Confessions Of A Subprime Underwriter

Everybody has a “bailout plan” these days.  I would like to briefly posit a few solutions of my own, with an eye on the root causes of the financial stress our system is in.

First, let’s examine the immediate and systemic problems that must be addressed.

Problem number one is a credit market that is not issuing credit.  Banks are unwilling to lend to one another because there is no confidence that anyone will be able to repay the loans, even in the very short run.  This problem must be addressed first.

Problem number two is a severe devaluation in mortgage backed securities and other fixed return securities and derivatives.  These devaluing securities owned by banks require the banks to acquire additional capital to maintain solvency and proper reserve ratios.  As they raise capital their stock gets diluted and their long term earnings come under pressure, causing their stock to drop and their ability to raise additional capital to fail.  Then comes the rating agency downgrade and a quick death.  This problem must be addressed second.

The third problem is market uncertainty.  Banks are being nationalized, the equity and derivative trading rules are being changed midstream, and Wall Street is justifiably worried that any actions they take might be invalidated or attacked by the government with no notice and in an arbitrary way.  This problem must be addressed third.

Then we come to the systemic problems that led to the collapse in the first place.  They are the destruction of our social nexus caused by uncontrolled and rapid globalization, the destruction of the value of the dollar, the destruction of real wages and the need to work (literally) four times as many hours to maintain a family’s standard of living, the decapitalization of our manufacturing and increasingly key service industries in favor of capitalization of foreign business, a shift to a service economy that is subject to wild volatility during times of stress (like right now), and a dependence upon foreign industry and raw materials for survival.

So, first we need to get the credit markets issuing credit again.  The Federal Reserve Bank has been unable, to this point, to stop this phenomenon from occurring, and in fact the credit market seizure is getting worse.  I am, in fact, beginning to wonder if the Fed (as Jim Cramer famously said) “knows nothing”, or if they are not complicit.  Assuming there is no conspiracy to help the big boys gobble up the little boys in the financial sector, Congress should conclude that the Federal Reserve is simply failing in its duty as lender of last resort.  Congress needs to immediately charter a United States Bank to issue short term credit and purchase high quality securities to assist banks in their day to day survival requirements.  The President must also invoke Executive Order 11110 and once again begin issuing United States notes, backed by precious metals, and begin an orderly phase out of the reliance upon the Federal Reserve Bank to maintain monetary policy stability.  The U.S. Bank should begin issuing credit at a “discount window”, and it should issue credit at 1% or lower.  The Fed is fiddling while Rome burns, and should have been cutting rates all this time, instead of signaling rate increases while banks are failing.  It is truly unbelievable how much confusion there is at the Fed about our economic condition and how to remedy it.

Our second problem is the devaluing of mortgage backed securities.  The first thing to understand here is that subprime mortgage bonds, in many traunches, are actually still performing better than FHA loans, yet because of the perceived iron clad insurance policy on FHA, there has not been as severe a devaluing of FHA backed debts.  Because the bond insurers now have credit ratings lower than the bonds they insure, the insurance on conventional mortgage bonds is worthless, which led to another round of credit market tightening and a prolonging of the uncertainty on Wall Street.  But the fact is, most of the traunches of conventional mortgage backed securities contain loans that would also qualify for FHA insurance, had they been FHA originated loans.  These traunches need to be quickly underwritten by FHA and insured.  Borrowers should be given a rate reduction on their loan and asked to pay a mortgage insurance premium.  The rate reduction will cancel out the mortgage premium so that their payment does not increase.  Additionally, a loan workout should be offered to delinquent borrowers which allows their rate to stay the same but their monthly payment to decrease: in other words, the term of their loan must be extended.  30 year loans should be reamortized as 40, 50, 60 year or even longer.  In this way the bank will still receive the same annual percentage rate, and the borrower gets relief from their high payment.  Loan payments in this workout should become fixed.

