Origins of the Foreclosure Crisis

Where Did This All Come From

Over the past several years, there has been a 21^st century phenomenon that is popularly called "subprime lending".  There is no set definition for what subprime is. Subprime is basically a catch-all phrase that describes mortgage loans that are generally riskier than the more conventional ones. 

Conventional Loans

The conventional mortgages normally gave loans of a maximum 80% of the purchase price or the value of a property, and the lenders made loans only to people who have a good history of paying their bills on time.

Here is what a conventional loan might look like:

Let's say you buy a piece of property for $100,000. 

You put a down payment of 20% of the purchase price on it, or $20,000.

And you take out a loan for the remaining $80,000, for 30 years at a fixed rate of  interest.  Let's say the interest rate is 6%.  You make an agreement with the lender to make monthly payments for the next 360 months. 

You pay your closing costs that usually include an appraisal fee, a few months in advance of monthly principal and interest, a year of home insurance, a few months of real estate taxes, and the fee for the lender attorney.  Let's say the total closing costs are $3000.

If your closing costs are $3000, you come to the closing table with the $20,000 for your part of the purchase plus the $3000 in closing costs.  You get the deed to the property.  You are the new owner.  And you sign a note, or agreement to pay, with your Lender for the $80,000 loan.  The lender takes a mortgage on your house, which is their security for the loan.  It gives them the right to take the property in foreclosure if you do not make your payments.

There have always been more liberal lending programs that the conventional loan.  Programs like the VA- or Veterans Administration- loans allow low down payments to Veterans.  There have been FHA loans , too, or loans underwritten by the Federal Housing Authority.  As a matter of fact, since the subprime lenders collapsed, FHA is the remaining lender with more liberal loan guidelines.  And those guidelines are expanding with recent legislation.

And then we got subprime programs.  Some people who probably should never had bought property started investing.  The cash flows did not work.  The easy lending standards drew them in, and when those standards got changed, it began driving them back out. Those buyers can no longer qualify to buy property with  the loan programs we have now that subprimes are gone.  

Subprime Lending Programs

Here is where subprime lending came from and what it looks like.

The Federal Reserve lowered interest rates 13 times. 

As the rates came down those 13 times, Wall Street investors began to look for ways to make more money on their investments.  The interest rates they were making were just not cutting it for them.

 The lenders came to them and said, I know a way we can make some more money.  Let's loan to people with lower credit scores.  And let's give them more than 80% financing.  Let's give them 100% of the purchase price for their new property instead.  We'll be taking on more risk, so we can charge them a higher rate of interest and we can make more money doing that.  And Wall Street said, great idea.  Let's do it.

And then the lenders came to them and said, I know a way we can make some more money.  Let's loan to people who are in business for themselves and can't prove their income.  We'll call it a no-doc loan.  They will just tell us how much they make and how much they can afford, and we will loan them money.  And we will be taking on more risk so we can charge them a higher rate of interest and we make more money doing that.  And Wall Street said, great idea.  Let's do it.

And then the lenders came to them and said, I know a way we can make some more money.  Let's make loans that start off with a really low rate of interest.  That way more people can qualify to buy houses.  And then we will move the interest rates up higher as time goes on.  We will be taking on more risk, so we can charge them a higher rate of interest, and we can make more money doing that.  And Wall Street said, great idea.  Let's do it.

And so on, with more and more creative ways to provide money to borrowers, and make more and more money in return for taking on higher and higher risk.

The new financing options that were created brought 22% more buyers into the real estate market.  People could buy that never even thought of buying before.  They could buy with no proof of income.  Perfect for real estate investor/speculators. They could get a loan just on the basis of their estimate of how much they were going to make when they sold the property in a few months.  People with absolutely no savings could get into a house with 110% financing, more than enough to buy and cover closing costs and even the first few months' mortgage expenses.  That means almost 1 in 4 real estate sales that took place from 2000- 2005 were funded with programs that no longer exist today!

45% of all nonprime loans that were written were no doc- no documentation. And the projections are that 20% of those, or 1 in 5 of those will go to foreclosure before this is over.    The pressure on the subprime lenders is immense.  Many of their better loans- the ones that they collect money on- are going to be moved to FHA and other lenders.  They will be left with even worse loan portfolios.  It will be a LONG time before they will be in a position to offer creative financing options as they were- if ever!

How about pent up buyer demand?  Besides the 22% of new buyers who came into the marketplace in the early 2000's, most people who ever dreamed of owning a home went ahead and bought one.  Home Ownership increased from the more historically normal 66% of all households to a high of 69.1%, and is now declining again slightly as people lose their homes to foreclosure.

The Lending Process

What happened in the subprime lending market, is this:

Let's say you buy the same piece of property for $100,000 that we talked about earlier.  But now you buy with a subprime loan instead of a conventional mortgage.

You get a first mortgage loan for $80,000, for 30 years at 6% interest.

