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(I've alerted Mods that I question posts on Blog shouldn't apply to Copyright Rules...so here's the rest:
On 12/07/07 Alan Milner wrote:
Mark Hanson’s concise and excellent analysis of what happened in the mortgage industry from 2003 to 2007 is both extremely accurate in terms of the historical background, and probably prescient with respect to the prediction of hardships yet to come.
The only thing Mr. Hanson didn’t is address was the “why” of the situation. Why did supposedly rationale people behave in such an outrageous manner, doing such egregious harm to so many families?
Let’s dispense with the boogey man argument right here: no one set out to drive millions of American families into bankruptcy and foreclosure. This wasn’t some vast conspiracy. It was just a lot of people all trying to stay above a rising tide.
There are, in fact, several real- as opposed to imagined – reasons why what happened.
I put only ten years into the mortgage industry, from 1997 to 2007, when American Home Mortgage went under, taking me with it, but during those years I worked for a small lender, a small broker and a national company that claimed to be (but really wasn’t) the tenth largest lender in the United States. I held every position on the retail side from mortgage originator to general manager, and was one of the people who started the internet mortgage phenomenon.
Nevertheless, even from this limited perspective, I also saw the handwriting on the wall a long time ago, when I returned to the business late in 2003 after a bout with cancer.
The turning point came in June of 2003, when a spike in wholesale rates caught a lot of people holding a lot of unlocked commitments, myself included. In May of 2003, I was writing full-doc, 30-year fixed rate, 80% LTV rate and term transactions on primary residences at UNDER five percent.. In June, the rates shot up suddenly by a full point, into the six percent range, and NEVER went back to the 5% levels again.
As it happened, my cancer episode coincided with the spike in interest rates, being diagnosed the same week that rates spiked. When I came back to work in the fall of 2003, everything had changed. The refi boom, on which everyone in the industry was making obscene amounts of money, was faltering badly. Companies that had geared up to meet the huge demand represented by the refi boom were suddenly overdeveloped, overstaffed and overextended, and facing an almost immediate implosion.
The Pay Option ARMS and other, even more exotic instruments, became the industry’s saving grace….but the fact of the matter is that many families were already over-extended by their conventional refinance transactions BEFORE the Pay Option ARMS became the rage of the industry, taking on second mortgages as the prime rate fell from a ten year high of 9.5% in May of 2000 to a FORTY YEAR low of 4.75% in December of 2001 off a 4.5% low dating back to August of 1960.
I don’t know which is more remarkable, the 50% drop in the prime rate over an 18 month period from 9.5% in May of 2000 to 4.75% in December of 2001, or the fact that we had hit a forty year low on this product.
A lot of the money generated by this largesse went right into the stock market, where a lot of stocks were selling way under their price points in the immediate aftermath of the September 11th attack on the World Trade Center.
Focus on the September 11 attack for a moment. On August 22, the prime rate stood at 6.5%. On September 18th, the Fed cuts the rate by half a point. Then, from September of 2001 to June of 2003, the rate continues to decline to a historic low of 4.00% in June of 2003. The last time the Prime Rate was 4.000% was on September 11….of 1958!
And then something very interesting happens. The prime rate starts going up, forcing millions of American families into a squeeze play as the monthly payments on their second mortgages started to inch up. This encouraged them to refinance, consolidating their first and second mortgages into new first mortgages, often using an exotic instrument such as the Pay Option ARM. This is when and how the disaster before us took root.
If you look at the history of inflation rates, you see a fairly moderate rate of inflation rate of around 3% per year. However, that reflects a common misconception. From 2000 when this all began to 2006, the most recent complete year, and you see that inflation over that period has totaled almost 20%. When viewed from the perspective of the Consumer Price Index, the cost of living has increased by more than 100% from 1982 to 2006, but the average price of a new home has increased more than four times that rate.
In 1982, the conforming loan limit for Fannie/Freddie mortgages on single family homes was $107,000. In 2006, the limit was $417,000, an increase of 389%. (Remember that the Fannie/Freddie limits are based on an assumed loan to value ratio of 80%, so we could increase these values by 20% to improve the accuracy of the example, but the illustration would remain constant.)
In 2000, the year the dot.com implosion began, the conforming loan limit was $252,700. In 2006, the maximum loan amount was increased to $417,000, an increase of 65% over a six year period. During the previous six year period, the maximum increased from $203,150 in 1993 to $252,700 in 1999, an increase of 24%. In other words, the conforming loan limit increased three times faster during the years from 2000 to 2006 than it did from 1993 to 1999.
Since inflation was clearly not the driving force behind the run up in real estate values, what was?
In single word: speculation. All of a sudden, people who never dreamed of owning more than one home had three or four, a primary residence, a second home and one or two investment properties.
Speculators created a market that fueled further construction, while simultaneously taking product off the market that would otherwise have moderated the increase in values.
