WHITE PAPER REPORT ON THE MORTGAGE CRISIS

FROM MICKEY CARLTON

Thomas Mortgage & Financial Services, Inc.

407-788-5100    m.carlton@thomasmortgage.com

How did Americans progress from being the world’s economic leader to becoming the world’s economic anchor?

Friends and clients keep asking me, “What happened? Three years ago our economy was booming and our home values were rising at an intoxicatingly dizzy rate.  Last October, the US stock market was making historic highs. Today, home prices are dropping like the temperature in December, our stock market has lost over 40% of its value and we are being told that world economies are on the brink of a severe recession. How could things go so terribly wrong so very quickly?”

It is a hard question to answer, but I was sitting at ground zero originating mortgages while it was happening. I saw the beginnings and I believe I understand the beginnings. I can answer some of the questions about the latest developments provided the reader accepts my disclaimer that much of what is to follow is a combination of fact and personal opinion.  Robert Greenleaf said, “Only speak when what you are about to say will improve upon the silence.”

My desire is that these comments will add knowledge and insight to what the reader is seeing in the media and, by so doing, will improve upon the silence. 

ONCE UPON A TIME

In the beginning, mortgage applicants were asked to answer two questions:

Question Two: Do you have the willingness to repay the loan?

An affirmative answer to the first question came from the verification of sufficient employment, income and assets to suggest that the ability to repay was present.

The answer to the second question was arrived at by examining the borrower’s credit history to determine whether or not he or she had repaid other debts. It was that simple.

Lending guidelines began to loosen during the mid 90’s. Loan programs sprang up that were designed to increase homeownership among Americans of average (and below average) economic means. The most egregious of these programs were referred to as subprime loans. The subprime loans were joined by loans sanctioned by the Community Reinvestment Act (CRA). Finally, along came the “liar loans” to complete a package that has led us to our presently dire circumstances.

SUBPRIME LOANS

Subprime loans were granted to people who could not give acceptable answers to Questions One and Two, as detailed above. Typically, such borrowers had less than perfect credit, sketchy job histories or little or no down payments. These loans carried a higher interest rate than “conforming loans”.  They also contained terms that allowed the rates to rise dramatically in years subsequent to the purchase date. Prepayment penalties made it difficult to “refinance out of” such loans. Subprime loans were land mines granted to people who had already demonstrated an inability (by their employment, income, asset and credit report status) to handle a mortgage. In the early days, these loans were made by banks other than Fannie Mae or Freddie Mac. The initial profitability of these loans eventually led Fannie and Freddie to offer their own versions of subprime; usually at less onerous conditions than the private versions.

The subprime loans were a pimple on an elephant’s back when compared to the massive number of mortgages originated. In a vacuum, their failure to perform might have had little effect on the overall economy. As we shall see, they did not exist in a vacuum.

COMMUNITY REINVESTMENT ACT LOANS

Congress passed the Community Reinvestment Act (CRA) in 1977.  It has been revised many times over the years since the initial passage. The primary purpose was to encourage lenders to increase access to mortgages for borrowers who lived in certain low to moderate-income areas that were deemed (by Congress) as not being serviced sufficiently. Lenders, at the urging of Fannie and Freddie, who were encouraged by Congress in the mid to late 90’s, began making mortgage money available to such borrowers at very liberal terms under very loose underwriting guidelines. Liberalizing the guidelines was the only way to make such funding available to the targeted areas because the socioeconomic makeup of the areas left most residents unable to qualify for mortgages under “conforming” guidelines; i.e., Questions One and Two, as noted above.

A study by the Joint Center for Housing Studies at Harvard University found that “data for 1993-2000 show home purchase lending to low-income, moderate-income neighborhoods grew by 94%--more than any other category.”

Like subprime loans, these loans were a very miniscule number when related to total mortgage financing. Like subprime loans, their failure to perform might not have had a significant effect on the overall economy if they had been operating in a vacuum. Like subprime loans, they were not operating in a vacuum.