You get another second mortgage loan for the remaining $20,000.  This is also sometimes called a piggyback loan.  Because the second lender is in second position, the risk for this second mortgage is higher for the Lender.  If anything goes wrong, the first mortgagee will get their money first.  The second mortgagee is next in line after the first.  So the second loan normally gets written for a shorter period of time and for a higher interest rate.  Let's say your second mortgage is for 12 years at 12% interest.

You still have to come up with the $3000 in closing costs at the time of your purchase.

You leave the closing table with a deed on your property.  The only money of your own that you have put into the property is the $3000 in closing costs.  But the property was worth $100,000 when you entered the room to close on your purchase, and it is still worth $100,000 an hour later.  And you owe the whole $100,000 on the property instead of just the $80,000 that you would have owed with a conventional loan.

Of course, you and your lenders are all confident that in a few months or a year the property value would increase and be worth more than the total loans of $100,000.  And that is just what was happening, wasn't it?

And then the subprime lenders got more creative than that.  They offered loans of 100%, or the whole $100,000 on a purchase, instead of a piggyback loan package.  Usually, when the loan was for more than 80% of the total value of the property, they put on PMI or purchase money insurance.  PMI is an insurance policy to protect the lender in case the homeowner cannot make their payments.  It is an extra monthly charge added into the payments.  And PMI continues on the payments until the property value increases enough to add a safety net for the Lender.  Once values go up enough, the PMI can get removed from the payments.

And then the subprime lenders got more creative.  They created loans for more than 100%.  So in the scenario we have been discussing the lender would loan not only the $100,000 to buy the house, but also the $3000 for the closing costs as well.  When everyone walked away from the closing table, you own a $100,000 property and you have a $103,000 loan on it.  Your loan starts out being even greater than the market value of the property! 

Why on earth did the lenders offer these programs? 

Two reasons.  One, they were convinced that the property values would continue to go up for the most part, and protect their loan.  And two, the more creative they got, the higher interest rates they could charge.  That meant more profits for the lenders.

Whatever loan a lender makes, whether conventional or VA or FHA or one of these subprime loans, the loan underwriters have a due diligence process they go through to make the loan.  When a loan program is created, it has a number of components.  And each of these components is carefully spelled out in advance by the Lender's investors before the loan program is made public.  The Lender's investors are the source of the money the Lender has to lend out to the homeowners.  Obviously the terms and conditions of the loan are laid out.  The Lender and its investors also agree on the requirements for a home and a homeowner to qualify for a loan.  And they agree on how they will handle missed and late payments.  And then the Lender makes the loan program public and starts getting applications for the program.  With each application, the Lender has to a due diligence procedure to see whether the applicant and the property meet the investor guidelines. 

Due Diligence

The lender looks at 2 kinds of information in its due diligence process:

          They look at the ability of the homeowner to make the payments, and

          They look at the value of the property.

With a conventional loan, the Lender looks carefully to make sure they believe the homeowner is going to be able to make the payments.  One piece of information the lender looks at is the credit score of the borrower.  This is a number based on the outstanding debts of the homeowner, how current the payments are, and the homeowner's past history of making payments. 

Other information the lender uses to makes its loan decision are:

          The earnings of the homeowner and

          The total assets and debt of the homeowner

The lender gathers lots of documents to build its file and make the loan decision: It looks at bank statements, tax returns, and pay stubs.

And then the other key consideration in making a loan is the value of the property.  To find this out, the lender has an appraisal done.  An appraisal is designed to show the market value of the property today, based on how it compares with similar properties that have sold in the area within the past few months. 

When the lender puts all that information together, they can decide whether the homeowner applicant qualifies for the loan program they are offering.  A conventional loan keeps these two elements of the due diligence process in a balance. Both the ability to pay and the current property value count in making the loan.

But some investors grew more and more confident in the rising real estate market values.  They believed that the real estate they were making loans for would continue to go up.  So the loan they were making today for $100,000 would very soon be a loan on a property that had a market value of $110,000. Many became less and less concerned with the ability of the homeowner to make the payments.  The balance between ability to pay and property value got skewed toward the property value, and then even toward the probability of future property value.

These investors also got greedy! The Federal Reserve Bank was lowering interest rates over and over again to keep the economy growing.  That meant that investors were earning low interest rates on the loans they were making.  In order to make more money, they needed higher interest rates. The interest rates charged on a loan are lower when the risk is lower, and higher when the risk is higher.  So many investors said, let's get higher interest rates.  To get paid more, they had to risk more.

And they relied on the increasing property values to protect them from making bad loans, more than on the ability of the borrowers to make their payments.  Of course, they built expectations of default, or missed payments, into their formulas for making loans.  These lenders knew the loans they were making were risky and that some of them would go to foreclosure.  They charged higher interest rates that were designed to pay for their future losses.

The lenders seriously miscalculated on the number of defaults.  As long as the real estate market was going up, their expectations were pretty accurate.  After all, if you buy a property for $100,000 with a loan of $103,000, and in a year it is worth $110,000, you as a buyer just made $7000 on paper.  You have a good incentive to make your payments and protect your profit.  After a few years of value increases like that, you can sell the property and put your profit in pocket.  So you do all you can to make those payments.

