A Small Town Banker’s Perspective

Editor’s Note: This article is the first in a three-part series about the current mortgage crisis in America.

by Jerry O’Connor,

President The National Bank of Waupun

January 2010

Fundamentally an economic crisis is preceded by a breakdown in one or more of the systems or operations that the affected parties originally believed would sustain and shelter them from a… crisis. What preceded the current American mortgage crisis is a fascinating study of the consequences that are experienced when there is a breakdown by and between: sound economic principles; political/social engineering agendas; artificial government intervention; a failure in regulatory oversight; large-scale unbridled greed and ignoring the long-term values that underlie these decisions.

Former Federal Reserve Chairman Alan Greenspan told Congress in prepared testimony in October of 2008 that “the current global financial crisis is a ‘once inacentury credit tsunami’ that policymakers did not anticipate.” The current Fed Chairman Ben Bernanke speaking on the housing bubble stated he, “never saw it coming, never, it really caught me totally by surprise.”

Needless to say, there seemed to be few, if any policymakers, regulators or industry experts from Washington to Wall Street and down through Main Street who had a business model that would have predicted the economic consequences we as a nation are facing at this time. They acknowledged that minor market disruptions were a normal part of economic cycles, but those that are charged with governing and protecting our economy seemed to have no idea that we were about to experience a near miss for a global economic collapse.

The “American dream” has provided home ownership for millions of families and still remains the envy of most of the world. Except for a few down cycles, the American residential mortgage market was one of the most stable sectors in the global economy.

The housing boom leading up to the recession of late 2007 was the engine that propelled the entire economy for nearly 20 years. New home construction triggered expected market segments to greatly expand in areas such: lumber, plastics, building supplies, plumbing and electrical supplies, electronics, appliances, heating and cooling units, concrete, asphalt, excavators, landscapers, etc.

New markets grew out of this huge expansion that resulted in: new subdivisions (even entirely new communities), increased inner city home ownership, larger homes, condos, vacation homes, new retail expansion to support these markets, new office complexes, expansion of local government services and buildings, new schools and hospitals, etc. There was a large transfer of populations to places like Phoenix, Florida and other gulf or coastal regions. Literally the entire economy appeared to benefit from this economic juggernaut.

When the economy began to unwind in late 2007, it was blamed on “sub-prime mortgage loans.” Up through mid-2008 the Fed Reserve and Wall Street/Washington power brokers told us this crisis would soon pass. However, this was promptly followed by a sharp contraction in housing starts. Suddenly, buyers were more difficult to find and the largest boom markets were facing thousands of unsold new and existing homes inventory. With the contraction in new construction starts, the balance of the economy soon lost it’s footing on what was becoming an unnerving and slippery economic slope.

By 2009, this event was being referred to as the most threatening economic crisis since the Great Depression. In 2008 and 2009, we saw the government provide massive bailouts and investments and/or takeovers of Fannie Mae and Freddie Mac, AIG, large banks, General Motors, Chrysler, etc. This was only the beginning.

What had happened to the american housing juggernaut? What changed the historically stable mortgage market so that it was the driving force leading us into what will be known as The great Recession?

ALOOKBACK:Theconsequences of this crisis are that we have seen a lot of good people seriously affected by the dramatic change in our nation’s economic fortunes. As with most economic crises, there are multiple forces that contribute to the failure of a particular market sector.

THIS REVIEW will focus on a few major factors that generated the most significant influences on America’s mortgage and the larger economic crisis. Certainly there were others contributors to this crisis- but this focus is on the residential mortgage related issues.

First, it is worth reviewing past lending principles and comparing them with the new, changed lending guidelines. This former system worked well for us in the past. But, it appears that the more recent changes to the loan approval process evolved into the enormous flaws that would ultimately undermine the mortgage-lending arena.

