If the housing market crash was made into a murder mystery, perhaps, the American public would 'Clue' into the facts of the crime. A Belgian detective would guide us through the canards, false leads and 'tell tale' clues intricately woven into the unfolding mystery, to reveal the surprising culprit to a gasping audience. And, unlike the revelation on the Orient Express and contrary to the assertions of American punditry, here the murderer is . . but one.
Though I needed no impetus for this story, a recent New York Times report can be blamed for instigating me. The report was not really news, as stories about 'underwater' homeowners walking away from their homes have sporadically appeared since the start of the housing market crash in 2007.
This subject tends to pop up and fade quickly amidst the larger attention the banks have been getting over their self inflicted liquidity crisis. Each story mentions the mechanics, economics, ethics and prevalence of walking away, and most of these are laced with implications of personal wrong doing, guilty consciences, and the portrayal of banks as victims in this scenario.
It's natural, for most of us, to react to debt default with a wince, though that's only true when it applies to an individual. We've become so accustomed to corporate or business bankruptcies, as just routine, that they don't evoke any emotions at all, unless it involves us personally. Though a company must deal with some practical issues of renewing credit lines, it's just business, not personal, whereas, individuals have to fear both the stigma to their credit worthiness and to their social reputation, even if its only imagined.
The stories on this subject reflect that double standard as they reveal the personal angst of homeowners contemplating defaulting, yet cast few aspersions on the culpability of banking institutions, many of whom have been rescued by the federal government with their jobs spared in the process. The banks are betting on the guilt, shame and prospective effects on credit and employment, which a mortgage default could have on an individual, to keep such acts to a small trickle. Thus, the banks aren't bending over backwards to aid their mortgage clients.
The report, "No Help in Sight, More Homeowners Walk Away", by David Streitfeld, adds some new information and thinking to the routine story. It gives some numbers on those who walk away as part of an investment decision as opposed to those who do it because they are struggling to keep up with the monthly loan payments. And, it is the first story of this type, I've read, that turns the corner on assigning guilt and responsibility. But, before getting to that corner, the usual questions of personal ethics are raised.
Mr. Streitfeld interviewed a homeowner who was in the 'underwater' predicament and reported this, "Others, like Mr. Koellmann in Miami Beach, made only one mistake: they bought as the boom was cresting." Mr. Streitfeld likely took liberty to call Mr. Koellmann's purchase a 'mistake' because Mr. Koellmann himself referenced it as such, saying, "I took a loan on an asset that I didn’t see was overvalued. As much as I would like my bank to pay for that mistake, why should it?”
Streitfeld's contention, "they bought as the boom was cresting," implies that Mr. Koellmann, and others, knew that real estate was over priced, relative to today's pricing, at the time they bought; or that they should have known it was going to drop in value, to where the price is today. But, Mr. Koellmann's statement indicates he wasn't aware that the property was over priced (at the time of purchase). Thus, the question then is, 'Should Mr. Koellmann have known the price was high relative to what it would be three years later?' For me, the answer is, "Of course not!"
Consumers are very good at comparison shopping, at least those who find it necessary due to finances or those who simply don't like 'over' paying for anything, which encompasses most everyone. If I were to interview Mr. Koellmann, I'd likely discover that he'd spent a long time looking for a property to purchase, made a lot of comparisons, in other words he performed due diligence. At the time Mr. Koellmann purchased his condominium, he paid the price which was the value of the property, unless there was some other fraud related specifically to his condominium.
The housing market is the most competitive market we know. While we are often worried about monopolies and oligopolies in many of our markets, we have at the other end . . . the housing market, where there is almost a 1:1 ratio of buyers and sellers. That astounding number of suppliers for a product means that no one seller or type of seller, such as builders and renovators, can affect a price rise above that set by the market, i.e. supply and demand. Only fraudulent acts on a massive scale could impact either supply or demand to the detriment of the larger market.
Fraud on the supply side has not occurred on any sustained or large scale basis. It has occurred sporadically and its appearance brought about the widespread use of building codes. County and municipal code enforcers, private building inspectors and value judgments by consumers have acted as regulators on the supply side of the housing market equation.
