Excerpt
Outline
A) Introduction
B) How could the housing crisis have happen? What solutions can be offered to prevent such a disaster in the future?
I. The Borrowers-Loan Originators Level
1) The loan extension itself
a) underwriting standards and fraud
aa) underwriting
α) lowered underwriting standards
αα) low and no documentation loans
ββ) down-payment requirements; Loan To Value (LTV) and Customer To Value (CLTV) ratio
γγ) value appraisal -automated value appraisal
δδ) automated underwriting
β) solution underwriting
bb) fraud
α) fraud by borrowers
β) fraud by brokers
γ) solution fraud
αα) borrowers fraud
ββ) brokers fraud
b) final conclusion underwriting and fraud borrowers lenders - level
2) Adjustable Rate Mortgages (ARMs) and Predatory Lending
a) ARM in general
aa) interest rate cap
α) periodic adjustment cap
β) lifetime cap
bb) payment cap
b) different kinds of ARMs
aa) hybrid ARMs
bb) payment option ARMs
c) Effects on the borrowers and how ARMs are used by lenders
aa) minimum or limited payment: effect
bb) hybrid ARM
cc) interest only ARM
d) solution ARM-predatory lending, future prevention
aa) introduction
bb) Proposal by Governor Edward M. Gramlich May 24, 2000
cc) Proposal by Michael D. Calhoun President Center for Responsible Lending September 20, 2006
dd) Proposal by Arthur J. Murton Director Division of Insurance and Research Federal Deposit Insurance Corporation (FDIC) April 16, 2008
ee) conclusion ARM lending-crisis / predatory lending; future prevention
II. Governmental Level
1) What has already been done to prevent ongoing foreclosures or at least to mitigate the problem
d) Center for Responsible Lending (CRL) fixed interest rates for ARMs; reduction of principal balances or of the interest rates
b) The American Securitization Forum (ASF) Framework
c) The (Federal Housing Administration) FHA Secure Initiative
d) conclusion ASF Framework, FHA Secure
2) Further legislation that has been brought on the way;
H OPE F OR H OMEOWNERS A CT 2008
a) Introduction
b) The Law
c) concerns
III. The secondary market trading level
1) The process of securitization
2) credit enhancement
3) what went wrong on the secondary market (with due diligence)?
4) The meaning of the secondary market itself and predatory lending (facilitated by the secondary market9
C) Final Conclusion
A. Introduction
The question, on the current housing / lending crisis in America, what should we do now?, can only be answered when it is figured out why it got so far; in especially, why existing legislation did not work, what role predatory lending played and how far high finance on the secondary market, with .Collateralized Debt Obligations ( CDOs ) and the selling /purchasing of so called high-risk junior tranche played a role, and last not least on this level: how could it have been be possible, that almost an avalanche of class actions has been rolling over courts grounded on the alleged breaching of acts that were implemented straight on the experience of The Great Depression of the 1930´s; like Securities Exchange Commissions ( SEC ) Rule 10b-5, having its basis at least in the 1934 Exchange Act[1]
Were "bad" subprime loans that were doomed from the beginning to default, given because of unscrupulous predatory lenders / loan brokers making immoral profits out of extremely high interest rates[2], so they are to be blamed.
Were states like Georgia (and Mew Mexico, New Jersey) forced, for these predatory lending methods, to implement borrowers protection acts, long before the crisis became vivid, like the 2001 Georgia Fair Lending Act (GFLA), but those efforts were stopped through the intervention of the Feds before the Officer of the Comptroller of the Currency (OCC) who pre- empted those laws as far as it was in conflict with federal banking law[3], making them that way worthless. Are the Feds and the OCC, and so far United States governmental institutions, to be blamed, for pre-empting laws that could have at least mitigated the effects of the crisis?
Does the crisis, also, happen because of the 1977 Community Reinvestment Act (CRA) respectively the 1975 Home Mortgage Disclosure Act[4] (HMDA) that "forced" banks and others to lower their underwriting standards and give (unwillingly) subprime loans to borrowers who never will be able to pay back their loans[5] and therefore those institutions had to charge much higher interest rates on such borrowers, just to weigh out the risk of default; in all, is the government, in respective are the Feds to be blamed for its / their legislation to help minorities?
