by
D. James Croft1
There’s a lot of finger pointing now concerning who’s responsible for the current financial meltdown. The culprits named today include: greedy Wall Street executives, the Bush administration, the Clinton administrations, Congress, the Securities and Exchange Commission, the Federal Reserve Board, banking regulators, perpetrators of fraud, and many more.
So really, “who done it?” The answer to that question is the following: To one extent or another, all of the above.
What we have been experiencing is a “perfect storm” in the world of finance. And it’s a category five. The amount of damage being visited on financial institutions in the United States and abroad is so great and so extensive that no single factor or perpetrator can be identified as the primary cause. Many factors and human mistakes, most of which are interrelated, have come together in an unfortunate convergence that has brought about these financial problems.
Below, I have laid out, in a somewhat simplified form, my view of what has transpired in the recent past. I have emphasized the happenings in the mortgage industry since they are at the heart of the problem and because that is the industry I know. I will focus on the failures of Fannie Mae and Freddie Mac and touch only lightly on securities dealers like Merrill Lynch and Lehman Brothers, since I have less familiarity with them.
The factors and players discussed below are a “dirty dozen” listed in their rough order of impact.
• Changed Structure of the Mortgage Industry
• Privatization of Fannie Mae and Freddie Mac
• Mortgage Industry and Wall Street Innovations
• The Rating Agencies
• Hubris (“We can price for risk” and other generally arrogant assumptions)
• Congress and Weak Regulation
• Inexperience and Naiveté of Mortgage Industry Managers
• Changes in Accounting
• The Press and News Media
• The Housing Bubble
• Borrowers
• Fraud and Misrepresentation
Each of these factors/participants is discussed briefly below. While a “brief” discussion may be helpful to a layman’s understand, it may somewhat oversimplify each of the issues.
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Changed Structure of the Mortgage Industry
Forty years ago, the mortgage industry was dominated by savings and loans like the one depicted in the movie “It’s a Wonderful Life.” An S&L took depositors’ money and then loaned it to people buying homes. These home mortgages were put into the S&L’s portfolio, and the borrowers made monthly payments for 20 or 25 years, or until they sold their home.
It was simple. The S&L industry was called the 3-6-3 industry. They paid depositors 3% for their funds; they made mortgages to home owners at 6%; and they were on the golf course by 3 in the afternoon.
Moreover, the S&L performed every function in the lending process: the salaried loan officer was an employee; so was the appraiser; and so too were the people who collected the monthly payments in a function known as “loan servicing.”
Today most of the functions in the mortgage industry are performed by different companies, each of which has a different expertise and set of motivations. The entire mortgage process is now compartmentalized.
This brings some advantages. Each function is now much more efficient. A big savings and loan used to service mortgages totaling $100 million. And all the accounting that took place was done by hand. Today, specialized companies service mortgages valued at billions of dollars, and computers handle most of the work.
But there are some disadvantages to this efficient and compartmentalized approach. The primary disadvantage is that no single compartment ends up with the full responsibility for the quality of the mortgages originated. No one associated with the origination process ends up “owning” the mortgages, so there is little incentive to make sure they are quality loans.
In fact, everyone gets paid on the basis of the volume of loans originated. It’s always been the case that the real estate agent doesn’t get paid unless the loan is approved. But under the new lending structure, the mortgage broker doesn’t get paid until the loan closes. And now the appraiser, who is often a self-employed entrepreneur, depends for his or her income on referrals made by the real estate agent and/or the mortgage broker. If the appraiser doesn’t “cooperate,” he/she doesn’t get any new business. This Gang of Three end up scratching one another’s back, and at times put loans through the system that are much weaker than they appear on paper. So:
The changed structure of the mortgage industry meant that no one on the loan origination team had an incentive to make good loans—just lots of loans.
The sad refrain you hear among quality control people in the mortgage industry is, “Production (loan volume) is king.” And those who have pushed for better loan quality have been the industry’s Rodney Dangerfields.
