As I covered previously the Federal Reserve kept interest rates at historical lows for 46 consecutive months and this combined with the Bear Market in stocks from early 2000 through October 2002 caused both individual and institutional investors to seek higher returns elsewhere.
They found them by buying Mortgage Backed Securities or MBS's. At first they just bought the cream of the crop with yields in the 5% range. Then GREED set in and 5% was not good enough anymore, they wanted 6%, then 7%, etc. But, to provide those higher rates of return the MBS's contained riskier loans.
However, a majority of these loans still had the backing of Fannie Mae or Freddie Mac and they were all still rated AAA by the credit rating agencies like S&P, Moody's, etc.
Everyone was making more money-institutional investors like mutual funds, hedge funds, pension funds, individual investors, Wall Street investment banks, commercial banks, the credit rating agencies, Fannie Mae and Freddie Mac. Everyone was fat and happy.
Unfortunately greed spiraled out of control by 2004 and all heck broke loose. All sanity was thrown to the wind. Mortgage lending standards basically went away. Let me give you some examples-
•· 95% No Documentation Loans where the lender does not know about the borrower's employment status, income status, or asset status.
•· 100% loans with a 540 fico score. I know that with a 585 fico score there is a 50% chance of a 60 day delinquency in the first year of a loan for that borrower. At 540 the chances have to be nearly 100%. I said at the time, "the bank should ask for a set of keys at closing knowing that they will be foreclosing in the near future."
•· 100% stated income loans with a 640 fico score where income is not verified or considered. Thus, you had Wal-Mart clerks making $90k on their loan applications and being approved.
•· Allowing borrowers to have "cash on hand", boarder income, or second jobs with no verification of the job or income. Thus, everyone now had a second job making good money every month.
So, who was to blame for the lack of underwriting standards? Nearly everyone. Out of greed, Wall Street investment banks kept creating new pools of MBS's with evermore risk and the credit rating agencies kept declaring that they were AAA rated, and Fannie Mae and Freddie Mac kept buying and backing these loans.
Trillions of dollars were being handed to banks and mortgage companies to make more and more loans with decreasing standards. You see banks and mortgage companies don't make the rules anymore; Fannie Mae and Freddie Mac do and so did the Wall Street investment banks.
Greed and lack of lending standards led to the next three reasons for this Mortgage Mess and I will cover this topic tomorrow.