Of course, at the root of this problem is the loss of value in real estate.  In order to begin finding a bottom in real estate, three things must be accomplished: supply must be reduced relative to demand, credit must be available to buyers, and there must be employment available in the local market.  More on the employment problem later.  Credit must be made available to buyers by the now nationalized Fannie and Freddie with solid mortgage insurance from FHA.  Underwriting must be based on solid standards which were lacking previously, with less attention paid to credit score, and more attention paid to credit history, with less attention paid to gross income ratios, and more attention paid to disposable income and assets, and more scrutiny of valuation.  The value pushing appraisers and fraud pushing mortgage brokers have to be eliminated from the industry (and prosecuted if necessary).  As confidence returns in the mortgage backed security market, credit will become more available to borrowers on main street as well.  Finally, to solve the supply and demand problem in the housing market, local communities should begin purchasing blighted foreclosed homes owned by banks.  If an investor has not bought a home on a bank’s REO list after 90 days, the city should buy it… and tear it down.  The home should not be rebuilt for at least 5 years, and it should not sit in blighted condition in the neighborhood.  Federal money should be allocated for the program to assist communities that will need to issue bonds to begin the purchase program.  The cities will then have to tighten their belts, stop giving constant raises to underutilized city workers who are protected by public employees unions, and repay the Federal government and pay off their bonds.  Local participation is going to be necessary to clean up this housing glut.

To address this market uncertainty problem, Treasury Secretary Paulson will need to issue an apology of sorts.    He will have to come out and flat out renounce the practice of changing the rules at midstream.  Chris Cox over at SEC has to go and someone appointed that the markets will trust.  That person must then re-institute the “uptick rule” that prevents short selling in a falling stock market, but also begin to allow the practice of short selling itself, which plays an important role in the market.  The market is in a state of disarray at the moment because traders are afraid of their own government, and do not want to take on risk not knowing if the rules of the road are going to change 2 hours from now as Paulson and Cox fiddle with market regulations.  New and trusted leadership at SEC, and perhaps at Treasury, along with a return to known and trusted market regulations should quickly solve this problem and return buyers to Wall Street.  Truly, with the solutions above in place a bottom should be found rather quickly in stocks, and I suspect a violent market rally would likely occur as long term investors begin to see massively discounted stocks ripe for the picking.

Then we have to address the macro picture by realizing what happened to individual borrowers who are walking away from their homes.  Over the last 40 years, the share of GDP paid as wages has dropped dramatically as our labor market has been exposed to unfair and un-capitalized competition from abroad. We cannot expect American laborers to compete with foreigners that can live on $2 a day, and expect wages not to fall, or products to be offered so cheap that the difference is made up (especially understanding that marginal theory of value governs pricing, and that pricing is established over a longer run based on supply and demand… have we forgotten that fact?). Free trade agreements have caused massive unemployment in blue collar jobs, and now increasingly high paying white collar service jobs as well are being destroyed.  Even with our devalued dollar exports have not even begun to show signs of keeping up with imports, the imbalance of which amounts to a massive drag on GDP and in effect a national credit card to finance consumption.  We are doing as a nation what individuals have done with their family budgets: we are borrowing now to consume, and just as families are defaulting, eventually so will our nation.  Confidence in the United States as a solvent debtor is waning, and for good reason perhaps.

But the solution is simple.  We must return to what worked from July 4 1789 until roughly the early 1970’s.  We must begin to re-institute protection of our national free market economic system such that capital is invested in domestic workers and domestic firms.  We should begin to phase in tariff protection and phase out the income tax.  Every month for the next 40 months, Congress should impose an average 1% tariff increase until our trade deficit and Federal budget are balanced.  The tariff will protect workers who will be able to demand higher wages over time.  The tariff slowly phased in will not cause a dramatic increase in prices, except as pricing is used by international corporations as a punishment and political tool.  New firms will form domestically to take over for any lost foreign firms that are unwilling to pay the tariff for political reasons.  Our still devaluing dollar due to the increased money already injected into our system will prevent our exporters from being unduly injured, and increased consumer demand here will offset any losses.  Income tax reductions due to increased tariff receipts will also increase consumer demand and personal savings.  Prices should not expected to rise relative to wages, however.  It would be wise to remember that inflation was historically very low under our U.S. Bank and tariff system, and that massive inflation really began with the onset of the Federal Reserve system, and then fueled further by free trade agreements.  We must take the free trade at all cost ideology out and allow the legitimate criticisms of Riccardo and the like to be taught in our economics departments.  There is a need for a national free market system which preserves the benefits of specialization without the costs of foreign dumping, currency manipulation, under-capitalized low wage workers, open borders and the underground economy, and the like.  As the percentage of GDP paid to workers begins to increase again, the family balance sheet will begin to improve, and disposable income will begin to rise.  Consumer confidence will increase very quickly and businesses will invest their capital domestically.  As Adam Smith said, domestic capital investment for domestic consumption employs twice as much labor as foreign investment for domestic consumption, and it was indeed to this cause that the invisible hand led the entrepreneur in to best benefit his nation, as well as himself.

