DAYTON (Second Quarter, 2008) – Unfortunately, the reality of the current mortgage-lending crisis is harsh.  It is harsh for the millions of homeowners who cannot now afford to stay in the homes they have purchased, but housing values are so depressed they cannot afford to leave.  It is harsh for homebuilders who were lulled into a false sense of security that the home buying market was no longer cyclical.  It is harsh for the thousands of rank and file employees of financial institutions and mortgage brokerage companies who are now out of work.  It is harsh for the “average guy on the street”, who is watching his stake in the “American Dream” of home ownership disappear in weeks or months.  In essence, the mortgage crisis is harsh for virtually everyone.

The fundamental question of, “How did it get so bad?” must be answered.  For most Americans, the mortgage loan crisis and the resulting meltdown of the housing markets “blindsided” us.  While the crisis has grabbed the headlines in recent months, it has been growing progressively worse for some time now.  The following paragraphs are intended to shed some light on the causes and the effects of the current crisis: it is every bit as twisted as a Crime Scene Investigation; and, perhaps it is.

Home ownership is the “American Dream”.  Home ownership allows some of the largest remaining tax deductions for individuals, for mortgage interest paid each year.  It is a societal sign of arrival for many Americans when they close on the purchase of their own home.  Two out of every three American households are homeowners.  For many families, the purchase of a home is the largest investment they will make in their lives and the home is the largest single “asset” they have to show on their personal financial statements.  To say that home ownership is one of the foundation stones of American life is not an exaggeration.  “Then why is this foundation of American life currently under attack?”

We have to dissect the mortgage and housing markets to look for clues to the current “mortgage mess”.  Let’s begin with a look back at the economy of the recent past.  The U.S. economy has been moving forward, albeit with less than spectacular growth until recently.  The country has added jobs, but many of these jobs are in service industries or the retail segment of the economy, not the wealth creating jobs in industry the country used to rely on for growth.  The banking industry has evolved through consolidation and the creation of secondary financial markets to be dominated by a small number of integrated financial institutions that provide ranges of services under one roof that were actually outlawed during the Great Depression.  According to the politicos and the “talking heads”, “The Sun was coming up on all four sides of our nation and its economy.”  “Doesn’t it make you the slightest bit skeptical when things seem too good to be true?” 

As I said above, a secondary market for financial instruments was created.  The reason for this new financial vehicle is fundamentally sound.  After financial institutions originate loans, they are “pooled” and sold as investment instruments.  The investment instrument is backed by the loans, or mortgages, that comprise the “pool”.  Investors receive their payments as the borrowers make payments on the loans in the pool.  This enables the originating financial institutions to free up their resources to make more loans.  The originating institutions may, or may not, retain the loan servicing, making sure payments are made, real estate taxes are paid, and insurance on the collateral properties is maintained, etc.  Loan servicing is done for a fee paid to the servicing agent, or institution.  Let’s do a brief recap of the process so far, financial institutions and loan brokers originate loans.  The loans are funded by financial institutions who in-turn pool the loans and sell them to investors.   The originating institutions’ resources are replenished by the sale of the pooled loans, so they can repeat the process.  It is easy to see that this process significantly expands the capacity of financial institutions to originate loans.  While this may be a significant positive advance for the banking institutions, it can result in rampant abuse.  The institutions originating the loans typically collect origination fees, when they sell the pooled loans they receive servicing fees, and when the securities backed by the loans are sold to investors the investment banks, which may be owned by the financial institutions originating or funding the loans, receive fees and commissions.

Banks are publicly traded and they are dependent on their financial performance to drive their stock price, so substantial year-over-year earnings growth in an economy that is experiencing minimal inflation means substantial “real” returns to stock holders and an improved competitive position for the top performing financial institutions.  “Are you beginning to get the picture?”

The financial institutions don’t want to disappoint their shareholders by not being able to maintain the earnings growth rates they have historically demonstrated, so the pressure is on to increase earnings quarter after quarter and year after year.  How did the financial institutions do that; they accelerated their mortgage originations through their own networks of branches and through correspondent relationships with third party mortgage brokers.  For most financial institutions, mortgage loans have been among the largest individual transactions they close.  It is only natural for these institutions to want to accelerate the pace of mortgage transactions and, besides, they are going to sell the loans so they don’t appear on their balance sheets in the future if they go bad.  “We have now unlocked a fundamental human weakness – GREED!”

Now that we have unlocked the “Greed Monster” let’s find ways to maximize its potential.  Loan originators are paid commissions for loan originations; i.e., more originations equal more commissions.  The loans originated, by loan officers and loan brokers, are only funded by banks for a short time.  The loans are pooled and sold to investors as “mortgage backed securities”.  The resale process has existed for some time utilizing the mechanism of  “Fannie Mae” and Freddie Mac”: agencies of the Federal government that act as loan guarantors.  Unfortunately, these two agencies have rigorous underwriting standards for the loans they purchase and pool.  These underwriting standards represent a potential drag on the momentum of the mortgage market for originating financial institutions, so the investment bankers created similar securities that they would sell directly to investors to go around the underwriting standards of the Federal agencies.  This enables the financial institutions’ loan officers and third party brokers to underwrite and close mortgages they would not otherwise be able to sell.  Hence the creation of a new, mortgage lending term “Subprime borrower”.  While the term was meant to describe borrowers that did not fit the rigorous, conventional mortgage underwriting standards, it has come to mean every sort of bad credit known to mankind.  If underwriting standards are no longer that important then some of the ancillary requirements can’t be that important either: things like down payments and proof of borrowers’ jobs and income for example.  The risks couldn’t be that significant; the loans are pooled and surely every loan in the pool couldn’t go bad…”Yeh, Right!”

