A rotten mortgage

by Myron M. Cherry

It spoils the whole barrel

Up until a few months ago, home prices continued to escalate. People were purchasing homes for $100,000 and fixing them up to sell them for $250,000 or more. Those higher-end homes costing upwards of $800,000 were resold for profits of $50,000 or $100,000. Everyone was following a similar trend. Television shows were even created that focused on buying and "flipping" homes for a profit.

Part of the American dream involves owning your own home. But did the American dream also include buying and flipping homes? You might think so because as home prices continued to rise, those who were unable to make their mortgage payments found themselves playing the flipping game. But why were those homeowners unable to carry a second mortgage being loaned money in the first place? After all, banks do not typically loan money to those lacking adequate income. Even Vegas casinos are careful when extending credit. So why would financial institutions take such a risk?

Enter predatory mortgage lenders—a group of unregulated and unscrupulous companies who advertise anywhere you can get a mortgage with a five or 10 percent down payment. These small mortgage companies added all sorts of fees onto the loan, calling them initiation charges, service charges and other fancy names. They even allowed applicants to lie about their earnings. I know a couple who applied for a $125,000 mortgage and completed a form saying they earned $175,000 in annual income. In reality, the husband was out of a job and the wife made $40,000. When I asked why they "fibbed" about their income, they told me their local mortgage company encouraged them to do so and told them not to worry as "it was just a technicality." After all, the market was going up! The small mortgage company made three percentage points in cash at the closing and immediately sold the mortgage to a larger mortgage company who did not check the validity of the information provided, since it too, was planning to sell the mortgage to an even larger company.

As time went on, this mortgage was packaged with many other mortgages —tens of millions—until some financial wizard on Wall Street decided to group them all together as collateral to support a financial instrument known in the industry as a mortgagebacked security. A mortgage-backed security was a fancy name for a bond, which simply meant an obligation to pay based upon the assumption that mortgages and their payments would be timely discharged. Soon, these mortgage-backed securities began to have a combined market value in the tens of billions and were being traded in the marketplace. Banks purchased them (large investment banks such as Bear Stearns bought a great deal of them), and municipalities invested their trust funds in them. All these companies continued to make the same "bet" that started this process in the first place—that is, that mortgage-backed securities were a secure investment since housing prices were on the rise.

Remember the couple I mentioned previously? Their financial position eventually caught up with them, and they could not make their mortgage payment. This same scenario happened to many homeowners across the United States as the number of people who received easy credit and could not make their mortgage payments began to multiply. This, in turn, began to affect the value of homes, and since the housing market took a downturn, people ceased not only buying homes but building homes. This caused a ripple effect in the market as fewer goods, services and employment positions were now available.

Big industry players like Lehman Brothers, Citibank, Credit Suisse and Bear Stearns began to question how many mortgages, in the billions of mortgage-backed securities they owned, were high risk and could not be repaid. In other words, how many of the mortgages were obtained by homeowners, similar to the previously mentioned couple, who could not afford the loan and did not have the money to make the payments or the income to support the credit they originally received? The answer remained unclear. So, some of the big banks attempted to sell their positions in order to limit or reduce the large risks they were carrying on their books.

However, as word spread, people stopped buying mortgage-backed securities and related financial instruments because they did not know what their values were. Due to the fact that there was an oversupply of the instruments and no buyers, their values began to plummet. While there may have been good mortgages mixed in with bad mortgages, what was the ratio of good versus bad? Again, the answer was unclear. Many began to realize that the easy credits advanced by unregulated and unscrupulous mortgage brokers were really nothing but a bunch of poor loans. Banks became scared and refused to lend money even to those who could afford loans. As such, a gigantic credit freeze ensued not only in the United States, but throughout the world as these mortgage-backed securities were everywhere.

The Federal Reserve sprang into action and made more money available to banks at lower rates hoping they would continue to loan money, but this time to those who could pay it back. It was not only the banks that held these “worthless” securities, but investment banks like Bear Stearns. Ultimately, to prevent a broader financial collapse, the government lent billions of dollars to JP Morgan, allowing the bank to buy Bear Stearns at a highly discounted value.

Someday, when the dust settles and people discover which mortgages are good and which are bad, these mortgage-backed securities may increase in value. But until then, those institutions containing numerous mortgage-backed securities may go out of business and only those institutions which have enough solid assets will be able to hold onto this "worthless" paper. But based on accounting rules, even those successful institutions must document them as worthless. This is why you currently see financial companies reporting billion-dollar losses. After all, as Paul O’Neill, former Secretary of the Treasury, recently remarked, "If you lined up 10 bottles of water and told people one of them contained poison, no one is going to buy any of them."

We are now in the midst of figuring out how the big institutions should be regulated in the future. This includes discovering how to stamp out the unethical and unscrupulous mortgage brokers while simultaneously trying to stimulate the economy to prevent the credit squeeze and help homeowners who are losing their homes.

This is an economic problem and a hot political issue. While America has a strong and vibrant economy, these markets need supervision to prevent this problem from recurring. However, the amount of regulatory bureaucracy added should be regulated, as too much could impede upon the entrepreneurial spirit that makes our country so great. After all, America runs on the engine of small business and the consumer; if it did not, our economy would be destroyed.

The federal government must also find a way to regulate investment banks and other large financial buyers who invested in mortgage-backed and similar securities without adequate due diligence. Since these securities were interlocked throughout the financial market,and had established names attached to them (such as Citibank, Bear Stearns and Credit Suisse), the loss attributed to the "housing bet" had an even greater negative impact because everyone trusted the system—but only greed monitored it.

The lesson here is to remain vigilant, keep working hard and attempt to change the politicians who allowed the big boys to take these massive gambles without proper oversight.

If you have a particular subject that you would like me to cover in this column, send me an e-mail at mcherry@cherry-law.com. I would be interested in your comments. Until then, be well and good business.