Until the 1970s borrowers had to pass one-on-one detailed scrutiny by bank officers. Since then the trend has been to treat bank lending like a computer game: an abstract manipulation of numbers, unattached to the character and economic circumstances of the borrower. Federal banking regulations can’t prevent the new fiascos awaiting us at the hands of computer-jockey bankers who don’t understand business and lack judgment that comes only with extensive experience.
These earlier posting on this website complement the Wall Street Journal opinion piece reproduced below.
Transition in Banking
Fiduciary Responsibility and Judgment vs. Caveat Emptor
From Personal to Colossal
Case Study: Fed-Induced Speculation
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The Trouble With Robo-Lending
There’s a lot to be said for bankers knowing their customers. Too bad the financial reform bill does nothing to restore that tradition.
By AMAR BHIDÉ
The scandal of the improper handling of foreclosures won’t go away. GMAC Mortgage and J.P. Morgan Chase are investigating whether their employees engaged in practices such as the “robo-signing” of foreclosure documents, falsely asserting that they personally reviewed the details of each case. The Federal Reserve has announced its own “intensive review.”
Illegal repossessions are deplorable. But it is also time to confront the long-term problem of robo-lending that led to the robo-foreclosures.
Traditional mortgage lending was based on on-the-spot decision making. Bankers would evaluate mortgage applications taking into account what they knew about the applicant, the property and the local market, and after talking to borrowers to ascertain their beliefs and intentions. Staying in touch afterward facilitated judgments about adjusting terms, if that became necessary. Foreclosing without knowledge of the specific circumstances was out of the question.
But high-touch gave way to high-tech. Statistical models that took no heed of specific circumstances replaced the bankers’ on-the-spot judgments. The use of models also facilitated securitization. Investors could know precisely the values of all the variables (such as the borrowers’ credit scores) for every mortgage that was securitized and didn’t have to worry about the poor judgments of lending officers. Mass production ensured a dependable, high volume supply of the raw material needed.
Giant data-processing factories collected and passed on mortgage checks and took responsibility for foreclosures if borrowers couldn’t pay. And when the housing crisis hit these thinly staffed operations were trapped between their contractual obligation to security holders to foreclose and the legal requirement for case-by-case review. Robo-signing was an almost inevitable result.
Advocates of high-tech finance continue to applaud judgment-free lending as an advance comparable to Henry Ford’s assembly line. Models, they say, reduce the costs of making lending decisions. Making it easy to securitize mortgages also helps investors diversify. And because diversification reduces investors’ risks, home buyers can borrow more cheaply.
In fact, the mass production of consumer loans isn’t like the mass production of consumer goods. Robo-lending and the securitization it facilitates lead to the misallocation of capital and economic instability. In models used to assess creditworthiness the income of an employee of an auto plant scheduled for closure is indistinguishable from the income of a federal judge. Moreover, not all lending can be easily mechanized. Arguably small business lending has been neglected because it is harder to mass produce than housing loans.
When many lending officers make independent case-by-case decisions some will inevitably be wrong, but these mistakes usually don’t imperil the economy as a whole. When all lending is based on nearly the same model, few can escape its defects. The easy diversification of securitized loans can engender carelessness and unwarranted complacency.
It used to be an article of faith that housing prices in different local markets were uncorrelated, making geographically diversified portfolios of mortgages bulletproof. But they weren’t. Quite possibly because as investors learned to treat housing as a single asset (and credit was extended using a national model) prices in different markets began moving in tandem.
Requiring lenders to exercise on-the-spot judgment is long overdue. The growth of mechanistic lending was fostered by government sponsored agencies that underwrote the risks of mortgage-backed securities that conformed to certain criteria but did not require lenders to exercise case-by-case judgment. As banks abandoned the case-by-case approach to lending in favor of centralized models, so did their examiners. Instead of scrutinizing individual loan files, regulators turned to one-size-fits-all capital requirements.
Mechanistic lending and mechanistic regulation has demonstrably failed. Today, like it or not, the government has become the guarantor of virtually all the obligations of the banking system, not just housing loans. It therefore owes a duty to taxpayers to demand that bankers take the time to know their borrowers and not merely plug a few numbers into their models.
Unfortunately, policy makers continue to do everything they can to bring mass-produced credit back to life. The 2,300 page Dodd-Frank financial reform law mandates a slew of new rules and regulatory bodies but does virtually nothing to reinstate old-fashioned borrower-by-borrower banking prudence that is essential in a dynamic, unregimented economy.
Mr. Bhidé, a professor at the Fletcher School of Law and Diplomacy, is the author of “A Call for Judgment: Sensible Finance for a Dynamic Economy” (Oxford University Press, 2010).
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