Can Private Banking Prevent The Next Mortgage Crisis?

Jim Herbert has a better idea, one that could change the lending system nationwide. It’s an example of rational capitalism, and that by itself will scare a lot of people.

Herbert is a banker, but a banker with a difference. He heads First Republic Bank (NYSE: FRC), a leading private bank and wealth management company with assets of more than $45 billion. In 2014, Herbert was named “Banker of the Year” by the American Banker magazine.

Private banks are institutions which help the rich manage the burdens of great wealth with such services as financial education, wealth transfers and philanthropy. And while they may have relatively few clients, the clients they do have tend to reflect both clout and sophistication.

Herbert’s innovation is very simply an effort to hold loan officers accountable. It addresses a crucial issue in banking and many other industries as well, the problem of misaligned incentives.

Loan officers have traditionally be paid on the basis of such things as the number of loans they produce, their total value, their average value and their pricing. However, under Dodd-Frank, compensating loan officers on the basis of pricing — selling loans at premium prices when borrowers actually qualify for lower rates — is now illegal under rules banning so-called “yield spread premiums.”

The remaining traditional performance measures create a crucial imbalance because they compensate loan officers on the basis of production for a current period, say a quarter or a year. There’s no penalty for loan-term performance: If a loan goes bad a few years down the road that’s a problem for the lender or the investor, the loan officer has already gotten a commission.

Herbert wants to change the system and his idea is pretty simple: align incentives — and penalties with a “claw back” program.

First Republic, says the American Banker, “has a claw back policy in place that says if a loan goes bad within the first three or four years, loan officers will be the first to absorb the loss — even though loans themselves are approved by the credit department.”

The loan officer does not just lose the commission from the loan, Herbert says, but the bank will go back and seek four to six times the original fee.

Claw Backs For The Masses?
Because First Republic deals with a financially-elite clientele there isn’t much chance of a claw back — the magazine reports that over a four-year period the bank had four losses among some 2,500 mortgage loans. This is possible because the bank has tough underwriting standards and demands 40 percent to 50 percent down.

But would the claw back system work with other lenders, lenders who make loans to borrowers who are not at the pinnacle of the financial system?

There’s no doubt that as a matter economic self-preservation loan officers would be a lot more cautious and conservative if the penalty for error was real, visible and directly impacted the loan officer’s checkbook. The result would be far fewer mortgages and that would mean lots of yelling and screaming about “tight” credit from brokers and builders, individuals not taking a loss on failed loans.

And — to be fair — the First Republic system might go too far with retail lenders because the failure of a mortgage may have nothing to do with underwriting problems. For instance, if a company closes and an individual loses their job and is foreclosed that’s hardly evidence of poor underwriting. The same is true with a borrower who has massive and unexpected medical bills. Unlike the rich and famous clients who use private bankers, retail customers likely don’t have trust funds or massive wealth to off-set job losses or hospital bills. The rich can essentially hide current losses by dipping into assets — and protect mortgage loan officers when they do.

$15 Trillion
While the details would have to be refined for the average retail mortgage lender, Herbert is on to something with his claw backs because the country simply can’t afford another mortgage meltdown. According to Mark Adelson, chief strategy officer at The BondFactor Company and a former chief credit officer of Standard & Poor’s, a full and fair accounting of the mortgage crisis would show losses of as much as $15 trillion. And much of that loss, as Adelson explains, is directly related.

“Securities dealers started converting from partnerships to corporations in the 1970s,” says Adelson in his paper, “The Deeper Causes of the Financial Crisis: Mortgages Alone Cannot Explain It.”

“The trend continued through 1999, when Goldman Sachs, the last major securities firm in partnership form, converted to corporate status,” says Adelson. “The conversion meant that managers were no longer necessarily the firm’s owners. The separation of management from ownership gave rise to the classic principal-agent problem, especially when the firms came to have employees with responsibility for taking risks who did not also have substantial pre-existing equity stakes. These employees took risks with shareholders’ money. If the outcomes were positive, the employees reaped huge gains through incentive compensation schemes. If the outcomes were negative, employees’ downside was limited. They might get fired and have to get a new job, but their accumulated personal wealth was generally not at risk.”

While the lending system today is substantially less risky than before 2008, the possibility of increased risk looms in the future as standards change and new loan products are introduced. One way to brake such trends is to assure that loan officers and underwriters are personally responsible for mortgage outcomes — in essence, precisely what Mr. Herbert is doing at First Republic.

Will the Herbert plan spread to other private banks? Given big down payments and little risk the idea of greater loan officer accountability should be appealing to other private banks, if only to remain competitive with institutions such as First Republic.

For retail banks the idea is unlikely to spark much interest. A lender who proposed such a program would simply drive top loan officers to other firms without personal-accountability policies, lenders willing to let loan officers play by the old — and more risky — standards.

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