The Great Mortgage Market Implosion of 2007
The Evolution of Risk Based Lending
George W. Lawrence
The Great Mortgage Market Implosion of 2007
Table of Contents
Chapter I Introduction Page 5
Chapter II Pre-depression Years Page 11
Chapter III Lessons from the Great Depression Page 15
Chapter IV Recessions of 1973-75 and 1980-82 Page 21
Chapter V Savings and Loan Crisis Page 24
Chapter VI Recession of 1990-1991 Page 31
Chapter VII Post Recession Real Estate Market Page 34
Chapter VIII Subprime Mortgage Market Explosion Page 37
Chapter IX Mortgage Market Implosion Page 45
Chapter X Fraud in Lending Page 51
Chapter XI New Laws for Predatory Lending Practices Page 61
Chapter XII Help for Home Owners in Default Page 67
Chapter XIII Conclusion Page 73
Author: George W. Lawrence
Revised November 20, 2008
This course and materials distributed are intended to assist REALTORS® and other
industry professionals by providing current and accurate interpretation concerning the
subject matter covered. However, no assurance is given that such information is
comprehensive in its coverage of such subject matter or that it is suitable in dealing with
a client’s particular problem or related circumstance. Accordingly, information published
or provided should not be relied upon as a substitute for independent research to original
sources of authority. No accounting, legal or other professional advice is rendered nor is
any responsibility assumed for updating or revising any courses or course materials
presented, distributed or sponsored.
This course explores the history of the evolution of real estate lending institutions,
practices and products which led to the credit market crisis of 2007. The author has not
offered an opinion as to the actual cause and effect, if any, of the facts provided as they
relate to the events which unfolded during the past two years or so. Rather it has been left
up to the student to make his or her own conclusion to what extent the historical events
discussed should have offered red flag warnings.
This course is designed to enable students to:
Develop an understanding of how lending institutions evolved in the U.S.
Understand the significance of political and economic policies during times of
financial crisis and how they impacted the housing and lending communities.
Gain an insight into how and why lenders and Wall Street investors felt comfortable
in developing and offering risk based loan products.
Understand the basic process of the secondary mortgage market and packaging and
selling mortgage backed securities.
Gain an understanding of how risky subprime mortgage products were able to be
offered as mortgage backed securities and why the insurers accepted them.
Understand how the slowing real estate market and rising interest rates in 2004 led to
the collapse of the subprime market and the eventual credit market crisis.
Learn the extent to which industry professionals as well as the borrower participated
in mortgage fraud and the most common activities involving fraud.
Understand new regulations which have been implemented or will soon be
implemented to protect the consumer from predatory lending practices, confusion in
settlement and closing statements, as well as those new provisions designed to better
educate the mortgage originator.
The Great Mortgage Market Implosion of 2007
A. The Housing Bubble Begins to Leak
It was fall 2005. After enjoying nearly ten years of relatively low mortgage
default rates, double digit price appreciation, low interest rates and brisk sales
activity, the housing market started showing signs of weakness.
1. Home sales started a steady downward slide in late 2005 and housing
inventory began to rise.
3. Prices began to soften in early 2006.
4. Significant numbers of subprime mortgage defaults showed up in 2006.
B. Sub-prime Loan Problems Appear
A number of factors appear to have contributed to the market's change of
direction. First both former U. S. Fed Chairman, Alan Greenspan 1, and Freddie
Mac CEO, Richard Syron ,2 finally acknowledged we had a bubble in housing. So
called housing bubbles occur when values increase rapidly until they reach
unsustainable levels as they relate to incomes and other economic factors3.
1. In this case “other economic factors” include the Fed’s decision to attack
inflation. Beginning in June 2004, embarking on a campaign of systematic
rate increases, sixteen in all, the Fed took the fed funds rate from 1% to
5.25% before resting. As a result home mortgage rates started to rise late
in 2005, going from an average of about 5.75% to over 6.75% by mid-
20064. The market, not surprisingly, cooled.
2. Then short term fixed rate loans which converted to adjustable after two or
three years, referred to as “2/28” and “3/27”, originated starting near the
end of 2003 began showing increasing delinquencies.
a. Offered to borrowers with substandard credit, these are loans with
moderately higher fixed rates than prime or Alt-A for the first two
or three years then become adjustable for the balance of a thirty
"Greenspan alert on U.S. home prices", Financial Times, Sept. 17, 2007
"Subprime Shock Waves", Bloomberg, Sept. 25, 2007
"Housing Bubble Trouble", The Weekly Standard April 10, 2006
"Mortgage Rates Historical Chart: Contract rates of fixed rate mortgages", FHLMC
b. The margins on these ARMs are significantly higher than typical
prime ARMs, oftentimes 4 to 6 percent. An initial fixed rate of 7%
could jump to 13% or higher.
c. Even before payment resets took place, many borrowers found
difficulty continuing to make the initial payments which had rates
considerably higher than prime rates and even higher than Alt-A
loan rates. Most found it difficult to refinance, having not cured
whatever situation it was which led them to these risky loans in the
first place. The lucky ones were at least able to sell. But as the
slowing market caused values to continue dropping, exacerbated
by sellers with sub-prime loans reducing prices in hopes of at least
getting out with something, eventually even selling wasn’t an
3. Foreclosures and the downward trend in both home values and sales
C. Wall Street Mortgage Portfolios Collapse
It wasn't long before the effects were felt in Wall Street. Lenders originating these
high risk loans had sold them in the secondary mortgage market to investment
bankers who in turn used some creative financial engineering to market them.
1. They packaged them as residential mortgage backed securities (RMBS),
nothing unusual there, but then they sliced them up using a method called
Collateral Debt Obligation (CDO) in a way that made them more
attractive to investors than the risky subprime collateral should have
allowed, and sold them off.
2. As real estate values continued their downward adjustment and mortgage
defaults increased, pools of mortgage backed securities lost not only their
income stream but their value. The investment bank and the investors who
purchased them began to see their holdings vanish, and soon all left the
3. Not only did the market suffer billions of dollars of losses, subprime
lenders no longer had a source to place their loans. They were essentially
out of business. Some closed their doors, some filed bankruptcy.6
D. Home Values Slide
As these events unfolded, the pace and amount of foreclosure activity increased.
Home values steadily dropped, eroding the equities of most home owners. Even
"Bear Stearns Hedge Fund Woes Stir Worry in CDO Market", Barrons June 21, 2007
"New Century files for Ch.11 Bankruptcy", MarketWatch April 2, 2007
credit worthy borrowers who had obtained standard “prime” loans began to fall
victim to the market. We began to see a “foreclosure driven” real estate market.
