Bankers’ Hours column: The elements that can spark a financial collapse are always there
OK, class, this is the session we’ve all been waiting for: a short but hopefully stimulating account of the actual meltdown of the planet’s financial structure in 2008. I note a lot of empty seats out there, but thanks for sticking around.
The columns on the thrift crisis of the mid-’80s wasn’t what I intended to write. I actually started a piece on Credit Suisse, the Swiss banking super monster and its recent woes in connection with Greensill, a big private lender, and Archegos, a “Family Office” investment entity. Unrelated, but very embarrassing — and expensive — for Credit Suisse. I was about a third of the way through the composition and realized I’d seen this in macro before.
A banker friend who’s read these articles questioned whether people are interested in financial history, and why indeed. Who wants to listen to a geezer telling banking war stories from long ago? But the intriguing element of the past two crashes is that nobody believed the first would happen, and, after it did, all were certain that it wouldn’t happen again, because laws and regulations had been rewritten to make absolutely certain that it didn’t. But it did.
The underlying cause was the same, and, as we’ve noted, that trigger was an excess of money on the table, which created an unsustainable supply and demand imbalance. It’s a natural financial phenomenon, and it’s been occurring ever since humans started buying, selling and trading. The elements that can spark a collapse are always there, a lurking San Andreas Fault of potential disaster.
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I was in the trenches for both train wrecks, witnessing two collapses of the financial network in real time. It got to be just another day at the office.
Meltdown II started in the ‘90s. The secondary mortgage market, which for decades had consisted of the government sponsored enterprises (GSE’s) bundling home loans into securities, as well as banks and mortgage companies selling to each other. It worked well; too well, actually.
That began to change in the mid ‘80s, and by the turn of the century, U.S. mortgage-backed securities were arguably the world’s hottest investment.
As mortgage loan originators and the capital sources that packaged the deals worked feverishly to create the investment product, the housing industry was striving to build the collateral for the loans. It wasn’t long before the mortgage tail was wagging the housing dog, and the financial sector was worshipping loan production with merely a nod at loan quality.
That nod was a dependence on a borrower’s credit score. Home loans were being spit out of the sausage grinder with no income verification, no asset determination, virtually no underwriting at all. However, if a borrower had made timely payments on the F-150 and the Camry, then it was a green light to closing. Nobody — not the originating bank or mortgage company, nor banking regulators, and certainly not the marketers of the MBS paper, such as Lehman Brothers, Merrill-Lynch and Bear, Stearns — paused to consider that the borrower in question was taking on a very big new obligation. Even though the packaging conduits cratered, the execs running them did pretty well. A while after the crash, the gentleman who ran the mortgage operation for Bear-Stearns rented Aspen’s Jerome Hotel for his daughter’s bat mitzvah.
Everybody involved in the effort saw what they wanted to see. And ignored what they didn’t. Once, in 2009, I was having a beer and reminiscing with a former fellow employee from the sausage factory. The waitress overheard us and said, “My husband and I were one of those who bought and shouldn’t have. We found we could get a loan which we knew was too big, to buy the house we’d always wanted. We figured we’d think of something and, if we had to, could sell the property for at least what we paid for it. Of course, we couldn’t.”
And then, there were the representations and warranties embedded in every contract between mortgage seller and purchaser. They were the Catch 22 that reversed the flow of loans from originator to purchaser, requiring loans to be bought back after they defaulted and the file was audited. Bit of background here: If you sell a loan and want it off your books, it has to be “without recourse,” meaning if it goes bad, you don’t have to buy it back. But the loopholes in the “reps and warranties” effectively assured that a violation could be found that could compel the originator to repurchase the mortgage.
The effluvia started running back downhill, and in the end nobody from Fannie Mae to WAMU, the Seattle based thrift that became the largest bank failure in the nation’s history, could handle the flood. The problem was that the loan purchaser could say, “You knew, or should have known, that this borrower did not qualify.” Didn’t do a bit of good to say, “But we were just following the guidelines of your program.”
By the end of September 2008, Fannie and Freddie were both the property of the U.S. taxpayer, an event so unthinkable at the time that it could be compared only to, well, maybe Tom Brady going to Tampa Bay and immediately winning a Super Bowl. Venerable Wall Street brokerage houses that had thrived for over a century, becoming household names, closed. Of the 90 largest bank failures in U.S. history (over $1 billion in assets), 39 were a result of the 2008 meltdown. A lot of other banks were closed as well. Total bank failures in 2008 and came to 510.
Most of the smaller banks and thrifts weren’t making toxic home loans for sale in the secondary mortgage market. They were, however, funding construction loans to build houses to provide collateral for loans that couldn’t be repaid and to fund land purchases and development to create subdivisions for those houses. Once the individual loans went bad, the entire housing industry was hopelessly infected, and the dominoes went down almost overnight.
As a coda to the mess, it might be appropriate to deflate an urban legend that’s blossomed post-meltdown. The dastardly mortgage broker has been viewed as a Snidely Whiplash, leading unsuspecting homeowners into foreclosure, ultimately one of the root causes of the debacle. Sure, there were crooked brokers … and bankers and appraisers and Realtors. But the loan originators were simply people doing the job they were hired to do, creating loan product for the creators of the mortgage-backed investment products. They were not a root cause. They were, however, hired by those who were, from borrowers to bankers, and everybody in between, who used brokers to facilitate their own financial ruin.
A couple of true stories, one an example of a broker attempting to do the job he was paid to do, the other, well, an actual attempt at fraud.
I received a loan package that another lender had turned down. It was a stated income purchase mortgage, that involved a librarian in an obviously mid-level position with a stated income figure of some $96,000, which was really, really egregious, even for the stated income program. I called the young broker who’d originated the deal and asked the obvious dumb question: “How does a librarian make almost a hundred grand a year?”
The response: (Sigh. I work my tail off to provide loans for these people, and I have to talk to some dinosaur who doesn’t understand the mortgage business.) “Because, sir, that’s what it takes to qualify for the loan.” The kid was simply doing the job as trained and selling the product as designed.
In the other case, I was researching an application that looked very wrong, an FHA refinance. After determining that just about all of the documentation was bogus, I talked to the lady applying for the loan and determined that she’d done what the broker told her to do.
“So you don’t actually have a job that pays (x dollars) a month?”
“Well (expletive), Mr. Banker, if I made that much money, I wouldn’t need a loan, now would I?”
She had me there.
Pat Dalrymple is a western Colorado native and has spent more than 50 years in mortgage lending and banking in the Roaring Fork Valley. He’ll be happy to answer your questions or hear your comments. His email is email@example.com.
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