Roots of the Meltdown

In the following chapter from my book, I lay out the roots of the mortgage market meltdown, and point out one huge policy decision that probably drove more of the “bubble” than just about any other factor. Strangely enough, that policy, repeated tax-free capital gains on house sales, has gotten virtually no press, nor any treatment in the dozens of books that purport to explain what happened and why.

Tax policy is the blunt instrument that shifts the wealth of nations, the ultimate in having the government choose winners and losers. If you give one type of participant in a large market a tax advantage over others, eventually they will own everything.

While a few members of the tax-disadvantaged crowd will always succeed, they are just like the few people who win the Lottery. They don’t change the trend.

From 1950 to 1980 (roughly), tax policy rewarded capitalists that reinvested earnings in their businesses, set aside earnings for workers’ retirement or bought and depreciated plant and equipment. We had very high maximum tax rates, but the “take” of the Federal government was very close, as a percentage of GDP, in Eisenhower’s two terms to the level it was at during Bill Clinton’s terms.

The big difference between the 1950’s and the 1990’s was that profits from working for a salary or operating a profitable business were taxed at the maximum rate in the post-Reagan decades, while profits from buying a business and stripping out its retained earnings were taxed at the lowest rates, if at all.

Beginning with the leveraged buy-out boom of the 80’s, and continuing with the tax-advantaged treatment of employee stock options and culminating in the housing finance mania of the post-millennial decade, we chose, as a nation, to tax asset stripping at a lower rate than we taxed asset building.

We were on a national binge of cash-out refinancing. Joe Sixpack, as always, was the last to come to the party.

Without further introduction, here’s my chapter called

The Roots of the Subprime Meltdown

Just as the seeds of future collapses are planted in the excesses of the growth period that precedes them, so the seeds of the next growth phase are planted in the crisis that precedes it.

The subprime crisis really had a series of problems preceding it. The LTCM collapse, the Y2K panic, the dot-com bubble bursting and the response to the 9/11 attacks all created an environment that convinced the Fed to lower short term rates to 1% and leave them there for nearly three years. That more than revived the mortgage market; it sent the mortgage market flying.

Concurrently, on every level from the Federal government down to the single-income household, what it meant to be able to “afford” something changed.

The children of the Great Depression were uncomfortable with debt and believed that “affordable” meant you would be able to pay off the debt, in full, even if times got tough. The goal of having a mortgage was to have it paid off and own your home outright.

The Boomers had learned the lessons of inflation in the 70’s and 80’s, and came to believe that “affordable” meant being able to cover the payments. In a curious reversal of logic, the fact that mortgage interest became the largest tax deduction available to the average American, made it financially irresponsible to have a home without owing money on it.

A change in the Federal income tax rules in the late 1990’s also initiated a tax-free $250,000 capital gain exemption on first or second homes ($500,000 for a couple), and allowed that exemption to be taken every two years, as many times as taxpayers wanted. That freed homeowners to take profits on existing homes at a faster rate than ever before.

Homeowners who had large embedded gains in their homes could trade up if they could get financing on their next homes. Given their large down payments (30% or more), the “Option ARM” was offered to everyone with a good credit record, giving borrowers the dubious privilege of letting their loan balances increase by paying less than the stated interest rate (negative amortization).

[Option ARM (or Pay-Option ARM) – Adjustable Rate Mortgage that offers the borrower the option of several payment amounts: 1) Interest only – the principal stays the same; 2) Fully amortizing – the principal and interest are paid off over time, similar to the conventional mortgage, except the payment amount changes when the interest rate changes; and 3) Minimum payment – a low (or very low) interest rate paid that doesn’t even cover the interest due, with the extra interest added each month to the balance of the loan until the loan balance grows to limit, usually 15% higher than the original balance.]

Lenders felt safe making these loans, because they knew it would take nearly five years of minimum payments before the loans grew to 80% of the value of the houses. The slightly higher stated interest rate also allowed lenders to make larger profits.

High-end homebuilders, prime mortgage lenders and affluent homeowners reveled in the new growth regime. In fact, with rates so low, some banks could even offer “teaser” rates averaging just 4.5%, since CD’s and bank deposits were only costing about 1% to 1.5% in the artificially low rate environment the Fed had engineered.

While they collected 4% teaser rate interest on their Option ARM loans and paid out approximately 1% on their deposits, the banks were comfortably cash flow positive. Even better, the stated interest rate was 6% or higher on these loans and lenders reported earnings based on this rate. Most of the borrowers took the option of making the minimum payment and allowing the balance of their loans to rise, or negatively amortize.

The only missing piece for a true mania was a flood of new buyers. They soon came in the form of first-time buyers for houses that were being sold by the trade-up buyers, and in the form of speculators who were looking to buy houses and quickly sell (“flip”) them to other, new buyers.

