What Really Happened in the Mortgage Meltdown

by Ron Haynes

Lehman Brothers, Bear Stearns, Merrill Lynch, AIG, Fannie Mae, Freddie Mac, Indy Mac, Goldman Sachs. You hear these names every day in the news. You hear we’re in a “credit crunch,” a “mortgage crisis,” and the terms “bailout,” and “golden parachutes.” Democrats blaming deregulation (funny considering that they voted for deregulation by repealing the Glass-Stegall Act back in 1999), Republicans looking around for someone to blame and not sure who, Libertarians suddenly in favor of government intervention. What in the world is going on? You know it has something to do with bad mortgages, “toxic mortgages” as the news media says.

But what’s really going on and what really happened to cause it?

NYC Trip 2008 0051I’d be willing to wager that you’re aware that some less than stellar borrowers managed to convince some mortgage companies to give them a loan to buy their dream home. Politicians would love for us to think that everyone was altruistic in this mess except for those “greedy” bankers and mortgage lenders. But the truth of the matter is that this mess rests squarely on the political meddling of the government, and how it used strong arm tactics to dictate who would get mortgages.

All the media hype used to be about “redlining,” the practice of refusing to make mortgage loans to applicants who lived in certain lower income neighborhoods. Neighborhoods full of voters. Voters who wanted houses. In theory, a banker would draw a red line around certain neighborhoods that were off limits for the bank’s loan underwriters. No one in the government or the media cared that the people living in these neighborhoods were known for having bad credit. No one in the government or the media really cared anything about the borrower’s credit history in general, or debt-to-income ratios, whether the borrower even had a job, or loan-to-value ratios, or a borrower’s personal net worth and they certainly didn’t think these factors should be considered in the mortgage process. That just wouldn’t be “fair.” Owning a home in America is a right, by God! They even coined a term for it–NINJA loans–no job, no income, no assets. But these were voters, constituents, and they needed representation, regardless of what made sense. Things just escalated from there.

And guess what happened? Political correctness won out over common sense. The Feds made it crystal clear to banks and mortgage companies that if they did not bring more minorities and low-income Americans into the world of home ownership there would be a steep price to pay. Congress established programs like the CRA (Community Redevelopment Act) that helped activist groups and community organizers essentially halt a bank’s efforts to grow if that bank didn’t increase the portion of its loan portfolio that consisted of these unqualified borrowers, and hence the “subprime” mortgage mess. XYZ bank didn’t want to loan money to Harry Homebuyer because Harry had a job history that looked like swiss cheese, owed way too much money on his 37 credit cards, and wasn’t exactly known for making payments on time. Then politicians told XYZ Bank to figure out a way to make that loan or forget about opening those new branch offices across the state. The loan, and millions like it, was made under political pressure and predictably, the loan failed and now here we are. That’s your government at work. Attorney General Janet Reno and President Clinton promised “vigorous enforcement” of these Acts and other programs and also promised to insure the demise of any who stood in their way.

Lenders were aware that a very high percentage of these loans would soon be worthless, but it was a price that had to be paid if the bank was to expand and grow. And to top it off, the Feds had these quasi-governmental companies called Freddie Mac and Fannie Mae that would buy these mortgages anyway. Certainly a government backed company could not fail…could it? These trash loans to unqualified borrowers were then bundled up and sold to Freddie Mac and Fannie Mae who held them for a time and then re-packaged them again to sell to other institutions and banks, who were understandably eager to reap the benefit of potentially rising interest rates from the adjustable rate loans. The banks and investment firms certainly thought the Fannie and Freddie loan bundles were sound since they came from governmental agencies. The expectation was that these loans would soon be paid off when rising home values led borrowers to “tap” their equity through a re-finance or sell to move up to a nicer home. Uh-oh. Those drastic increases in real estate values didn’t happen, did they? Now the chickens are coming home to roost.

