The Mortgage Meltdown – How We Got Into This Mess, Who’s Responsible, and Why We Should Keep Capital Punishment
by Paul Elis, President, PMB Capital                   Inc.

Who’s most responsible for the mortgage debacle?  It’s the powerful but blind and ignorant packagers and promoters of  the eight, nine and ten digit stacks of securitized mortgages and the “experts” who represented the buyers of those  securities.  These captains of the universe poured hundreds of billions of dollars into weak mortgages, touted them as strong investments, and encouraged and fed this insanity.  The vast majority of these mega-dollar movers and shakers are probably not larcenous as much as just ignorant of reality.  They may know the securities industry but they don’t understand the basic building block of the securities we’re discussing – the individual mortgage.

First, let’s look at the contributing players who are not the people I consider the primary culprits:

First, and the least of the guilty, is the incredibly large number of owner borrowers who either really believed that a free lunch was being given away or that the day of reckoning on their adjustable rate mortgage would never come.  Sure, some of them were “sold” a bill of goods by loan agents, but, let’s face it:  The majority of these borrowers got into these loans knowingly.  They took the easy way out; that of opting for the teaser rate and the low initial payment on an adjustable rate time bomb.  They probably owed more on their house than they should have and then, as we all know, couldn’t walk the walk when the inescapable mortgage payment adjustment came around and payment shock  followed.  Many of these people blindly accepted the       absurdity that prices would just continue to go up and up and, abracadabra, they could refinance – as though refinancing can cure any financial problem.  They ignored or never understood the most basic tenet of consumer credit:    You can’t borrow your way out of debt.  I never fail to be amazed at how some people always, always, always  choose the easy way out of every problem and are unconcerned  with long term consequences.  We know these people. They go through life snatching defeat from the clutches of victory.

Acknowledged: some empathy and sympathy needs to be expressed for those homeowners who we know really are the victims of economic and personal problems beyond their control.   They are the minority but this article   respects their personal difficulties and sympathizes with their tragedies.

Another constituency in this second tier cast of guilty characters are the loan agents.  Some of these people are clearly unscrupulous but most of them fell into the same trap of unrealistic expectations and always-make-the-easy-choice mentality that affected so many homeowners.

Then there are the real estate speculators, not to be confused with legitimate long-term investors and competent  rehabbers.  Speculators were a major influence in driving home prices to unrealistic heights and are now, by virtue of  their inevitable loan defaults, major contributors to the ensuing flood of loan defaults and, by extension, the  resulting collapsing property market.   Investing in  real estate is a time honored way of building capital and             serves a socially desirable purpose in supporting a stock of available rental housing.  But, the only sure winners in this endeavor are those with long term perspective and technical knowledge of a great number of real estate      business factors such as purchase contracts, financing negotiations, insurance policies, maintenance, lease documentation, title insurance, legalities, etc.   I further submit that loan agents who encouraged speculators to take out loans on their primary residences in order to speculate should lose their licenses.  And, the homeowners who bought into this mindless idea of risking their families’ well being in order to place bets on home should face ten years to life for being “felony-stupid,”  although losing everything is probably sufficient punishment.

And, another contributing player is the government. I’m not faulting public policy of encouraging home ownership through the availability of high mortgage amounts at cheap rates.  However, if Washington is going to facilitate highly leveraged home purchases, it better have a “plan B” ready when economic reality belies the underpinnings of these tenuous loans and the foreclosures begin.  —Oh, I’m sorry,  I forgot: Real Estate can’t go down in value, especially in California.

One more lesser guilty group I’d like to pounce upon: The home selling agents, mostly Realtors, who encouraged buyers to buy as much home as possible by using loans that obviously carried a downstream risk of  a huge “payment shock” upon rate adjustment.  —Not that a brokers’  counsel to a buyer to consider buying a less expensive house would have been well received or heeded.

NOW, HERE’S THE CENTRAL ISSUE.  Let’s talk about primary responsibility, the 800 pound gorilla among the guilty.  J’accuse: The folks who “packaged” and sold  these bundles of securitized mortgages and the representatives of the buyers that stupidly recommended their purchase by  institutions.  These are the guys who kept shoveling fuel into the engine.  We’ll add to this list of “most guilty”  the rating agencies who, insanely, rated these securities  backed by such fragile mortgages as strong investments.         In fact, I think the rating agencies are probably the most  inexcusably at fault, but that’s subject matter for another  article.  The captains-of-the-universe financial types  who created and marketed the hundreds-of-millions and billion dollar securities had a total understanding of the securities business BUT—  They had no understanding at all of the individual mortgages that comprise these bundles of  loans. To paraphrase: they may have been able to navigate around their ivory towers but they didn’t know the street.

Putting aside the ruthlessly greedy and the downright criminal persons (and there were, no doubt, some of these),  the people involved in the upper tiers of the securities business didn’t understand the one-loan-to-one-family consumer mortgage issues.  Like so many real estate macro-economic          conditions, the driving force of this industry came from the buyer’s of the securities product.  In other words, there were vast sums of money lusting to buy these securities. So, of course, the high loan to value and subprime mortgage  product was created, securitized and marketed.  It’s kind of the debt counterpart of the real estate equities’ periodic phenomenon of overbuilding.  The driving force in overbuilding often is not market requirement for the space so much as the availability of  too much capital tempting  otherwise unjustifiable development.

