What Went Wrong
(summary from last month)

Housing prices in many areas were inflated by market speculators and lax lending standards. Homebuilders overbuilt to cash in on the money cow produced by the almost complete lack of lenders assuring borrowers were actually qualified for loans they received. If a person was breathing and could sign on the dotted line they 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 the loans they could not afford. When a homebuyer or a speculator got into payment trouble they simply walked away from the home because they had no money invested and there was no longer any equity in the home. What the market participants really created was a mortgage lending perfect storm.

Roles, Responsibilities
Borrowers – Failed to inform themselves about the largest and most important financial transaction which they will enter. Some were never qualified for a loan at all. Many either purchased too expensive of a home and obtained a risky loan (ARM, Interest-Only) that would later cause the loan default. Some maxed out their credit cards and refinanced into a risky loan. After they obtained the new loan they maxed out the credit cards again, and many individuals simply lived beyond their means. Statistically, America has a negative savings rate, and this is just another example of unfettered spending. You can have some sympathy for these borrowers. The speculators on the other hand took a risk, lost and deserve little sympathy.

Appraisers – In an age of speculation the values assigned to many properties were simply not supportable or likely to hold up when the housing market declined. Housing is a completely cyclical business and declines inevitably follow housing appreciation periods. In short, very few appraisals assigned realistic property values. But money was cheap, so noone questioned the values.

Mortgage Broker or Loan Officer - The loan officer and broker’s income is tied to the production of mortgage loans. Their duty is threefold: 1) Ensure the borrower can qualify financially for a loan; 2) Educate the borrower about the loan process and the fees they will need to pay; and 3) Place the borrower in a loan type that is appropriate for their financial situation. Needless to say, many officers only took the fee income and moved on without the slightest regard for the borrower. Many became millionaires but the lenders they worked for went out of business. The borrower loses their home and the loan officer drives off in his Ferrari. They will resurface at another firm somewhere and do it all over again without regard for the borrower, the loan quality or fees charged.

Mortgage Banker, Bank or Savings & Loan – Failed to enforce reasonable borrower qualification standards for loans presented by their loan officers. They bought risky loans from brokers, and almost every standard for borrower qualification I learned in my career disappeared. Minimum cash down payments paid by the borrower. Credit score qualifications dipped to the lowest standards ever, and in fact became irrelevant except for the high the fees the banker charged the borrower (obscene fees). Lenders made loans with stated income and stated assets as claimed by the borrower on the loan application with no confirmation! These are now commonly referred to as Liar’s Loans. All this occurred because the investment banks and mortgage conduits bought these suspect loans and assumed the risk.

Fannie Mae (FNMA), Freddie Mac (FHLMC), Investment Banks, Mortgage Conduits – FNMA and FHLMC are not exempt from blame for purchasing these loans but did not have the exposure levels of the banks, investment banks and conduits. Investment banks and mortgage conduits were the true culprits for allowing the market to become irrational and speculative. The competition and greed for ever-larger loan volume and securities issuance allowed the near-complete disintegration of rules and guidelines for loan risk and quality. They bought nearly every loan closed and the selling mortgage firms dictated the terms of the bids they would accept. The market was upside down. If the conduits and investment banks had upheld reasonable loan standards and watched for housing area appreciation bubbles, the mortgage origination firms would not have had a place to sell the sub-standard, high-risk loans. The spigot would have been shut off very quickly when there was no place to sell the high-risk loans they had produced.

Rating Agencies – The rating agencies were divorced from the realities of the markets’   dissolution of lending standards at all levels. The mistake they made is that they assumed their highly sophisticated loan performance models would support the ratings they issued for the mortgage-backed securities. They are a fee-driven business and needed the business from Wall Street. The reality is that the loans were much worse than any experience in the history of mortgage lending. The subsequent ratings the investors relied on to purchase the securities wildly understated the default risk, the loss of cash flow and overall losses. The 2006 book of mortgage business is generally considered the worst pool of mortgage loans in lending history. The rating agencies should have been out-front in assigning high-risk ratings and premiums to protect the investor’s funds.

Hedge Funds, Mutual Funds, Banks, Investment Banks, Insurance and Financial Companies – These investment vehicles and firms, with the exception of the investment bankers, were probably more of a victim of the insanity but Caveat Emptor applies. They were the ultimate holders of this risky debt and have suffered huge losses. The losses will continue to accrue through 2008 as the ARM loan adjustments force even more foreclosures and the losses pile up. Lawsuits against the rating agencies and conduits who issued the mortgage-backed securities most likely will be filed.

State Regulators, SEC, Federal Reserve, Comptroller of the Currency, Office of Thrift Supervision – if the investment banks and conduits were the primary enablers of the lending insanity, then the regulators were the secondary enablers. I place most of the emphasis on the state regulators because many do not adequately license, control and monitor the brokers, loan officers and appraisers to ensure that consumers are not abused.

In short, the pain in the housing market and subsequent credit market contraction will continue to make headlines and cause global economic pain and disruption. The current regulatory piecemeal approach we have for the mortgage lending and asset-backed securities industry is no longer adequate. The existing regulatory framework should be promptly replaced by a system governed by comprehensive federal laws covering all of the marketplace participants. The housing area is an important sector of our economy and can no longer be left open to allow the rampant exploitation we have witnessed. The participants have proven, time and again, that they are incapable of managing it in a responsible fashion. It is time for comprehensive federal action.