From Prime to Subprime, America’s Home-Mortgage Meltdown Has Just Begunby
Eric Englund Inflation
is an immoral tax that leads to immoral values Having been in the credit profession for the past 23 years, I have observed several cycles involving the loosening and then the inevitable tightening of credit-underwriting standards. Of course, the Federal Reserve stands at the epicenter of such cycles. While money and credit are flowing like beer at an Irish pub on St. Patrick’s Day, everyone ends up looking like an attractive credit risk. When it appeared that the U.S. economy was heading into a recession, after the collapse of the dot.com and telecom bubbles, the Federal Reserve opened up the taps and encouraged one and all to imbibe its tasty, low-cost credit – with the most popular "flavor" being the mortgage loan. At this point, mortgage lenders merely became bartenders serving anyone who walked in the door. To reach this nadir in mortgage-lending standards, it is inescapable that the "Five Cs" of credit were ignored regardless if a mortgage loan was deemed prime, Alt-A, or subprime. This is exactly why the home-mortgage meltdown has just begun. One aspect of my job entails analyzing personal financial statements. Twenty years ago, without a doubt, households had much healthier financial conditions. Back then, in proportion to household net worth, savings were much higher and debt levels (especially automobile, credit card, and mortgage debts) were dramatically lower. It is alarmingly common, today, to see households with well under ten thousand dollars in savings yet half-a-million dollars in mortgage debt – not to mention thousands of dollars in credit card debt and tens-of-thousands of dollars in automobile debt. Such households are literally one or two missed paychecks away from being destitute. Yet, amazingly, the heads of such households are considered to be prime-level borrowers (as long as there is adequate income to cover monthly debt service and expenses). What has happened, in the sphere of personal-credit underwriting, is that risk parameters have been redefined with the word "prime" having been defined downwards. Credit Socialism America’s unfolding mortgage-debt crisis did not emerge in a vacuum. When Alan Greenspan’s Federal Reserve pounded the federal funds rate down to 1%, in June of 2003, it is crucial to understand that such a low rate materialized due to the Fed’s aggressive creation of money and credit. In other words, America’s monetary central planner "knew" that massive inflation was needed to "rescue" the economy from the above-mentioned dot.com and telecom implosions. Housing was specifically targeted by the Federal Reserve to serve as "…a key channel of monetary policy transmission." With this colossal inflation of the money supply, I would argue that a hyperreality surfaced in the housing market – with corresponding bubbles emerging in consumer electronics and automobiles. During such episodes of heavy inflation, people tend to lose their sense of value including suspending any fear of debt. In his remarkable piece, Hyperinflation and Hyperreality: Thomas Mann in Light of Austrian Economics, Dr. Paul Cantor masterfully describes how central banking brings about such a destructive hyperreality:
In addition to dealing with the psychologically corrosive affects of inflation, mortgage lenders have become interwoven into what James Grant deems "mortgage socialism." Since FDR’s New Deal, a veritable alphabet soup of governmental and quasi-governmental entities has served to intervene in America’s mortgage market to slake Uncle Sam’s thirst for putting Americans into homes regardless of creditworthiness. For example, in 2004, George W. Bush clung to the coattails of the emerging housing bubble and took credit for America’s increase in the rate of homeownership. He saw fit to take such credit as he viewed newly minted homeowners as a voting block to count on in the 2004 presidential election. Accordingly, the alphabet soup of federally sanctioned housing-market interventionists – Fannie Mae, Freddie Mac, Federal Housing Administration, Ginnie Mae, Department of Veteran Affairs, etc. – served the governing plutocracy’s political ends. What many fail to comprehend is that socialization of mortgage credit inherently means that mortgage-lending standards have been systematically watered down. For decades, Freddie Mac and Fannie Mae have been buying mortgage loans from qualified lending institutions and then securitizing bundles of such loans into mortgage-backed securities (MBS) – which are typically sold to institutional investors. Ginnie Mae, which is backed by the full faith and credit of the U.S. Government, does not securitize mortgage loans but does guarantee investors the timely payment of principal and interest on mortgage-backed securities insured by the Federal Housing Administration or guaranteed by the Department of Veteran Affairs. Freddie and Fannie also guarantee the timely payment of principal and interest on their securities but do not have the full faith and credit of the U.S. Government backing them – although the assumption is that Uncle Sam will not allow Freddie or Fannie to fail. As the housing bubble was expanding, the private sector aggressively jumped into the mortgage-lending fray with an eye toward profiting from securitizing and selling bundles of mortgage loans in the form of mortgage-backed securities – think of companies such as Countrywide Financial and Bear Stearns. A most important aspect of these mortgage-backed securities is that they are not backed by the full faith and credit of the U.S. Government. However, and this is critical, these private brands of mortgage-backed securities were created by bundling mortgage loans that were originated using the same low underwriting standards as prescribed by Uncle Sam’s socialized mortgage-credit hawkers. To compete in this arena, it was essential to drop lending standards down to the lowest common denominator. Yet, even if there were a few "old-school" credit managers expressing concern, top management – at the private firms producing these MBS products – didn’t heed such apprehensions because most of the mortgage loans weren’t being retained as they were being securitized and sold for a profit. Hence, shoddy credit underwriting became the problem of the MBS purchasers. Old-school credit managers, undoubtedly, are still familiar with the Five Cs of credit – which will be covered in depth below. And when it comes to lending large sums of money related to home mortgages, each and every one of these "Cs" is important to the credit-underwriting process. Alas, such old-fashioned underwriting isn’t conducive to rapid-paced credit creation – beloved by the MBS peddlers – and most certainly goes against the egalitarian spirit of mortgage socialism. In an April 8, 2005 speech, Alan Greenspan gushed about how technology has streamlined credit underwriting and made credit more accessible to all Americans. Here is what he stated at the Federal Reserve’s "Fourth Annual Community Affairs Research Conference":
