The Mortgage Crisis

(Initially posted December 7, 2007 at 9:04 AM)

The media coverage regarding the sub-prime mortgage problem rivals the attention given to any major national or international event, and for good reason. It IS a national and international crisis. While the majority of the public seems more interested in celebrity missteps, the crisis is having devastating effects on millions of families due to the loss of homes, jobs and investments. The lack of interest could be because most American homeowners are not affected, or it might be because most people don't really understand the media references to Fannie Mae, securitization, 2/28s, resets, or even the phrase sub-prime. The average unaffected homeowner only knows they have a large loan against their house requiring big monthly payments and that they have to pay it for a long time. They would rather leave the secondary market mechanics on the trillions of dollars of mortgage loans to the bankers. Nonetheless, there is still a problem: a big, difficult problem. In essence, our industry has experienced its own tsunami that is worldwide in impact. What is not a difficult, however, is identifying the cause of the sub-prime mortgage mess.

It is important to summarize what the current problem is before listing the contributors to the mortgage crisis. Simply, there are millions of homeowners who have mortgage loans that are unaffordable because they have interest rate adjustments that put the monthly payment outside of their budgets, thereby exposing them to loosing homes that, perhaps, some should never have owned. In addition to the devastating displacement of families, the ripple affect, despite the government bailout that has been proposed, is massive. Home values are declining at a rate greater than the normal real estate cycle, the housing market is experiencing inventory problems not faced in over a quarter of a century, and builders and their contractors are in the midst of a significant slow-down. Industries related to home construction have, obviously, also been affected, thereby compounding the economic impact. This, in addition to the disruption of the credit markets that required emergency Fed intervention, lest funds necessary for business operations and economic growth became unavailable causing a slowdown and an internal collapse of the U.S. economy. Foreign banks and governments, who relied on the integrity of the American investment banking system, have also had to infuse currency to offset concerns about their own banking systems. England and Germany, especially, have experienced challenges because of their participation in American investment, but the damage is not limited to just those countries.  These are just some of the problems being experienced, albeit the major ones.  Now for the cause.

The mortgage crisis, in this writer's opinion, began on Wall Street. Although they do not deserve all the blame, Wall Street investment bankers and large mortgage lenders created an expectation that was not realistic. They did so out of greed and, therefore, they deserve the biggest portion of the blame. Investment bankers and lenders who had made billions on the packaging and securitization of standard mortgage loans that were underwritten using sound risk analysis, subsequently discarded conventional credit wisdom and disregarded historical lessons about fluctuating real estate values. They relinquished good credit, documented income, and strong collateral underwriting requirements for the prospects of higher returns on loans that rewarded poor credit, no income verification and no collateral equity. The President accurately referred to this policy as irresponsible in his December 6^th speech regarding bailout proposals. Their greed was fueled by the unending appetite of private, institutional and government investors, both nationally and internationally, that consumed mortgage backed securities and collateralized mortgage obligations by the trillions. The final loses on defaulted mortgage loan portfolios have not yet been realized. Lenders are taping into billions of dollars of reserves to offset loan loses, as are investment bankers whose hedge funds that guaranteed the portfolios’ performance failed to provide enough protection. Some lenders and mortgage bankers have gone out of business, leaving thousands of employees out of work. Although there might be little sympathy for investors’ losses, the decline in asset value has affected retirement funds and municipalities reserve accounts around the world.

Another group of contributors to the crisis has been the lenders’ loan officers and the Mortgage Brokers. Driven by lucrative commission incentives in the form of either servicing release premiums or yield spread premiums, originators generated applications and loans for anyone who contacted them. In the originators defense, they were being provided with loan programs for borrowers that had previously been excluded from homeownership. Much like high risk car insurance arranged by agents and provided by insurance companies for drivers with poor driving records, sub-prime borrowers were the mortgage industry’s equivalent to “high risk drivers.” Brokers and loan officers were negligent, however, when they failed to inform borrowers that their rate—and therefore their payment—would increase in two or three years on these special programs, and that there were prepayment penalties amounting to thousands. In addition, the abuse of no income verification programs, which were intended to accommodate borrowers who could not provide conventional income documentation, put many homeowners in loans that were guaranteed to fail. There have been statistics showing that 20% of sub-prime borrowers made late payments on their loans during the first six months, and long before any rate resets took place.

Borrowers must also assume some blame for the crisis. The availability of a loan program does not necessary mean that everyone should obtain one. Borrowers with poor credit, no down payment, short periods of employment and debt ratios that approached 60% of their gross income obtained loans and 100% financing. Some of those borrowers were unable to make their rent payments on time, yet one morning they woke up and decided to buy a house….and they were able to get one! They pleaded with loan officers to help them get a loan for their home purchase, sometimes forcing the loan officers’ to compromise judgment about need versus true eligibility. If a loan officer used good moral and ethical judgment and told the borrowers they were not eligible, the borrowers just went somewhere else where their pleas were accommodated. In his December 6^th bailout speech, President Bush also made a reference to homeowners who should not have taken out a loan.

Finally, the government bears some responsibility for the mortgage crisis. While the American public generally opposes government intervention in private enterprise, mortgage lending is already integrated with federal banking regulations and government service enterprises. HUD and FHA are government agencies, while Fannie Mae and Freddie Mac have the backing of a federal government charter, even though they are private enterprises. Alan Greenspan expressed concern some years ago about variable rate and interest only loan programs, but sub-prime loans did not seem to be the focus of his comments. Now the Fed is trying to balance a reduction of discount and funds rates against a risk of economic inflation. Congress is attempting to pass a Mortgage Reform Bill, a reaction that gives the appearance of being a consumer protection reaction, but the bill might have an unintended effect of constricting mortgage lending, and perhaps contributing to a recession and a further challenge to the housing market.

Much of our nations’ achievements have been the result of concerted and united efforts—a team concept—to accomplish the objectives that have made our country great. This crisis, unfortunately, is an example of a team concept driven by greed and inattention that has caused damage which could take many years to reverse, at a cost of misery and disruption to many American families. It’s time to restore integrity to Wall Street and “Let the Buyer Beware” principles to our free market.

Joseph Ferraro, President

Sterling Financial Group, Inc.