Risk-Averse Portfolio Lending. Throughout its 40-year history, Golden West was a risk-averse residential mortgage portfolio lender. Portfolio lenders keep loans on their books, suffer direct losses if loans do not perform, and therefore are incented to originate and hold high-quality loans in their portfolio that perform. Portfolio lenders also maintain a continuing relationship with borrowers and can work directly with borrowers who might be experiencing problems or need to modify or restructure their loans.
In a commoditized business like mortgages, with narrow profit margins, successful portfolio lending requires: (i) making good loans to reduce the risk of loan losses (known as chargeoffs), (ii) keeping general and administrative (G&A) expenses low, and (iii) maintaining sufficient capital to grow the business and provide a financial cushion during difficult economic cycles. These were all critical to Golden West’s strategy and operations. Read a chart showing that (a) Golden West had among the lowest delinquencies, foreclosures and losses of any major financial company, including fixed-rate lenders, (b) had among the lowest expense ratios in the industry, and (c) maintained high capital. Golden West management and employees received countless trainings underscoring the importance of these key principles, in what the company referred to as “Five Easy Pieces.” Read a summary description of Five Easy Pieces. Golden West’s focus on these core principles enabled the company to achieve compounded earnings growth of 19% over its 40-year history, a record virtually unmatched in American business history.
As a risk-averse portfolio lender, Golden West originated adjustable rate mortgage (ARM) loans for 25 years that were carefully structured to create minimal risk to borrowers. The principal risk to a borrower of an ARM is “payment shock,” which refers to a significant payment increase if interest rates rise. As a portfolio lender that would suffer direct losses if borrowers failed to perform on their loans, Golden West’s economic interest was aligned with borrowers in wanting to minimize the risk of payment shock. Read a summary of the history of the ARM and the structural features of Golden West’s portfolio Option ARM that were designed to protect borrowers against payment shock. As noted below, in contrast to Golden West, other lenders who were focused principally on loan volume markedly changed the structure of the Option ARM in ways that significantly increased the risk of payment shock to borrowers.
Contrast with a Volume-Driven Mortgage Banking Business Model.
The other primary business model for mortgage lending is mortgage banking. Mortgage banking operations make money from originating, selling and, in some cases, servicing loans. This business model requires generating a high volume of loans that can be sold, either individually or by pooling loans into securitization structures that are sold to investors. Mortgage banks are often unable to work with borrowers who may experience problems because the loans have been securitized and sold to others.
The history of mortgage banking shows that it is a highly cyclical business, with many operations going out of business every 5-7 years (when interest rates go up, mortgage banks get trapped by interest rate risk, and they have no cushion to absorb losses). In the most recent cycle in the late 1990s and early-to-mid 2000s, mortgage banking volume was facilitated by historically low interest rates, investors searching for yield (and finding it in mortgage securitizations), as well as advances in technology, including automated underwriting, FICO credit scoring (which allowed lenders to charge higher prices for greater risk – so-called “risk-based pricing” – which, in turn, fuel the growth in the subprime industry), and automated valuation models in lieu of standard appraisals.
High-volume mortgage banks significantly changed the structure of the traditional ARM in 2003 to generate large volumes of Option ARMs for sale. These restructured Option ARMs could be sold into the secondary market at higher yields because of higher risk (risk-based pricing), resulting in larger profit margins for mortgage banks. But in changing the structure of the traditional portfolio Option ARM, mortgage banks increased the risk that a borrower’s monthly payment would materially increase and cause payment shock to borrowers. Read a chart that shows key changes made by mortgage banks to the Option ARM, including: (i) increasing the likelihood that the borrower’s payment would increase significantly in a relatively short period of time, (ii) reducing the starting rate used to calculate the borrower’s minimum payment, (iii) making loans with high loan-to-value ratios of 90-100%, and (iv) reducing underwriting standards. In the aftermath of the mortgage crisis, stories were written about a large number of Option ARM loans that would soon recast to a higher payment and cause payment shock; this was certainly true as to the mortgage banker Option ARM, but not true as to the Golden West portfolio ARM.