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Tuesday, September 23, 2008

An Updated Summary of the Real Estate Boom Turned Mortgage Crisis Turned Financial Crisis

How did we get here? Here is a detailed analysis as I see it today and have seen it for the last nearly seven years from inside the mortgage industry.

At the end of 1999, Alan Greenspan first began raising the Prime Rate. Many have speculated as to his motivation, however there is no doubt the result, he popped the internet bubble. By the time the damage was done roughly three trillion dollars had been lost in the stock market by the end of 2000. This jarring economic event was followed by the jarring economic events of 9/11 and the revelations of malfeasance at Enron, Worldcom, et al. As such, by the end of 2001, our nation was on the brink of economic disaster. Ironically, one of the by products of the weak economy was a strong housing sector. That's because the weak economy helped usher in a low mortgage rates. (interest rates, in their simplest form which of course rarely happens, work in the opposite way of the health of the economy) While President Bush was cutting taxes, Alan Greenspan was busy furiously lowering interest rates. By the time he was done, Alan Greenspan had dropped the Fed Funds Rate below 1%. I put most of the blame on this crisis on Greenspan himself as a result of this irresponsible rate decrease. As you will see, what happened afterwards was the culmination of the monster started by this rate decrease.

At the time, the economy was very weak except for one sector, housing. That's because the weak economy had lowered rates dramatically. We were into year two of the so called refinance boom. Real estate was picking up. By lowering rates so dramatically, Greenspan left banks with no choice but to borrow and borrow aggressively. With the Federal Funds Rate (the rate banks borrow from each other at) at less than 1%, banks were literally paying nearly nothing to borrow money. Suddenly banks were flushed with cash. Except there was really only one place to put it that was doing well, real estate or in their case mortgages.

The problem soon became that banks had more money than they had mortgages. So somewhere between 2002-2003, we began the first expansion of sub prime. Wall Street, which securitized sub prime through Mortgage Backed Securities, took notice of the expansion of real estate. They began taking more notice of a product that hadn't been in favor since the early 1990's. Only Wall Street had a problem, a happy problem at that. They had absolutely no trouble selling these bonds. In fact, selling these bonds was too easy. In other words, money was being left on the table. How was this happening? This was a culmination of several factors. In 1999, there was banking deregulation bill that broken down the figurative wall between banks and financial services companies. It allowed banks and and other financial services companies to delve into each other's businesses, including purchasing MBS. This created more players available to purchase mortgage bonds. Second, the outrageously low rates allowed more players access to money to purchase these bonds. Not only were banks and financial services companies using the outrageously low rates to borrow money to fund loans, but to borrow money to buy mortgage bonds. All the players used to loose money to get into every part of the industry. Why not? There was lots of money available and it was the only industry moving.

Bond traders are capitalists like any other person. If a bond trader walks onto the floor with a billion dollars worth of bonds at 8:30 in the morning and by 9:00 they are all out, they are going to want to bring two billion next time. The problem is that the guidelines in the mortgages backing those bonds didn't allow for more than one billion. As such, Wall Street demanded bonds with looser restrictions to feed the growing appetite of mortgage bond buyers.

At first, the guidelines restrictions were getting more aggressive but marginally. For a while, sub prime offered so called stated loans but only to self employed borrowers. That's who they were meant for. Self employed borrowers had complicated financial situations and stated was meant for them. Yet, mortgage brokers, like myself, were constantly complaining. When would banks begin to offer stated loans to so called W2 borrowers we asked. This means a stated loan to borrowers that were on salary or even hourly wages. Of course, this seemed ridiculous at the time. After all, there is no good reason not to show W2's when the income is so easy to track. Well, of course, there was one "good reason" and that reason is at the heart of this problem. (fraud)

Enter Argent Mortgage into the sub prime field, they were are relatively new player on the so called street somewhere around 2004. Yet, they were associated with a well known, if not notorious, mortgage company, Ameriquest (they were sister companies). Suddenly, they were walking into mortgage companies with products never heard of before. Their account representatives were often known for making half a million and even a million dollars yearly. How did Argent manage to pull this off? Keep in mind that mortgage bonds were selling like hot cakes and Wall Street bond traders were more than willing to entertain their proposal for securitizing these aggressive loans.

If you were an account executive with any other sub prime bank, you were constantly complaining that it was impossible to get loans when Argent always offered a more aggressive deal. If some bank could do a no money down loan at 660 credit score, Argent could invariably do it at 640. At first, the rest of the street relented, but soon enough, the rest of the sub prime world began following suit of Argent. It was on.

