The state of the economy has been an interesting subject to me, as of late. People I know and come into constant contact with have been struggling to figure out how the nation and the economy got into the mess it did. I am asked, “What is sub-prime, and how does it figure into what is happening now?” I’ve found myself having to explain a lot of things to a lot of people in ways they can understand, mostly derived through my own research and experience and trying to understand it myself first! Most of my friends, people from all professions and educational backgrounds, have come to me because I’m the most knowledgeable person they know about the subject, simply by dint of my last job. I worked as a Personal Banker for a major bank for 3 years, with securities and insurance licenses. I do not possess a college degree of any type, having chosen military service instead. I like to think of myself as intelligent and well read, and over the next few days, I would like to diary what has happened, from my perspective, in an effort to explain how we got here.
As I went over in "Understanding the Crisis, Part 1: What did NOT cause the Crisis" the right wingers are attaching blame to this crisis where it doesn't belong. In that diary's case, it was the Equal Credit Opportunity Act (ECOA) and the Community Reinvestment Act (CRA), laws which eliminated racial, gender, and other types of bias in lending practices. This diary will focus on another argument making the rounds: That the borrowers themselves bear most of the burden of responsibility. What I will show is some of the sales tactics used by the lending institutions themselves, from the perspective of the borrower themselves, and the person whom they interacted with directly (a job I did for 3 years): The Loan Originator/Officer/Salesperson, which we'll just call the Originator.
Lets say you go to an originator about buying your first home. Its 2002 or 2003. You engage in small talk, and he asks you what you think you can afford a month. You say about $1,500. He says:
"Good News! We have a great new lending program that lets you take advantage of these historic low rates! We can get you up to $800,000 for your first home!"
The first thing you need to understand is that the Originator is a Commissioned Salesperson. Some, who work for bank branches, like I did, receive a base salary with a commission payout for many things, including loans. Most others, such as independent brokers or employees of banks' lending arms, are 100% commissioned salespeople like car salesmen. I use car salesmen as an example because I was one for a year after I got out of the service, and because the sales techniques are similar and sometimes identical. Understanding this is key to understanding the culture of greed that was fostered from the ground up, and every step of the way, in the mortgage crisis.
This is not to say that all people in the trenches of the mortgage and secondary lending business, like Home Equity Loans, were greedy to the point of corruption, far from it. We were selling an actual product with an actual purpose; we were enabling people to buy a home, or borrow the money to fix up their existing one, in record numbers and at record low rates. Not only that, unlike being a Realtor (another profession making money hand-over-fist) we needed no specialized training, no licensing, and no college degree, only the ability to sell and follow the procedures laid out for us. A lot of the "get rich quick" methods had to do with linking up with a small independent brokerage outfit and do the leg work. I knew a few people who did it in their free time while going to school or working other jobs.
For this, we were given the ability to make lots of money. The lending industry's commissions are calculated by "Basis Points", sometimes called "Bips." or "BPs". A BP is 1/100th of 1%, or 0.0001. A commission would be "x" number of BPs of the total loan amount. For instance, a 30 bp payout on a $250,000 loan is $750 paid to the originator. However, commission is never this simple. There are always incentives to go for the gold. The most common one is to create tiers based on volume or total dollars booked. For example, if you did 5 loans in a month, or $1M in total lending, your payout could be increased to 40 bp. 10 loans or $2M could get you 50 bp, and so on. So, for 10 loans at $250,000 each, one could get $1,250 per loan, for a total payout of $12,500 vs. $7,500 at a 30 bp payout.
This in and of itself is not where most of the problems were. 20 years ago, when loans were pretty much only the standard 30-year fixed loans that conformed to Fannie/Freddie requirements (also called "Prime" loans), the ability to get more loans per month had a lot to do with working hard to find qualified people. Qualifications were steep because the ability to repay was given a high priority, but a 30 year fixed was a great deal because the payment would stay the same the entire 30 years.