E. The Cost of Foreclosure
The cost of foreclosure is not limited to the lender or the borrower. Neither is it
limited simply to financial loss. The stress and emotional impact of a foreclosure
on the borrowers can be insurmountable. Oftentimes it leads to divorce, illness
and even suicide. It confuses and displaces children, leaving behind schoolmates
and neighborhood friends. The financial cost is borne by neighbors and
government as well. According to an April 2007 study by Senator Charles
Schumer, (D. NY), and the Joint Economic Committee of Congress, “Sheltering
Neighborhoods from the Subprime Foreclosure Storm”, the typical cost of a
1. Borrower: $7,200 in administrative costs, principal paid and moving.
2. Lender: $50,000 in foreclosure expense, property repair, legal fees and
costs to resell.
3. Local governments: $19,227 in lost property taxes, upkeep, sewage and
maintenance, unpaid utility bills and reduced tax base.
4. Neighbors: $1,508 in lost value through neighborhood deterioration due to
vacant and neglected properties, diminishing security.
F. Searching for Blame.
Many are quick to point their fingers at the lending industry, mortgage brokers
and real estate agents as the exclusive culprits, ignoring the possibility that more
than a few borrowers knew exactly what they were getting, and a good number of
them certainly misstated their qualifications.
While there certainly were a number of those in the industry who engaged in at
least aggressive if not predatory practices, I would like to think that most of us
were simply participating in helping the borrower achieve the American Dream
by way of loan plans designed for those prospective home owners and borrowers
who had been disenfranchised. In fact as you begin reading what I hope will be an
interesting journey I think you’ll be surprised by the comments made by members
of the Federal Reserve actually praising subprime lending!
Unfortunately, however, there were a few in our ranks who did indeed trade ethics
for enrichment and gave the media the fuel to paint us all with the same brush.
G. New Programs Increase Market Liquidity, Strengthen Regulation and Offer
Aid to Homeowners
Recent and innovative changes implemented by the financial community and
government agencies offer hope in restoring the confidence to absent investors to
return and help jump start the mortgage industry. These new programs include:
1. The Housing and Economic Recovery Act of 2008, effective October 1,
2008, increased loan limits for high cost areas for both conforming and
a. The new permanent limits for Fannie Mae and Freddie Mac
include an increase of up to $625,500 maximum loan amount
based on 115% of the area’s average housing cost, but not to
exceed 150% of the base conforming loan amount, $417,000.
For all areas in which 115% of the average housing cost is
equal to or less than the base conforming loan amount the
maximum loan would be not less than the base conforming
2. FHA new limits follow the same guidelines and maximum limit based on
115% of the average housing cost of each Metropolitan Statistical Area
(MSA, typically an individual county) up to $625,500. If 115% of the
average housing cost of an MSA is equal to or less than the base
conforming loan amount the maximum loan would be 65% of the base
conforming loan amount, or $271,050 (65% of $417,000).
a. All down payment assistance programs for FHA, such as
Nehemiah, are abolished under the Act.
2. The Act also established a new government agency for the oversight of
Fannie Mae, Freddie Mac and the Federal Home Loan Bank, the Federal
Housing Finance Agency (FHFA), a world class empowered regulator
according to the Secretary of the U. S. Treasury, which hopefully will
offer greater confidence in the investment community of the stability and
security of the GSEs. However, on September 8, 2008, fearing the GSEs
were greatly undercapitalized after reviewing what some believed to be
misleading accounting practices, the U. S. government took direct control
of Fannie Mae and Freddie Mac, placing them under the control of the
FHFA as conservator. It remains unclear at this time what the future holds
for them and therefore for a secondary mortgage market facilitator of
affordable home loans. Some favor selling them off to become completely
privatized with no government support, clearing impacting affordable
housing. Yet others in Congress want to see them become government
agencies, much like FHA. Even others vision them as government
3. Under the Act, the U. S. Treasury is authorized to buy preferred stock in
Fannie Mae and Freddie Mac, providing them essentially with an
unlimited line of credit for a term of eighteen months beginning October
4. The Act provides for rigid regulation of mortgage brokers and other loan
originators, requiring them to register with the newly established
Nationwide Mortgage Licensing System and to be licensed under a state
system to be identified or established by the state’s Secretary of State.
a. Originators must submit to a background and credit check.
b. They must also complete certain educational courses approved by
the Nationwide Mortgage Licensing System and Registry and
successfully pass an approved examination.
c. Licenses must be renewed annually, requiring at least eight hours
of specific continuing education.
d. Mortgage originators are defined by the Act as essentially anyone
who assists a loan applicant or prospective borrower in obtaining
financing, such as a mortgage broker, mortgage banker and real
estate agent, except in an administrative capacity such as a loan
processor unless that person is an Independent Contractor in which
case registration and licensing is required.
5. Established a new FHA refinance plan “HOPE for Homeowners”,
apparently patterned after the 1933 “New Deal” relief and recovery
program “Home Owners Loan Corporation”, (see Chapter III), to help
homeowners presently in default or who soon no longer to be able to
afford the current monthly mortgage payment. This new plan brings $300
billion in funding to FHA lenders and opens the door to approximately
400,000 additional homeowners who need help but who may not be
eligible for FHA Secure.
6. Independent of the Act, the U. S. Treasury and FDIC announced their
support and approval of a guaranteed “covered bond” program to
complement the traditional mortgage backed security industry, designed to
attract global investors back into the U.S. mortgage marketplace. Treasury
Secretary Henry Paulson, Jr., said as he announced the program, July 28,
2008, “We are at the early stages of what should be a promising path,
where the nascent U. S. covered bond market can grow and provide a new
source of mortgage financing.”
a. Major issuers of covered bonds, which actually have been issued
by Bank of America and Washington Mutual to a limited extent
since 2006, will include Bank of America, J.P. Morgan-Chase,
Citigroup and Wells Fargo.
b. Covered bonds have been used in Europe since 1769 and
historically have offered a greater degree of security to the investor
compared to the typical mortgage backed security. Unlike a
mortgage backed security which is sold by the issuer and removed
from its balance sheet, a covered bond, secured by a pool of loans,
remains on the books of the issuer as an asset while the investor
receives interest from the issuer’s cash flows.
c. A unique feature offering enhanced protection to the investor
requires the issuer to replace any loan in the pool which becomes
nonperforming with one which is performing.
d. Additionally in the event of the issuer’s failure to perform, the
investors have recourse to the loan pool, and in the event the pool’s
liquidation is insufficient they have a claim against the issuer’s
7. Freddie Mac, on August 1, 2008, announced it was doubling the amount
of money it pays mortgage servicers for each workout that helps a
delinquent borrower with a Freddie Mac-owned mortgage avoid
foreclosure, and will reimburse servicers for the cost of door-to-door
outreach programs, as well as make changes intended to streamline the
workout process. The compensation for repayment plans will double to
$500 from $250 while loan modification compensation will increase to
$800 from $400, effective today. Compensation for short-pay off will
increase from $1,100 to $2,200. In order to qualify for the reimbursement,
the mortgage must be at least 90 days delinquent, the servicer has to have
had no prior contact with the borrower, and the outreach must have been
done by an independent third party vendor.