LIAR LOANS

The initial profitability of loans with these relaxed standards led to more and more liberal lending guidelines. Eventually, reduced documentation mortgages became very popular. As an example, a “reduced-doc” loan might have excused the need for tax returns for a borrower who wanted to finance a house before he or she had filed their return. Such a borrower with excellent credit would obtain financing with a “stated income” loan. The loan carried a slight increase in the interest rate to compensate the lender for the increased risk of “trusting the borrower”. These loans eventually grew into “stated income/stated asset” or “no income/stated asset” or, in extreme cases, “no doc” loans. In theory, there was no problem with trusting the borrower because the guidelines called for excellent credit and a reasonable down payment. It was theorized that such a borrower would not lie about his or her income and assets. Theory did not hold up in the real world.

Incompetent and/or unethical lenders began to use these reduced doc loans to qualify people who could not pass Basic Question Number One; i.e., “can you afford to repay the loan?” Lenders, with the complicity of their borrowers (and borrowers, with the complicity of their lenders) began to lie about income and assets as a means of qualifying buyers for homes. Investors, mesmerized by the growing value of houses, used these same liar loans to qualify for multiple investment properties, their intentions being to flip the houses for quick profits. Buyers lined up at builders’ show rooms to place deposits on homes they never planned to occupy.

Can it be any mystery that these loans have not performed well?

Borrowers used these loans to purchase homes they could not afford. Investors used these loans to take dramatic risks in the housing market. With regard to the investors, the flaw was that investors do not get rewarded for taking risk. Investors get rewarded for buying cheap assets. Homes were certainly not cheap assets in the summer of 2005. Historically, investors who shovel money into ever-more risky assets have not been rewarded; they have been punished. Such has been the case with the investors who bought homes that they could not afford to hold.

The negative impact of non-performing liar loans has been compounded by the fact that many of the borrowers returned every two or three years and used the increased equity in their homes to secure another liar loan in order to pay off credit card debt. Because their actual incomes were never truly enough to qualify for their total liabilities, they would have to buy groceries, gasoline, Christmas presents, etc., with credit cards, using their actual paychecks to struggle with the mortgage payment. Some of these purchase money loans made as early as 2000 had been refinanced at least twice by the time property values topped out in 2006, thereby tripling the initial exposure.

AND THE HOUSE OF CARDS CAME TUMBLING…

The issuance of subprime loans, CRA loans, liar loans and other lesser mistakes has caused a crash because of their cumulative effects. These three loan categories combined to create massive artificial demand from people who, without them, might never have been able to buy a home or, more likely, would have only been able to buy a less-expensive home. This demand was largely responsible for the insane increase in home values experienced from 2002 to 2006. Home values dramatically exceeded long term growth lines.

A key feature of subprime loans was their adjustment factors that would kick in after two years. Subprime borrowers would wake up one morning and find that their interest rate had gone from 7% to 11%, 12% or 13%. Faced with such a dramatic increase in monthly housing expense, the borrower would be faced with foreclosure. In the early days, this was not a problem because their numbers were miniscule. However, after several years of issuing subprime mortgage debt, the cumulative effect of these foreclosures began to weigh heavily on home prices. In many cases, entire neighborhoods had been financed with subprime mortgages.

As the subprime loans began to cave in, so did the CRA loans. In both cases, these loans had been made to people who could not reasonably answer Questions One and Two of the loan originator’s bible.  The impact of their failures put a top on home values.

Suddenly, the much larger number of borrowers who had liar loans began to experience trouble. The speculators who had purchased investment properties with the intention of quickly flipping them for a profit were stuck. Many of the investors had used reduced documentation loans to acquire the properties. They never meant to hold the properties for longer than a few months. They had no real reserves to carry the properties and they could not demand enough rent to offset the carrying costs. They could not sell the homes because values had topped out. They could not service the debt because they never really qualified.

