Bailout Nation

by Barry Ritholtz

  The housing boom was the ideal environment for these products, and residential mortgage-backed securities (RMBSs) were especially popular. Bundling thousands of mortgages together, Wall Street wizard’s created CDOs composed of a series of tranches of underlying mortgages of varying quality. Each tranche had a different risk level, and offered higher (or lower) yield levels. This allowed fixed-income managers to choose exactly the returns they needed. Those seeking greater returns had to take on more risk—but AAA or AA was still investment grade, right?

  Note that this wasn’t a U.S.-only phenomenon: Mortgage-based paper was repackaged as CDOs and purchased en masse by fixed-income managers around the world. Global fund managers—in Europe, in the Middle East, but especially in Asia—were big buyers of mortgage-backed securities. This is how the U.S. housing bust became a global issue. It explains how subprime borrowers in Southern California could default on their mortgages, setting off a chain reaction that ended with the collapse of Iceland.

  This was the financial bedrock upon which our modern Bailout Nation was built. When that bedrock was found faulty, the entire economic edifice built atop it crumbled.

  Part III

  MARKET FAILURE

  Source: By permission of John Sherffius and Creators Syndicate, Inc.

  Chapter 10

  The Machinery of Subprime

  The superior man understands what is right; the inferior man understands what will sell.

  —Confucius

  How did all manner of exotic subprime mortgages and their derivatives wind up festooned all over the global financial system? To understand that question, we need to put on our detective caps and do some digging.

  In the old days, traditional lenders—depository banks—accounted for the lion’s share of mortgage writing. They are fairly well regulated by both the Federal Reserve and the Federal Deposit Insurance Corporation (FDIC). These banks typically are run in a very conservative, purposeful fashion. Banks have a funny way of looking at lending: It’s not the loans you reject; it’s the ones you approve that get you into trouble.

  Hence, traditional lending tended toward borrowers who could put down a large down payment, had good income and credit histories, and could service the debt easily. These were the prime borrowers, and they tended to make safe bets for lenders.

  Over time, other nonthrift participants got increasingly involved in the home loan industry. Independent mortgage brokers were able to steer loans to any bank. The savvy ones developed a reputation for knowing which bank offered the best rates at any given time.

  Some developed an expertise in home buyers who did not quite meet the high standards of the major banks. Borrowers with lesser bona fides were considered subprime. Perhaps their credit scores were not as strong, their down payments smaller, or their incomes not as great. This was a small niche market that was serviced by a handful of firms. Given the inability of subprime borrowers to get a prime loan, along with the increased risk of default due to the weaker ratios, these lenders were able to charge a premium for their services.

  Most large, reputable banks steered clear of subprime. It was too messy, with too many defaults. It simply didn’t fit in with their risk-averse model.

  Starting in the early 2000s, conservative lending became unfashionable and aggressive risk taking appeared. Fiscal prudence was replaced with weakened (and eventually, irresponsible) lending standards. It soon reached a point where much of the industry tossed out the garden-variety mortgages that had served them so well, and replaced them with jungle-variety loans.

  In the new era of banking, “lend to securitize” became the industry’s standard operating procedure, and the subprime mortgage machinery’s assault on suburban America began.

  One of banking’s major changes in the latter part of the twentieth century was the rise of the nondepository mortgage originator. Often located in California, these lenders used an army of independent brokers to push their products. Like so many mushrooms in cow dung after a summer rain, these brokers sprouted up in the early 2000s. They were the prime salespeople of the subprime adjustable-rate mortgage (ARM).

  These firms were not like traditional banks. They had no depositors to provide them with a capital base. They started with seed money, but once that grubstake was exhausted, they could not write more loans. To do more business, they had to move the existing paper off their balance sheets and replace it with fresh capital. Hence, they had little choice but to sell the mortgages they underwrote just as soon as they could. They found a willing buyer in Wall Street, which was all too happy to purchase these loans for securitization purposes.

  Wall Street’s insatiable demand for mortgages to securitize led originators to completely abdicate all lending standards. If you could fog a mirror, you qualified for a mortgage. The best example of this was found in California. Anthony Ha reported in the Hollister Free Lance that Alberto Ramirez, a strawberry picker earning just $14,000 a year, was able to obtain a mortgage to buy a home for $720,000.1

  That was just the most egregious example. Anyone with a modicum of experience in the mortgage industry will confirm the rampant disregard for lending standards during the boom years. This was very different from the way traditional banks operated. To your local banker, a mortgage is a reliable and secured form of lending. With few notable exceptions, lending standards by banks had always been rigorous. When a traditional depository bank originated a mortgage, it assumed it would hold on to the loan for the full 15- or 30-year term; depository banks felt no compulsion to resell them. Guarding against default over the life of that loan was the key to not only being profitable, but staying in business.