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Privatization of Fannie Mae and Freddie Mac
When they were set up, Fannie Mae (1938) and Freddie Mac (1970) were government agencies charged with buying and guarantying “investment quality” (aka “prime”) mortgages from lenders in order to replenish the lenders’ funds and enable them to make more loans. Initially, the loans they could buy were capped at relatively small amounts to encourage lending to low and moderate income families. That cap, however, has grown over the years and now exceeds $400,000.
The lender is a little like the owner of an orange grove. He/she can sell oranges to individual consumers directly or can sell them to a wholesaler who buys in bulk, using standards that guaranty the oranges’ freshness and sells them to grocery stores, which sell them to consumers. Mortgage lenders (the orange grove owners) sell mortgages to Fannie and Freddie (the wholesalers) who then guaranty the repayment of the loans and sell securities backed by those mortgages to Wall Street Investment Bankers (the grocery stores). They, in turn, sell pieces of these securities to consumers’ mutual funds, pension funds or personal portfolios.
When Fannie and Freddie were government agencies, they didn’t worry much about generating huge profits.
But for several reasons that were legitimate at the time, both became private companies2, or more formally, Government Sponsored Enterprises (GSEs), and their stock was traded on the New York Stock Exchange (NYSE). As with all private companies, making profits, growing earnings and pleasing Wall Street analysts became very important to them. Their executive compensation and bonus plans were tied to their earnings.
Since both Fannie and Freddie made money on each of the loans they purchased and guaranteed:
Both came under pressure to buy lots of loans.
Hopefully, “investment quality” loans, of course, but lots of them. Again, “Production is king.”
And produce they did! When hundreds of savings and loans failed in the early 1980s due to holding fixed rate mortgage loans in their portfolios3, all lenders started looking for ways to sell off their mortgages. Fannie and Freddie were the major buyers. They grew and grew, and so did their profits. Wall Street loved them, and investors loved them. They were growth stocks.
By the late 1990s and the early part of this decade, Fannie and Freddie were buying roughly 60% of all mortgages made. That was about the limit of their ability to purchase loans due, among other things, to the fact they were restricted by law to buying “investment quality” prime loans. They were beginning to run out of ways to grow revenues and profits. That is to say, their very success at doing what they were set up to do threatened their growth in both revenues and profits. To maintain growth, satisfy Wall Street, keep stockholders happy, and generate more profit-based compensation and bonuses, these firms needed to buy even more loans.
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Fannie and Freddie were both in danger of slower growth due to their
having saturated the market with their purchases of prime loans.
Mortgage Industry and Wall Street Innovations
About this time, members of Congress, consumer advocacy groups and the White House (under both Clinton and Bush) encouraged the mortgage industry to make more loans to first-time home buyers, minorities and potential homeowners with less-then-perfect credit. The mortgage industry and Fannie and Freddie responded enthusiastically. This meant they could make less-than-investment-quality loans (aka “subprime”) and increase their volume. Remember, “Production is king.”4
The designers of mortgage loans came to the rescue. The traditional fixed rate 30-year mortgage wasn’t well-suited for borrowers who couldn’t meet the underwriting requirements for prime loans. So many mortgage lenders, with the help of Wall Street, invented new types of loans:
• “Teaser rate” loans: the initial interest charged is below the market rate and increases over time to the point where borrowers pay at the market rate or slightly above (hopefully after borrowers’ incomes increase)
• Negative amortization loans: borrowers make low payments that don’t pay down the principal of the loan at first; the loan balance grows; and larger payments later in the life of the loan eventually pay down the balance (hopefully after borrowers’ incomes increase)
• “Option” loans: borrowers just pay what they can afford each month; if it’s not enough to cover principal and interest, the shortfall is added to the loan balance; the borrowers later “catch up’ by making large payments (hopefully after borrowers’ incomes increase).