Some homebuilders encouraged first-time home buyers through “builder buydowns,” setting up special accounts to cover some of the interest payments owed by the borrowers, effectively lowering their interest rates to 1% to 3% for the first few years. Some builders even subsidized the real estate taxes. These subsidies effectively put homeownership within the reach of buyers who were otherwise incapable of supporting the financial burden of home ownership.

Along with the general rush on home buying, subprime mortgage teaser rates dropped to an average of 7.5% for an initial two-year period, making home buying affordable to a segment of the borrowing public that wasn’t able to own a home when rates were higher.

These subprime loans were very attractive to lenders. Subprime borrowers pay 3% to 4% more than prime borrowers and subprime loss rates had averaged just 1% to 2% per year during the prior fifty years. The raw profits of 2% to 4% per year from this kind of lending were much better than the 0.5% to 1% per year in profit that the conventional, prime mortgage lending business provided.

Unwarranted confidence led lenders to take new risks when making loans to subprime borrowers:

  1. “Liar loans,” or mortgages without income verification. These were a small but growing minority of subprime loans, peaking out at close to 30% of all subprime mortgage loans in 2007.
  2. No down payment loans. These were occasionally loans for 95% or 100% of the home purchase price, but were more frequently loans for 80% of the purchase with a second “piggyback” loan at a higher rate for another 15% to 20% of the purchase price. Investors in the 80% LTV first mortgages sometimes weren’t informed that the piggyback second lien existed, which increased their risk.
  3. Speculative investor loans, sometimes classified as loans for owner-occupied second homes. These also grew from less than 5% of the subprime universe to more than 10% for a few of the issuers of subprime mortgage debt.
  4. Lending without requiring escrow for taxes and insurance in order to quote the lowest possible monthly payment.
  5. Layering two or more of these risky lending practices into a single loan.

There are limited circumstances in which it makes sense to make a loan to a borrower who can’t provide normal income verification. These loans have normally been made to people who run their own businesses or live off their investments.

These “no doc” loans were historically strong credit performers, especially when borrowers made meaningful down payments. The mitigating factor for these “non-conforming” loans without income verification was the fact that financing was limited to 70% to 75% of the value of the properties by most lenders. At least that’s the way it was until the mania got into full swing.

Bank examiners never liked this kind of loan, and made it clear in their capital requirements and examinations that they preferred the safety and uniformity of mortgage securities or “prime” mortgage loans with full income documentation. The segment of the population that was a good credit risk but that desired non-conforming loans was served by non-bank lenders.

Unfortunately, once mortgage lenders outside the traditional banking system had seized on “no doc” loans as a popular option with borrowers, they cranked up the volume far past the limited pool of borrowers who may be good risks for this type of loan.

These “no doc” loans drew out thousands upon thousands of liars, which naturally led them to become known as “liar loans.” The big payoff? For virtually “nothing down,” and a simple lie, borrowers were buying winning sweepstakes tickets. All they had to do was sell their homes for a nice profit a year or two later. At the rate that home prices were appreciating, it looked like that was a safe bet.

At a late 2007 conference, I met the owner of a company that does very thorough checks on borrowers using the information in mortgage loan files. He found that one large selection of files they reviewed included borrowers who had used Social Security numbers that were not their own, and this comprised more than 5% of the borrowers. Those borrowers took the concept of “liar loans” to a whole new level.

Some borrowers turned their 100% financing into a genuine economic benefit regardless of the fact that they ended up losing the homes to foreclosure and ruining their credit scores. They simply took advantage of the fact that it takes considerably longer to foreclose on a house than it does to evict a tenant.

In 2007, a number of lenders experienced a huge increase in the number of EPD’s, or Early Payment Defaults. These were mortgage loans that stopped paying in the first, second or third month. While it varies by state, in most states it takes a year or so to complete a foreclosure. Fraudulent mortgage borrowers could pay the equivalent of one or two months’ rent in mortgage payments (or none at all) for a house they might be able to live in for a year or longer. It sure beat not paying the rent, and being evicted by the landlord shortly thereafter.

Even for subprime borrowers who wanted to make their payments but weren’t sure they’d be able to, there wasn’t that much at stake. These borrowers already had lousy credit scores, so they weren’t losing much if they chose to default on their mortgages and live in their houses for free.

For prime borrowers who spent years building a good credit record, the risk of lowered credit scores acted as a real deterrent to this kind of behavior, even if the mortgage loan balance might be equal to or greater than the value of the home in a forced sale.

The environment of mortgage lending in this era permitted a special class of unscrupulous borrower to borrow money from their lenders, and pay nothing in return. It may have been the fault of the borrowers themselves, the real estate agents, the home builders’ salespeople, the appraisers, the mortgage brokers, rogue (or stupid) loan officers at the lenders, or a combination of the above.

