The economic mess we’re in right now was caused primarily by the sub-prime mortgage market collapse. In his TV special “House of Cards” David Faber gave a detailed 2 hour expose’ on what happened and why. Below is a look at each level of the scheme that brought us to this crisis. What seems clear is a lack of responsibility and common sense at each level. What also seems apparent is that greed is very powerful and can have malignant consequences.

PROSPECTIVE HOMEOWNERS (the Borrowers):
It started in California. After 2001 just about anyone could get a mortgage and buy a home. It then spread across the country. It was like a “yellow brick road” to the American Dream. Many who never thought they could participate suddenly had a shot at the Dream. They could get a mortgage with insufficient income, high debt and even bad credit. Looking back some would say that as long as you could “fog a mirror” you could qualify for a mortgage, buy a home, and enjoy the American Dream. Many mortgages required no verification of income or assets. Even buyers with no credit, or bad credit, had no problem getting a mortgage.

Being offered a mortgage you can not really afford, but being told you could refinance it in a year or two, and then make a bundle because housing prices were skyrocketing, was the sales pitch. It seemed too good to be true, and too good to pass up. On both counts, it was.

MORTGAGE ORIGINATORS:
The companies that meet face to face with home buyer and prepare the mortgage applications are called originators. Originators of mortgage loans are paid a fee that is a percentage of the loan amount, for each loan they process. Due to the huge increase in mortgage applications after 2001, loan origination companies were scurrying to hire new employees – many who received little or no training. More disturbingly, there was essentially no registration or licensing requirements in most states for the loan origination industry.

From 2001 to 2005 there was a “housing bubble” in many parts of the country. This occurs when home prices rapidly and dramatically increase in price, usually because of low interest rates, relaxed lending standards and speculation fever, about “flipping” i.e buying a house and then selling it at a significant profit a short time later.

When the mortgage market took off due to the housing bubble, even former pizza delivery persons could get a job working for a mortgage originator, and go from making minimum wage plus tips, to $20K or more a month as a “loan officer.”

The downside risk to the originators of the risky, sub-prime mortgages was minimal. The originators were paid a healthy origination fee on each mortgage they generated. There was no penalty for generating risky loans, even if they were based on mortgage applications that contained inaccurate statements about the borrower’s qualifications and ability to pay. The originators bundled large groups of mortgages together, some good and some bad. They then sold these bundles, passing off the risk of the sub-prime loans. The amount of money that mortgage originators made in this scheme was staggering.

As long as housing prices continued to rise there was no apparent downside to home buyer & borrowers. And, they faced no real consequences for submitting less than completely accurate information in their application for a mortgage.

“No document” or “minimal document” loans were often generated by the originators and even encouraged. Such mortgages produced profitable fees for originators, but received little to no scrutiny as to whether they were good or risky loans. These kind of loans grew to become routine with many mortgage originators. Over time, mortgages issued without documentation to confirm the borrower’s income, assets, debts and creditworthiness became common place.

WALL STREET - A Substitute for Freddie Mac and Fannie Mac
When Freddie Mac and Fannie Mac “passed” on buying up some of the sub-prime mortgage bundles offered by the originators, Wall Street firms were happy to step in and buy the mortgage bundles. Wall Street repackaged them as mortgage-backed securities and later more complex financial instruments such as CDO’s (collateralized debt obligations). If one firm on Wall Street hesitated to buy an originator’s bundle of mortgages, the next Wall Street firm would be happy to buy them. The competition for these bundles of mortgages, which Wall Street could resell as so-called “investment grade” securities for large profits, increased dramatically. Soon it seemed no bundle of sub-prime mortgages was too risky to float. There was just too much money to be made in the process.

At the same time there was essentially no government scrutiny of these new securities. There were no specific limitations or regulations on what Wall Street’s investment banking houses could do with these mortgages. Nor was there meaningful oversight by the SEC or other federal regulatory agencies.
This, and the massive profits made in selling these mortgage backed securities led to an ever increasing demand by Wall Street for more mortgage bundles. They could make billions repackaging and reselling these mortgages as securities.

Wall Street firms sold these repackaged mortgages around the world – to individual investors, institutional investors, cities and governments – as “investment grade” securities. Investment grade securities are considered the least risky of all investments. They are given a “rating” which runs from the “AAA”, the highest rating, to “BBB” the lower end of “investment grade.” For example, Faber’s special told the story of a small city in Norway that invested millions in CDO’s purchased through a highly regarded London brokerage firm. They were told that their investment was rated “AAA” by well known and reliable rating firms. The city had no reason to know, or even suspect, that their investment was risky. They relied on the ratings and the reputation of the London and Wall Street firms that were selling these instruments as “investment grade” securities.

FREDDIE & FANNIE REJOIN THE PROCESS:
Fannie Mac and Freddie Mac are the largest mortgage lending companies in the world. After a while they saw that billions were being made by Wall Street firms selling the sub-prime mortgages as investment grade securities. They decided they were missing out. So, they rejoined the process and also started buying up sub-prime mortgage bundles to resell as mortgage backed securities. This further increased the demand for bundles of new mortgages. It also increased the competition among buyers of these mortgages (like Freddie, Fannie and Wall Street firms) to acquire more and more new mortgage bundles. The result was an ever rising demand on an already frenzied market hungry to buy up and sell sub-prime mortgage bundles. The high demand drove originators to be more aggressive in making mortgage loans, and even less selective in the quality of the loans they made and bundled.

