The recent financial crisis has had enormously harmful impacts on employment, the housing industry, consumer income and indeed the whole economy. This crisis resulted primarily from inadequate mortgage underwriting.
The last clear chance to avert disaster was detection in the examination process of the toxic mortgages banks were originating, whether or not they had already sold these mortgages.
How could examiners have missed the multiplicity of loans to borrowers with little or no skin in the game, and or with unknown or unbelievable incomes? How about the mortgages with potential for negative amortization and dramatic, unaffordable payment increases?
I don't think the explanation for this is gross stupidity, carelessness or crookedness on the part of examiners and supervisors. A much more plausible reason for their dramatic and universal failure is that Congress has mandated regulators to do far too much.
And in the aftermath of the crisis, Congress is continuing to add to the volume of rules to be enforced, without proportionately increasing the number or the competence of the examiners.
An examiner who aims to enforce equal opportunity lending, the U.S. Patriot Act, employment diversity, the Card Act, Reg E prohibitions, the Community Reinvestment Act, the Fair Credit Reporting Act, and the increasing multiplicity of other regulations allegedly intended to protect consumers—this overburdened examiner won’t be spending much time looking at asset quality. He has too much else to do.
And after all, the "A" for Assets — all assets together, not just mortgages—accounts for only one sixth of "CAMELS." But if too many of the assets stink, then requiring a few percent more equity or assuring otherwise brilliant management won't change the outcome: failure.
Assets are more important than any other determinant of bank solvency. They decide whether the FDIC will lose 5% assets, or its more usual one-third.
Here is a firm foundation to build upon. The FDIC has a sincere, even a burning desire to minimize losses to the deposit insurance funds. It's fair to say that this is the agency's top priority. However, the megabanks that caused most of the damage tend to be supervised primarily by others, the Federal Reserve or the Office of the Comptroller of the Currency. These agencies are focused on different issues and are executing multiple and diffuse agendas. Congress has further expanded and hence confounded and diluted their responsibilities and focus.
It's perhaps understandable that OCC and Fed examiners didn't ask: "What if home prices stop going up?" It's unforgiveable that they didn’t notice inadequate or badly appraised collateral — or the absence of any reason for a non-resident borrower with three homes in the same city to make payments if he couldn't continue to flip the houses rapidly. They didn't bother to check whether banks were selling mortgages with warranties and representations that were unverifiable or patently false.
Prudential regulators must judge the prudence, the sustainability of lending strategy and its execution, not just compliance with a myriad of specific rules. This requires sampling of actual loan files.
The more complicated the rules and the greater the multiplicity of rules, the greater the chance that they'll miss the mark and elicit counterproductive, expensive, evasive responses. Poorly managed regulatory implementation even of seemingly simple and common sense new rules results in contradictory nonsense, as in Durbin and credit card ability-to-pay. This growing heap, this tower of rules utterly overshadows the most fundamental rule of banking, which is to focus unwaveringly on asset quality.
Now that Congress, the President and even the general public have bought into splintering the regulation of banks so that they can receive different pokes from different folks, with additional specialized agencies focused on churning data and avoiding crises—it is time to bring on one more team of specialists. Perhaps the only one that will really matter.
Let's have examiners who focus single-mindedly, relentlessly on asset quality and on contingent liabilities for assets sold. Who should do this? How about the FDIC?
Revolutionary? Fifty years ago the response would have been "But, that's already the most important duty of every single bank supervisor." Since then, this fact has been buried under the additional mandates—with several hundred rules still to come. Of the new regulations elicited by the crisis, not many aim to deter bad assets.
We need urgent progress towards a more pointed and reliable asset examination process — not a wacky debate about Qualified Residential Mortgages, safe harbors and the alleged need for the megabanks to be internationally competitive. Competitive with whom? The Spanish banks? The British banks? The Chinese banks? They all share the same fatal defect: bad assets.
Andrew Kahr is a principal in Credit Builders LLC, a financial product development company, and was the founding chief executive of First Deposit, later known as Providian.