When we return to the first principles that made us great we can raise ourselves up from this crisis.  It would be wise now to review the writings of Henry Carey, Alexander Hamilton, Adam Smith, and so far as we define our free market economy as a national construct protected from foreign interference, we should look also to the Austrian economists like Von Mises and Hayek.

Respectfully submitted to benefit our free and independent nation,

The trouble at Fannie Mae and Freddie Mac this week reminded me of a story that I heard from a very reliable friend and coworker about Angelo Mozillo, the CEO and Founder of Countrywide.  The story goes that as Fannie and Freddie in the past were mired in accounting scandals and irregularities, Angelo would say that “If Fannie goes away, Countrywide is big enough and strong enough to step right in and make a secondary market for loans on our own.”

It’s likely that Mozillo had these thoughts for years, and it might be that very hubris which contributed to the decision to securitize riskier and riskier paper, and to do so with more and more leverage and less equity.

But to be fair, it certainly was not just Countrywide that was too highly leveraged and too liberal with credit standards.  The entire industry caught that same disease, and many died from it before Countrywide realized it had a cold.  For many smaller subprime wholesalers, the idea was to keep 60 to 90 days of operating expenses on the books liquid, and to lend and fund every penny of every credit line they could get their hands on.  The way money was spent by some of these wholesalers, sometimes I wonder if the executives didn’t know all along that the plane would run out of fuel, and that they would parachute out eventually.

I was chatting with a former account executive friend of mine today and I asked him the question, “would we have survived if we had kept standards up, cut out the NIV’s early, and tightened standards”?  His opinion was no way: he felt that any company that did that would have failed in the competitive marketplace, and that the rest of the industry would have brought them down anyway.  Indeed, this fatalistic opinion is very common in the industry, especially among salespeople.

But I do not share this view.  The question is layered risks.  If a wholesaler had offered only high LTV’s but maintained very strict credit quality and assets in reserves, their paper would likely still be performing.  Better yet, if a wholesaler in subprime had offered truly high quality NIV loans, but only up to 70% LTV, the housing price fallout would not have made them a casualty yet.  If a subprime wholesaler had sought more organic growth and less leveraged growth; a slower approach, they might still be in business.  And indeed, some subprime lenders ARE still surviving, and the internals of these firms should be looked at.  But in truth, most lenders took on all the risks at the same time.  They layered them up justifying each one as “necessary in a competitive marketplace”.

Apparently, even Fannie and Freddie are far too highly leveraged.  But alas, the taxpayer and consumer will bail them out and take on the penalty for their poor choices, either through inflation of the money supply, or a bailout, or both.

Ultimately, the banks, hedge funds, and lenders behaved just like their borrowers.  People were buying houses with no down payment, paying no costs, and sometimes taking cash out at closing.  At the same time, Wall Street was issuing loans and buying paper with little or no cash on the balance sheet, at least not nearly enough to weather a storm.  As borrowers whose jobs were shipped to China collapsed and dumped the house, Wall Street followed suit as hedge funds failed, lenders closed down, and now even big banks are failing.  The whole country has the same disease: addiction to credit and massive delusional hubris; all driven by the love of money.

Busy day today.

Now that S&P has downgraded ABK and MBI to a “AA” rating, 2 of the 3 big rating agencies have said that these big bond insurers are riskier investments than many of the the bonds they insure.

This does not bode well for mortgage backed securities, which S&P also said today are not improving much in the secondary market. Would you invest in these assets, after the way they have performed the last 12 months, when there is no meaningful insurance behind them?

Looking at this in the most basic way, following Occam’s razor so to speak, it appears to me that the credit crunch in mortgages is not slowing, and might be accelerating. If that is true, so will the slide in home prices continue or accelerate.

How will the Fed, now turning hawkish on inflation (for good reason!) deal with an accelerating financial crisis?

Perhaps this possibility is priced into markets, as the drop in the S&P on the news was shallow and short lived, but looking down the road, this cannot be good news. Expect increased market volatility going forward, and watch the dollar drop.

I’ve said it before and I’ll keep saying it, if we do not protect our market from cheap foreign products and sovereign wealth looting of our assets, there is no solution to this problem, and stagflation is coming.

Well, now Philly Fed President Plosser is signaling the same concerns about moral hazard that we heard from Kohn and Placker earlier, saying that “there needs to be clear rules for Fed intervention in markets”.

