Who Stole the American Dream?

by Hedrick Smith

  Enter a second WaMu Option ARM offered in a mailer from Homegate Mortgage in Ohio. When Terboss phoned Homegate, he said they told him that they could cut his payments by about $1,000. Terboss shared with me the loan proposal that Bob Norris at Homegate had sent him. It showed an interest-only payment of $3,027.56 a month, a minimum payment of $500 below that, and a big black arrow pointing to a “fully indexed rate” (interest) of 5.025 percent. That was well below Terboss’s existing WaMu loan interest rate. Eager to save nearly $1,000 a month, Terboss bought the proposal, and Homegate did his loan application over the phone.

  Before settlement, Terboss said, he never saw any documents from Homegate. They did the closing in Terboss’s office—in a rush. “It was a very strange closing,” Terboss said. “Homegate hired a local guy to handle the closing. He was very unorganized, didn’t have half the papers with him. That should have been a signal. I guess I was more trusting of banking interests than I should have been. He was a total sham.”

  The next surprise was his first payment notice—for $1,600. Terboss, thinking it was a mistake, called Washington Mutual. They told him it was a teaser rate for the first month; the normal rate would kick in next month. And kick in it did! The interest-only payment was $4,900—$1,000 more than his old payment, not $1,000 less, as promised.

  Terboss, who is normally soft-spoken, was livid. “I immediately called the bank and said, ‘There’s been some confusion here.’ The bank would not even talk to me. They said to me: ‘This came through a broker. We are not responsible. We have sold off your mortgage already.’ They would take no ownership at all.” Terboss fought back. On December 11, 2007, less than a month after signing the loan agreement, Terboss faxed WaMu requesting that the bank revise the mortgage: “This is not how it was represented…. I am not in a position to make payments of $4,928.95 a month…. We need to figure out a better arrangement or we’ll have to void this mortgage.” WaMu gave him the cold shoulder.

  As a lifelong businessman, Terboss was shocked. At first, he had assumed that it was all a mistake and that Washington Mutual would correct things. But on second thought, he concluded that he had been deliberately cheated and that WaMu was part of the scam. When he checked his loan documents more carefully, he found he’d bought a high-cost, non-prime loan, even though he qualified for prime. The basic interest rate was 8.263 percent—significantly higher than the rates on his two previous loans. And then he saw the payoff to the broker—the “ysp” in tiny print, tucked in a corner of one form—$18,875.

  “The guy made $18,875 for getting me into that terrible loan!” Terboss fumed.

  The Final Sting

  But that wasn’t the end of his troubles. When Terboss tried to get out of his loan by paying it off, he discovered the final sting—a prepayment penalty of $21,000 that would sock him if he paid off the loan ahead of time. It was a provision stuck into the loan, according to Seattle housing attorney David Leen, precisely to stop people like Terboss from exiting their loans once they discovered they’d been snookered. Leen had seen scores of such cases, and they infuriated him: “It’s as if the broker sold you a house, set it on fire, and locked the back door so you couldn’t escape!”

  Infuriated, Terboss paid his way out of the WaMu loan, but it cost him dearly—$50,000 in prepayment penalties, closing costs, and fees for a new loan from CitiMortgage. What’s more, his new loan was for $777,500—almost exactly $150,000 more than his first mortgage when he bought the house. Each time he had refinanced, he got hooked into a bigger loan, meaning that he had effectively lost $150,000 of the equity he had put into his home. He thought about selling, but he couldn’t recover his money.

  As a businessman, Terboss had long trusted bankers, but no longer. When I asked Terboss about lessons learned, he replied coldly: “I learned that the banking industry is not what you think it is. It is not your local bank trying to help you. It is big banks trying to make money off the consumer in ways that are not appropriate…. Dealing with these guys was a nightmare. It was a totally fraudulent deal. They lied all around. They were unethical. It pains me even to think about it now.”

