If you're still a bit fuzzy about what caused the 2008 financial meltdown, here's a bit of insight, courtesy of the Justice Dept.
In 2007, mortgage lender Countrywide Financial was trying to figure out how to meet its loan production targets as the housing market--especially the sub-prime segment--began to cool down. So it revamped its lending procedures to eliminate many of the "toll gates" that tend to hold up loans, such as verifying a borrower's income and eliminating checklists that underwriters must complete before approving a loan. Countrywide met its production targets, but severely degraded the quality of the loans in its portfolio. At one point, the percentage of loans with "material defects" was close to 40 percent--about 10 times the normal rate.
To maximize profits, Countrywide, like many other lenders, packaged its loans into mortgage-backed securities that investors would purchase, a standard practice for more than 20 years. Securities that met certain standards were guaranteed by the federal housing agencies Fannie Mae and Freddie Mac, whose imprimatur acted like insurance if some of the loans defaulted and the securities lost value. But Fannie and Freddie relied on the lenders to validate the quality of their own loans, without doing their own vigorous checking.
As the housing market began to tank, borrowers began to default in record numbers, and many of the loans packaged into mortgage-backed securities turned out to be far riskier than the lenders had acknowledged. That's the basis for the Justice Dept.'s latest lawsuit against Bank of America, which bought Countrywide in 2008 for $2.5 billion, hoping that its huge mortgage portfolio would make B of A the nation's premiere housing lender. Instead, the Countrywide deal became one of the worst corporate acquisitions in history, saddling a once-healthy bank with billions in losses and another $40 billion in fees for litigation and restitution, according to estimates by Credit Suisse.
The government now claims that Bank of America (then Countrywide) deliberately withheld information on its trashy loans from Fannie and Freddie, contributing to the collapse of the two housing agencies, which has so far cost taxpayers about $140 billion in bailout money. The feds want billions of dollars to compensate taxpayers for at least $1 billion in losses allegedly caused by Countrywide's relaxed lending standards. Bank of America doesn't dispute the charges, but contends that it has already made amends by, among other things, paying Uncle Sam $1 billion in a settlement reached with another housing agency earlier this year.
The case represents an intensifying effort by government prosecutors to hold banks accountable for the reckless lending that caused the 2008 financial meltdown and the recession that followed. So far this year, the feds have settled similar suits with three other banks, including Citibank and Deutsche Bank. Two other suits, including one against Wells Fargo, are still outstanding. Some critics feel the government action is too little too late, yet the information revealed in the lawsuits explains why the mortgage market is so tight today and why the overhang from the 2008 meltdown may persist for years.
The Countrywide suit, for instance, alleges that the lender basically did away with traditional underwriting standards that for decades had guaranteed banks kept their losses under control. To keep loan volume up, Countrywide initiated a "high-speed swim lane," known as the Hustle program, that was basically designed to approve as many loans as possible. For most loans, persnickety underwriters looking for problems were replaced with less-qualified "loan specialists" who earned bonuses based on the number of loans they pushed through the system. The specialists had the flexibility to change data on a mortgage application in order to satisfy software programs designed to spot trouble. Garbage in, garbage out, as data analysts like to say.
Some Countrywide managers recognized what was happening, and tried to convince company leaders that the firm was courting disaster. One of them was Edward O'Donnell of Pennsylvania, a Countrywide vice president who became a whistleblower providing a lot of the information that ended up in the government lawsuit. But at the time, the firm's management overrode such concerns, according to the federal lawsuit, , even though Fannie and Freddie had issued guidelines instructing mortgage lenders to tighten their underwriting standards, not lower them.
Borrowers today gripe about the voluminous documentation they must provide to get approved for a mortgage, including details explaining the tiniest blemishes on their credit reports, going back years. A lot of borrowers who would have legitimately qualified for a loan a few years ago get shut out now, and others find the paperwork so overwhelming that they give up. Bankers and their government regulators are probably being excessively careful, yet the shoddy practices that were common not long ago at Countrywide and other lenders helps explain why.
Another obvious hole in the system was the longs-tanding practice of Fannie and Freddie basically taking the lenders' word for it that their loan portfolios were healthy. It's self-evident today that the scale of deceit turned out to be massive, which is why Fannie and Freddie got stuck holding the bag for billions in losses on mortgages they never would have guaranteed had they known the facts. That's another reason there's so much top-to-bottom scrutiny of mortgages these days.
A final takeaway from the Countrywide suit is the extent to which banks were willing to offload their risks onto the government, even when it started to become obvious that somebody was going to lose a ton of money. It's well-known by now that the system was set up so that banks enjoyed the profits while taxpayers bore the losses, yet it's still worth recalling how widespread such abuses became--especially since new regulations to rein in such risky practices still haven't been finalized.
Rick Newman is the author of Rebounders: How Winners Pivot From Setback To Success. Follow him on Twitter: @rickjnewman.
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