Later this year marks the 10th anniversary of the bankruptcy of Lehman Brothers. The mortgage mess had been brewing long before, but the collapse of the financial services company was the focal event of the crisis, which came to be known as the Great Recession.
While it is unlikely that bad mortgages could lead to something quite on that scale anytime soon, mortgage originators should be the professionals who see this coming. What then would be the signs that this is happening again?
The single largest cause of the mortgage meltdown a decade ago was the fact that Wall Street investment banks became so adept at bundling and selling mortgages as part of investment-grade securities. These banks created a market for low-quality mortgages, creating pressure for more and more lenders to lower their underwriting guidelines to accommodate the demand.
If lenders are again encouraged to lower their guidelines to accommodate any new-found ability of Wall Street to sell anything, the mortgage mess will reoccur. Experienced people in the mortgage origination business know what constitutes a loan with a low risk of default and must resist compromising on that measure for essentially a short-term gain.
The Wall Street people who created the investment instruments that enabled bad mortgages to become part of investment grade securities not only did not know what constitutes a loan with low default risk, but they seemingly did not care. One consequence of the financial crisis is that many of these investment banks have since been merged with commercial banks and are now overseen by the Federal Reserve. This is both good and bad. On the positive side, there should be better oversight. On the negative side, the next Lehman Brothers will be part of the banking system and less easily disposed of in the event of a failure.
One cause of the 2008 financial fiasco was the vast expansion of the number of people who could borrow money to buy property. There are at least two things already happening that are allowing people to obtain loans who would not previously qualify.
One was instituted by the Consumer Financial Protection Bureau last year, which persuaded credit bureaus to remove most civil debt liens and tax liens from credit reports. The Wall Street Journal estimated this would improve credit scores for 12 million individuals, some by as much as 40 points.
Another is the expansion of Fannie Mae’s Home-Ready program, which is aimed at low- to moderate- income borrowers. One of the features of the program is its liberal interpretation of income, which allows lenders to consider the income of nonborrowers living with a borrower — such as adult children, friends or extended family. That nonborrower income can be viewed as a compensating factor in the loan-approval process for the program.
HomeReady is similar to the National Homeownership Strategy of 1995 in that it has a social goal. Under the Federal Housing Finance Agency’s housing goals for Fannie Mae for 2015 to 2017, at least 24 percent of the single-family, owner-occupied mortgage loans acquired by the government-sponsored enterprise (GSE) must involve low-income families. At least 6 percent must be to very low-income families.
Borrowers need at least a 620 credit score to qualify for the HomeReady program. Freddie Mac has a similar program called Home Possible. If the Feds increase the percentage of such loans the GSEs must purchase, be concerned. Mortgages to folks with bad credit or high debt should stay inside the Federal Housing Administration (FHA) program. As long as the FHA mortgage insurance premiums cover the inevitable losses, the taxpayer is not picking up the bill.
One feature of many of the defaulted mortgages during the housing bubble was a lack of documented income. Borrowers would state their income, but no documentation was provided to back it up. Another problem was the fact that lenders did not, in many cases, track down borrowers’ tax returns even when they had IRS Form 4506, which allows third parties to receive tax returns.
Lenders did not want to know borrowers’ real income because knowing so might have been a deal-killer. If this happens again, beware. There are lenders who are making nonqualified mortgage loans already, but this is not happening to any significant extent — and non-QMs still have to meet the ability-to-repay provisions instituted under Dodd-Frank.
“ Some lenders who thrived on refi volume may decide to dive into risky territory and generate more loans of lower quality. ”
Another troubling practice from the past crisis was the way many appraisals were conducted. At that time, many loan officers would find an appraiser who would simply deliver the necessary value to make the loan deal work. Much has been done to improve the process and track appraisers since then. A key element of those reforms is to ensure the loan officer is not choosing the appraiser directly. The appraiser should be chosen randomly from a list of approved appraisers without any indication of estimated value in advance of the appraisal, other than the sales agreement. This ensures a more objective and accurate appraised value.
A more difficult issue to assess is the fact that appraisers are disappearing. Appraisers have always been underestimated. Now, every appraisal is scrutinized and scored. People have to put in many hours before they can become licensed and certified appraisers, and few people are willing to do this lately. Not enough people see the benefits of the job outweighing the negatives.
To solve this problem, the industry may come to value computerized appraisals rather than ones done by an experienced professional, and this has risks which are not yet known. There are databases which can do a fairly good job of estimating home values. They may even provide drone photos of the exterior. Still much could be wrong and go unnoticed with an inspection that skips the home’s interior.
Interest rates have been on the rise this year and that’s led to a dramatic decrease in refinancing. Some lenders who thrived on refi volume may decide to dive into risky territory and generate more loans of lower quality going forward.
These may be subprime first liens, home equity lines of credit and other second-lien loans. Keep an eye on the big companies that have thrived on refinances, as some may be tempted to make riskier home-purchase loans to make up for the lost refi volume.
In 2014, the Consumer Financial Protection Bureau issued regulations defining qualified mortgages. If lenders follow the guidelines, their risk of being forced to buy back mortgages is diminished. A loan may be deemed a nonqualifying mortgage, however, because it involves stated income, interest-only, a high debt-to-income ratio or a 40-year term, for example.
Chain of distrust
Scrutiny should be paid to lenders who do a large volume of fully documented non-qualified mortgages. It also may be the case that scrutiny should be paid to private equity companies making mortgages. Not all of these types of mortgages, however, are high risk. One example is someone who is retired and who has a low income but significant liquid assets. If someone has a low income but $5 million in liquid assets and wants a $1 million loan on a home worth $2 million, do you really care about their income?
The mortgage industry is a chain consisting of the borrower, the loan officer, a mortgage broker, the bank and finally the holder of the beneficial interest of the payment cash flow. What happened during the financial crisis a decade ago was that a lot of borrowers stopped making their mortgage payments.
Consequently, the chain of production became a chain of distrust. Commercial banks stopped trusting mortgage banks, commercial banks stopped trusting each other and Wall Street stopped trusting commercial banks. Mortgage lending essentially ground to a halt. The other part of the problem was interbank lending dried up. This was relevant to the mortgage business because many of the subprime mortgages at the time were made by mortgage banks that depended on credit lines from large commercial banks.
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While the root causes of the financial crisis 10 years ago may have been elsewhere, mortgage originators generated the bad mortgages and became the folks who got a good share of the blame, scrutiny and regulation. It’s likely they’ll get the same treatment if it happens again.