  John Terboss, Bre Heller, and Eliseo Guardardo—and many others like them who talked to me—were all casualties of the New Mortgage Game, victims of hidden financial stings in their mortgages that wound up taking value out of their homes, leaving them poorer at the end or permanently in hock to their banks. People saw their equity shrink and their savings evaporate. That was actually the strategy of the New Mortgage Game, and that is how it played out all across America.

  CHAPTER 14

  THE GREAT WEALTH SHIFT

  HOW THE BANKS ERODED MIDDLE-CLASS SAVINGS

  The American people realize they’ve been robbed. They’re just not sure by whom.

  —GRETCHEN MORGENSON AND JOSHUA ROSNER,

  Reckless Endangerment

  Our present economic crisis was, by and large, foisted on Main Street by Wall Street—the mostly innocent public taken to the cleaners, as it were, by the mostly greedy financiers.

  —JOHN C. BOGLE,

  founder, the Vanguard Group

  HOUSING EPITOMIZES DIVIDED AMERICA. It lies astride the fault line of the economic earthquake that split the country. The housing bubble and bust did more to devastate middle-class wealth in a relatively short span than any other single development.

  In the 1990s and 2000s, the secondary market in housing mortgages gave birth to probably the most massive operation for creating, packaging, and selling debt in American history. It powered the growth of debt on a logarithmic scale, making the home mortgage market even larger than the market for U.S. Treasury obligations.

  When that massive debt bubble burst, people quickly pointed to the subprime mortgage market as the villain. It is true that the implosion of the subprime market set off the housing collapse, but subprime was not the cause of our economic debacle. It was a symptom.

  The underlying causes of the massive depletion of middle-class wealth lay both in the mind-set of the New Mortgage Game and in a sequence of new laws and policies that changed the rules on banking. These changes fundamentally—and dangerously—altered the relationships between bankers and homeowners. Mortgages got passed on from mortgage brokers to banks, from regional banks to Wall Street banks, and then got bundled into huge anonymous investment pools and sliced into segments so that the vital link between lender and borrower got lost—and along with it the financial safety of the system.

  The Flaw in Greenspan’s Model

  The crash and its waves of foreclosures and high unemployment were no accident of the unfettered workings of a free market. They sprang from the deregulatory fever that burst forth in the pivotal Congress of 1978 and gained momentum in waves of deregulation passed from the Reagan era to the Bush era, as well as from former Federal Reserve chairman Alan Greenspan’s belief that Wall Street banks and the subprime market could regulate themselves and his unyielding faith that the free market could be trusted.

  When Cassandras warned as early as 2003 that the housing market was overheated and headed for disaster, Greenspan dismissed the risk of “a sharp decline, the consequences of a bursting bubble” as “most unlikely.”

  Greenspan was wrong, as we saw, tragically. But only in hindsight, well after what he termed “the greatest global financial crisis ever,” did Greenspan admit to Congress that “I found a flaw in the model”—the economic model he had been using for forty years—and “I was shocked.” For a man given to painstakingly qualified circumlocutions, that was an astonishing admission from Greenspan. He was referring to his long-held laissez-faire premise that government oversight and regulation were unnecessary impediments to the market because the banks could manage their own risk. In 2011, Greenspan went on to admit that the crash of 2008 “has cast doubt on this premise.”

  The Upside-Down Mortgage

  At its core, the New Mortgage Game turned the basic concept of a home mortgage upside down.

  Since the 1930s, banks h
ad helped average Americans purchase and eventually own their homes by enabling them over thirty years to build up home equity. The banks made long-term loans and patiently enabled borrowers to pay off their debt and, ultimately, take full title to their homes, free and clear. That gave average people a foundation for financial security in retirement.

