A Small Town Banker’s Perspective
A Small Town Banker’s Perspective
by Jerry O’Connor, President
The National Bank of Waupun
January 2010
Editor’s Note: This article is the second in a three-part series about the current mortgage crisis in America.
CHANGE IN MORTGAGE LOAN
DELIVERY SYSTEMS:
Numerous regulatory changes in the banking industry brought about by de-regulation culminated under Clinton in the Banking Act of 1999. This allowed for massive expansion of the US Global Bank players ability to grow to a size that is now defined as “too big to fail.” This became another implied guaranty that provided for the exercise of poor, short-term gain decisions.
Concurrently, the players who originated mortgages and the compensation models they used would come to have an immeasurable impact on the mortgage market. Lending was no longer confined to the traditionally trained lender. Basically anyone could get into this business with little or no experience.
New mortgage brokers or mortgage bankers entered the market. It is worth noting that most of these brokers originated loans, sold them off through a variety of pipelines to secondary mortgage market. These folks did not have to service these loans or walk a borrower through the collection process. They never had to sit down with a family and explain that they were going to lose their home. This is a lesson not soon forgotten by a young banker.
These new breeds of lenders were sales reps… and they were motivated first and foremost by commission dollars. As this delivery vehicle evolved, it did so with a “commission paid for a mortgage generated” model. In this compensation model, volume trumped quality. The goal was to get a deal done and never have to worry how it worked out for the homeowner. You were not going to have to service the consequences generated from a poorly underwritten loan. Someone else would have that pleasure. You received your commission and moved on to the next transaction.
Larger banks, having a need to provide big dividends to stockholders, were being left behind. So they quickly adopted this compensation model as well – they went to paying commissions based on volume (a model rejected by traditional Community bankers). Once again volume trumped quality. They would also sell off their mortgages to FNMA and FMAC–who seemed to have no end in sight for the monies they could make available for this market. (Traditional Bank Formula: Volume>Quality = Loss)
Why were Fanny and Freddie buying all this paper? Because their management was also being compensated with hundreds of millions of dollars in bonuses paid for volume produced – not on quality credit.
The new delivery system was literally a greed based lending model and it was primed for large scale abuse.
WALL STREET’S ROLE:
Up to this point, we have identified the roles played by politicians and their government sponsored enterprises (or lackeys might be a better term). Their motivation was fundamentally social and not economic in nature. These changes would certainly contribute to a crisis. However the real fuel for this fire was produced on Wall Street.
Previously noted was that FNMA and FMAC would package, securitize and sell their mortgages into the marketplace. The buyers are typically trusts, institutional investors (e.g. pension funds), regulated financial institutions; foreign governments, etc. and they are serviced by the Wall Street brokerages. Traditionally, these are conservative investors that trade lower rates for lower risk. They could feel very safe buying a product that, for all practical purposes, had an implicit guaranty from the Federal government of the United States.
However, Wall Street was limited in their trading – since some of these Mortgage Backed Securities (MBS’s) could not pass the quality test of their buyers. Wall Street was very aware that a MBS could be packaged with both Prime loans and Sub-Prime loans. How much increased risk did this mix of good and bad assets represent? These had the characteristics of a junk bond. As such, bank regulators were critical of these investments. Without adequate bond ratings, a similar determination came from Institutional type investors.
In order to meet this challenge, Wall Street created a new hybrid financial instrument or derivative, known as a “Credit Default Swap.” This product represented to the buyer that the issuer would insure the buyer of the MBS from any losses that might be incurred as a result of the sub-prime mortgage risk imbedded in the portfolio mix.
Now you had, “Made in America” real estate mortgages approved by FNMA and FMAC, the US government guarantying your MBS and the credit default swap form of insurance to cover the toxic assets that were layered into the security offering.
What could be better? What could go wrong? AIG (the largest US insurance carrier) was also the largest provider of Credit Default Swaps! With this new tool, Wall Street had a product that seemingly the whole world wanted.
With this new enhancement, Regulator’s signed off on these revised MBS’s as “bank qualified investments” and the Ratings Agencies ratcheted up this mixed bag of prime and sub-prime mortgages to AAA ratings.
