Running Right Back to the Bank
Richard Fairbank, the founder and chief executive of McLean's Capital One Financial, is one shrewd operator. He also hates to lose. So his decision this week to close his newly acquired GreenPoint Mortgage division, write off $860 million of his shareholders' money and run like hell from the wholesale end of the mortgage business may be telling us something important about the future of credit markets.
GreenPoint came to Capital One as part of last year's $13 billion acquisition of North Fork Bank, based in New York. GreenPoint's business was making mortgage loans through independent brokers and selling them almost immediately to Wall Street investment bankers. These underwriters, in turn, packaged them as collateral for mortgage-backed bonds that were sold to investors, including pension funds, hedge funds and university endowments.
GreenPoint's specialty was "nonconforming" loans -- loans that could not be sold to Fannie Mae or Freddie Mac. For the most part, these weren't subprime loans or loans to people with sketchy credit histories. Some were jumbo loans, above the $417,000 limit set by Congress. Others were "option ARMs," adjustable-rate mortgages that essentially allowed borrowers to decide how they would pay each month. Then there were the famous low-documentation loans, which dispensed with such things as home appraisals and income verification.
Back in March 2006, when Capital One struck its deal for North Fork, these types of loans were hot products in the financial world and GreenPoint was a major source of profit for its parent. Now, of course, such loans are in such bad odor that nobody on Wall Street wants to touch them. And Fairbank has concluded that the market is unlikely to turn favorable anytime soon.
But here's the thing: Capital One is not getting out of the mortgage business. Rather, with the acquisitions of North Fork and Hibernia National Bank, based in Louisiana, it is getting into the banking business -- a business that provides a reliable source of funds (checking accounts, savings accounts, certificates of deposits) that its employees can use to make a wide range of consumer loans (home, auto, home equity, credit cards) to customers it knows in communities it understands through a network of bank branches.
Savings deposits? Bank branches? Know your customer? Sounds like back to the future, doesn't it?
Indeed, only a short time ago, some were ready to write off the old-fashioned banking business completely. In the brave new world, investors would manage their money from home, transferring funds by computer and using the Internet to find the best deal on a mortgage or the highest interest rate for their savings. Rather than banks serving as the key link between savers and borrowers, credit would be "intermediated" by global credit markets using complex new securities capable of hedging and pricing any risk -- credit risk, interest rate risk, currency risk, even political risk.
To a large degree, Capital One is a product of this new world of securitized lending. Its model has been to raise much of its initial capital by issuing stock and bonds, using the proceeds from those bonds to finance credit card balances and loans of various sorts, and then replenishing its money supply by selling the loans to Wall Street for packaging and sale to investors.
But now, along with the rest of us, Capital One has discovered something important about these credit markets.
On the plus side, we have learned that these markets are generally so much more efficient at "intermediation" that they have not only lowered the cost of capital but generated fees and spreads along the way that old-fashioned bankers could only have dreamed of.
At the same time, we have learned that these markets are not good at evaluating credit risk. Lack of knowledge about the borrower is one part of it. The perverse incentives created by the fee structure are another. In time, so many bad loans get made that investors start to have doubts. At first, the doubts can be limited to one category of loan or one type of security. But quickly, these doubts give rise to wider doubts about other types of loans that are originated, securitized and rated in the same way. Because they can't distinguish the good from the bad, they begin to shun it all, selling what they have and refusing to buy more.
Don't get me wrong: Banks can get themselves in similar fixes. Loan officers are not that different from investment bankers when it comes to herd behavior. The sudden refusal by investors to have anything to do with asset-backed securities is the modern equivalent of an old-fashioned bank run by depositors.