THE $700B BAILOUT DILEMMA - AN INSIDERS VIEW
The focus of our nation this past few weeks is on the near-collapse of our financial industry. With all the uncertainty and seeming fragility of our financial system, the feds have decided that salvation can come only in and through a massive taxpayer-funded bailout. Where did this come from? How did we get here? And most importatnly right now - why $700B?
I have a unique view of this issue because I worked on two sides of the mortgage business from whence the larger part of this crisis came. From 2002-2006 I worked as an independent loan agent making home loans to consumers. From 2006-2007 I worked as a wholesale Account Executive for a mortgage subsidiary of (gulp) Lehman Brothers. As a loan agent I enjoyed the fruits of unprecedented growth in the housing sector along with the easy lending standards. We all did. And many homeowners benefited as well. The media and many politicians like to make it sound as if every non-prime loan has foreclosed or is currently in default. Not so. Cerainly the larger percentage of those in default/foreclosure had non-prime loans, no argument there. But if you want to blame greedy subprime lenders for this mess then you must also blame congress and the Clinton administration. Aha! Yet another stab at the liberal left you say! But no, tis not so when you know the history of subprime and how it was partially born out of legislative action, way back in 1993...
I have a unique view of this issue because I worked on two sides of the mortgage business from whence the larger part of this crisis came. From 2002-2006 I worked as an independent loan agent making home loans to consumers. From 2006-2007 I worked as a wholesale Account Executive for a mortgage subsidiary of (gulp) Lehman Brothers. As a loan agent I enjoyed the fruits of unprecedented growth in the housing sector along with the easy lending standards. We all did. And many homeowners benefited as well. The media and many politicians like to make it sound as if every non-prime loan has foreclosed or is currently in default. Not so. Cerainly the larger percentage of those in default/foreclosure had non-prime loans, no argument there. But if you want to blame greedy subprime lenders for this mess then you must also blame congress and the Clinton administration. Aha! Yet another stab at the liberal left you say! But no, tis not so when you know the history of subprime and how it was partially born out of legislative action, way back in 1993...
The following was cut and pasted from the Wikipedia entry for the Community Reinvestment Act which was revised in 1995:
In early 1993 President Clinton ordered new regulations for the CRA which would increase access to mortgage credit for inner city and distressed rural communities. The new rules went into effect on January 31, 1995 and featured: requiring numerical assessments to get a satisfactory CRA rating; using federal home-loan data broken down by neighborhood, income group, and race; encouraging community groups to complain when banks were not loaning enough to specified neighborhood, income group, and race; allowing community groups that marketed loans to targeted groups to collect a fee from the banks.
So, the Clinton administration wanted greater home ownership rates in urban communities and minority groups. There was no way this would happen through conventional lending standards as most of the targeted citizens would not qualify under conventional lending guidelines. Enter the subprime loan.
Relation to 2008 financial crisis
In an article for the New York Post, economist Stan Liebowitz writes that the CRA encouraged a loosening of lending standards throughout the banking industry despite warnings of default. Banks were allowed to loan to consumers who were not credit worthy with "no verification of income or assets; little consideration of the applicant's ability to make payments; no down payment." He notes that the Fannie Mae Foundation singled out Countrywide Financial, whose commitment to low-income loans had grown to $600 billion by early 2003, as a "paragon" of a nondiscriminatory lender who works with community activists, following "the most flexible underwriting criteria permitted." The chief executive of Countrywide is said to have "bragged" that in order to approve minority applications, "lenders have had to stretch the rules a bit."
A recent Wall Street Journal editorial on the current mortgage crisis argued that "Washington is as deeply implicated in this meltdown as anyone on Wall Street" because politicians "promoted housing and easy credit". The editorial lists the CRA as as one of the subsidies and policies, and stated that it "compels banks to make loans to poor borrowers who often cannot repay them".
In a piece for CNN, Congressman Ron Paul, who serves on the United States House Committee on Financial Services, partially attributed the current "economic downturn" to the Community Reinvestment Act, charging it with "forcing banks to lend to people who normally would be rejected as bad credit risks."
