Part One provided the pieces that drove the housing boom. Now we will see how they all came together. There were abuses pushing the envelope, by seemingly all involved.
THE BUYERS
First up were the home buyers, wanting to take advantage of the home price boom. What many buyers amazingly chose not to realize, was that they were dealing with the biggest financial transaction of their lives. In far too many cases, the main issue was how much of a home could one afford based only on the monthly payment on the mortgage. That was why adjustable rate loans with initial “teaser” rates (much like the 0% rate on credit cards for an initial period) were wildly popular. The fact that the loan was most likely adjustable after two years (and would affect the payment) was not considered important. There were also the “flippers”, investors who bought homes to fix them up, to sell at a profit soon after.
This 2005 blog post from Calculated Risk described the time pretty well.
“In this LA Times article “They’re In — but Not Home Free”, the writer describes a woman that is “able to afford, barely, her first home”. She has taken out “an adjustable-rate mortgage that won’t require her to pay any principal for three years”. She is already strapped, working overtime to pay her bills, and doesn’t know what she will do in three years. She is a gambling that either her income will increase or that the value of her home will rise enough to sell at a profit.”
“Californians are adopting a “buy now, pay later” strategy on a massive scale. The boom in interest-only loans — nearly half the state’s home buyers used them last year, up from virtually none in 2001— is the engine behind California’s surging home prices.”
“A recent report by the National Association of Realtors (NAR) reported that 23% of all homes nationwide were bought by investors. Another 13% of homes were purchased as second homes.”
Investopedia gives a great description of the role of buyers. The main points were:
“1) A lack of financial literacy and excessive risk-taking by mortgage borrowers.
2) Speculative and risky behavior by home buyers and property investors fueled by unrealistic and unsustainable home price appreciation estimates.
3) The short-term relationship between a mortgage broker and a borrower under which borrowers are sometimes encouraged to take excessive risks.
Following the dotcom bubble, values in real estate began to creep up, fueling a rise in homeownership among speculative buyers, investors, and other consumers. Low interest rates, relaxed lending standards—including extremely low down payment requirements—allowed people who would otherwise never have been able to purchase a home to become homeowners. This drove home prices up even more.
Too many home buyers use only recent price performance as benchmarks for what they expect over the next several years. Based on their unrealistic estimates, they take excessive risks. This excessive risk-taking is usually associated with the choice of a mortgage, and the size or cost of the home the consumer purchases.
There are several mortgage products that are heavily marketed to consumers and designed to be relatively short-term loans. Borrowers choose these mortgages based on the expectation they will be able to refinance out of that mortgage within a certain number of years, and they will be able to do so because of the equity they will have in their homes at that point.”
A Propublica piece from April of 2012 outlines very well many unsavory aspects to what happened, detailing the story of Sheila Ramos:
“Every step of the way, from her first subprime loan to foreclosure, her downfall was abetted by a mortgage industry so profit-driven and disconnected from homeowners that the common interests once linking lender and borrower have been severed. The lending arms of the nation’s largest financial institutions helped plunge the country into crisis through their abuses and blunders, and they responded to that crisis with still more abuses and blunders — this time in how they handled people facing foreclosure.”
Ms. Ramos owned her $200,000 Florida home, free and clear. She decided to take out a mortgage for $90,000 to start a business. Months later, in June of 2005, injuries from a car accident drastically affected her business, and she struggled for ways to pay off the loan. That was when she saw an ad from Equity Trust Mortgage that said “REFINANCE NOW, LOW RATES” and promising, “Aggressive Programs: Fast Approvals, Fast Closings. Programs from good to poor credit. Non-income OK, limited credit OK.” She contacted them and got a loan.
In December 2006 she refinanced again, since her home was now appraised at $400,000. The new loan was also an adjustable rate mortgage, and her initial monthly payment was nearly triple that of her first mortgage. The loan was made by a nationwide subprime lender called Mortgage Lenders Network USA.
By February 2007, it had declared bankruptcy. Before it collapsed, Mortgage Lenders Network sold Ramos’ loan to Wall Street. The buyer was Merrill Lynch, which bundled it with 6,282 other mortgages totaling $1.4 billion and packaged them into a security, the “Merrill Lynch Mortgage Investors Trust, 2007-MLN1.” Investors were invited to buy different classes, or “tranches”, of the security, arranged from least to most risk. Most of the mortgage loans, like Ramos’, had been made to borrowers with poor credit histories. Nevertheless, the credit-rating agencies Moody’s and Standard & Poor’s gave AAA ratings to the security’s safest classes, meaning they were supposedly investments of the highest quality, with minimal credit risk.
