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The following is the testimony of Patricia Lindsay for the Financial Crisis Inquiry Commission
Hearing on April 7, 2010:
Thank you for inviting me to speak this afternoon. My hope for today’s session is that I
give you a unique perspective into Subprime lending. I know I was not alone in not
understanding the steadily increasing risks taken in the years before my employer New Century
Financial Corp. stopped making loans in March of 2007. I grew up in the real estate business
where my father was a Broker and a hard money lender. A hard money loan is a short term loan
to a borrower who has a significant amount of equity in the property and cannot qualify for a
traditional bank loan. I became an Account Executive at Beneficial Mortgage the end of 1996.
Beneficial was one of the original subprime lenders who held their loans in their portfolio rather
than selling them. There were a lot of similarities between Beneficial and my experience with
hard money lending, Beneficial and the various hard money lenders with whom I worked were
very aligned in their thought process on how to evaluate a loan. We had three things that we
used to evaluate a loan; Credit, Collateral and Capacity. We would look at these three C's and if
any were lacking, like credit, a borrower better have some compensating factors, like great
collateral. There was a fourth C, character, that went missing when the loan process became
more impersonal and the prospective borrower never met face to face with the lender.
I joined New Century Mortgage as a Wholesale underwriter in June of 1997 and left New
Century in December of 2007. I was part of a skeleton crew kept on to help unwind the
corporation after they filed bankruptcy. I found the lending standards at New Century were
much different than the hard money standards I had learned. I really didn't understand what it
meant to securitize a loan, but thought they must have found the secret sauce, so to speak, on
how to take already risky borrowers and give them more money than the traditional hard money
or portfolio lenders could. I loved my job at New Century, and found my niche growing and
developing fraud detection and prevention measures across all of the business channels in the
company. New Century provided me with all of the training and tools I wanted and needed in
order to be the best asset to the company. I attended numerous seminars, became proficient at
my job then began speaking at the seminars and teaching. We talked about the three C's when I
came to New Century and common sense lending. These were terms I stopped hearing in the
last few years. There was no longer any common sense, the three C's had disappeared and the
risk was layered rather than offset . The business became volume driven and automated. A
broker could get a loan pre-approval in 12 seconds or less with our proprietary system. If we
couldn't close a loan quickly, one of our many competitors would. With this increased speed, I
was tasked with finding a way to automate fraud detection. With the support and backing of
Executive management, in 2005 I brought in a company who used our known fraud loans to
build a predictive analytics tool that ran in tandem with our loan origination system. High risk
loans were identified and reviewed by a local risk manager who either cleared them or
recommended further action.
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Key Points:
The growth and evolution of the subprime mortgage industry:
•
The niche market of subprime lending grew and evolved into huge business when
unlimited funding became available through Wall Street via securitizations.
Before Wall Street came on to the scene, there were specialty finance lenders, like
Beneficial Finance and Beneficial Mortgage, who filled this niche market. They
catered to borrowers who could not qualify for a conventional loan because of
poor credit, a high debt to income ratio ("DTI") or other mitigating factors. They
would offset their risk by commanding a higher interest rate and providing a
lower loan to value ("LTV") financing. The riskier the borrower (i.e.; unsteady
income, poor payment history), the higher the probability of a default, thus the
need to offset the risk by reducing the LTV.
The presence and impact of fraud in subprime origination:
•
People who may not have committed fraud before did so by making material
misrepresentations to buy a property. The 100% financing products on purchase
money transactions provided a vehicle for people to enter into buying a property
without putting forth any money. The stated income product eliminated the
ability to prove fraud without supporting documentation. When previous
products required some supporting documentation in order to get a higher LTV, it
was easier to identify the fraud and stop it. Straw buyers were recruited for their
credit scores specifically to avoid having to provide income documentation. And
they would also claim that the property was to be owner occupied, as 100%
financing was not offered on non-owner occupied properties. The numbers that
we (at New Century) were seeing and identifying as true fraud loans were a
minuscule number compared to the number of loans we were funding every
month, so I think the products offered had a bigger impact on losses and defaults
than fraud did, at least as far as New Century's loans.
