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Wall Street’s Mortgage Product Design and the Design of the Titanic
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Editor’s Note: The following item was written for Flipping Frenzy by Dr. Gary Lacefield, a nationally recognized expert on fair lending and housing-related practices. Dr. Lacefield was a Senior Civil Rights Analyst, Investigator, and Conciliator for HUD, where among other accomplishments, he negotiated the 12 largest civil rights settlements involving housing providers in the agency’s history.
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The designers of the Titanic proclaimed it as greatest-and-safest ship ever built…”Unsinkable!” In a similar “safety statement,” Wall Street also proclaimed to the mortgage industry–and anyone else who would listen–that their mortgage-driven products for sale were “risk free” and “just as safe.”
- The Titanic only carried 20 lifeboats which, if fully utilized, would have saved just 50 percent of its passengers. So that means that in a perfect’ situation, 50 percent still would have died even if they’d been able to get to the lifeboats that were available.
- Wall Street’s plunge into the subprime mortgage-based securities world failed to price their products correctly, based–in hindsight–on the risk now realized with those products. It now appears that approximately 80 percent of the high cost loans in this country are in trouble of drowning because of the underlying borrowers’ inability to perform.
- The designers of the Titanic claimed that the reason that they failed to carry an sufficient number of lifeboats was because ‘The White Star management was concerned that too many boats would sully the aesthetic beauty of the ship.’
- Wall Street fell into the same trap: They were afraid that if they priced the risk of these boutique mortgage products appropriately, borrowers wouldn’t find them appealing.
- The Titanic’s purported safety features and proclamations of “unsinkable” were based upon a design that relied on the improbability that several of its watertight compartments would never be compromised at the same time. The very incident that was not likely to happen did… on its maiden voyage.
- Wall Street’s product underwriting guidelines were designed to ensure that the firms creating these securities would never be impacted because all of the risk was diverted to the originating lenders. Wall Street didn’t anticipate that their mortgage products were so poorly designed that the originating lenders would start to fail, with virtually zero buffer between them (Wall Street) and the borrower.
- The Titanic’s quality assurance was seriously flawed, allowing trapped water to overflow from one airtight compartment to the next–its ultimate undoing.
- Wall Street’s underwriting design allowed many borrowers to fall prey to the opportunities presented by the nature of the product. When the borrowers failed to perform, the overflow of defaulted loans spilled over from one company to the next, causing each of the smaller companies to close.
- The Titanic served several classes of people, but was clearly designed for the wealthy. There were 325 First Class passengers on board during that fateful trip. But in order to underwrite the cost of the passage, they also sold steerage to second class (285) and third class (706) passengers. It’s no coincidence that more First Class passengers survived (202) than either second class (118) or third class (178) passengers.
- Wall Street designed these specialty mortgage products for the First Class borrowers, but designed the products so that second and third class borrowers would be able to underwrite the programs. It’s no coincidence that more of the wealthy borrowers are less affected by the results of these programs compared to the impact suffered by the middle and lower income borrowers. Foreclosures and defaulted loans are at the highest number since the Great Depression.
- The Titanic was staffed with a crew of 913 which represented about 46 percent of the total on board. Over 700 perished when the ship sank representing almost half of the casualties.
- So far, over 165 lenders of size have “imploded” with at least another thousand, smaller mortgage companies and brokerages failing. Over 45,000 jobs have been lost in the mortgage industry in the past five months alone. Early (conservative) estimates indicate that there will be over $100 billion in credit losses. All of this carnage is a direct result of the availability and miscalculation of risk associated with the aforementioned mortgage products by Wall Street.
- The Titanic tragedy was investigated by the government and changes were made within the industry to reduce the risk associated with ocean travel.
- What do you think our government’s going to do about the mess created by Wall Street? A review of the government’s intervention in the last half century includes the creation of the following “bail-out” type programs for the housing sector:
- Since 1970 we’ve had the Emergency Home Finance Act of 1970.
- The Emergency Housing Act of 1975.
