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This Mess We’re In
by David Nett | Jan 16, 2008

The current mortgage crisis, and its impact across the American economy, was almost entirely avoidable. The problem was, the folks who saw it coming were the same people who drove the escalation in the first place, and they were largely able to game the system in such a way that they made massive amounts of money, while pushing the bad effects of the inevitable crash off onto the rest of us.

Full disclosure here: I currently work in a technology sector which serves the mortgage industry. As a result, I know a little bit about how mortgages, and the industries which service them, work -- more than the average Joe. The idea that all of this -- the increase in defaults and the ripple effect that could have on the larger US and world economies -- was somehow unforeseeable is a ludicrous lie. At my company alone, executives and expert consultants have been talking about the looming downside of our sub-prime craze for three to four years, maybe longer. Many of our experts are regular industry lecturers and advisors to state and federal government, and have, over the past couple of years, spoken about this very real possibility to various industry and government groups.

The trouble is, while the cash was flowing, nobody wanted to listen. And those few who did listen and understand were either not in positions of influence, or knew that they'd arranged things so that by the time the system came crashing down, they'd have already become fabulously rich (or, in most cases, more fabulously rich).

Let's step back for a moment to understand how and why these "accelerated increases in delinquency levels" occurred. What follows is a simplistic narrative, and leaves out a lot of detail and complexity (including the spectre of intentional fraud), but the gist is what's important here (and, I feel it's a good deal more accurate than the over-simplistic narrative often heard in the sound-bite media).

In the old days, when a person wanted a mortgage, that person had to go to a bank. That bank carefully considered the potential borrower's ability to repay the entire loan before lending that money. Once the loan was made, the bank collected the repayment and interest. If a borrower defaulted, the bank took possession of the property and re-sold it, a proposition with a lot of inherent cost. It was in the bank's best interest to make certain a borrower could pay, and not to lend too much money to too many homeowners. While this was a workable, conservative approach, it made it hard for people who had anything but the best incomes and credit to get loans.

Along came government programs like Fannie Mae and Freddie Mac. They bought certain mortgages from lenders, putting more cash back into the banks, and allowing banks to make more loans. But Fannie and Freddie were pretty conservative as well -- only buying "conforming" or "prime" loans: loans to people with excellent credit, and only under a certain dollar amount. When Freddie and Fannie started to do well off the interest from these loans, other investors saw an opportunity. They bought loans from Fannie and Freddie, as well as directly from banks. Because they had looser rules than the government programs, they did not have to be so conservative. Banks started to loosen their rules. They could offer riskier loans to borrowers without good credit (sub-prime borrowers), and charge a higher interest rate, and then sell those "non-conforming" loans to private investor groups. While there was more risk that default might occur, because the interest rates were higher, investors saw an opportunity for more profit. In buying more and more of these non-conforming loans, they encouraged the banks themselves to write more non-conforming loans.

Enter the mortgage brokers. As the mortgage market volume increased, banks simply could not keep up with the personnel demands of taking loan applications, reviewing them and offering loan options. Mortgage brokers stepped in to pick up the slack. Mortgage brokers took applications from potential borrowers, gathered applicable information, helped the borrowers look as good as possible on paper, and then shopped those completed applications around to various banks, looking for someone who would lend to their clients. If a bank decided to lend to a broker's client, the broker received a small percentage of that loan as payment for doing the legwork.

In most cases, brokers get paid when the mortgage they sponsor has reasonably met repayment expectations for one year. And, since most brokers get a percentage of the loan they sponsor, it is in their best interest to encourage their clients to take the largest loan they can get, so long as they can repay it. Or, rather, so long as they can repay it for the first year. After that, it doesn't matter to the broker, 'cause he's already gotten paid. And, once a bank sells the mortgage to an investor, provided the mortgage doesn't default due to fraud (which is difficult to prove), the bank has gotten paid and doesn't care if a borrower is making payments. With the brokers' encouragement, and the allure of easy money from greedy investors who continually ignored the risks and repurchased packaged mortgages in increasingly complex funds and segments (and, in fact, basically begged banks to make more, riskier loans so they could gobble-up the imagined profits), banks started to experiment with the kinds of loans they offered, especially to the sub-prime markets.

