**Forgetting the Three Cs of
Lending **

At its core, lending is a simple business. Its goal is to provide money to people and then to be repaid with a profit. From times immemorial, prudent banking granted loans according to three main principles:

1) Credit and character – The borrower had to have a track record of having met his obligations and be considered trustworthy.

2) Capacity – The borrower had to be able to pay the debt from existing income.

3) Collateral – The value of the collateral had to exceed the loan balance.

The financial crisis of 2008 is a crisis of structured loans that violated, to varying degrees, all of the above principles; particularly the second. As a result, U.S. and foreign financial institutions now hold large portfolios of promises that can no longer be credibly valued. How were these portfolios valued in the first place? We describe a very abstract statistical model that the rating agencies did not, as it turned out, consistently apply. The following discussion is for our readers who are curious about the nature of the investments at the heart of this financial crisis.

In 1996, Moody’s published a report called, “The Binomial Expansion Method Applied to (Collateralized Bond Obligations and Collateralized Loan Obligations)”. The paper utilized the binomial statistical model to estimate the expected losses and therefore the credit ratings of various structured mortgage tranches. The binomial statistical model is a way of handling a series of discrete observations, such as a given number of loan defaults within a mortgage pool. As the number of loans becomes large, the probability of having a given number of defaults converges to the probability given by the bell-shaped Gaussian distribution. The Moody’s paper promised that “(the) Binomial Expansion Technique...combines the best of two worlds: a high degree of accuracy coupled with computational friendliness…” All quantitative models, however, are only as good as their assumptions. Our comments on this report are in italics.

The BET Finally, as far as defaults are concerned, the behavior
of this homogeneous pool of D assets

*(binomial expansion technique)* method is
based on the diversity score concept. *(This merely says that as the
number of cases increases, the probability of defaults decreases due to
some diversification.)* The idea is to use the diversity score to build
a hypothetical pool *(as it turned out very hypothetical, that had not
much connection with reality)* of uncorrelated *(subprime mortgages
were very correlated with the trend of housing prices)* and homogeneous
assets *(the assets were homogeneous because they weren’t structured to
the situations of the borrowers)* …that will mimic *(they hoped)*
the default behavior of the original pool…*(that’s all the diversity score
was)* can be fully described in terms of D possible scenarios: one
default, two defaults…up to D defaults. The probability **P _{j}**
that scenario j (j defaults) could happen can be computed using the
so-called binomial formula:

*(we
summarize)* **Pj** =
f(D, j, p)

(D= the number of cases, j is the number of defaults, p as defined below)

Where p represents the weighted average probability of
default of *(any particular mortgage in)* the pool…*(This assumption
was based on historical experience.* *The concept of an average
default probability of any particular mortgage was likely a meaningless
concept, since there was an increasing trend of bad mortgage underwriting
in 2006 and 2007).*

Let **Ej** be the loss for the note to be rated under
scenario j. (The loss, expressed as a percentage, can be easily computed by
taking the present value of the cash flows received by the note holder,
assuming there are j defaults, and using the note coupon as the discount
factor).

Finally, the total expected loss, considering all possible default scenarios, is calculated as follows:

D

Expected Loss = Sum **P _{j}E_{j
}**

j = 1

* *

*(Banks have loan loss reserves. But loans should not
be approved without the justified expectation*

*of repayment, because otherwise reality is guaranteed
to exceed. We also note that financial institutions *

*are highly leveraged.)*

The structured finance ratings methodology contained unrealistic statistical reasoning that was inappropriate to the billions of dollars squandered. According to this methodology, the probability of a large number of simultaneous mortgage defaults in a large portfolio was very small, essentially following a Gaussian distribution. But the underlying loans were not made according to the three simple lending principles above. With the collapse of the Gaussian convention, there is now no accepted way to value large portfolios of problem subprime and Alt-A loans except by analyzing each loan individually, renegotiating if necessary, then simply summing their totals - when house prices stabilize. Call this belated due diligence that now has to occur at the loan servicing level.

We were curious about how these portfolios were valued. The analysis above allows us to trace present financial problems to faulty loan underwriting and deal structure. To say that large portfolios of subprime and Alt-A mortgages cannot be valued is not to say that the individual mortgages are valueless. Some of the mortgages will pay as agreed, others can be renegotiated and restructured.* However, a blind faith in financial risk models that assumed a fairly placid Gaussian market is at the root of the financial crisis of 2008 - when the real markets proved otherwise.

“It is hard for us, without being flippant, to even see
a scenario within any kind of realm of reason that would see us losing one
dollar in any of those transactions.” A Former Structured Finance
Executive August,
2007 “We foolishly believed that the firms had a strong
culture of self-preservation and responsibility and would have the
discipline not to be excessively borrowing…Letting the firms police
themselves made sense to me because I didn’t think the S.E.C. had the staff
and wherewithal to impose its own standards and I foolishly thought the
market would impose its own self-discipline. We’ve all learned a terrible
lesson…” Professor James D.
Cox Duke School of
Law The banks that structured the securities and investors
both failed to do “fundamental credit analysis,” said Janet Tavakoli… “They
were using correlation models, they were using spread models, but they
weren’t doing analysis on the underlying corporations (borrowers).” Bloomberg October, 2008

* We do not comment upon the CBO/CLO derivatives that also bedevil the financial system.

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