The investment bankers convinced themselves that the mortgage-backed securities they were pumping into the market could not fail!  Had the risks been accurately analyzed and quantified? – No Way!  The security created by the investment bankers was a new breed of investment vehicle.  It appears clear now that the entities charged with evaluating the underlying risks and expressing opinions based on their analyses, in the form of investment grading, were “asleep at the switch”.

Now let’s revisit the housing markets and look at the prerequisites for a disaster.  Both existing home sales and new home sales were being completed at a breathtaking pace between 2000 and 2004.  In many attractive markets, explosive price increases were the norm.  Historically, housing has had a fundamentally solid track record of value growth, at the least a hedge against inflation, over the long term.  Beginning in 2000, the housing markets began to escalate to unprecedented new levels of activity.  The following three or four years saw the numbers of sales of existing homes and new homes shatter old records.  Housing values seemed “bulletproof”, but what was driving this market velocity?  Loan originators were finding new and creative ways to qualify almost anyone for mortgage loans.  Values were increasing at a record pace because virtually everyone was a potential buyer: it’s the basic supply and demand relationship at work, so down payments could be minimal or nonexistent.  You could even achieve a twenty percent down payment, considered standard by underwriters, by funding equity lines for the difference between the conventional first mortgages and the purchase prices of homes.  Funds to make loans were plentiful and inflation was under control so interest rates were low; even lower if the borrowers were willing to take some interest rate risk in the form of adjustable rate mortgages.  Finally, borrowers could even get loans without proof of employment or verification of income.  Borrowers had to sign affidavits attesting to their own employment and income.  “We all know that everyone is basically honest…Right?”  Based on the liberal underwriting criteria for borrowers, what part of getting something for nothing did loan originators and the financial institutions not understand?  In addition, aren’t the fundamental market conditions, like “housing values will always go up” and “interest rates will always stay low”, out of the control of lenders and borrowers alike?  “So we reveal another human weakness – STUPIDITY!”

By 2004 some cracks began to appear in the “rock solid foundation” that the whole mortgage market was built on.  Housing values and existing home sales began to sputter in some localized areas, but other “hot spots” remained strong.  Investors in mortgage backed securities for so-called “jumbo mortgages”, those over the $417,000 plus threshold generally recognized as more risky, were beginning to experience defaults in the loan pools they had purchased.  The Fed was getting concerned about inflation and interest rates began to creep upward.  As a result, many adjustable rate mortgages originated in an extremely favorable borrowing environment began to adjust and borrowers could no longer afford the payments.  As these defaults began to increase, the investors in mortgage-backed securities began to experience problems with their payments, even the loan pools backing credit rated securities.  Obviously, investors are not going to buy more similar securities if their existing investments have failed to perform.  As defaults in existing mortgage-backed securities investments began to spread, the flow of funds into these investment vehicles reacted in the opposite direction.  The failure of investors, in the domestic and international markets, to buy more mortgage-backed securities cut off the flow of funds into the financial institutions originating mortgage loans.  Without mortgages, average American households cannot afford the “American Dream” whether it is a new home or an existing home.

It’s time for another recap.  Investors, worldwide, quit buying mortgage backed securities, the originating financial institutions and investment banks are being called upon to perform on guarantees provided to sell the securities backed by mortgage loans made in the past, and the value of any of these securities that may have been retained by the financial institutions must be written down or, worse yet, written off.  Hence, the liquidity crisis in the financial services sector of our economy.  

By 2004, existing home sales and new home sales began a downward trend in some markets.  Generally, new homebuyers must sell their existing homes in order to have the down payments to purchase new homes.  If these potential buyers cannot sell their existing homes, or sell at prices that yield down payments, they cannot afford to purchase new homes.  So, the downward spiral began.  By 2005, the pace of existing home sales was showing signs of more significant weakness and the downturn in new home construction was becoming widespread.  Some of the large-scale homebuilders decided to become mortgage lenders, following the practices they observed in the financial institutions that had been financing their sales.  Imitation can be flattering; in this case it was just dumb.  2006 did not bring any relief to the homebuilders, nor did 2007.  2008 appears to be more of the same.  Statistics now indicate that existing home values may be slipping; in some isolated markets they are crashing.  The fundamental logic suggests that the longer and deeper the retrenchment in existing home values, the longer it will take to revitalize the new home construction markets.  Many homebuilders of all sizes will not be around when the markets finally turn positive.  The rate of foreclosures in some markets has placed those isolated local markets in a “freefall” condition.  “So how do we get out of this mess?”  The answer to this question is complex, but we must move swiftly to reverse current market trends to bring some sense of stability to the economy, in general, and avoid the “D” word, depression.

