I face two challenges in discussing the role of the Fed. First, to accuse Greenspan of poor judgment would be hypocritical. The financial gains my company achieved were a by-product of the Fed’s actions. To call him negligent, knowing that I cheered every time new rate cuts were announced, comes across as disingenuous. Second, I understand the basic workings of the Fed but economic policy is not my forte. I’ve read volumes on the subject, books written by some of the smartest economists and policy makers in the country. While many view his tenure at the Fed as nothing short of genius, there are some, like Alan Abelson of Barron’s, who take a contrary position. His article in the August 13, 2007, issue of that magazine summarizes the perspective that is closest to my own:
As we watched the great unraveling of that tangled web that financial engineering spun, we couldn’t help but think of the acute discomfort being felt by that outstanding public servant Alan Greenspan, who, during his celebrated tenure as head of the Federal Reserve, more than anyone deserves credit for nurturing the ownership society. Mr. Greenspan, lest we forget, went far beyond the call to entice people, no matter what their circumstances, into buying a home by whacking the cost of credit to as near zero as you can get and still lay claim to being somewhat rational, and urging them to go for those new-fangled adjustable mortgages with deceptively low initial interest rates.
Beyond even his cleverness at blowing successive “smart bubbles,” so that the newest one (for example, housing) was nicely calculated to offset the fallout from its burst predecessor (the stock market), and his adroit ability to please his political masters . . .
Financial mischief on such a grand scale is not a one-man job, and Mr. Greenspan, needless to say, had a lot of help from Wall Street, Washington, and points north, south, and west. But there’s no diminishing the singular part he played.
And just as the contempt for risk that made possible the gross extravagances in housing and the financial markets was sustained by confidence that Mr. G would always bail out the participants—the so-called Greenspan put—so the current collapse in housing and the financial markets merits a special designation, one that similarly recognizes his critical role. How about the Greenspan Kaput?
What I find to be most telling about Greenspan’s tenure is how he, by his own admission, misunderstood what was happening in the subprime market. In 2004 he went so far as to praise the industry for safely extending access to credit for people once excluded from the housing market. Ironically, his comments occurred about the same time we started to question whether the subprime business model made sense given the cracks showing in the system.
Borrowers
Let’s be honest. As consumers, we couldn’t help ourselves. As if the temptation to max out our credit cards wasn’t bad enough, the lure of cheap money was impossible to resist. Whether it meant buying a bigger home, refinancing to a lower interest rate, or tapping into home equity, this was a once in a lifetime opportunity.
Unfortunately, when opportunity comes knocking, greed and ignorance are not far behind. The following examples represent the kind of loan applications we underwrote on a daily basis. They show how a wide range of borrowers, even those not manipulated by brokers or lenders, contributed to the demise of the industry. To do them justice, I’ve adapted comedian Jeff Foxworthy’s classic routine You Might Be A Redneck If . . . to the mortgage industry.• If you ever signed a federal home loan application knowing your income wasn’t reported correctly . . . You may have set yourself up for mortgage disaster.
• If you viewed your home as an ATM machine and continued to cash out time and again . . . You may have set yourself up for mortgage disaster.
• If you flipped spec properties with regularity and you’re now stuck with deals you can’t unload . . . You are headed for mortgage disaster.
• If you took out an ARM loan because the ultralow teaser rate was the only way you could qualify . . . You did set yourself up for mortgage disaster (unless the government says you qualify for a rate freeze).
And finally . . .• If you signed a promissory note and thought the line “I promise to pay” was more of an option than a requirement . . . You are truly a subprime borrower.
All kidding aside, there’s nothing humorous about the fact that nearly two million people might lose their homes to foreclosure in the next few years. However, I have no sympathy for borrowers who knew what they were doing but still blame mortgage lenders for their problems. Cheap money and easy credit may be hard to resist, but that doesn’t justify letting greed and ignorance drive your decisionmaking.
What percentage of borrowers currently in default (at least 30 days late) fit this description? The answer is speculative, but my conservative estimate is that at least half of all borrowers understood what they were getting into, probably more. Still, to say 50 percent of borrowers didn’t understand what they were doing raises another concern. Is it possible the majority of consumers entered into the largest financial decision of their lives despite being unaware of what they had gotten themselves into?
The government, for all its efforts in this area, has done more to create confusion than to protect the consumer. When a loan closes, borrowers sign enough documents to make their head spin. I’ve had seven mortgages in my life, and every time I walked out of the loan closing I wondered why the process had to be so complicated. For the first-time homebuyer, the process is often overwhelming. On many occasions I’ve seen borrowers at the closing table develop that deer in the headlights look.
Though the process is far too confusing, each document does provide the borrower with some vital piece of information. There may be a lot of paperwork to understand, but ignorance is not a valid excuse. To protect themselves at closing, borrowers should get the answers to five questions:1. What is the payment and can you afford it? Be certain to ask whether this includes the property taxes and insurance.
