Monday, May 07, 2007

Could New Century Have Stopped?

When I bought my current house, I told my wife that it may take us several years to make good money from our investment. I reasoned that the housing market had moved so fast, interest rates were very low, and supposedly many borrowers were getting approved based on teaser rates. Rates were likely to rise and lending standards to strengthen, both of which would put pressure on the housing market, probably leading to a few years of near-zero real returns on housing. That was in 2001.

We all know I wasn't alone in worrying about the housing market years before problems started actually cropping up. Given this, why did mortgage lenders keep lending at a breakneck pace? After all, the senior managers at a mortgage lending firm have probably been in that business for a long time. They should know well the cyclical nature of the business, and also be well
aware that weak lending standards tend to lead to pain. Why not pare back your business and wait for better times? Particularly with sub-prime lenders. Why didn't they increase lending standards, even if that meant losing business in the short-run, believing that it would allow them to survive when the pendulum swung the other way?

The cynic would say they just tried to make as much as they could while times were good. The executives knew that stock and bond holders would wind up holding the bag, while they withdrew as much cash as possible. I'm not going to disagree with this view. But I don't want to turn this into a post about the principal/agent problem in public companies. That's a topic well
covered in other spots.

I'm here to say that mortgage lenders like New Century really couldn't have stopped making loans, no matter what their outlook was and no matter what their ethical tendency was.

First, consider what would have happened had New Century's management decided to severely cut back their lending? First, it depends when they decided to do this. What if they did it way back in 2001, when I was worried about housing? Or even 2002 or 2003? The management team would all be fired within a year or two, because sub-prime continued to perform extremely well, and New Century's stock would have dropped compared with competitors.

On top of that, New Century has warehouse loans and other liabilities. It is likely that getting out of those liabilities was impossible and/or very expensive. In addition, they had payroll. If they pared back lending, they'd wind up laying off large numbers of staff. But that would have meant that when things turned around, they wouldn't have the staff in place to take advantage of the turnaround.

Its no different than mutual fund managers who kept buying tech stocks in the late 1990's, while admitting they thought the shares were overvalued. Or, I suspect, bond managers buying high-yield today. Its very very very very hard for managers to walk away from their core business, no matter what their outlook.

4 comments:

david andrew taylor said...

I think like most businesses, these lenders were very attracted to the short-term money being made without regards to the long-term outlook. It wouldn't really be their problem. I also bet a lot of these lenders moved on from their current positions. So, in effect, what do they care?

Anonymous said...

The "Good German" argument brought up to date. I like it.

Deborah said...

I did a post on mortgages, not from the perspective of the companies giving the mortgages, but the return on investment, I guess, sort of.

http://makingsenseofmyworld.blogspot.com/2007/05/low-interest-rates-as-destructive-as.html

w said...

I fully agree with you. It's a matter of businesses following trends not about rational reasoning. Businesses actually have no choice. It also explains why business cycles always go extreme either way (boom/bust). I can give you another example. Back in late 90's, Nortel would spend 5 billion worth of stock to buy a company that hadn't had a working product. The CEO, John Roth, later confessed (I paraphrase): "either we die at that time (by not buying startups therefore seeing their shares drop) or die later (when the bubble finally burst)". In other words, Nortel had no choice at that time. Actually, it's much less risky to do the same stupid things other are doing, because you won't be singled out. Keynes said it best: "A sound banker, alas, is not one who forsees danger and avoids it, but one who, when he is ruined, is ruined in a conventional and orthodox way along with his fellows, so that no one can really blame him".