Monday, January 19, 2009

Why Did WAMU Abandon Underwriting Standards?

It was just disheartening,” said Sherri Zaback, a mortgage screener for Washington Mutual. “Just spit it out and get it done. That’s they wanted us to do. Garbage in, garbage out.

This quote, from an excellent piece in the New York Times, epitomized the loan underwriting process which prevailed not just at WAMU, but at all the major players (Countrywide, Indymac, etc.) which have crashed and burned.

Why did this happen?

To differentiate itself and capture market share, a lender needs to be more attractive than its competitors in one or more of these dimensions:

  • Price Factors - Interest Rate/Loan Fee, Processing Costs
  • Leverage - Loan-to-Value, Income Ratios
  • Credit Standards – FICO Scores, Prior bankruptcy and foreclosure history
  • Terms - Loan term, Amortization, Payment adjustments (for variable rates), Recourse, Escrow requirements
  • Ease of Execution - Documentation to be completed, Accessibility to lender personnel
  • Speed of Execution - Application, Rate Lock, Closing
  • Certainty of Execution

By the early 2000s it had become more and more difficult to differentiate performance. With the advent of securitization, all lenders had access to the same pool of investor money and interest rates were very uniform. Leverage, credit standards, and terms were all a function of the rating agencies’ default models, and the lenders competing for market share all adopted the most aggressive levels permitted by these models. So, competition among the most aggressive lenders devolved to execution – how fast, easy, and certain they could deliver the loan.

The genius of WAMU and their ilk is just this – if you don’t ask any questions, your lending process becomes very fast, easy, and certain.

If you don’t ask for documentation, it’s easier for the borrower, you don’t have to spend time reviewing it, and there’s no chance it will disclose something that will prevent the loan from being funded (as Calculated Risk calls out, "A Thin File is a Good File)." Even better, you don’t have to spend money on staff to review documentation and ask questions about it, so your processing cost goes down.

If the documentation you do get (for example, a credit report) turns up a problem (for example, a fraud alert), look at the consequences. An underwriter has to look at the file (which costs time and money). They probably have to ask questions of the borrower (more time and money, the ease of execution goes down, the uncertainty of execution goes up). You might even end up turning down the loan, so all that time and money is wasted, the borrower and loan broker are upset, and your failure to execute may lead the broker to direct business elsewhere. Much better to just ignore that fraud flag (read more in this great post from Tanta).

So, these institutions saved a lot of time and money and built good reputations with their fast, easy, and certain executions. The irony is their reputations are destroyed and their successors are spending vastly more time and money cleaning up the mess.

More highlights and good commentary on the Times article at Option Armageddon, The Big Picture, and Naked Capitalism.