The funding of subprime originators through the use of warehouse lines of credit:
•
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Many, if not all of New Century's competitors were only able to operate with the
use of warehouse lines of credit. These warehouse lines were provided by large
financial institutions, many of which were the same Wall Street investors who
would buy our loans. They very helpful in the sense that they made sure we had
enough money to close the loans that they were waiting in the wings to buy. It
was a very efficient model from a productivity standpoint. New Century had
several warehouse lines of credit with many different banks which enabled the
funding of 20k+ loans (approximately $5B) per month, at the peak. New
Century did not have the liquidity to make these loans without the use of
warehouse lines of credit. When New Century's lines were shut down in March
of 2007, business stopped. New Century's repurchase requests increased
significantly as well. There became a need for a new department to be developed
in 2006 to centralize these requests and help my department out. In early 2007,
our repurchase process slowed, indicating there may have been a cash flow
problem.
The impact of so-called "originate-to-distribute" model for mortgage origination
and any concerns with that model:
•
The Definition of a good loan changed from, “One that pays” to “One that can be
sold”. The loans were no longer held by portfolio lenders, but sold to investors,
most of whom placed them into securities. We had lost the ability to follow and
monitor the performance of any loans that we did not hold either on our servicing
platform or in a security we had an interest in. We did monitor the performance
of the loans to which we had access, but this was not the whole picture. Virtually
all of New Century's loans were sold and or securitized and not held in a
Portfolio.
The quality of underwriting in the years leading up to the financial crisis, including
the exceptions to underwriting policies and procedures that I observed:
•
Loose guidelines allowed people to buy homes they couldn’t afford. Loan terms
started in the early years, when I came on the New Century in 1997, with the
2/28 ARM ("2/28"), this is a 30 year adjustable rate loan that has a fixed interest
rate for the first two years then would go to an adjustable rate, usually adjusting
every 6 months until the loan became fully indexed. Later on, somewhere around
2004, the fixed portion of the loan was just interest only and a 40 year term was
added into the products being offered, although the 30 year term was still the most
widely used. These loose guidelines included 100% financing to borrowers with
low credit scores and no supporting proof of income.
Risk Management practices in subprime origination, including any changes in risk
management leading up to the financial crisis:
•
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Risk managers at New Century were viewed as a roadblock rather than a resource
in many instances. We had Risk Managers placed in production groups all across
the country, and they had daily tasks that they were to perform. They would have
targeted audits in addition to helping the group with researching any items of
concern. Things like brokers on watch, multiple social security numbers for a
borrower, or other discrepancies that needed to be clarified. If the risk manager
could get to the bottom of the discrepancy and clear it, the file would be stronger
because what started off looking like a problem was shown to be an error or
whatever the case maybe. The real problems arose when the initial issue may
have been cleared, but something else was discovered. One of the biggest
changes we made in Risk management was eliminating a document we had called
the Purchase Money check list ("PMC"). In the late 90's we did a post mortem
review of failed loans when New Century had taken a loss. An overwhelming
number of those loans were purchase money transactions with certain
characteristics. To help mitigate any future losses, we required these transaction
be reviewed by the local risk manager an fill out the PMC. During these reviews,
many times the risk managers would find other issues that were not part of the
PMC. The production groups were constantly complaining that the risk managers
were finding other things when they were only suppose to be looking at the PMC.
Around the middle to the end of 2005 at one of our Operations meetings it was
announced that the PMC would no longer be used and we were "blowing it up",
which received cheers by sales personnel. There was a lot of tension in many of
the groups between the risk managers and production. I was called upon to help
bridge the gap with a couple of groups. The sales mangers would complain that
the risk managers were "killing" their deals and making their account executives
anxious. But there were also groups where there was synergy between risk and
production, where the risk managers were respected and utilized.