In an article for the New York Post, economist Stan Liebowitz writes that the CRA encouraged a loosening of lending standards throughout the banking industry despite warnings of default. Banks were allowed to loan to consumers who were not credit worthy with "no verification of income or assets; little consideration of the applicant's ability to make payments; no down payment." He notes that the Fannie Mae Foundation singled out Countrywide Financial, whose commitment to low-income loans had grown to $600 billion by early 2003, as a "paragon" of a nondiscriminatory lender who works with community activists, following "the most flexible underwriting criteria permitted." The chief executive of Countrywide is said to have "bragged" that in order to approve minority applications, "lenders have had to stretch the rules a bit."
A recent Wall Street Journal editorial on the current mortgage crisis argued that "Washington is as deeply implicated in this meltdown as anyone on Wall Street" because politicians "promoted housing and easy credit". The editorial lists the CRA as as one of the subsidies and policies, and stated that it "compels banks to make loans to poor borrowers who often cannot repay them".
In a piece for CNN, Congressman Ron Paul, who serves on the United States House Committee on Financial Services, partially attributed the current "economic downturn" to the Community Reinvestment Act, charging it with "forcing banks to lend to people who normally would be rejected as bad credit risks."
Now you know the governments' involvement and, dare I say, encouragement of subprime proliferation. The Clinton Administration wanted increased home ownership and indeed this was accomplished - with subprime loans. Clinton & Co started it and unfortunately Bush & Co didn't stop it.
Fast forward a decade later. CDO's & CMO's (collateralized debt obligations; collateralized mortgage obligations) became all the rage on Wall St and beyond. Why? Because you could earn a yield 1%-2% above government and in some cases corporate bonds, but with nearly identical risk of default. This was achieved by "securitizing" mortgages and slicing them up into sellable pieces on the street. In the early and mid 2000's the default rate on mortgages was still quite low, making the overall yield very attractive. Given the positive risk/yield factor, CDO's were the new hot commodity among private equity firms, hedge funds, pension funds, etc etc. Subprime lenders in particular, could make 2 to 5 points on each loan, sometimes as high as 7. That's how hungry Wall St had become for mortgage-backed securities (MBS). In other words, Wall St turned the valve open to full blast and flooded the mortgage market with liquidity. But if you're a bank, what do you do with available liquidity when your standards are too high to find borrowers for all of it? That's easy, lower the standards! Wall St and the investors who bought CDO's effectively green-lighted banks to lower lending standards because they wanted more MBS and the only way to get more was to open up lending to the folks who otherwise wouldn't qualify. You following all this?? 100% loans for folks with 580 scores. Reduced documentation, stated documentation, NO documentation; even loans for people with TIN numbers!! Basically if you had a pulse you probably could have qualified. I know because I saw all of it and participated in some of it.
WHAT HAPPENED??
Never trust a chain-smoker to guard the powder kegs. If a person has bad credit and no savings, it is usually indicative of an overall lifestyle that presents an unduly risk to a lender. Banks and mortgage lenders gave loans to otherwise unqualified borrowers. The attitude at the time was that sometimes it will work out and sometimes it won't; but the sum of it all was still on the plus side. I was happy to offer those people a non-prime loan that would otherwise have no chance at purchasing a home. Some of those people still own their homes and were able to convert to more favorable loan terms as their credit improved - a successful example of the subprime idea. But a large part (probably the larger part) of those that received subprime financing, lived up to their non-prime billing and whether self-inflicted or not, reached a point they could (or would) no longer pay. When the payments dried up, the yields on the MBS declined and the risk factor incresaed. As the yields declined to at or below that of corporate and government debt, investors began a "flight to quality" putting their money back into good ol' boring bonds. When that occurred, flow of capital slowed to a trickle and the valve was effectively shut off. No more money for non-prime borrowers. Probably a good move. But one problem lingered - builders had built to accommodate the growing population of qualified buyers. The building blitz was in full swing. Now their potential buyer base had shrunk by 50% or more and they were stuck with inventory they couldn't find buyers for. Similarly, the resale market for homes was already flooded and now their potential buyer pool had been squeezed. Too much housing supply, not enough (qualified) buyer demand, and.... Economics 101: prices fall, fast.
