How did we get here, and can be done to avoid a repeat?
Greed!
Yes, I said the “G” word. While there have always been people in the market who are greedy, usually they were a minority, and weren’t spread throughout the parts of the industry in such mass. There’s plenty of blame to pass around, as the problem didn't stem from just one industry segment.
So, what happened? Let’s take it a segment at a time:
Homebuilders
Traditionally, homebuilders have been local to one community or one region. Over the years, many grew larger and became national. Some of the growth was internal, and some was through mergers. As growth happened, many of these companies became less providers of housing and more financial machines. They lost their soul, their old reason for being. It didn’t matter what they were producing- it could be ball bearings. All that mattered was feeding the machine and increasing revenues while keeping costs down.
Lenders
It used to be that when a bank made a home loan, it kept the loan in its portfolio. Over the years that changed, as securitization of mortgages allowed lenders to sell their mortgages on Wall Street. This theoretically was a good thing, as the banks were then able to lend more. However, since someone else now owned the loans, underwriting became more lax. After all, the reasoning was, it’s not going to be our problem. Initially, securitized mortgages were prime loans and there was little risk for the eventual owners of the mortgages. But that changed.
Subprime loans
Initially, lenders who specialized in sub-prime mortgages kept them on their books, as there was no market for a securitized product backed by them. As time went on, the market for mortgage backed bonds outstripped supply. The solution was to put those loans on the market. The problem was, they weren’t the same as higher-quality mortgages. The lenders who specialized in such loans had become experts on them over the years and knew how to underwrite, price, and manage them. They had high interest rates that compensated for higher delinquency rates. The lenders’ underwriting standards and risk awareness worked together so that the net income was about the same as for prime loans. This wasn't fully understood my the bond market, which just looked at the interest rates, and had lax due diligence regarding the quality of the underlying mortgages.
A-Alt loans
Should "A" stand for "abuse"? It shouldn't. These loans were created for a special purpose. Many creditworthy self-employed borrowers used to have trouble "proving" their income for loan applications. This was because they often used creative accounting, moving expenses from the personal side of the ledger to the business side. While this reduced their taxes, it played havoc with showing their true income to lenders. Thus, these loans, often referred to as stated income, were developed. Originally, they were carefully underwritten to make sure that the borrowers really had the income that they claimed. However, some lenders and mortgage brokers decided to bend the rules to get more income for themselves,. They used the loans for people who didn't really have the qualifying income, thus earning the nickname liar loans.
Payment-option adjustable-rate mortgages
Again, these loans were created for a legitimate purpose, but ended up being used wrongly. The concept was that the borrower generally had three monthly payment options each month- pay the regular amount (which included the interest and amortized principal), pay just the interest, or pay a "minimum payment", which kept the loan current but raised the principal by the difference between the interest amount due and what was paid. The theory was that these loans gave a borrow great flexibility if there was a temporary reduction in income, say due to a health problem.
Underwriting
When a loan is underwritten, the lender looks at the borrower's creditworthiness, ability to make the monthly payments, and the value of the collateral, in this case the home. Abuse here was using the initial or "teaser" interest rate for an adjustable rate mortgage for determining whether the borrower could afford the loan, rather than what the rate would be when it went to "normal" in a couple of years. This is a bad situation for both the borrower and lender, as it sets up a likely failure scenario.
Mortgage Brokers
Most people used to go directly to lenders to apply for home loans. As the market expanded, mortgage brokers were employed by lenders to generate business and to do the initial underwriting. Theoretically it was a good idea, if the broker-generated loans were adequately monitored. The problem was that they weren't. Incentives
In addition, the way that many lenders compensated brokers was by "yield spread premiums", which invited abuse. How? The way that this method worked, like all things, started out to be a good thing for the borrower, but again, greed and abuse got in the way. The lenders had rate sheets wherein they quoted different combinations of rates and points (prepaid interest). This allowed the borrower to have the option of paying a lower rate by paying more points up front, or vice-versa. The rate was determined by the borrower's creditworthiness. What happened was that the broker wouldn't show the rate sheet to the borrower, but would make selected quotes. For example, a borrower qualified for a 6% loan at 0 points. The broker would quote 1 point for that loan. As the additional point was higher than the lender's quote, the broker would get the extra, as a premium. This situation gave an incentive to some agents to push borrowers into higher cost mortgages in order to fatten their paychecks.
A rising market
Some loan agents (including those working for lenders, mortgage brokers, and builder-affiliated mortgage originators) encouraged home-buyers to buy homes that were clearly out of their financial reach. By using faulty loan underwriting, they were able to "prove" to the buyer that he or she could afford to buy the house, even though in the real world this wasn't true. When the potential buyer addressed this situation, the answer was that the house would soon be worth more that it was now and that it could be sold or refinanced before the higher payments kicked in. This was a total reversal from the "conventional wisdom" that people bought homes to stay in, rather than as a speculative investment.
Appraisers
Generally, most appraisers are honest. Appraising real estate is more of an art than a science, maybe even a "black art". A good appraiser understands the market and its nuances and gives a fairly accurate idea of a home's worth. However, with the demand for loans, lenders started to be less picky about the people who did this work. In addition, in order to handle the larger number of appraisals, many stopped employing independent appraisers directly and instead hired large regional or national appraisal management firms which contracted with local appraisers for the actual work. Unfortunately, sloppiness crept in and pressure was placed on appraisers to "make the numbers". Intimidation was used was to have the purchase contract price be a "comp" (comparable sale), with the theory being that the price was a true reflection of the market, though at that time the purchase wasn't complete, and thus in normal appraisal practice wasn't given full weight.
The bottom line is, it was a disaster waiting to happen.
So, what now? First, there needs to be some house cleaning. More supervision needs to be in place for the disparate parts of the lending chain. Second, the incentives for bad underwriting and fraud need to be curtailed. And third, what we don't need is knee-jerk reactions from Congress. We need real reform, not band-aids clamping down so hard that the credit markets can't service the industry.
What else can be done?
A good start would be to change the securitization model to "covered bonds", which are more the norm in Europe. The primary difference from the current bond model is that the lenders keep the loans on their books and issue bonds secured by them, rather than selling the loans. This creates an incentive for the lender to make sure that the loans are properly underwritten.