• Stated income loans: borrowers with good credit scores don’t have to document their incomes; they just “state” an alleged income figure on the application form, and there is no effort to verify the figure with W-2 forms or tax returns. There mortgage industry assumed that even if borrowers inflated their incomes a little bit, they would “grow” into the stated figures (hopefully after borrowers’ incomes increase)5
One of the reasons the loans listed above were “subprime” is that their eventual repayment depended to a large extent on the assumption that over time there would be increases in borrower income. While that might seem like a weak assumption, it was believed that because the houses themselves were assets behind the loans, they would adequately serve as collateral for the debt. That is to say, if any borrower defaulted, the house could be sold to liquidate the mortgage debt. And home prices were rising so fast that few doubted the ability of the collateral to cover the debt (see the “Housing Bubble” section below).
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So subprime loans didn’t’ seem too risky if one was assuming growth in borrowers’ incomes and/or continued housing price appreciation. Only the most negative Cassandras of the financial world had the temerity to doubt those two assumptions.
Fannie Mae and Freddie Mac began to buy these types of subprime loans in the mid-1990s. And Wall Street’s financial gurus found ways to take packages of loans purchased by Fannie and Freddie and restructure them into complex securities that were then sold to banks, investment banks, insurance companies, mutual and pension funds and foreign investors.
The “spreads,” or profits, Wall Street could make on repackaging these loans were greater than what they could make on many of their other activities. The push for extraordinary profits, which some would call “greed,” and the herd mentality of Wall Street6 combined to blind many of the players (who should have known better) to the risks of these investments.
Wall Street and lenders invented many new loan products that had never been used before and packaged them into securities whose attributes were both untested and poorly understood.
The Rating Agencies
These complex securities were, in turn, divided into still more complex securities called “tranches.” By this level in the “restructure, package and sell mortgages” game, these mortgage backed securities were so complex that most investment managers at mutual and pension funds didn’t really understand their risks. Rather than hiring their own expert financial analysts to determine these risks, they relied on the securities rating agencies like Standard and Poors (S&P) to tell them how safe the securities were.
Unfortunately, S&P didn’t understand them very well either. Many tranches of these securities were rated as having relatively low risk, based on incorrect assumptions in overly optimistic mathematical models. Even some sophisticated investors who suspected higher risks were present simply ignored their instincts and purchased the securities without sufficient analysis.
Purchasers of mortgage backed securities relied too heavily on flawed credit
ratings issued by rating agencies that underestimated their risks.
Hubris (“We can price for risk” and other generally arrogant assumptions)
If negative amortization, option, teaser rate and stated income loans sound risky to you, you’re right. They all have a greater risk of default than the typical 30-year fixed rate prime loan.
But the economists and financial gurus at Fannie and Freddie, on Wall Street and at the Credit Rating Agencies said, “Yes, these loans and the complex securities they back are more risky, but they can be structured and priced for this increased risk.”
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However, risks can be estimated and priced best when there is a history of performance behind the loans. These were new loans and securities that had never existed before. There was no real-world history. So the gurus built mathematical models and estimated the risks.
Wall Street is known for its bright people. But “bright” doesn’t necessarily equate to “wise.” Wisdom is a scarce commodity, but it is often based on long years of experience that build strong instincts and intuition. The mathematical model makers at Fannie, Freddie, the Wall Street investment houses and the credit rating agencies were often bright without being wise. They grossly underestimated the risks. The new mortgages and the securities they backed turned out to be far more risky than the mathematical models predicted.
When members of the industry or those outside the country’s financial centers raised questions and/or objections, they were told, “You don’t understand,” or “Things are different now.”
The hubris of the mortgage gurus did them in.
Congress and Weak Regulation
It’s hard to know which came first, the chicken or the egg—Congressional inaction or weak regulation. But since regulators can only use their congressionally granted authority, Congress gets first billing.
