Post-Crisis and Below Average: A Financial Sector Report Card

SMITH BRAIN TRUST – The Smith School's Clifford Rossi remembers pacing his office in a 41-story office tower in Midtown Manhattan, watching Citi’s stock price plunge again below $4 per share and thinking that it appeared to be teetering on the brink. The stock had lost nearly 70 percent of its value that week, nearly 90 percent since the start of the year.

It was November 2008, and he was chief risk officer for Citigroup's Consumer Lending Division, overseeing the risk of the bank’s $300 billion secured consumer asset portfolio. Wall Street was in the grips of the worst financial crisis since the Great Depression. The crisis had brought down investment bank Lehman Brothers, was crippling many of its U.S. peers and was shoving the global economy into a deep recession.

“We were, all of us, at the precipice of an almost cataclysmic disaster of monumental proportions,” he says of that period, now a decade ago. “This may sound like hyperbole, but it is not.”

In the intervening years, Rossi left Wall Street and took up residence in academia. He is now a professor-of-the-practice and executive-in-residence at the University of Maryland’s Robert H. Smith School of Business, teaching about corporate risk and banking and how to manage both. Among other things, he teaches advanced professional development programs designed for senior risk management professionals in the banking industry. The subject, he says, has never been more relevant.

As the 10-year anniversary of the crisis approaches, Rossi is taking a close look at the financial sector, evaluating what appears to have been learned. “A lot of things have changed,” says Rossi. “A lot of regulation has come along. But there are still a lot of things that are problematic about the next boom cycle.”

So he’s writing the financial sector’s report card.

Upholding Standards in Lending Practices; Avoiding Subprime: B-minus

Some worrying trends are beginning to emerge again in mortgage issuance. California-based Carrington Mortgage recently announced a move into what it is calling “non-prime.” Rossi calls it “a nice way of saying ‘subprime.’” He’s noticed a shake-out in the industry where commercial banks have ceded market share to so-called nonbank lenders that have “very little” regulatory oversight. “When we see TV ads today promoting Rocket Mortgages, for example, I wince a bit,” Rossi says. He points also to Angel Oak Capital, which is beginning to issue mortgages for securitization that have characteristics that appear riskier than those that Fannie Mae or Freddie Mac would buy. “It’s not a lot of the market that’s doing this. Not at all,” Rossi says. “But these things are starting to trickle back. And a lot of people are telling me about a loosening of standards that is beginning to happen.”

Underwriting Practices; Asset Appraisals: B 

“Right before the crisis, when loan demand was approaching its peak, we had instances of bartenders who were underwriting loans,” Rossi says. “Today, we have people who are actually qualified underwriters doing that work.” Today’s loans seldom include any kind of rule exception – an unconventional salary history, for example, or a borrowing limit that doesn’t match the borrower’s income. Such exemptions were commonplace before the crash. However, Rossi says, there are signs that lenders are relaxing on some important lending criteria, such as borrower debt-to-income ratios.

In the past, Fannie Mae and Freddie Mac would require a full, in-person, qualified appraisal on a home loan. During the housing boom that preceded the crisis, however, appraisals were frequently overvalued, in large part due to pressures from lenders who were caught up in the flipping, building and buying frenzy. After the crisis, appraisals were held to a stricter standard, with banks closely scrutinizing home-price estimates that seemed overly generous.

Now those standards are beginning to loosen, Rossi says, and some firms are beginning to allow automated estimates more often for determining home values, with no human appraiser involved. “While these appraisal models have their place in the process, we need to maintain balance between the human aspect and the machine, particularly with many housing markets considered to be overvalued” Rossi says.

Risk Governance: B+

In governance and risk, some important, positive steps have been taken, Rossi says. At the biggest banks, there are new requirements for having board committees that oversee risk. More and more, chief risk officers report to the boards of directors in some capacity. “And that’s good governance,” he says. However, even today we see cases where companies aren’t doing enough to tamp down risk, Rossi says. It’s evidenced in some of the scandals that have emerged recently at such banks as Wells Fargo. 

Financial Regulation: C+

“Ten years after the crisis, one would expect this to be a pretty stellar grade,” Rossi says. It’s not. In some areas, regulations amounted to overkill, Rossi says, while other areas were left virtually untouched. 

Reducing Risks; Boardroom and C-Suite Review: C-

At many large financial institutions, the CEO and chairperson of the board is too often the same person. “As institutions, we need to do more to truly reduce the conflicts of interest between management and shareholders,” Rossi says. “That just hasn’t been done.” One of the biggest deficiencies Rossi sees on bank boards is their relative lack of direct experience and understanding of bank risks.   

Creating Qualified Mortgages: B

The government now sets minimum standards for mortgage quality for mortgages. “That’s both good and bad,” Rossi says, “because the government doesn’t know what should be called a ‘quality mortgage’ any more than the man on the street does.” At the same time, the industry failed to police itself and so bears a good deal of responsibility for the amount of regulation that came after the crisis.

Credit Ratings Agencies: F

The failure to impose rules that would eliminate ratings agency conflicts of interest, he says, is a “glaring oversight.” Ratings agencies continue to be paid by issuers of securities, even after the crisis revealed that the agencies often overvalued and under-scrutinized assets. “That’s a problem. And nobody has done anything about it,” Rossi says.

Regulatory Capital Requirements: B+

Increased capital requirements for financial institutions would become one of the most conspicuous changes that resulted from the crisis. “Higher capital requirements were a good thing, but I think we maybe have gone over the edge on that,” Rossi says. “There is a point at which you can impose too much capital on banks which severely restricts lending activity . It is a fine line.”

Loan Manufacturing Quality: Incomplete

Although most institutions have improved their operational controls since the crisis, Rossi says he can’t give an ‘A’ grade in the subject, which covers the people, processes and technology required to actually administer a loan. “We simply won’t know until the next crisis how good an effort they made,” he says.

Modeling Risk/Retention Requirements: B+

The risk-retention requirement, or “skin in the game” rule, was said to be the most important part of the Dodd-Frank regulatory overhaul. It stipulated that companies that package most type of loans into bonds must keep on their balance sheets at least 5 percent of the securities they create. Rossi says the requirements have been implemented by the SEC on asset securitizations following the Dodd-Frank Act requirements. “Firms absolutely need to own some risk and be in some first-loss position,” he says. “And it has to be meaningful.”

Overall, it’s not a terribly impressive report card, Rossi admits. “We have absolutely come a long way in many regards,” he says. “But in other respects, we’ve learned nothing.”

In 2018, home prices have mostly clawed back to where they were before the crisis. Several markets – Denver, San Francisco, Washington, D.C. – are hot again and home-flippers are busier and busier. Meanwhile, a robust economic environment and relatively low interest rates are helping to pump up real-estate markets. And Rossi sees an environment that could become a catalyst for another mortgages “mini-boom.” Moreover, Rossi is most concerned about industry turnover and its effect on risk-taking. Rossi sees a lot of new faces in the industry who have never experienced a boom or bust cycle and that is worrisome. “There is a tendency to repeat history unfortunately because we all suffer from a bit of myopia when it comes to how we view markets and risk.”

“Are we better than we were before 2008? Yes, way better,” he says. “But when I look at where we might be going at this point in time, a decade after the crisis, I would say be careful. I’d say be very careful.” 

He warns of a potential “creep” that he says is starting, with some companies contemplating new ways to dip a toe into subprime and thinking about new securitizations of assets. “It gives me pause, and makes me think, ‘This is a changing environment,’” he says.