The whole reason that real estate prices in many areas escalated so quickly was because there was such an incredible amount of money available, again thanks to the Federal government. Simple supply and demand economics came into play and when you have a ton of money and only a few properties, the price WILL increase. Any 18 year old Economics 101 student could tell you that.

Today this government created crisis is being peddled to the American public by one certain political party as proof that the free market and capitalism are failures. Nothing could be further from the truth. What we’re seeing is the inevitable, yet predictable result of political interference in free market economics. If the government had let well enough alone, had let bankers make smart decisions with their money, had refused to bow to the political pressure of community organizers and activists, we wouldn’t be experiencing this crisis.

Anytime government gets involved in anything other than what it was Constitutionally set up to do, the result is bureaucracy, failure, poor performance, and shoddy results that are easily outpaced by the private sector. And they want to take over health care? They can’t even manage the VA, let alone all the hospitals in the country. They semi-took over education and look at the mess we’re in. Most kids can’t even find the US on a globe.

So why isn’t this story front page news? Why aren’t the big TV networks leading off the evening news with stories about how the Feds screwed up yet again? Come on, are you kidding me? Do you really expect the media to blame this mess on deadbeat borrowers and political meddling in the free market when it’s so much easier and politically expedient to put the blame on those evil and greedy lenders and capitalists? Remember, there’s an election going on.

Note: One of the community groups that were intimidating banks into making these dumb loans was an outfit called ACORN. There is one presidential candidate that did a lot of “community organizing” for ACORN in Chicago, I believe. I won’t mention his name so as to avoid politicizing this blog too much.

photo credit: akeg

About the author

Ron Haynes has written 1000 articles on The Wisdom Journal.


The founder and editor of The Wisdom Journal in 2007, Ron has worked in banking, distribution, retail, and upper management for companies ranging in size from small startups to multi-billion dollar corporations. He graduated Suma Cum Laude from a top MBA program and currently is a Human Resources and Management consultant, helping companies know how employees will behave in varying situations and what motivates them to action, assisting firms in identifying top talent, and coaching managers and employees on how to better communicate and make the workplace MUCH more enjoyable. If you'd like help in these areas, contact Ron using the contact form at the top of this page or at 870-761-7881.


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{ 16 comments }

Frugal Dad

And the funny thing is that Buffett sweeps in with $5 billion for Goldman Sachs and he is heralded as a savior. Isn’t what he did capitalism at its finest? Isn’t this exactly the kind of thing the left rails against when it happens on Wall Street, or involves an oil company or energy conglomerate? The government should stay out of this mess, allow prices to reduce naturally, and consolidation to take place.

Mike

Not one economist in a thousand would place the blame where you are placing it. Your view is nothing more than political spin from AM talk radio.

Unsubscribing. You’ve shown your true colors.

Ron

#Mike→
Sorry to inform you but many economists already HAVE placed the blame at the feet of Congressional meddling…and I haven’t listened to AM radio in a long, long time.

My true colors are red, white, and blue and I think we need to get the government out of the private sector.

LP

Those really responsibile for this will not even be spanked.
But the tax payers and our Country itself,
are going to take a beating in this financial conundrum.

The bailout, or now as they are calling it…
“the rescue plan”, :roll: is blatant socialism at it’s finest.

voice of reason

To Mike:

I’M an economist. I agree with Ron.

Jan

Great article ,Ron!!!!! I did not know about all the arm twisting…but then the government tends to be that way whenever they get involved. As a side point….education….does that really take place in public schools??? NO! The public school is not broken…it is working perfectly. They are turning out good little worker bees!!!

Four Pillars

Good one! I suspect the natural greed of the bankers was a larger factor than you have portrayed here but the government push for “a home to go along with every chicken in every pot” sounds pretty reasonable.

Most kids can’t even find the US on a globe.