This new Wall Street investment has been referred to as a “cocktail investment.” The reality is that many investors literally became intoxicated when these offerings were served to the public.
The bonfire was now fully fueled and the increased market temperature began a fateful climb. However like the story of the frog placed in a pan of water… most of the marketplace had no idea of what a Credit Default Swap was or that the traditional lending rules had been dangerously altered.
Then Washington and Wall Street blessed this mixture assuring home buyers, investors, bond holders and everyone in between that they had the tools in place to protect everyone from harm. What we knew before – and are painfully reminded of now – is that if you violate certain fundamental principles, as was done in this case, you are living in a house made of cards
THE BORROWER’S ROLE:
Not to be missed in all this activity is the Borrower’s role. Many people were unaware of the behind-the-scenes process related to their mortgage. Many homeowners were not and have not been affected to this date.
But many, in all income categories, found themselves with more debt payments than they could service. Property values in many areas plummeted. Frequently there had been volumes of credit card debt added at the same time because the “new rules” of lending provided for it. We had a recipe for disaster!
Many buyers should have stuck with the gut feeling that told them, “This is amazing that I am able to buy this property. I don’t know how the lender or broker thought we could afford it?” In reality most borrowers knew this was simply too good to be true. It would only take a short period of time to prove it.
In many cases borrowers were betting on the future while trusting the industry not to give them a loan they could not afford…and unfortunately this strategy ended in tragedy.
THE REGULATOR’S ROLE:
Interestingly, the Banking Regulators failed to identify this huge bubble growing. Neither did they spread cautions that the Washington/Wall Street mortgage models could end in the level of calamity we have seen.
The Securities Regulators did not see the Credit Default Swap as a security product, but then again the Insurance Regulators did not think it was an insurance product. The banks and other investors looked at this product as a risk management tool, without knowing if the companies standing behind it were solid enough to face a crisis. The Federal Reserve never saw this coming.
In the end the new hybrid “cocktail investment offering” that ultimately fueled an economic tsunami went completely unregulated. How could that happen?
The entire government apparatus that is supposed to protect the public was AWOL. But it should be noted that they survived the firestorm with all of their body parts intact, since they have had more than enough fingers to blame the crisis on somebody else. To date, we are not aware of one single person in these agencies that lost their job over this colossal failure. Where is the accountability? If there is none we are in trouble! Will they protect us in the future any better than they did over the last 10 years?
THE CRISIS
If the economy would have remained stable for a long period of time into the future and if property values remained stable with moderate increases in value over a long period of time this scenario may have been tolerable.
However, this was not the case. Inflation in most markets far exceeded historical, supportable levels. In some areas it was simply unbelievable at 20- 30% or more annually. The consequences of the earlier decisions described herein were accelerating and too few had the knowledge to avoid the minefields of this seriously flawed new financial model.
When the sub-prime mortgage concerns began to surface in late 2007 and into 2008, homeowners were not able to make mortgage payments. This was followed by literally billions of dollars in FNMA/FMAC MBS’s moving toward default. This was followed by investors filing claims against the Credit Default Swap polices they had bought from Wall Street. There were simply too few dollars to meet this economic implosion.
America was facing a financial disaster that very few were prepared to address. Ben Bernacke and Alan Greenspan as the Chairman and former Chairman of the Federal Reserve Board confessed they had no idea this potential for such a massive economic collapse existed. Their mindset would be echoed at the Treasury Department, FDIC, Financial Regulators, by foreign governments, foreign investors, the nation’s largest banks and Wall Street.
Beginning with the government mandating certain lending decisions, without accounting for the impact of these changes, America ignored and violated time-proven patterns of prudent lending where both lenders and borrowers were far more protected than they would be in the wildfire that we now find ourselves in.
What began in late 2007 as a concern for sub-prime mortgages has ballooned into the largest economic contraction since the Great Depression.
