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Coronado

Managing the Mortgage Meltdown by J. F. Kelly, Jr. 3/20/08

I was working as Director of Training and Development for Great American Bank when I first learned of a new financial product being readied for marketing. It was called an adjustable rate mortgage, or ARM, and it promised to transform the mortgage lending industry. That it did, many feel for the worse.

ARMs, of course, feature variable interest rates that adjust, usually upward, in accordance with a schedule or index. The advertised advantage was that the borrower could benefit from a lower, more affordable, initial rate. The unadvertised feature was that it protected the lender against rising interest rates. The borrower’s expectation was that his earning power would probably increase enough to handle the interest rate adjustments and/or that rising home values would make it possible to refinance later at more advantageous terms. It sounded reasonable. Annual income generally rises and so do home prices, right?

There were, of course, skeptics. Some traditional bankers thought it was almost immoral for S&Ls to offer a variable rate product that could lure homeowners into assuming an obligation that they might someday be unable to afford because of changing personal fortunes or economic circumstances. I was one of those conservatives who hated surprises. I wouldn’t touch such a product. Give me a fixed rate that I can count on.

Customers, however, tempted by the initial teaser rates, eagerly bought them up and the housing market surged. (The S&L industry, meanwhile, collapsed, but that’s another column.) These early variable rate products were still fairly conservative with caps to prevent excessive increases. Success fosters greed, however, and soon these ATMs morphed into more exotic products. Creative financing displaced careful underwriting and soon there were mortgage lenders who could manage to find a loan for any prospective buyer with a pulse. Home ownership became the foundation of the American dream to which all Americans were somehow entitled.

Home prices rose in accordance with the “greater fool” theory. It was assumed that there would always be someone willing to buy our property for more than we paid. Talk about irrational exuberance! Experts warned of a bubble as homeowners basked in the warmth of their rapidly expanding net worth and buying power. They lived large and vacationed well as they tapped into the equity of their homes through refinancing or equity loans, another ingenious product developed by lenders and marketed to increasingly overstressed borrowers who were urged to “let your home work for you.” Everyone wanted a piece of the action now, some through mortgage-backed securities including high-risk, sub-prime mortgages. Even an idiot could make money in real estate.

Or lose. The bubble finally burst as bubbles do. The American economy, largely fueled by consumerism, almost immediately went into a dive, from which it has not yet begun to pull out. Homeowners watched their equity shrink or disappear entirely and reduced their spending accordingly. The enormity of the damage began showing up elsewhere with financial institutions and other investors discovering that their portfolios had more exposure than they thought to mortgage-backed securities of now uncertain market value and therefore all but impossible to sell. Lenders panicked A credit crunch ensued. Businesses and individuals suddenly found it difficult and more expensive to borrow. Business investment slowed. Jobs disappeared. The downward trend became a spiral, building on itself.

Who is to blame, or does it really matter at this point? It does because unless we learn from history we are doomed to repeat it. First, the lenders bear much of the blame. The adjustable rate mortgage was a good idea for some borrowers but certainly not for all or perhaps even most because it transferred too much risk from the lender to the borrower. Nor content with a reasonably conservative product, the lenders expanded it into complex contracts that caused clueless buyers to take enormous risks. How could they expect people who couldn’t figure their own taxes or balance a checking account to read and understand loan documents? Second, the buyers need to accept blame because no one forced them to sign those tedious documents that obligated them to amounts that could exceed the market value of their collateral. Hard to understand or not, a loan document is a legal contract. Finally, the federal government can be faulted for failing to adequately regulate this speculation-driven mess that somehow created the notion that every American, even those without reliable income, should be able to “buy” and “own” a home and that the mortgages for which these homes were collateral were actually assets of value which could be securitized and traded on the market.

What to do now? My sense is very little until we get more of a feeling for the true value of assts like homes and where the bottom really is. Real estate and mortgage-backed securities became vastly over valued and the market needs to establish their true worth which is what a willing buyer with choices will pay. Efforts by the government to prop up prices by buying foreclosed homes or defaulted mortgages or to mandate freezes on mortgage rate adjustments would be ill-advised because such actions, aside from being unfair to some parties, would only delay the final day of reckoning when assets must be properly priced in accordance with demand.

President Bush was right to warn Congress not to overreact and make matters worse. Meanwhile, lenders have every incentive to work with distressed borrowers to revise contract terms where possible to keep their loans performing. The last thing that banks want is to acquire more foreclosed real estate and book losses after selling it at a discount. Is there a light at the end of this tunnel? Undoubtedly, but it’s too far away to see clearly yet. Unwise federal actions will make it dimmer still. CRO

copyright 2008 J. F. Kelly, Jr.

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