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Jack M. Guttentag The Mortgage Professor

Jack M. Guttentag, The Mortgage Professor

The Private Mortgage Industry's Role in the Current Crisis

by Jack M. Guttentag

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Posted on Tuesday, July 29, 2008, 12:00AM

The blame game for the development of the current mortgage crisis is now in full swing, and, with one exception, no major participant escapes unscathed:

1. Lenders and investment bankers drastically relaxed their underwriting standards in response to the euphoria associated with rapidly rising home prices during 2000-2006. They approved loans that could not possibly be repaid without an indefinite continuation of house price inflation.

2. Bank regulators ignored the breakdown of underwriting standards until it was much too late to take effective action.

3. Mortgage brokers and loan officers encouraged borrowers to buy more house than they could afford, and to accept toxic mortgages that they did not fully understand.

4. Consumers allowed themselves to be seduced into buying houses they couldn't afford, into purchasing second and third homes on speculation, and into depleting their existing equity through cash-out refinances, in order to maintain lifestyles they could not sustain.

5. Rating agencies provided AAA and AA ratings to securities issued against pools of new types of extremely risky loans, when they had no adequate statistical basis for estimating potential losses on the loans.

6. Fannie Mae and Freddie Mac invested in such securities, taking large losses and weakening their capacity to be a source of strength during the crisis period.

7. The Federal Reserve kept interest rates low well past the point where they should have raised them, and, as a regulator, was as asleep at the same switch as all the other regulatory agencies.

The exception is the private mortgage insurance (PMI) industry. It is the one sector that has not been cited as contributing to the crisis.

Since the industry was reconstituted in the late 1950s, it has enabled borrowers to obtain conventional loans -- those not insured or guaranteed by the federal government -- with down payments of less than 20 percent. Insurance premiums were scaled to down payment -- the smaller the down payment, the higher the premium.

PMIs must place half of their premium inflow in contingency reserves which can't be touched for 10 years except to meet unusually large losses. This encourages the companies to set premiums based on estimates of losses over long periods, so premium rates change infrequently. And it severely dampens the temptation to make a lot of money in a short period by taking advantage of ebullient markets. PMIs can't pay themselves premiums net of losses in the current year, as most lenders and investment banks can.

The PMIs did not fully participate in the euphoria and excess that preceded the crash. They did insure some risky loans that would not have been acceptable to them earlier, but for the most part they stuck to their guns. As a result, their market share declined with the emergence of "piggybacks" (when a home is purchased using more than one mortgage from two or more lenders).

Lenders discovered that they could make 95 percent and even 100 percent loans by getting other lenders to offer second mortgages for the amounts over 80 percent of property value. Piggybacks carried higher rates than the first mortgages, but in many cases the cost to the borrower was smaller than the cost of mortgage insurance. The interest on piggybacks was deductible, while mortgage insurance premiums were not. In addition, borrowers could pay off the second mortgage in full at any time, whereas getting rid of PMI was a hassle.

Of course, the PMIs did not give up market share willingly. They induced Congress to make mortgage insurance premiums deductible, at least for a period, but this had only a small impact.

Had PMIs followed the prevailing pattern during the go-go years, they would have cut their insurance premiums sharply and gone after the riskier loans. But they didn't, and the piggyback market thrived until the crisis hit. At that point, the market got an object lesson in the value of PMI. First mortgage lenders discovered that piggybacks provided substantially less protection against loss than PMI. As home prices declined and the crisis grew, a large proportion of piggybacks (the market has now virtually vanished) lost all or virtually all of their value.

Borrowers experiencing payment problems discovered that having to deal with two lenders was a substantial barrier to getting loan contracts modified. In contrast, mortgage insurers will often help borrowers negotiate modified contracts with first mortgage lenders.

Nonetheless, the PMIs have been badly hurt. Losses have been eroding their capital and reserves, and their stock prices have tumbled badly. Yet the industry is doing exactly what it was set up to do, which is to cover losses to lenders during a period of stress, out of reserves that they accumulated during periods of prosperity. The industry should play a more prominent role in the very different housing finance system that emerges in the future.

 

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  • Yahoo! Finance User - Monday, August 4, 2008, 7:53PM ET  Report Abuse

    • Overall: 1/5

    Re: dmerrick888: You are so correct, and as a former banker, our bank which used Washington Mutual to do it's mortgage originations, had banks like ours to push us Personal Bankers for mortgage applications back in 2003. The bank I worked for had us guaged to do anywere from 18-20 of these mortgages to be opened during that time. While I am glad I never got anywhere near that goal, as personally my conscious wasn't in it, as I could see people coming into my bank, with little down buying homes in my town that were running close to $500K, (some where going for 3 quarters of a million, but those house are still vacant, getting their copper pipes stolen by drug addicts..) with bank accounts that were really pitiful. But that was 2003, and the idea was easy credit, easy come, easy go to your new home. I knew then as my manager did that this was a precursor for disaster in this country. As it turned out, I was right. One of the other things, is that these days, a banker isn't anything more than a salesman. If you think that a banker is a ethical person, the answer is emphatically NO! It has nothing to do about helping a person save money, just hand out credit apps like aspirin, and bring in those bucks. When I got my 2 year degree, I was shocked to find out that I was a anomaly. My fellow bankers, some of which prior to being a banker were behind a counter at McDonalds, asking if you wanted an apple pie or fries with that. Just sell, sell, sell, and regardless of the customer back then, just give them a mortgage they can't afford. Washington Mutual made out like a bandit, the bank I worked for, their stock was running over $25/share when I started, now their stock is 9.95. Needless to say, the mortgage meltdown had something to do with this. Lastly, you are right, that most of the blame being thrown around, has FAR LESS to do with the consumer, than those involved with the hedge funds, scrupulous lenders, and Real Estate agents with a one track mind...Greed over Ethics. Now they want the Government to bail them out? This is a joke, as most of the 4/5 stars would call this socialism if the consumer wants a bailout, but if it's a bailout for lousy economic policy that leads to deregulation, it's simply Good for Business, which is Good for America. With practices and economic policies like that, it doesn't take rocket scientist to figure out, we are selling out the American Dream, and outsourcing it for the worldly masses, who come to this country easily with money that is more worthy than the greenback. What a joke this country is...In God We Trust...as long as God isn't a Banker!