Like most products, supply follows demand. Therefore, demand is the driving factor in the expansion of the housing market and its variation determines real estate values. Note, also, demand must be measured in dollars, thus, Mr. Koellmann's contribution to demand is more than a single unit, it is the amount of money he is able and willing to, or ultimately does, spend on residential real estate. This is important in order to understand that increasing demand, which drives prices up is not simply the result of a market expansion in the number of buyers, but the total amount of money chasing the available supply.
Wikipedia: In economics, demand is the desire to own anything and the ability to pay for it and willingness to pay. (emphasis added)That definition, if quantified would be the total amount of money tendered for a product or service. If in a microcosm of the housing market there exists 10 houses, demand in that microcosm is the sum of the money which 10 buyers are able and willing to tender for their purchase. If buyers are able and willing to tender more to own the houses, then the value of the houses increase by that amount. There isn't anything else which determines value, only a supply of a commodity and a demand for that commodity as measured in dollars.
In the U.S., demand in the housing market is most often created by an arrangement between one who desires to purchase real estate and a lender who agrees to front an amount of money for the purchase, based, in theory, upon an assessment that the borrower has the ability to pay. Unlike on the supply side, where a rather vigilant exercise of government regulation is performed by building-code inspectors, there is no exercise by government in validating the demand side.
Demand facilitated through mortgage financing became prevalent in the United States after the Great Depression and grew to fully dominate the market. The home construction industry and the mortgage banking industry grew simultaneously in conjunction with each other. Throughout this history, increases in demand resulted from three factors, 1) population growth, 2) increases in median household wealth, adjusted for inflation, and 3) the reduction of risk to lenders by actions of the federal government.
In the twentieth century, the federal government took steps to broaden the consumer market for owner occupied homes by facilitating a reduction in risk for lenders. Seeing an economically viable market, not being serviced by lenders (most being too small to assume much risk), entities and policies were put in place to offer loan guarantees (thus distributing risks) and a source of funds for lending (through brokering the loans as investments). The two largest of these entities are the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac).
Fannie and Freddie are huge actors in the mortgage market. Their combined holdings or guarantees represent close to half of the mortgage holdings in the U.S. At first glance, that makes them a serious suspect in this caper. The two have had their critics, but if anyone provided a check on the viability of home loans, it is them. Though they were under political pressure to aid in the effort to broaden home ownership among Americans, they also were a private entity with shareholders, and were the only secondary market guarantor or buyer who had a systematic process of standards and practices to qualify the loans they would back or purchase.
In Congressional testimony, of 2007, the then President and CEO of Fannie Mae said this:
Unfortunately, Fannie Mae-quality, safe loans in the subprime market did not become the standard, and the lending market moved away from us. Borrowers were offered a range of loans that layered teaser rates, interest-only, negative amortization and payment options and low-documentation requirements on top of floating-rate loans.
In early 2005 we began sounding our concerns about this 'layered-risk' lending. For example, Tom Lund, the head of our single-family mortgage business, publicly stated, "One of the things we don't feel good about right now as we look into this marketplace is more homebuyers being put into programs that have more risk. Those products are for more sophisticated buyers. Does it make sense for borrowers to take on risk they may not be aware of? Are we setting them up for failure?"
Mudd, Daniel (April 17, 2007). Excerpt from "Opening Statement as Submitted to the U.S. House Committee on Financial Services"Loans not qualifying for purchase by Fannie or Freddie, and not intended to be held by the lender, were destined for private market securitization. Those loans were not subject to any standards of underwriting outside of the banks who originated them. Underwriting is the process (and responsibility) of assessing a potential borrower's ability to repay a proposed loan and, in the case of mortgage loans, assessing the value of the collateral.
This underwriting process is wholly within the lending institution originating a loan and is the pivotal step in the bank's approving or denying a loan. Of course, the process uses as its guide a standard minimum risk level set by the bank. Degrees of risks in lending are a well researched subject, with vast quantities of historical data available to ascertain risks levels for given factors. Thus, changing one's long established minimum standards is a step which is virtually certain to bring a proven result.