H. Planning for the Future
To better understand why the financial markets reacted as they did, why
originating lenders and mortgage brokers felt comfortable in offering risky
loan products such as sub-prime and Alt-A, to what extent actual fraud on the
part of brokers and borrowers contributed to the problem, and what the future
may hold, to the extent we can reasonably guess, taking a look at the evolution
of real estate lending and how other troubled economic times impacted the
housing market may offer some meaningful insights and allow the real estate
professional to better plan his or her business strategies.
II. Pre-depression Years
A. Early Banks
It was not until after the turn of the 19th Century that commercial banks began to
offer long term lending for any purpose, including real estate. Most loans were
short term, payable in thirty to sixty days, and usually were provided to merchants
to pay costs of manufacturing or purchasing goods until they could sell them to
1. One problem was the political climate in post-revolutionary war America.
A national banking system as advocated by Alexander Hamilton to pay off
the federal debt and to offer a uniform and stable currency was fiercely
opposed by Thomas Jefferson, Secretary of State, who felt it was
unconstitutional and should be left up to each state. Jefferson also believed
a central bank would favor industrialism and the wealthy, abandoning the
nation’s farms and working class. But with President George
Washington’s support Hamilton succeeded in establishing a banking
system with the first Bank Act of 1791 and the creation of the Bank of the
United States. Short lived, its charter expired in 1811 and Jefferson was
able to prevent it from continuing until the Second Bank of the U.S. was
established in 1816. It too lost to national banking foes, including
President Andrew Johnson, and its charter expired in 1832.
2. After the Second Bank of the U.S. ceased to exist banking was the
business of state governments, each issuing its own currency supposedly
backed by adequate reserves of gold and silver to pay the bearer of the
bank notes on demand. That wasn’t always the case and in fact was
usually not the case. By 1860 there were thousands of worthless bank
notes floating around the country, crippling commerce and short term
lending. Counterfeiting was rampant and hundreds of banks failed
3. Finally with the passage of the National Currency Act of 1863 and the
National Bank Act in 1864 signed into law by Abraham Lincoln a new
national banking system was born under the supervision of a “Comptroller
of the Currency”. Under this new system national banks would buy U.S.
government securities and place them on deposit with the Comptroller of
the Currency, receiving in return national bank notes, elaborately engraved
and with the name of the national bank on it, for example “First National
Bank of Waverly” or “Merchants National Bank of Providence.”
4. Although the Bank Act brought more stability to the nation’s banking
system, especially in requiring each bank to maintain certain capital
reserves, there was no actual central federal banking structure to
adequately regulate the money supply in response to economic conditions.
The nation was at the mercy of the aggregate total of each individual
bank’s capitalization. The financial Panics of 1893 and 1907 underscored
the problem causing severe financial losses in all markets with no central
federal bank available to pour money into the system
5. The Federal Reserve Act of 1913 gave the banking system the central
control it required with a regulatory body which could monitor and govern
the nation’s money supply as necessary. The Act did away with the
national bank system with its individual notes and established a central
bank which would issue Federal Bank Notes. It provided a more stable
source of liquidity for the financial markets and the ability to inject capital
into the banking system if needed, including lending
6. In spite of the significant improvements resulting from the Federal
Reserve Act, it would take the Great Depression to make real estate
lending a major part of the business of commercial banks. It is easy to see,
therefore, why today’s major home lending institutions evolved from other
B. Terminating Building Societies
The real evolution of today’s real estate lending began around the early to mid
19th century when life and times were simpler. The way we did business was
simpler as well, and that included financing the family home or ranch. Borrowing
the concept from the English who had been financing homes through Terminating
Building Societies since 1775, Americans began forming village based lending
associations comprised of a town’s citizens who would pool their money for the
purpose of financing the purchase of homes and farms7
1. Most contributors were working class people who generally would not
have access to the banking system to finance a home. The terminating
society would be created and begin accepting members who would make
small periodic savings deposits into it. Once the agreed upon number of
members had been reached the society was closed or “terminated” to new
members, and the members continued to make savings deposits until a
desired amount had been raised, taking usually about ten years.
2. The order in which each member had the opportunity to obtain a home or
farm loan from the society was determined by ballot or lottery. The winner
would receive an interest free loan from the association for about 60% of
the home’s purchase price, with the 40% balance coming from the
member’s personal contribution account. Repayment was then made to
the society, usually in semi-annual installments.
3. The concept worked to the benefit of only a portion of the members as the
society would run out of money, naturally, before all could obtain
U.S. Dept. of Housing and Urban Development, “Evolution of U.S. Housing Finance System”, April 2006
financing. Those remaining would only be entitled to the return of their
savings deposits, on which they received no interest. For awhile it worked.
B. Building and Loan Associations
Terminating Building Societies became more permanent after a few years,
referred to then simply as “building societies”, and remained open to new
members, many of whom had no intention of buying or building a home,
increasing the chances for others to obtain financing, and leading to the
development of permanent savings institutions.
1. Permanent building societies led to the birth of building and loan
associations, the forerunners of today’s savings and loan industry. The
first record of a savings institution in the U.S. was the Oxford Provident
Building Association in Frankfort, Pennsylvania, established in 1831.8
2. The building and loans were community rather than neighborhood based,
but still for the most part relied on depositors’ savings accounts to make
real estate loans. Unlike the early building societies interest was earned on
savings and financing was not interest-free. However, earning the highest
return on capital invested was not the most important principle of the
building and loan but rather operating in the best interest of all members
of the association. Its policy would be continued some years later with the
creation of the savings and loan industry and its original public policy by
which it was governed.
3. Loan terms of both the building societies and building and loans were
from 6 to 10 years, offered semi-annual, non-amortizing (interest only)
payments and had only adjustable rates. Later loan plans offered ten year
amortizing payments with the entire balance due in 3 to 5 years. All
programs required 50% down payment.
4. Liquidity issues would plague the building and loan industry. Since there
was no such thing as a secondary mortgage market place in which a bank
or building and loan could sell its mortgage paper, they relied on
depositors’ savings accounts and investors contributions to make real
estate loans. Once deposits were depleted, they were out of the lending
C. Early Mortgage Backed Securities
While the securitization of mortgages is generally considered a product of the
20thCentury, they were used briefly beginning around 1880. Western U.S.
mortgage brokers would originate farm loans, package them into pools of about
Funk & Wagnalls New Encyclopedia, 2006
$100,000 each and issue debentures (bonds) secured by the loans. They would
then sell the bonds to Eastern investors and insurance companies.9
1. There was considerable risk to the broker who would remain liable to the
investor in the event of default, being required to repurchase loans if the
borrowers couldn’t bring them current. Default was a constant possibility
with inconsistent underwriting practices of the time.
2. Securitization lasted only about a decade. Beginning in 1890 several years
of severe weather took their toll on farm income resulting in numerous
losses and foreclosures. Then the financial “Panic of 1893” caused the
entire market to collapse.