- The Emergency Housing Assistance Act of 1983.
- The Emergency Housing Assistance Act of 1988.
Based on historical data, it’s easy to see that financial crises recur on average, about once a decade–and apparently–so do emergency housing acts: It seems probable that, given the current mortgage credit related issues, the Fall of 2007 will bring about a new emergency housing act.
A year ago, it was common to say that while house prices would periodically fall on a regional basis, they could not on a national basis, because it hadn’t happened in the large U.S. market since the Great Depression. Oops! Housing prices are falling on a national basis, as measured by the S&P/Case-Shiller national index. Additional reports reflect the following:
- With excess supply and falling demand, it’s not terribly difficult to forecast further drops in house prices: The recent Goldman Sachs housing forecast points out “substantial excess supply” and that “credit is being rationed,” as well as projecting average house prices will fall 7% a year through 2008. This is along with projected falling home sales and housing starts, with some experts predicting “more than a 15% real drop in national home price indices.”
- The June 30, 2007 National Delinquency Survey of the Mortgage Bankers Association (MBA) reports:
- A total of 1,090,300 seriously delinquent mortgages
- Serious delinquency means loans 90 days or more past due plus loans in foreclosure
- Of the total, there are 575,200 subprime loans
- Subprime mortgages, which represent about 14% of mortgage loans, are 53% of serious delinquencies
- The survey reports 618,900 loans in foreclosure, of which 342,500 or 55% are subprime
- One constant of the mortgage finance world is that adjustable rate loans have higher defaults and losses than fixed rate loans within each quality class: The June 30, 2007 numbers illustrated through the (serious) delinquency ratios as follows:
- Prime fixed 0.67% Prime ARMs 2.02%
- Subprime fixed 5.84% Subprime ARMs 12.40%
- FHA fixed 4.76% FHA ARMs 6.95%
(It’s worth noting that the particular problem of subprime ARMs leaps out of the numbers. Also notice that FHA and subprime serious delinquency ratios for fixed rate loans aren’t radically different. The FHA is predominately a fixed rate lender, whereas subprime is about 53% ARMs. The total range is remarkable: The subprime ARM serious delinquency ratio is over 18 times that of prime fixed rate loans.)
- A central problem is that during the boom the subprime market got very much larger than it used to be: In the years of credit overexpansion, it grew to $1.5 trillion in outstanding loans, up over 8 times from its $150 billion in 2000. So the financial and political impact of the subprime level of delinquency and foreclosure is much greater.
- The American residential mortgage market is the biggest credit market in the world, with about $10 trillion in outstanding loans:
- Residential real estate is a huge asset class, with an aggregate value of about $21 trillion, the single largest component of the wealth of most households
- A 15% average house price decline would mean a more than $3 trillion loss of wealth for U.S. households, which would be especially painful for those who are highly leveraged.
- Moody’s recently forecast that the “unexpectedly steep and persistent downturn” in the mortgage and housing sector would last until 2009.
- The interrelated series of problems stemming from the deflating housing and mortgage bubble will trigger a sharp decline in home prices: The related fall in home building that could lead to an economy-wide recession and carry with it the potential for a substantial decline in consumption, as well as a potentially serious decline in aggregate demand.
- With these risks on the horizon, experts are (predictably) encouraging the Federal Reserve to ease credit: The Fed–as well as other central banks–have already provided a significant amount of liquidity support to the panicky international credit markets. These markets continue to suffer from not knowing exactly who is in trouble from leveraged speculations in subprime securities and from great uncertainty about what such securities are worth:
- Many are calling on the Fed to lower the fed funds rate further: Lower short term rates make it cheaper to carry leveraged positions in securities unable to be sold at prices acceptable to the seller and help ease the panic.
- The severe problems with subprime mortgages and securities made out of them, related defaults and foreclosures, and falling house prices will continue well into 2009.
- Of subprime borrowers trying to refinance adjustable rate mortgages with resetting interest rates, the survey found that 64% of the subprime homeowners were unable to do so.