CNBC is reporting that banks have approached the Fed recently asking for the same type of sweetheart deal that Jamie Dimon and JPMorgan Chase got when they used Fed assistance to gobble up Bear Stearns.  The more things change, the more they stay the same it appears.

This financial crisis has taught us nothing, it appears.

The purpose of this blog was to get out there a very simple combination of principles: “the love of money is the root of all evil” and “be sure your sins will find you out”.  If you behave greedily, a price will be paid.

Our nation has behaved greedily for 40 years now, abandoning true attempts to balance our budget, balance our trade deficit, and fund our retirement system.  As a result, the baby boomers have no personal retirement savings, they expect generation X to pay two to four times as much in social security taxes to cover the gap (all the while their wages are being attacked by free trade globalization), and their organization: AARP, wants to INCREASE benefit payments.  And why?  The love of money: the belief that they can consume foreign made products and save a few pennies at Wal Mart, which has driven the destruction of wage rates, the loss of millions of jobs, and the utter failure of our government to balance budgets and maintain social security.

Disgusting.

Many homeowners are asking for bailouts of their loans, asking for adjustments in fully disclosed contracts from adjustable to fixed rates, and in many cases today they are completely able to make their payments: they are looking to make a quick buck.  It’s difficult now to distinguish between the legitimately strapped borrower who needs a hand and the greedy guy asking his neighbors to pay for his bad decisions.

Disgusting.

But perhaps worst of all are these big investment banks begging the Fed to help them takeover smaller companies.  They want to vacuum up their competition, and they want the Fed and the taxpayer to guarantee they don’t lose any money.

Disgusting.

I sincerely hope that the lesson learned from this crisis will be that the market needs to be allowed to operate without artificial interferences (be they foreign or domestic).  That bad decisions need to be allowed to result in bad consequences.  That more greed is not the answer to problems created by previous greed.  That the nanny-state cannot put a safety net under everyone.  That we are all responsible in one way or another and need to look in the mirror honestly.  That perhaps we should spend less time watching American Idol and more time planning for retirement and studying the philosophy of those we elect.  But it appears to me at this point that Gordon Gecko marches on, leading the charge on Wall Street, and perhaps on Main Street too.  Our experiment in Republican government is on a slow decline, and soon I fear it will be sold to the highest foreign bidder, and vanish.

Yes, it’s that serious.

Jeffrey Lacker, President of the Federal Reserve Bank in Richmond just made comments that are fairly rare; he is criticizing the Federal Reserve policies regarding intervention.  He is saying that the Fed should not get in the way of the market, and that intervention has caused imprudent risk taking.  CNBC is reporting on his comments right now.

It appears that the speculation of my previous post may be correct; the Fed might just be hinting that if another investment bank, or small and medium sized depository institutions fail, there might not be a bailout.  With the rumors running around Wall Street about Lehman Brothers, I can only wonder if these insiders have LEH in mind as they signal a return to moral hazard as a concern.

Admittedly, I’m reading between the lines here, and my speculation might not be correct.

But let’s start with the Fed’s Donald Kohn, and his comments that just hit the wire, as reported by Dow Jones Newswire.

“WASHINGTON (Dow Jones)–The banking industry’s challenges are far from over, according to Federal Reserve Vice Chairman Donald Kohn, who told U.S. lawmakers Thursday that banks are likely to continue reporting weak earnings and asset valuation writedowns in coming quarters.

 

That said, the Fed is urging the bank holding companies it supervises to continue to boost capital and prepare themselves for the possibility that liquidity conditions could tighten, Kohn said in prepared congressional testimony.

 

“Over the coming months, we expect banking institutions to continue to face deteriorating loan quality. House prices are still declining sharply in many localities and losses related to residential real estate - including loans to builders and developers - are bound to increase further,” he said. “Moreover, banking organizations must be prepared for the possibility that liquidity conditions become tighter if uncertainties in the capital markets fail to subside or if credit conditions deteriorate significantly.”

 

This kind of “uncertain outlook” means banks should boost capital injections and continue their consideration of dividend cuts, he said.”

The Fed’s credit facilities have been stretched, and there was a surprisingly high amount of political fallout to the bailout of Bear Stearns by the Fed (even for a country where Google searches for American Idol more than double those of Barack Obama, who most voters had never heard of a few months ago, but now support in the largest numbers).