  That wasn’t how the newfangled lend-to-securitize originators worked. In one of many examples of misplaced compensation schemes we have seen, they were paid on the volume, not the quality, of their loans. Besides, they didn’t need to find a buyer who was a good risk for 30 years—they needed only to find someone who wouldn’t default before the securitization process was complete. Thus, they had very different standards from the traditional lenders. The sellers of these mortgages made warranties to the Wall Street buyers of this paper that the borrowers would not default for 90 days—enough time for the loans to be sold off and repackaged as residential mortgage-backed securities (RMBSs).

  This was a radical change in lending standards.

  In the past, lenders had to make sure the borrower was good for the full 30 years of a mortgage. In the old days, a bank would make a mortgage loan and hold on to it until the home was either paid off or sold. If there was a default—even 20 years later—it was the original lender (the mortgage originator) that was on the hook. Some securitization took place, but it was a small percentage of outstanding mortgages. That was why the borrower’s ability to repay the loan was the primary basis of all lending.

  What happened in the recent housing bubble—it’s more accurate to describe it as a credit bubble—represented an enormous paradigm shift. Mortgage originators no longer had to find someone who could carry the debt for three decades—they had only three months to worry about! Hell, practically anyone could meet those requirements!

  That alone was enough to guarantee trouble. However, for the most part, the industry itself was lightly regulated or, in some cases, not regulated at all. It was ripe for lots of abuse. By the middle of the decade, the mortgage lenders had become the new boiler rooms.2

  The many sleazy mortgage brokers and originators who sold loans they knew were likely to default were most definitely the inferior men Confucius warned of. And the banks that underwrote these loans certainly weren’t superior.

  Fraud in Real Estate, Mortgages, and Home Building

  Minor amounts of real estate-related fraud have always existed. During the housing boom years of 2002 to 2007, it became a pandemic. These various fraudulent actions helped make the housing boom much bigger—and the bust that much more painful:• Appraisal fraud: Historically, there was no incentive to inflate appraisals. But with the r
ise of the mortgage brokers—many working closely with real estate agents—the business of steering appraisals to the most generous rose rapidly. By inflating appraisals, many appraisers found they could attract more referral business; some even managed to always hit the target prices given by real estate agents, which contributed significantly to the huge run-up in home prices.In 2005, more than 8,000 appraisers—roughly 10 percent of the industry—petitioned the federal government to take action against such abuses. But both Congress and the White House did nothing, allowing this rampant fraud to continue unabated.3

  • Referral fraud: Complicit in appraisal fraud were mortgage brokers and real estate agents who knowingly steered referrals to appraisers they knew would give them the valuation they sought. These people were co-conspirators, as they paid for, aided, and abetted the actual fraud. And they did so for personal gain—higher prices and more transactions meant bigger commissions for all.

  • Application fraud: It’s an open secret that mortgage applications were usually completed by mortgage brokers, rather than by the borrowers themselves. “Just leave those lines blank; we’ll take care of them” was a common refrain. Savvy brokers knew how to meet the requirements of each bank in order to get loans approved.That banks knew what was going on and looked the other way does not make this deception any less a felony.

  • Mortgage fraud: Anyone who filled out a mortgage application and put false information on it committed fraud. Borrowers who overstated assets or income, or understated debt or financial obligations, to obtain a mortgage committed fraud.Ultimately, lenders are responsible to be proactive against all forms of deception. That they so willingly looked the other way was one factor that made this era such an aberration.

  • Predatory lending: There are numerous examples of lenders deceptively convincing borrowers to agree to loan terms that are abusive. One of the most common versions in recent years was representing an adjustable-rate loan as a 30-year fixed-rate loan. Other mortgage brokers placed qualified prime and Alt-A applicants into more expensive subprime loans for the sole purpose of generating greater commissions. A significant percentage of subprime loans appear to have been a form of predatory lending. As of this writing, the FBI has arrested nearly 1,000 people in connection with this form of fraud.

  • Home builder incentive fraud: With their houses dropping in value, many builders became creative with incentives. By August 2008, the FBI was investigating cases where disclosure of incentives wasn’t made to the lender (i.e., the builder misrepresented the true price of the sale).When false statements are occasionally made in the course of business, you have potential trouble. Once they become the norm, it has turned into systemic fraud.

  Banks that were originating mortgages for securitization found that their manual processes—humans pushing paper around—could not keep up with the now insatiable demand. So they did what other industries throughout time have done: They automated.

  Ultralow rates drove the initial demand for mortgages, but it took new a technology—evaluation software—to allow mortgage applications to be processed in numbers never before possible. Computers replaced what was previously a human judgment process.

  The nearly insatiable assembly line Wall Street was running for mortgage-backed securities drove the demand for bundling mortgages; home price appreciation kept even poor credit risks from defaulting for some years. These factors are what led to the huge spike in real estate sales from 2002 to 2007 and the accompanying explosion in issuance of mortgage-backed securities. It was a vicious, self-reinforcing cycle, but a highly profitable one as long as the real estate sector kept growing.

  Farmers say you have to “make hay while the sun is shining.” Bankers saw the nearly unquenchable demand for mortgages, and they knew it was time to make hay.