Are borrowers to be blamed for buying houses on loans, knowing that they never will be able to pay back those loans from their incomes but anticipating that they could sell their homes for a profit or refinance with accumulated equity, due to risen housing prices[6], and therefore "tricked" lenders?
Were those "tricks" only possible because of lowered underwriting standards[7]?
Were borrowers just seduced by teaser loans like a "2/28" hybrid Adjustable Rate Mortgage (ARM) loan[8], for example
Are investment banks and holders / managers of CDOs to be blamed for giving even "bad" subprime mortgage loans worth as they were securitized and then traded as parts of so called high risk junior tranche[9] of these CDOs; inviting lenders / loan originators to lower their underwriting standards, as they could sell those loans then for a lump sum to a trust, a Special Purpose Vehicle ( SPV )[10], [11], thinking that they have not to take any care whether these loans ever will default, but then being sued for "material misrepresentation or omission" on SEC Rule 10b-5, by those trusts; lack of due diligence.
This work will, in the question to whom the fault is and then how to manage the crisis, emphasize on three levels:
1) The borrowers - lenders (loan originators, brokers) level and
2) The Governmental level; what has been done by government itself to prevent the crisis or at least to mitigate and
3) The secondary market trading level, the role of due diligence and the possibility for lenders to sell originated loans to trusts.
So : what has to be done now to prevent such disasters for the future, and what has to be done now, and what has been done to "fight fire"
B. How could the housing crisis have happen? What solutions can be offered to prevent such a disaster in the future?
I The Borrowers - Loan Originators Level
Why did so many subprime mortgage loans default? And what has to be done now to prevent such a "crunch" in future?
1) The Loan Extension itself
a) Underwriting Standards and Fraud
Up to a quarter of the underperformance of the 2006 vintage of subprime Residential Mortgage Backed Securities (RMBS) may have resulted from inadequate underwriting and fraud[12]
aa) Underwriting
α) Lowered Underwriting Standards
Lenders typically (should) make a loan decision based on four key factors: a borrower’s current income in relation to the amount of the mortgage loan; the borrower’s credit history; the appraised value of the house that secures the mortgage; and the extent of the down payment for the loan[13]
According to an analysis paper by BasePoint Analytics[14] , underwriting became too closely aligned with the sales and production operations, during the mortgage boom[15] and "the focus was on closing as many loans as possible, without adequate regard for risk management"[16] and "loan volume was the historical yardstick"[17] With other words, loan originators themselves lowered underwriting standards because they set quantity before quality. No wonder that BasePoint comes to the conclusion: "loan quality is also paramount"[18].
αα) Low- and No-Documentation Loans
But further more, from 2001 to 2006 the percentage of "low-documentation" or "no-documentation" loans rose from 20.5 percent to 50.8 percent[19] and loan originators seem to have knowingly disregarded income misrepresentations given by borrowers, as they jokingly referred to stated income loans as "liar loans", but approved loans based on grossly unreasonable (stated) incomes[20].
So far, at least one point of the above announced definition of underwriting, the creditworthiness´ of borrowers, was grossly disregarded - by lenders, in respective their loan brokers.
ββ Down-payment Requirements; Loan To Value (LTV) and Customer To Value (CLTV) ratio
Down-payment requirements, in addition, were also drastically lowered, usually homebuyers (say borrowers) were expected to put down 20 percent of the house’s value as down payment because down-payments assured lenders that buyers (borrowers) had enough of personal investment in the property to repay the debt and maintain the asset. But due to changes in underwriting standards down-payment requirements were lowered from 20 percent to 0 percent in some (loan) products.[21].
But its empirically proofed that there is a relation between low down- payment requirements and higher default probabilities[22].
Because aside the down-payment is the Loan To Value (LTV) ratio; and the LTV ratio is defined as the percentage of the amount of money loaned to the appraised value of the real estate pledged as security for the loan[23]
So the conclusion is: if the down-payment is lowered drastically, and in some cases even set to zero, than the LTV ratio has to be higher.
