Why Wall Street Matters in the Mortgage Mess

Over the last couple weeks, I have seen many accusations that government — the Fed, Congress, the President, the FHA, etc. — are going to bail out investors and leave delinquent mortgage holders to drown in debt. Even Jimmy Carter has been accused of caring more about investors than homeowners; I challenge you to show up to a Habitat for Humanity work site and say that. While I see the frustration that leads to this conclusion, it neglects certain realities of our mortgage mess.

As most of you know, in the old days Joe and Jane Average would save money for a sizable downpayment before even looking at real estate. Then they would go down to the bank with a couple years worth of tax forms and a few months of bank and brokerage statements. The bank would look at a credit report and call their boss to make sure they make enough money (according to “Modern Real Estate Practice”, housing expenses should not exceed 28% of monthly income, and other debts combined with housing should not exceed 36%), and even call the current landlord to make sure they pay on time. The money came from the bank’s depositors, so the bank was careful.

FHA guarantees changed the picture by being an “insurance policy” for certain buyers — but these buyers still had to have certain qualifications, and a host of disclosure laws apply to any loan that FHA touches. Fannie Mae and Freddie Mac took advantage of the fact that mortgages can be sold and assigned. They basically said to the bank “Listen, you can wait 30 years for that mortgage to mature, or we can pay you a hefty percent of the interest you would have earned today, taking a lot of risk off your books, letting you book a profit on the mortgage now, and giving you enough money to write a new mortgage to somebody else.” Of course they would only buy loans that met certain criteria: loans below a certain amount; interest rates below a certain rate; a certain amount of equity; a bunch of disclosure forms that had to be signed by the borrower before the loan even closed. They also have (in theory anyway) the ability to blacklist lenders that they consider “abusive.” These rules have eased and tightened over the years. Since the loans were still backed by real houses, lived in by real people who met real qualifications, nobody saw a problem.

Fannie and Freddie weren’t the only ones buying mortgages and mortgage backed securities. But the new players — banks, brokerages, institutional investors, hedge funds — were held to lower rules than Fannie and Freddie. They figured that the paper was still backed by real houses occupied by real people, so what’s to worry about? The housing bubble continued to grow larger, fed by mortgage brokers who only cared about closing the next deal, because after all somebody else would be holding the bag when it blew.

I would be remiss if I did not address the demand side at this juncture. Rising prices convinced Joe and Jane that they needed to act quickly; they didn’t want to be priced out of the market, and they didn’t want to miss what was increasingly presented as a sure-fire investment opportunity they could live in. However, the economy being what it was, they didn’t have a large downpayment. And they qualified for a mortgage based on their combined incomes, regardless of the fact that one of them could easily lose their job (or in Jane’s case, require maternity leave). No problem, said the friendly loan officer.

Friendly loan officer got them a loan, but at a higher interest rate. Or he got them an Adjustable Rate Mortgage that started off low, but would get higher — he reassured them that by the time it adjusted, they would surely be making more money, right? Or he got them a loan with a prepayment penalty — did you know that in some states it is legal to have a prepayment penalty equal to all the future interest payments?

But Joe and Jane weren’t making more money later. Between stagnant job creation, wages that never did keep up with inflation, rising health care costs, and skyrocketing gas costs, they were really behind the 8-ball. They couldn’t refinance because they were effectively making less money. They couldn’t sell the place because it was worth less than the mortgage amount. Even if they could sell or refinance, they faced a prepayment penalty of several thousand dollars they didn’t have.

It is also worth noting that in this environment, some unscrupulous people who never had any intention of owning a home committed fraud which left whoever owned the mortgage in trouble.

When the assorted investors who owned mortgage backed securities realized what was going on — that massive foreclosures were headed their way — the market for these products dried up. Because there was no longer a functioning market in which to sell mortgages, it became very difficult to write new mortgages almost overnight. This of course was very very bad news for people like Joe and Jane who — before this mess — actually had a chance of getting refinanced. Wall Street matters because they are the ones who can lend Joe and Jane the money to keep their home.

When Mr. Bernanke lowered the Discount Rate (not the prime rate, that is controlled by banks), he was effectively saying “Look, if you banks need to borrow some money it’s ok, we’ll lend it to you. When he authorized “injecting liquidity” he was saying “Here’s some money. There’s Joe Average’s loan application. You think you can figure this out?” So far, this is (slowly) working and markets are stabilizing. Mr. Bernanke still insists he won’t be bailing out investors who made bad judgements, but he stands ready to lower the rates that banks charge one another when they need to borrow short term.

And that brings me to Mr. Bush’s proposals, which — surprise surprise! — include a tax cut. Another component would be lowering FHA requirements. If it works as described, and helps people refinance into lower cost FHA loans without putting undue risk on the FHA, that will actually help. However, the most complete description I saw of the proposal would still require 3% equity and “steady employment”. This will absolutely not help people whose homes are worth more than they owe. Absolutely not on the table (at least from the Administration’s side) would be letting Fannie and Freddie increase their portfolios. For that matter, “not under consideration” is tightening rules on disclosure of ARM calculations or capping of prepayment penalties at the federal level.

The Seattle Times calls the proposal “limited“, and I am inclined to agree.

Cross-posted at Central Sanity.