It is common knowledge that the financial health of the U.S. consumer is largely tied to the health of the housing market.
The explosive growth in the home equity finance marketplace reminds us that the American homeowner has grown too comfortable with the concept of his house as an ATM. A robust housing market and a robust employment market have combined to produce tremendous consumption and drive domestic growth.
As the number of new affordable mortgage products has grown wildly, the capital markets have become increasingly involved in providing long-term financing for these loans. Between 2000 and 2005 the value of U.S. home mortgages for one-to-four-family homes grew from $4 trillion to over $8 trillion.
According to the Federal Reserve Z1, statistical release of December 2006, the portion of the one-to-four-family residential mortgages financed by the capital markets was three times the financing supplied by commercial banks, savings institutions, and credit unions combined.
So the community banker who took care to actually underwrite a mortgage he was going to hold in portfolio was often replaced by a mortgage banker with no portfolio and no capital at stake. In fact, some of these mortgage brokers were rewarded not for producing loans that would be bankable, but for loans that generated the fat fees fast.
In three years, from 2002 to 2005, the capital markets increased their share of the mortgage marketplace from 56% to over 60%. That meant a banker no longer hade to hold a loan or sell it into the secondary market of cautious investors. Wall Street would buy just about any loan for the yield, regardless of risk.
Demand for mortgage-backed securities also has risen dramatically over the last several years. At the same time there has been a large increase in the percentage of foreign central banks approved to invest in mortgage-backed securities (2% in 1998 to 44% in 2006).
As an interested observer of and customer in the mortgage markets for nearly 40 years, I've learned that nothing drives innovation in mortgage products like other people's money. Until recently much of that money flowed into the subprime mortgage market, with unfortunate results.
The surge in late payments and defaults in the subprime home mortgage market sector has been well documented. Dozens of subprime mortgage lenders are out of business or headed there. And we hear the worst is yet to come when many more mortgages reset.
Consider that according to the Office of Thrift Supervision, 80% of subprime loans were originated through mortgage brokers. Now consider:
- There are no national standards for licensing or oversight of mortgage brokers.
- Some states license offices, not individuals.
- 24 states have no specific educational or experience requirements for mortgage brokers.
In Washington the administration, the federal regulators, and Congress are moving to address the issue. Recently, Sen. Charles Schumer of New York introduced S 1299, the Borrower's Protection Act of 2007. Among other things the bill would establish on behalf of consumers a fiduciary duty of care for mortgage brokers and originators.We must mirror these corrective actions on the securities side. Steps need to be taken to require more due diligence and more disclosure about the risks. Underwriters should perform a series of due diligence tests on a sample of subprime loans in order to determine whether the representations and warranties are accurate. Further tests are needed as well, including a review of credit practices for loans, and quality of originators' financial strength and compliance practices.
The credit review should check the borrower's ability to repay, credit history, and determine that the dollar amount of the loan amount is supported by an accurate appraisal. The compliance review should check the agreements between the borrower and issuer, including a determination that documentation was completed properly, a check that all disclosures required by law reflect the relevant transaction, and verification that the loan terms reflect the quality of the credit.
Due diligence should also be applied with respect to the quality and standing of originators of loans, including reviewing outstanding complaints. And for loans that adjust, it is important to check the ability of the borrower to pay higher rates in the out years.
Another contributing factor to the subprime problem was recently highlighted: the growing use of unverified stated income.
As Comptroller of the Currency John C. Dugan pointed out: "Sound underwriting … suggests that a mortgage lender would almost always want to verify the income of a riskier subprime borrower to make sure that he or she had the means to make the required monthly payments. But the norm appears to be just the opposite — nearly 50% of all subprime loans last year accepted stated income." Mr. Dugan believes the federal agencies should address the practice in pending guidance.
Without question, the subprime market will be cleaned up. But its problems are a reminder that there is no free lunch and there are few shortcuts that don't have consequences.
Sadly, this whole mess could have been avoided if community bankers had not been cut out of the mortgage underwriting business by the unscrupulous brokers who have produced so many of these predatory loans.
A paper processor operating from a two-room office in a strip mall is no substitute for a community bank. A community banker has skin in the game and is subject to a regulatory structure that protects the consumer. The community banker offers mortgage and home equity loans at competitive prices. Community bankers are dedicated to responsible home financing and sound business practices.
Yes, the community banker has access to the world's capital markets through the Home Loan banks and other regulated government-sponsored enterprises. But the community banker never loses his focus on the people on Main Street who are his customers and neighbors — today and every day.