Definitely a issue but the bigger problem is how many Americans (of any age) can find Canada on a globe? :)

Mike

Ron

#Four Pillars→
The desire of bankers to generate a profit for shareholders WAS a factor. It was a natural by product of the government intervention in the mortgage qualification mess. If Harry Homebuyer, with no job and no income and no assets could get a zero down, 125%, 5 year ARM amortized over 40 years with a 7 year balloon, so could Harvey Homeflipper, who had good credit.

Once enough loans were collected to be sold to Fannie Mae, they were sent off and then Fannie sold them to Lehman on a 20 to one leverage deal as a collateralized debt obligation and when those mortgages hit more than a 5% default rate, BAM! Only multiplied by ten thousands upon ten thousands.

What’s funny is that much of this debt is being sold to the government at 22 to 30 cents on the dollar, even though the underlying real estate is still valued at 80+ percent of its original value. But because of the US government’s requirement that firms use mark to market accounting, they have no value on their books for the margined accounts. If the Feds would temporarily lift the mark to market accounting rules, this whole thing could be settled for probably less than $50 billion. But by making it into a larger problem, the politicians get to swoop in to save the day for the mortgage companies … and the auto makers … and who knows who else?

Four Pillars

Good point about the value of the collateralized loans – I’ve often wondered how these loans seem to be valued pretty close to ‘worthless’ given that not many houses in the US have lost more than say 50% of their value in the last few years.

fathersez

We have programs in Malaysia where the Government mandates a certain percentage of their loans to be for low cost homes.

The buyers of these homes would typically be those who would not pass any credit worthiness tests. Still, when the @#$% hit the fan in 1997/98 it was not these guys who caused the trouble, but the bigger corporate chieftains.

I have to say that I support this mandatory lending allowances for the lesser privileged. (But giving them a loan for a McMansion is not what I am supporting.)

Scott

I think you place far too much blame on “government programs” and ignore that a lot of people in the private sector made a lot of money while the pyramid was growing. This wasn’t the result of bankers being forced to build that pyramid like Egyptian slaves. It was the result of the same thing that brought us the S&L crisis in the 80′s – simple human greed, and the purchase of enough political influence to get regulators to simply ignore how fundamentally unsound those packaged mortgage securities were. The government programs you describe may or may not have provided a partial excuse, but this didn’t go on for more as long as it has because banks were losing money! Government is far from perfect, but at its best it’s there to protect us from the excesses that history has shown, time and again, will follow naturally if markets are not regulated. Calling for less of that when we’re in a mess made by lack of regulation seems terribly wrong-headed. Way too simplistic.

Ron

#Scott→
Yes, it is a simple explanation and I wrote it that way by design. But no matter how you slice it. THIS WAS the fault of a meddling government.

The CRA Act started in 1977 under Carter in an attempt to “get more people into home ownership.” Why were these people not already in homes? Answer: they had credit histories that were horrible, meaning they were a tremendous risk for non-payment…sub-prime if you will. Would YOU loan money to a known risk? No? Why? Guess what…bankers didn’t want to either. Along comes Congress and “Jimma” to save the day and then Clinton, in 1995, signed legislation that allowed the re-sellers of these mortgages to hold only 2.5% in reserves in case of default. And no matter how you slice it, the majority of these loans were made to Democratic voting blocks.

In 1995, Congress decided that it would tweak the CRA by allowing the securitization of of CRA loans as packages. Remember: the purpose of the CRA was to allow “equal access” to lending to all people located in a lending institution’s geographical area (usually a 3 to 5 mile radius).

THEN, Clinton signed the repeal of the Glass-Stegall Act in 1999. In the Senate, 50 Republicans voted for repeal, 40 Democrats voted for it, 8 Democrats voted against it, and 2 Republicans abstained…one of them was John McCain. Glass-Stegall was the legislation that prevented banks from dabbling in the securities market. The purpose was to insure the viability and security of depositors.