Could it be that Kohn is telling banks they might just be on their own if their balance sheets  continue to decline.  Officials are warning about possible bank failures, and just as this story hit the newswire, news that the MBA is reporting that foreclosures are have reached 1979 levels came out.  In fact the mortgage crisis is not ending, probably because Hill and Obama have been promising to bail out borrowers who can demonstrate that they can’t make payments (an easy thing to demonstrate if you buy a jet ski and a new car, spend your stimulus check at Wal Mart, and pay the mortgage last or not at all expecting a bailout from the government, a phenomenon that is certainly giving strength to the crisis.  Otherwise able borrowers are now admitting that they are letting the mortgage go to waste because of the promised safety net of government help).

The ‘moral hazard’ is playing out and the Fed might be more concerned about it than they have previously let on (and perhaps for good reason based on the way some borrowers are now behaving; nobody is learning the lesson; greed is just being shifted to other areas).

It’s just speculation, but it could be that the smaller or medium sized players will be allowed to fail; the Fed might not be willing or able to bail out everyone.  Kohn might be signaling that today.

Let’s talk common sense for a moment.  You are thinking about investing in stock.  Would you want a quote that is current for the stock you are buying, or would you be willing to buy the stock at a price quoted 12 to 24 months ago?

Do you think perhaps the value of your stock might have changed in the last year or two?

Well, in the subprime mortgage market, underwriters were asked to approve loans (in essence, approving the bank’s investment) with housing data that could be 12 to 24 months old, occasionally even older.

The appraisal guidelines at First Franklin stated that the appraisal report must be dated no more than 120 days prior to disbursement, and could be updated during that 120 days to give the appraisal a total life of 6 months.  (the ‘update’ is an addendum from the appraiser, who is hired by the broker, that there has not been a fundamental change to the home or value since the original date of the appraisal and inspection).

So we have at this point a value that could be up to 6 months old for most transactions (and up to 12 months were allowed for new construction loans!) .

As for the appraisal itself the comparable sales which are the ‘meat’ of the report upon which value is justified, could be up to 12 months old as of the appraisal date.  So our 6 month old appraisal could have comparable sales up to 12 months old, giving us a grand total of 18 month old comparable sales, and up to 24 months old for new construction.

Does anyone see a problem here is a bearish real estate market?  Is it any surprise that when values started to drop, even a little, that loan losses on foreclosures went WAY up.

On top of the stretched values, on top of the occasional appraisal fraud, on top of the sloppy appraisal work, we have data that could be 18 months old.

When this type of situation would come up, the underwriter would often order a review appraisal, but that same review would routinely later get waived by management as a customer service to brokers that don’t want the transaction held up.   The argument from sales was always “the guidelines allow you to waive the review!  who are you to argue with the guidelines?  you are not here to nit-pick and second guess loans!  stop with the ‘common sense’  and ‘layered risk’ mumbo-jumbo and just approve what you are authorized to approve!”

So here is the lender in March 2006 for example, giving a borrower with a 580 credit score a loan for 100% of the value of his home (no down payment, and often 6% concession from the seller to pay closing costs), on an adjustable rate loan, up to 50% of his gross income in debt,  on a home value that is less certain than the weather in Cleveland tomorrow.

THIS is the type of paper that is now considered toxic, and it should not be a surprise.

So how did this happen?  In part, incremental guideline changes.  A tweak here, a tweak there, loosen up on this, raise the max LTV a little bit, and over time the guidelines are completely different, and so is the quality of the paper being sold.

Clearly a sense of long term vision and primary truths were lost in this process.  It is obvious to me that sub prime decision makers took for granted that the economy would always stay good (was it really ever good for the blue collar and lower income borrowers that made up the bread and butter of subprime?).  They also clearly took for granted the idea that real estate values would never drop.

It’s as though nobody ever read an economics text book, or they were unable to apply the maxims to real situations.  When the supply of labor is increasing, wages tend to decrease.  When the money supply is increasing, buying power tends to decrease.  When the supply of a product for sale increases, prices tend to decrease.  We have been systematically adding other nations to our economic ‘division of labor’ (aka free trade).  We have been systematically inflating our currency.  We had been in a real estate bubble for years. Will we learn the lesson that primary truths and first principles will eventually catch up and burst bubbles?

Straw Buyer: (definition) “a person used to serve as a cover for a questionable transaction.  The ‘buyer’ is compensated for his services and walks away from the loan.”