  The automation systems permitted rapid processing of bad credit risks, but it was the outstanding sloppiness and violation of the banks’ own internal procedures that allowed even more bad loans to get written. Hard as this may be to imagine, some loan documentation was so incomplete that federally mandated Truth-in-Lending Disclosure Statements were omitted. Without the proper disclosures, a mortgage could become unsecured—meaning the bank no longer has a first priority lien on the mortgaged property.

  Across the mortgage industry, corner cutting and shortcuts were official corporate policy. There was headlong rush to originate, process, and securitize mortgages—and the wherewithal to repay the mortgages be damned. Loans were written to people with low FICO scores, on properties with very high loan-to-value (LTV) ratios; documentation was often poorly filled out. An entirely new category was created: so-called no-doc (no-documentation) loans. Today, we know these products as “liar loans,” thanks to the commission-driven mortgage brokers who encouraged borrowers to get creative when filling out the no-doc applications.

  Funky Loans

  As the securitization process heated up, mortgage originators came up with increasingly exotic loans. Alan Greenspan had applauded these as “innovations.” We subsequently found out that they were merely clever ways to get home buyers to borrow the most amount of money possible, with no regard to their ability to repay these loans, in order to generate the highest commissions. Predatory lending was the term used to describe the most egregious of these loans.

  Mortgage Types

  30-year fixed: The traditional mortgage; fixed rate, no gimmicks.

  2/28 ARM: An adjustable-rate mortgage that came with a fixed, two-year teaser rate. After the two years had elapsed, the mortgage would reset, as much as 300 basis points above the prior teaser rate. The 2/28s were mostly offered to subprime borrowers—those with weak FICO scores and modest incomes. This allowed even bigger mortgages to be written, since the first 24 payments were artificially low. The sales pitch was: “Buy as much house as you can get. Refinance before the reset.”

  Interest only: Mortgage payments were reduced dramatically by not paying back any of the principal.

  Piggyback loan: This loan let a borrower take out an equity loan against the property to be used for the down payment; it was on top of a primary mortgage.

  Reverse amortization: Each month, the total outstanding amount owed went up.

  Liar loan: No income verification was required.

  “No money down”: A mortgage that required 0 percent down payment.

  High loan to value: A mortgage loan of up to 120 percent of the property’s value, versus the traditional 80 percent.

  NINJA loan: No income, no job or assets.

  For one of the most astounding examples of the industry’s grotesque role in the housing boom, consider this JPMorgan internal memo, titled “Zippy Cheats & Tricks.” Zippy was the name of JPMorgan’s automated loan processing software. The memo taught loan officers how to “cheat” the firm’s own system. It offered some “handy steps”—workarounds, really—for getting questionable loans approved:

  Zippy Cheats & Tricks

  If you get a “refer” or if you DO NOT get Stated Income/Stated Asset findings . . . Never Fear!! ZiPPY can be adjusted (just ever so slightly).

  Try these steps next time you use Zippy! You just might get the findings you need!!

  Always select “ALTERNATE DOCS” in the documentation drop down.

  Borrower(s) MUST have a mid credit score of 700.

  First time homebuyers require a 720 credit score.

  NO! BK’s OR Foreclosures, EVER!! Regardless of time!

  Salaried borrowers must have 2 years time on job with current employer.

  Self employed must be in existence for 2 years. (verified with biz license)

  NO non-occupant co borrowers.

  Max LTV/CLTV is 100%.

  Try these handy steps to get SISA findings . . . 1. In the income section of your 1003, make sure you input all income in base income. DO NOT break it down by overtime, commissions or bonus.

  2. NO GIFT FUNDS! If your borrower is getting a gift, add it to a bank account along with the rest of the assets. Be s
ure to remove any mention of gift funds on the rest of your 1003.

  3. If you do not get Stated/Stated, try resubmitting with slightly higher income. Inch it up $500 to see if you can get the findings you want. Do the same for assets.

  It’s super easy! Give it a try! If you get stuck, call me . . . I am happy to help!

  Tammy Lish (503) 307-7079 tammy.d.lish@chase.com

  Let me point out this was not some little fly-by-night outfit; it was JPMorgan Chase bank. This internal Chase memo accidentally found its way into the hands of Jeff Manning, a journalist with the Oregonian. It was the basis for an article titled, “Chase Mortgage Memo Pushes ‘Cheats & Tricks.’ ”4

  Tammy Lish was subsequently fired from Chase for releasing the memo publicly. Before then, it had been circulated only internally within the firm.

  Indiscriminate lending by mortgage originators helped inflate the housing boom. While housing was an extended asset class, it was not a true bubble. To be sure, it was frothy as all hell, and some areas—namely California, Southern Florida, Arizona, and Las Vegas—were bubblicious. But the actual bubble was found in credit. As of Q1 2009, house prices have corrected on a national basis about 25 percent, according to the Case-Shiller index.

  Credit, however, has absolutely collapsed.

  At the center of it all was subprime lending, especially among the nonbank mortgage originators. They lent to unqualified borrowers, fed the derivatives market, and ultimately helped bring about a disaster—in housing, in subprime mortgages, and in mortgage-backed securities. This was the epicenter of the credit crisis.