Key Points to Remember:
1. Early commercial banks for the most part offered only short term
loans, usually to manufacturers and merchants who would repay in about
about 30 to 60 days, giving them time to sell to their customers.
2. Due to the political opposition to a federal banking system, it would not be
until the Bank Act of 1864 and the Federal Reserve Act of 1913 to bring
stability to the U.S. banking system and make long term lending a major
part of the banking industry.
3. Terminating Building Societies, first “community based” institution for
savings accounts established for real estate loans.
4. Building & Loan associations, first “permanent” savings and loans.
Primary emphasis placed on best interests of its members instead of
earning greatest return on its capital.
5. Typical loan plan of the time was 6 to 10 years, semi-annual interest only
payments, some 3 to 5 year terms with 10 year amortization.
6. Mortgage backed securities first issued by mortgage brokers in western
U.S. in 1880’s, sold to eastern investors, led to numerous defaults due to
lax underwriting standards. Disappeared after the financial Panic of 1893.
“Mortgage Companies and Mortgage Securitization in the Late Nineteenth Century”, Kenneth Snowden,
Associate Professor, Bryan School of Business and Economics, University of North Carolina at Greensboro
III. Lessons from the Great Depression
A. Then and Now: Similarities and Differences
History has a way of repeating itself. There are some interesting similarities
between the Great Depression of 1929 and the current economy. But it’s
important to understand there are some significant differences as well.
1. As pointed out by Marc LaBonte, a U. S. government economist, "the
(Great Depression does not provide a meaningful comparison to current
(21st Century) events, as the 1929 economy was characterized by the
maintenance of a gold standard and little financial regulation”10
2. On the other hand we have seen bank failures due to risky investments,
speculation and easy credit, both then and now.
B. Easy Credit and Good Times
One could likely say the root cause of today’s so called subprime implosion was
easy credit, just as it was during the good times following World War I.11 The
stock market had become to the average mom and pop investor what real estate
has become today. Everyone wanted for themselves what the major investors and
the wealthy were enjoying, a leveraged ride on a runaway stock market, with the
end to attractive values and profits nowhere in sight. 12 It was the “Roaring
Twenties” and Americans became hooked on easy credit, businesses and
consumers alike, with a “dollar down and a dollar a week” allowing them to buy
homes, automobiles, home furnishings and stocks. Especially stocks.
1. Thousands of home owners went to non-banking sources (the sub-prime
lending community of the time) and pledged the family home in order to
finance their purchase of stocks. The market was chasing “400” in the
Dow Jones and everyone wanted to get in on it.
C. Black Thursday and Black Tuesday
As it became to be called, “Black Thursday”, October 24, 1929, the stock market
experienced its first ever catastrophic sell off, followed by its largest losses on
“Black Tuesday”, October 29, 1929, causing widespread panic. These events were
preceded by a number of market losses beginning around September.
“The Current Economic Recession: How Long, How Deep and How Different From the Past”?, Marc
LaBonte, Economist, Congressional Research Service, January 10, 2002
"The Great Depression", Robert Samuelson, The Concise Encyclopedia of Economics
1. It would be ten years before the economy would see any meaningful
2. One of America’s leading economists at the time, Irving Fisher,
declared shortly before the crash in 1929, “stock prices have reached what
looks liked a permanently high plateau”. And on October 21, 1929,
following steady but gradual losses beginning on September 3, 1929 he
explained, “the market was only shaking out the lunatic fringe”. Both were
comments which were to cost him his reputation.14
a. It’s easy to see how he could have adopted such an attitude.
Compare that to our California real estate market, especially before
the bubble burst in the ‘90s. Few were worrying about devaluation,
and when it started to happen, even fewer thought it would be as
severe as it turned out. As it turned out it looks as if we forgot our
lessons from the ‘90s as well.
D. Federal Reserve Bank’s Mistakes
Just as many thought the initial wave of subprime foreclosures was a mild bump
in the mortgage market, many economists believed the crash of 1929 would result
in only a recession, and a short lived one at that. Of course they were proved
wrong. The market’s slide and the depression which followed was caused, claims
Federal Reserve Chairman Ben Bernanke, by the result of faulty Federal Reserve
action, or lack of such action as the case actually was. 15
1. The Fed first allowed the expansion of the money supply in the 1920s to
the extent that it led to a speculative and an unsustainable boom in the
stock market and capital goods. A bubble to be exact. The Fed failed to
put the brakes on in time.
2. We were enjoying high levels of employment through business growth
and expansion financed by private debt outside the banking system with
high interest rates collateralized by mortgages on homes and businesses.16
And the bubble was primed to burst.
3. When the Fed finally decided to slow things down and began raising rates
in the spring of 1928, for whatever reason they continued to do so through
a recession that began in August 1929, certainly deepening the economic
problems and, some believe, actually causing the depression.17
"The Great Depression, America 1929-1941", Robert S. McElvaine, New York: Times Books, 1981
"Irving Fisher of Yale", William Barber, The American Journal of Economics Sociology
"Remarks by Ben Bernanke, H. Parket Willis Lecture in Economic Policy" FDR Library March 2, 2004
"Beckoning Frontiers", (Memoirs of M.S. Eccles, Fed Chairman 1934-1948), Alfred A. Knopf, 1951
"Bernanke", H. Parket Lecture in Economic Policy, FDR Library, March 2, 2004
4. On September 3, 1929, the Dow Jones Industrial Average peaked at
386.10, then, losing investor confidence and steam it started a downward
slide, closing the day at 381.17.
5. Over the next month the DJIA lost 17%, briefly recovering about half its
losses over the next week. Then on October 24, 1929, Black Thursday,
12.9 million shares were traded in a sell-off frenzy, with prices
6. The following Monday, October 28, 1929, the Dow suffered another 13%
loss as more investors sold off stocks.
7. Tuesday morning, Black Tuesday, October 29, 1929, the market opened
for business only to finish the day with a 12% loss, a record 16.4
million shares traded, closing at 230.07 and a 40% total loss since Sept. 3.
a. At the end of the day the market wound up losing $14 billion in
value, a total loss for the week of $30 billion, ten times more than
the annual budget of the United States federal government, and
greatly exceeding what the U.S. had spent in all of World War I.18
E. Bank Failures Cause Americans’ Savings to Evaporate
Banks which had invested heavily in the stock market began to suffer losses. It is
estimated up to 40% of the money supply normally available for purchases and
bank payments were lost due to bank failures.
1. In all 9,000 banks failed during the 1930s.
2. It was no wonder that consumers lost confidence in the banking system,
withdrawing their savings and hoarding cash. Those who didn’t act fast
enough lost all.
3. By 1933 depositors saw $140 billion of their savings disappear due to
bank failures as there was no deposit insurance. That would happen as one
of Franklin Delano Roosevelt’s New Deal programs.19
4. As savings accounts became depleted, banks were required to become
extremely conservative in lending practices, holding on to reserves.20
Businesses, and consumers, encumbered by heavy debt began to suffer
with nowhere to go for refinancing.
