The History of the Mortgage Collapse
by Loren Keim
I'm reposting this now because I think it's critical for us to understand that it isn't only banks that are creating our issues - too many of our politicians and regulations truly damage our ability to succeed.
Why is America in Financial Chaos?
Why are so many Americans in such financial trouble? How many homes will end up in foreclosure by the time the economic crisis has ended? How can we, as a country, pull out of this nosedive? Experts around the country have been debating this situation since early 2008. What's clear is that the crisis is a complex issue and resolving it won't be easy or done quickly.
The real estate market, and the broader economy, is cyclical. We all know it, and we've all heard it. Life is a rollercoaster ride and at times it goes up and at times it goes down. In May of 2006, I was on a stage in front of hundreds of real estate agents, appraisers, and local professionals at Lehigh University in Bethlehem, Pennsylvania. I was attempting to forecast the coming real estate market. My belief was that the fundamentals of the economy were fairly solid, but that prices had risen too fast in comparison with income levels and that the market would have to slow down, and possibly shrink.
In the presentation, I likened the coming decline a slow leak in a balloon that would hopefully have a soft landing. Obviously, in hindsight, we all see that the balloon has been riddled with bullets, grenades, and a few missiles. During the presentation, a mortgage broker, Robert Wilfinger, pointed out that we weren't accounting for the huge number of subprime loans that he believed would be foreclosed, which, he believed, would lead to a sharp decline in home values. He also explained that the mortgage industry had become too lax. Lenders were giving loans to virtually anyone who could breathe.
Part of the reason that lenders were giving loans so freely was a change in policy in Washington that eased restrictions on lending in order to assist more families in owning their own homes instead of renting. While this was a noble cause, it was not the best use of our financial system and is one of the primary reasons that we're in this historic decline.
"But Loren," you may ask, "what does this have to do with me? I can't pay my mortgage because I lost my job. I don't really care about this whole subprime thing. I had a normal mortgage."
You can't sell the house because it's worth less than you paid for it in 2006. It's worth less because the mortgage market has collapsed, making it more difficult to get mortgages and driving real estate prices down. The mortgage market has collapsed because our government and many other governments made decisions based on "feel good" politics rather than making sensible decisions. I've included this section because I am a firm believer that history repeats itself. At this point in time, we are passing stimulus packages and housing packages to try to correct the symptoms, but ignoring the real fundamental problems. If I can explain to you what I now believe happened, hopefully somewhere down the road we'll be better prepared to avoid the next catastrophic real estate loss.
In 1990, approximately 64.2% of Americans owned their own homes. Lenders carefully selected who would receive mortgages based on a few key indicators of their ability to repay the loans. In the real estate industry, we called these indicators the four "C's". They include:
•q Credit Worthiness. If the borrower doesn't have a decent credit score, it shows they have not paid their bills on time. If the borrower isn't paying their bills now, what would make a lender believe they will get better at paying them once they own a home?
•q Capital. In business, it's called having skin-in-the-game. Lenders don't want to loan the entire amount of a purchase, because the buyer or borrower doesn't have anything invested in the purchase. If their situation changes, it is easier for the buyer or borrower to walk away because they don't have anything to really lose, other than their credit rating.
•q Collateral. The home simply has to be worth what the buyer is paying for it. A lender doesn't want to risk having to take back a property and re-sell it if there isn't enough equity to sell the home in the case of default.
•q Capacity. The borrower has to have an income that allows them to make the payments. Lenders carefully determined whether or not the borrower could make the payments by assessing how long the borrower had been employed and what percentage of their income could be used to make the mortgage payment.
This system of carefully screening candidates for mortgages worked effectively in keeping the number of foreclosures very low for most of the last century. During the 1990's, the Community Reinvestment Act (CRA) was used to pressure lenders to reduce restrictions on the qualifications of buyers in order to increase the number of home owners, and particularly to assist minorities and low-income home buyers in purchasing homes. In fact, in 1999, the New York Times reported "that Fannie Mae and Freddie Mac were under pressure from the Clinton administration to increase lending to minorities and low-income home buyers"[i]
During the beginning of his administration, the 1992 Housing Bill set a goal for Fannie Mae and Freddie Mac to have 30% of their home loans be made to low and moderate income households. In 1996, that number was raised to 40% and then raised again to 42% in 1997.[ii] The GSEs then gave preferential treatment to mortgage companies and lenders who reduced their underwriting criteria. Countrywide Financial Corp. was the first to sign HUD's "Declaration of Fair Lending Principals and Practices."[iii]
All this boils down to the fact that these quasi-government institutions were the largest buyer of loans, and they actively reduced the restrictions required for obtaining a mortgage. Most lenders followed suite in order to take advantage of writing more loans and selling them to these institutions.
Programs became available, through Fannie Mae and Freddie Mac lenders and through Subprime lenders, offering 100% financing, 103% financing and in some cases, up to 125% financing. The supposed logic behind this idea was that buyers had decent credit and stable jobs but weren't able to save any money, so why not loan them the entire amount? Unfortunately, it also means that these home buyers had little or no money put into the property, and therefore, little to lose by walking away. It also left no equity for a lender if the buyer defaulted on the mortgage.
Even that wasn't enough. Programs were created that allowed borrowers to state their income on applications rather than actually provide proof of their earnings. In this case, the logic was that self employed people didn't show all their income, or couldn't prove it readily, so these individuals could not be turned away from being approved for a mortgage. The lender would simply charge them a slightly higher interest rate than the norm for the privilege of "stating" their income.
