As promised, I will take a few minutes and briefly walk you through the financial mess, as it pertained to the “Sub-Prime” mortgage industry, as well as the prime mortgage industry and Wall Street. My hopes in writing this are to make everyone aware of the systemic risk that still lurks around every investment portfolio, every blue collar pay check, and every welfare payment out there. To really understand how this happened we must travel back to 1977. The Carter administration had passed a law called “The Community Re-investment Act of 1977”. Carter was under pressure to pass a law that forced banks to lend in certain areas that were extremely high risk. The term they used for banks refusing to lend in areas where foreclosure and fraud were the norm was “redlining.” This was the start of the sub-prime industry (although it didn’t materialize until a decade and a half later).
Now fast forward through Reganomics, and the push for deregulation. The notion of Free Market Capitalism was sweeping the nation due to the policies of the Regan administration. Under the Clinton Administration the Department of Housing and Urban Development (HUD) increasingly put pressure on Fannie Mae (FNMA) to increase its purchase of Community Reinvestment Act (CRA) securities from approximately $7 billion to over $20 billion annually, almost 50% of its annual security purchases. In 1999, The Graham-Leach-Bliley Act or Securities Modernization Act was passed by President Clinton. This act allowed banks to compete in the financial industry and vice versa. Now Wall Street could gain access to FNMA, FHLMC, GNMA securities among other “high return/low risk” investments.
Now enter the sub prime lenders. It was late 2000 and companies were trying to institute ways to increase lending to low and moderate income individuals. One of the ways of doing this was to loosen the guidelines on stated loans. A stated loan is a loan originally created for self employed individuals who write off a majority of their taxable income and report to the IRS, a low Gross Adjusted Income. By looking at their credit score and judging by the assets they had in the bank, the risk of high debt to income ratios was reduced. For example a self employed individual who took in 150k in income but had substantial business “expenditures” an only reported 75k in gross income, may have a debt to income ratio of 65-70% when in reality, had the business owner not written off as much income the ratio would be lower. Looking at the credit score (680-720 was the US average FICO score at the time representing a strong ability to repay) and the amount of money the borrower had in the bank (typically 3 months of principal interest taxes and insurance or more) the bank would allow the borrower to “state” 150k on their loan application.
After the events on September 11, 2001 Alan Greenspan lowered the Fed Funds rate to 1% (meaning if you invest in US Treasury Bonds you could expect a meager 1% return). The global economy needed a new market to invest trillions of dollars. The sub-prime mortgage companies, the rating agencies that were rating their securities, and Wall Street had a product that global investors would fall in love with. There were decades worth of data that said “If the fico score is X and the Loan to Value is Y, then the likely hood of repayment is Z” Now take this to a market that is commonly exposed to risk and tell them you are going to pay 4-7% on their money with little or no additional risk. It was a dream come true for investors. They poured more money into the US Mortgage markets, and therefore created an economy that was sustained purely by real estate. If not real estate what was fueling the post 9/11 economy?
This “thriving” economy created a natural sense of competition between mortgage lenders, pushing the envelope of lending, while maintaining the average default rates became the norm. New and more aggressive products were developed, such as option arms, interest only loans and No Documentation requirements. The rating agencies, however, were still telling Wall Street that these bonds were performing when in fact there was not sufficient data to accurately report on. Everyone was under the impression that housing prices would continue to rise, and if they did we would have little to no issues. It was similar to Bernard Madoff’s Ponzi scheme, but legal. If the home prices keep going up, people will naturally refinance, payoff debt and get out of their exotic loan prior to its payments having financial consequences on them.
Slowly, residential home values began to fall. The rating agencies that once held companies like Lehman Brothers and Bears Stearns in high esteem, turned their back and down graded their ratings from AAA to near junk bond levels. This instantly forced the global economy to stop pouring money into these companies and eventually sucking the life out of the mortgage market. The people who needed to refinance their current mortgage to avoid payment adjustments could not find a mortgage. Panic and crisis ensued. This is an extremely shortened version of what happened but hopefully it paints a clear picture.
Addressing the vilification of anyone who was involved in the mortgage industry at this time is challenging. People were all doing jobs and were employed to do so. Analysts looked at numbers and reported on numbers. Wall Street looked at profits and reported on profits. Mortgage Banks looked at default rates and lent in respect to minimizing defaults. Sales people, such as myself, sold products we were given. Home owners took out loans to refinance or purchase houses. That is it, no conspiracy, no criminal intent, a cycle that had little or no regulation that spun out of control. Now as stated before, as in any industry, there were scammers. I receive phone calls from “government specialists who can give me stimulus money to lower my monthly debt payments” I hear of kidney dialysis institutions not informing their patients about transplant opportunities to keep the Medicaid payments coming, lawyers who say they can win your case but insist you pay them a $5,000.00 retainer. Scammers are everywhere. To single out everyone and suggest they are criminals requires a lack of understanding or plain ignorance. There were mortgage brokers who lied to borrowers for profit, there were borrowers who forged documents to accelerate approval, and there were appraisers who inflated home values to aid brokers. At every step of the process there were con men, as in any industry a small percentage of fraud is expected.
Now let me be clear, this is not the only factor to prevent future economic crisis’. We need reform on Wall Street, reform of lending laws, reform on Real Estate agents practices and in many other areas. It would take a book to underline all the holes that need to be filled to prevent future economic crisis. But let’s first examine our spending habits, the purchase of many items in our life on credit. Credit is what created this bubble. Americans have gotten themselves into the practice of financing everything we buy instead of saving for purchases. I am sure I missed some key facts or haven’t clearly explained every issue I touch upon. So please when replying to this post, offer criticism that can be translated into action. Any defamatory comments will be removed. Let’s talk about the issues that led up to the crisis and hopefully we can work to make America a better place for our children.