Lonnie Glessner

Follow the Money

The first two parties in this Mortgage Mess have been the Federal Reserve and Wall Street. Today, I want to cover the third party involved in this mess and it is my own industry, the mortgage lending industry.

First and most importantly, many "leaders" of my industry have fought against the attempts to enforce ethics or licensing in my industry. They were seen as barriers to entry which were supposed to be bad. I have always considered them useful and very much needed. Personally, it's a bummer I have to take time off from work soon to take 40 hours of licensing classes and to take an exam; but I will do it for the greater "good".

Many mortgage "professionals" in the last 10 years have been anything but professional in my opinion. Most of them are in the business only for themselves and for how much money they can make on a borrower. Some of them have been "liars and cheaters" and have brought down our industry to the level of car salesmen.

Next, with no licensing or training in most cases, many mortgage brokers did not really know or understand what they were selling. Most of them did not realize that their clients could not afford these loans now or in the near future. Unfortunately, most mortgage brokers have no financial training or experience besides selling mortgages. These people are dangerous to their clients.

The most toxic mortgage of all has been the Option ARM that was pioneered by WAMU and World Savings Bank. I have met very few if any mortgage brokers besides myself who really knew how these loans worked and could explain that to their client. In my 10.5 years of experience I have never closed one of these loans because they have never made financial sense for my client.

But, many mortgage brokers only saw the FAT commission checks that came with these loans. In the summer of 2006 lenders and banks were offering us commissions as high as 6% of the loan amount or $18,000 on a $300,000 loan to close one of these loans, which were six times our normal commissions from a bank or lender. This is why these loans were sold to borrowers.

Second, a huge majority of mortgage brokers only offered their clients sub-prime loans even if those clients might qualify for a prime loan or a FHA loan. Why? Follow the money, big fat commission checks. This was a common strategy for home builders' lenders as well. FHA loans were more work and more headaches; but they were always a far better loan for the client. As we now know hundreds of thousands of sub-prime loans have imploded because they are bad loans for the clients.

Third, was fraud committed by mortgage brokers, borrowers, and occasionally appraisers and real estate agents too. Mortgage fraud is a huge white collar crime. Mortgage brokers have falsified borrowers' employment status, job history, income, assets, credit, home values, etc. to get their clients a loan. This fraud led to "artificial" home buyers which led to more demand and higher prices until the deck of cards was blown over when these buyers could not make their house payments.

Next week I will cover the final two parties to this Mess and the final party will take some time and it may surprise you as this party is getting no blame at all in the mainstream media right now.

Heads in the Sand

As I explained yesterday greed led to the devastation of lending standards that had been around for decades. Today I want to cover four more reasons that led to this HUGE Mortgage Mess.

First, after awhile no one on Wall Street truly knew what they were buying or providing the money for and the credit rating agencies like S & P, Moody's, Fitch's did not really know what they were insuring. Everyone thought that the mortgage lending standards of the past were not needed anymore and so old fashioned.

Plus, Fannie Mae and Freddie Mac were still backing a majority of these loans and it was assumed (wrongly now) that they knew what they were doing. But, Wall Street and the credit rating agencies thought if Fannie Mae and Freddie Mac are still willing to back these loans with their blessing everything must be ok.

However, greed had set in at Fannie Mae and Freddie Mac too. Plus, Fannie and Freddie were receiving huge amounts of pressure from another party to this mess that I will introduce you to later.

Earlier this decade throughout much of the country home prices soared as millions of more home buyers were now able to buy homes because lending standards had been thrown out every window and door in the building. At this time if could fog a mirror you could buy a home.

What happens when demand for a product soars? Prices soar and with time supply will increase to try to meet that demand. This is the first lesson in economics.

As demand increased and prices soared underwriting standards became even more lax. Why? Who cares if you have to foreclose later when home prices are rising 20% a year, you are protected. So they thought.

Third, the investment banks leveraged themselves to the hilt to make even more money because they thought it was impossible to lose money with this game. We have lots of protection they believed. Whereas commercial banks can only borrow $10 for every $1 in assets an investment bank could borrow $30 for every $1 dollar in assets. Thus, they loaded up on debt to make even more money.

Fourth, this led to Fannie Mae, Freddie Mac, some banks and insurance companies, and investment banks to become too big for us to allow them to fail. For example, AIG is a trillion dollar plus company with "tentacles" in nearly every other financial firm in the world.

Wall Street was the second major player in this debacle for a total of six different reasons that I have covered in my previous blog and this blog. Tomorrow, I will cover the third party to this Mortgage Mess.

As I covered previously the Federal Reserve kept interest rates at historical lows for 46 consecutive months and this combined with the Bear Market in stocks from early 2000 through October 2002 caused both individual and institutional investors to seek higher returns elsewhere.

