A Nation of Moochers (19 page)

Chapter 10

MORTGAGE MADNESS

The greatest bailout in history began when the financial world realized that betting trillions of dollars on unaffordable mortgages was a bad idea.

Any account of the housing market before the deluge is necessarily a story of near madness: of ever-increasing risk and financial blindness and recklessness, mixed into a toxic stew of greed and arrogance. The early years of the twenty-first century saw a public-private partnership of financial irresponsibility.

Behind the massive housing collapse was the idea that everyone has a right to a house or at least that it would be a public good if housing was widely distributed to groups and individuals who would normally not be able to afford their own home. This was what was meant by “affordability”: that the path to home ownership should be eased for people who had no or almost no down payment; that mortgages should be made available to people with shaky credit histories; and that people should be encouraged to buy homes more expensive than their incomes would suggest they could afford. The mechanisms of affordability were many: subprime mortgages; adjustable rate mortgages (ARMs); interest-only mortgages; guarantees by taxpayer-backed Fannie Mae and Freddie Mac for loans with loosened credit standards. If that wasn’t sufficient, there were so-called liar loans, and even the classic NINJA mortgage: no income, no job, no assets.

As the bubble grew, the home mortgage itself was turned on its head, transformed from a stable long-term investment and token of financial prudence and planning into a short-term casino game. Where traditional mortgage standards placed a premium on personal responsibility and financial probity, the new rules rewarded fecklessness and encouraged cutting corners.

No down payment? No problem. Not enough income to service the loan? Easily handled with ARMs and interest-only loans. Lousy credit score … just sign here. You need to own this house and we need to make it affordable!

All of that took a wrecking ball to the culture of deferral of gratification, of saving, investing, and working to be able to acquire a house as a visible symbol of responsibility. By short-circuiting the process with a rush to spread the housing wealth, politicians and investors alike ignored warning signs, fought off reform attempts, and pushed further into the murkiest waters of high-risk lending.

The result: massive collapse. Irresponsible lenders, speculators, and borrowers took down with them the value of the homes of responsible homeowners and then applied for bailouts. This was mooching on a global scale.

The Securitization Bubble

In 2000, as the new century dawned, interest-only loans accounted for a mere 0.6 percent of new mortgage loans; by 2005, they had grown to 32.6 percent of the total. By 2004, 46 percent of new home loans in dollar value (33 percent in numbers) were adjustable rate mortgages. And in 2005, 43 percent of first-time buyers put no money down at all.
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Many of these were sold by lending outfits anxious to write as many mortgages as fast as possible, with the largest possible dollar values, regardless of risk. How did that happen?

The early 2000s saw a boom in both the “securitization” (the resale of mortgages as investments) and the explosion in so-called nondepository mortgage originators who sprang up, writes Barry Ritholz, like “so many mushrooms in cow dung after a summer rain.”
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The new mortgage brokers aggressively hawked affordable and increasingly exotic mortgages designed to get people into homes they otherwise could not afford.

The deals were possible because the mortgages were not held by the loan originators, but were instead quickly off-loaded. They were abetted by both the federally backed Fannie Mae and Freddie Mac, which bought many of the dicey loans, and by Wall Street, which developed an avaricious craving for more mortgages to slice, bundle, and sell as securities. Wall Street, recalls economics writer Arnold Kling, “made riskier and riskier bets, but as long as home prices kept increasing, defaults were rare and market participants enjoyed nice profits.”
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In the days before the affordability bubble, it was understood that traditional borrowers would put down large down payments (preferably 20 percent), had good income and credit histories, and could service the mortgage debt easily. These were the so-called prime borrowers and they were prudent bets for lenders. They were also thirty-year deals, so the focus was always on the long-term stability of the lender-borrower relationship. That all changed in the brave new world in which salesmen, paid on the volume of mortgages they could sell, quickly sold them off to whatever greater fool would have them. In other words, notes Ritholtz, the industry underwent an “enormous paradigm shift.” Volume—and the pressure to make the sale—replaced prudence, which led to a “radical change in lending standards.” Lenders no longer needed to find buyers who would be a good risk for thirty years; “they needed only to find someone who wouldn’t default before the securitization process was completed,” or about ninety days.
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The clamor for the exotic and lucrative mortgages meant that numbers were fudged and standards were bent—incomes were invented or inflated, appraisals massaged, piggy bank loans juggled, value-to-loan ratios ignored, and the money flowed. “If you could fog a mirror, you qualified for a mortgage,” quips Ritholtz, noting that a strawberry picker with an annual income of $14,000 was deemed qualified for a mortgage to buy a $720,000 home.
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Let’s consider that strawberry picker and his $720,000 house for a moment. On one level, the loan was pure madness, but on another, it represented the triumph of the “affordability” crusade. A man making $14,000 a year was able to afford a house valued at three quarters of a million dollars. What could be more affordable than that? Of course, this required a great deal of Other People’s Money, but that was always implied in the whole frenzy.

Some of these loans were undoubtedly what could be described as “predatory” (although it is a strange form of predation in which money is pressed on the victim rather than taken from him)—written by unscrupulous lenders anxious to score quick fees and the long-term risks be damned. But even if this is true, there was also predatory
borrowing,
as homeowners leveraged massive increases in their square footage and financed their lifestyles with meager investments of their own money.

Meanwhile the mortgage securities—known as collateralized debt obligations or CDOs—seemed to be paying off handsomely. High ratings and decreasing transparency created the illusion of safety and prudence. Even though many of the mortgages were based on hinky subprime loans, ratings agencies gave them stellar AAA ratings and investors across the globe snapped them up. They became so popular that Wall Street created ultra-exotic CDOs that were backed by other CDOs, each step more complex and less transparent. In other words, nobody really understood what they had or how chancy the whole scheme had become.