There were different types of straw buyers.  It could be an actual person with good credit and verifiable income; sometimes a family member of the actual buyer “trying to help”.  In more extreme cases the straw buyer is a phony identity, created by a scam artist.  A phony social security number, credit history, and identity are created.

The first case was fairly common.  The second case was not, but I’d like to give you a real life example of that extreme case to give my readers a sense of how insane it could get in subprime.

We receive a loan application from a mortgage broker that I did not recognize, and the AE is all fired up because the broker tells him there are dozens more loans coming; that he is hooked up with investors and Realtor contacts that will provide a steady stream of 4 to 10 purchase loans every month, all of which he wants to send to us.

The first four loans come in together and I remember some of the details because of how outrageous they actually were.  Needless to say, over the steadfast objections of the sales person, these loans were declined and nobody up the chain was willing to overturn them.

First, the borrower had about 15 aliases on his credit report and ‘identitypro’ scan (a third party tool we used to verify identity and weigh risk factors).   Secondly, the borrower’s signature on the loan application looks nothing like his signature on the purchase agreement; not even close.  Third, he spells his name wrong on the purchase contract.  Fourth, he has different job titles and employment histories on various versions of the loan application sent by the broker.  Fifth, he lives in California and he is buying four houses in the Cleveland Ohio area.  Sixth, the appraisals show that the purchase contract that the appraiser reviewed were for a much lower value than the contracts we saw; but the appraised value was somehow much higher; the exact figure on the purchase contracts supplied by the broker.  (how ironic).

Now, as you can imagine, I’m getting pretty suspicious.  Any one of these discrepancies alone could be explained away, and I had even begun to approve the loan with conditions (also called ’stips’ or ’stipulations’) for additional documentation to verify the identity and explain these issues.  But I smelled a rat and started to dig more than usual.  In fact every time I dug a little further, this deal began to smell more and more.

First I attempted to verify employment (something not typically done in underwriting, usually a processor would handle these details later).  What I got was a phone number on the application that didn’t work.  So I dug around on the internet to find a working phone number for the employer listed on the application.  I call them up and they do not know who the borrower is.  Giving the broker the benefit of the doubt, I call them to get a working number, thinking *maybe I called the wrong employer.  I get a number several hours later and call it: it’s a cell phone and the ‘gentleman’ on the other end answers the phone “Yo.  Who this?”  I explained who I was and why I was calling and I get the response: “oh, yeah… he work here.  I’m his boss”.  I just politely said thank you.

Now I KNOW the deal is bogus, but I also know how this would play out if I stopped digging: the sales person would put pressure on me to approve with conditions, brow beat the processor to waive or clear the conditions saying: “he didn’t spell his name right, it was a typo; you don’t need a copy of his social security card, stop slowing down the deal” and “get real, so what if the guy that verified employment sounded like a street thug; how do you KNOW it wasn’t legit?  The underwriter is being a prick, just get the deal done.”  And that deal would have gotten done.  If I had declined it at this point without digging further, I would have ended up explaining myself to the angry sales person who is convinced I have a vendetta against him, his boss, my boss, and eventually the branch manager.  Sales would never take ‘no’ for an answer (in most cases, but not true of every sales person) unless there was clear proof of fraud.  The burden of proof was unquestionably lifted off the broker and borrower and put on the underwriter; all loans were good loans until unequivocally proven otherwise; not the other way around like it should have been.

So I dig further.  I do a reverse look up on the borrower’s home phone: unlisted.  I do a reverse look up on his past business phone numbers; cell phones all.  I do a deed search on the home he supposedly owns: listed in a completely different name who will come up later in the discussion; a gentleman we’ll call “Terrance”.

So I went another step further; I wanted to tie this up.  I called the listing agent and selling agent.  I called the damn Realtors (who I hate talking to; generally they are the most self important and smug people on the planet, a condition that occurs from making big money for having a license and the ability to use the multiple listing service, without any other need for knowledge, skill, or professionalism; but this rant is a separate post).  I played dumb.  I get the listing agent on the phone and just ask about our appraiser getting access to the homes for a full review, and start a conversation where I can work into asking about the buyer without tipping my hand (knowing that if these Realtors are in on the scam, which they usually would be in this case, that they would be wary of these types of questions).  When I gain his trust a bit I ask about the ‘negotiations’ with the buyer, and he tells me that he didn’t attend the signing of the purchase offer (which is not unusual) and that I should call the buyer’s agent (who works in his office, of course).  So I did.