  The cruel New Economy twist was that bankers developed strategies that did exactly the opposite. Instead of enabling ordinary Americans to achieve The Dream, they fashioned stratagems that stole the dream. The sales pitch from Washington Mutual, Long Beach Mortgage, and hundreds of other profit-hungry banks and brokers was that homeowners should think of their houses not as nests or nest eggs for their retirement years, but as ATM machines where they could withdraw money. Subprime junk loans were structured and marketed in ways that put new homeowners in perpetual hock to the bank. The Option ARMs, home equity lines of credit, and other arcane loans sold to millions of solid middle-class borrowers sucked rivers of money out of their homes into the banking system. “Equity stripping,” bankers called it. People saw their equity shrink and their savings evaporate.

  Washington Mutual senior vice president Harry Tomlinson extolled the New Mortgage Game in an interview with James Grant, editor of Grant’s Interest Rate Observer. “What I see,” said Tomlinson, “is a shift in the mortgage product, going from a product used to buy one’s home … to a product where people can leverage their home as a financial asset. And that’s a big shift.”

  Greenspan and “Home Equity Extraction”

  Think of it this way: All those exotic mortgage loans and Wall Street’s vehicles of “structured finance” were debt machines. They were instruments of a financial system that destroyed value for middle-class Americans. The housing boom of the 1990s and 2000s enriched the banks and steadily impoverished millions of middle-class Americans—and not just at the end, when housing prices fell, but all along. Trillions were lost even before the crash because homeowners were pulling so much equity out of their homes.

  Greenspan hailed this trend, which he called “home equity extraction.” He saw it as good for the nation’s economy after the dot.com collapse. In 2002, Greenspan estimated home equity withdrawals at $700 billion a year. Other economists worried. They saw average American families going $700 billion deeper into debt, year after year, but Greenspan welcomed that mountain of borrowing.

  Greenspan wanted homeowners to draw savings out of their homes to finance their consumption and thus power the economy. As he told Congress on November 13, 2002, that process was rescuing a sick economy. “It is important to recognize that the extraction of equity from homes has been a significant support to consumption during a period when other asset prices [that is, stock markets] were declining sharply,” Greenspan testified. “Were it not for this phenomenon, economic activity would have been notably weaker….”

  Many borrowers happily collaborated in that process, figuring the housing boom would replenish their savings. Some stripped their homes of value to live a more luxurious life—to buy second and third cars or plush yachts, build home entertainment centers, or take fancy vacation trips.

  But far more people took out high-interest home equity loans for practical necessities because their salaries or wages were not keeping pace with inflation. They pulled money out of their houses to pay medical bills, to fund college educations for their kids, to finance home improvements, or simply to keep up with the rising cost of living. A hefty chunk of the new borrowing put no money into the homeowners’ pockets. It went to pay high loan fees and yield spread premiums to aggressive and sometimes deceptive brokers, and to fatten the bonuses of bankers and the financial elite on Wall Street.

  A Seismic Shift of Wealth

  At its peak, the New Mortgage Game worked for several years, but when the housing boom that Greenspan promoted went bust, the losses were titanic. American homeowners lost trillions in plummeting home prices from mid-2006 to the start of 2012. But that’s only half of the story.

  Less visible was the massive loss of equity in their homes that average Americans suffered before the housing bubble burst in 2006. Back in 1985, Americans actually owned 69.2 percent of the value of their homes (the banks owned the rest), according to Federal Reserve data. By 2011, the homeowners’ share of housing wealth had plunged to just 38.4 percent of the total value. Homeowners lost nearly a 30 percent stake in what had been the nation’s $20 trillion housing stock—a collective loss of about $6 trillion primarily through equity stripping.

  In short, the fantasy promise that housing prices would go up forever and you could borrow on your home time after time, combined with deceptive sales pitches on junk mortgages, seduced millions of middle-class families into draining the precious equity that they had painstakingly built up in their homes.

  That steep national drop in homeowner equity, from nearly 70 percent down to below 40 percent of total housing value, represented a monumental transfer of the absolute core of middle-class wealth from homeowners to banks. Trillions of dollars in accumulated middle-class wealth were shifted from average Americans to the big banks, their CEOs, and their main stockholders. For the first time in decades, banks owned more of the cumulative value of American homes than the so-called owners.

