411 from BoA on ARM SNAFU

Liam McGee, president of global consumer and small business banking at Bank of America Corp., visited the editorial board Tuesday, to discuss the bank’s approach to mortgages and other consumer products. Bank of America, along with Citigroup Inc. and JP Morgan Chase & Co., is currently floating an idea to create an $80 billion fund that would create liquidity in higher-quality commercial paper securities.

New regs

Jon Healey: There was a story in The New York Times today noting that a new study showed that defaults on 2007 mortgages, mortgages — adjustable-rate mortgages issued in the first six months this year — were, uh, as great if not greater than defaults in 2006. So I was wondering if you could, um, suggest why that might be happening and what the fix might be.

Liam McGee: Well I would remind you that we did not play in that market. We were not an adjustable, ARM lender of any consequences.

Eryn Brown: Even in the prime space...

Liam McGee: Uh, very little of that.

Jon Healey: Because there isn’t much demand for it, in the prime?

Liam McGee: Uh, I think it was strategic. If you go back to our strategy, we did not want to be in the sector of the market where there was higher return but a higher risk element. So we did some but it was not a big part of our portfolio. I think the larger issue — and it’s not surprising that recent vintages, particularly those originated by unregulated lenders, were very aggressive in terms of loan value and creditworthiness, FICA and whatever else you want to have — I think you’re seeing some of the last vestiges of some of the aggressive unregulated lenders. You know, when you look at the business, and you say, Gosh, what’s, what really caused this subprime issue — and I was just back in D.C. with some of Barney Frank’s staff and even some of the California legislators — it’s really the unregulated lenders that, that caused this. And I think that’s where you’re seeing some of the proposed legislative remedies, around regulating the unregulated mortgage brokers and the like.

Most of the — most, but not all — but most of the regulated lending institutions I think for the most part did a pretty good job of loan-to-value and creditworthiness. It was really the unregulated lenders, and the preponderance of mortgage brokers. I think when you go back and do the post-mortem on this it’s going to be the presence of unregulated brokers. [...]

The risk here of course is that we’ve got to be sure about the unintended consequences. Because credit needs to be available for average families. So we actually applaud as a company some of the proposals to regulate the unregulated. We think that’s good for the industry. We think however that we’ve got to be careful it doesn’t spill over and cause obstructions for those that behaved responsibly, and we believe we were one of them, and curtail the availability of credit. We believe that will have dramatic implications for the U.S. economy, if an unintended consequence is that credit is not as available to creditworthy average Americans.

Tim Cavanaugh: Isn’t that what has been happening in the last few months?

Liam McGee: Uh, not for us. As I said before you came in, we’ve been actually growing market share in this business. We haven’t pulled back at all. It’s clearly been in a perverse sort of way good for us, some of this shakeout, because there has been; there is a flight to quality going on in the mortgage business. There have been average consumers today who may have been almost totally focused on variable rate, and rate, and just getting in, are now more interested — there’s more of a balance I should say in terms of: if this lender says they’re gonna fund, can they and will they fund? That’s helped us. And we’ve been as you know, aggressive, in our No-Fee Mortgage Plus; and that’s really changed the industry in terms of taking some of the fees out. And we can do by the way that because we use our own distribution systems. It’s, it’s, the origination cost on average is lower to sell a loan to our banking center than to sell to a commissioned sales force. So we, in its simplest form we pass along much of that savings to the customer by not charging some of those nuisance fees. So there is, I think there is a paradigm shift going on in the mortgage business. There’s a flight to quality. We’re clearly benefiting from that. Consumers are starting to make value tradeoffs. As I said earlier, some of the proposed legislation that gets at regulating the unregulated lenders and originators we think is good for the industry. We just have to be cautious that it doesn’t impact...

Eryn Brown: Are there specific pieces of legislation that you’re concerned about?

Liam McGee: Well in theory... I think it’s premature to know that. I think Barney Frank’s legislation is in an early... but I think conceptually, conceptually, the notion of regulating those who were unregulated and didn’t have the same mores that a company like ours did is a good idea. But the devil’s in the details.

Who speaks for the deadbeats?

Jon Healey: If you guys aren’t in the subprime business, and um, there is a, a, uh flight of capital to institutions like yours, how will higher-risk borrowers ever get into homes?

Liam McGee: Well I think that’s an important issue that we’ll have to be a part of it, but there are some, candidly, some “high-risk” borrowers who should not have gotten loans in the first place. Whether they were, some of those unregulated lenders were more focused on creating liquidity flows. Originating paper, securitizing them and coming back in. It was more about that than about, um, responsibly lending somebody money to get into a home. There were clearly excesses by unregulated, I think you’re seeing that. And some of the vintages you were just talking about, some of that is a reflection of that. But as I said earlier we’re not seeing that in our portfolio. Our loss rate is like 1%. It’s just, it, it hasn’t changed, so we’re just not seeing that.

I think those that put people into homes that belonged in homes, with an appropriate loan value, appropriate creditworthiness, are going to do just fine in the cycle. [...]

Jon Healey: Forgive me for harping on this, but I still think there are ways to make loans to those who are greater risks, and have standards, and still know that a certain percentage of those are not going to make it because these are people who are being too aggressive about their own abilities — or may be knocked out by some sort of job loss or something.