Lenders found they had a growing and private secondary loan market (i.e. not Fannie Mae or Freddie Mac) where they could pass off the risk of an issued loan without its investment quality being questioned. And that market was willing to pay them handsomely for their tainted products, allowing them to profit both on issuing the loan and then selling it. Mortgage underwriting standards and ethics among lenders diminished considerably in the years leading up to the housing crash. This Wikipedia excerpt explains the run up of investment money:
So why did lending standards decline? In a Peabody Award winning program, NPR correspondents argued that a "Giant Pool of Money" (represented by $70 trillion in worldwide fixed income investments) sought higher yields than those offered by U.S. Treasury bonds early in the decade. Further, this pool of money had roughly doubled in size from 2000 to 2007, yet the supply of relatively safe, income generating investments had not grown as fast. Investment banks on Wall Street answered this demand with financial innovation such as the mortgage-backed security (MBS) and collateralized debt obligation (CDO), which were assigned safe ratings by the credit rating agencies. In effect, Wall Street connected this pool of money to the mortgage market in the U.S., with enormous fees accruing to those throughout the mortgage supply chain, from the mortgage broker selling the loans, to small banks that funded the brokers, to the giant investment banks behind them. By approximately 2003, the supply of mortgages originated at traditional lending standards had been exhausted. However, continued strong demand for MBS and CDO began to drive down lending standards, as long as mortgages could still be sold along the supply chain.
Note: The reference to 'mortgage brokers selling the loans' should be clarified. While brokers receive fees for their service, they act only as a marketer of products (loan packages) offered by one or more mortgage banks; underwriting responsibility is with the lender/mortgage bank.Though accurate in pointing out the culpability, the article's choice of words in phrasing the last sentence is far too lenient. While the author is merely summarizing the cause and effect which produced the injury, it sidesteps the responsibility of the chief actor here whose reaction to the incentive (cause) is THE very ACTION responsible for the housing surge and collapse. No other actor among all the many who have been accused had the singular ability to produce this event. Other players could have threatened, lied, cheated, or bribed, but none whether individually or in tandem with each other could have brought about this particular calamity on such a massive scale. It was all contingent upon that singular act of underwriting.
The backup systems meant to detect and aid in correcting a violation by this actor failed in their roles, these being banking regulators under the direction of the Federal Reserve, the Federal Reserve's officers and Board of Governors who are specifically given the task to be wary of signs of systemic risks to the U.S. economy, and the private security ratings agencies. Their failures are large, and they should be held accountable in as severe a manner as is available. And, yet, still the triggering violation of ethical responsibility lies with the mortgage underwriter.
There are always those who attempt to bribe someone to violate their legal, ethical, or moral responsibility for some gain. All professions have their role in our system of commerce, whether a bank clerk, store clerk, minister, soldier, public official, auto mechanic, doctor, financial adviser, journalist, or security guard. All perform critical functions within that system which are relied upon by all others within the system. It isn't accepted that one is alleviated of responsibility by virtue of receiving sufficient bribes to do so.
Relaxed underwriting standards generated more lending, translating into more demand for housing, which of course pushed prices upward in most markets, which triggered builders to create more supply, which also created more issues with housing affordability. And as prices went higher lenders became even more scurrilous, going still lower in their underwriting standards to find new borrowers, thus continuing the pretense of rising home values, and threatening the entire American economy.
The 'lowering of lending standards' is the simple language used to explain the vast increase in sub-prime loans and the subsequent housing boom and bust. The description is far too benign, which is one reason why those acts have failed to ring the right cord with the public and the media.
It must be understood that these acts were not inadvertent. Mortgage banks (lenders) intentionally and strategically lowered underwriting standards. It defies all common sense to believe that there could exist a case of such widespread and simultaneous gross incompetence in lending. Rather it must be that these were acts of conscience and deliberate efforts to deceive, by producing more mortgage product than could otherwise be produced using safe and prudent lending practices. Mortgage lenders produced loans which they knew were not viable for the borrower or safe investments for any lender. They committed professional and ethical fraud in their transactions with the borrowers and legal fraud when selling the loans to investment banks and others. It also must be believed that lenders were all too aware of the growing cumulative ill effect of their fraudulent acts on the very collateral which secured the loans they issued.
