As a Real Estate Agent and Loan Officer last decade, I was in a great position to watch what really happened to cause the Lesser Depression. How do my observations, given context by all of the articles written about the Real Estate Bubble and the financial collapse in 2008, compare to the narrative we often hear?
Get ready to get mad all over again, but this time for the right reasons. More after the fold.
I was reading the New York Times’ website late last night, as is my tendency on my days off, and read an interesting article titled, “U.S. Is Set to Sue a Dozen Big Banks Over Mortgages,” by Nelson D. Schwartz. While an interesting article, I can’t say that it gave me much hope about our economy, or that “Justice Will Be Done!” The gist of the article seems to be that the banks made bad loans, securitized them, and fraudulently misled investors into thinking that these were low risk, high return securities. One thing that I did after reading the article that I seldom do is read the comments by the readers, and there were a lot, currently almost 500.
I only got through about the first eight pages of comments before I finally lost the will to read more, but I did see three basic responses to the article. The first was that this was very overdue, and that the bankers would finally, thank the Lord Almighty, be seeing Justice! for their wrongs. The second, which I largely share, is more a realization that not much is likely to happen as a result. Maybe a slap on the wrist kind of fine, but not much more.
The third response is what I’m really writing about. It’s the narrative about the reasons for the entire Banking and Real Estate Debacle that we all know to be true. Let me summarize it for you:
Late in the Clinton Administration, in an attempt to get more low-income people into the housing market, the Department of Housing and Urban Development, Fannie Mae, and Freddie Mac started pressuring the bankers to make more dodgy loans to those lower income families, even though they didn’t want to. Eventually, bad people figured out they could lie about their income and get Interest Only mortgages for homes they could never afford, and the defaults on these loans brought the banks to the edge of insolvency. The government, not wanting to allow these too-big-to-fail banks to fail, saved the banks by infusing huge amounts of our tax dollars into them. The End.
If your point of view is an Ayn Randian, “Government and Poor People are always bad, and Rich People and Corporations, I mean ‘Job Creators,’ are always good,” then this narrative makes sense. But I’m sure you know what I’m going to say next: As with most narratives we know to be true, this one isn’t.
Let me give you some background about myself so you understand why I know this topic fairly well. Late in the Clinton era, I studied for and got my Real Estate Sales license. In the years since I have worked for three different Real Estate companies. Two of those companies I have worked for had me working as both a Real Estate Agent and a Loan Officer. The loan work I did was almost entirely from 2004 to 2008, so I was active in the go-go days of the real estate bubble, putting me in a good position to see what was happening “in the trenches” as we say. After the collapse of the bubble, I got out of Real Estate, like many other people, and my license has since expired. With my credentials thus established (or thoroughly trashed), let me give you my observations on what really happened.
First, some background. There are three basic categories of loan applications; most people have heard of two of them. So called “Full Doc” loans are called by the industry “Verified Income, Verified Asset,” or VIVA loans. The infamous “Liars Loans” are called “Stated Income, Stated Asset,” or SISA loans. The third, the ones most people haven’t heard of, are called “No Income, No Asset,” or NINA loans.
With VIVA loans, the person applying for the loan fills out the entire loan application, called a “Ten-Oh-Three” for the 1003 form designation, which includes the applicant’s credit score, information about the property being looked at, and verifying documents, such as paystubs and bank statements for the last six months. The mortgage originator then calls the bank and the person’s employer to verify that the information in the application is correct. These loans are considered low-risk because the bank has all of the information relevant to the loan’s likelihood of payback, namely their credit history through the credit report, their income, and assets should they lose their job. Because these loans are considered low-risk, they usually come with low interest rates for the borrower, and importantly, low commissions for the Loan Officer originating the loan.
