The causes for the worst economic crisis since the 1930s are many, but at the core of the problem was a sweeping relaxation of underwriting standards by lenders, fostered by a climate of excess capital, escalating housing values, and readily available profits from the making and selling of home loans.
Not only were lenders approving mortgages without proof of income, borrowers could get loans without down payments, at reduced and sometimes zero interest rates, with the ability to defer monthly payments.
At the frontline of the mortgage lending system were brokers such as Dan Williams, who helped borrowers find the best terms for their loans.
“Everyone was happy as long as housing prices continued going up,” said Williams, who now heads up his own firm, San Diego Lending Solutions in Mission Valley. “As long as the gravy train kept flowing, there were a lot of people that were doing lots of things that weren’t right.”
Williams said while he was working at another mortgage brokerage firm about four years ago, the standard practice was to ask borrowers to provide documentation, including paycheck stubs, to determine how much they could borrow and their ability to repay the loan.
Yet lenders and the ultimate buyers of the loans, quasi-government agencies such as Fannie Mae and Freddie Mac, would dispense with documentation if a borrower’s credit score was high enough, Williams said.
“Back then (2004), if you had a FICO score of 640 to 680, maybe even 620, they would not be required to show the documentation,” he said. “If you didn’t look like you were blatantly lying, you got a loan.”
That sort of easy money had been flowing freely beginning earlier in the decade as the Federal Reserve Bank cut interest rates to spur economic activity. The rapid rise in housing values, especially in hot growth areas like Southern California, prompted greater interest in buying homes, not only as a residence but for speculative investment purposes, said Alan Gin, an economics professor at University of San Diego.
“The housing boom created a feeding frenzy and led to more people wanting to participate in the run-up in prices,” Gin said. “That affected the mind-sets of borrowers and lenders.”
As the banks continued to dole out more mortgages, Wall Street kept the spigot flowing by creating more securities based on monthly mortgage payments. For the most part, mortgages weren’t held by the banks that made the loans, but were sold in bundles to larger investment banks or Fannie Mae.
The mortgages were ascertained for risk and comingled with larger bundles of mortgages, then sold to investors all over the world. These mortgage-backed securities found plenty of investors, and for good reasons.
“They were relatively secure because they were backed by people’s homes, and in a good economy, they continued to appreciate in value,” said Charlene Davidson, an investment banker with Costa Mesa-based McGladrey Capital Markets. “There was a huge demand.”
Raising The Risk Factor
Another factor that helped pump up the housing market was the banks’ expansion of their client base to include more low-income borrowers. Thanks to changes in regulations approved by Congress in 1999, banks pushed loans to borrowers who formerly wouldn’t have been able to qualify.
“Not only did they relax the standards, you could say they eliminated them,” Davidson said. “Honestly, anybody could get a loan.”
To offset the higher risk, these so-called subprime loans charged higher interest rates, and often came with options to pay either the interest or principal. Some had options to skip a monthly payment. Nearly all mortgages were made at reduced market, or “teaser” rates, sometimes at zero percent interest, but then adjusted upward after a set period, usually in one to three years.
Starting in mid-2004, the Federal Reserve raised its benchmark Fed funds rate 17 times through mid-2006, reaching as high as 5.25 percent, to keep inflation in check. As interest rates increased, mortgages reset to higher rates, causing monthly payments to rise as well.
Many subprime borrowers couldn’t afford the higher payments and defaulted. This situation was happening about the same time that housing values were declining, effectively preventing borrowers from refinancing their mortgages to a fixed interest rate.
And without having much equity in the house, many simply walked away from their properties.
As the number of foreclosures increased, bonds containing these riskier loans were affected, reducing their values. The problem was compounded because the mortgage securities often contained both prime and subprime mortgages, and sometimes other asset groups such as credit card portfolios. Unraveling the securities was impossible and as foreclosures kept increasing, these securities became harder to trade.
Ross Starr, an economics professor at UC San Diego, said the mortgage-backed securities aren’t like stocks or bonds where an active market exists and values are set daily. Nor are the institutions that are holding such securities obligated to disclose how these are performing.
“It’s not transparent who owns what,” he said. “The result is that many lenders fear their counterparties have a weak asset position, and may go broke.”
As uncertainty over asset quality escalated this year, more lenders, particularly larger banks, began hording cash, and were reluctant to lend to each other even on overnight loans. Since the securities were owned by international banks and other entities, the problems expanded on a global scale.
“Global financial markets and economies are more intertwined than they ever were,” said Gin.
Exacerbating the situation is an even less transparent market involving credit default swaps, or insurance policies on the mortgage-backed securities. Essentially, the swaps insure the bonds and are used by buyers to hedge their risk should the bonds default or pay off early.
But what sounds like a reasonable thing has gotten way out of control because there’s no requirement to retain the underlying assets the swaps insure, or even own the bonds, Davidson said. The global market for the swaps, recently estimated at $62 trillion, is largely unregulated and so complex that few understand it, she said.
Stabilizing The Markets
Bankers and other financial industry observers applaud coordinated moves by the world’s largest governments to stabilize markets by injecting vast sums of cash into their largest banks to maintain liquidity and encourage the trust recently undermined.
“It’s all about trust all the way around,” said David Ely, a finance professor at San Diego State University.
Ely said a main part of the governments’ plan to address the crisis is infusing the banks with new capital by buying stock, thereby strengthening their capital positions, the key measurement of a bank’s safety.
“A lot depends on what banks do with this capital. The hope is that they’ll lend the money out,” Ely said. “If the banks are still cautious, and sit on the capital then the strategy won’t be effective.”