END CONSEQUENCES- THE
COST OF THESE DECISIONS AND
POOR OVERSIGHT
Every homeowner in America has been negatively impacted. If not through a frightening failed mortgage experience, then they have been affected by greatly depreciated values of their own homes.
In 2008 the Federal Government took over FNMA and FMAC and we are absorbing billons of dollars of losses caused by the poor lending practices they authored and sanctioned. The original bailout cap for these two was $400 billion dollars. Earlier in 2009, Fannie Mae and Freddie Mac requested $800 billion dollars in available bail out money. The U.S. Treasury announced on Dec. 24, 2009 that the Treasury had now increased this guaranty to an unlimited amount of money through 2013.
The President never addressed the FNMA/FMAC risk scenario in the budget he presented in early 2010. Therefore, the Treasury and White House can simply implement their CRA policies and relief mechanisms through Fanny and Freddy, without a budget or Congressional oversight or constraints – all at taxpayer expense. What form of economics will they use and what agenda will drive those decisions?
To illustrate how over-the-top the Freddy and Fannie lending practices were, only 66,000 of 903,000 applicants have been approved for permanent debt relief so far. The balance cannot reasonably demonstrate the capacity to service the revised debt requirements.
Additionally the Federal Housing Authority (FHA) has another $752 billion in loan guaranties for borrowers who were financed with as little as 3.5% down. (Today those homes with 3.5% down are worth less than the outstanding loan balance. How long will this group pay for houses that aren’t worth what they paid? Or how much will the government write them down?)
On October 12, 2009 FHA in its Annual Report to Congress indicated that their capital was at .53% and loans past due 30+ days were 17.71% of the portfolio. If 30% of these loans fail, the taxpayers would be called on to pony up to $30 billion.
The government has provided $182 billion in bailout monies to AIG to cover their faulty Credit Default Swap products. The U.S is now the largest stockholder in AIG. Take note that out of this bailout money, 16 banks, including Goldman Sachs, Deutsche Bank, Societe Generale and Royal Bank of Scotland, were paid more than $62 billion to cover their bad bets – thanks to the ever-helpful US Taxpayer. Other firms such as Lehman Brothers were simply allowed to fail – leaving their good faith stockholders with billions more in losses.
THE AMERICAN TAXPAYERS
Maybe the most prominent lesson is the profound reminder that the “government” is composed of the American people. When all of these commitments and guaranties are made in the name of the Federal Government they are not backed up by some invisible government agency or some bureaucrat – no, the buck stops with the taxpayer. We are the ones paying for all of these losses incurred by our “government” on our behalf. It is a terrible price that will be paid for generations to come.
How much money are we talking about? According to a Bloomberg article, in just one short year (March 2008-March 2009), the bailouts managed to spend far in excess of nearly every major one-time expenditure of the USA, including WW1 & WW2, the moon shot, the New Deal, total NASA budgets, Iraq, Vietnam and Korean wars—COMBINED.
• Marshall Plan: Cost: $12.7 billion, Inflation Adjusted Cost: $115.3 billion
• Louisiana Purchase: Cost: $15 million, Inflation Adjusted Cost: $217 billion
• Race to the Moon: Cost: $36.4 billion, Inflation Adjusted Cost: $237 billion
• S&L Crisis: Cost: $153 billion, Inflation Adjusted Cost: $256 billion
• Korean War: Cost: $54 billion, Inflation Adjusted Cost: $454 billion
• The New Deal: Cost: $32 billion (Est), Inflation Adjusted Cost: $500 billion (Est)
• Invasion of Iraq: Cost: $551b, Inflation Adjusted Cost: $597 billion
• Vietnam War: Cost: $111 billion, Inflation Adjusted Cost: $698 billion
• NASA: Cost: $416.7 billion, Inflation Adjusted Cost: $851.2 billion
TOTAL: $3.92 trillion
A recent Bloomberg article does an excellent job of breaking down the insanity. The U.S. government and the Federal Reserve have spent, lent or committed $12.8 trillion, “the U.S. has already spent $4.17 trillion and has further allocated $12.8 trillion – an amount that approaches the value of everything produced in the country last year, to stem the longest recession since the 1930s…”