REVIEW OF THE HISTORICALLY PROVEN MORTGAGE LENDING MODEL:

In the past, the historical freemarket exercise of making residential home loans, developed into what the banking industry came to rely on to qualify and manage loan portfolio risk. The three basic components were:

❍ The 28/36 rule: These Debt-to Income ratios represent a percent of the borrowers gross income:

• Housing Ratio (28%): When you add the cost of a mortgage payment (Principal and Interest plus real estate Taxes and home Insurance -known as PITI), this expense would not exceed 28% of gross household income

• Total Debt Ratio (36%); this is the total of PITI plus any other debt service payments (car loans, credit cards, student loans, etc). This expense would not exceed 36% of gross household income

• Loan to Value guidelines (LTV): Prudent guidelines indicate that a good loan will not exceed 90% of the appraised value of a property. These guidelines allow for a property to come through a collection process and allow the lender a margin for holding and marketing costs. This guideline reduced the risk of portfolio loss exposure in the event of a foreclosure.

❍ Maximum amortizations: The maximum term for paying back a loan would not exceed 30 years.

Mitigation: With these rules in place, a lender could make occasional exceptions with tools such as: Private Mortgage Insurance for loans in excess of 80% LTV, Personal guaranties by qualified guarantors (typically family members) for loans exceeding the 28/36 rule or the LTV guidelines. But lenders did not stray far from these rules. These lending practices provided a relatively safe harbor for lending that proved to be quite effective for both the Lender and Borrower.

This lending model, in essence defines a well-structured or “prime” mortgage. This long tested free market exercise protected both lenders and borrowers- since borrowers did not want to lose their homes and lenders did not want to own them- as the result of loan defaults.

There were no artificial safety nets to protect lenders and borrowers from exercising poor judgment in this financial exchange. If they practiced poor lender/borrower choices, they would both pay for their share of the consequences.

In the end this tempered resistance to each other’s needs provided protection for all. This was how the free market exchange was meant to work.

A NEW LENDING MODEL: THE FORCES THAT SHAPED A TRAGEDY

Washington’s Role: Community Reinvestment act

President Carter signed the Community Reinvestment Act (CRA) into place on October 12, 1977. The Carter-era CRA purported to prevent “redlining” -- that is, the denial of mortgages to minority borrowers -- by pressuring banks to make home loans in “low- and moderate-income neighborhoods.”

The CRA forced banks to lend to un-creditworthy borrowers, mostly in minority areas. Age-old standards of lending prudence were thrown out the window. In their place came harsh new regulations requiring banks not only to lend to un-creditworthy borrowers, but also to do so- on the basis of race for a form of Social engineering. This would prove to be a well-intentioned initiative with unwanted consequences.

President Clinton supercharged the program, despite warnings from some members of Congress in 1992. Clinton pushed extensive changes to the rules requiring lenders to make questionable loans. Calls for feasibility studies or risk assessments were summarily dismissed.

Failure to comply meant your bank might not be allowed to expand lending, add new branches or merge with other companies. Banks were (and are) given a so-called “CRa rating” that graded how diverse their lending portfolio was. In the name of diversity, banks were under pressure to make loans that they previously would not have qualified as a good credit risk. Enforcing this initiative is a primary service provided by Community Organizers…

Meanwhile, Congress gave Federal National Mortgage Association (FNMA) and the Federal Mortgage Acceptance Corporation (FMAC) the go-ahead to finance these new mortgages by buying these loans from banks, then repackaging and securitizing them for resale on the open market.

However, in order to achieve the mandate for financing these less qualified loans, Fannie and Freddie had to change the approval ratios (that previously governed “prime loans”) for all borrowers. That’s how the contagion began. With those changes, the “sub-prime loan” market took off. From a mere $35 billion in loans in 1994, “sub-prime loans” soared to $1 trillion by 2008 (out of a $12 trillion national portfolio). a Monumental Change in Lending guidelines:

The CRA regulations were substantially revised again in 1995, in response to a directive to the agencies from President Clinton. This resulted in lending guidelines being further loosened.