Liam McGee: At a macro level, once the subprime stuff sorts out, I do think companies like ours, because we have — you know, if somebody has a checking account with us for ten years, and let’s say in that ten years never has an NSF check, and their FICO score is low, that in effect might be, to some might be a subprime loan, but to us might be near-prime. Or they have a credit card. Small limit but they handle it responsibly. So if that’s your point, yes. But that’s not subprime in the abusive way that some of the lenders talked about. And we do some of that today but we don’t consider it subprime because we know the customer. But that’s again, one of the advantages that some of the more responsible lenders will be able to do that. Then you’ll be able to use your balance sheet. But the days of chasing mortgage volume just to get volume, regardless of the value, which is what some of these lenders did, particularly in the last cycle, I just don’t think that’s good for anybody. Least of all the person who gets in a house and isn’t likely to be in there for a while.

Bailout

Liam McGee: I don’t think we should lose sight — even with the stress in the U.S. housing market; there is a correction going on right now, it’s just a question of how big the correction will be — those that made loans responsibly are paying them. And I don’t think we should lose sight of that.

Tim Cavanaugh: Is there any role for the private sector or the government to help out the irresponsible borrowers? Let’s leave the lenders out of the equation for now.

Liam McGee: I think that’s a public policy issue. I think our view is that in general the market should sort that out. I mean the borrowers themselves had some responsibility as well. And I think that’s a public policy issue and I, obviously it’s going to be debated. But I, and clearly there’s business opportunities for us. There’s clearly borrowers that are responsible, that got into mortgages that need to be reset. And that’s a good business opportunity for us, to get those people locked in. And we’re attacking that pretty aggressively. You may have seen some of our advertising attacking that. The thing with us is, part of our ethic is we’re not going to make loans to people where we have a high probability or any probability of foreclosing. That’s just not consistent with our brand. We gave up profits and were heavily criticized by some in Wall Street for not having done that in the prior five or six years. But I think that decision has been vindicated. [...]

What was interesting about [No-Fee Mortgage Plus], and we did some of the research with our customers, we had thought customers were primarily driven by rate. What they told us was as long as the rate is fair, the thing that bothers us the most is paying all those fees. It can add up to thousands of dollars. No-Fee Mortgage Plus saves the average borrower about $3,500. And second, people want to be sure the loan’s going to close on time. And so if you look at our value proposition it directly addressed those things. So I think when you have a value proposition that’s different, particularly in this environment, that paradigm may be shifting. [...] Our advertising speaks to: Do you have to a loan that needs to be reset, and are you worried about a responsible letter, that’s going to be fair and will lend. And that has really resonated. [...]

Tim Cavanaugh: When you speak about resetting loans, I’m wondering how do you reset, you have somebody who can’t afford the rate they’re paying right now, how do you reset a loan to something that they can pay without losing money yourself?

Liam McGee: Well we price it obviously, we price it against our funding with an appropriate margin. But if you can get at this part, you know rates are trending down, somebody has a variable loan that’s going to reset at a higher rate, the formula was set when they got the loan, and they can now refinance that with a fixed-rate loan — 15, 30 — at a relatively low fixed rate, that’s a much better transaction for them than having to reset at the original rate that would be an above market rate.

Tim Cavanaugh: But wasn’t the...

Eryn Brown: The original lender takes the loss, right? Because you’re buying the loan?

Liam McGee: Yeah, I mean, they might have a mark to market in terms of their prepayment. I mean the big thing in the mortgage business is the mortgage servicing, so somebody’s going to have a mark to market if their paper prepays at a higher rate than the math was originally.

Moral hazard and good business practices

Jim Newton: There’s a fair amount of political pressure to provide some relief to people who got into these loans, for good or bad. Is there, I mean you indicated a preference to letting the market sort that out. What’s the downside to the government stepping in and trying to help some of these people who are in this situation now?

Liam McGee: Well anytime you have a “bailout” of some of those bad business practices you have that moral equity issue I think. And I just think it’s, it’s attractive on the political stump to say that; I just think we have to be — and this is not about our company, just as a U.S. citizen...

Jim Newton: I understand.

Liam McGee: ...we have to be very careful that, that something of that sort doesn’t re-encourage that sort of behavior once we get through this cycle, two or three years from now. That we’re back in the same place and there’s a precedent set. We kind of believe that responsible companies ought to live with the consequences of their, of their actions. There’s no question that there’s probably some small sub-segment of responsible customers who didn’t understand because they were misled or misrepresented or whatever. And I think Barney Frank’s proposed legislation really heightens the liability for those that, that have those kind of behaviors, and we subscribe to that.

But there were also consumers who knew exactly what they were doing. And we think that, whether or not the lender was regulated or not, I just think we have to be very careful. I’m not rushing to a solution. Because there was accountability all around. It wasn’t just the lenders.

Jim Newton: And is the fact that Bank of America was not swept up in this the way some were a tribute to the regulatory environment in which you work or the business practices you impose on yourself. And the reason I ask that is, is there a regulatory solution that will mitigate this going forward, or is it merely the adoption of better business practices?

Liam McGee: I think it’s some of both. Honestly the regulatory scrutiny we get, as opposed to those that largely created this problem, where they had no regulatory scrutiny, certainly creates and environment that, we have many masters, one of which are the regulators.

But I would say for us in fact it was a very deliberate business strategy.