Since it is highly unlikely that we will ever be able to curb the two human weaknesses cited above; GREED and STUPIDITY, we will have to find ways to control both of these detrimental weaknesses.  Controlling human weaknesses may be the easy part of the problem to fix.  How we restore credibility in the worldwide market of investors: corporations, institutions, and governments, that bought our financial “shell game” is going to be the difficult task.  The U.S. must have willing multinational investors to buy our debt in order for our economy to operate.  We can argue over the long-term intelligence of this dependency later; for now we cannot wean ourselves from this dependency in the short run.  The likely solutions to the current problem will have to address both the human weaknesses and credibility restoration, concurrently.

It is likely that the traditional underwriting standards used successfully for years in the mortgage market will have to be “dusted off’ and applied without exception.  Adjustable rate mortgages may be subject to a new set of underwriting guidelines to protect against borrower defaults when interest rates reset to higher levels.  The Fed has recently circulated a “guidance” that suggested underwriting standards for adjustable rate mortgages should include the calculation of debt service payments to borrower income based on the highest interest rate that the mortgage could reset to over the life of the loan.  This “draft guidance” has met with strong resistance from the Mortgage Bankers Association.  It is more than a little difficult to be sympathetic with the folks who consciously helped lead us into this financial mess.  The message being sent by the Fed appears to be clear: there will be underwriting standards that include measures of financial capacity and character in making mortgage loans in the future.  It is also likely that there will be more regulatory oversight of the mortgage business in the future.  Based on the decisions already made by some large mortgage companies, the days of third party mortgage brokers may be numbered.  Proposed strict underwriting guidelines and oversight are measures that must be taken to restore credibility in the worldwide investor markets.  Investors must be confident that the securities being offered for sale have been underwritten with some degree of thoroughness and consistency.  Hopefully this will help those institutions, corporations, and governments to forget about the proverbial “bags of air” we sold them in the past.  Only time will tell, but it is likely that our financial institutions will be operating at a reduced pace until a sense of credit quality is restored to the investment vehicles offered by our financial services institutions in the future. Before moving on in this discussion, it is important to point out that mortgage loan pools may be the most problematic at this time, but similar investment vehicles were widely used for automobile loans and credit card debt.  There are some indications that these securities may be vulnerable as well.

Now back to the housing market.  Housing will continue to languish until the credit markets are restored to some sense of order.  Some of the possible solutions to this problem have been outlined above.  Unfortunately, existing home prices will probably be soft as long as the market is inundated with homes for sale and, in some markets, foreclosed homes for auction or for sale.  Lenders are not known for their patience in dealing with foreclosed properties.  Most lenders will want to sell the properties they have taken back at the earliest convenience even if they take a substantial loss in the process.  Lenders are simply not equipped to deal with the magnitude of the foreclosure problem confronting them at this time.  Of course, this destabilizes the market for conventional home sales if potential buyers can buy a comparable home in any given neighborhood at a reduced price from a lender.  

As the value of existing homes continues to slide in some markets, even people who can afford to make their mortgage payments are sending lenders the keys because the owners’ hard earned equity is gone and not likely to be regained in the near term.  This market condition cannot be allowed to spread to the market in general.

The Fed has a tightrope to walk.  They cannot allow the fundamental underpinnings of the U.S. banking system be called into question.  While working to maintain the liquidity of our financial institutions, the Fed cannot do anything to forgive the transgressions of the financial services industry without sending the message that the abuses just witnessed in the mortgage business are in some way “OK”.  The worldwide market of investors in our debt would not be pleased with that sort of message to our financial services industry either.  Neither can Congress forgive the excesses of borrowers who may have knowingly lied to get loans they simply could not afford.  The danger in this message is that the vast majority of homeowners who pay their mortgages regularly may question the wisdom of continuing to make their payments.  Finally, there are those homeowners who were led into unaffordable loans by predatory lenders.  It is difficult to sort out the numbers of borrowers who may have been victimized in the current mortgage mess.  Certainly, there are many victims in the aftermath of an industry driven to excess.  Ultimately, the American public, collectively, is the victim of the excesses of our financial institutions because it will be the taxpayers of this country who will pay the bill for these excesses.  Hopefully, this time, we will be able to remember the outcome of these excesses so that we do not repeat them in the foreseeable future.

No doubt the lawsuits will fly and hearings will be held, but will we, as a nation, actually learn anything from this crisis.  There was a time when households bought homes and never moved again.  Households actually paid off their mortgages.  Homes were a “cost of living” not an “investment”.  Loans were something to avoid, not collect like trophies.  People had savings accounts and put money away for the “things” they wanted and just for “a rainy day”.  Today everyone has cash flow, but it is difficult to find people with true net worth.  The application of more stringent underwriting standards to obtain credit will be a real “culture shock” for many.  If we really learn something from this crisis, it is likely that we will experience a fairly long recession because people will actually reduce their consumption and live within their means.  “Now there’s a concept!” 

Originally published in the April 2008 & the Second Quarter 2008 Issues of Gem’s Newsletters

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