The new rules had to apply equally to all applicants:

• If you raised the bar for the 28/36 rules for some borrowers- you had to raise it for all.

• If you raised the bar for the 90% LTV rules for some borrowers- you had to raise it for all.

• If you increased the 30-year mortgage term for some borrowersyou had to increase it for all.

• The new rules were defined and standardized by FNMA and FMAC (see more below) Consequences of the New Lending Rules That Were Instituted:

• The 28/36 rule was stretched out to 40%/60% -and even higher;

• The shift in the LTV rules provided for mortgages up to 125%+ of appraised values

• 30 year mortgages were stretched out to 50 years or “interest only” payment requirements

• Adjustable Rate Mortgages: loans could be originated with artificially low rates that allowed a homeowner to get into a house, but left the question unanswered: “when that loan re-priced to a higher rate, would the borrower be able to continue meeting the new higher payment schedule?” Too many borrowers took this option because… it was the only way they could qualify for the loan

The change in lending qualifications applied, not just to lowincome families, but also to all income brackets. This, maybe unintentionally, triggered what became other high risk lending zones. The new rules would provide more borrowing power for higher income earners as well as low. These changes fueled the boom in larger homes; second homes, vacation homes -especially in areas like the coastal states or retirement homes in Arizona and the Southwest. New construction in these areas exploded. Unseen by many was the fact that sub-prime mortgages were being generated in all demographic areas and included many income levels.

Sub-prime loan defined: What should be noted is that all of those loans exceeding the traditional “prime loan” lending guidelines were by their very nature “sub-prime loans.” In other words, these loan structures and qualifications were embedded with the components that would subject this portfolio to higher levels of default. This became the tectonic shift that would greatly contribute to the nation’s residential mortgage crisis.

The CRA power players- and Rule Makers:

The Federal National Mortgage Association (FNMA) and the Federal Mortgage Acceptance Corporation (FMAC) are Government Sponsored Enterprises (GSE’s) that buy the lion’s share of America’s residential loans. They operated under the auspices of having an implied Federal Government Guaranty for the mortgages they package, securitize and sell into the marketplace. Although this guaranty was not written down- it was rightly assumed -that if something went wrong- the US government would stand behind the FNMA and FMAC mortgages.

FNMA and FMAC successfully raised trillions of dollars with this model. With the implied guaranties of the US Government, this proved to be a winning combination- for increasing both mortgage debt and home buying opportunities.

FNMA and FMAC created and enforced the new rules for mortgage lending -in step with the CRA mandates. In fact 9 in 10 secondary market mortgage loans were approved through the underwriting software provided through FNMA’s Desktop Underwriter® and FMAC’s Loan Prospector®. Every market segment seemed to accept and trust the guidelines set by these Power Players. Freddy and Fanny drove the market.

If a lender originated a loan that was approved under these underwriting programs, they were assured that they could sell the loan off to FNMA or FMAC and thereby transfer any loss exposure.

FNMA and FMAC as of 2008 owned or guaranteed about half of the U.S.’s $12 trillion residential mortgage market. You would truly have to question the oversight being exercised by the Federal Housing Finance Authority (FHFA), which acts as the Regulator for these companies. Didn’t someone somewhere question the integrity of these new underwriting rules? Was no one considering the potential consequences of these fundamental lending guidelines?

The Bush II administration issued various warnings during 2005-2008 to Congress to reign in the exuberant lending pace of FNMA and FMAC. Their concerns were repeatedly rejected by House Banking Chairman Barney Frank and the Senate Banking Chairman Chris Dodd, for being overreactive or excessively critical.

In reality FNMA and FMAC executives were contributing huge amounts in political contributions to both parties. This totaled $4.8MM from 1989 to 2008. It’s just that those such as Dodd and Frank, who wielded the most power and oversight of FNMA and FMAC, would get the biggest donations.