Prices fall, values drop, and when a home is no longer an asset, what's the point of paying the high payment? Rent! If you owe more than its worth, you're only renting it anyway! At least this is the mentality of many homeowners that found themselves in the squeeze. In addition, many people with adjustable rate mortgages (ARM) were coming near the end of their initial fixed period and would not be able to refinance due to their home being worth less than the amount financed. Falling values + adjusting rates = mass foreclosures.
Mass foreclosures leads to declining neighborhood values which means Joe 700 credit with a fixed loan still gets hurt because his house is worth less after three John 580 credits just defaulted in his neighborhood. Joe can't take that job in Kalamazoo because he can't sell his house for the same or more than he owes, thanks to his defaulted neighbors. Joe is stuck. Down the street, Jack has good credit, makes good money, but took out an ARM thinking it was a good idea. Jack is hosed too because he won't be able to refinance or sell out. What will Jack do? He makes the current payment just fine but it won't be fine when it adjusts up $500 each month. Jack pays for a few months but decides its just not worth it. Jack had good credit, now he has a foreclosure thanks to all the John 580's in the neighborhood that foreclosed earlier. What seems to only effect lower-credit borrowers now effects good credit, good income citizens.
SO WHAT NOW??
Subprime is gone away and the whole CRA idea with it. Housing capital can't be looked at like government program money - it is not disposable and has consequences if not repaid. So now we face a bailout of epic proportions. It is proposed that the Treasury will purchase bad CDO's from banks and hold them as assets with a potential return when the market begins to stabilize. Risky move. Because the mortgages were cut into securities and sold off, its unknown what security belongs to which mortgage. Therefore, you'll never quite know the value (or lack thereof) of what you hold. Two things need to happen for this to be a success: 1) Banks must work with homeowners to keep them from foreclosing. Collecting 70% of a payment is better than 100% of none. This will prevent foreclosures and help stave off further value declines. 2) Overall housing market must stabilize and begin to gain value. When this will happen is anyone's guess.
The other idea is to purchase equity stakes in the banks themselves. This is what was done in the UK. That is an equally risky move because the government would be using your $700B of tax dollars to buy up bank shares. STOCKS with your tax dollars!! How is your 401K doing these days?? That's borderline crazy and it blurs the lines between government and private industry. If you own a business then good luck, you're on your own in these perilous times. Uncle Sam's help stops at the corner of Broad and Wall.
And that, my friends, is an insiders view of this mess. I sometimes reflect with regret that I was a small part of it all. I will say that I honestly tried to do the best I could for borrowers and, if I was guilty of something according to my peers, I charged too little. I never wrote up a negative amortization Option ARM for anyone, I always saw them as "voodoo lending". Whenever possible I made fixed loans. Did I make subprime loans? Yes. The programs were there, the borrowers qualified, and they wanted a piece of the American dream - to own their own home. Should I have said no to that? Wall St didn't see it, banks didn't see it, loan agents, borrowers - none of us saw what could happen. Even the guru himself, Alan Greenspan, at the helm during all of it, didn't see it coming. And if the nations most revered economist who himself warned against "irrational exuberance" didn't see it, how could we?
WHAT HAPPENED??