In the face of the mortgage industry ‘s changed structure, Fannie and Freddie’s privatization and the massive product innovations dreamed up by the industry and Wall Street, the regulatory structure for the mortgage industry remained pretty much the same as it had existed (or failed to exist) in the early 1980s.
The one agency assigned to oversee Fannie Mae and Freddie Mac, the Office of Federal Housing Enterprise Oversight (OFHEO), was underfunded and largely ignored by the two major companies it regulated.7
There were some in the industry who wanted more regulation of Fannie Mae, Freddie Mac and the institutions that make mortgage loans.8 Some participants in both the Clinton and Bush II administrations warned that Fannie and Freddie should be reigned in. Federal Reserve Board Chairman Alan Greenspan testified before Congress that Fannie and Freddie posed “systemic risks” to the economy.
But such arguments seemed academic and arcane. Besides, Fannie and Freddie were massively profitable and seemed very healthy. And they were, after all, helping people live the American dream of home ownership.
There were some in Congress who proposed increased oversight of the two financial giants. But Fannie (especially) was a lobbying powerhouse without equal. Freddie largely rode Fannie’s coattails. Whenever Congress was asked to consider legislation adverse to these two, Fannie
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would bring in an army of lobbyists who flooded the halls of Congress to fight any proposal that would rein in the GSEs. Their mantra was, “This legislation will hurt homeowners in your constituency.” They won virtually every battle.
It is difficult to know the extent to which members of Congress failed to trim Fannie and Freddie’s sails due to the campaign contributions they received, but both GSEs were active supporters of their friends on the Hill.
In addition, it should be noted that all mortgage lenders that are not federally insured commercial banks or thrifts are regulated by state agencies. Many states treated their mortgage lender licensing functions as revenue generators. They had few requirements to qualify applicants for a mortgage lending license. While a few states have put some teeth into their licensing laws in the past few years, the foundations of the mortgage meltdown were laid in a period when state mortgage regulators were ineffective, underfunded and overwhelmed by the lobbying efforts of mortgage trade groups and Fannie and Freddie.
Blaming the financial crisis on weak regulation is easy, and it’s partly true. But European banks and financial institutions have significantly stronger regulatory oversight than their counterparts in the United States. Yet they too were major purchasers of securities backed by subprime loans, and many of them have needed rescuing. This causes one to ask whether stronger regulation would have been a major deterrent in this crisis.
Regulators were not completely asleep at the switch—they were just dozing. Congress, however, was snoring in a sleep induced by pills it received from the GSEs’ lobbyists.
Inexperience and Naiveté of Mortgage Industry Managers
Weak oversight in the brave new world of mortgage lending might not have created quite so many problems were the managers of the lending institutions wise and wizened. But the front lines and middle management of the mortgage origination industry have always been manned by young people. The mortgage origination process is pressure-packed and a young person’s game.
Unfortunately, many of the industry’s decision makers at the origination level were young and naïve. Few had ever been through an economic downturn. Many acted as though downturns were a thing of the past. When under the pressures for producing a lot of loans (did ever I say “Production is king?”) too many of these “lightly experienced” managers at lending institutions cut corners and ignored time-tested mortgage underwriting principles.
Many people on the front lines of mortgage lending in the past decade
had never seen (or thought about) a housing downturn.
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Changes in Accounting
It is clear that the accountants for Fannie Mae and Freddie Mac “caught” neither the former’s $10 billion overstatement of profits nor the latter’s $5 billion of understated profits. These accounting failures contributed to a loss in confidence about the financial soundness of these two entities. They also put a serious dent in the lobbying power of the two GSEs on Capital Hill, but many in Congress still stood behind them.
A more important problem in the field of accounting for mortgage-related assets is the accounting requirement of “marking assets to market.”
In the past, most assets owned by a company were carried on the company’s books at the historical cost the company paid. If the company bought a machine, it recorded the value of that machine at what the company paid for it and then depreciated it (wrote down its value) over the useful life of the machine. If the machine cost $80,000 and was expected to last for ten years, the company could write down its value by $8,000 each year.
