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While watching the congressional testimony of the federal regulators yesterday, one of the representatives started waving around the Financial Report of the United States and quizzing the witnesses. SEC Chairman Christopher Cox got slapped pretty hard for not being able to answer the representative’s questions.
It is only a few pages and very easy to understand…
I figured it might be helpful to describe the structure of the loan origination process used in my previous post. Understanding 1990s era subprime loan origination offers a baseline for comparison with subprime offerings over the last few years.
This example was typical of actual lending at The Associates (TA) during the mid to late 90s. TA, the largest publicly traded finance company in the U.S, was acquired by Ford in the late 80s and then spun off again in the mid-90s and was then acquired by Citi in 2000. http://www.citigroup.com/citi/corporate/history/associates.htm
Account executives, commissioned employees of TA, solicited deals from independent mortgage brokers. The brokers found borrowers (the end consumer) through a number of channels including bulk mail, cold calls, advertising, etc. The broker worked with the borrower to structure a deal – this involved gathering the necessary information to meet the requirements of a particular loan type (financials, debt, etc). The deal was then shopped around to different lenders (TA account executives routinely visited the brokers to keep them up to date on products and rates. The account executives could also do pre-approvals in the broker’s office). If TA was selected; the deal was then submitted to TA for underwriting. The underwriters were located in a small number of centralized, regional offices.
Brokers are independent operators and they get paid a commission when a deal closes and therefore have a financial interest in the deal closing. Account Executives, as TA employees received both a salary and commission based on deal volume and meeting sales goals, as such they also had a financial interest in deals closing. The underwriters were salaried TA employees who did not get compensation based on deal volume. There was a running battle between sales and underwriting – sales pushed for deals to be approved while underwriting pushed back as they were the gatekeepers and charged with maintaining deal quality. Senior management had to balance the often competing objectives of meeting sales goals while maintaining quality standards.
These TA loans were considered subprime and non-conforming as the borrowers had credit problems, excessive debt and other credit-worthiness issues. Most of these deals did not meet the GSE (Fannie/Freddie) underwriting requirements. Once the deals closed they were held by TA and serviced in-house. (As far as I know, and this is by no means certain, these deals were not being packaged and sold as mortgage backed securities.)
Also, it is my understanding, that underwriting was taken seriously. The underwriters were professional, they were aware of fraudulent activity and they actively sniffed-out questionable material. Deals that did not meet underwriting standards were turned down. I don’t know about the soundness of the TA risk models but the interest rates on these subprime loans were several percentage points higher than prime loans – meaning the risk of the loan was expressed through higher interest rates. (I mention this as underwriting standards and interest rate spreads play a significant role in the future meltdown – I will get into this later.)
I learned most of this from a family member working in operations for TA. From my vantage point, TA was a legitimate company providing a needed service to credit-challenged people in a fraud ridden environment. My understanding of predatory lending and all of the associated ills and issues developed much later. (I will get into more fraud issues later.)
The following links provide a rather different portrayal of TA:
From Tearing Down the Walls by Monica Langley:
After Citi acquired TA – they suspended 3,600 independent brokers of subprime mortgage loans – about 60 percent of the Associates’ contractors-for having inadequate licenses, using questionable tactics, or failing to sign a code of conduct…
Google Books p. 367-369 http://tinyurl.com/5r7wlh
Shareholder Resolution Follows Associates First Capital to Citigroup
Citigroup Settles FTC Charges Against the Associates
Record-Setting $215 Million for Subprime Lending Victims
FTC subprime lending cases since 1998
As well as a senior developer and an internet strategist.
There has been a lot of talk about all of the ills of subprime and a fair amount of discussion over what happened and who is to blame. I thought it might be helpful to see what an actual subprime loan looks like and see why it was issued in the first place.