THE ENABLERS? – Investment Rating Firms:
This process, or scheme, probably worked because of the investment ratings given to the mortgage backed securities sold on Wall Street. The reason they were “selling like hot cakes” was because they were rated by S&P’s, Moody’s, Best and other rating agencies as “Investment Grade” securities. If the true risk of these securities was accurately represented in their ratings, it is doubtful that these “toxic” investments would have spread so quickly and pervasively to investors around the world.

Obviously, these new securities were not “investment grade.” Some former employees of the rating firms appeared on Farber’s “House of Cards” broadcast and admitted that their firms this was the case. The problem was that if one rating firm would not give the desired rating, the Wall Street client would just take its securities offering to another rating firm, who would give the needed stamp of approval. The competition among rating firms, and the attractive fees associated with the rating process, resulted in rating firms, in the view of some observers, “selling their souls.” They invented complex, mathematic formulas to try to intellectually justify the “investment grade” ratings given to these securities. This made the ratings appear to be based on rational and reliable analysis. With an “investment grade” rating from a well known and respected rating firm, Wall Street was able to sell these new and risky securities as fast as they could offer them.

This process worked smoothly and went essentially unnoticed for years. This was primarily due to two factors, i.e. the “Housing Bubble” and the time delay before the number of sub-prime mortgage defaults inevitably went ballistic.

The “Housing Bubble” resulted in residential homes increasing in value faster than ever before in our country’s history. Home prices were increasing in some locales by double digit percentages in the course of a single year. While this was happening homeowner with sub-prime mortgage, that they really could not afford, had a safety net. They could simply re-finance, probably get a lower monthly payment, and even put some extra cash in their pocket from the refinance. With the extra cash the homeowner could buy (or pay off) a car, pay off their credit cards or contract for an addition or other improvements to their home. This greatly stimulated the consumer economy, giving it the appearance of being strong and bustling.

What’s wrong with this picture? One of the problems was that the Wall Street firms relied on a big assumption. Their whole scheme assumed that housing prices in the USA would continue to rise annually at a rate of 6% or more – indefinitely. This estimate was without precedent, irrational and unreasonable, according to economists and students of history. We’ve all heard the saying that “what goes up, must come down.”

With mortgage backed securities, and then CDOs, comprised of thousands of loans that borrowers could not afford to pay, it was just a matter of time before loan defaults and foreclosures started. Once the defaults started, they snowballed, and foreclosure rates soared. This eventually caused housing prices to decline dramatically. By 2007 there was an over-supply of homes for sale on the market. These homes were only being sold at distressed-sale prices. So, the “housing bubble” burst. With that, the ability of a borrower to avoid disaster by refinancing a sub-prime mortgage they could not really afford evaporated. Borrowers found themselves stuck with mortgages they could not afford to pay. Even worse, they now found that their mortgage was “upside down,” that is, the amount of their mortgage was more than the value of their house. This drove many homeowners to walk away from their mortgages, with the inevitable increase in defaults and foreclosures. With more foreclosed homes on the market at distressed prices a downward spiral in housing prices followed. What began as a modest snowball rolling down the hill turned into a massive avalanche.

The GOVERNMENT
What was the government’s role in all this? Some might call it encouraging “free enterprise.” Others might say the government was “asleep at the wheel.” What its called probably has more to do with one’s political views than reality and common sense. What is not debatable, however, is that the U.S. government stood on the sidelines and did nothing.

Federal Reserve Chairman Alan Greenspan admitted to Faber that his monetary policies probably supported and encouraged the sub-prime mortgage process. His goal of promoting economic growth focused on keeping interest rates low and employment up. He had no desire to pursue monetary policies that would stop the sub-prime mortgage scheme because doing so would necessarily cause a dramatic increase in interest rates, which would depress general business activity. Such action would also cause unemployment to skyrocket, up to perhaps 10%, or more. Even if he saw it coming, Chairman Greenspan simply could not stop the process without being blamed for sabotaging the U.S. economy. Interestingly, Greenspan even admitted to David Farber that he, with all his economic genius, did not fully understand the complex CDO instruments Wall Street was selling to investors.

MY VIEW:
The sub-prime mortgage mess makes it clear that whether you like government or not, there is a place for it, and for regulation. Otherwise, greed and a policy of “anything goes in business” eventually will get out of control. Here, trusted and well respected businesses and institutions charged down paths capable of destroying whole economies, and possibly the financial stability of the entire World.

Some might say these titans of business, these pillars of our society in their grand financial institutions, would never do that – they have more ethics and responsibility than most of us Americans.

Others might say, if you stand to make a bonus of $160 million in one year, and there are no regulations or laws specifying that what you’re doing is illegal or wrong, you can rationalize doing just about anything – no matter how irresponsible it is; and no matter how much damage it causes.

Gary Craw