5. Home owners who had financed the family home to buy stock lost
everything. With their savings gone and their stock worth nothing (the
Dow was down to 41.22 by July 8, 1932), defaults and foreclosures
"pbs.org", New York, A Documentary Film
"Farm Prices, Myth and Reality", Willard Cochrane, League of Nations, World Economic Survey '32-'33
"DJIA, 1924-1935", Chart, Eleanor Roosevelt National Historic Site
6. The Fed had allowed nearly a one-third reduction in the U. S. money
supply. Because of the Fed’s actions what should have been only a
recession turned into the Great Depression.21
7. Construction work in the housing industry and factory orders in
8. Unemployment jumped from 3% in 1929 to 25% by 1933, and excluding
farm payroll was actually over 33%.
F. The New Deal: Relief and Recovery
Within 100 days of Franklin Delano Roosevelt assuming office in 1933, his “New
Deal” act was signed into law. With the aid of a Democratic controlled congress,
it called for the establishing of 42 new agencies designed to turn the economy
around by creating jobs and establishing new government programs and agencies
to promote the general welfare of the American people. Among them were:
1. The Securities and Exchange Commission (SEC)
2. The Federal Deposit Insurance Corporation (FDIC).
3. The Home Owners' Loan Act
4. The National Industrial Recovery Act
5. The National Housing Act and the Federal Housing Administration
G. The Home Owners' Loan Act
In June 1933 the Home Owners' Loan Act was signed into law, establishing the
Home Owners’ Loan Corporation (HOLC) whose sole purpose was to provide
relief to homeowners in or nearing foreclosure, similar to today’s “Hope for
Homeowners” FHA refinance program.
1. Under the program, the U. S. government would buy loans in default or
foreclosure from the originating bank, paying for them with government
bonds with a guaranteed 4% yield. The home owner would then make
payments on new refinance loans directly to the HOLC. The HOLC
was authorized to make loans for three years, ending in 1936.23
a. Terms were 15 years fully amortized with a fixed rate of 5%
b. Over one million loans were originated.
c. Only 20% of the loans wound up in default and foreclosure.
"The Great Depression", Eleanor Roosevelt National Historic Site
"It's not a Wonderful Life", Andrew Jakabovics, Center for American Progress
H. The National Housing Act
Passed in 1934, the National Housing Act established the Federal Housing
Administration. Its goals were, first, to promote jobs in the housing construction
trades and related industries, such as building products and suppliers, and
transportation of materials, second, it was to provide affordable housing through
government insured loans, with long term financing for both rehabilitation and
purchases of owner occupied homes.
1. The National Housing Act consisted of four major features.24
a. Provide insurance against loss on property improvements.
b. Provide Mutual Mortgage Insurance
c. Establish National Mortgage Associations to buy and sell FHA
loans, each with capital stock of at least $5,000,000.
By 1938 no private National Mortgage Association had
been chartered, due to the slow pace of the recovery and the
recession of 1937, whereupon the Federal National
Mortgage Association was created (Fannie Mae), a
government agency, to do the work.
d. Provide insurance for savings accounts with the establishment of
the Federal Savings and Loan Insurance Corporation (FSLIC).
2. Desperate times called for desperate action. Out of financial crisis, through
creative thinking financial wizards developed a unique and novel loan
program. With the goal of making home ownership available to all, not
just the wealthy or reasonably comfortable, they set about to create a loan
program which the average worker could realistically obtain.
a. Before 1934, lenders required 50% down payment and offered loan
terms of three to five years maximum. Even before the depression
few had the cash resources or incomes to be able to buy a home
subject to such loan terms. The Depression eliminated almost
b. The first FHA loan plan had a term of 20 years, fully amortized,
and a maximum loan to value of 80%.25 The idea was that the
typical home owner would work for about twenty years, making
small affordable monthly housing payments during the entire term.
When it was time to hang up the tools of trade and receive the
obligatory gold watch the family home would be paid off.
In 1938, the loan term was extended to 25 years and
allowed up to a 90% loan to value.
"The FHA Story, 25 Years of FHA", Julian Zimmerman, FHA Commissioner, May 1, 1959
In 1948, the loan term was further extended to 30 years
with a maximum allowable loan to value of 95%.
In 1957 and 1958 higher loans to value were authorized.
In July 2008 FHA loan limits finally were raised to the
GSE limits which also had limits increased by fifty percent.
Just as the Great Depression led to sweeping changes in the
lending industry the mortgage market crisis of 2007 led to
significant changes in the FHA program.
3. With Fannie Mae in place to buy these new FHA loans, and Mutual
Mortgage Insurance protecting the profits guaranteed to investors who
would in turn buy loans from Fannie Mae, Americans in previously
unheard numbers would finally become home owners.
Key Points to Remember:
1. Root cause of the Great Depression was “easy credit”, similar to the mortgage
market meltdown of 2007.
2. Homeowners refinanced through “subprime” lenders to finance purchase of
stocks. The 1929 crash saw both the value of stocks decline or evaporate and their
homes as well.
3. According to Federal Reserve chairman, Ben Bernanke, incorrect action on the
part of the Federal Reserve at the time caused what should have been a recession
to become the Great Depression
4. Due to the great numbers of bank failures, 9000 in all, depositors saw $140 billion
in savings disappear. Banks still in business all but ceased lending.
5. Homeowners still encumbered by heavy debt had few sources for refinancing,
declining home values made selling difficult. Widespread foreclosures resulted.
6. Home Owners’ Loan Act of 1933 established the Home Owners’ Loan
Corporation (HOLC), offered help to homeowners in default. For three years
bought existing loans from originating lenders and refinanced with government
7. The National Housing Act of 1934 established new standards in lending including
use of leverage, long fully amortized terms. Created a secondary mortgage market
place for lenders, introduced once again mortgage backed securities to attract
capital for lending.
IV. The Recessions of 1973-1975 and 1980-1982
A. Arab–Israeli Conflict Hits Home
In 1973 the war between Israel and a coalition of Arab states led by Egypt and
Syria was in full swing. The United States had long been a supporter of Israel and
had naturally favored Israel in the current conflict. Putting pressure on the West,
the Arab states retaliated by placing an oil embargo on the countries which were
supporting Israel, including the United States.26 The effects on the U.S. were
1. Gasoline prices jumped over 45%, and led to rationing.
2. The New York Stock Exchange lost $97 billion in six weeks.
3. Factories cut production and laid off workers.
B. Stagflation: The Fed Makes a Choice between Inflation and Jobs
As inflation grew the Fed introduced a tightened monetary policy, in spite of an
increase in unemployment.27 The Fed was more concerned with rising energy and
food costs, and around the fourth quarter of 1973 the U.S. entered what would
become its most severe recession since the Great Depression. Five years after its
recovery in 1975 it would be followed by an even greater recession in 1980.28
1. Unemployment increased from 5% in 1973 to 9% by 1975.
2. Inflation went from 7% in 1973 to 9% in 1975.
3. With stagflation crippling the economy (the combination of high
unemployment accompanied by inflation), the Fed had a dilemma: control
inflation or address unemployment?29
a. Today we see growing evidence of stagflation. As in 1973, the
Federal Reserve Board is faced with the challenge of controlling
inflation or growing the economy.