But its shown that when LTV ratios are (only) raised from 90 to 97 percent; default rates for new homes increase sevenfold.[24].
With other words: the higher the LTV ratio the higher the risk to default; and as down-payment requirements were lowered drastically the LTV ratio rose the same.
Another method to "outfox" the down-payment requirements is the so called piggyback loan, which is defined as a home financing option in which a property is purchased using more than one mortgage from two or more lenders[25].
But such strategies (the subprime lending plus piggyback lending) increased lenders risk because piggyback loans are 43 percent more likely to default than standalone first mortgages of comparable size[26]. The percentage of piggybacks by number of loan rose from 2001 to 2004 from almost 15 percent to more than 35 percent, and the percentage by dollar volume from 20 percent in 2001 to more than 40 percent in 2004[27].
With other words: the lenders risk to go into default rose dramatic alone in- between 2001 to 2004, through piggyback lending.
The ratio of such loans is called Customer Loan To Value (CLTV), which is defined as the percentage that the first and second mortgages make up to the property value[28].
But in the period of the mortgage boom lenders obviously gave 100 percent CLTV loans, otherwise BasePoint Analytics wont suggest not only to replace 100 percent loans by maximum 75 percent CLTV but to do something more[29].
(... see solution underwriting for the more)
γγ) Value Appraisal - Automated Value Appraisal
Because of the crucial meaning of LTV, and therefore the property’s value, the appraising of such values can be seen as one of the most important elements of the home-loan origination process[30].
The traditional appraisal was a six step process, including: problem definition; preliminary survey and appraisal plan; data collection and analysis; application of the aforementioned three factors to value; reconciliation of the value indications and the final estimate of defined value [31]. In the traditional system appraisers were chosen from organized blind pools[32].
But in an effort to increase efficiency and reduce costs, the lending industry has significantly risen reliance on automated value models with the effect that agents and brokers chose appraisers themselves, making the process less objective because brokers have (for their premiums) a strong interest in seeing the property change hands; and in the way brokers are compensated, they have an incentive to increase the appraised value of the home[33].
Therefore appraisers were set under pressure by brokers to estimate the value of homes higher than the objective value; with the effect that the integrity of the loan was undermined even before it was originated, and, in addition, that the servicers ability to estimate default rates and losses in a declining real estate market was reduced.[34]
δδ) Automated Underwriting (AU)
Aside with automated value appraisal came the automated underwriting (AU). Until the late 1990´s AU system origination was non-existent, but is common now.[35] Lenders claimed that even if the system approved credit- poor applicants that otherwise would not have been approved, it increased underwriting standards and was more accurate in assessing default probability (than the traditional underwriting)[36].
Before AU was implemented a borrower’s total mortgage payment was not to exceed 28 percent of monthly gross income, and total debt load was not to exceed 36 percent of monthly gross income.
By using AU models, lenders some times approved loans in which the monthly mortgage debt service expense exceeded more than 50 percent of the borrowers monthly income[37].
As a conclusion can be announced that before AU, borrowers were given loans they were able to afford as they still had at least 64 percent for living but through AU this was shortened to 50 percent, and less. If one keeps in mind that a (subprime) borrower not only has to pay mortgage rates but also to keep maintenance, pay for heating, water, current and so on to live in his home, and still is neither clothed nor fed nor has fuelled his driving, than one wonders how a (subprime) borrower wants to make ends meet with only having 50 percent, or less, of his gross income left .
Its no wonder than that he / she is doomed to default if something unexpected happens, like the reduction of extra hours that the borrower did count on or even a loss of job to have him / her going into default.
But Mason and Rosner[38], the most cited on this part of this work, show that expenses even can exceed up to 95 percent if AU is combined with hybrid Adjustable Rate Mortgages (ARMs)[39], this will be broader discussed in a following part.
β) Solution - Underwriting
A BasePoint paper refers to the lack of underwriting in the past with a simple but true solution; by suggesting that originators need to revise the role of underwriting[40].