Joe makes $4,000 per month but he built up serious credit card debt (groceries, electronics, music, travel, medical bills, whatever) and after monthly expenses, he has nothing left. Joe gets a letter in the mail (or a phone call) from XYZ Mortgage, Inc. The letter says – we can help you consolidate your debt. So, Joe decides to meet with the broker and they go over his financials:
Joe’s gross income: $4,000 (~$50,000 annually)
Joe’s net income: $3,250
(I have played it a little loose with the numbers here since I don’t have anything specific to work off but this was fairly typical of a subprime loan in the late 90s. In the 90s though, the interest rate spread between prime and subprime loans was wider, 3% or more (I think) then it was during the bubble. The interest rates used here may be low and may actually paint a somewhat more favorable picture. This example is a 30 year fixed rate loan.)
$150,000 mortgage ($1100/mo) (8% fixed, 30 years)
$10,000 credit card 1 ($250/mo)
$15,000 credit card 2 ($375/mo)
car, ins, taxes, etc. ($700/mo)
Joe’s total monthly fixed expenses: $2,525.00
$500 groceries (has kids)
$100 misc. (many other possible variable items)
Joe’s total monthly variable costs ~ $1,000
$2,425 + $1,000 = $3,425 = no breathing room
The broker informs Joe he can get a new $175,000 mortgage and move the credit card debt into the mortgage to free up some cash. The new deal looks like this:
The appraiser reports that Joe’s property is worth $200,000 indicating the property has appreciated by $50,000. (This could be legitimate appreciation or the broker may have informed the appraiser in advance that he needed a $200,000 valuation so the deal could close. There is a considerable amount of documentation that this type of appraisal fraud is common. More on this later.)
New $175,000 mortgage (1300/mo.)
New monthly fixed expenses:
$175,000 mortgage ($1300/mo)
car, ins, taxes, etc. ($700/mo)
Monthly total: $2,000
Old fixed – new fixed = available cash
$2,425 – 2,000 = $425
Once Joe has his new subprime loan, he has around $400 of additional cash available per month.
Does Joe live happily ever after?
A lot of that depends on Joe. Does he start saving money? Does he get a new credit card offer in the mail and get himself into credit card debt again? One thing that people may have trouble understanding is that once you have gotten yourself into debt, it is very difficult to get out. The burden just increases over time. Getting in debt is a lot like gaining weight. When you are 200 pounds overweight, it is that much harder to get up and exercise.
In this example, the debt-to-income ratio is 50% ($2,000 debt / $4,000 income). [I think Fannie will go up to 40-45% debt, I need to look that up.]
So, even under the best circumstances where the borrower is fully documented and the broker acted properly, the situation is tenuous. If you start layering-on the various forms of mortgage fraud (falsified income documents or statements, appraisal overstating property value, predatory lending, concealed debt, etc.) and the situation is entirely unworkable. The borrowers will default even if it is not an ARM.
If you are going to blame the Federal Reserve for keeping interest rates too low and creating a credit bubble (which basically means that money was cheap enough for people to act irresponsibly) then I think you need to drag the credit card companies into the equation as well (as this example illustrates). (it is a lot easier to get a credit card than a mortgage.)
Let’s look at a variation on this loan. Now, suppose that Joe’s house, though it appraised for $200,000 was really only worth $170,000. He’d owned the house for seven years but his neighborhood was not seeing the type appreciation of some of the other, nicer neighborhoods. When the broker placed the order for the appraisal, he also informed the appraiser that he needed a $200,000 valuation (Joe is likely not aware of this). So, the appraiser, not necessarily a bad guy, but dependent on the brokers for income, cherry picks the comps (the property comparisons), the appraisal is good enough to get through underwriting and the deal gets approved. Now, for whatever reason (lost his job, he needs to re-locate, etc) Joe needs to move. This time, when the house is appraised it comes in at $170,000. Joe figures out that if he sells his house he won’t have enough to pay-off the loan, realtor fees and other expenses – he is underwater.
There are many different types of subprime loans but this is a fairly typical example…
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