March 10, 2009

• Truth in Lending

    When my kids were really little, we had a favorite story that I read every night for weeks.  Dr. Seuss’ “Yertle the Turtle”.  Suess was a genius ahead of his time.  He thought he was writing a lyrical little bedtime story about the exploitation of power, when he was in fact writing an allegory for the mortgage bubble of the 2000′s. 

  Seuss started with a pond, and so did we.  We started with a pool of money.  In all of history up until the year 2000 the entire sum of money held in the world added up to about 35 Trillion dollars.  That’s the total amount of savings in the US, Great Britain, China, Argentina, and the Congo plus the money in every other country.  35 Trillion.  Between 2000 and 2008 that pool of money doubled from $35 Trillion to $70 Trillion. 

  In Seuss’ story, Yertle, the leader of the pond, feels that he’s outgrown his little kingdom and he needs to rule more.  He reasons that he’s the leader of anything he can see, so the only thing he needs is to see more.  He demands that some of the other turtles climb up on a rock.  He climbs up on them and he’s a happier turtle.

  So if you’re a banker, or an investment firm, and someone makes a deposit with your company, it’s your job to find some kind of security you can buy that will provide a return on their investment.  If you are an investment banker in 2001 you find yourself in the unhappy position of holding a lot of deposits with no new securities to buy.  What do you do?  Traditionally, the investment of choice was US Treasury bills.  They were the safest thing in the world, and they provided a return.  Not a huge return, but something.  In 2001, Alan Greenspan made an announcement that drove the investors away from T Bills.  He said that for the foreseeable future, the US Federal Reserve would set the rate of return on T Bills at about 1%. 

  Investment bankers started looking for something that would provide a higher rate of return than 1% but would still be safe, and they spotted the American Dream.  Historically, U S mortgage default rates have been very low at about 2%.  So a bundle of mortgages, sold to an investment house, seems like it’s just as good as t-bills only instead of 1% they are paying 5-7%. 

  Just like Yertle the Turtle, the investment bankers are convinced that there’s something better over the horizon.  Yertle demands that more turtles come and climb onto the rock, on each other’s backs, to raise his throne a little higher. 

  Money pours in which is then in turn lent back to consumers desiring to purchase a home, or refinance the home they’re in.  Mortgage interest rates fall as lenders compete to get loans.  Housing prices rise, sharply, because there’s more demand.  And by 2003 everyone who wants a mortgage and can qualify under the historic risk guidelines has a house.  But remember, that global pool of money is still increasing at an exponential rate.  There are trillions more dollars looking for investments to buy.  People are calling the guys at Morgan Stanley and Bear Sterns saying, “Get me another $100 billion dollars worth of security and get it now.”  So Morgan Stanley and Bear Sterns are calling people at Countrywide and Fremont saying “find someone else to sell a mortgage to”. 

  Yertle the Turtle is the king of a pond, and a house, and a cat, and a cow, but he wants more, so he calls for more turtles.

  Telemarketing centers open and the average American renter starts getting 2 and 3 calls during dinner every night asking if they don’t want to get into a house, oh, and by the way, the rules have changed so if they didn’t qualify before, they certainly will now.  Traditional loans require that you document your income, that you have a certain amount of time on the job, that you have a certain amount of assets, that you have a down payment for your home … Under the new rules, you can have a stated income as long as you have verifiable assets in your bank account.  This is great news for self-employed people.  It’s also a way to pull in some people who are just outside the ring of qualification, but who would like to have a house. 

  But more money is coming in from the global pool and banks have to become more aggressive to get new loans on their books.  So they went to Stated Income/Stated Assets.  Basically, you tell the bank ”I’m a waitress, I make $40K per year, and I have $15k in my savings account.”  The lender gets an accountant to write a letter saying that it’s reasonable for someone in this industry to make that amount of money.  The lender isn’t asking for w-2′s or bank statements, just getting an accountant to say that it’s possible that you might be telling the truth.  Another wave of people get loans.

  Then another wave of money comes to shore, and the rules have to be stretched again.  Finally at the peak of the lending frenzy in the summer of 2006 lenders were writing loans called NINA’s – no income, no assets.  If you had a pulse and a credit score, you could get a loan for a house.  Lenders were willing to do this because people have historically been known to do anything to keep the roof over their head and again, the default rate has only been about 2%.  They figured that in the worst case scenario, maybe 8-10% of those loans would default, but it wouldn’t matter because the price of real estate never falls so if the bank did get the house back it would be worth more than it was when it was sold so there’s no loss (except to the guy who bought the house and now has to go back to renting, but really he had his chance.)  

  The turtles down at the bottom of King Yertle’s throne are starting to feel some stress.  Their knees are shaking and their backs are aching, but Yertle doesn’t care.  He’s seen the moon rise higher than himself and he demands that more turtles come to raise him a miles above the earth. 