They found them by buying Mortgage Backed Securities or MBS's. At first they just bought the cream of the crop with yields in the 5% range. Then GREED set in and 5% was not good enough anymore, they wanted 6%, then 7%, etc. But, to provide those higher rates of return the MBS's contained riskier loans.

However, a majority of these loans still had the backing of Fannie Mae or Freddie Mac and they were all still rated AAA by the credit rating agencies like S&P, Moody's, etc.

Everyone was making more money-institutional investors like mutual funds, hedge funds, pension funds, individual investors, Wall Street investment banks, commercial banks, the credit rating agencies, Fannie Mae and Freddie Mac. Everyone was fat and happy.

Unfortunately greed spiraled out of control by 2004 and all heck broke loose. All sanity was thrown to the wind. Mortgage lending standards basically went away. Let me give you some examples-

•· 95% No Documentation Loans where the lender does not know about the borrower's employment status, income status, or asset status.

•· 100% loans with a 540 fico score. I know that with a 585 fico score there is a 50% chance of a 60 day delinquency in the first year of a loan for that borrower. At 540 the chances have to be nearly 100%. I said at the time, "the bank should ask for a set of keys at closing knowing that they will be foreclosing in the near future."

•· 100% stated income loans with a 640 fico score where income is not verified or considered. Thus, you had Wal-Mart clerks making $90k on their loan applications and being approved.

•· Allowing borrowers to have "cash on hand", boarder income, or second jobs with no verification of the job or income. Thus, everyone now had a second job making good money every month.

So, who was to blame for the lack of underwriting standards? Nearly everyone. Out of greed, Wall Street investment banks kept creating new pools of MBS's with evermore risk and the credit rating agencies kept declaring that they were AAA rated, and Fannie Mae and Freddie Mac kept buying and backing these loans.

Trillions of dollars were being handed to banks and mortgage companies to make more and more loans with decreasing standards. You see banks and mortgage companies don't make the rules anymore; Fannie Mae and Freddie Mac do and so did the Wall Street investment banks.

Greed and lack of lending standards led to the next three reasons for this Mortgage Mess and I will cover this topic tomorrow.

Since July 2007 over 200 mortgage lenders and banks have gone under. Investment firms have declared bankruptcy or been sold at deep discounts. Two large and very public banks have been declared insolvent and one of them was sold for a penny on the Dollar. The nation's fourth largest bank, Wachovia, just avoided insolvency by selling itself to Citigroup for a small fraction of its one-time worth. Homeowners have lost over a trillion dollars in home equity. What is going on? We are living in historic times.

What has caused the financial calamity that our country and our world now faces? I came up with over 20 reasons for this mess and I believe there are five major parties at fault to this calamity. The first party is...

The Federal Reserve-

On May 16^th, 2000 the Fed raised the Fed Funds Rate by ½% to 6.50% where it stood until January 4, 2001 when they dropped this key rate by ½%. By the end of 2001 the Fed Funds Rate was down to 1.75%, a drop of nearly 5% in one year!

On November 16, 2002 the Fed lowered this rate by ½% to 1.25%. In 2003 on June 25^th they lowered the rate to 1% where it stayed for one year, until the Fed raised the Fed Funds Rate to 1.25% on June 30, 2004. By the end of 2004 the rate was 2.25%.

The Fed Funds Rate was at 3% or lower for 46 consecutive months from September 17, 2001 until June 30, 2005. The Fed Funds Rate had never been below 3% in its previous 30 years! Yes, the Fed was forced to act drastically by cutting rates after 9/11; but they kept rates too low for too long it appears in hindsight.

Let's look at the broadest measure of the U.S. stock market, the S&P 500. It opened trading in 2000 at 1469 and closed the year at 1320, down about 10%. In 2001 it ended at 1148, down another 13%. On October 9, 2002 the Bear Market reached its bottom at 768 and the S&P finished the year at 879.

In June 2003 when the Fed lowered its rate to 1% the S&P finished that month at 974, an increase of 27% from its low in October 2002. The Bear Market was now clearly in the rearview mirror; yet the Fed lowered rates again and they kept the Fed Funds Rate at 1% for 12 months until June 2004, when the S&P was now at 1140 an increase of 48% from October 2002.

What were the benefits or repercussions of these super low interest rates? First, both individuals and businesses borrowed more money as money was super cheap. Second, in tandem with the Bear Market from 2000-2002 investors, both individuals and institutions were demanding higher rates of return.

You see you can't run a pension fund with huge obligations every month on 1% or 2% returns that were possible in bank CDs or Treasury securities at this time. Thus, pension funds and mutual funds had hundreds of billions to invest where higher rates of return were possible; but they needed a new investment vehicle.

Guess what they found? Mortgage backed securities or MBS's which provided an additional return of 1.50% to 2% over and above Treasury bills and bonds. Plus, these MBS's were AAA rated by the rating agencies and some of them had the government's implicit guarantee or backing on them. This was the perfect prescription for them!

But, it led to ... I will lay out the second reason for this Mess soon.