By 2005, the guidelines were getting more and more aggressive nearly daily. Somewhere around this time banks relented and began offering stated to W2 borrowers. (it might have even been earlier. Everything at this point happened quickly and its hard to keep an accurate timeline straight) It didn't matter. No matter how loose the restrictions Wall Street had no trouble selling their bonds. Everyone was buying these instruments including mortgage giants Fannie Mae and Freddie Mac. In fact, often times, the very bond sellers ended up selling portions to themselves. Everyone wanted a piece and the more you fed the so called monster the more the monster wanted it.

It didn't matter one iota to anyone from the borrower, the mortgage broker, to the bank, and Wall Street itself that the underlying mortgages were likely fraudulent. Here is why. Real estate was exploding. If a mortgage was done with no money down on a property worth 250k, that was fine since that property would likely be worth at least 300k by the end of the year. Many times borrowers were simply able to refinance right out of their original mortgage and into a new one before there was any real trouble. As long as property values were exploding, the fact that most of the mortgages were fraudulent (which they were since many of these mortgages were these so called W2 stated) was almost inconsequential. The whole entire industry became predicated under the ridiculous notion that real estate values would continue to go up forever.

We were now in the middle of a full blown 21st century Gold Rush. Now, you needed to get as deep into real estate as possible. If you were buying, selling, marketing, investing, or in any way (for instance even software developers began marketing to real estate companies) related to real estate you did well. Because deregulation broke down the wall, everyone could get in. Furthermore, things became so sophisticated that financial services companies literally began to make up products to serve the mortgage industry. For instance, AIG began marketing credit swaps which were insurance for mortgage bonds.

Somewhere around this time, the seeds of two new problems also began to materialize. First, all these financial services companies figured something out. If they made X buying a billion dollars worth of bonds, they could make Y buying thirty billion, and Y was much bigger than X. Suddenly, there was the explosion of something called leverage. In other words, financial institutions began putting down some large amount of money and borrowing a lot more in order to build bigger and bigger positions in mortgages.

Second, by August of 2003, the refinancing boom was over. Interest rates for so called conforming loans, loans to good borrowers, had leveled out. Yet, interest rates for sub prime continued to get more and more aggressive well into 2006. With no money down loans being all the rage, Fannie/Freddie began losing significant market share. At its height, sub prime accounted for about 40% of the mortgage market. That was obscene as it usually accounted for somewhere in the neighborhood of 15%. Fannie/Freddie responded by making their own low and no money down loans more available. (as opposed to the silly and wrong notion that they did this to respond to lending in low income neighborhoods) Most troubling was that these two giants made it much easier to do so called 80-20 and 80-15 loans. These were loans that required either no money down or five percent. By splitting such loans into two, the borrower avoided paying mortgage insurance. When things ultimately went bad on such loans, borrowers oftentimes simply stopped paying the second loan entirely because the second loan really had no recourse since any foreclosure proceeding would give money to the main loan first and leave whatever is left to the second. Since one could expect no more than 70% of the value in any foreclosure proceeding, if you only owned the last 20%, your lien was largely ceremonial. On top of this, so called prime banks were creating a lot of so called Alt A loans that also aggressively mirrored Fannie and sub prime and offered borrowers yet another option for little or no money down loans.

By the end of 2006, the proverbial chickens finally began coming home to roost. The real estate market finally took a breather. Suddenly, Wall Street thought it a good idea to closely examine exactly what they were holding. They didn't like what they found. Often times, they found that their own systems for monitoring the quality of their own paper was erroneous. Many times, Wall Street monitored only what percentage of the loans made the first payment. In reality, they simply didn't monitor them at all because as long as real estate was going up it didn't matter.

In a flash, all that paper that sub prime banks were used to selling were disintegrating, and with it sub prime as an industry. Suddenly, just as quickly as guidelines were changing for the better only a year or two earlier, they were changing just as quickly for the worse. Yet, for the first part of 2007, this crisis seemed as though it would only be limited only to subprime.

Then came August of 2007. Suddenly the same Wall Street folks began examining their so called Alt A paper, these were loans done by prime banks but loans they wouldn't sell to Fannie Mae. They were discovering that these loans were in the same sorry shape as sub prime. Quickly Alt A began to disintegrate along with sub prime.