4. The Fed decided to attack inflation, and continued on a path of increases
to the Fed Funds rate which prolonged the recession and stagflation.
a. The Fed Funds rate, 6% in 1973, jumped to 12% in July 1974.
"The Prize: The Epic Quest for Oil, Money and Power", Yergin (New York: Simon & Shuster 1991)
"Inflation, Recession and Fed Policy", William Poole, Pres., Federal Reserve Bank of St. Louis, Midwest
Economic Education Conference, St. Louis, April 11, 2002
"Shades of Stagflation", Mark Gongloff, CNN/Money, Feb. 21, 2003
b. Long term mortgage rates went from 7.5% in early 1973 to 9.25%
in mid 1974.
5. In late 1974 the Fed began a series of rate cuts which helped bring both
inflation and unemployment down somewhat, but by mid 1977 inflation
was creeping up again, and was back into double digits by 1979. 30
C. The Fed Engineers a Recession to Fight Inflation
Economic woes simply would not go away in the '70s. Another oil crisis caused
fuel and energy prices to jump in 1979 and inflation skyrocketed. In the middle of
all this, the nation's Savings & Loans’ problems were becoming worse.
1. By May 1980 inflation was up to 14.4%
2. The Fed was fixed on ridding the economy of inflation, and steadily
increased the Fed Funds rate to over 19% by July 1981.
3. The recession that followed was intentionally engineered by then Fed
chairman, Paul Volker. By tightening the money supply, he sought to
defeat inflation.31 Home sellers and buyers lost in the process.
4. 30 year fixed mortgage rates rose to 18.5% by October 1981.
5. The prime rate reached 21.5% in June 1982.
6. All sectors of the business community felt the effects, and unemployment
reached 10.8% in December 1982, an all time high since recovering from
the Great Depression and a rate of 12% in 1941.32
D. The Fed Opens the Money Supply and the Recovery Begins
Through a combination of deficit spending and a gradual reduction in the Fed
Funds rate, the economy began its recovery as 1982 came to a close. Fed
chairman Paul Volker opened up the money supply and led the nation’s economy
to a rapid recovery.33 The Fed Funds dropped to a low 5.85% in October 1986.34
1. 30 year fixed rate mortgages slowly fell to 12% by mid 1985.
2. Loan availability due to S&L problems continued to impact real estate
lending. Home ownership fell from over 65.5% in 1981 to 63.5% in 1986.
InflationData.Com; and U.S. Dept. of Labor: Bureau of Labor Statistics
"Did the Federal Reserve Cause the Recession?", Paul Krugman, New York Times, April 1, 1991
"Fed Funds Historical Rate Chart from 1955", Federal Reserve Bank,
Key Points to Remember:
1. Energy prices contributed to slowing economy, eventual recession.
2. Stock market suffered significant losses.
3. Federal Reserve challenged with stagflation, chooses to fight inflation and let the
economy struggle with job losses.
4. Fed continues to tighten money supply through 1982 recession, home buyers
cannot qualify for financing.
5. Inflation under control by end of 1982, however lending problems persist.
5. Savings & Loan crisis hampers lending liquidity. Home ownership falls.
V. The Savings & Loans Crisis
A. The Federal Home Loan Bank System
Established by the Federal Home Loan Bank Act of 1932 to provide a source of
liquidity for the Savings and Loan industry, the Federal Home Loan Bank System
consists of twelve regional Home Loan Banks. Although the Regional Banks were
federally sponsored, they were owned by stock holdings of the member
associations of their respective regions, and were supervised by the Federal Home
Loan Bank Board. In 1933 the Home Owners' Loan Act authorized the FHLBB to
charter and to regulate the federal savings and loan associations.35
1. Legislation for the S&Ls was driven by a public policy goal of
encouraging home ownership, unlike that of commercial banks which
included commercial and business development.36 The S&L's business
was essentially restricted to accepting funds from depositors for savings
accounts and originating long term fixed rate residential mortgages using
the monies from the savings accounts funds (S&Ls were prohibited by
federal law from offering adjustable rate loans until 1981).37
2. The next step in the evolutionary process was the creation by the National
Housing Act of 1934 (which also created the FHA) of the Federal Savings
and Loan Insurance Corporation, providing federal deposit insurance
protection for the S&Ls depositors just as the Federal Deposit Insurance
Corporation provides for commercial bank depositors. With the birth of
the FSLIC, S&Ls could more effectively solicit savings accounts offering
federal protection against loss. One difference between the two, however,
was that the FDIC was established as a separate agency while the FSLIC
was part of the FHLBB.
B. Weak Examination and Budgetary Restraints Plague the S&Ls
From its inception, the FHLBB suffered from weaker examination, supervision
and enforcement practices than those which regulated commercial banks.
Additionally, it was subject to tight budgetary restraints on staffing and
compensation, unlike its sister agencies.
1. These were all conditions which would lead to a compounding of the S&L
crisis as the industry entered the 1980s.38
"Savings and Loan Crisis", Bert Ely, The Consise Encyclopedia of Economics
C. Regulation “Q” Restricts S&Ls’ Ability to Compete
Part of the restrictions the government placed on the S&Ls included a ceiling on
the interest they could offer depositors when Regulation Q (The Banking Act of
1933) was extended to thrifts in 1966.39
1. As we approached the end of the decade in the 70s, the then high inflation
rate with equally high rates offered by money market accounts caused
depositors to begin moving their savings accounts away from the S&Ls
and into high-yield money market accounts.40
a. The result was disintermediation caused by income from mortgage
loans being less than savings rates they had to pay to depositors.41
Although with some deregulation beginning in 1978 and again in
1980, the S&Ls could not effectively compete with non-regulated
industries offering the high rates of money market accounts. In
1981, for example, the difference between savings rates and
mortgages was 1%. The S&L would have to lend at a loss!42
2. Additionally, most of the S&Ls assets were in the form of low fixed rate
mortgages in a market with rising rates. With due-on-sale clauses not
uniformly enforceable at the time, borrowers selling their homes would
transfer their lower-than-market rate mortgages to buyers, preventing the
S&L from being paid off and releasing the funds allowing them to loan to
the buyer, or someone else, at current market rates.43
3. As interest rates continued moving higher, the value of these portfolios of
fixed rate loans being held by the S&Ls moved lower, eroding their capital
and threatening insolvency.44
D. Federal Deregulation Backfires
Savings & Loans began closing their doors as losses mounted. In an attempt to
forestall further insolvency, the government stepped in with relaxed regulation.45
In 1980 through 1982, congressional and regulatory action sought to accomplish
solvency for the S&Ls with four major policy objectives:46
"Congress, Regulators, RAP and the Savings and Loan Debacle", Ahmad W. Salam, The CPA Journal,
"U.S. Savings and Loan Crisis", Rob Jameson, Sungard Bancware Erisk, August 2002
"The 1980s", The Learning Bank, Federal Deposit Insurance Corporation, May 2, 2006
1. Enhance economic survival of the thrifts by reducing its interest rate risk
by allowing it to diversify its assets and remove its restriction of lending
on only residential real estate.
a. Depository Institutions Deregulation and Monetary Control Act of
1980 allowed for the following:
Invest up to 20% of assets in consumer loans.