The application for a SISA loan is very similar, except there is no verification by the mortgage originator that the information on the 1003 is correct, except, of course, a full credit check. These loans are considered riskier than VIVA loans—after all, the applicant may have lost their job or may have put in incorrect information on the 1003, and as a result, the interest rate given for SISA loans tends to be higher than that of VIVA loans, and the commission for the Loan Officer originating the loan tend to be higher as well.
The third type, or NINA loan, is quite a bit different from the first two. Most of the information on the 1003 application is left blank. The only information the loan originator wants is the person’s name, their social security number, a credit report, and the information about the property the loan is for, including the property’s current value. Since the loan is, in theory, secured by the value of the property, the bank assumes that the loan is good if the property assesses at a value of or in excess of the value of the loan. There is no attempt to find out if the person applying for the loan even has a job or any money saved up. If that information is on the application, it is either returned unprocessed, or ignored by the loan originator. For that reason, I refer to these loans as “Don’t Ask, Don’t Tell” loans. These loans are considered the highest risk, and as such, carry the highest interest rates, and had the highest commissions for the Loan Officers.
In addition to these types, there are basically two different types of interest that can be charged; fixed interest rates, which stay constant for the life of the loan, and adjustable rate mortgages, or ARMs, which have a base which doesn’t change, and an amount in excess of that which varies depending on some external factor, such as the LIBOR (London Inter Bank Offer Rate, an interest that banks in London charge other banks for loans.)
Now, lets add in some different amounts you can pay, depending on the loan. There is the Full amount, where you are paying off part of the principle amount borrowed and the interest each month; an Interest Only payment, where you pay only the interest and defer the principle payment; and then there’s the Optional payment, where you pay only some of the interest generated for the month, and the rest gets added into the principle. Eventually the Optional and Interest Only payments disappear, and you must start paying the Full amount (called Recasting), but by that time the principle can accumulate into quite a bit of extra money. The Optional payment system was always bundled with ARMs, and were called Option ARMs by nearly every bank. In addition, virtually all of these loans had provisions that prevented you from refinancing the loan without paying a big penalty until a certain date, which was always set to be well after the date the Optional payment had disappeared, guaranteeing the bank a nice profit when you couldn’t make the Full payment and had to refinance.
Now, here is where the problems crop up. If you accept all of the risk for these loans, as banks used to in the Glass-Steagall era, it’s easy to come to the conclusion that making mostly VIVA loans makes the most sense, and making any NINA loans seems insane. We know the government was backing VIVA loans through the VA and FHA, so it’s understandable that the banks would make these loans. Why would they make NINA loans?
The answer is Securitization. The banks took all of those loans that they made and put them all together in a bundle, divided the bundle into shares, and sold them as if they were bonds or shares of stock through their investment banking divisions, an act that wasn’t possible under the Glass-Steagall, post Great Depression regulation that was allowed to die. If you put enough VIVA loans in with a bunch of SISA and NINA loans, then you could imagine your money was safe, and you got paid a handsome amount of interest from the borrowers as well. If the housing market was increasing at a value at or above the rate of inflation, and the borrowers didn’t default at too high a rate, then your investment would be good. Besides, they had insurance companies, such as AIG, covering losses due to foreclosures that didn’t sell for the amount of the loan.
That was the theory, and was what the banks told the rating agencies, who gave these securities the same AAA rating that they would government debt even though there was less than a 0.02% chance that the government would default on their loans, and a much, much higher chance that a mortgage borrower would default.
So far, so good. But here was the problem: A false sense of security was built up by securitization. NINA loans, backed by the value of the home and nothing else, were considered to be as safe an investment as VIVA loans, except they brought in much more money through their much higher interest rates. Banks and investors wanted that money, so the banks felt the pressure from their executives and their investors to make more NINA loans. They had gotten greedy and addicted to those high returns on investment.
What happened next was predictable. In order to make the most people eligible for the highest interest generating (hence profit generating) loans, Option ARMs were welded to NINA loans, allowing people to make lower-than-interest payments on their high-interest loans.