Now this buyer’s agent was not so clever, or was truly in the dark.  She loved to talk.  We talked about the business, we talked about the neighborhood, we talked about the damn tile in the bathroom and the leaky but not “too leaky” basement which I was not even aware of yet.  And then she talked about the transaction and the buyer.  It seems she had sold about 10 properties to this buyer, but had never actually met or even talked to him.  She had only spoken to “Terrance” on the phone: who explained to her that he is the buyer’s “business manager”.  Terrance, being the business manager for this ‘buyer’ would find the properties, use this Realtor to buy them, and do the entire transaction by fax and power of attorney.  These homes were not listed by the Realtors until a purchase offer was ready!  They had a market time of about 1 hour!  Of course the mortgage broker had not let us in on it yet, but they wanted to close with a power of attorney as well.  “Terrance” would be signing for our 30-something able bodied, hard working borrower.

When I asked the Realtor how it was possible that our borrower would not know how to spell his own name on the purchase agreement, and how his signature was completely different on the loan application than on other documents, the phone went dead.  For probably 20 seconds or more; silence.  Her response was telling.  “Well I don’t know, maybe Terrance signed some of them.  But I know these are legitimate deals, we’ve closed several already, and Terrance told me there are about 40 more homes he wants to buy in the next 30 days.”

40 more.

(pause for impact).

40 more.

This Realtor saw 40 commissions at 3% as a slam dunk.  She was probably shopping for a new Beamer that afternoon.  She just LOVED “Terrance”.  What a nice guy he is.  How easy it was to deal with him.  How she never met him either.  He was buying these homes from California sight unseen.  She never questioned it, or she was in on it, one or the other.

On this deal, I cut out the middle man.  I went directly to the branch manager, laid out this case and told him I didn’t want these deals.  He immediately agreed.

Went I returned to my cubicle in the underwriting beehive I had 2 messages.  The first was from the broker, who called me several four letter names for having the “audacity” to call a Realtor to verify information.  The second was from our AE, who wanted to know “why are you accusing my broker of fraud, and trying to kill our business with a broker that was going to bring in $1 million+ every month in deals?”  I hadn’t even contacted the broker again.  In fact, the only time I did talk to the broker was to get that employment phone number.

I didn’t take the bait; I referred the AE by email to our branch manager and sent out four declines.  I listed all sorts of reasons; unverifiable information, contradictory information, layered risk factors, excessive number of investment properties.

I honestly thought those loans would come back “restructured”, but they didn’t.  Eventually (and this was a rarity) the AE came to agree with my decision later, and cut off that broker.

I assume that those loans got approved somewhere else.  They always do.  After all, they had already done several, and this buyer wanted 40 more.

I wonder now where the scam was and how deep it went.  It could be that this “Terrance” was the only scammer; and the Realtors and mortgage broker were just negligent.  But it could have been the Realtors, and there may not have been a borrower OR a “Terrance”.  On the other hand, it could have been the mortgage broker or just the loan officer at that shop.  Or it could have been all or some of the above.  I truly don’t know.

I think that a lot of people do not realize that underwriting guidelines changed frequently in the sub prime arena.  Sub prime is a different animal than conforming lending, and changes came quickly.  There were several forces driving these changes, which I’ll comment on briefly below, but first I’d like to give you a sense of the frequency of these changes, and the impact these changes had.

The line in the industry regarding guideline changes was the same line about the weather in Cleveland; if you don’t like what you have right now, wait a few hours and it will be completely different.  This is an exaggeration of course, but guidelines were changing all the time.

First, understand that sub prime underwriting guidelines were not as simple as what the brokers saw: a product matrix and rate sheet.  The First Franklin Product Manual, which was not unusual in the industry, was several hundred pages in length.  In was beginning to resemble the tax codes near the end, because tweaks and changes were made all the time.

Roughly monthly in 2004, 2005 and 2006 there would be changes, with massive change coming at least quarterly.  By massive change, I mean fundamental alterations which would have a major effect on credit quality (either to improve it as things were unwinding, or to extend more credit during the boom cycle).  In 2007, the changes began to come even more quickly as the company struggled to improve credit quality without destroying volume (which became impossible due to the sheer panic on Wall Street by the middle of 2007).