President Bush, as well as numerous members of Congress and the FHA have suggested using the FHA as the means to create a refinancing capability for subprime mortgages: This makes sense because the FHA itself is—and has been since its creation in 1934—a subprime mortgage lending institution. Of course they didn’t call it that, but historically if you couldn’t qualify for a prime loan, you went to the FHA.
- The latest MBA survey shows that serious delinquencies for fixed rate FHA and subprime loans are similar:
- So are total past due loans: 14.54% of subprime loans are past due, as are 12.40% of FHA loans.
- The difference is in the foreclosure inventory: although both are far over the prime foreclosure ratio of 0.59%, the 5.52% for subprime is two and a half times the 2.15% for the FHA.
- The FHA, being itself the principal credit risk taker, logically has more ability to practice forbearance and loss mitigation: But with falling house prices, the amount the FHA could responsibly refinance is liable to be less than the outstanding principal owed on the subprime mortgage:
- Here the owners of these mortgages, typically investors in structured mortgage-backed securities (MBS) issued by a securitization trust, need to take a loss for the difference
- Investors in such speculative instruments should not be bailed out, and the loss in economic value has occurred already…it is a matter of its becoming a ‘realized haircut.’
- Putting this in the context of the evolution of the mortgage market: The Mortgage Bankers Association has reported that subprime mortgages grew from 2.4% to 13.7% of total mortgage loans between 2000 and 2006. But the proportion of prime loans also increased, from 72.6% to 76.6%.
What went down? It was the market share of the government’s FHA (and much smaller VA) programs, which fell from 25.2% to only 9.7%. The combined share of subprime plus FHA-VA stayed more or less the same, but within that, subprime took a lot of market share away from the government alternatives.
In closing, from the October 12, 2007 issue of Daily Real Estate News
“The study suggests that as home prices rose throughout the U.S. in the early 2000s, lenders grew more willing to let high-rate borrowers get bigger loans as measured against their annual incomes. In 2005, borrowers who were given high-rate mortgage to buy one-to-four-family homes were loaned 2.1 times their reported annual income. That was 4 percent more than regular borrowers received.“
Filed under: Subprime Mortgages, Mortgage Meltdown, Dr. Gary Lacefield
A Ralph Roberts Site, Copyright 2005-2008 |
This one I agree with you on. It reiterates many of my points and issues on the topic.
Wall Street not only passed the risk down to the lenders and brokers-many of whom they knew could never cover any loss-they mainly passed it on to those who invested in the securitized instruments. It was this passing the risk forward that created the storm.
Wall Street and their relaxed underwriting did not care about repayment. They had nothing to lose and everything to gain. They are the main cause of the demise of the mortgage industry, mortgage companies and the tens of thousands of industry unemployed. They opened the door for fraud, saw it happening and turned a blind eye. THEY COULD HAVE PREVENTED MUCH OF IT by underwritng properly.
Investors who purchased AAA rated investments carrying “false” ratings by the rating agencies were defrauded. These investors were not unsupecting homebuyers but sophisticated world wide institutions, pension funds and governments. At no time did Wall Street have any risk. They needed only to create more “paper” and reap more profits.
By doing so, they had an endless source of money to lend. Debt financed by debt financed by more debt. A very sophisticated scam.
This is where the fraud in the mortgage industry truly was.
Government bailouts? Absolutely NOT! Bear Stearns, one of the largest of the sub prime creators should not get taxpayers money for participating in destroying our housing market. I say give that money to the homeowners who need the help.
Lenders, now servicing loans, are still reluctant to do workouts with homeowners. By not doing so they are not only preventing a solution, they are actually working to the detriment of the investors holding their misrepresented AAA paper.
To date, nothing proposed by our government is close to helping solve the problem. In fact, in some cases they are making matters worse. Case in point, Fannie Mae has made it even more difficult to qualify. They are now charging a higher rate for those with a score between 620 and 679. (620 has always been the benchmark for qualification). Is this higher rate not a “sub prime” rate in effect?