Let's say, something happens, and you can't make those payments.  You can sell the property, and pay off the loan.  Or the lender can foreclose, and sell the property and get their money back.  That all works as long as the values continue to go up.

The rising real estate values and low interest rates kept whetting the lenders' appetites for more and more creative loans, with higher and higher interest rates for higher and higher risk.

They developed ARM's or adjustable rate mortgages.  These would start with a really low rate of interest, and low monthly payments.  The low monthly payments in the beginning of the loans made it easy for people to qualify for the loan based on their income today.   As long as their income grew at the same rate as the interest rate on the ARM went up, the homeowner would continue to have the ability to make the payments.

Some other creative developments that happened with subprime loans were the no-doc loans.  These were designed for people like business owners who often had a difficult time proving their income.  A business owner does not have a paystub to show what they make.  They have profit and loss or P & L statements.  A P & L is less proof of actual income than a paystub from a business owned by someone other than the borrower.  It does not mean the business owner was not earning the income they said.  No-doc loans were designed to lower the standard of proof of that income. 

The business owner could just state that their income was x amount per month.  They might even show a bank statement.  Or there might be no documentation at all.  That is why they are called no-doc loans.

Many people took advantage of these no-doc loans.  Not only the business owners they were originally designed to help.  Real estate investors used no-doc loans.  The business of the real estate investor was making real estate investments.  So their income was the great real estate investment they were making.  They were banking on the increased value of a property after they bought and held for a while.  Their income that they stated on their no-doc loans was the amount of the expected property value increase.  Investors who were doing rehabs on a property also used no-doc loans.  Their income would be based on the increase in value they were planning to get from the improvements they were going to make to their investment. 

And some people even committed fraud and said that they had higher income than they actually had.  Some of them were told this is just the way the system works today, and it is OK. Some of them were first time homebuyers, just looking to have the American dream of homeownership.  And many of them are now caught in the foreclosure debacle today.  I know.  I speak with them every day.

It is estimated by the Mortgage Brokers Association that 40% of all the no-doc loans that were written will end up in possible foreclosure.

The Subprime Meltdown

What happened to break the back of this aggressive lending game?  It certainly worked for a good number of years.  The normal cycle of real estate, from peak to peak, is 15 years.  This cycle, from peak to peak, lasted from the late 1980's to 2005, or 18 years!   And the liberal loan guidelines certainly added to the length of the cycle.

What happened is kind of a perfect storm.  Several things came together at the same time.  What happened is The Federal Reserve Bank stopped cutting interest rates.  They started increasing them.  They said they were looking to ‘normalize' the interest rates.  People who had already bought with ARMS's began getting rate adjustments on their loans.  Their monthly mortgage expenses skyrocketed.  Sometimes to more than they could afford.  Even though the FED has lowered interest rates again, the adjustable rates are still going up, because they are not based on the FED's discount rate or prime rate, but on formula calculations that are lagging the interest rates set by the FED. 

What happened is the cost of utilities doubled and tripled.  Almost no one planned to be able to make the high payments for heat or electricity, or even gas for their cars.  And these are beginning to affect food prices.

And what happened is housing values increased so much that people could not afford to continue to buy.  There were fewer new buyers because buying cost too much.  The loan programs had gone as low as they could go, and were starting to go up. 

What happened is that buyers of rental properties had more vacancies than they had planned on.  Many former renters had become buyers.  So these property owners got less rental income than they had planned on, and could not make their mortgage payments.

What this resulted in is this:

o   Higher monthly payments on mortgages

o   Higher utility bills

o   Fewer buyers 

•·        Lower rental income

That all meant higher bills and lower income.  And it meant fewer buyers to fuel increasing property values.  As borrowers began to miss payments, the rate of foreclosures began to creep up.  This brought more and more properties to the market.   That meant more supply and less demand.  And the law of supply and demand meant that property values began to stop going up and began to come down.

And the subprime loans that had brought in so many new buyers and fueled the extended price increases collapsed.  Without those loans, fewer new buyers could qualify for loans.  Again, a decrease in demand for real estate resulted.

Now people facing late payments on their mortgages had a new problem.  They were unable to sell.  That house they bought a few years ago for $100,000 is now only worth $90,000. And they owe $103,000.  They are stuck.  They can't make the payment, the interest rate is due to go up again, and the house is worth less than they owe.

Their lender sends them a series of letters, finally with a really nasty one after 3 months of missed payments on the mortgage.  The lender is threatening a foreclosure.

A foreclosure is where the lender moves to sell the property to get its money back.  If the sale results in the lender getting more than is owed on the property, the homeowner eventually gets the difference.  These days, the lenders are not able to get the full amount they are owed.  They are taking losses on their loans.  And the homeowner is getting nothing.

There are solutions to this foreclosure crisis.  And they do not all come from Congress!  Our free-enterprise system can bring the solutions to help people avoid foreclosure.  There are 8 different solutions.  See http://profitsfromshortsales.com to get more information on what they are, and how you and/or your buyers can profit from the foreclosure mess.