By the end of 2007, we were facing two new problems. First, there was FASB rule 157. This forced financial institutions to place a "fair market value" on even illiquid assets, which mortgage backed securities now were. Facing significant write downs, these institutions began to attempt to sell their paper furiously. Of course, no one was buying the paper already and this only perpetuated the problem. The more extreme problem was the fact that much of this paper had been bought on margin, and often extreme margin. When the underlying security is doing well, leverage is just fine. When it is doing bad, leverage causes margin calls. Suddenly, massive financial institutions were scrambling to raise billions.

We now have hundreds of billions of distressed mortgage paper of which the underlying mortgage was done fraudulently. These massive financial institutions couldn't get enough so they borrowed billions in order to hold even more of it when that was a wise thing to do. Now, it has caused them come up with billions they simply can't raise. As such, they are folding, being eaten up, or begging the Federal Reserve for credit lines. Thus, what could have been merely a sub prime crisis, spread to Alt A, prime, and eventually into the entire financial system.

This vicious cycle boiled over in September of 2008 when Lehman Brothers failed and sent fear through the rest of the system. The federal government decided to give the whole industry a $750 billion bailout. It was supposed to go to buy these "toxic assets" but instead the money was simply given away. It was also supposed to prop the financial system up so it would lend and spread that money into the rest of the economy.

That's not what happened at all. These institions were saved but they all begin to focus on things besides lending. Can you really blame them? After all, their entire businesses blew up after lending too much. Goldman Sachs was making money trading oil and currencies. Others made a lot of money in mergers and acquisitions. Lending, on the other hand, only got even tighter and hasn't yet relented.

Meanwhile, the Obama administration did everything it could to spread money throughout the real estate system in an attempt to prop up the market. The administration also created a $75 billion program to save borrowers by modifying their mortgages. Only the program was totally chaotic and poorly managed that only about ten percent of the number of loans that the administration wanted to modify actually got done.

Then, lurking around the corner is the threat of a second and third wave of foreclosures. For instance, in 2010, sub prime adjustable rate mortgages have a resurgence of adjustments. In 2011, option arms will adjust in large numbers. In 2012, commercial loans will adjust in large numbers. That combined with massive deficits for years to come make it impossible to have any sustained growth for the next three years at least.

The toxic assets were eventually largely taken care of when marked to market was augmented. That's about the only good news as the nightmare from this confluence of events is just beginning.


Anonymous said...

Excellent. I hope more people read this.
I appreciate the information and your insights.

mike volpe said...

Thanks for the vote of confidence. I hope to see you here again.

Anonymous said...

Excellent summary, but I you might be missing one thing: My understanding is that these MBSs were sliced and diced and repackaged into Collateral Mortgage Obligations (or some other typ of name) so that the good Fannie/Freddie mortgages were now intermingled with subprime and alt a loans in these collective pools.

mike volpe said...

I never heard about the bonds being interwoven. I think that Fannie/Freddie made their own beds by buying a bunch of these, which of course was totally unnecssary.

Anonymous said...

That description is correct from my viewpoint. The increase in real estate was enormous and I was woiting for the inevitable correction. The basic underwriting standards for loans went out the window. When people with 30 K gross annual incomes bought 500K houses, I new a big crash was coming.

My question is why should we bail out the institutions that made such poor choices?


Anonymous said...

I came over to your site because I read a comment that you left at Hot Air where you disputed the role that Fannie & Freddie had in the sub-prime collapse. I have to tell you that both your comment at Hot Air & your article here are very insightful and I do not disagree with any of the facts you have presented.
As a Conservative and a real estate professional (one who understands what Fannie/Freddie does and has known about CRA for years) I do have a few comments:
1) Fannie & Freddie were only insuring conventional loans, but they were purchasing for their portfolio sub-prime & Alt A paper. It is to my understanding, these portfolios or "mini-hedge funds" that they operated that caused the GSEs to fail.
2) I'm not a financial professional, but I would point to the failure of Fannie & Freddie as a trigger of this current financial crisis. I understand that this may be simplistic, but that event looks like the "emperor has no clothes" momment. It created a crisis of confidence.
3) Both political parties were committed to increasing homeownership (each for their own partisan reasons). The Democrats chose to defend Fannie Mae because they viewed it as a method to increase homeownership amongst low income buyers.
Based on the 3 points above, this is why Conservatives pound on the Democrats about the Fannie & Freddie failure. Your point is well taken, though, that this argument oversimplifies the problem and does not fully explain it. Unfortunately, though, the average news consumer is not able and/or willing to fully investigate the entire problem.

mike volpe said...