They have also increased the length of time one needs to be out of BK or Foreclosure. With the numbers of people forced into BK and foreclosure today, it will be that much longer for them to qualify. More importantly, this new qualification is retroactive, meaning if you were close to qualifying, you now must wait even longer.
I have seen nothing that will help in the near term. I do believe however, that this problem and declining values will go far beyond 2009 with a full recovery taking years beyond that.
Dr. Lacefield, you and I are on the same page here.
Thanks
Comment by Larry Rubinoff — April 13, 2008 @ 2:56 pm
I really wish that the federal government would spend more time researching why Wall Street allowed this nightmare to happen! I already know why the federal government is targeting the small mom and pop brokers and loan originators, it’s the same old story—big government preys on the weak and the fat cats on Wall Street get off easily. The FBI has already announced that mortgage fraud is it’s number one concern and that they have increased their staffs in that division. It would have been impossible for these loans to have been originated if strict underwriting guidelines were in place. No-docs, stated income, multiple homes ok’d, and many other poorly designed programs, allowed for underwriters to “coach” originators which lead to everything goes—-in other words, just get it closed! I know that after the government locks up enough of these small hapless originators and brokers, they will declare that they have “righted all wrongs”. I guess that this just the American Way of doing business. I wish that someone would tell the Feds that they are going after the wrong ones, that they could become more effective by prosecuting the major players on Wall Street. Dr. Lacefield and Larry Rubinoff really understand the root of this problem.
Comment by mark calhoun — April 15, 2008 @ 11:34 am
Mark:
Just as during the Great Depression, when bad paper was knowingly being sold to investors, the government was aware but condoned the actions by the banks and took NO action to preserve the “prosperity” the nation was enjoying. More millionaires were being created then ever before. Sound familiar?
Bill Clinton during his presidency claimed that he was responsible for increasing homeownership to the highest levels ever. In fact, it was the evolution of sub prime mortgage programs that allowed the increase. More available money, lower qualifications =’s more buyers. Could the government then and now have “urged” these banks to lower qualifications and lend “more” money? This is not outside the realm of possibility or reality.
You are also correct in saying that if strict underwriting proceedures had been followed many loans would not have been made.
I, as a broker, I submit a package with the requirements for the loan program to the lender’s underwriter. It is then the lender’s underwriter that determines if the loan is approved and funded or denied not the broker. Since many loans were approved and funded and many, as we now see, were fraudulent it appears there was a conspiracy between many crooked originators and brokers. But WITHOUT the approval by the lender whose job it is to verify the information in the file, many fraud loans could not have occurred.
The Feds are going after “mom and pop” shops is that it is easier just as you have said. Just as in the War Against Drugs, the emphasis was on the street guy and small user more then it was on the cartels and main players. The little guy is just simply more visable and easier to get.
Don’t misunderstand, some of these “mom and Pops” (many of whom were very sufisticated) deserve to be caught and prosecuted. However, it was still with the aid of the “fat cats.” Wall Street was very much complicit.
Large corporations and the government are in bed together. It is obvious as corporatons could not practice “socialized capitalism” when things go bad and pure capitalism when business is good. Case in point, Bear Stearns bailout!! to make matters even worse, Bear Stearns is laying off literally thousands of “little” people while the top, high wage earners will keep their jobs as reported by CNBC today.
The report also said that even though these people will get a 9 month severance package, many of them will have a difficult time finding new jobs. More unemployed, more foreclosures, more bankruptcies, more problems for middle class Americans. Victims all.
As to telling the Feds who to go after, you can do that. You can also contact your Congressman and Senator. The more they hear “from” the people, the more it will do to “right” some of the “wrongs”.
Speak Out America.
Comment by Larry Rubinoff — April 15, 2008 @ 6:46 pm
I just love you Mr. Larry Rubinoff! Your points are clearly defined and they bring light to the “dark underside of our government and the Wall Street Gang”.
Comment by mark calhoun — April 16, 2008 @ 1:07 am