[The analogy that follows is overly simplified, but it explains the concept somewhat concretely.] So what happens if a new invention comes along in the fifth year of the machine’s life, making the machine totally obsolete? If it were sold in the used-machine market, it might bring only $1,000 for its scrap metal value. But on the books of the company it would be listed at $48,000 (the beginning value of $80,000 less four years of depreciation, which is $32,000).
The question can be asked, “What is the real value of that machine, $48,000 or $1,000?” Those who follow “historical accounting principles” would say that the best value is $48,000. Those who advocate “mark-to-market” accounting principles would say $1,000 is correct.
Over the last couple of decades, accounting rules have evolved to the point where financial institutions that hold securities like those that are bundled mortgages have been required to mark them to market.9 Since there is currently a loss of confidence in anything to do with mortgages, there is almost no market for them. So the financial institutions that own any security tied to them have seen the market value plummet and have had to write down these securities and take losses.
The problem with this scenario, however, is that the current loss of confidence is as much a psychological panic as it is an economic reality. Average investors are frightened about owning mortgage-related securities, and managers at mutual and pension funds don’t want to be caught with these supposedly “toxic” securities in their portfolios. So everyone is selling, and few are buying. Therefore, the prices of these items are falling below their true economic value, i.e. the value to which they will return in the long run, after the panic has passed.10
But in the meantime, the financial institutions are required to mark the securities down to panic-sale levels and take losses on their books even though the assets have not been sold. It’s a ludicrous situation.
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One of the legislative proposals under consideration involves having the SEC “suspend” the mark-to-market accounting requirement for three or four years. Another proposal has the U.S. Treasury buying up these assets that have been marked down below their true economic value and then holding them until the panic passes. They could then be sold in an orderly fashion and might even generate a profit for the taxpayers after a few years. Finally, the Financial Account-ing Standards Board (FASB) is studying ways to let companies estimate the real economic value of any investments for which there is no active market. The selling of securities involving subprime mortgages is virtually dead right now, so that market certainly qualifies as “not active.”
Mark to market accounting has clarified financial institutions’ current economic condition, assuming they have to sell their assets today (at fire sale prices). However, this clarity masks the longer term values these institutions will likely realize.
The Press and News Media
Since panic selling is driving mortgage related securities to values below their true economic value, it’s legitimate to ask, “Why is there such a panic over owning them?”
Part of the problem is the unknown. These securities are designed in such esoteric ways and are so new to the financial markets that no one is sure how they will really behave.
However, a large part of the problem is that the 24/7 media inundates the pages of newspapers/magazines and television shows with a frenzy of stories about how badly these mortgages are performing. It’s true that we are seeing historic highs in mortgage defaults. However, the average person doesn’t understand the true economic values of these securities, and he/she panics. Investment managers at mutual and pension funds panic at the thought of their stockholders or beneficiaries finding them with such “tainted” investment in their portfolios.
So everyone sells, driving prices of the securities lower and fulfilling the dire prophecies of the TV networks’ most inflammatory talking heads. Due to this “crisis of confidence,” it will take a significant amount of time for the true economic value of mortgage backed securities to be reflected in their market prices.
The press has been an echo chamber where contagious panic
has been reverberating louder than the sound at its origin.
The Housing Bubble
Those of us who have been around a long time have seen the investment pendulum swing back and forth between various types of assets. Some of the biggest swings have been between investments in the stock market and investments in real estate. We have been through a number
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of investment cycles where one type of investment does well and then falters, only to be followed by shifting investor preference for the other type of investment.
In the last half of the 1990s, stocks were hot—especially if they even hinted that they were involved with the Internet. When that bubble burst, real estate became hot (again). The prices of single family homes were rising so fast that some buyers didn’t even bother to move into the homes they purchased. They just rented or held them for six to eight months and then resold (“flipped”) them for a higher price.11 Investor speculation drove prices higher.