These included changes to LTV/CLTV limits, product additions or eliminations (such as “rapid refi”, “rapid purchase”, “no doc”, “dividends loans”, “bank statement qualifications”, and others), appraisal review requirements and AVM / “express valuation” changes, asset requirements, and changes to the list of acceptable forms of documentation in all areas changed frequently.  These changes probably had the least impact on underwriters, believe it or not, because after underwriting 200 loans a month over and over, we knew our guidelines better than the backs of our hands.  But the changes definitely caused confusion for sales, processing, and the brokers; who had other considerations than simply internalizing guidelines (although there was a direct correlation between guideline knowledge and sales success).

These “small” changes could not possibly have been gamed out by actuaries; they were coming way too quickly.  In the bureaucracy that is a mortgage bank, it’s amazing to get anything done quickly, but guideline updates were an exception.

This tells me that there was a sense in upper management that these changes were “small” or that there was  a “let’s see what happens if we do this” attitude.  The guidelines were being written and tweaked by trial and error, in my view.  I remember conference calls where during the questions and answers portion there would be statements made to the effect of “after data on this latest change comes in, we’ll have a better sense of what impact this change will have on credit quality”.  Now, being fair, there is no way to expect the committee involved in guideline re-writing to be psychic.  Truly only time WILL tell what effect a given change would have on credit quality.  But what I never heard was a discussion of macro-economics.  It may very well be true that these were discussed: I was not on any guideline re-writing work group, but I never heard much discussion of macro-economics when new guidelines were presented or defended.  I never heard discussion about a possible housing bubble; or the effects on loan losses that would occur as home prices dropped.  I never heard discussion about job losses due to outsourcing, which I know drove a great deal of the defaults nationwide, and particularly in the mid-west.

Here’s what I DID hear, and thus I know that these were the driving considerations as guideline changes were made.

1) sales feedback.  It always came through that sales was driving guideline changes.  Feedback “from the field” was a prime consideration in guideline changes.  Sales wanted more products, less documentation, higher LTV/CLTV limits, lower credit score qualifications, and less scrutiny on valuation, among other things.

2) competitive research.  If another company was doing it, there was a good chance we would eventually do it; although I will add that First Franklin was often a leader in the industry and truly did always maintain better credit quality than several of its peers; which is a major reason FF survived as long as it did, and why there were so many bidders willing to pay such a high price for us in the third and fourth quarters of 2006.

3) secondary market.  Our investors (prior to our being acquired by one of them: Merrill Lynch) had a major impact on our credit standards.  They even appear to have had a seat in the discussions, at least informally.  Certain products and changes that sales wanted just would not fly with our investors, but at other times it was clear that if our investors WOULD buy loans with certain changes; that alone would justify making the changes.

Clearly, the demand for these securities was enormous on Wall Street; driven by two things: loose monetary policy at the Fed, our enormous Federal budget deficit, and poorly negotiated trade agreements that resulted in enormous quantities of dollars being held by foreign corporations and investors, which created an insatiable demand for dollar based fixed income securities.

My view is that our guideline writing policies were too myopic; focused on sales concerns instead of longterm credit quality.  Secondly, the decline of sub prime lending was due in no small part to the overemphasis of short term considerations of investors (Merrill, Lehman and Goldman, all buyers of FF paper, for example, attempting to keep up with each other in securitizations to meet earnings estimates each quarter) instead of a long term focus.

FHA reform is being “debated” in the House of Representatives.  Even though the private sector managed risk better than FHA (where default rates are higher than in subprime, and rising), the House is prepared to increase FHA’s mandate and allow more loans to be made to borrowers currently in foreclosure.   If that isn’t scary enough, the “debate” is currently centered not on the cost to taxpayers, not on credit quality, not on the role of limited government in a market economic system, not on our budget deficits and the need to keep government lean; no, the debate is on whether or not the taxpayers should pay for the legal fees of the borrowers in foreclosure.

Can someone give me ONE REASON that ANY AMERICAN should continue paying their mortgage?  The election year Congress is falling all over itself to reward you for not paying your bills.

It’s a sad and vicious cycle; the market system got excessive because of greed at every level, which we’ve discussed in this blog.  And the solution to the excesses of Wall Street is excess in Washington DC.  We turn to socialism, further disrupting the market, to solve the problems of excesses in the market.  This FHA “reform” is doomed to fail before it begins; it’s rooted in a flawed principle: that government can manage markets better than the private sector.  The taxpayer cost is going to be enormous.

The question I have is this: when these borrowers don’t pay off their FHA mortgage; will they sue FHA for predatory lending?  Will they picket on K-Street instead of Madison Avenue?  Will they claim that FHA took advantage of them too?