The Cluster F of SubPrime

For those of you who might think me hypocritical for my condemnation of the contributors to the housing crisis, boo.  I was a loan officer but I certainly didn't create the policies, debt instruments, or institutions that blew up the world.  I was under direct orders to produce more loans and play stupid at corporate meetings where we were meant to stare in awe at Senior Vice Presidents of Liquid Lunches and Nonsense. 


At a corporate meeting one time I had the distinct pleasure (where is my sarcasm font?) of meeting some loan officers from Baltimore that I referred to as Dumb and Dumber.  Turns out that they were doing almost half the volume I was but making three times more than me in commission.  This really troubled me, not because I felt like I was doing something wrong, but because it seemed as though something must be rotten in Baltimore, hon.

After a few cocktails, they explained that they put all their customers in sub-prime loans because the commissions were so much higher.  This was shocking to me because I never really found the sub-prime loans necessary, nor desirable to do.  They were a complete pain in the ass and required me to subject myself to my least favorite part of the business which was dealing with more colleagues (assholes) than necessary.
The other reason I avoided sub-prime loans was that typically I could get a marginal borrower into a better loan, whether it was an FHA, alt-A, or sometimes even a prime loan and that meant better terms and rates for my customer.

I did two sub-prime loans that I remember, one for a guy who slipped out of FHA eligibility because he lied to me about his child support obligation and one for a Veteran.  I did not feel bad for putting the lying guy in a sub-prime loan.  When I explained to him that not disclosing his child support had made him look eligible for the loan but when I received his paystub, his ratios were too high to qualify, his response was, "Fuck it, I'll quit paying the bitch.".  Welcome to a 9% interest rate on a 2/28 ARM asshole.  I will gladly take my commission and maybe even send some of it to your ex.

Mr. Veteran had a certificate of eligibility but did not meet the VA underwriting guidelines because he had a foreclosure that was too recent for the program, if memory serves, it had been less than two years.  Here is the worst part.  When he was out of the country, in military service, his wife had an affair and decided not to pay their mortgage anymore.  She ran off with another guy and let the home go into default.  He returned home from the sandbox to a sheriff's sale notice and divorce papers.  I hated that this guy had to go sub-prime, I truly thought it was a total travesty by our government that this man couldn't get a good loan.  I took a huge loss on his loan, meaning I priced the loan so that I was making less than the required amount by my company, giving my customer a better rate and me a tiny little commission.  I felt like it was the least I could do for someone who got screwed by their wife and the government in rapid succession.

The overlooked thing about sub-prime loans is that the interest rates really were not that high when you consider the inherent risk of the loans.  To put it in perspective, interest rates on sub-prime loans made to crappy borrowers were lower than those rates in the late seventies and early eighties that great borrowers paid.  Sub-prime borrowers even had the option of getting into a 30 year fixed loan, not all of them were the two or three year adjustable rate types.  The reason most sub-prime borrowers did not get into 30 year fixed loans at eight or nine percent is that there was every incentive for the loan officer to put them in the shorter term adjustables.

If you worked for a broker, you were paid in yield spread premium, and most often the investors would limit yield spread on the fixed rate loans meaning lower commissions for the originator.  The invisible hand of profit would guide loan officers into selling the crappy terms to their customers and not even mentioning that they had a fixed rate option, just to earn the minimum rate of return.  Much like Fannie Mae, investors knew that many loan officers are just truly sleazy sales people and they provided originators with incentive to put customers into loans that were not ideal.  Most account executives on the wholesale end and your sub-prime specialists on the retail end, would tell you the only way to make the money you were due was to put the customer into the 2/28 ARM.  The sales pitch for this was, "It is the best way for you to make money because in 18 months you will get to refinance them again!".  An obvious problem with this logic is that in 18 months most of these borrowers were more likely to qualify for food stamps than a new mortgage.

I hear stories now of more loan officers like Dumb and Dumber who put good borrowers into bad loans to make more money.  I have also heard about loan officers who targeted single females and minorities and put them into sub-prime loans.  I don't think this was as prevalent as people perceive.  I think it was largely a problem in Metro areas where there was tremendous fraud going on from the appraiser, realtor, and loan officer.  Not that it is o.k., it just wasn't that common.

What I think is scarier than sub-prime loans is the number of sub-prime borrowers that were given prime loans.  This is a huge reason for the crisis we are in.  It is one thing to trade risky loans that people are aware are risky, even if they are rated decently.  It is entirely different for Fannie Mae to endorse loans as low risk that really stink like sub-prime loans.  As they say here in the heartland, you can put a pig in a dress but it is still a pig.  Fannie Mae spent a lot of time pimping pigs in dresses.

Fannie Mae is a Bitch

If you haven't heard of Fannie Mae or her crazy ass cousin, Freddie Mac, then I am assuming the aliens have just returned you to earth.  Congratulations on your safe return from abduction.