The FBI pursued 1204 mortgage fraud cases in fiscal 2007, resulting in 321 indictments and court orders for $595.9 million in restitution.

Typically, rings of fraudsters operated by selling the same houses over and over again, at ever-higher prices, increasing the value of many houses in the neighborhood simultaneously, so it was very difficult for loan reviewers and underwriters to detect a problem when looking at individual loan files. The final act in the scam was to take out mortgages on a number of the inflated properties, and then disappear.

It didn’t help that politicians, activists and reporters decided to unilaterally champion the cause of innocent homeowners losing their homes and assign all the blame to other parties. Unscrupulous borrowers got a free pass to allege they were tricked into lying about their income, claiming the terms of their loans were never disclosed and they were victims of predatory lending.

Were there predatory lenders? Of course. A few. Was it commonplace? The answer is no.

The fact is that most larger mortgage lenders have compliance rules and training programs specifically designed to prevent their employees from making predatory loans. Ten years ago, too many lenders took large losses due to predatory lending lawsuits to behave any differently.

Let’s not overlook the fact that loan application documents with “stated income” were sworn and notarized legal contracts. It does seem extreme that some politicians believe that several million borrowers were tricked into committing perjury, or somehow didn’t understand that the ridiculously high number they furnished as income was a legal assertion that they truly earned that much money.

There can be bad apples in every basket. But when organized groups set out to defraud by creating loan files that meet a mortgage originator’s criteria, complete with verifiable appraisals and comparable property sales, it is a stretch to blame the lender. Certainly some originators were easier to fool than others, but this kind of fraud could only be prevented by eliminating the kind of financial mania and irresponsible activity that was engulfing the real estate and mortgage business.



6 Responses to Roots of the Meltdown

  1. Patrick says:

    Great stuff, Howard. It’s written at just the right level – not too simplified, but not overly pedantic either. I really appreciate both excerpts from your book and look forward to the bound, published version soon.

  2. rwe2late says:

    You spoil an otherwise accurate article describing the “micro” aspect of the meltdown when you contradict yourself by asserting “it is a stretch to blame the lender“ .

    I say self-contradict because in another article you point out that:
    “…macro players set the policies and took the actions that created an environment where the originate-to-securitize business model was terrifically profitable. Unfortunately, the macro players also provided the accelerant that turned what could have been a market correction into a market calamity.
    The macro players set up the largely unregulated mortgage lending business that steered market share for subprime and non-conforming lending away from the banks, making it easy for the micro players so inclined to take advantage of lax oversight.

    In essence, a huge interconnected system existed to create mortgages, create mortgage bonds, and then to create new bonds from bonds that had just been made, all in very big hurry, with almost every entity along the line unloading the risks as they took home the profits. None were taking home profits as fast as the Wall Street dealers …”

    When the big players set the rules, deceive investors. and make huge profits, it is most inaccurate not to blame the big players (the lenders)when things go awry. As I am sure you are aware, the most effective scams always bait the patsy with a lure of reward.
    Unfortunately, the conclusion of your “Roots of the Meltdown” article can be misused by some in an attempt to exonerate the “lenders”.
    There are many who would like, either conveniently or prejudicially, to place the primary, if not the sole blame for the meltdown, on the micro players.

    • hhill51 says:

      Thanks for the comment…. It is always a struggle with a complex topic to make it accessible without getting lost in the details. I think the problem you’ve identified can be fixed with the substitution of “mortgage broker” for “lender”…
      You clearly get the point that the individuals at the point of sale — those brokers, loan officers, borrowers, appraisers, etc. — have their share of blame to take, but lion’s share goes to the people who set the policies at the institutions executing the business and their regulators, e.g. the “conduit” lending operations at the Wall Street firms that provided roughly 70% of the money lent out to subprime borrowers or the regulators that turned a blind eye because those conduits were “nonbanks.”

    • hhill51 says:

      I think I fixed it by making it clear that I was talking about the mortgage originators where I used the word “lenders” before. Only a few friends and I were using the phrase “predatory borrowers” back then, but they were certainly part of the game.

  3. james says:

    It seems to me that all involved were/are over 21. The lenders were knuckleheads and weasels but I am sure there were a lot of those on the borrowing side that fall into the same category.

    The only really bad part of the whole thing, at least to my mind, is that the problems are being foisted onto the ordinary taxpayer.

    However I am sure history indicates it has always been that way.

    Be smart.


  4. aldytop says:

    I recently came across your weblog and have been reading along. I thought I would leave my very first comment. I don’t know what to say except that I have enjoyed reading. Nice blog. I’ll keep visiting this weblog really often.

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