People who owned homes felt wealthy. People who didn’t own homes felt panic. With housing prices going through the roof, they feared if they didn’t purchase a home right away, they would never be able to buy one. They grew willing to stretch beyond their means just to get that little house with the white picket fence. Their panic also drove prices higher.
And mortgage lenders accommodated them. This was one of the reasons lenders and Wall Street developed the teaser rate, negative amortization and option loans discussed earlier. A major rationale for these untested mortgages (that flew in the face of time-honored underwriting standards) was that new types of loans were tickets to get homebuyers onto the real estate gravy train.
One of the factors contributing to the inaccuracy of the financial gurus’ pricing models was an assumption that mortgages were among the least risky investments in the world. After all, a family would, it was assumed, cut back on food, entertainment, auto expenses, etc. just to make sure the mortgage was paid. The last thing the average family wanted to do was to default on their mortgage and lose a home.
Housing prices rose much faster than consumers’ personal income. That condition can’t go on forever. Sooner or later, real estate values would have to flatten out, or even drop. Everyone in the mortgage industry knew this. But they were driven (and paid) for generating lots of mortgages. And besides, the compartmentalization of the mortgage industry meant they retained very little of the credit risk associated with the soon-to-be-overpriced homes.
But two things changed that long-held assumption. The first was that many new mortgage loan products required little or no borrower down payment. A default on such a mortgage didn’t cause the borrowers to lose as much as if they had to save for the traditional down payment their parents paid. The second was the fact that many homes purchased to be “flipped” became speculative investments where a defaulting borrower didn’t have to move out—only turn the keys over to the lender.
The housing bubble turned shelter into investment. Many homeowners– with the help of Wall Street, lenders and mortgage securities purchasers–became real estate speculators.
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Borrowers
The panic and greed of mortgage borrowers contributed to the financial crisis.
Borrower ineptitude and naiveté are responsible for some of the bad mortgages. Asking only a few simple questions would have informed many borrowers about the implications of the loans they were taking out.
One can argue that most borrowers don’t understanding the lending process well enough to know that they are getting into loans they won’t be able to afford. There is some truth in that. Borrowers correctly rely on mortgage professionals to guide them through the process. How-ever, when the mortgage professionals are getting paid to produce high lending volume and bear little credit risk, they aren’t prone to warn borrowers that they might be getting into loans over their heads. The mortgage professions simply said, “If Fannie or Freddie will buy this loan, then they think the borrower is financially qualified. Who am I to question the judgment of the big dogs in the industry?”
Greed, false hopes and financial ineptitude of borrowers contributed to the crisis.
Fraud and Misrepresentation
Of course, some borrowers didn’t really qualify for the loans that Fannie and Freddie would buy. Since most mortgage originators were paid on the basis of their loan production, some fudged numbers and information on borrowers’ application forms. Some of this fudging consisted of:
• Incorrect, overinflated income figures on “stated income” loans.12
• Phony documents in loan files produced using “Desktop Publisher” and other software that can produceW-2s, bank statements, financial statements and tax returns that are very difficult to distinguish from real documents.
• Inflated appraisals written by dishonest or pressured appraisers, some of whom received kickbacks for their “cooperation” and others of whom feared low appraisal values would cause their referrals to dry up.
Some borrowers got into mortgages they couldn’t afford due to the fact that the industry leaders who set the underwriting standards (Fannie Mae, Freddie Mac and the large mortgage insurance companies) lowered their underwriting standards too far. But others got into these loans because commissioned loan officers “adjusted” their mortgage application packages to make them seem qualified—even when they didn’t qualify under the very relaxed standard under which the industry was operating at the time.
These fraudulent loans were often the first to default—sometimes even before the first payment was made. They were the vanguard of the default cascade that began with the bursting of the housing bubble.
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Most mortgage originators were honest. But some, driven by the
quest for volume (production is king), engaged in fraud and misrepresentation to
make weak borrowers look like qualified borrowers.