BasePoint suggests not only to replace stated loans by full or light document loans, but to assess the relationships between the income, the age, the professional and job years of the borrower, regardless of the type of document[41]; not only to replace 100 percent loans by maximum 75 percent CLTV, but make determined usage of consortium data for assessing property valuation by comparing to the property valuation distribution[42]; not only to set restrictions on investment property loans, but assessing income and property value[43]
The solution in respect of lowered down-payment requirements is self evident: just rise them back to the standard 20 percent, even for subprime borrowers.
Stop automated value appraisal and go back to the traditional system of organized blind pools that brokers can’t chose appraisers any longer themselves, and instrument them for their own purposes.
And: go back to manual underwriting, and don not just rely on computer programs; its to be a given that underwriting needs time and can not be done with a few mouse clicks, as it is on One Stop Financials [44] for example -they offer a home loan approval within five minutes!-.
And, in addition, take care that the monthly mortgage debt service does not exceed a maximum of 50 percent of the borrowers income also in respect of higher ARM adjustments because borrowers have to keep maintenance for their homes and have to live at least which seems to be, as shown, almost impossible if the debt service is above 50 percent.
bb) Fraud
Historically mortgage fraud has been defined as “any material misrepresentation in a loan application which influences a mortgage lender to approve an application which would have otherwise been declined.” [45]
α) Fraud by Borrowers
The damages caused due to mortgage loan fraud in the housing marked are dramatic; according to a paper by BasePoint Analytics published in 2006, for the same year (2006) it was estimated that fraud will result in a net loss of more than three billion dollars[46], and foreseeing the crunch the paper forecasted losses rising to almost 4.5 billion dollar the following year, due to increased rates of fraud[47].
But who is to be blamed for, and who has got to change attitudes? BasePoint announced in a recent paper (2008) that over the last few years (borrowers) fraud was suspected, and (loans were) funded anyway but these suspected frauds were not disclosed to the investment community[48].
According to another BasePoint paper (published in 2006) [49], up to 10 percent of mortgage applications contain a material misrepresentation (by borrowers)[50].
Mortgage fraud was considered as a cost of doing business because even if a loan defaulted during the mortgage boom the properties involved in foreclosures were resold quickly, in many cases without much loss to the lender[51]. If there were losses at all, regarding that housing prices constantly rose from 1997 to their peak in 2003[52].
The conclusion so far is: in the boom period on the mortgage lenders were not much encouraged to defend against fraud, either because the risk of loss was minimal or they even could have made profits out of risen property values, as to say out of mortgages, and so far out of foreclosures. It does not wonder that lenders in the boom period some times funded up to 100 percent CLTV loans (see above: solutions, underwriting standards), even if the risk of default was dramatic therefore (see underwriting standards down- payment requirements); they just expected the value of the collateral, the property, to get a lot higher than it was in the date of funding the mortgage backed loan.
[...]
[1] Ferrell, Allen, Bethel, Jennifer E. and Hu, Gang, "Legal and Economic Issues in Subprime Litigation" John M. Olin Center Discussion Paper No. 02/2008, retrieved April 10, 2008 http://papers.ssrn.com/sol3/Delivery.cfm/SSRN_ID1103553_co de36761.pdf?abstractid=10965 82&mirid=5
[2] Bagley, Nichlas, Slate (Jan. 24, 2008): Crashing the Subprime Party, retrieved April 03, 2008; http:www.slate.com/id/2182709/pagenum/all
[3] Bagley, Nicholas id.
[4] Liebowitz, Stan.,New York Post (Feb. 05, 2008): The Real Scandal - How feds invited the mortgage mess, retrieved April 09, 2008 http://www.nypost.com/seven/02052008/postopinion/opedco lumnists/the_real_scandal_243911.ht m?page=0
[5] DiLorenzo, Thomas J. (Sept. 06, 2007) The Government Created Subprime Mortgage Meltdown, retrieved April 03, 2008 http://www.lewrockwell.com/dilorenzo/dilorenzo125.html,
[6] Ferrell, Allen,,Bethel, Jennifer E. and Hu, Gang, "Legal and Economic Issues in Subprime Litigation" John M. Olin Center Discussion Paper No. 02/2008, retrieved April 10, 2008, page 17 http://papers.ssrn.com/sol3/Delivery.cfm/SSRN_ID1103553_co de36761.pdf?abstractid=10 96582&mirid=5
[7] Ferrell, Allen; Bethel, Jennifer E. and Hu, Gang id.