Where it all began to break down was in the increased use of riskier types of loans. Understand, that when I say riskier, it does not necessarily mean a person with lower credit, but the complexity of the loan itself. "Interest Only" or the (IMHO) disgusting "Negative Amortization Loans" are risky simply because it presents the borrower with a change in payment during the loan duration. For those who don't know what these are, as I did not before I got into banking, here are some simple descriptions:
Interest Only (IO) means that for a set period of time, 1 - 5 years, you are being billed for ONLY the interest payment. Lets say that you have a 5 year interest only loan on a $250,000 home. At 6%, the 30 year fixed payment would be just under $1,500. However, because you are only paying the interest, your payment is only about $1,209 for the first 5 years. The problem is that at the beginning of the 6th year, your principal is still $250,000. You now only have 25 years to pay that loan off, meaning your new payment is now $1,610, $100 greater than the 30 year fixed amount and a full $400 more than what you had been paying up to now. Oh... and the bank gets to set a new rate. You're welcome.
Negative Amortization (NegAm) is, in effect, selling a rate no matter what. Remember those ads for the "2% loans". They were NegAm loans. Basically, the rate you were being charged was only 2%, but the loan was for 6%. Using the above example, you were only paying $403 a month for the same $250,000 loan. The other 4%, though, was being tacked onto principal. At the end of the interest only period, your payment would shoot sky high, as you are now paying almost $300,000 off in 25 years. About $2,000 a month.
The important thing to understand about these two loan types from an Originator's perspective is that they commission payout on them is higher than a 30 year fixed. On a single NegAm Loan, the Originator might get 50 bp. But, it gets better.
Remember how I said I was going to compare Originators to Car Salesmen? Here's the reason why. When negotiating price of a car with a Car Salesman, what is the number one technique they use? Answer: They sell payment, not total cost. They ask how much you can afford a month, rather than the total amount you want to pay for the car. With IO and NegAm loans, the question shifts from how much the house itself costs to how much you can pay per month.
Let's go back to the initial scenario. You've never bought a home before want to buy your first home, but don't know what you can afford. You are asked a few questions, culminating in the, "How much can you pay?" question. You respond with "$1,500 a month." A lender does some calculations, and comes to the conclusion that you can get a $250,000 30 year fixed. Or almost $800,000 on a NegAm. The $250,000 would get him $750 at 30 bp. An $800,000 loan would get him $4,000 at 50 bp. The company is letting him double dip by paying him a higher percentage for a greater loan value. What do you think he's going to do?
"Good News! We have a great new lending program that lets you take advantage of these historic low rates! We can get you up t0 $800,000 for your first home!"
Welcome to sales. The ultimate problem with this is that the vast majority of people, especially those buying their first home, know nothing about the process, how loans work, the types of loans that are out there, etc. They are wowed with the prospect of not only being home owners, but living the American Dream in that 3,000 sq. ft. home they see being built everywhere. The originator tugs on their emotions and keeps the excitement up. When signing loan documents, they are shown stacks and stacks of papers and a "sign here, sign here" presentation, told they have 3 days to cancel, but are overwhelmed and never go over the details when they get the papers home.
Please, don't assume I am trying to say that all lenders did this. Most of the banks, at least initially, tried to keep this type of lending to a minimum to keep their risk low. However, I saw companies like Ameriquest show up out of nowhere, market the hell out of the American Dream, make my friends $10K a month for a short while during the boom, and then quietly go out of business last year. As usually, the 2% ruined it for the rest of us.
It continued, though, in the secondary lending markets as well. Home Equity Loans, traditionally taken out as lump sums at a fixed rate, were fast being replaced by Home Equity Lines of Credit (HELOCs), which were lines of credit paid back at variable rates, like using your house as a giant credit card. When I sold cars, I actually saw someone buy a $50,000 luxury SUV and pay for it with his Home Equity Line of Credit. People would buy huge homes Interest Only and take out HELOCs to furnish rooms they didn't need, also Interest Only. Reality shows like "Flip this House" encouraged people to buy, fix, and sell for profit. I knew people who would take out Equity Loans on an existing house to buy another one, and do it again, and again, and again.
The responsibility I assign to the borrowers is minimal, and mostly just disappointment in allowing themselves to be taken in by all the hype without taking a step back and seeing what was going on. However, I don't judge people too harshly, given the blitz of marketing, fostered at every level of the process, to want more, more, more. Most of this, really, can only be looked at in hindsight, and while the people at the top levels with the education and experience that were overshadowed by greed, it isn't until now that we can say, "Maybe I should have read those loan documents a little closer, or thought that it was a deal too good to be true."
You may ask yourself how these people got these loans in the first place. The next part in my series will focus on Underwriting Standards, Regulations, and how drastic changes in those caused Originators to offer these loans in such large amounts in the first place.