The owners of primary residences who had secured their homes with fraudulent statements of income and assets were struggling to make the payments on their mortgages, automobile notes and credit cards. Suddenly, with no increase in equity, these homeowners could not stroll down to the bank for a new refinance that would “pay off” their credit card debt and give them new life. Suddenly, they found themselves unable to service their personal debt. They owed more on their homes than the homes were worth, so they could not refinance and they could not sell.

The failure of subprime and CRA borrowers to perform was only the catalyst for the current crisis. They put a top on the run-up in home values making it more difficult for investors and other troubled borrowers to service the debt or stave off the day of reckoning. The market imploded inwardly as the relatively small numbers of subprime and CRA problems pressured the far greater number of liar loan borrowers. Suddenly, home values were crashing and no one was safe, not even the “fully documented” buyer/borrowers who had adequately answered Questions One and Two.

COMPOUNDING THE PROBLEM—WHY IT IS GLOBAL

One reason that loan guidelines were relaxed and ethical behavior became so abhorrent was the lack of liability at all stages of the mortgage process. My mortgage company sells the mortgages that we originate.  Once we sell them, we are “off the hook” for their performance unless we are found to have committed some form of fraud. We sell the mortgages to larger mortgage companies or banks. These entities may continue to service the loans (send out statements and collect payments) but they sell the paper to Fannie, Freddie or an investment banker. They are then “off the hook”. The investment banker (or Fannie and Freddie) then packages the cumulative loans and sells them as “collateralized securities”. Now, even they are “off the hook”, theoretically. (Well, not exactly, as we shall see.) A better system of responsibility would have greatly encouraged the professionals to be more ethical and demanding in their efforts to secure acceptable answers to Questions One and Two. This issue, incidentally, has not yet been addressed. More regulation is not the answer. What is needed is more liability, at every stage of loan origination, for the future performance of the borrower. It is impossible to regulate morality. Extended, long-term payouts based on performance might induce a much higher degree of ethics and morality than a new stack of regulations.

The reason the problem has become so significant, in a global sense, is that these collateralized securities were significantly leveraged and often over-rated by national bond rating agencies. Investment bankers found that they could sell the securities with better returns by selling insurance on the bonds. Only, they did not exactly sell insurance.

They sold complex instruments called “credit default swaps” that supposedly served as insurance in case the mortgage bonds did not perform as expected (which they most certainly did not). These swaps were not called insurance (even though that was their intent), so they did not have to be regulated as insurance. As a result, they were not regulated, at all. This meant that the sellers of such swaps were not required to keep suitable “loss reserves”.

The bankers and insurance companies sold these highly leveraged mortgage backed securities using swaps as inducements to their customers. They did so with the assumption that home prices never really go down, so the bankers incorrectly assessed their risk. They were very wrong in their assumptions regarding risk. Home prices did go down, just like any other investment. The big banks, mortgage companies and insurance companies have not been able to “make good” on the bonds because they did not keep suitable reserves to cover losses.  Consequently, the US Treasury (actually, you and I) has to bail them out.

We can all play the blame game about who is at fault. None of that will change the circumstances and it is a little late to go back and perform quality control checks on ten years worth of high-risk loans.

WHY BAIL THEM OUT?

The ill-fated mortgage securities were sold to huge investors such as college endowment funds, retirement funds, corporate pension funds, foreign central banks, Russian billionaires, Saudi oil ministers and the Norwegian fishing villages made famous by the widely circulated stick figure explanation of the mortgage crisis. As you may imagine, the holders of these bonds are extremely displeased by the losses they have incurred as a result of buying securities that, in many cases, were triple A rated by our rating agencies and were covered by these swap arrangements. These angry bondholders are using whatever threatening language is available to them (no more oil, no more dollar reinvestment, higher tariffs, etc.) if the US does not stop the bleeding.