Like a true socialist (really, what else is a monetary central planner), Greenspan celebrated credit egalitarianism in this speech – in which he concluded:
Lately, Alan Greenspan certainly hasn’t been cheering about subprime mortgages. I wonder why not? The Five Cs of Credit In days long past, creditors actually underwrote their loans to such a standard that default was unlikely. Consequently, the Five Cs of credit were taken quite seriously by loan officers. The Five Cs of credit are character, capacity, capital, collateral, and conditions. What follows is a brief description of each of the Five Cs – as tailored to making personal and home-mortgage loans. Character: This is the general impression you make on the lender. The prospective borrower’s educational background and professional experience will be reviewed, along with his credit score. It is important to manage one’s personal credit carefully. There is a strong correlation between past credit history and the propensity to take care of present and future debt obligations. Ultimately, the creditor is seeking to gauge the honesty and reliability of the borrower. In days past, a banker would have had a long-term business relationship with each customer and would have come to know each customer’s reputation within the community. Capacity: Honesty alone does not pay the bills. Here again, educational background and professional experience enter the equation. A loan officer will look at a borrower’s current employment, job history, and skill-sets to discern stability, earnings power, and responsibility. Most certainly, the applicant’s current income and monthly expenses will be key factors considered in the loan-underwriting process. Nonetheless, just because a loan applicant may have adequate current income, to make the monthly mortgage payment, does not necessarily mean he is a good risk for a long-term loan. A spotty employment history, perhaps indicating instability and irresponsibility, certainly does not mesh well with granting a mortgage loan. If such a person is also looking to purchase a house for the first time, he may not even understand the personal and financial commitments associated with homeownership. Capital: A personal financial statement provides a critical snapshot as to a loan applicant’s financial condition. Within the balance sheet, the individual will list assets and liabilities. After making underwriting adjustments (mostly to the valuation of assets), the applicant’s net worth can be derived by subtracting total liabilities from "as allowed" assets. It is at this point that a lender will determine if the loan applicant has the financial strength to qualify for the loan. A few key questions will come to the underwriter’s mind. For example, is the applicant too leveraged to qualify for the mortgage loan – as indicated by a high debt-to-net-worth ratio? Does the applicant, moreover, have sufficient liquidity (e.g., cash and securities) to make a 20% down payment? After making the down payment, will there remain an adequate "rainy-day" fund for the mortgagor to survive several months of unemployment which entails supporting all household expenses and debt service? Collateral: In home-mortgage lending, the house is the collateral. It is crucial to understand that a house, in most cases, is a non-income producing asset. A house, typically, is purchased for the utility it provides as a family’s primary shelter. The lender will maintain a security interest (i.e., a lien) in the house until the debt is fully repaid. Should the borrower fail to make the monthly payments, foreclosure and liquidation would ensue to help repay the loan. Conditions: Lending decisions are partially based upon the conditions of the local, regional, and national economy. For instance, would you want to be originating long-term home loans to Detroit autoworkers? Some lenders may answer in the affirmative, while structuring the loans to factor in applicable economic risks, while others would deem such a proposition as too risky. Another condition to consider pertains to the neighborhood in which a house is located. Some lenders may prefer to make home loans related to newer houses in more affluent neighborhoods. Thus, the value of the collateral is more likely to remain unimpaired. Should foreclosure come to pass, the lender may stand a better chance of fully recouping the value of the loan. Conclusion If a loan officer does not feel comfortable with the risk profile of a loan applicant, then it is his responsibility to say "no" to the prospective borrower. Although this may come as unwelcome news, the loan applicant eventually may realize that the loan officer kept him out of financial danger. Declining to make a poor loan, additionally, meshes with the objective of underwriting sound and profitable loans. The Five Cs of credit are invaluable when it comes to originating quality loans.
September 24, 2007 Eric Englund [send him mail], who has an MBA from Boise State University, lives in the state of Oregon. He is the publisher of The Hyperinflation Survival Guide by Dr. Gerald Swanson. You are invited to visit his website. Copyright © 2007 Eric Englund |
To
be sure, when the federal funds rate declined to the surreal level
of 1%, lenders and borrowers behaved as if they were transacting
with Monopoly money. 