Lower and lower credit requirements continued to push the pool of potential home buyers into the depths of unqualified individuals. The checks and balances of the mortgage industry were totally out of whack with reality. Low interest rates, combined with low or no down payments and easy credit with very few verifications is a recipe for mortgage disaster.
In many cases across the country, there were lenders who were conservative and unwilling to follow these new reduced guidelines. Some of these banks and mortgage companies were sued by community action groups claiming they were discriminating against segments of the population based on archaic rules. Most lenders gave in, rather than go through the negative publicity and legal costs associated with continuing along a more conservative path.
Part of the dramatic rise in prices was directly attributable to the rise in home ownership. From 1993 to 2005, the percentage of Americans who owned homes jumped from approximately 63% to approximately 69.2%. Although that is only a 6% increase, those new homeowners were first time buyers.
In any given year, approximately 9-10% of the population purchases a home, and a little better than a third of those buyers are first time home buyers. When the number of first time home buyers was increased, it created a huge demand for first time homes, which drove the prices up. Those home sellers then relocated into "move-up" homes, creating a significant demand for those. Home owners who planned to never move again reconsidered. A home owner living in a moderate home and never expecting to afford a "dream home" now found that "dream home" within range. The increasing prices of moderate housing, combined with historically low interest rates created an opportunity to move to a luxury property that many people never expected to achieve.
Ultimately, the combination of easy credit, low interest rates, high affordability, low unemployment and high immigration all coalesced to create one of the highest periods of home appreciation in history. Like all good things, this too must end.
In September of 2003, Treasury Secretary John Snow went before Congress to propose a regulatory agency to oversee Fannie Mae and Freddie Mac, because the White House was concerned about their lending policies. Fannie Mae donated large sums of money to key congress people and no oversight was established. Congressman Barney Frank replied "Fannie Mae and Freddie Mac are not in a crisis". He actually pushed back that Fannie and Freddie needed to do even more to increase home ownership in America.
Hearings occurred in 2004 and 2005. A second attempt to regulate Fannie Mae and Freddie Mac was also blocked. In hearings, Congresswoman Maxine Waters stated that she was unhappy they were trying to "fix something that frankly wasn't broke. Mr. Chairman, we do not have a crisis at Freddie Mac and particular at Fannie Mae".
I submit that if these programs had not allowed unqualified home buyers to purchase homes, the housing recession would not have been nearly as severe. Foreclosures would not be reaching their current levels, and it is unlikely that housing prices would have dipped as low as they have.
In the mid 1990's, our firm, Century 21 Keim Realtors, began receiving mortgage company offers that appeared too good to be true. At the time, mortgages were just beginning to appear that offered low down payments and the acceptability of buyers with very low credit scores. These loans came at the price of a high interest rate. If the lender was going to take the risk of loaning to a borrower with limited qualifications, the borrower would have to pay a premium for the money. Later programs allowed nearly anyone to take advantage of low interest loans.
Several of our clients took advantage of these programs and eventually, after paying on the loan for a year or two and establishing a payment history, refinanced them to lower rates. As lenders started reducing restrictions and offering great loan products to buyers, we used those products instead.
In the late 1990's, I received a call from a reporter who wanted me to give him a quote before he fried me in the press. I calmly asked what the problem was, and he replied that our firm had intentionally injured a client by allowing them to take a higher-than-normal interest rate loan. That couple and their children were being thrown out into the street because we had allowed "predatory lenders" to take advantage of the couple.
The interest rate they had paid was 3% over the prevailing rate at that time. I explained to the reporter that the buyer had poor credit and no down payment. The facts were that the buyer was getting into a home with virtually no money out of pocket and a payment of less than $650 per month. To rent a home, like the one they purchased, would be likely to cost $750 per month or more. They were actually able to own a home cheaper than rent.
They were paying a premium in order to try to earn a piece of the American dream. Too many people in the country now expect everything to be given to them. The lender's premium on the mortgage rate was simply a function of the risk the lender was taking in even writing the loan for this borrower. I again stressed that despite the rate, the buyer had actually purchased the home for less per month than they would have paid in rent. It also tuned out that the buyer wasn't able to pay the mortgage because the buyer had gone to prison on charges of armed robbery, not because the payment was too high.
The reporter was shocked that there actually was another side to the story and that it couldn't easily be spun as mortgage company greed. The reporter found another story and ran that one instead.
Giving buyers the chance at home ownership is an admirable thing, but it has to be done with sensible rules that won't destroy our country and our way of life. Forcing the banking system to give away money to anyone and then propping it up with government backing by raising taxes is not the answer.
Please don't misunderstand me. There is plenty of blame to go around. Mortgage brokers made money in fees by writing loans. Appraisers made money estimating the value of homes for those mortgage brokers. Financial institutions made money packaging the loans and selling them to Fannie Mae or selling them as Mortgage Backed Securities. Even Wall Street Rating Agencies made money by rating the mortgage backed securities. There is plenty of guilt to go around, but it starts with government intervention.
The mortgage system is broken and needs to be fixed by people that are not part of the problem. Congress can't effectively fix the problem, because they are much of the blame for our current economic situation.
[i] Peter J Wallison. The American Spectator. Bloomington: Feb 2009. Vol. 42, Iss. 1; pg. 22, 6 pgs
[ii] Phil Gramm. Wall Street Journal. (Eastern edition). New York, N.Y.; Feb 20, 2009. pg. A.17
[iii] Phil Gramm. Wall Street Journal. (Eastern edition). New York, N.Y.; Feb 20, 2009. pg. A.17