by Tanta on 10/09/2007 11:52:00 AM

John Dugan, Mr. I Hate Stated Income and also Comptroller of our Currency, is on the warpath again:

San Diego, CA – Comptroller of the Currency John C. Dugan said today that banks need to strengthen their underwriting standards, particularly on loans sold to third party investors.

“I am here to say that bank underwriting standards for these products, in many cases, moved too far away from what they would have been if the bank had held those loans on its own books,” Mr. Dugan said in a speech to the American Bankers Association’s Annual Convention.

Mr. Dugan noted the many positive aspects of the “originate-to distribute” model, but said there can be negative effects on underwriting standards, including relaxing significantly the incentives to use caution and prudence in underwriting loans sold to third parties.

“When a bank makes a loan that it plans to hold, the fundamental standard it uses to underwrite the loan is that most basic of credit standards that I’ve already talked about: the underwriting must be strong enough to create a reasonable expectation that the loan will be repaid,” the Comptroller said. “But when a bank makes a loan that it plans to sell, then the credit evaluation shifts in an important way: the underwriting must be strong enough to create a reasonable expectation that the loan can be sold—or put another way, the bank will underwrite to whatever standard the market will bear.”

Comptroller Dugan outlined what needs to be done. “I am here to say that banks need to strengthen their underwriting standards so that they move back towards the fundamental principle of maintaining a reasonable expectation that loans will be repaid, even if the loans are to be sold to third parties – and that goes for mortgage loans, leveraged loans, or any other syndicated credit,” Mr. Dugan said.

What Dugan neglects to mention--or at least, what isn't in the reported summary of the speech--is the vicious feedback loop that goes on with this model. The problem is that for many years, banks often used a standard for determining an "investment quality loan" based on what secondary market investors--traditionally, Fannie and Freddie--would purchase. So when the GSEs and private investors relax standards for what counts as "capacity to repay," banks find themselves with a widening gulf between their own portfolio standards and "what the market will bear." This begins to suggest to portfolio managers that internal credit standards are "too tight," and so the banks don't just lower standards for loans they intend to sell, they lower standards for their own portfolio production.

(Hat tip FFDIC)