Although Fannie Mae sounds like someone who could whip up some mean homemade potato salad and serve it to you in a kitschy Pyrex bowl, she really is a bitch.  Her cousin, Freddie Mac, probably beats his wife.  The whole family of Ginnie, Freddie and Fannie share more than just hillbilly names, they share government sponsorship.  Here is an oxymoron for you:  Fannie and Freddie were set up as private firms with government sponsorship.  Now obviously they functioned with the private sector motive of profit (How's that working out for you?) but they also were intended to lube the capital markets to foster the public good of homeownership, particularly for the middle class. Unlike Fannie and Freddie, who operated with the inherent assumption that they were government backed although they were private, Ginnie Mae actually was government backed.

I'm not going to wax indignant here about the inanity of this but I must get on my soap box briefly to point out a few things that are not getting enough attention.

1. If the perception is that you are government backed then people will behave as though you are government backed.  If I hand you $100 and send you into a casino with the instructions that you can keep all of your winnings and not be responsible for your losses, you will behave more recklessly than if you were responsible for paying me back if you lost.  This in a nutshell is why Fannie and Freddie took on so much risk.  Also, they were explicitly encouraged by the government to do so.
2. I have a problem with the "homeownership is a public good" mentality.  I had a problem with it before I got into the mortgage industry and now it really makes me seethe.  Homeownership is not a fundamental human right.  Oh and turns out, homeownership isn't proving to be that great for people.  
3. What we know now is that the perception of government backing=government backing.  Go figure.

The point of this post isn't to pontificate about the unintended consequences of government intervention, no, I will save that for happy hour.  Really I just want to begin to describe the types of loans Fannie and Freddie allowed me to do that were considered prime, meaning low risk.  It will make you feel sorry for sub-prime loans, they took all of the heat in the beginning and were the tiniest part of the crisis.  Poor little scapegoats.

Fannie Mae and Freddie Mac had a monopoly over the secondary mortgage market.  If you have ever had a mortgage the odds are Fannie or Freddie had something to do with it.  For those of us on the front lines, the goal was to make every loan a prime loan which was a loan that Fannie or Freddie would approve.  The reasons for this were numerous but fundamentally, loan officers want to earn commission.  The more easy loans you can do, like those Fannie and Freddie approve, the more money you can make.  The folks at Fannie and Freddie understood that and they gave loan officers the tools to be lazy while making tons of money. 

Both Fannie and Freddie had proprietary automated underwriting systems, desktop underwriter(DU) and desktop originator(DO), that made being a loan officer less painful.  Anywhere I went with a laptop and an internet connection, I could run a customer's loan application through these underwriting systems and receive a loan approval in five minutes.  A. Hole and I have gotten loans approved at happy hour which is the ultimate in utility maximization.  Making money while drinking with friends, brilliant.

The loan approval from Fannie or Freddie would list the conditions for final loan approval, including the types of documentation the customer would need to provide so that they could close on their mortgage.  If a loan didn't receive approval through these systems it might qualify for a manual underwrite as an Alt-A (more on this later) or sub prime loan.

These automated underwriting systems were designed to approve loans based on the layers of risk.  The layers of risk in the industry included debt to income ratios, appraised value, cash reserves and assets, employment stability, property type, and credit profile.  All of this sounds sensible, right? 

In practice, this automated underwriting system was inconsistent and sometimes left you scratching your head.  My theory on this is that the underwriting system was tweaked on a regular basis as a method of controlling risk and liquidity.  I don't know this for a fact, but it makes sense given the fact that you could run the same loan through the system a week apart and get two different results.

At the peak of the housing boom these automated underwriting systems were spitting out approvals the way the Duggar Family spits out kids.  Nothing was finer than to be a loan officer with a whole stack of loan files with neat little Fannie Mae approvals in them.  As I said before, sub-prime loans have really been thrown under the bus by Fannie and Freddie.

During this glorious peak I was getting prime loans approved on a regular basis through Fannie for customers with debt to income ratios of 65%.  YES, I said 65%.  The debt to income ratio was calculated by adding up the mortgage payment, debts listed on the credit report, taxes, and homeowners insurance as monthly expenses and comparing them to the customer's GROSS monthly income.  Not only did we not include monthly expenses like utilities we calculated the ratios on pre-tax income.  Wow.

When I returned to the lovely world of economics I finally grasped what this meant.  For the average person, a 65% debt ratio to gross income would result in a monthly shortage.  Fannie was basically approving loans with the implicit assumption that the borrower would have to deplete their savings for luxury items, like groceries and child care.

I am not an idiot but when I say I was in true believer mode when I was in the industry, I mean it.  I really thought I was making people wealthier.  Now I know that a great majority of these loans depleted wealth by giving somebody a declining asset (their home) and encouraging them to drain their 401-K and savings just to pay their bills.  This tandem punch resulted in the largest ever decline in household wealth between 2007 and 2008.

Like I said, Fannie Mae is a bitch.