As a country, we must act quickly to recover lost credibility.  This is why Congress passed the bailout bill. The international community is withholding dollar investments and exacerbating an already critical circumstance with regard to the availability of credit. Without credit, economic activity stops. The bailout is an attempt to restart the wheels of commerce, wheels that run on credit.

Why give the money to the very Wall Street investment firms that are often credited with creating the problem? Remember that the mortgage-backed securities and swaps that have leveraged the housing problem into a crisis are very, very complex instruments. The very people who wrote the instruments are the only ones with the expertise to put the bailout money in proper position to shore up the damage. It is not as if Congress could give this money to a group of Washington bureaucrats and ask them to fix the problem.

Washington bureaucrats do not have the expertise or the trading facilities to fix something they did not create and do not understand. So, the foxes are being supplied with taxpayer money and being asked to repair the henhouse.

WILL WE LIVE HAPPILY EVER AFTER?

As a country, we have recovered from the Great Depression, the stock market collapse of 1987, the savings and loan failure, and several lesser calamities.  No one, not George Bush, nor the presidential candidates, not the Chairman of the Federal Reserve, not the Treasury Secretary, or the FDIC Chief and certainly not me, knows how or where this will end. Each disaster leaves us with a better idea of how to resolve the next one. In the current circumstance, I am hopeful that the securities being backed by taxpayer money will eventually become sufficiently valued to repay you and me, the taxpayers. I am confident that we will survive this current crisis.  It is not always the strongest or most intelligent that survives, but the one who is willing to adapt. I believe we, as a country, are adapting.

I believe our current economic crisis, and ones that preceded it, are like the forest fires that nature sends from time to time. The fire is terrifyingly hot and creates panic and devastation. But the aftermath is renewed life. Dead trees and underbrush are gone. New plants emerge where shadows and weeds existed. Animals return in new and healthier numbers. Life is renewed.

Our mortgage lending practices, starting with loan originators and buyers who ignored ethics and the laws of risk/reward at the bottom and extending to the bankers who sold questionable securities at the top, created a balloon of unsustainable home value, akin to the dead spots in the forest. This economic abnormality had to be corrected. The mortgage crisis is the fire that will eventually, after significant pain, put the economy back on firm ground.

WHEN WILL HOUSING AND THE GENERAL ECONOMY RECOVER?

Again, no one knows the timetable. We must adapt and move forward to create a recovery.

Residential housing has never been meant as a storehouse of value. Houses are built to store families, lives and dreams. The fact that home values almost always rise over the long term is a bonus to a home’s inherent function as a place of shelter, not a guarantee or a promise. Regardless of the anticipation of gain or the likelihood of gain, it is a home’s function as a shelter and a “living center” that is the reason people dream of home ownership. In today’s world, there are wonderful values in the housing market and the price bar for home ownership is returning to affordability. Americans of modest means are once again going to be able to own their own place.

There is an abundance of mortgage money available regardless of what you have heard about the credit crunch. People who can answer Questions One and Two in a satisfactory manner can still obtain mortgage money at reasonable rates.

Housing problems have always recovered from the bottom up. Housing markets do not start to recover with the sale of high-end, lakefront homes. They recover when Jim buys his first home, allowing Bob and his growing family to move up to a larger, more spacious home, thereby enabling Sam and Diane to buy their lakefront mansion.

This economic crisis has already been as terrifying as the raging forest fire. While it may be under control, the fire is not “out”. It will take some time for the economy to recover from this blow. The smart people will tighten their belts for the short term, purchase undervalued assets for the long term and look back on this as an opportunity. It is said that when God closes a door He opens a window. Adapt. Look for the window.

Mickey Carlton

Executive Vice President

Thomas Mortgage & Financial Services, Inc.

(407) 788-5100

m.carlton@thomasmortgage.com

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Thomas Mortgage & Financial Services, Inc. - 1180 Spring Centre South, Suite 223 - Altamonte Springs, FL 32714
Office Phone: (407) 788-5100 Fax: (407) 788-2274

We lend in the following states: FL



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