The “offering document” for that MBS – 326 pages – came with warnings about the recent rise in delinquencies, and that the rates on the loans could jump after 2 years. Also, a decline in housing prices could make it impossible for borrowers to sell their homes or refinance, trapping them in foreclosure. And that most of the loans went to people with poor credit. But it also asserted that the loans in the pool had been made according to reliable underwriting guidelines, meaning the borrowers’ history, assets and income had been carefully reviewed by Mortgage Lenders Network. “The consumer’s ability to pay is of primary importance when evaluating applications,” it said. Still, Merrill Lynch could not “provide any assurance that MLN had followed the stated guidelines with respect to the origination of any of the Mortgage Loans.” Just as home buyers were only concerned with the initial monthly payment they could afford, investors buying these MBS only cared that they had a AAA rating.
In the crisis’ aftermath, it is not surprising that many firms selling these types of securities were sued by institutional investors. In a federal lawsuit filed in September 2011 against Merrill Lynch, the federal agency overseeing Fannie and Freddie claimed the companies were swindled when they purchased the pool that included Ramos’ loan (and 87 other securities sold from 2005-07). Merrill has denied wrongdoing. As in dozens of other cases filed in recent years by investors in subprime securities, the suit argues that the mortgages were worse than the offering documents represented them to be, leading to large losses.
According to the complaint, the appraisers, working with lenders and brokers, inflated the value of homes. In the case of Ramos’ pool, the suit claims that more than a quarter of the loans exceeded the value of the homes, while the offering had said that none did. The offering also misrepresented the number of properties that were actually investments for flipping, not primary residences, the suit says. Those are seen as riskier loans because the borrower is likelier to abandon the property.
Then there’s the issue of how much money the borrowers were making. While subprime loans were by definition given to people with poor credit histories, those borrowers were supposed to have sufficient income to make their payments. But the suit charges that many didn’t. Lenders and brokers often failed to verify the borrower’s income or just made it up.
Mortgage brokers were the ground troops for the subprime boom. Not only did they steer a borrower to a certain lender, they typically prepared the paperwork for the loan. They often claimed to be acting in the best interests of the borrower, but they had a financial incentive to steer their customers to more expensive loans. Their compensation was often tied to the interest rate: the higher the interest rate, the more they were paid. And they had no long-term stake in the loan: “For brokers, compensation generally came as up-front fees,” states the FCIC report. “So the loan’s performance mattered little.”
Ramos says she clearly explained her situation to her mortgage broker Stan Petersen, who had the opportunity to verify her meager earnings. The mortgage file, reviewed by ProPublica, includes an authorization form allowing Petersen to examine Ramos’ bank statements and tax returns.
Fifteen months later, when she was facing foreclosure, Ramos began to investigate the facts of her loan. She requested her loan documentation from Petersen’s office, which provided it. She says she was shocked to find that her loan application listed her income as $6,500 per month. The application, reviewed by ProPublica, includes other inaccuracies. It lists her as actively self-employed, but her business had fallen apart by that point. It also states that she was not currently delinquent on any mortgage even though Petersen’s company, according to the loan file, had reviewed documentation showing that she was. She called Petersen, she says, and asked why he’d falsified her income. She recalls his answer: “‘Well, you got your loan, didn’t you?'”
The mortgages bundled into “Merrill Lynch Mortgage Investors Trust, 2007-MLN1” have not fared well. As of October 2011, about 40 percent of them had been foreclosed on. Another 21 percent of the borrowers are behind on their payments and facing foreclosure. Moody’s and S&P now rate the safest classes of the security — once judged as having “minimal” risk — as having “very high” risk. It’s a junk bond.
THE SERVICERS
Now we get to the really disturbing part of the story. Remember that for many decades, the bank that made the loan held onto it and collected the payments. In today’s system, that’s rare. Instead, the job of actually dealing with homeowners and collecting loan payments falls to mortgage servicers. Serving homeowners is decidedly not the mortgage-servicing industry’s focus. Servicers rarely have a stake in the loan itself. They are middlemen, collecting payments from homeowners, keeping a small cut and passing the bulk to investors. They make money keeping costs low. Hiring employees to speak to borrowers about avoiding foreclosure, for example, increases costs and diminishes profits. So, in general, servicers make money by providing as little service to homeowners as possible. During the housing boom, the industry underwent a dramatic consolidation. In 2004, the 10 largest servicers handled about a quarter of the country’s mortgages. By late 2008, the five largest handled about 60 percent. It was a high-volume, low-cost business that boiled down to processing payments, and interaction with the customer was minimal.
Once the housing market crashed, delinquent homeowners stopped sending their monthly checks, so instead of processing payments that had come in like clockwork, servicers suddenly had to take on the much more expensive tasks of making collection calls, considering the homeowner for some sort of modification or payment plan, and seeking foreclosure if the homeowner fell far enough behind. Servicers were unprepared. Their employees lacked sufficient training, and there were too few of them. They lacked proper equipment and relied on outdated computer systems. And there was little financial incentive to spend time working with customers.