Finally, banking de-regulation legislation in the late 1990's removed barriers which had formerly prevented brokers, banks and stock market investors from colluding when creating mortgages. In the face of multiple market pressures, suddenly freed from the last remaining bit of regulation, the system started to break down.

Gone were the the days where, in order to buy a home, you needed a 5% or 10% or 20% down payment, and all mortgages had a fixed interest rate for 15 or 30 years. Buyers had all kinds of options. Interest-only loans, where (for a set period of time) buyers made only interest payments and paid no principle, became a popular way to buy, build equity (so long as property values continually increased, buyers could still build equity), and then sell or refinance into a more traditional loan. But the real kickers were the Adjustable Rate Mortgages, or ARMs. These loans carry a (usually very low) fixed rate for a short period of time. After that period is over, the mortgage holder can jack the rate up to market rates and beyond. Using hybrid ARMs and Interest Only options, coupled with 100% (and in some cases up to 125% or more!) financing, brokers could conceivably get their clients a home with no money in the bank for a very low (initial) monthly payment.

In part because more people were getting more loans and looking to join Bush's "Ownership Society," homes, as a commodity, became scarce, and home prices skyrocketed. Promise of huge payouts encouraged brokers to fudge their clients' loan applications in order to get them bigger loans, and to encourage even high-rated borrowers to borrow beyond their means, or accept riskier mortgages than those traditional ones for which they qualified. Banks often decided not to pay for even the most basic automated services which checked loans for quality and risk before funding (much less hire hordes of expensive, highly skilled mortgage underwriters to deal with the ballooning loan volume), deciding that huge profits would offset any losses due to fraud. And investors and rating agencies created ever more complex securitization schemes at the back end, allowing them to invest in risky loans with high profit potential, and spread the risk across the broader U.S. economy (and, indeed, the world economy). The banks, brokers and investors worked together to create a lending and securitization system where risky, highly profitable loans could be made, without that risk falling on the shoulders of any one entity.

That securitization, in the end, is what bit us all. Because, thanks to loose (if any) regulation, investors were able to spread the risk of even the flimsiest wild-ass investments across the economy, they were able to pump massive amounts of money into essentially bad mortgages without worrying about the downside. And, as they had gambled, when the artificial bubble finally did burst, when those adjustable rate mortgages were unleashed and home foreclosures began to skyrocket and the bottom fell out of the market, the losers were the homeowners (including those who didn't default, but who lost huge amounts of value when the market tanked) and the stock holders across the economy, to whom the risk had been spread. The bank executives, securities executives, hedge fund managers and investment bankers, who claimed hundreds of millions of dollars in bonuses each year over the past two or three years, have walked away from the mess they engineered virtually unscathed. Sure, banks and brokerages and servicing companies are folding left and right, laying off thousands and screwing stockholders, but their executives have all made out just fine. More than fine. Way, way more than fine.

No one "in the know," including all the executives and managers at the top of the money-shuffling industry, was unwitting about this. And yet, while we clamor for the banks to freeze interest rates and foreclosures (which they mostly can't do anyway, thanks to the complex securitized ownership and servicing arrangements of most of these mortgages), and we beg the Fed to inject cash into the system and fall all over ourselves to devise "stimulus packages," no one is calling for those executives to give their hundreds of millions (in aggregate, billions) of dollars back. And it wouldn't do any good if we did.

What happened with what we're now calling the sub-prime lending disaster was not accidental. It was engineered and, for those few who understand the markets, largely foreseeable. Extraordinarily wealthy money-shufflers colluded to make themselves wildly (more) rich, and push the downside onto the rest of us. And it worked. Frankly, it was a lot like the Enron scandal, except the collusion was more subtle, it spanned multiple industries, and, thanks to reckless deregulation of the investing industry, it was, at least mostly, legal. And now, as our economy spirals into recession (thanks to this, the price of energy, the costly war in Iraq, etc.), we the people, as always, are left holding the bag.

Welcome to 2008, America. Hold onto your butts. It's gonna be a rough year. For most of us non-banking-executives, anyway.