[8] Ferrell, Allen; Bethel, Jennifer E. and Hu, Gang id.
[9] Testimony of Michael Kanef, Group Managing Director, Moody´s Investors Service, Before the United States Senate Committee on Banking, Housing, and Urban Affairs, Sept. 26, 2007; retrieved April 12, 2008, page 27 et seq., Annex I "The Process of Securitizing Subprime Mortgages", pages 26 et seq. http://banking.senate.gov/public/_files/kanef.pdf
[10] Bagley, Nicholas, Slate (Jan. 24, 2008): Crashing the Subprime Party; retrieved April 03, 2008; http:www.slate.com/id/2182709/pagenum/all
[11] Testimony of Michael Kanef, Group Managing Director, Moody´s Investors Service, Before the United States Senate Committee on Banking, Housing, and Urban Affairs, Sept. 26, 2007; retrieved April 12, 2008, Annex I "The Process of Securitizing Subprime Mortgages", pages 27 et seq., pdf, http://banking.senate.gov/public/_files/kanef.pdf
[12] The Impact of poor Underwriting Practices and Fraud in subprime RMBS Performance, fitch ratings ltd, November 28, 2007; press release, page 1 of the pdf, retrieved April. 11, 2008 www.americansecuritization.com/uploadedFiles/Fitch_Orig inators_1128.pdf
[13] Testimony of Michael Kanef, Group Managing Director, Moody´s Investors Service, Before the United States Senate Committee on Banking, Housing, and Urban Affairs, Sept. 26, 2007; retrieved April 12, 2008., Annex I "The Process of Securitizing Subprime Mortgages", page 26 of the pdf http://banking.senate.gov/public/_files/kanef.pdf
[14] BasePoint Analytics, White Paper from 2008 "Rebuilding The Mortgage Industry - The Path Back To Profitability", requested April 09, 2008, retrieved April 11, 2008 http://www.basepointanalytics.com/mortgagewhitepapers.shtm l
[15] id. page 4
[16] id. page 4
[17] id. page 4
[18] id. page 4
[19] Ferrell, Allen; Bethel, Jennifer E. and Hu, Gang, "Legal and Economic Issues in Subprime Litigation" John M. Olin Center Discussion Paper No. 02/2008, retrieved April 10, 2008, page 18 & page 75 http://papers.ssrn.com/sol3/Delivery.cfm/SSRN_ID1103553_co de36761.pdf abstractid=1096582&mirid=5
[20] BasePoint Analytics, White Paper from 2008 "Rebuilding The Mortgage Industry - The Path Back To Profitability",requested April 09, 2008, retrieved April 11, 2008; page 3
[21] Mason, Joseph R. and Rosner, Josh, "How Resilient are Mortgage Backed Fecurities to Collateralised Debt Obligation Market Disruptions?" (February 13, 2007)., retrieved April 14, 2008, page 5 Available at SSRN: http://ssrn.com/abstract=1027472
[22] Mason,id. page 5
[23] Midfirst Bank Glossary on Banking Terms, retrieved April 23, 2008 https://www.midfirst.com/library1.asp
[24] Mason, Joseph R. and Rosner, Josh, "How Resilient are Mortgage Backed Fecurities to Collateralised Debt Obligation Market Disruptions?" (February 13, 2007)., retrieved April 14, 2008 page 5 Available at SSRN: http://ssrn.com/abstract=1027472
[25] Mortgage News Daily, retrieved April 27, 2008 http://www.mortgagenewsdaily.com/wiki/Piggyback_Loans.asp
[26] Mason, Joseph R. and Rosner, Josh, "How Resilient are Mortgage Backed Fecurities to Collateralised Debt Obligation Market Disruptions?" (February 13, 2007)., retrieved April 14, 2008 page 8 Available at SSRN: http://ssrn.com/abstract=1027472