What these figures show is a wholesale, and widespread, campaign to refinance the losses experienced during the dot.com implosion by sucking value out of the real estate market. The availability of easy money, combined with a stock market full of under-priced stocks created a boom market for both stock brokers and mortgage brokers, often acting in collusion, to take advantage of cheap money from real estate to buy into the market.
The resulting refi boom had an unintended consequence: it depleted stores of previously owned homes. People who are cashing in on the increased value of their homes aren’t going to turn around and sell them. The created a boom market for new construction.
Think this out. Adam Smith strikes again. (The original, not the copy.) Refinance transactions have no impact on comparative housing values except insofar as supply and demand increases the asking prices of the units currently on the market. Increasing values on previously owned homes on the market increases the marketability of new construction, which usually gets priced at a 10% -20% premium over similar but previously owned homes in the same communities.
This creates an inflationary spiral affecting the values of both existing and new homes. Home owners see the higher prices being paid for similar homes to theirs, and demand higher prices for their homes.
Two extraneous (as in non-real estate) factors affected this spiral: the dot.com implosion and oil price gouging.
From 1995 to 2000, thousand of companies made the leap from start-up to IPO but, beginning in 1999, many of these highly touted ventures started to crash and burn.
In February of 1995, the Dow Jones broke 4000. On November 21, it breached 5000. On March 29, 1999, the Dow Jones crashed through the 10,000 point mark. Ten months later, the DJ hit a high point of 11,723 in January of 2000, then begins a gradual decline when George W. Bush becomes president. The NASDAQ, of course, was an even more dramatic indicator. In March of 2000, the NASDAQ hit the 5000 point mark. Nine months later, in January of 2001, it had fallen below 2500 – before September 11 sent it crashing further.
Two questions arise.
First question: Where did all that money that fueled the dot.com boom come from? Companies were founded on venture money. Initial public offerings were used to buy out the venture partners. The IPOs were usually gobbled up by institutional investors. Institutional investors then depend up subsequent sales of stocks to smaller investors to rack up the enormous profits that were made on dot.com issues, until they crashed, which left the small investors usually holding the bag.
Some writers have referred to the real estate bubble as a Ponzi scheme. It was. But it was also a game of musical chairs, as all Ponzi schemes are. Someone always gets left holding the bag.
Robert Shiller, the Yale economist predicted the dot.com crash in his March, 2000 best seller, “Irrational Exuberance”, also predicted the collapse of the real estate bubble in a 2005 article in a Barron’s article entitled, “The Bubble’s New Home,” in which he writes that “Once stocks fell, real estate became the primary outlet for the speculative frenzy that the stock market had unleashed.”
Second question: When the dot.com bubble burst, where did the money go because there was a lot of money made on the boom before it collapsed? And where the new investments go when the dot.com world turned into a swamp?
The answer is the same in both cases: real estate, of course.
But not just real estate. In fact, this is when we start to see a tremendous rise in the percentage of investment property purchases compared to owner-occupied purchases. Statistics on this issue are proving very hard to get, but my own experience was that there was a very significant increase in investment property purchases. The speculators had arrived in force.
The fact of the matter is that many of us saw this coming, but were powerless to do anything about it because, as Mark points out, we can only sell the products that Fannie, Freddie, FHA, and the major investment houses and their partner banks gave us to sell. They had to create these questionable instruments because they were already holding multiple billions of dollars in bad paper, and needed to generate fast revenues to obscure their losses.
I saw this beginning in 2003, as the number of loans sent back for repurchase from lenders back to the mortgage originators began skyrocketing. When I researched the problem, I discovered major lenders with boxes and boxes of closed but not reviewed loans sitting around waiting to blow up. (I’m not naming names, but one of the companies was headquartered in Richmond, VA, and they’re still in business.)
Several other factors contributed to the development of the disaster.
These included the development and dissemination of automated underwriting systems, which made it possible to hire virtually unskilled workers and turn them into mortgage processors. In many cases, lenders were allowing 90% of their transactions to pass through the system untouched by real live underwriters.
There was nothing wrong with the software itself. There was a lot wrong with putting that software into the hands of loan officers and mortgage originators. Garbage in, garbage out. Whether it was a result of incompetence or outright malfeasance, many of the bad loans now choking the system got into the system because many originators ran the loan through an automated underwriting system, forged documents to backup the application, and colluded with appraisers and settlement agents to grease the deals.
As long as the originators only had access to the front end part of the system, the loan origination software, everything was good. When the loan origination software was integrated with the decision engines used by the automated underwriting systems, disaster was inevitable because the foxes weren’t only in the hen house….they were all over the farm. We had given largely untrained, inexperienced and sometimes untruthful salesmen the keys to the kingdom.
Proof is self-evident. American Home Mortgage had one of the most sophisticated loan origination systems in the industry, and it was fully integrated with the automated underwriting system. There was a second system used only by the processing staff, but the information came from the originators, not from the raw documents in the files.
American Home was the splashiest of all the mortgage company failures for good reasons. This was one of the
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