What happened next was the home flipping extravaganza. If a low to moderate income person could qualify for those crazy loan programs, so could anyone else…and they did. The flippers, the inverstors, the home builders, and scores of others jumped at the chance to get into real estate and make their fortune. As long as prices increased, and those borrowers were able to keep up with the payments, everything was fine. Once prices moderated and no one could refi over and over again, once interest rates began to rise, once the economy tightened up, and once those ARM and interest only loans adjusted…it hit the fan. When you only keep 2.5% reserve, it doesn’t take much to go belly up. Also when you consider that many of these CDO’s and MB Securities with 10 tranche layers, were purchased on margins up to 40 to 1, it truly doesn’t take much to go belly up. Even a 20 to 1 margin loses money on a 5.01% default rate.

The cause of the S&L crisis had its roots in the tax reform act of 1986. It removed tax shelters on real estate, decreasing the value of those investments (which were held more for their tax-advantaged status than for profitability). According to L. William Seidman, the former chairman of both the FDIC and the Resolution Trust Corporation (formed to buy and re-sell S&L assets), “The banking problems of the ’80s and ’90s came primarily, but not exclusively, from unsound real estate lending.” (page 57 of http://www.fdic.gov/bank/historical/history/vol2/panel3.pdf).

Finally, please don’t drink the “greed” Kool Aid. Who was more greedy: the politicians for votes, the bankers for trying to generate profits for shareholders, or the homeowners who, making $40,000 applied for an $800,000 mortgage? No one WASN’T greedy.

It is a very complicated problem, but it started out simply as an attempt to buy votes through increased homeownership for voting blocks that historically did not pay their bills on time. And believe me, I had a front row seat right in the middle of it when I worked for a bank/mortgage company in the late 80′s/early 90′s.

And I’m not necessarily calling for less regulation. Just less government meddling and social engineering. Bring back the regulation that most Democrats, Republicans, and then President Clinton repealled. That would be fine with me.

ben

You say the free market wouldn’t have failed if government hadn’t of meddled. One might also say that the market had already failed by not allowing all working Americans to get homes.

I’m not advocating handing out mansions to unemployed folks who can’t hold a job (although something needs to be done for them!), but the reality is that to keep a manufacturing economy working, you need low paid workers. Add in high health care costs (that are unpredictable by nature), and you have a recipe for a portion of that work force to have high debt or bad credit.

For the market to “work”, it would require a bunch of people who are crucial to the American economy being in a severe amount of emotional and financial discomfort.

Why should anybody (let alone a politician) see that as a system that is “working”? There’s no higher law that states that free markets are the morally right path to true enlightenment. Obviously in this case the balance tipped too hard the other way, but I would be very cautious about believing that truly deregulated, “free” markets would have solved all the problems either. Remember that truly “free” markets require equal access to information, a problem that has reared it’s ugly head time and time again in the American economy. Should the government come in and fix that?

Ron

#ben→
Thanks Ben, you have a very well thought out comment.

I personally think we SHOULD go back to better banking regulation because one (just one) of the triggers was the repeal of the Glass-Stegall Act that prevented banks from dabbling in securities. The problem today is that we couldn’t re-instate it without 100 gazillion pork projects and earmarks being added to it. They need to simply repeal the repeal!

Access to information? We’re on the same page.

The most I would involve the government in the mortgage process is to offer insurance. We already do that with FHA, though. It went haywire when we relaxed the qualifications. Bring back the qualifications!

CV

Hi Ron-

I have been enjoying many of your posts, especially the ones lately where you’ve been linking the big picture crises to individual behavior. That’s a welcome and much needed connection, imho.

There are a host of causes for our current economic drama, not the least of which is government regulation– or lack thereof. Given this, I was really disappointed with this particular post that blames the Wall Street crisis on any of us seeking to end racist and sexist discrimination in lending practices. While there might be some grain of truth in the view that anti-redlining legislation led to this crisis, this view is being discredited (pun intended) far and wide.