Just as Ramos didn’t know that Merrill Lynch had bought her loan and then sold it to investors, she also didn’t know that Merrill Lynch had selected its own subsidiary, Wilshire, to collect her payments. In the offering documents for the security that included Ramos’ mortgage, Merrill Lynch assured investors that homeowners would be in good hands. Wilshire had ample experience with borrowers who were “experiencing financial difficulties.” Their employees were hands-on, prepared for “substantial personal interaction with the borrowers to encourage them to make their payments timely, to work with them on missed payments, and to structure individual solutions for delinquent borrowers.”
Typical for mortgage servicers, those phone calls would come from the company’s collections department. At the same time, homeowners would hear via letters and phone calls from Wilshire’s “loss mitigation” team, which was charged with deciding whether to foreclose or pursue a “viable workout opportunity.” The offering documents give little detail on how foreclosure might be avoided. However, the company said it would be quick in deciding to foreclose if necessary.
Ramos had taken out the loan because she was experiencing financial difficulties. But she was continually falling behind and catching up. She says she often thought she’d made a timely payment only to find that Wilshire considered it overdue. Late charges and other fees made her climb steeper. The company’s employees often called and pressed her to make her payments, but she says no one could clearly explain the reason for certain charges or what she needed to do to catch up. Her complaints echo those of consumer advocates and tens of thousands of borrowers who say servicers routinely lost documents, didn’t answer questions, kept homeowners on endless hold or transferred them to people who knew nothing about their situations. Indeed, servicer errors have often made bad situations worse, sometimes even pushing borrowers into foreclosure. The accounting problems have been exposed in bankruptcy proceedings, which can force servicers to disclose exactly how they handled loans.
Around this time, government began trying to find solutions like loan modification programs, which lowered the interest rate on the loan to keep homeowners from defaulting. This would mean smaller returns for investors of the mortgages, but a modification was preferable to foreclosure. Given plummeting home values, a modification would often save the investor money. It seemed like the ultimate win-win.
But even if a homeowner qualified for a modification, there was no requirement that the servicer offer one. In fact, there were no requirements at all for servicers. They earn their main revenue through a small fee for handling each loan, usually between .25 and .5 percent of the principal each year, depending on the type.
But here’s the key, servicers have another big income stream: penalty fees and foreclosure-related charges. If Ramos or other troubled homeowners could somehow scrape together the money to pay such fees, great. But the true genius of the servicer’s business model is that it didn’t matter whether borrowers could pay the fees. If a homeowner went bust and the house was sold through foreclosure, no problem. The securitization contracts ensured the servicer was first in line to collect. In simple terms, if Ramos kept paying, Wilshire made money. If she lost her home, Wilshire made money.
It was a virtually fail-safe income stream.
In 2008, Ocwen, a subprime servicer similar to Wilshire, received about 19 percent of its mortgage-servicing income from such fees. In fact, some servicing executives assured analysts that mounting delinquencies would actually help their companies. David Sambol, chief operating officer for Countrywide, then the country’s largest subprime lender and servicer, pitched this idea to stock analysts during a fall 2007 earnings call. His company, he claimed, would benefit from “greater fee income from items like late charges” and the company’s “counter-cyclical diversification strategy” of running businesses involved in foreclosing on homes, such as property inspection services. As more and more homeowners ran into trouble and then foreclosure, the servicer could count on more short-term income, not less. In 2010, the Federal Trade Commission sued Countrywide, accusing it of a widespread scheme to profit from delinquencies and foreclosures by hitting homeowners with bogus or marked-up charges. Countrywide settled the suit without admitting any wrongdoing. It agreed to stop overcharging borrowers and pay $108 million to consumers who’d been affected.
In 2008 Wilshire’s owner, Merrill Lynch, reacted to the downturn not by expanding but by freezing hiring at Wilshire. No new staff was added, and departing employees were replaced by temp workers, many of whom had scant experience in the mortgage industry. For Merrill, the logic was clear: The bubble had popped; investors were no longer willing to buy packages of subprime loans, so there would be few if any new loans for Wilshire to handle. So what if most of the old loans would now require far more time and effort? Wilshire would just have to make do with the staff it had.
In 2009, as part of a report on Wilshire’s servicing performance, the credit-rating agency Fitch analyzed how people in Ramos’ situation — subprime borrowers who were delinquent in early 2008 — had fared. A year later, only about 12 percent had either caught up on their payments or managed to pay off their loans (mostly through selling or refinancing). The rest — fully 88 percent — had already lost their homes, were in the foreclosure pipeline, or were still behind and likely destined for foreclosure.
Part 3 will get into the wacky world of high finance, and the mind-numbingly exotic products created out of the staid world of bond investing in mortgages, which was what almost literally brought down the capitalist system. These products were described years earlier by famed investor Warren Buffett as “financial weapons of mass destruction”.