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Buying a house is the biggest purchase most will ever make. Normally, people do not have enough cash to pay for the purchase, so they get a mortgage loan to complete the purchase. After the sale, the buyer has legal title to the property. However, if the buyer defaults on paying the loan off, the lender can sell the property to recover the amount owed.

Before our Great Depression, the typical mortgage required a 50 percent down payment with the balance financed over five years. Last year, I was in Switzerland and stayed at a rustic lodge. I asked the lady who operated the lodge why she did not buy it. She said that in Switzerland, you must make a down payment of at least 25 percent. This causes real estate prices to be relatively steady–no significant booms or busts.

During the Great Depression, President Roosevelt wanted to stimulate the economy and make home ownership more affordable for people. The Federal Housing Administration (FHA) was created in 1934 to insure lenders against losses on mortgages. FHA developed the 30-year, fixed rate loan program to provide lower monthly house payments. The program was so successful that many lenders did not have enough money to meet the demand for mortgage loans. To increase the money available for mortgages and standardize lending practices, the Federal National Mortgage Association (FNMA) was created in 1938. (Many call it Fannie Mae.) It buys FHA-insured mortgages and resells them as mortgage-backed securities (MBS) in the financial markets. With FNMA as the primary buyer of mortgages, fair and consistent loan terms, interest rates and underwriting guidelines were created and enforced. A borrower was expected to have adequate income and make a meaningful down payment.

Subprime Mortgages
Now let’s fast forward to the current period. Following the crash of the technology bubble, the Federal Reserve lowered its discount rate in January 2001 to 6 percent and continued dropping rates until they reached 1 percent in June 2003. This caused mortgage loan rates to drop sharply, creating a huge stimulus for the housing market. Another stimulus to the housing market occurred when Wall Street created credit default swaps (CDS). These are guarantees against default provided by hedge funds, investment banks and others. The risk-averse pension plans were now willing to buy subprime mortgage-backed securities.

For a while, everyone was making lots of money–homebuilders, suppliers, mortgage companies, real estate agents, appraisers, inspectors, lawyers, interior decorators, Wall Street, guarantors of the MBS and others. When a homeowner could not make his house payments, the momentum of low interest rates continued to push housing prices higher, thus reducing the default losses.

To keep this money machine going, mortgage loans were now available to low-income and bad credit homebuyers. Low teaser rates for two or three years, followed by a floating rate for another 27 to 28 years helped to attract more buyers. A graduate student with $20,000 of annual income got a $600,000 mortgage and a migrant laborer earning $600 a week borrowed $720,000.

This mania attracted some unethical and illegal behavior. Loans were made with limited documentation and limited verification. For example, if a loan requires annual income of $100,000, the borrower would claim whatever is needed to meet the loan requirements. Some would buy houses well above the asking price by paying his friendly appraiser to inflate the house’s fair value. At closing, the crook pays the seller his asking price and pockets the inflated value. The mortgage may be paid for a month or two while the sham is repeated several times before he skips town. FNMA, FHA and other traditional lenders were crowded out of the market by the more aggressive players on Wall Street.

Substandard Regulators
Even the venerable Alan Greenspan got it wrong in 2005 when he said, “These improvements have led to rapid growth in subprime mortgage lending … fostering constructive innovation that is both responsive to market demand and beneficial to consumers.” Wall Street is too smart to expect adequate returns by lending to low-income and bad credit borrowers over a 30-year period. Instead, Wall Street sold subprime mortgages to the public. In hindsight, before the crash, where were the Federal Reserve, SEC and other regulators?

Conclusion
We need reasonable and sound mortgage lending regulations, including a required meaningful down payment. This would encourage our citizens to become significant net savers. Our economy’s growth and reputation is harmed when we have significant booms and busts in subprime mortgages and in our financial markets.

Next month: Brokers and Fiduciaries.




October 2007

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