So, by 2005, you see Vice Presidents of banks going to Real Estate and Loan companies and tell their agents and Loan Officers that they could get as much as 2-3% of each NINA loan they originate as a commission, instead of the much smaller commissions they could make on VIVA and SISA loans. 2% of a $500,000 loan is $10,000, which is a pretty damn good paycheck. If you could sell the house as well as make the loan, you could possibly double that paycheck. And yes, I did see this happen. In fact, I even saw some agents help the people who sold their home to buy their next home and give the agent the loan business as well.
The Real Estate and Loan companies, seeing the opportunity to make huge amounts of money, started training their agents to sell the loan based on the Optional payment, not the Interest Only, or Full payment. When that started working, it became necessary to increase the number of clients, which the Real Estate companies did by recruiting as many agents as possible and sending them to Real Estate Schools that were little more than diploma mills. These newly licensed agents were then sent out to sell these loans to their family members, and really, if aunt Mabel has her nephew come in and tell her she can refinance her current condo and keep it as a rental, use that money as the down payment on a new house, and have extra left over to go on that vacation to Cancun and still make the (Optional) payment, well, why not trust the kid? He is family, after all.
Except he doesn’t have experience in the Real Estate Market and doesn’t know a bubble when he sees one. His friends have all been asking Aunt Mabel’s friends to do the same thing and they’ve pushed the price of homes in their market to ridiculous levels. Eventually the Optional payment disappears from Aunt Mabel’s monthly statement, and her Social Security check won’t cover the full amount, and neither will the rent check from her renter, and she loses both homes, as do her friends. The investors who put their money into Aunt Mabel’s mortgages through Securitized loans are no longer getting any interest from Aunt Mabel or her friends. They foreclose on all of those homes and flood the market, finding that $500,000 loan secured by Aunt Mabel’s then $500,000 home, is now secured by a $250,000 home, and they lose their principle amount as well as their interest. Other homes in the area are now worth less, and even if the people who own them can make the payments, they can’t refinance the home if there is an emergency, such as a medical emergency, and insurance companies may not want to cover their home either.
So that brings us to 2008, when as much as Ten Trillion Dollars worth of mortgage loans were in jeopardy. Banks who drank their own Kool-Aid and bought many of those toxic securities were on the brink of collapse, and Aunt Mabel and her friends were losing their houses.
Let me summarize: Greedy Bankers pressured rating agencies to give excellent ratings to their dodgy securities, and convinced investors to buy them. Then they bribed Real Estate and Mortgage Loan companies to make Option ARM NINA loans to everybody, regardless of ability to pay, until the bubble in the market for homes burst. When the insurance companies that were supposed to cover the dodgy securities couldn’t cover them, the bankers then held the economy hostage until we bailed them out with tax dollars to the tune of TENS of trillions of dollars (not entirely due to our own Real Estate market), not requiring their executives to take a pay cut or pay back any of their bonuses that they made during the bubble they inflated.
The narrative I gave earlier of the evil, corrupt, or incompetent government, in collusion with evil borrowers has nothing to do with what I have seen or figured out from news stories. Instead we have bankers pushing for, and getting deregulation, which allows them to merge retail (mortgage loans) and investment (securities) banking, take huge risks by paying large amounts of money to Loan Officers to mislead people into taking dodgy loans that they couldn’t repay, and passing that risk onto investors they misled with the help of the ratings agencies. Together these people, misled by their own greed, have hauled our economy into a lost decade that they would, quite frankly, rather do anything to stay in if it means that they can put off their day of reckoning.
Instead of Atlas Shrugged, I’m finally left with a mental image of an old silent movie, where the evil banker attempting to foreclose on the family farm has chased the heroine off of a cliff. As she holds on to the edge of the cliff, barely able to grip it, a man on a white horse shows up, looks over the cliff at the damsel in distress, and tells her: “Hey, I’ll distract the bad guy by suing him on behalf of the investors in his bank while you pull yourself back up. Ok?”