  American homeowners, especially the ones who couldn’t afford the homes they were sold, have reached their limit.  The credit cards are maxed out, they’ve refinanced to draw out the “equity” their homes gained through appreciation to try to borrow their way out of debt.  And for the first time in history, investment bankers are seeing something really scary.  The default rates on American mortgages are starting to rise beyond the worst case scenario predictions. 

  I haven’t mentioned the policies of the Bush administration, but they are important.  I know some of you will be unhappy that I have to bring this up, but you’ll just have to get over it.  The facts of history speak for themselves.  Two things happened in 2005 and 2006 that were critical to understanding what happened next.  First, a Republican Congress relaxed the net capital rule for the top 5 investment firms.  

  The net capital rule, established in 1975, allows the SEC to oversee broker-dealers who trade securities for customers as well as their own accounts. The rule requires that the firm maintain a debt-to-net-capital ratio of 12 to 1 or less.  If the firm reaches that limit they have to stop trading, so most firms maintain a much lower ratio.  Starting in 2005 that rule was relaxed to allow the five largest firms (that’s Lehman Brothers, Goldman-Sachs, Bear-Stearns, Merrill-Lynch, and Morgan Stanley) to lend at a ratio of up to 40-to-1.  They were allowed to lend obscene amounts of money based on the shaky premise that mortgage backed securities were just as safe as money.

  This was followed in 2006 by “bankruptcy reform”.  Under previous bankruptcy laws, if a family could no longer pay it’s bills, it could appeal to the court for relief and the courts had the power to restructure debt so that it was possible for the family to pay it back.  Under the 2006 Reforms, primary residences were taken off the table.  For the first time in my lifetime, a family in trouble had no way to get relief and repay their debt. 

  At the same time another significant event came from the consumer side of the aisle when the US Savings rate dipped into negative numbers for the first time since 1933.  American households, tapped to their limit spent more than they earned for an entire year. 

  Remember that the subprime boom began in 2003 with that wave of money that pushed lenders to offer ever more risky products to lure new borrowers into the market.  Many of those risky loans were the now infamous adjustable rate mortgages set to increase 2-3 years after origination.  As the mortgages reset, consumers could no longer meet their debt service from their regular income and had to cash out their savings to stay afloat. 

  As Yertle the Turtle reached Celestial Heights and basked with contentment in his kingdom, something he never expected to happen, happened.  All the way down at the bottom of the stack was a plain little turtle with a plain name, Mack.  Then plain little Mack, did a plain little thing. He burped and his burp shook the throne of a King.   

  With the savings gone, and no one interested in refinancing that house back down to a rational interest rate after the terms reset, that 8-10% worst case scenario default rate began to push 12-15%.  As more and more homes were lost to foreclosure the price of homes began to fall.  The same market pressures that pushed the bubble up, now pushed it down, and fast.  On average on every street with a foreclosure, the price of all the other homes on that street falls 9%.  Suddenly people who had never been at risk were upside down on their loans, they owed more than the homes were worth. 

  Being upside down meant if there was an emergency medical bill, or an unexpected layoff, the source that Americans turned to for their personal bail-out dried up.  More and more people defaulted, the backers of those mortgages had to make good on them, and the pool of money began to slosh wildly. (Market volatility)  Strong well-capitalized companies saw their stock value fall overnight to bargain basement prices because people started pulling so much money out of the market. 

  The problem now is that it isn’t just people at the very bottom, who should never have gotten a mortgage, feeling the pinch, it’s everyone. 

  And no matter how angry it makes me that people profitted to high heaven from all the bizarre deals written over the years, I’m very much afraid that if we simply let them go down, they will suck all the rest of us into the black hole with them. 

  This has been a very brief overview of what happened.  I’ve left out the incremental greed from appraisers who routinely were told “what was needed” in the way of valuation of property and mortgage brokers who profitted through payments (not disclosed to borrowers) paid to them by lenders for putting a borrower in a higher interest loan.  I’ve not mentioned the real estate agents who ”shopped” their clients in neighborhoods beyond the client’s reasonable reach because they were going to make between 6 and 10% of the purchase price of the home as their commission.  I haven’t touched on the number crunchers who kept churning out mathematical models based on 1990′s lending practices which bore little or no relation to the exotic mortgage products being offered after 2002.  I haven’t mentioned the bond ratings agencies who were offering AAA ratings to securities that they had no idea how to value because no one knew what was in them.  I haven’t touched on builders who decided there was not enough margin in affordable homes and built homes that on average cost more than 4 times the amount of the median American income.

  In the arc that formed between the middle class American trying to buy a house and the middle class Chinese trying to save some money there was a huge line of people who all made decisions based on wishful thinking and greed.  We may yet stave off a worldwide meltdown, but it won’t be a simple task, and it will be an expensive one.

  • 10:43 pm
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