Better to Look 'em in the Eye

With today's news of HSBC and their growing problems in subprime lending, it appears as though we're now about as far removed from old-style mortgage lending as we'll ever be.

That is, old-style lending where the local banker would look across his desk at the prospective homeowner and decide whether his bank wanted to develop a long-term relationship with that person.

Maybe a few face-to-face sessions between purchasers of mortgage backed securities and high-risk borrowers seeking to profit during the latest financial bubble could have avoided the mortgage mess that is now just being discovered by much of the Western world.

Some of the details in today's story($) from the Wall Street Journal are enlightening.

Complicated Web
The mortgage market in the U.S. is a complicated web of mutually dependent businesses. Mortgages are frequently bought and sold several times over, and the default risk often lands far from the institution that originated a mortgage. Banks and mortgage brokers size up would-be borrowers and make the loans. These lenders sell many of the loans to mortgage wholesalers, which gather them into pools and flip them to large financial institutions or banks like HSBC. Some of these buyers, including Wall Street investment banks, package the mortgages as securities for sale to investors, a process known as securitization.

HSBC Mortgage Services, a South Carolina-based arm of the bank, was active in several parts of this web. One unit, called Decision One Mortgage Co., originated mortgages, many of them to subprime borrowers. HSBC sold some of these loans, but it held others as investments, collecting the interest income they generated and shouldering the risk of loss if they soured.

But the old Household branch network didn't reach everywhere, and HSBC was eager to boost the size of its mortgage business quickly. So it became a big buyer of subprime loans originated by others, which it held in its own portfolio. It purchased loans from approximately 250 wholesale mortgage companies, which themselves bought the loans from independent brokers and banks.

In 2006, the main operations of HSBC Mortgage Services moved from Charlotte, N.C., to a new Fort Mill, S.C., facility, which HSBC said offered 60% more space to accommodate expected growth. The unit also added to its mortgage-processing staff in Florida.

HSBC focused on buying second-lien loans. Also known as piggyback loans, they allow home buyers who are unable to scrape together down-payment money to borrow it. By cobbling together a bigger first mortgage from one lender and a second-lien loan often from another, home buyers can borrow 100% of the purchase price of a home. In the event of default, the first-mortgage lender has first claim on the property, which leaves the second-lien lender in a riskier position. For that reason, second-lien loans carry higher interest rates -- making them potentially more lucrative for lenders.

HSBC bought lots of mortgages. It was the top buyer of loans from Fieldstone Investment in Columbia, Md., a large mortgage originator. According to Fieldstone's securities filings, HSBC bought Fieldstone mortgages with a face value of $1.2 billion in 2005. By March 2006, the second-lien loans on HSBC's balance sheet totaled $10.24 billion, up from $6.3 billion in September 2005.

Bobby Mehta, HSBC's top executive in the U.S., said the bank was building its mortgage portfolio in a disciplined manner. "We've done them conservatively based on analytics and based on our ability to earn a good return for the risks that we undertake," he told investors in May 2005.

Tricky Business
Assessing the quality of big mortgage pools and predicting how many of the loans will go bad is a tricky business. Typically, HSBC would first specify to a mortgage wholesaler what kind of loan pool it was looking for, based on the income and credit scores of borrowers. Then it would send in its analysts to review the portfolio.

Zan Hamilton, chief executive officer of Lime Financial in Oregon, says his mortgage origination firm got used to having HSBC employees hunched over their computers sorting through mortgages for sale, trying to ensure they met HSBC's standards.

This is all part of the "wealth creation technology" that the nation's central bankers claim is responsible for much of the prosperity since the bursting of the stock market bubble seven years ago.

Maybe someone should have actually looked borrowers in the eye, rather than just looking at the numbers.

Then maybe some homeless dude wouldn't be sleeping at one of Casey's houses.