2. Is this the correct type of mortgage? In other words, is it a fixed-rate or an adjustable-rate mortgage? If it’s an ARM, is it clear to you how and when the rate will adjust?
3. Is the loan amount correct?
4. Is there a prepayment penalty? If so, do you understand what it means and how it will work?
5. Do the closing costs closely resemble the figures provided on the Good Faith Estimate? The loan officer should explain in detail any variation greater than 1/2 percent of the loan amount.
Getting the answer to these questions helps the borrower to be sure that the loan is correct. The potential for confusion arises from having to sign dozens of documents, with no time to read them, when a one-page form would do the trick. As this book was going to press, Congress was considering whether such a document should be used for all mortgages. In my opinion, that would go a long way toward simplifying the process.
Income and Down Payment Become Optional
While ultralow interest rates started the boom, aggressive underwriting standards kept the wheels turning even as rates started to rise. The numbers from my company, which are indicative of what took place within the industry as a whole, tell an interesting story. In 2001, stated income loans represented 25 percent of our business, while 15 percent of borrowers financed with no money down (or no equity in the case of a refinance). By 2004, the figures rose to 35 and 38 percent, respectively. By 2006, just over 50 percent of borrowers financed with no money down even as property values were starting to retreat.
Let’s put this in perspective. As early as 2004, only one out of four borrowers was financing a home using a down payment and proving income. I doubt that the industry’s founders could have foreseen a day when the fundamental principles of risk management would no longer apply. Did the broker steer consumers toward these loans? No question. Were lenders writing loans that never should have been written? Absolutely. Throw in the actions of Wall Street and the rating agencies and you’ve got one heck of a mess. But to stop there is shortsighted. When a borrower signs on the dotted line, he must be held accountable.
I’ll jump on my soapbox for a moment. If borrowers had been slightly more responsible, this crisis wouldn’t be as severe. Having been taught to never borrow more than I can afford to pay, their actions strike me as reckless, which may sound peculiar coming from a former subprime lender. Admittedly, mortgaging my parents’ home to fund my company makes preaching fiscal responsibility seem a bit hypocritical, but there’s a big difference between taking a well-timed and calculated risk and putting yourself into a position where you are highly likely to default on a loan.
In a country where the government can’t balance its own checkbook, consumers live on credit, and the collective savings rate is zero, we’ve become conditioned to spend first and figure out how to pay for it later. The allure of cheap money and easy credit was too much to resist, especially for those borrowers who could least afford it.
Retail Mortgage Lenders
I’ve avoided discussing direct lenders until now for several reasons. First, brokers originated the majority of all subprime mortgages, which meant they were the primary drivers of the product. Second, most subprime loans originated by retail lenders were done through big companies, lenders like Countrywide and Wells Fargo. Having worked on the wholesale side of the business, my experience is best suited to discussing this business channel.
However, a book on subprime lending wouldn’t be complete without mentioning Ameriquest Mortgage. In my opinion, this lender did more to give subprime lending a bad name than any other company. In January 2006 Ameriquest settled a lawsuit with state prosecutors and lending regulators for $325 million, resolving allegations that the company defrauded and misled consumers. While their tactics are now well documented, it wasn’t until we hired two former Ameriquest employees that I learned what these tactics were. Our new employees told us that at Ameriquest every loan was supposed to charge the maximum fees, interest rates, and prepayment penalties in order to make the company money. The business model focused heavily on cash-out mortgages, which enabled Ameriquest to collect front-end fees from the borrower’s equity. The “stick it to the consumer” mentality they described to me translated into borrowers being charged, on average, three to four points in loan origination fees. If you want more information on the company’s tactics, just Google “Ameriquest Mortgage.” There are numerous blogs that include stories from disgruntled customers.
The greatest irony comes in the aftermath of the settlement. It’s widely believed that Roland Arnall, billionaire founder of the company and a major contributor to George W. Bush’s campaign, agreed to the settlement to clear the way for his confirmation vote in the U.S. Senate. Exactly 20 days after the settlement was announced, Mr. Arnall received Senate approval as the U.S. Ambassador to the Netherlands. I wonder if presidential candidate Barack Obama, who wants to prosecute all negligent subprime lenders, would have included Mr. Arnall if he made it to the White House. As it turns out we’ll never know. Mr. Arnall died in Spring 2008.
In the meantime, I’ve written President Bush asking for the next ambassador position that comes available. Since Mr. Arnall and I both ran subprime mortgage companies, and I didn’t have to pay one-third of a billion dollars as a result of my business practices, it stands to reason that I’m well suited for the job. Of course, not having contributed millions to the Bush campaign might explain why I’m still waiting for a response.
