The country didn’t end up in a housing crisis without reason. The industry’s lending practices played a huge part in eroding one of the major pillars of the American economy. Qualifying for a mortgage and buying a home used to be one of the biggest challenges and accomplishments in the lives of most Americans, but by the middle of the current decade it was almost as easy as filling out a form. What happened? What role did lenders play in the current housing crisis?
Borrowing from the Local Bank
After World War II borrowers seeking a mortgage would simply visit their local bankers to discuss their borrowing needs. The borrower’s assets were likely deposited right there at the bank, so the banker would be able to verify them. The borrower would also provide support documentation to verify income. And, the borrower would likely be required to put a significant down payment on the property, which provided a large incentive to keep making mortgage payments.
Risk of foreclosure was kept to a minimum by adhering to this formula. Defaulting on the loan would put the borrower at substantial risk of losing that large down payment. Further, it was more than likely that the banker and the borrower were part of the same community. Proximity bred familiarity, which in turn kept bad loan underwriting to a minimum for many years.
Reagan and the Invention of the Mortgage Backed Security
Things started to change during the 1980s. During the initial years of the Reagan administration, mortgage interest rates were 14 percent and rising. It was under President Reagan that the initial path toward financial deregulation began. Savings and loan institutions (S&Ls) were given much more leeway to attract depositors and lend money to them. Rates dropped and mortgages became more affordable for more Americans.
This same period fostered the financial invention that would serve as the springboard for many of today’s mortgage problems. This financial breakthrough was the mortgage backed security (MBS), a financial product that allowed investors to purchase the various streams of a mortgage payment pooled across a number of homeowners. By dividing these payment streams into portions called tranches, these products created a whole new class of investors who clamored after these collateralized debt instruments.
Mortgage Brokers, 9/11 and Easy Money
Despite a number of ups and downs, mortgage-backed securities helped power enormous growth in mortgage underwriting. Soon mortgage volume shifted from S&Ls to large commercial banks, along with an army of third party mortgage brokers, selling their mortgage products through their own internal sales teams. Many lenders were not depository institutions; they loaned money provided to them by Wall Street, then went back for more.
The financial shock of 9/11 forced aggressive actions in monetary policy by the Federal Reserve. These expansionary actions were a series of interest rate reductions that brought interest and mortgage rates to historic lows. With easier money, the economy and the housing market took off across most of the country.
American lenders were left in a quandary. There was a seemingly infinite demand for more mortgages, but it was becoming harder for borrowers to qualify under the same standards that had been used in the past. The decision was made to relax lending standards, making mortgages cheaper and easier than ever. Soon new products hit the market, including Option ARMs (Adjustable Rate Mortgages), pick-a-payment loans, and negative amortization loans (negAMs). Getting money was easier for borrowers and lenders alike.
Let the Good Times Roll
By 2004 and 2005 the market had become a smorgasbord of bad mortgages. It wasn’t uncommon to find lenders making loans with little or no down payments, accepting sloppy appraisals and requiring minimal, if any, documentation of income or assets. Despite these lowered lending standards, housing prices continued to rise. Wall Street continued to want more mortgages. Profits flowed freely. Interested in getting a piece of the cash cow, more mortgage originators entered the business. With little experience, many of these originators pushed borrowers into choosing potentially dangerous products while their commission checks ballooned. The crash of the housing market soon followed.
Lenders were hit hard with huge losses on bad mortgages, a drying up of capital to make additional loans and the disintegration of investor markets. Today, many of the biggest lenders are no longer independent companies. Washington Mutual, Wachovia, Countrywide and Argent are among the casualties. Many lending institutions that once employed thousands have gone out of business. Some filed for bankruptcy. Tens of thousands of mortgage brokers and other mortgage service providers have left the industry.
Borrowers have been hurt even more. Many face foreclosure, while others can’t afford their payments or owe more than their house is worth.
As the industry struggles to recover lenders have become much more risk averse. Many are also willing to do their part in helping borrowers endure the difficulties of a housing crisis that the lending community helped to create.