You seem to hold your view very strongly, so I wanted to suggest that you check out a post on Alternet.org: 11 Racist Lies Conservatives Tell to Avoid Blaming Wall Street for the Financial Crisis By Sara Robinson.

Here’s a clip of the intro:
“The real blame for the current economic crisis, conservatives would have you believe, lies not with anything they did, but rather with the 1977 Community Reinvestment Act — a successful Carter-era program designed to get banks to stop covert discrimination, and encourage them to invest their money in low-income neighborhoods. …. Conservatives are twisting the facts beyond the breaking point to support their revisionist history. But don’t be fooled: the financial crisis was caused by conservative financial follies and bankers run amok and nothing more. Here are the basic myths they’re trying to push about the CRA — and the facts that will enable you to fire back.”

Can you see a way to incorporate these criticisms of the “CRA explanation” into your analysis?

And, have you considered (1) whether the bank you worked for misapplied the principles behind the CRA, or (2) whether implicit racism, etc. in discussions at your bank encouraged awareness of less-qualified blacks getting loans, to the exclusion of noticing the less-qualified whites who were also getting loans? Remember this rough statistic: (Only) 13-14% of Americans are black. Could loans to the unqualified subset of that group really be at the root of this all?

thanks- cvh

Ron

#CV→
To begin correcting a problem, one has to first admit it. I’m not the first to recognize that problems come from government interference in the markets. Here’s an article from nine years ago in City Journal that outlines many of the problems the CRA began http://www.city-journal.org/html/10_1_the_trillion_dollar.html

Another problem I have with the 11 responses articles is it’s blatant racism. Just say the words “low income” and suddenly you’re talking about a racial group? What a stereotypical broad brush! That’s racism at its ugliest.

The financial industry is one of the most heavily regulated in the world. The number of regulations are astounding, but I DO advocate some of them coming back such as the Glass-Stegall Act (signed by Clinton with 50 Republicans and 40 Democrats backing — but not John McCain).

No matter how it’s spun, the CRA was a mandate by the Federal government to lower lending standards to certain groups. And government meddling in financial markets (the CRA wasn’t regulation, it was social engineering) results in blowups like we have now. No, it wasn’t the sole reason, but like everything else the Government gets hold of, it opened the floodgates.

Then the Clinton Administration rewrote the CRA to REQUIRE loans be made to low credit quality borrowers. And engaged FNMA and FRE to buy these loans. In order to make loans and homes more affordable for lower income borrowers lenders had to come up with unusual loan products. Interest only, Option ARM, 125% LTV, and low teaser rate products were the solutions for helping people who did not otherwise qualify get a home, as REQUIRED by CRA. These low standards for qualification were THEN applied to everyone who wanted a mortgage. Hence, the “floodgates.” All because of Government intervention.

Besides, nobody made loans “under the CRA program.” The CRA is not a loan program. It set numerical targets for lending by location, race, and ethnicity, and often required lending to uncreditworthy persons to get a satisfactory CRA rating. It did indeed cause Freddie and Fannie to take on huge amounts of trash loans. The chief executive of Countrywide Financial, the nation’s largest mortgage lender, is said to have ‘bragged’ that in order to approve minority applications, ‘lenders have had to stretch the rules a bit.’” See http://en.wikipedia.org/wiki/Community_Reinvestment_Act#Criticism and the following references.

The CRA probably started out as a well meaning, well intentioned program to increase flows of credit to borrowers and neighborhoods that banks had traditionally neglected (why would a profit making organization neglect them? Hmm…). The CRA itself simply says that banks are obliged to “serve the credit needs” of all the communities where they are located. It required regulators to examine each bank’s record of doing so and to take this record into account when deciding whether or not to approve applications for new branches or mergers with other banks.

Liberals think that government can solve all problems. Conservatives think that business can solve all problems. I happen to believe that people should solve their own problems and get the government out of the way.

Where do you land in this political quiz? http://www.theadvocates.org/quizp/index.html

I’m Libertarian.

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