All that was left to complete this abdication of common sense was the support of the federal government. Support? The feds were cheerleading the process and bankrolling the march of folly.

As mortgage madness spread, the federal government actively stoked the flames. Far from reining in the spread of questionable loans, Washington pressured Fannie and Freddie to buy increasingly risky loans. “Once,” reported
The New York Times,
“a high-ranking Democrat telephoned executives and screamed at them to purchase more loans from low-income borrowers, according to a Congressional source.” At the same time, “Shareholders attacked the executives for missing profitable opportunities by being too cautious.”
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The CEOs of the two federally backed companies “eventually yielded to those pressures, effectively wagering that if things got too bad, the government would bail them out.”
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This is where moral hazard goes to die.

Bipartisan Madness

While greed undoubtedly drove much of the mortgage mess, politics constantly provided the spur. History will record that the mortgage madness and subsequent bailouts occurred under both Democratic and Republican presidents and that many of the policies and practices that led to the crisis were advanced by both conservatives and progressives (albeit with different motives and agendas).

Even amid warnings that many of the subprime loans were unsustainable, the Bush administration ratcheted up the pressure for riskier loans, in pursuit of what Bush called the “ownership society.” Reported
The Washington Post
: “Eager to put more low-income and minority families into their own homes, [the Department of Housing and Urban Development] required that two government-chartered mortgage finance firms purchase far more ‘affordable’ loans made to these borrowers. Administration officials publicly complained that Fannie and Freddie were not being as aggressive as the private market and must do more.”
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Bush’s goal was to create 10 million new homeowners, largely backed by low-interest loans and the implicit government guarantees. To make that possible, Bush’s Department of Housing and Urban Development let Fannie and Freddie count the billions of dollars vanishing down the subprime hole as “a public good that would foster affordable housing.”
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In 2003, Fannie and Freddie bought $81 billion in subprime securities; the next year, they had purchased $175 billion, fully 44 percent of the market. By 2006, Fannie and Freddie had backed off a bit, buying only $90 billion in subprime securities. But the damage had been done: From 2004 to 2006, Fannie and Freddie bought $434 billion in securities backed by subprime loans, fueling the lending frenzy by creating a huge taxpayer-backed market for the funny money loans.
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“Every dollar they pumped into subprime securities made the real estate bubble worse,” declared the conservative Heritage Foundation.
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Even as the market began to unravel, Freddie’s defenders rationalized the failures. “It’s like a kid who gets straight A’s and then gets a DUI. Is the kid [messed] up?” one lobbyist for Freddie argued. “No, he made a mistake.… You can’t just get rid of Fannie and Freddie.”
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By this point, though, the support for the risky lending was solidly bipartisan.

Laying the Fire

Long before there were subprime, no-down-payment, interest-only mortgages, before the rise of collateralized debt obligations and NINJA mortgages, there was the Community Reinvestment Act, a Carter-era law given teeth under President Bill Clinton. The law was originally designed to encourage banks to make loans in “disadvantaged” neighborhoods. While its role in the housing meltdown has been both downplayed and exaggerated by partisans, the CRA clearly laid the ground for much of what was to follow, including the underlying push for “affordability,” the political mantra that drove and rationalized the flight from financial sanity that eventually resulted in the housing crash.

Defenders of the Community Reinvestment Act frequently cite a study from Harvard’s Joint Center for Housing Studies that concluded that loans covered by the CRA accounted for just 9 percent of the mortgages given to low-income individuals and neighborhoods. In contrast, independent mortgage companies accounted for the majority of such loans.
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But this understates the groundbreaking significance of CRA. While Fannie and Freddie and Wall Street recklessness provided the blowtorch that set off the bonfire, it was the CRA that laid the kindling.

Hindsight, of course, is convenient in the wake of the bursting of a bubble, but there were warnings before the deluge gathered force. In 2000, Howard Husock, writing in
City Journal,
sounded the alarm for what he called “The Trillion-Dollar Bank Shakedown That Bodes Ill for Cities,” and explained how the CRA changed the political and financial dynamics of mortgage lending.
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For the first decade or so of its regulatory life, Husock noted, the CRA was generally ineffectual. But in the 1990s, the Clinton administration transformed it into “one of the most powerful mandates” shaping the nation’s financial system.

Under Clinton, new CRA regulations gave advocacy groups greater clout in pressuring banks to make marginal loans. The new rules required bank regulators to evaluate how well banks responded to such pressure. “The old CRA evaluation process had allowed advocacy groups a chance to express their views on individual banks, and publicly available data on the lending patterns of individual banks allowed activist groups to target institutions considered vulnerable to protest,” wrote Husock. But the Clinton administration’s formal invitation was a “clarion call” for activists like the National Community Reinvestment Coalition and community groups to mobilize to pressure banks to make more low-income loans.

The impact was swiftly felt. Merely by threatening to complain, activist groups were able to “gain control over eye-popping pools of bank capital, which they in turn parcel out to individual low-income mortgage seekers,” observed Husock. Notably, the now-notorious activist group ACORN Housing snagged a $760 million commitment from the Bank of New York. Another group, the Neighborhood Assistance Corporation of America, scored a $3 billion agreement with the Bank of America, and on and on it went, with similar deals in virtually every major city. Husock quoted one “affordable housing” activist who had landed $220 million in mortgage cash to parcel out saying: “CRA is the backbone of everything we do.”
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