The ability to pay is the essence of demand, for without financial ability no demand exists. Banks provide that ability to pay a seller by fronting the money. Demand for housing rose precipitously only because of the artificial stimulus generated by the rampant fraud in mortgage banking. And, yet, media analysts, either embarrassed by their own incompetence in not correctly calling the crisis or acting at the behest of the banks, and political spinsters, with their own agenda, wrongly incriminated others to suit themselves.
Many professionals and homeowners who simply performed as any market would have them do, became scapegoats to shift attention away from the banking industry, or to falsely castigate a political opponent. Prejudice and bias were unsparingly used to create a web of faux villains from builders, appraisers, home renovators, and home buyers, who were cast as speculators or too stupid, too poor, or too greedy.
Among the worst aspersions were those cast upon home builders, who in fact reacted to the market properly by increasing supply as demand rose. If the President or the head of the Federal Reserve Board had informed the country in 2003 that the increased demand in the housing market to come over the next few years was only temporary (phony) and therefore builders should not build anymore homes, then sure, blame the builders. But, that didn't happen. In other words, there wasn't Over Building; at the time the home supply wasn't even keeping up with the growth in ($) demand; evidenced by the precipitous rise in prices.
The case could be made that more houses should have been built given the increased demand. The problem was that demand (willingness and ability to pay) was being fraudulently manipulated to appear greater than, in fact, existed. When actual demand increases, increases in production are desirable responses, being the most fundamental inhibitors of increasing prices. It is the suppliers/producers who then invest, and risk, their capital to produce additional supply for the market. The housing industry has, for as long as anyone can remember, been among the most stable and safe business sectors in America, but the unprecedented and unforeseen actions of the mortgage banks poisoned the entire market leaving builders holding a tremendous debt load and bringing financial ruin to many.
Lenders (mortgage bankers) who participated in these underwriting scams, individually and severally, are guilty of tortiously interfering with the business prospects of builders, and possibly other businesses, who sustained economic damages as a direct result of the collapse in the housing market. Builders should have, either individually or in class action, sought recompense from culpable mortgage lenders through the civil courts, using common law provisions.
The seeming complexity of the whole event allowed vast amounts of red herrings to appear, political spin to go unchecked, victims to go unacknowledged and villains to slither away undetected. Virtually everyone in the media who makes their living observing, reporting, analyzing, advising and otherwise offering commentary upon the financial markets, everyone in government who had any role being responsible for regulating those markets, and virtually every top management official in the nation's mortgage and investment banks, were all guilty to some degree in abetting the cover-up.
It continued with books such as, "Our Lot" by Alyssa Katz, about which the author states:
I think the message of my book, unfortunately, is that it's to some degree everybody's fault, including, I should say, liberal activists, with whom I'm extremely sympathetic, and think were right.The book is a good presentation of evidence, but fails in its examination. It does not distinguish cause and effect and thus ultimately fails to identify the pivotal acts which were the genesis of the economic calamity. It is intellectually lazy or perhaps timid, foregoing any analysis of the process or identifying the roles played by each actor and the purpose of those roles, i.e. the formal function which each role has in maintaining the health of the housing market.
Any astute analysis would have keyed in on the mechanics of the whole process, identified the critical failure and thus where the professional responsibility rested, as would any good mechanic in looking for the 'source' of an engine break down. By generalizing with its blurred focus it conveniently avoids confrontation. The book's only virtue is its historical overview of our national failure to prevent the occurrences of real estate booms and busts.
The media's massive use of generalizations to assign culpability, whether from ignorance or self-interest, are not only wrongs themselves for the injustice rendered to the victims, but indicate that the fundamentals are not understood, or at least not acknowledged. The latter indicates that the badly needed changes to our financial checks and balances will not occur and abuse will follow in another generation, whereupon another book shall appear waxing over our historical failures to prevent such events.
To knowingly offer incentives that encourage wrong doing is reprehensible (yes, the investment banks), but when the wrong doing itself is executed by professionals charged with a specific role for which they are accountable and the wrong doing is a direct violation of that role, who do we hold ethically and legally responsible?
It was the Underwriter.
-RLee
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