Skinning the Mortgage Market
By Andrew Gordon
What happens to the pharmacist who fills a prescription without a doctor’s signature?
Or to the gun seller who falsifies information on a buyer’s application?
These people are licensed. It means they’ve been trained in how to dispense drugs or sell guns. And it also means that they have a legal obligation to follow mandated procedures.
If they don’t, they could go to jail.
Of course, that’s only if they’re caught ...
This brings us to the mortgage business.
Is there anyone left in America who doesn’t think there was fraud committed by licensed lenders and brokers? And that this fraud took place on a massive scale?
I bet you either know somebody who is in danger of losing their home, or you have heard stories from friends and family of people in this predicament.
I had lunch with a friend of mine on Saturday. He was telling me about his father who bought a house in Florida for more than $300,000. He had been badgered almost every single day by brokers encouraging him to take out a home mortgage. He finally relented.
He was working part-time. How he could qualify for a $300,000 loan is anyone’s guess.
But I think guessing can get us pretty close to the truth. Some of the numbers on the loan application were inflated. They had to be to get the paperwork approved by the bank’s automatic underwriting system.
Now I don’t know this for a fact. And I don’t know who did the inflating – my friend’s father or the broker. But even if it were my friend’s father, I suspect just a little double-checking by the broker could have unearthed much more modest numbers.
My friend’s father has been in and out of the hospital recently. He fell behind on his payments long ago. Now his house is in foreclosure and on the auction block for $50,000. So far, there have been no bids.
This is a tragic situation. And variations of it are being played out all over the country. But the variations can be very different. Some foreclosed homes were vacation homes. Some were new homes. Some were upgrades over previous homes. And some were bought by investors who wanted to sell them quickly for a handsome profit.
We have some very sophisticated buyers caught up in the housing contraction. And some are on the other end of the spectrum. We have wealthy buyers and buyers of very modest means. We have buyers in booming markets (like Phoenix) and buyers in depressed areas (like parts of Detroit and Cleveland).
Some of these buyers are more to blame than others. And I’d say that my friend’s father wasn’t entirely blameless. But regardless of the degree of culpability, all of them were enabled by a supposedly lax lending system. But “lax” doesn’t do justice to what happened.
How about “deliberately sabotaged?”
A memo just came to light that shows just how “lax” those standards were. Its title is “Zippy Cheats & Tricks.” Zippy is Chase’s automatic underwriting system for mortgage loans. Loans must be approved by Zippy to go through.
“Never fear,” says the memo. “Zippy can be adjusted (just ever so slightly.)” All brokers had to do was group tips, bonuses and other stuff into base income. If that didn’t work, says the memo, just inflate stated income by “$500 to see if you can get the finding you want.”
In the interests of disclosure, I have to admit that Chase was the bank that approved my “no-doc” refinancing loan in the mid-1990s.
You see, I’d do anything to avoid paying taxes. (I know I’m not alone in this. I just think that I should get to spend the money I earn ... or at least as much of it as possible.)
During this period, when I ran my own international business consultancy, I had tons of flexibility on how to reward myself. So, to keep Uncle Sam’s greedy mitts off as much of my money as possible, I gave myself an extravagant expense account and a relatively low salary. Travel, hotels, a car ... and a lot of other stuff went under business expenses. Of course, I made sure it was all perfectly legal.
But when I wanted to refinance my house, I couldn’t show my real estate broker the documented income I needed to qualify for a new loan.
He didn’t blink. He had been to my house. He had seen my car. He knew I spent half my time in countries whose names he couldn’t pronounce. He knew I stayed at five-star hotels. He said, “No problem. We’ll give you a ’no-doc’ [short for no documentation] loan.”
Some time after, I found out that these became known as “liars’ loans”. Since they didn’t need proof of income, they were easy to exaggerate and hard to verify. To his credit, the broker asked for a copy of my business’ latest bank statements. I gave them to him and a couple of weeks later, my loan was approved. I locked into a fixed rate that lowered my monthly payments by hundreds of dollars. I was happy. The broker got his commission. And the bank got a loan it could securitize and sell in the secondary markets.
My “no-doc” debt is pretty safe. But probably nobody knows that except me. It’s probably grouped with a lot of other “no-doc” loans that have gone or are about to go bad.
I suppose I was a beneficiary of this loosey-goosey mortgage lending era. The mentality has now reversed. “No doc” used to be better than no loan. Now, no loan is preferred to “no doc.”
Instead of trying to figure out who’s to blame more – dumb lenders or dumb borrowers – let me try to explain how an industry trained to follow rules and regulations and licensed to execute them, fell off the tracks.
Very simply, the system broke down at the front end of the mortgage lending chain – where brokers toil and underwriters give the green light.
The problem was, brokers don’t get paid for the quality of their loans or for the creditworthiness of their borrowers. They get paid by the numbers they generate.
In other words, they have no “skin in the game.” “Skin” refers to recourse in case of loss. For example, investors buying a security from J.P. Morgan may require that it retain a piece of it. J.P. Morgan thus has “skin.”
J.P. Morgan, in turn, may require that Chase, the lender that originated the loans, repurchase those loans that don’t meet J.P. Morgan’s standards. Chase now has “skin.”
Brokers, as I said, don’t have “skin.” They could and many did make millions of dollars by churning out loan after loan. They could even make a lot more money than their boss and sometimes the CEO.
It took a financial crisis and massive loan write-downs nearing $300 billion to reign in brokers. Rampant fraud has been replaced with rampant stinginess. The numbers tell the tale. The value of all new mortgages plummeted to $450 billion in the fourth quarter of 2007, down 38 percent from a year earlier.
“Skin” is no longer a problem. Banks have reverted to strict lending practices not seen for 20 years, according to industry insiders.
But how about the next round? Congress has begun looking at proposals to restructure the oversight of our entire financial system. You will hear claims that the new system will prevent this kind of thing from ever happening again. I wonder.
The proposals don’t give brokers “skin”. How could they? It’s impossible to give brokers a stake in the downside as well as the upside of the business they’re in. They simply don’t earn enough to take a piece of every loan they originate.
Instead, the government proposes to step up the supervision of practices that hurt consumers. And it’ll probably work ... at least for a while ... until complacency once again sets in.
But what will happen when enough people find a good enough reason (MONEY!!) to circumvent the system? Will the new oversight system do better than the old one? I guess it couldn’t do any worse. Good Investing,Andrew Gordon
P.S. To let me know what you thought of today's article, send an e-mail to: email@example.com.
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