If each of the ivory tower-dwelling captains of the  universe had earlier in their career spent six months as a street level loan officer working with homeowners and learning  the nuts and bolts of the product itself and of the lender – home owner relationship and had then worked six months more as  an underwriter learning each component of a healthy loan and      acquainting themselves with the misinformation or fraudulent        information so often submitted on loan applications, they would have had an appreciation of the realities of the  mortgage industry.  If they had worked for six months as a collection officer gaining real world knowledge of what goes   wrong with defaulting borrowers, they would know that 90, 95  and 100% loans just don’t hold up when a borrower starts to  have problems.  As a former director of the California Mortgage Association, I have close friendships with many of  the leading entrepreneurial lenders in the private money loan  industry, “street level lending.”  Many of these  real-world business guys and gals won’t do a loan over 55 or 60% of the property value and many of them can instinctively  sniff out a fraudulent loan application.  They’re good at deal-making, they usually take an active part in the             underwriting of each mortgage and they know when a loan is risky.  I submit that if the mega-dollar shufflers had spent a six month internship with these top of the line  mortgage entrepreneurs who wouldn’t consider doing a loan over 55 or 60%, they would have recognized the absurdity of trusting the 90, 95 and 100% loans.

The captains of the universe and their security lawyers obviously came up with criteria for individual mortgages to be placed in their securities bundles.”   I’m  wondering who sat at the conference table when these criteria were discussed.  Was there a “lowly” loan collection  agent with thirty years of real world experience present alongside with the billion dollar salesperson?  Was there someone participating who is actually a successful  entrepreneurial mortgage lender?  Or, was the conference  dominated by a senior vice president who saw visions of mega-dollar commissions and an annual bonus equal of 100 families’ home mortgages?  Where were the scarred and  experienced street-smart entrepreneurs when they were            needed?

My mortgage investors haven’t had to take back a property through foreclosure on any loan written in the last nineteen years.   My IQ is probably 20 or 30 points lower than that of the financial wizards – but I’m a  whole lot smarter.  I’m committed to designing and underwriting loans one at a time that economically work for my  fund and for the borrower who, let’s not forget, is the guy or gal who has to actually write the mortgage payment check each month. My focus is where it belongs, on the borrower, not on      the billion dollar securities buyer. The all-powerful financial emperors were focusing in the wrong direction!

A couple of random comments:   First, I’m  probably not going to vote for John McCain but I deeply and  profoundly admire his stand on NOT bailing the mortgage industry out of its self-created mess.  While Clinton and      Obama were busy pandering to the masses about bankrolling a fix, only McCain had the guts to say that the rest of us tax payers shouldn’t bail out these morons and shouldn’t reward  stupid investing or irresponsible borrowing.  Good for you, Mr. McCain.  I hope you will go down as my most  admired unelected presidential candidate during my lifetime.

Second comment about the current state of the mess: If there needs to be a fix, I propose no grace at all for the lenders.  But maybe we can do something for the “upside down” homeowner which could save his house and, thus, help stabilize the market.  There is some talk about  legislation or court mandates reducing mortgage loan balances downward to the market value of the homes.  That’s  another brilliant idea from the panderers.  So, now we’re   stealing from one class for the benefit of another class and creating a whole sea of bankrupt lending institutions who are,  once again, going to cry for a bailout, except this time they  would have a valid point.  Here’s my thought:  In cases of borrower distress, where the mortgage loan balance is now higher than the property value, the existing loan could be bifurcated into an economically sustainable first mortgage and a second mortgage representing the portion of the loan not supported by the property value.   The second loan  would become a “sleeping” second with no monthly payments and  would be paid back with no or very little interest at such time as the owner occupied home is sold, to the extent that the sales price at that time covers that second. This way, the lenders maintain their rightful claim to their capital and the  homeowners stand a better chance of staying in their homes.  This would be both humane and economically responsible.  Also, first mortgage loans with variable interest rates should be tightly capped as to payment increases.

Thirdly, loans are unfortunately not now readily available for investors who want to buy many of the distressed and foreclosed homes, the purchases of which would greatly help to stabilize the market.   It’s every bit as stupid to    NOT give strong and credit worthy investors 65 or 70% loans as it is to give weak and fraudulent home buyers 90 to 100%  loans.   I don’t understand the regulators’ policies here.  Once again, the people who presume to regulate    don’t have a clue how things really work.

Fourth comment:  The lenders who were engaged in illegal lending practices and the borrowers and agents who submitted fraudulent loan applications should be aggressively prosecuted.

These people could give Capitalism a bad name.

Note:  Paul Elis The author is a fund manager in the investment property mortgage business and does not make consumer or homeowner loans. Neverthelss, he’s one of the most astute proffessionals I know in this business. He is available at paulelis@pmbcapital.com