated) and investment banking (where investment vehicles are created).

We’ve seen no substantive changes here. There are now higher capital requirements, but many believe that these requirements are still not high enough. A bit more regulation and review is moving back into the system, although we don’t yet know the full impact of these actions. But, looking back, history tells us that regulations will ease as the market settles.

Ultimately, it still takes two numbers to make a mortgage loan. First you have to have a good-to-excellent credit evaluation on the borrower. Secondly, you must have a solid valuation placed on the real estate collateral by a reputable and knowledgeable appraiser. This evaluation must not only be reliable but verifiable by underwriters, reviewers and other third parties.

During this last lending cycle, many believe that these two data points were manipulated to manufacture more loans for the investment pipeline. In hindsight, we understand that this manipulation occurred in too many cases and we lost or lacked transparency in the quality of these loans as they traveled upstream through the investment channels. For example, most investors in any RMBS had limited knowledge of the location and quality of the homes used for collateral in the loans making up their investment. Now, as these investments are worked out and wound down, obtaining better collateral information is a chief objective of many investors.

Check back tomorrow for Part 2 of this post.

Director of FNC Consulting Jon T. Fisher has developed process solutions for his clients in technology and real estate for 25 years.