Federal Bail-out, Return to the Source?

When the news hit the street, subprime borrowers took the first hit. No one seems to remember the sequence of federal manipulations or new mortgage terms, which were onerous to the point of being predatory. Terms which were deceptive and misrepresented by the mortgage brokers and lenders. Everyone in the industry wants to wheel and deal, but no one wants to milk the cow.

I used a term that is well understood in an agricultural community. The problem is greed and impatience. When a house is sold or refinanced there are so many up front fees for the closing costs, realtor commissions, appraisals, title search, surveys, loan origination, insurance, and taxes. Every sale or refinance added 3 to 15% to the cost of the home because of fees.
It did not change the fact that mortgages are amortized from 15 to 40 years.

The tax laws were changed in 1986. Interest was no longer tax deductible on credit cards, automobile and personal loans. Until that time I received interest statements from every financial institution where I made recurring payments totaled them and deducted all the interest on my taxes. I don’t know why, maybe the banks cried over the amount of paperwork, then made political contributions and lobbied against the practice. After that changed all deductible interest on a personal tax return was linked to your home. Then the practical tax advice was to consolidate and borrow against your home. The average American was encouraged to have a second mortgage or refinance. Either way the result was the same. You extended the term and it was secured by your home.

Credit card companies lost market share. New customers were offered low rates to open accounts. Customers were offered balance transfers or cash advances at low interest rates. In 1997 or 1998 I received a balance transfer offer that was too good to pass up. The rate on the transferred balance was fixed for the life of the balance at prime –(minus) 4.4%. The interest rate started at 4% APR, went up to 5%, then it dropped to 0%.

The fed lowered interest rates to stimulate the economy. While interest rates were low between 2002 and 2004, it was good for people that used credit. People bought more expensive homes, second homes, and investment properties to be able to deduct the interest. Property renovations became the rage.

OPM (Other Peoples Money), I bought distressed or foreclosed properties at bargain prices and lived in the house while making renovations. Interest-free credit for 12 months paid for floor covering, appliances, and other materials. The property was sold or refinanced with cash back at closing (cash out refi) before the interest rates on the cards increased to the standard rate. Sale or refinance of the home would cover the fees, recover my down payment, pay off the credit cards, and pay my real estate agent. In retrospect, all I accomplished was staying busy.

The experience was fun and challenging for me, but it was bad for banks. Inflation was relatively low, but if you kept money in a traditional savings account you just watched the value of the nest egg diminish every day. People withdrew the bulk of their savings from banks and invested in managed accounts. My local savings account is little more than a rainy day fund. I budget and deposit monthly increments to cover insurance premiums, local taxes, and automobile repairs. It is convenient and readily available to me. It does little to help banks conduct business as they did in the past. Four banks failed in 2001and eleven banks failed in 2002.

The first collateralized debt obligation (CDO) was introduced in 1987. In 2001 David X. Li introduced the Gaussian copula models which allowed for the rapid pricing of CDOs. We’ve all heard the term “Mark to Model”. That’s the model. In a perfect world, the value of a CDO could be calculated at any time during its cycle. Oh, the marvels of higher mathematics and better computers. Unfortunately the Model is only accurate in a vacuum and could not be trusted on MBS with 75% of the assets paid off early because they sold or were refinanced, or when loans defaulted (because of ridiculous loans or inadequate underwriting standards), or when property values declined.

The fed lowered interest rates and the prime rate fell from 9.5% in January to 5.5% in December 2001. The same year the “Model” was developed. It was a calculated risk and the plan was to churn the economy and burn the savings. The prime interest rate continued to decline until it stabilized at 4% in July 2003 until June 2004. Equity stripping and Reverse Mortgages became the new prosperity to fuel the economy. That was the beginning of the “Housing Bubble”.

In 2004 interest rates increased and activity slowed in most of the states. Margins were too narrow, fees consumed most of the equity, and interest rates were higher. Home purchases and refinances dwindled to a more realistic level. People found their comfort level and decided to maintain rather than take on more debt.

New mortgage products and terms were created that targeted subprime and Alt-A borrowers. These were minimally qualified or unqualified naïve borrowers and speculators. Adjustable rate mortgages with introductory teaser rates, optional payments resulting in negative amortization, no or borrowed down payments, no documentation, and no oversight. Risk assessment was downplayed and the money began rolling again. Higher paying products were needed to woo investors and replace mortgages that had been refinanced away from products higher interest rates.

I won’t go so far to say the Fed caused the problem, but they sure did contribute to it. The market gains and housing bubble were an artificial prosperity based on increased debts. Now the chickens have come home to roost, and at what cost?