Homebuilders and Realtors
If mortgage brokers helped steer the subprime industry off a cliff, homebuilders and realtors were only too happy to come along for the ride. I’ve combined these categories for the purposes of our discussion and left them for last because their actions had a minor impact compared to the other players.
After leaving my company, I worked for TBI Mortgage, the builder-owned mortgage company of Toll Brothers Inc., a luxury homebuilder. Builder-owned mortgage companies exist primarily to help the builder sell more homes. Profitability and controlling the loan are important, but home sales generate far more income than mortgage loans. Since no other type of lender has selling homes as a primary objective, builder-owned mortgage companies are an anomaly. Serving two masters, borrower and builder, can also put them in a difficult position. One experience during my tenure at TBI showed how contentious this relationship can get.
A customer in Raleigh, North Carolina, was buying a model townhome in a golf course community, which meant it came fully furnished. The purchase price was $452,000 but there was a problem with the appraisal. Like every other townhome in the community, the value came in at $400,000, more than $50,000 below the contract price. The furniture was worth another $15,000, but mortgage guidelines don’t allow it to be included in a home’s value. This created a problem on several fronts. First, the builder was upset that we didn’t get an appraised value to support the purchase price. Does this sound familiar? As the VP of sales for the region, I usually didn’t get involved in specific loan files unless there was a problem. It took me some time to make the builder realize why we couldn’t provide an overvalued appraisal. Second, when the buyer found out about the appraised value he naturally became upset. Asking someone to pay $50,000 over market value has that effect on people.
The builder eventually lowered the price and the buyer brought in more cash to make the deal work. Shortly before the loan closed, I discovered the builder had ordered an appraisal when construction started months earlier. Do you want to guess the value his appraiser came with up? It was $400,000. The builder knew the home wasn’t worth $450,000, didn’t notify the mortgage company that he already had the property appraised, and still expected us to close it at the inflated value.
This story isn’t meant to paint Toll Brothers in a negative light. In general, aside from the tough business culture, they were a well-run organization. The example shows that builders, like everyone else, were focused on driving profits, even if it meant sticking it to the buyer.
In many ways, real estate agents resemble mortgage brokers. They only make money if the deal closes, and while they can represent the buyer or the seller, in most states they can also represent both parties at once. The independent nature of their business can lead to abusive behavior.
My friend Rich Trombetta, business owner and author of Mustard Doesn’t Go on Corn, shares his experiences with Realtors.
My wife and I were going to open houses on a Sunday when we came across a great house that we loved and wanted to make an offer. We spoke to the Realtor hosting the open house and he gave us his cell phone and contact information and asked us to call that evening. Although we were looking at homes we were not using a Realtor to assist with our search.
That night we made an offer and we were in back and forth contact with the Realtor from the open house. What happened next absolutely floored me. He told us our offer was slightly less than another offer that had come in that day but he would rather work with us since he would get the entire commission for the sale. Otherwise, he would have to split the commission with another Realtor who was representing the people that made the second offer.
I asked him, “Let me make sure I understand this. You would rather present a lower offer to your clients so that you receive a higher commission?” He was silent. I told him, “I don’t like this. I am not sure if I should contact the sellers, the attorney general, or your office manager.” He started to get defensive and I simply said good-bye and hung up the phone.
I have never trusted a Realtor since.
Of course there are plenty of Realtors that do an excellent job for their clients but, depending on whom we believe, the data paint some different conclusions. The National Association of Realtors (NAR) claims that the average seller who uses a real estate professional makes 16 percent more on the sale of a home than do sellers who go it alone. Although there’s no data to support this claim, it seems plausible that using a professional to sell any product will net a higher price than selling on your own.
Steven Levitt and Stephen Dubner, authors of Freakonomics: A Rogue Economist Explores the Hidden Side o
f Everything, share a different view. They obtained home-sale data from the Chicago area and discovered that realtor-owned homes stayed on the market 10 percent longer and made 3 to 4 percent more than homes sold for nonrealtors. They showed that economics is the study of incentives—how people get what they need, especially when others want the same thing. In the case of realtors, they believe that when an agent sells his own home, the incentive to hold out for an additional $10,000, for example, is great. As the homeowner, the realtor gets to keep the entire amount. When the same situation is applied to selling a client’s home, the realtor stands to gain only an additional $600 (based on a 6 percent commission). The relative payoff is so small that it isn’t worth marketing the property for a longer period.
Levitt and Dubner write in Chapter 4 of their book:
We smirk now when we think of ancient cultures that embraced faulty causes—the warriors who believed, for instance that it was their raping of a virgin that brought them victory on the battlefield. But we too embrace faulty causes, usually at the urging of an ancient expert proclaiming a truth in which he has a vested interest.
Confessions of a Subprime Lender Page 13