Every decade it seems has had a business debacle followed by outrage from the public and, if the outcry was loud enough, perhaps some new regulation or law from Congress that may or may not address the root causes of the problems. Caveat Emptor has never been more relevant.

In the mid-to-late 1990s we had the IT/Internet bust. 2002 - 2003 brought us Enron, WorldCom, Tyco, and Qwest Communications, to name a few. Absurd Internet buyout/IPO prices and executive compensation excesses that stretched credibility marked these excesses. Both scandals were also notable for the failure of the accounting profession, the last remaining barrier to executive excess and corporate greed. The very firm, whose founder Arthur Andersen established a legacy of absolute honesty,
succumbed to the corporate pressure existing in the 21st century. It spelled
the death of the firm and brought us the Sarbanes-Oxley Act.

The story I want to tell about the subprime mortgage crisis is no less spectacular for the sheer extent of the greed and lack of government, accounting and investor oversight. Subprime loans are home mortgages given to people with weak credit. The problem was that those relaxed credit standards were applied far too broadly and to far too many borrowers. In my career I have worked for, or with, all of the participants in the housing market discussed below. The current credit crunch crisis was largely avoidable if common sense had prevailed, and the default lessons of the past had not been blithely dismissed. But greed will make that happen, and it surely did. It was analogous to going to a frat party and no one ever had the sense to take the tequila bottle away. Now we are suffering the aftermath, and it is indeed a very big hangover.

Large roles in the crisis were played by naïve homebuyers and sophisticated investors alike. The amount of risk-taking by market participants was unprecedented in recent times. To understand the mortgage crisis and the resulting credit crunch, a brief description of the participants that play a role in capital markets for housing is in order. Phrases underlined are key roles for each participant.

Realtor - licensed to protect the interest of the buyer or seller. Must know the entire real estate transaction process including whether borrowers are financially qualified or not.

Borrower - educate him/herself about the entire loan process, loan types, fees and an honest analysis of his/her financial situation. As with anything else you are responsible if you buy something you cannot afford.

Appraiser - licensed to provide an accurate and supportable property value that serves as the basis for the mortgage loan.

Mortgage Broker or Loan Officer - the primary responsibility of the person playing this role should be finding the most appropriate mortgage loan type for those borrowers who qualify for a mortgage.

Mortgage Banker, Bank or Savings & Loan - these firms employ the loan officers that directly close loans in the firm's name. The banker also decides which loans from the brokers they will purchase. Brokers do not have the financial capacity to stay in business without the loans they produce being purchased by a banker.

Fannie Mae (FNMA), Freddie Mac (FHLMC), Investment Banks, Mortgage Conduits - typically called investors. FNMA and FHLMC are Government-Sponsored Enterprises (GSE). They were created by Congress to advance home ownership in America. They have federal oversight but are private stock organizations with boards of directors and are listed on the NYSE. Investment banks are firms such as JPMorgan, Morgan Stanley, Citi Group, Bear Stearns, Deutsche Bank, Lehman Brothers, Merrill Lynch, UBS and Credit Suisse, among others. They are global financial institutions. Mortgage conduits are firms such as Wells Fargo, Countrywide and GMAC. Their role is to purchase loans from the mortgage banks, banks and savings & loan firms. The investors should control the types and quality (risk management) of the loans they purchase and the financial condition of the firms they purchase loans from. All these firms buy thousands of mortgage loans and bundle them into mortgage-backed securities (bonds with various cash-flows) and Collateralized Debt Obligations (CDOs).

Rating Agencies - firms such as Moody's, Standard & Poors (S&P) and others. The rating agencies perform the analysis of the cash flow from the mortgage-backed securities that will result in any given number of economic-stress environments to the investors.

Hedge Funds, Mutual Funds, Banks, Investment Banks, Insurance and Financial Companies - purchase the mortgage-backed securities, CDOs and residual bonds from the GSEs and investment banks. Their investing bias is to obtain the highest yield possible. This is a key to the whole problem.

State Regulators, SEC, Federal Reserve, Comptroller of the Currency, Office of Thrift Supervision - regulation of all financial corporate firms to ensure full investor disclosure, transparency and regulation of consumer abuses. The perfect capitalist ideal is to let markets work and be efficient as possible, but the reality is that the excesses of greed overcame the capability and capacity of any regulatory agency or combination thereof.

HOW BAD IS THE CRISIS? Record delinquency and default rates across America. Record rates of foreclosure not seen since the Depression. Another two million foreclosures are expected in 2008. Billions of dollars pumped into the economy by the Fed. National Association of Homebuilders' index of sentiment among homebuilders is at its lowest point since it started 22 years ago. Hundreds of mortgage lenders are out of business. Investment banks and mortgage conduits ceased, or drastically cut back residential lending and securities formation. Huge quarterly losses as reported by the largest U.S. banks and others tied to their lending in this area and to other investment losses. The banks have had to band together to start a fund to buy the distressed assets that had to be sold by Structured Investment Vehicles (SIVs). Thousands of employees in all areas of the housing market are unemployed. The market is only halfway through the crisis. Adjustable Rate Mortgage loans (ARMs) are just beginning to adjust to payments that many borrowers will not be able to afford. The credit crunch crisis is expected to last until 2009.

WHAT WENT WRONG?
Market speculators and lax lending standards inflated housing prices in many areas. Homebuilders overbuilt to cash in on the money cow and almost any borrower was qualified for a loan. If you were breathing and could sign on the dotted line you could purchase a house with no money down. The crisis was sparked by the decline in property values and loan payments homeowners could not afford. This resulted in higher default rates for the speculators and those borrowers who had obtained these loans. When a homebuyer got in trouble they simply walked away from the home because they had no money invested, and there was no home equity. It was a mortgage lending "perfect storm."

Roles, responsibilities and recommendations for action in next month's Greg's Corner.