Mouth 2 Mouth

There are many factors that have contributed in creating a crisis in the credit markets.  We haven't seen the end yet, we're still learning about what created the problems we're facing now.

This system of loan origination is highly organized, and more recently some investment products were created that allowed financial institutions to more efficiently move mortgages into secondary markets and off their books.  The result was that lenders became more interested in originations than they were in creating quality products.  Fed Governor Frederick Mishkin calls it "the originate-to-distribute model."  

"The originate-to-distribute model, unfortunately, created some severe incentive problems, which are referred to as principal-agent problems, or more simply as agency problems, in which the agent (the originator of the loans) did not have the incentives to act fully in the interest of the principal (the ultimate holder of the loan).  Originators had every incentive to maintain origination volume, because that would allow them to earn substantial fees, but they had weak incentives to maintain loan quality. " Governor Mishkin 2/29/08

A memo circulating through JPMorgan Chase entitled "Zippy Cheats & Tricks"  ended up in the hands of Oregonian reporter Jeff Manning.  The memo explains how to push loans through the company's automated underwriting system, essentially encouraging fraud.  Manning it's unclear how widely the memo was circulated, but it does provide a piece of evidence supporting an issue I've been talking about for some time, and exactly what Governor Mishkin was trying to explain.

While loan submissions do have to be put together to fit specific loan products, suggestions from the memo like "Remove any mention of gift funds" asks the reader to commit fraud. While a lender rep might instruct a broker on how to structure loan submissions to fit a particular loan program,  I believe there was a fuzzy line between putting together a package that fit the program, and putting together a loan package that shouldn't have made it through they system in the game to bypass program guidelines enforced computerized (automated) underwriting systems and human underwriters.

Due to the interconnected nature of the loan industry, the effects from memos like these wouldn't have been restricted to JPMorgan Chase, these types of ideas would have been disseminated to all institutions from the top, and laterally.  As bank employees and brokers picked up practices from one institution, they could communicate them to others and take them with them as the changed jobs (which occurred often as the jobs in the mortgage industry boomed).  This is how I believe these and other "Cheats & Tricks" affected many institutions.

The resulting loans wouldn't meet the requirements for the packages they were bundled in.  Subsequent ratings would be meaningless.  This leaves us today with no idea what potential performance to expect from specific mortgage backed investment products.

This is not the only reason we are facing issues today.  High rates of leverage, dissaggregation, rapid (miscalculated) inflation are among many factors contributing to this credit crisis.  I suggest however, that this cheating contributed to increasing the volume of mortgages that currently are souring the performance of and investor confidence in credit markets.

Jeff Manning"Chase mortgage memo pushes 'Cheats & Tricks" The Oregonian 3/27/08 via Calculated Risk