By Bill Steigerwald
April 27 2008
Q: Where did the mortgage mess come from?
A: In the mid-1990s, when the whole lending profession was looking for greater and more expansive opportunities, they determined that by lowering the standards on mortgage credit they could greatly expand the volume of mortgages they wrote and simultaneously expand the volume of the number of people who became homeowners. The thought behind this initially was that while going to riskier borrowers could mean more defaults, because home prices had been rising steadily and almost automatically year after year, the risk of these loans would not be as great as many people thought. And in the event that people defaulted and foreclosed, we would have a higher valued asset that we could sell to pay off the loan.
Q: In other words, we made it a lot easier to buy and borrow for a home?
A: Right. And you have to understand that the entire lending business -- in fact nearly all aspects of the real estate business -- is driven by commission. Most of the professionals you will deal with from the minute you decide to buy a home until the time three months later that you sit down at the closing table and sign on the dotted line and take possession of the house, virtually every professional you come in contact with during that period will not earn a penny unless you show up at the table and sign on the line. Everybody's on commission. My estimate is that by going from the traditional lending standards of the past 50 years to the new modern or liberal lending standards, you added probably about 4 million to 5 million new households to the market. Every one of these people yielded some benefit, some profit, some commission, some revenue to all of the participants in this market, whether they are a real estate agent, a home builder, a mortgage broker, a surveyor, a home inspector.
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A: Exactly. Until the mid-1990s there was not much of a subprime market because subprime borrowers were largely excluded. No one wanted to lend them money. A subprime borrower is by definition somebody who has a FICO score below 660. From 660 it keeps on going down. These are people who have had a variety of credit problems in the past. They've either filed for bankruptcy or they have missed numerous payments on various obligations and so on and so on. The thought was that we know exactly what these people are because we are the ones who have lost on them in the past. But the notion was that with rising home prices and higher interest rates on these loans that we could offset and compensate for the much greater risk that we were taking on.
Q: This subprime mortgage mess has been sold and publicized "as a national crisis." But your Heritage Foundation map of foreclosure rates around the country shows that Pennsylvania is only 6.6 percent. Ohio (13.7 percent), Michigan (12.3 percent) and Minnesota (12.4 percent) are the worst states.
A: The thing is, the whole mortgage credit problem is really a series of completely independent and often regionally based problems. In the case of the states you just cited, these are the Rust Belt states, where the use of subprime loans was not in excess of the national average. But defaults in those states have been very high, and for the most part that's a function of adverse economics. With a reliance on manufacturing, and with many manufacturing firms having a difficult time competing, there have been a lot of layoffs in those states.
Q: So we shouldn't be blaming the subprime mortgage crisis for the high numbers in those states?
A: Right. Not in those states. Then you have pockets in other different places. What happened in the Detroit metropolitan area? Or in the economically healthy Atlanta metropolitan area? From what I can determine, essentially what you had was a combination of a lot of predatory lenders and predatory borrowers combining to enhance each others' well being. In places like Florida (11.4 percent foreclosure rate), you had high home prices as a consequence of abusive zoning regulations, which limited the supply, and a very frothy investment kind of recreation market. In California (10.6 percent foreclosure rate), you have the highest home prices in the country, where many otherwise ordinary people -- if they wanted to be a homeowner like their parents -- were forced to take on fairly excessive levels of debt to buy what in many instances is a relatively ordinary house.
Q: The national U.S. average for subprime foreclosures is 8.7 percent. What is the normal foreclosure rate on mortgages?
A: Well, historically pre-subprime it was close to about 1 percent. It bounced around between 1 percent and 2 percent. Many prime mortgages are experiencing problems now but nowhere near the level of the subprime market.
Q: How many households are we talking about?
A: I haven't seen a good grip on that in terms of what the total number of subprime mortgages are outstanding now. I have had some data on originations, for example, and from about 2003 to about 2006, about half of the mortgages originated were either subprime or "Alt A mortgages," which are risky prime mortgages. What they are is they are limited to prime borrowers but they are what they describe as "aggressively underwritten," so that the person who is getting an Alt A has a pattern of credit problems in the past but is probably providing you with limited documentation, getting a second loan to get a down payment and probably borrowing more than he can probably handle in the future. Over that period, these amounted to about 40 or 50 percent of all the loans that were taken out. In the sum of things, I think the subprime market may be closer to about 15 percent of all mortgages outstanding. Bear in mind that about a third of the people who own their own home, own it debt free.
Q: So if 15 percent of all mortgages are subprime, and about 8.7 percent of all subprimes are in foreclosure, why is the dollar figure so unbelievably huge when they talk about this mortgage mess?
A: First of all, the mortgage market is huge. So each year, something on the order of about $3 trillion worth of mortgages are written. And also understand during the same period, half of the mortgages that were written were refinancings. So there's not a great connection between home sales and home constructions and mortgage lending; mortgages have become a preferred mechanism, because of the lower rates and the tax-deductibility of the rates, for buying a car and fixing a kitchen.