  • Yahoo! Finance User - Monday, August 4, 2008, 1:08PM ET  Report Abuse

    • Overall: 1/5

    This article misses the real point that millions of common people are losing their homes and their realtors and brokers weren't involved? They didn't get any bonuses for marketing these adjustable bad loans? Alan Greenspan recommended that everyone should get an adjustable loan (while he personally got a fixed mortgage loan) then the interest rates were raised every month for 2 years. Someone knew what was going on. My realtor knew my broker who knew my appraiser and then they set me up with Indymac Bank. Here's a great loan for you! There's complicity here and I don't think we will know the real truth for years to come.

  • DONALD H - Monday, August 4, 2008, 11:52AM ET  Report Abuse

    • Overall: 5/5

    I didn't think anyone would have the brains or guts to write this piece. Where was our government controls to keep this from going on? Now its time for tax payers to bail this mess out.

  • delgado621 - Monday, August 4, 2008, 11:46AM ET  Report Abuse

    • Overall: 2/5

    Home buyers were seduced?. You have to be kidding. If a jewel thief breaks into a glass case to rob a beautiful diamond ring, the jewelry store should be held responsible because it seduced the thief by displaying the ring. I only have a few words to say to those who say they were led, seduced, directed or whatever other verb you care to use; to buy houses they couldn't afford and these words come courtesy of Don Henley/Glen Frey from The Eagles. "I turn on the tube and what do I see A whole lotta people cryin 'Don't blame me' They point their little crooked fingers at everybody else Spend all their time feelin' sorry for themselves Victim of this, victim of that Your momma's too thin, you daddy is too fat. Get over it"

  • Yahoo! Finance User - Monday, August 4, 2008, 11:12AM ET  Report Abuse

    • Overall: 2/5

    I heard a story yesterday that left a permanent scar on my respect for the Real Estate industry (AS A WHOLE). My brother in law's best friend got married in 2004. He and his bride did everything right. They saved up for years (a decade actually) for their wedding and down payment on a home. They bought a condo that was in their price range. The real estate agent (A "FRIEND" of the family), tried desperately to talk them into buying a bigger house. They wouldn't flinch because they had thought this whole thing through, and they knew exactly what they could afford. They wanted this condo and they wanted a 30 year fixed mortgage at the current rate. The broker who handled the financing was also a "FRIEND." When he told his "friend" that he wanted a 30 year fixed mortgage, his "FRIEND" the broker convinced him that (what is now know as) an "Exploding ARM" would be his best bet because he would get a less than 2% rate and then all he had to do was apply for a new one every couple of years. He fell for it, mostly because it was his "FRIEND" who was steering him in this direction. He signed the papers. 6 months later he begins to see the interest rate ratcheting up. By the end of the first year (into the 2nd) his interest rate was up to 11%!!! He went back to his "Friend" the money man, and complained about this ridiculous loan. He told him he wanted to get a new loan and this time he wanted the FIXED RATE 30 YEAR job. His "Friend" told him that fixed rate mortgages were "Old School Mom & Pop" and that nobody paid more than 2% any more because of the "new 21st century mortgages". So he asks his "Friend"... "Tell me, why would I NOT want to get a 30 year fixed mortgage with rates this low?" (I am told the rate was 5.5% at the time). His "Friend" the money man repeated his ridiculous "mom & pop old school" line. So he tells his "Friend", "Please stop with the ARM mortgage crap. I want a 30 year fixed mortgage." At that insistence his "Friend" FINALLY set him up with the fixed rate mortgage (which he qualified for from the very beginning, and asked for the entire time he was buying the house). He went home and called his buddy (my brother in law) on the phone and told him: "Listen man, I'm telling you, from what I just experienced I can guarantee there will millions of people losing their homes." February 07 rolled into view shortly after that. If this is how FRIENDS were "motivated" to sell subprime, I can only imagine how many people really did get HOODWINKED into signing their lives away. I used to think that homeowners were "probably" just as guilty because I assumed they HAD TO KNOW what they were signing. Evidently, the entire market was rigged to get as many people as possible into the subprime BLACK HOLE. It was all about the COMMISSIONS these jokers were raking in. The whole thing REEKS of "Moral Hazard." There will be no "bottom". Certainly not in the sense of a "return to normal." This Frankenstein monster IS going to take America down with it.

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