  That seismic shift of wealth represented the theft from millions of middle-class families of a vital component of the American Dream. A large portion of the baby boomer generation, heading for retirement, were left in dire straits. Instead of having paid off their thirty-year mortgages, they were stuck with homes “under water” and they may literally have to pay money to get out of them.

  Before the New Mortgage Game took over, people would plan on cashing out of the homes where they had raised their families and on using the proceeds to move to smaller, hopefully cheaper quarters in sunny Florida or Arizona. The housing bust changed all that. Even for those who hung on to their homes, it meant in many cases that sellers had to bring cash to settlement to cover the costs at closing. By economist Dean Baker’s estimate, nearly one-fifth of older boomers in their sixties face this new financial challenge right now, and unless the housing market changes dramatically, roughly one-third of the younger boomers, in their fifties, are on track for a similar shock when they retire.

  The Secondary Market—Separating Profit from Risk

  In going back to see how things got so badly off track, what emerges is a fatally flawed concept at the heart of the New Mortgage Game. It is the dangerous disconnect—the separation of Profit from Risk. The primary place where that happened was in what bankers call “the secondary market,” where regional banks sold their home mortgages and where Wall Street banks could buy those mortgages by the millions.

  The secondary market was the engine of the housing bubble of the 2000 decade. It financed the “originate and sell” strategy that became the hallmark of the New Mortgage Game. One predictable consequence of regional banks’ quickly selling off mortgages to Wall Street was that the brokers and bankers who originated the loans no longer cared whether those loans were paid back or defaulted, because they no longer owned the risk. They could pass the risk downstream to distant investors on Wall Street and beyond. Reliability was sacrificed on the altar of volume and profits.

  This was a watershed change for the banking industry. Traditionally, banks closely scrutinized the three Cs of borrowers—credit, collateral, and cash flow (income)—to make sure that 99 percent of their loans paid off. But as we saw with Bre Heller and the Florida brokers using the no doc, stated income, and NINJA loans, checking the borrowers carefully no longer mattered to the loan originators in the New Mortgage Game. They made fast, big profits from handsome closing fees.

  Then, Wall Street firms sliced, diced, and repackaged these mortgage loans into what became known as “synthetic” derivatives, or security pools with various levels of risk, and sold multibillion-dollar bundles of mortgages—or mortgage parts—known as “collateralized debt obligations,” to hedge funds, college endowments, pension f
unds, insurance companies, or investors in Germany, Japan, Abu Dhabi, or wherever. The investors loved them because mortgages used to be very safe investments and Wall Street bond-rating agencies still gave them AAA ratings.

  When Risk Is Everywhere, It’s Nowhere

  The growth of these pyramiding bank loans and derivatives followed the policy prescriptions of Fed chairman Alan Greenspan, who credited this process with diversifying risk and having “contributed to the stability of the banking system….”

  What Greenspan evidently discounted was the colossal danger in separating profit from risk—the problem that when risk resides everywhere, risk resides nowhere in particular. No one was minding the store the way the old-fashioned bank did when it lent money from its own depositors to their neighbors.

  When the roof fell in, the banks blamed borrowers who defaulted for behaving irresponsibly. But the banks themselves—and the Fed—had created a system of irresponsibility, by lending to millions of people who could not reasonably be expected to repay and then not carefully regulating the process for safety.

  “Ordinarily, the instinct for financial self-preservation should prevent lenders from making too many risky loans,” observed Simon Johnson, former chief economist for the International Monetary Fund (IMF). “The magic of securitization [reselling mortgages in bundles] relieved lenders of this risk … leaving them free to originate as many new mortgages as they could. Because mortgages were divided up among a large array of investors, neither the mortgage lender nor the investment bank managing the securitization retained the risk of default. That risk was transferred to investors, many of whom lacked the information and the analytical skills necessary to understand what they were buying. And the investors assumed that they didn’t need to worry about what they were buying, because it was blessed by the credit rating agencies’ AAA ratings.”