Summary
The bottom line is that there were at least a dozen factors that lead to the mortgage meltdown. No single factor could have caused the crisis by itself. They came together in a “perfect storm,” a perfect financial storm of Category 5 proportions.
The rough sequence in which these factors came into play and lead us to the current situation was as follows:
• The structure of the mortgage industry changed to the point where those involved in the origination of mortgage loans bore little risk if a bad loan was made. The fact that they were all paid on the basis of the number of mortgages originated encouraged quantity of loans over quality of loans.
• Fannie Mae and Freddie Mac were converted from government agencies to private companies. This led them to pursue profits, which were largely tied to the volume of the loans they purchased from those who originated the mortgages. They grew dramatically to fill the void created when S&Ls decided (for good reason) they couldn’t hold mortgages in their portfolios.
• The mortgage industry and Wall Street worked feverishly to develop new types of mortgages that would serve those who might not qualify for the traditional 30-year fixed rate mortgage. In the process, they were able to generate many new loans (production is king) that were of questionable quality (“subprime”) and had untested credit performance characteristics.
• Wall Street bought packages of mortgage backed securities from Fannie and Freddie and put them into more complex securities that many in the financial community didn’t understand. Credit rating agencies assigned credit ratings to these complex securities, often using assumptions (guesses) that turned out to be incorrect.
• The complex securities were analyzed by financial gurus who used mathematical models to estimate default rates. The models turned out to be seriously flawed.
• The models and analyses performed by Fannie, Freddie, Wall Street and the rating agencies were based in the assumption that increased credit risk can be priced. However, their assumptions about the level of risk in mortgage backed securities turned out to be incorrect.
• Congress could have reigned in Fannie and Freddie, but lobbying overwhelmed efforts to make the companies change the way they did business. The regulators that oversaw Fannie and Freddie were weak and underfunded due to congressional negligence.
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• While the “free market” often acts as a deterrent to risky behavior, even in lightly regulated industries, many people in the mortgage origination business were young and had never experienced a real estate bust.
• Mark to market accounting rules have exacerbated financial losses and masked the longer term value of mortgage related securities.
• The frenzied reporting of the country’s 24/7 media has contributed to the “taint” of mortgage related investment. Many money managers, fearing the ire of stockholders and customers if their portfolios contain such investments, have sold them at very low values although, in the longer term, they are likely to prove more valuable than the fire sale prices at which they are currently trading.
• The seemingly inexorable rise in the price of housing appeared to justify risky lending. It was assumed that when mortgages defaulted, the homes could be sold for more than the mortgage balance, and that low or no losses would occur.
• Someone had to sign the papers for all the bad mortgage loans. Those borrowers that were real estate speculators and those that were simply uninformed and naïve contributed to the problem.
• Unfortunately, some of the Big Three in the origination process (real estate agents, loan officers and appraisers) pursued loan volume through “adjustments” of borrowers’ loan applications and other documentation. Some of these loans were the first to go into default and foreclosure. They became the first clouds portending the perfect financial storm that lay just beyond the horizon.
Again, no single factor or player caused this crisis. All the factors cited in this discussion, and perhaps others, contributed. We can argue about the relative importance of each, but all had their part. We can point fingers at people, institutions, administrations, politicians and regulators. We can cite greed and dishonesty. But all the factors worked together, swirling into a destructive vortex that has inflicted widespread damage on the U.S. and world economies.
But storms always pass, and the sun comes out. We need to remember two things:
1) We may have to be patient in waiting for the sun, and
2) We will repair the damage.
1 The author is the founder and was CEO of the Mortgage Asset Research Institute. He retired at the end of 2007. In addition, he served (1988-1990) as the Chief Credit Officer at Freddie Mac. Prior to that (1981-1983) he was the Chief National S&L Examiner at the Federal Home Loan Bank Board (FHLBB). He has a PhD and an MBA from Northwestern University’s Graduate School of Management and a BS in mathematics from Stanford. He currently serves on the board of directors for a complex of 14 mutual funds.
