Sunday, May 10, 2009

Relationship Lending

An essay in a new University of Michigan Dissertation by Ben Keys finds evidence that "soft information" about borrowers might matter. The essence of the essay's findings is that banks underwrote mortgages they were forced to keep in portfolio more stringently than mortgages they packages into securities.

The instrument is clever: generally speaking, loans from applicants with FICOs of less than 620 were more difficult to secularize than loans with FICOs of more than 620. Keys and his colleagues found that loans with FICO scores of 619 performed better--substantially better--than loans with FICOS of 621. The argument is thus when banks are forced to keep loans in house, they underwrite more carefully, using soft information that securities holders (as opposed to underwriters) cannot observe.

This gives support to the view that securitization produces sloppy underwriting, and undermines "relationship" lending. There is some truth to this, but it doers not mean we should go back to the days when relationships dominated hard information. It was, after all, the reliance on relationships that allowed white men easier access to mortgage credit than women and minorities (not to mention single people).

The issue may not so much be the importance of soft information, but rather the quality of hard information. Securitized loans--which were based on well-documented credit histories, income and assets--performed quite well until maybe six or seven years ago. That is the point at which the quality of the hard information began to deteriorate.


Mike said...

Richard - big fan of your blog. I posted some of the graphs associated with this paper on my blog in a writeup - seeing it visually really drives home the point.

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