[27] Mason id. page 8, Figure 4
[28] E-Loan, retrieved April 24, 2008 http://www.eloan.com/templates/def_clv.html
[29] BasePoint Analytics, White Paper from 2008 "Rebui l d i ng The M o rt gage I ndus tr µ - The Path Back To Profitabilitµ", requested April 09, 2008, retrieved April 11, 2008; page 5 http://www.basepointanalytics.com/mortgagewhitepapers.shtm
[30] Mason, Joseph R. and Rosner, Josh, "How Resilient are Mortgage Backed Fecurities to Collateralised Debt Obligation Market Disruptions?" (February 13, 2007)., retrieved April 14, 2008 page 9 Available at SSRN: http://ssrn.com/abstract=1027472
[31] Mason, Joseph R. and Rosner, Josh, "How Resilient are Mortgage Backed Fecurities to Collateralised Debt Obligation Market Disruptions?" (February 13, 2007)., retrieved April 14, 2008 page 9 Available at SSRN: http://ssrn.com/abstract=1027472
[32] Mason id. page 9
[33] Mason id. page 9
[34] Mason id. page 9
[35] Mason id. page 10
[36] Mason id. page 10
[37] Mason id. page 10
[38] Mason, Joseph R. and Rosner, Josh, "How Resilient are Mortgage Backed Fecurities to Collateralised Debt Obligation Market Disruptions?" (February 13, 2007)., retrieved April 14, 2008 page 9 Available at SSRN: http://ssrn.com/abstract=1027472
[39] Mason id. page 10
[40] BasePoint Analytics, White Paper from 2008 "Rebui l d i ng The M o rt gage I ndus tr µ - The Path Back To Profitabilitµ", page 4 requested April 09, 2008, retrieved April 11, 2008; page 4 http://www.basepointanalytics.com/mortgagewhitepapers.shtm l
[41] BasePoint Analytics, 2008 id. page 5
[42] BasePoint Analytics, White Paper from 2008 id. page 6
[43]BasePoint Analytics, White Paper from 2008 id. page 6 http://www.basepointanalytics.com/mortgagewhitepapers.shtml
[44] One Stop Financials http://onestopfinancials.net/home_loans.htm
[45] BasePoint Analytics White Paper from 2006 "A Ftudµ on Mortgage Fraud and the Impacts of a Changing Financial Climate", requestetd April 09, 2008; retrieved April 14, 2008, page 5 http://www.basepointanalytics.com/mortgagewhitepapers.shtml
[46]BasePoint id. page 2
[47] BasePoint Analytics White Paper from 2006 "A Study on Mortgage Fraud and the Impacts of a Changing Financial Climate", requestetd April 09, 2008; retrieved April 14, 2008, page 3 http://www.basepointanalytics.com/mortgagewhitepapers.shtml
[48] BasePoint Analytics, White Paper from 2008 "Rebuilding The Mortgage Industry - The Path Back To Profitability", requested April 09, 2008, retrieved April 11, 2008; page 3 http://www.basepointanalytics.com/mortgagewhitepapers.shtml
[49] BasePoint Analytics White Paper from 2006 "A Study on Mortgage Fraud and the Impacts of a Changing Financial Climate", requestetd April 09, 2008; retrieved April 14, 2008, page 5 http://www.basepointanalytics.com/mortgagewhitepapers.shtml
[50] BasePoint White Paper 2006 id, page 5
[51] BasePoint id. page 6
[52] Ferrell, Allen, Bethel, Jennifer E. and Hu, Gang, "Legal and Economic Issues in Subprime Litigation" John M. Olin Center Discussion Paper No. 02/2008, retrieved April 10, 2008, page 60, figure 5 http://papers.ssrn.com/sol3/Delivery.cfm/SSRN_ID1103553_code36761.pdf?abstractid=10 96582&mirid=5 http://www.basepointanalytics.com/mortgagewhitepapers.s html