2 Fannie in 1968 and Freddie in 1989.
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3 In 1980 Congress passed the Depository Institutions Deregulation Act. The act mandated that a committee consisting of the chairs of regulatory agencies that supervised banks, thrifts (S&Ls) and credit unions lift the ceilings on interest rates these institutions paid for deposits. Government dictated deposit rates were to be phased out within six years. Prior to that time all such deposit interest rates were set at artificial levels determine by the government (under a rule known at “Regulation Q”). This committee was so aggressive that it completely deregulated deposit rates in less than three years. Residential mortgages, long considered some of the safest investments in the world, turned out to be very risky—not due to credit defaults but due to “interest rate risk.” The average S&L was paying eight or ten percent for funds and was receiving only five to six percent on the mortgage loans they owned. This created huge losses and caused S&Ls to look for places to sell their mortgage loans.
4 Some commentators have alleged that government pressure to lend to minorities and disadvantaged borrowers had lenders afraid to turn down poor credit risks. These commentators cite the Community Reinvestment Act (CRA) which encourages banks and thrifts to make loans to such borrowers as the main culprit. The problem with this argument, however, is that CRA only applies to federally insured institutions. But 70% to 75% of subprime lending was done by mortgage companies to which CRA does not apply. These lenders were simply anxious to produce more volume, and they didn’t bear the risk of poor quality loans. In addition, Fannie and Freddie were happy to participate since buying subprime loans gave them a whole new market to fuel Wall Street’s growth expectations.
5 The Mortgage Asset Research Institute had a client that saw many of its stated income loans go into early default. This client went back and verified the incomes of the defaulting borrowers with the IRS. It found that almost 60% of these borrowers exaggerated their incomes by half or more.
6 If you doubt that there is a “herd mentality” on Wall Street, just recall how foolishly virtually every investment banking house behaved during the dot.com era. Wall Street players touted companies that had yet to produce a penny of revenue, just because they planned to do business on the Internet.
7 When the agency told Fannie Mae it had to change its accounting practices and restate its financials, Fannie’s CEO Frank Raines publicly criticized the regulator and said he would ignore its direction. He said he would only comply with directives from the Securities and Exchange Commission. The SEC eventually backed the regulator, and Raines resigned from Fannie Mae.
8 A number of lenders formed a group called “FM Watch.” Their function was to keep tabs on Fannie Mae and Freddie Mac loan programs and warn Congress when these companies were overstepping their charters, developing inappropriate products or using their size and position of exert undue influence on the mortgage market. FM Watch had about as much impact as a fly on the hide of an elephant.
9 Some financial institutions like commercial banks classify their assets as either “hold-to-maturity” investment or “trading” investments. They only mark to market those in the trading category. Securities held by investment bankers (Wall Street firms) are all pretty much assumed to be for trading and get marked to market. This helps explain why the recent drop in prices of mortgage backed securities has caused huge losses for these firms.
10 Some economists have estimated that, at worst, the economic values of securities backed by subprime mortgages have dropped by 30%. But the market values for many of these securities have dropped by as much as 60%.
11 At one point in 2005, nearly 25% of all home sales in California involved investors that planned to flip the property.
12 The incomes listed on these loans were so notoriously inaccurate that industry insiders called them “liars’ loans.”
Thanks to new VAJoe member American Mom for sharing this blog with me so I could share it with you.
Doug’s Money Matters is a section of the VAJoe Blog to ask for quick financial tips and advice from an expert with more than 20 years experience in counseling families to live without debt and to reach there financial potential. Please leave comments on this Blog. You can learn more about the Money Matters advisor at his website. The posts and comments by JoeMoneyMatters reflect his two decades of financial counseling expereince. VAJoe.com does not endorse any financial strategies, but offers this blog as a service to its site members for discussion.