Raised deposit insurance to $100,000 from $40,000
Offer checking accounts
Issue credit cards
2. Adopt a policy of forbearance to give the industry time for
deregulation to work, thereby avoiding insolvency. Regulators,
lobbyist and legislators used a variety of means, including reducing
3. Encourage asset growth by allowing higher interest rates on savings
accounts through the elimination of Regulation Q.
4. Stop disintermediation by the following:
a. Allowed S&Ls to offer 6 month money market certificates
b. Allowed higher savings rates as described above.
c. Passed the Garn-St.Germain Depository Institutions Act of 1982:47
Allowed S&Ls to hold up to 40% of its assets in higher
yielding commercial real estate construction and
It allowed them to finance up to 100% of commercial
Allowed them to have up to 30% in consumer loans.
Allowed them to use land and other non-cash assets as part
of their capital requirements.
Authorized them to offer money market deposit accounts.
Established a time period of three years to resolve the
enforcement issue of due on sale provisions.
FDIC Learning Bank
E. The Garn-St. Germain Depository Institutions Act of 1982
Although included in the federal assistance program to aid the failing thrifts, the
Act would prove to be costly to them.
1. The Act provided a moratorium on lenders' ability to enforce due on sale
clauses in their notes for home mortgages. In doing so, fortunately for
home buyers and sellers, it propped up a sluggish real estate market for a
few years by allowing prospective home buyers to take over the low rate
in existing loans of sellers without fear of the effects from a due-on-sale
a. The downside to the S&Ls was the fact that it was trying to raise
much needed capital to keep their doors open by selling off low
fixed rate loans on their books at severe discounts.
b. Instead of being paid off at face value on transfer of title when
buyers would “take title subject to” sellers existing loans, they
were left still holding a low rate note which they would likely have
to sell at a discount to continue raising capital. The provision
prohibiting enforcement of due on sale was effective from October
15, 1982 to October 15, 1985. One bright spot, however, was that
the S&Ls could enforce due on sale provisions of all loans
originated on or after October 15, 1982.
2. Deregulation promoted the rapid growth of new S&Ls. One factor was a
new and extremely liberal approval process for new S&Ls. Prior to the
1980s charters for new thrifts were approved and granted based on the
needs of the community. After deregulation, the "FHLBB and the Office
of the Comptroller of the Currency approved any application as long as the
owners hired competent management and provided a sound business
plan". Thrift assets jumped from $686 billion in 1982 to $1,068 billion in
1985, a 56% increase and more than twice that of commercial banks. The
industry attracted high rollers and risk takers, including more than a few
new owners engaging in fraudulent activities, and many more just plain
3. With the ability to invest up to 40% of their own assets in commercial and
development projects and to finance up to 100% of a project, thrift owners
began moving from traditional residential mortgage lending into
commercial and business financing which promised greater returns:
ethanol plants, wind farms, Las Vegas casinos and commuter airlines.
S&L managers had no experience in these types of ventures and weren't
capable of adequately evaluating the risk.49
"Special Report: The Savings and Loan Crisis", Barbara Rudolph, Time/CNN, February 20, 1989
a. Thrifts which had invested heavily in energy investments,
especially in Texas and California, lost as heavily when oil prices
fell 75% from $39 per barrel in 1983 to $10 in 1986. Real Estate
markets which collapsed in California took with them the thrifts
which had financed them. 50
b. S&Ls residential mortgage origination dwindled beginning even
before the Garn-St. Germain Act was passed, and from 1978’s high
of 78% of assets fell to 56% in 1986 as they concentrated on the
prospects of greater profits in commercial projects, which for the
most part failed to materialize. 51
F. S&L Failures Increase from Inadequate Regulatory Examination
When much of the S&L industry was facing insolvency even as it entered the
1980s, the FHLBB's enforcement personnel were characterized as under
compensated compared to those at sister agencies, as well as being understaffed
and poorly trained.
1. A major problem was the enforcement structure itself. Examiners were
hired by and worked for the Office of Examination of the Bank Board
while the supervisory personnel, on the other hand, with authority for the
System itself worked for the FHLBB. Therefore no one really was directly
responsible for identifying a failing member thrift.52
2. 1982 would see 73 S&L failures, followed by 51 more in 1983.
3. S&Ls continued to fail to the end of the decade, from 65 failing in 1986 to
190 in 1988. In 1987, FSLIC became insolvent with a $6 billion loss.
a. S&Ls lost $30 million each business day.
b. A total of 747 FSLIC insured S&Ls had failed by the time it was
over, plus an additional 333 “technical” mergers, forced upon them
by the regulators. 200 FDIC insured banks failed and the FDIC
showed a loss.
G. The Financial Institutions Reform Recovery and Enforcement Act of 1989
The S&L industry recovered as George H. W. Bush takes office and announced a
plan to resolve its insolvency, the Financial Institutions Reform Recovery and
Enforcement Act of 1989 (FIRREA). Major provisions of the Act include:53
FDIC Learning Bank
1. Abolished FSLIC and established two new insurance funds administered
by the FDIC:
a. The Savings Association Insurance Fund
b. The Bank Insurance Fund
2. Established the Resolution Trust Corporation (RTC), a temporary agency
which administered S&L failures.
a. Funded the RTC with $30 billion from bond sales, $18 billion from
the U. S. Treasury and $2 billion from the FHLBB.
3. Replaced the FHLBB oversight responsibility of S&Ls with the Office of
Thrift Supervision (OTS).
H. The Cost of the Savings and Loan Crisis
The final cost of the Savings and Loan crisis is estimated to be $160 billion.54
1. Of that the U.S. taxpayers paid $132 billion
2. The thrift industry paid $28 billion.
3. And then we entered another recession!
Key Points to Remember
1. Savings and Loans regulatory provisions establish public policy of providing for
accepting savers’ deposits and for home loan financing, not commercial and
development projects as with commercial banks.
2. Savings and Loans suffered from weak examination and regulatory oversight.
3. In late ‘70s and into the ‘80s high savings rates offered by non-banking
institutions saw S&Ls depositors withdraw savings for these high-yielding money
4. Federal deregulation to aid S&Ls provide little help, and in fact back fire with the
Garn-St. Germain Act prohibiting due-on-sale enforcement for 3 years for all
home loans except those originated after the date the Act was signed into law,
Oct. 15, 1982.