Never trust a chain-smoker to guard the powder kegs. If a person has bad credit and no savings, it is usually indicative of an overall lifestyle that presents an unduly risk to a lender. Banks and mortgage lenders gave loans to otherwise unqualified borrowers. The attitude at the time was that sometimes it will work out and sometimes it won't; but the sum of it all was still on the plus side. I was happy to offer those people a non-prime loan that would otherwise have no chance at purchasing a home. Some of those people still own their homes and were able to convert to more favorable loan terms as their credit improved - a successful example of the subprime idea. But a large part (probably the larger part) of those that received subprime financing, lived up to their non-prime billing and whether self-inflicted or not, reached a point they could (or would) no longer pay. When the payments dried up, the yields on the MBS declined and the risk factor incresaed. As the yields declined to at or below that of corporate and government debt, investors began a "flight to quality" putting their money back into good ol' boring bonds. When that occurred, flow of capital slowed to a trickle and the valve was effectively shut off. No more money for non-prime borrowers. Probably a good move. But one problem lingered - builders had built to accommodate the growing population of qualified buyers. The building blitz was in full swing. Now their potential buyer base had shrunk by 50% or more and they were stuck with inventory they couldn't find buyers for. Similarly, the resale market for homes was already flooded and now their potential buyer pool had been squeezed. Too much housing supply, not enough (qualified) buyer demand, and.... Economics 101: prices fall, fast.
Prices fall, values drop, and when a home is no longer an asset, what's the point of paying the high payment? Rent! If you owe more than its worth, you're only renting it anyway! At least this is the mentality of many homeowners that found themselves in the squeeze. In addition, many people with adjustable rate mortgages (ARM) were coming near the end of their initial fixed period and would not be able to refinance due to their home being worth less than the amount financed. Falling values + adjusting rates = mass foreclosures.
Mass foreclosures leads to declining neighborhood values which means Joe 700 credit with a fixed loan still gets hurt because his house is worth less after three John 580 credits just defaulted in his neighborhood. Joe can't take that job in Kalamazoo because he can't sell his house for the same or more than he owes, thanks to his defaulted neighbors. Joe is stuck. Down the street, Jack has good credit, makes good money, but took out an ARM thinking it was a good idea. Jack is hosed too because he won't be able to refinance or sell out. What will Jack do? He makes the current payment just fine but it won't be fine when it adjusts up $500 each month. Jack pays for a few months but decides its just not worth it. Jack had good credit, now he has a foreclosure thanks to all the John 580's in the neighborhood that foreclosed earlier. What seems to only effect lower-credit borrowers now effects good credit, good income citizens.
SO WHAT NOW??
Subprime is gone away and the whole CRA idea with it. Housing capital can't be looked at like government program money - it is not disposable and has consequences if not repaid. So now we face a bailout of epic proportions. It is proposed that the Treasury will purchase bad CDO's from banks and hold them as assets with a potential return when the market begins to stabilize. Risky move. Because the mortgages were cut into securities and sold off, its unknown what security belongs to which mortgage. Therefore, you'll never quite know the value (or lack thereof) of what you hold. Two things need to happen for this to be a success: 1) Banks must work with homeowners to keep them from foreclosing. Collecting 70% of a payment is better than 100% of none. This will prevent foreclosures and help stave off further value declines. 2) Overall housing market must stabilize and begin to gain value. When this will happen is anyone's guess.
The other idea is to purchase equity stakes in the banks themselves. This is what was done in the UK. That is an equally risky move because the government would be using your $700B of tax dollars to buy up bank shares. STOCKS with your tax dollars!! How is your 401K doing these days?? That's borderline crazy and it blurs the lines between government and private industry. If you own a business then good luck, you're on your own in these perilous times. Uncle Sam's help stops at the corner of Broad and Wall.
And that, my friends, is an insiders view of this mess. I sometimes reflect with regret that I was a small part of it all. I will say that I honestly tried to do the best I could for borrowers and, if I was guilty of something according to my peers, I charged too little. I never wrote up a negative amortization Option ARM for anyone, I always saw them as "voodoo lending". Whenever possible I made fixed loans. Did I make subprime loans? Yes. The programs were there, the borrowers qualified, and they wanted a piece of the American dream - to own their own home. Should I have said no to that? Wall St didn't see it, banks didn't see it, loan agents, borrowers - none of us saw what could happen. Even the guru himself, Alan Greenspan, at the helm during all of it, didn't see it coming. And if the nations most revered economist who himself warned against "irrational exuberance" didn't see it, how could we?
