It's the Banks, stupid!

I love underdog stories, particularly sports ones but really, any underdog tale will do.  I was born with a soft spot for the underdog, the scapegoat, and the misrepresented.  This tendency makes me feel bad for mortgage brokers and sub-prime loans because big banks, the Federal Reserve, and Fannie Mae have really let them get thrown under the proverbial bus.

When I left a brokerage to go to the Bank of Hell I had no idea how uneven the playing field was.  In terms of checks and balances on loan fraud and quality, brokers were way ahead of the game.  The wholesale system has one inherent check on fraud, the underwriting of a loan took place outside of the office where the loan was originated.  This prevents a loan officer from having a personal relationship with their underwriter which goes along way in making sure loans are properly handled.  At the Bank of Hell, The Mortgage Devil's mantra was that we should sell real estate agents on the fact that we had local underwriting because it implied we could get loans done more quickly and also, it made real estate agents  feel good to know that if the loan had problems the loan officer could walk to the next office and shakedown the underwriter.  The truth is that local underwriting creates the opportunity for fraud.  Frankly, loan officers shouldn't be able to touch their loan files once they are done with the application, no good can come from it.

Obviously, there were shady brokerages and independent mortgage companies doing business during the peak and yes, a lot of these were sub-prime, but, there is a bigger story about the preferential treatment of banks over brokerages that isn't getting told.

The fundamental difference between mortgage operations was whether the company had a direct and contractual relationship with a bank or not.  The firm I started with had correspondent and wholesale relationships with investors and banks.  The firm was not owned by a bank nor directly affiliated with one but, because of our relationships I could sell the loan products of these other companies, including banks like Wells Fargo.  In contrast, the Bank of Hell owned its mortgage division while companies like Countrywide, owned a small bank.  There were tremendous advantages to having a direct relationship with a large bank and now I know that the major advantage of this was the bank's relationship with Fannie Mae and the Federal Reserve.

There are numerous examples of how these relationships allowed for more risky lending but I want to start with everyone's favorite loan, the Liar's Loan.  When I worked as a broker, very few of our investors allowed stated income loans to close without something known as a 4506-T, a form that the borrower would sign allowing the company to pull copies of tax transcripts.  The only investors we had that would allow stated income loans without this form were, shockingly, large banks.   Why does this matter?  Well, for starters a 4506-T pulled during the processing of a loan could confirm whether the borrower was lying about the income or whether they even had a job.  Smart loan originators knew better than to grossly overstate income on a loan with a 4506-T because there was the fear of getting caught, not getting paid, and potentially getting fired.  There were probably a number of loan originators who weren't aware of the potential for disaster but the majority that I knew, were very aware and this helped to reduce the risk inherent in a stated income loan.  My first manager in the industry hated the notion of tax transcripts, as he would say, "If underwriters can see your tax return it isn't a stated income loan."  That statement is what F. Ross Johnson referred to as a BGO or a blinding glimpse of the obvious.

So tax transcripts helped to reduce fraud by the loan officer but they served many functions.  A tax transcript pulled after the loan closed, but before it was sold, could have identified whether the loan carried more or less risk than the investor would expect. Sometimes investors wouldn't buy loans after pulling tax transcripts leaving correspondent lenders stuck with a loan they thought they could sell.

Tax transcripts could have prevented a number of issues with loan quality.  Imagine catching liars before the loan closes or before the loan was sold with an understated amount of risk.  In terms of mathematical assessment of loan quality, a random sample of the tax transcripts might have provided a firm with information on the thresholds of risk; ie, what percentage of liar's loans overstated income by 5%, 10%, or 20%.  This type of information could have been used to create thresholds for underwriters.  I'm sure some companies did use this information to reduce risk but the most important players in the industry weren't doing this and that includes Fannie Mae and big banks.   

At the Bank of Hell, we were able to do a number of Fannie Mae backed Liar's Loans.  There seems to be a huge misconception that Fannie didn't do these loans but the truth is that only large banks and large mortgage companies like Countrywide were given the ability to do these loans by Fannie.  I have heard a story that the Bank of Hell got access to these loans after pissing a bitch to Fannie Mae because Countrywide and Wells Fargo had them.  Who knows what kind of sketchiness went on behind the scenes as banks lobbied Fannie for the right for more risky, but prime, Fannie Mae loans.

The beauty of a Fannie Mae stated income loan was that there was no 4506 required, meaning there was no way that anyone would know how extreme the risk was or how bad the lie was.  Perhaps, that is how Fannie Mae wanted it.

At the Bank of Hell we had our own Fannie approved stated income/stated asset loan that A. Hole already blogged about.  Let me be perfectly clear, many of these loans were way riskier than sub-prime loans.  These loans were given to people with fair to excellent credit so while they didn't carry the credit risk, there was tremendous opportunity and incentive for loan officers to commit fraud with this program.  As A.Hole explained, the Mortgage Devil encouraged us to lie about borrower's income to get them into this easy loan program because you could take a loan from application to settlement in seven days. If you have been reading this blog you aware that we were doing Fannie Mae loans at 65% debt to income ratios.  This loan allowed loan officers to do loans with high debt to income ratios by falsely stating the customer's income so that it looked like it was 45% or less.

When these loans were bundled into pools they looked like low risk loans, they were Fannie Mae prime backed loans and had the implied backing of the United States government.  Fannie Mae pimped these pigs in dresses.

The scam gets worse when you add the folks on Wall Street to the mix.  When loans were bundled into securities for trade, these prime loans were mixed with sub-prime loans to reduce the risk.  You offer a lower rate of return on the non-risky piece (the Fannie Mae piece) and a high rate of return on the sub-prime piece which frankly, everyone knew had a very high probability of default.

In my opinion, Fannie Mae fucked it up for everyone.  There so called "prime" loans were riskier than a lot of sub-prime loans.  Perhaps the borrowers weren't credit risks, but they were overextending themselves with the help of Fannie Mae and the biggest players in the mortgage industry.  This means that virtually every loan pool sold understated risk substantially and investors who thought that Fannie Mae was synonymous with low risk, eventually found out that Fannie Mae was a giant phony. 

We have all bought things based on the implied quality of a brand name only to find out that we bought a name and nothing else.  This in a nutshell is one of the major reasons we are in this mess.  Most of our financial innovation and trading during the housing boom was based on Fannie Mae's name and the implied quality of the loans.  There were a lot of lemons in that pool and as I said before, Fannie Mae is a bitch.

For those of you that have seen the movie Tommy Boy, Chris Farley provides the perfect metaphor for what happened to our economy.  Fannie Mae was selling boxes of crap with a stamp that said "Guaranteed" and now we know what the guarantee was: our money and future economic prosperity.