Tim, thank you for the kind words. As to your points,

your first one is correct and that is the scandal. Of coruse, they bought a lot of these, however they didn't buy them because the market needed their purchase. They bought them because everyone else was making money and they wanted their piece. In fact, in my opinion, they sold the pols a bill of goods about CRA and then they went inot risky behavior while the politicians looked the other way.

My point is that they didn't start the ball rolling on the crisis. Their behavior is even more obscene. They merely jumped in on top of everyone else simply because these risky mortgages looked like a good place to make money.

As for two, that is subjective. This crisis would have happened whether they failed or not, but they failed because they, like everyone else, jumped into these bad loans. Ultimately, this happened because sub prime became ridiculous in terms of their guidelines and when it blew up everyone was in on it.

I totally agree with number three. I would be a partisan but I am also a mortgage broker and on this crisis I want the truth out, not partisan spin.

Anonymous said...

Analyze this forever but it will not resolve anything. What we have is the end of the great country of America. Uncontrollable, vile people let their greed get the best of them, laws were passed that permitted this greed to grow, and when you have some people working hard for $20,000 a year while others are doing relatively nothing for $2 billion a year - this is not capitalism - it is extreme Big Bully Greed. Who did this? A whole group of people in charge who thought it would be a great idea to stop the regulations. Now those in the middle class are no longer. Obama is simply going to do what Robert tells him to do - and that is even more dangerous. The group at the top who make the decisions got too greedy. The middle class is no longer. We are now the serf class. We are tied to our homes. The lord and lady of the manor will tell us when we can go anywhere. We already are in this situation. We are already told that we cannot afford to fly, we cannot afford gas to take a driving vacation, and we are doomed since we cannot afford attorneys to help us avoid the taxes that no one else pays. Why not make the tax laws fair and tax everyone who buys anything with exceptions for the very poor? Heck, this won't happen even if our country becomes a feudal state. The government wishes to control more than it wishes to maintain a democracy. As for me, I am voting to get everyone out of office who has been there more than one term.
Recently the ads in Portland stated that
Sen Gordon Smith spent over ONE MILLION DOLLARS ON A SET OF GOLF CLUBS. This is absurd. When we have people who cannot afford to get cancer medication, or dental work - this is absolutely absurd.

mike volpe said...

So, after saying that I shouldn't bother to analyze you went ahead and analyzed.

The problem with blaming deregulation is that well, that's just wrong. As everyone else that blames deregulation, you don't actually mention any specific deregulations that caused this. That's because it wasn't deregulation, but rather a lack of enforcement. Your pseudo populist, pseudo class warfare rant is obvious and it is tired. The only thing you know about this crisis is what you read in media that you think tell the truth.

Anonymous said...

Please read

Anonymous said...

Interesting, but leaves out the critical fact that all that mortgage money looking for a mortgagee found fertile ground in the housing needs for 20-40 million illegal aliens.

All data points to the uncomfortable fact that the bulk of subprime mortgages going into foreclosure are in the same neighborhoods where illegal aliens are found (Pew Hispanic Trust, Realtytrak, etc.). Without illegal aliens, the subprime fiasco would have never taken off.

Let's kill the nonsense that this started because of boomers buying McMansions. It was the eagerly marketed loans to illegal aliens to finance the CDOs and Bonds (and the great commissions they got with them) that started all this mess.

mike volpe said...

With all due respect to the last anonymous poster, ITIN loans (which are loans created to serve illegals) were a tiny fraction of the entire market. There were two banks that I knew of that did the loan. I once nearly had a loan get denied because it became evident that at eight years old, the borrower entered the country under false pretenses. This borrower had since gotten a SSN, paid taxes, and had perfect credit for more than twenty years. Yet, the bank still wanted nothing to do with the loan. To say that the mortgage crisis started because banks lent en masse to borrowers that were illegal is another conservative talking point, and I am a conservative telling you this.

Anonymous said...

I am also in the mortgage business. I agree 100% with this poster.

Those outside the industry are unaware of many material facts.

The fact that so many loans went to illegals also strengthened the problem.

The worst hosuing markets in the country are the same states with the highest illegal alien populations.

Anonymous said...

I just sat in a meeting where principals were discussing buying packages of mortgages that banks are having to sell in order to comply with regulatory pressure. The long and short of the story is they are making a lot of money doing triage on these loans. Now I am happy for my associates, but the economic reality of this deal is that their profit is really coming out of the pocket of the bank's shareholders (and maybe the FDIC if the bank was taken over).

This loss is really a result of a regulatory decision. Why can't the banks be allowed to keep these loans and run their own triage operation?

CSG said...

Thanks for your insight Mike. Makes a lot more sense now.