•
For the most part, there was not an equality between production (front end before
the loans close) and the back end. It was clear that the front end ruled because
they were bringing in the revenue. The only time the back end, specifically Risk
Management had any teeth was when fraud was proven. If fraud was proven, the
loan was locked and declined. If there was no physical proof of fraud, it became a
business decision whereby the sale managers had the final say whether the loan
would proceed or not.
The compensation and incentive practices for persons involved in originating
subprime mortgage:
•
Account executives, who were New Century employees who brought loans in
from brokers, were primarily compensated on commission of closed loans that
they brought in. I was compensated with salary plus bonus based on company
performance with part of that being discretionary based on personal performance.
The compensation was significant for the top producing salespeople, some of
whom were making several million dollars a year. Many of the sales managers
and account executives lacked any real estate or mortgage experience. They were
missing the depth of experience necessary to make an informed lending decision.
These same sales mangers had the ability to make exceptions to guidelines on
loans, which would result in loans closing with these exceptions, at times over the
objections of seasoned appraisers, underwriters or risk personnel. Some of the
best sales managers had underwriting backgrounds and were more closely aligned
with risk management and better at understanding potential problems, but this was
the exception and not the rule.
The growth, prevalence, and impact of so-called "exotic" mortgage products such as
low documentation and stated income loans, and teaser rate mortgages:
•
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The stated income, high loan to values ("LTV"), coupled with the 2/28, interest
only ("IO") loans impacted the market by making purchasing a home as easy as it
has ever been. Property values were climbing due to the easy money and
excessively low interest rates. Any problems, including fraud or defaults were
being masked by the rapid housing appreciation.
The role and practices of appraisers in subprime mortgage origination:
•
Properly valuing a property (one of our three C's, collateral) is one of the most
important components in a loan. In my experience at New Century, fee appraisers
hired to go to the properties were often times pressured into coming in "at value",
fearing if they didn't, they would lose future business and their livelihoods. They
would charge the same fees as usual, but would find properties that would help
support the needed value rather than finding the best comparables to come up
with the most accurate value. Some appraisers would take boards off boarded up
windows, to take the needed photos, then board the properties back up once the
shots were taken. Or they would omit certain important elements of a property by
angling the camera a certain way or zooming close in to make the property look
the best possible. This level of appraiser activism compromises their objectivity.
At the end of the day, we had a system that went into a downward spiral because of
layering risk rather than offsetting the risk because there was such a huge demand for the
products. Our loans were sold before we even made them, which put more pressure on the
production groups to get loans closed. Wall Street packaged and sold the Residential Mortgage
Backed Securities to unsophisticated bond buyers/ investors. By unsophisticated, I mean they
did not understand the true risk of the underlying loan product. The process was so convoluted it
was nearly impossible to get a fraud loan pulled out of the entanglement to repurchase it. I
actually had a Wall Street investment banker chastise me for trying to buy a fraud loan back.
This particular loan was back in 2002 or 2003 when there were hardly any loans coming back
from investors. His comment was, " You want me to pull this one loan out of this security? Do
you know what I have to do?" He proceeded to tell me that he had to find another loan to put in
its place and asked if I really needed to pull it. To his credit, he did as I asked, pulled the loan
and New Century repurchased it. It was at that point that I began to get a taste of the complexity
of how securities worked.
The rating agencies improperly rated these securities, deeming them much safer than they
actually were. It seems the lending process needs to return to the basics; true risk based pricing
and transparency. We have to look at the kind of market we are in, do we have cheap money
with increasing housing prices? If so, the loan to value ratios should be reduced to accommodate
the increased risk. I just know if I am loaning my personal funds, which I have done on several
occasions, I want to ensure I'm protecting my investment. By extension, the same common
sense should apply in the marketplace. A return to our core guidance of the three C's, and
offsetting the risk rather than layering it.
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