KISS. If I were running for political office and someone asked me how I would govern, I would say: KISS. Yes, that is right, KISS. I am proud to say that KISS has served me well in my life and I’m confident it will continue to do so. If you’re not familiar with KISS then let me tell you what it stands for, Keep It Simple, Stupid.
KISS is not a new concept and I take no credit for this philosophy. In it’s more developed form it’s called Occam’s razor, developed by the English logician in the 14th century. Simply stated this principle says “All other things being equal, the simplest solution is the best.
“Now why do I bring this up? Because of what Fed Governor Randall S. Kroszner said yesterday at the American Securitzation Forum in Las Vegas, Nevada. In discussing the subprime mortgage issue and ways of solving the problem moving forward, here is what he said:
We were particularly interested in ensuring that protections remain strong over time as loan products and lending practices change. Our analysis of the data suggested that the troubles in the mortgage market generally arise not from a single practice in isolation, but instead from the complex ways that risk factors and underwriting practices can affect each other, sometimes called “risk layering.”
Now, I don’t disagree with what he is saying, but I am confounded that the big wigs don’t seem to understand the basic issue. I’m not a securitizies analyst, nor am I a stock actuary and I certainly do not understand the complex world of risk calculation. However, I do understand the dynamics of home mortgages.
First of all let’s look at the basics. A home buyer needs a loan because they don’t have the money themselves to purchase the property. The buyer goes to a lender and applies for a mortgage. The lender then looks at credit scores, employment/income, assets and property type to make a lending decision.
As a former Physics major I can confidently tell you the lender is not facing a very complex problem here. It sure as heck is not rocket science. At the point of decision the lender should be considered about two things and two things only. The first is: can the borrower pay the loan back in full and on time? /Second: what should I (the bank) charge to account for the risk of lending the money over such a long time horizon?
For the greater part of the 20th century, the first question was answered by a simple debt to income ratio (DTI). What does the borrower make and given his other debt obligations can he afford to make timely loan payments? The safest ratio was deemed to be 30/40 (front and back).
Also for the greater part of the 20th century, lenders looked at the borrowers past history and decided (with the prevailing interest rates – such as the prime rate – mind) how much interest rate to charge. Since prime rate was the rate offered by the banks to its best corporate customers, banks made a basic determination on what to charge an individual person based on their past history.
Simple. And for the greater part of the 20th century these two simple parameters worked fine. So, Gov Kroszner. Let’s review Occam’s razor here for a moment. “All other things being equal, the simplest solution is the best.” So all the Fed needs to do is remind lenders the importance of DTI and why this has worked so well in the past. In addition, also lets remind lenders that the market has already provided a baseline for risk in the form of the prime rate. If lenders strictly adhered to these two simple parameters (as they did for the greater part of the past century) they can pretty much KISS the mortgage mess good bye!
P.S. I think the APR calculations on the Truth In Lending (TIL) is fundamentally flawed. But the Government continues to tout it as a means towards preventing abusive lending practices. This is a topic for a different day.