Q: How would you categorize the people who are foreclosing on subprime mortgages? Are they people who were misled by lenders, people who were dishonest and knew exactly what they were doing, or people who were either naive, stupid, clueless, however you want to phrase it?
A: Yeah, I think that there's just a lot of naivete and excessive optimism in the whole market. And recognize that the mortgage market today, and it has been like this since 1990, is a market in which there is a complete disconnection between the person who ultimately holds your mortgage and the person you actually sat across the table and borrowed the money from. The days of the savings and loan that lends you the money and puts it in their portfolio and holds it until it's paid off died in 1990 when the savings and loan industry collapsed. So today what you have is somebody several stages downstream who was told all sorts of things about the safety of this mortgage and who bought it.
At the same time, you have to remember that most of these mortgages went out with what are called "representations and warranties." That means that the person who made the loan warranted these mortgages to be of a certain quality, and if the mortgage failed to live up to that quality, then they would buy it back. Now what happened was, all those companies that made those representations and warranties -- while they were enormous, well-financed nationwide companies trading on the New York Stock Exchange -- they were very thinly capitalized. So all you needed was a whole bunch of people confronting faulted subprime mortgages to go back to the lender and say, "OK, time for me to exercise my representations and warranties that you provided. Here are the mortgages. I want my money back." And all of these firms were confronted with far more obligations than they had the capital to fulfill, and they filled for bankruptcy. Which meant that all the people at the other end who thought they had this right to get their cash back were trying to get cash from somebody who was essentially in liquidation and will never get it back.
This was compounded by the repackaging of these things into highly leveraged collateralized debt obligations and mortgage-backed securities, in which a lot of money was borrowed to leverage the potential return. But leverage is a double-bladed sword and when values collapse, leverage plunges and you quickly wipe out your equity -- so you have something that is essentially worth nothing, even though the value of the securities that were holding this whole thing together may have only gone down by 20 percent.
Q: Can we pin the blame on any one or any thing or any group for this crisis?
A: Not that I can tell. Unfortunately the real estate market tends to be as bubble-oriented or more so than any other. What happens is that otherwise sophisticated people who should know better begin to believe that the risks that we thought were there are really not there and they begin kidding themselves. What happens is that once people recognize that underwriting standards have declined, and that when you write a mortgage the person that you sell it to isn't going to ask for documentation, then all kinds of sharpies come into the market and take advantage of this.
There's so much money to be made in this. The typical mortgage originator made a commission between $750 and $1,500 on every mortgage they brought in. So if you're talking about that kind of money, as long as a person can breathe and sign their name and nobody really cares beyond that, you'll go out and put them in a house.
Was it any one person's fault? Was there any particular law? No. It was just the gradual decline in standards as sort of a license for the quasi-criminal elements out there to come in. If everybody in Pittsburgh decided to leave their keys in their cars, for example, you'd probably expect auto thefts to soar, right? It's the analogy to the mortgage credit market.
Q: If you could wave a magic wand, what would you do to end the crisis? Or do you just let it unravel?
A: I don't have anything specific, but what we have to recognize is that in 1995, the homeownership rate was a little bit below 65 percent. That's essentially where it had been in the 30 years up to that point. In 2004, thanks to the subprime market, it reached 69 percent, and that was a homeownership rate that was sustainable only through fraud and risk and irresponsible lending activities.
Now that we've returned to normal credit standards -- and that is you actually have to prove you can pay back the loan in order to get it -- we're going to be drifting back to the 64 percent or 65 percent homeownership rate. That means that over the next couple of years, somewhere between four and five million people who are now homeowners are going to be "un-homeowners." Simultaneously, that number of homes is going to come back on the market.
What Congress is essentially trying to do is to figure out how can we sustain that 69 or 68 percent. And the only way you can do that is by perpetual bailout because we simply got to that rate by allowing unqualified people to become homeowners.
What we need is an orderly transition back to the 64 or 65 percent where simultaneously housing becomes more affordable to people. Another side problem of the subprime market is that by bringing so many new people into the homeownership market, you had this frenzy of buying. And in many communities -- particularly communities that had very abusive zoning rules that limited supply, like San Francisco, Southern California, Florida, Nevada and select metropolitan areas -- the prices went through the roof. And through abusive land regulations you had created an affordability crisis. What we need to do is begin the process of unraveling that so housing becomes more affordable to people but at the same time those people for whom it is more affordable will also be people who are qualified to borrow the credit and likely to pay it back. So you are working your way back to a more normal and more sustainable and stable housing market. But that's going to be an awkward transition. Through that process there is going to be a lot of foreclosures. And a lot of financial institutions are going to take big losses, but I think at this point they are capable of doing that. Out of this we learn important lessons and that should be the limits of government's responsibility.
E-mail Bill at email@example.com
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