Key Points to Remember, continued:
5. Deregulation also changed its public policy mission of providing solely home
financing, with the S&Ls now able to finance risky high leveraged real estate
commercial projects and developments, wind farms, airlines and oil exploration
projects, activities in which the S&Ls managers had no experience.
6. The result was 747 S&Ls closing their doors, another 333 forced into solvency
through mergers with stable institutions.
7. The U.S. bails out the S&Ls with the Financial Institutions Reform Recovery and
Enforcement Act of 1989 (FIRREA).
8. Cost to the taxpayers is $132 billion.
VI. The Recession of 1990-1991
A. Primary Victims: Real Estate, Finance, Construction and Aerospace
In mid-1990 the nation's longest peacetime expansion came to a close. Although
not as severe as previous recessions, the 1990-1991 downturn would have been
even milder had it not been for the set of circumstances which propelled the
economy downward to begin with,55 the Persian Gulf crisis, the Savings & Loan
failures and subsequent credit crunch in mortgages.
1. Cutbacks in defense spending, especially aerospace losing 190,000 jobs
2. Unemployment reached 1.5 million jobs by March 1991, the official end
of the recession. Most job losses occurred in manufacturing, construction,
the real estate industry, finance, insurance and other related industries.
3. New real estate construction and home sales were negatively impacted by
the Savings & Loan crisis, with tighter access to credit and financing.
4. For the first time in our economic history, many of those who lost jobs
during a recession did not return to the same job or even the same
5. Never before did so many white collar employees incur job losses,
especially in finance, insurance and real estate.
6. In addition to white collar job losses, rust-belt industries and aerospace
manufacturing suffered significant job losses, the effects eventually
spilling over into just about every occupation.
7. New home sales peaked in 1989 then fell 25% through July 1990.
8. Existing home sales dropped 16% by January 1991 before recovering.
9. Home prices began a gradual decline.
B. The Fed Takes Action
Fortunately the recession was relatively short lived, officially lasting from July
1990 to March 1991. Then as the Fed intervened, triggering lower mortgage rates,
sales of both new and existing homes began to rise in early 1991.
"Industry Employment and the 1990-91 Recession - Job Losses Compared to Previous Recessions",
Christopher J. Singleton, Monthly Labor Review July 1993
"The 1990-91 Recession: How Bad was the Labor Market", Jennifer Gardner, Monthly Labor Review,
1. The Fed Funds rate dropped from 8.15% in July 1990 to 6.12% in March
1991. However, long term mortgage rates fell only slightly as the nation
recovered, from a high of 10.5% in mid-1990 to 9.5% in March 199157
30 Year Fixed Rates Fed Funds
(Chart 1: Freddie Mac Annual Average Mortgage Rates Historical Chart)
a. Rates continued to hover between 8.5% and 7.5% until April 1997.
b. It was not until late 2001 when we began witnessing the low rates
we enjoy today. The rate as of June 2008 stood at 6.32%.
c. Chart 1 below shows annual average mortgage rates since 1973.
Although the chart reflects annual averages only, the highest
monthly average rate during any month in the period was 18.5% in
Oct. 1981 and the lowest was 5.25% in June 200358
C. Businesses Become More Efficient, Result: Unemployment Remains
Even as the recession came to an end, unemployment in many sectors continued
to rise as business' streamlined operations shedding unnecessary jobs, resulting in
a much smaller share of the unemployed returning when the economy improved
than previous recessions. It would be October 1993 before unemployment would
return to pre-recession rates.59
1. Larger businesses restructured operations emphasizing efficiency with
fewer employees, tempering the recovery of loss jobs. Many smaller
FHLMC Mortgage Rates Historical Chart
businesses simply went away, their owners standing in the unemployment
lines alongside their former employees.
2. Efficiency led to greater labor productivity, reducing the need to increase
3. Unemployment was at 5.2% at the start of the recession rising to 7.8% in
June 1992 15 months after it officially end and continued up to nearly 8%
in mid-1996 before it began its downward trend.
D. Foreclosures Become Commonplace
The loss of household income as the recession progressed, combined with a
decline in home values, eventually resulted in numerous foreclosures.
Foreclosures are usually one of the last things that appear in a recession, and will
usually continue after the recession officially comes to an end, and we saw that
following the recession of 1990-1991.
1. By 1993, two years after the end of the recession, foreclosures had finally
became commonplace in California, and did not disappear until 1997.
Key Points to Remember:
1. 1990’s recession, which saw over 1.5 million job losses, was made even more
severe by the credit crunch in mortgages resulting from the S&L crisis.
2. Cut backs in defense spending saw 190,000 jobs lost, mostly in aerospace.
3. Housing construction suffered, causing job losses in housing trades, finance and
real estate professions.
4. First time in history the U.S. witnessed significant numbers of unemployed not
returning to the same industry as business’ streamlined operations to become
more profitable with fewer employees.
5. New home sales fell 25% by 1990, existing home sales dropped 16% before
6. Foreclosures became a growing problem as unemployment lingered.
7. The U.S. would not work through its REO inventory until 1997, six years after the
end of the recession.
VII. The Post Recession Real Estate Market
A. Foreclosures and “REO” Become Household Words.
The relationship between foreclosures and home prices is two directional. Heavy
foreclosures can both cause and be caused by declining home prices. This was the
case at the time, with each feeding on the other. California home prices started to
fall in late 1991, with foreclosure activity increasing steadily beginning in 1992,
reaching its peak in 1997.60
1. In 1996, over four years after the recession ended, mortgage delinquencies
hit an all time high and then started a downward trend. As foreclosure
activity accelerated, banks and savings & loans became more aggressive
in efforts to eliminate "real-estate-owned or REO", the term used to
describe real estate acquired by lenders through foreclosure, from their
books as well as non-performing loans secured by real estate which had
not yet completed, or even entered the foreclosure process.
2. Foreclosures and "REO" became household words in the real estate and
financial industries. Just about every lending institution and secondary
market investor was involved in the process, Commercial banks, savings
& loans, the GSE's (Fannie Mae and Freddie Mac), The Department of
Veterans' Affairs, The Department of Housing and Urban Development
and mortgage insurance companies. They each used a variety of marketing
methods to try to satisfactorily dispose of their inventories, which differed
among them depending on their own goals and regulatory agency
requirements. Marketing strategies included:
a. Listing properties with local real estate agents.
b. Outsourcing management and marketing responsibilities to third
c. Holding Public Auctions
d. Offering "pools" of properties to investors by bid.
B. The Broker Price Opinion
In assessing the marketability of foreclosed properties, lending institutions
typically will reply upon value representations provided by the real estate
community. The REALTOR's® research is documented on a form referred to as a
Broker Price Opinion (BPO), used by banks, the GSEs and asset management
companies. It was an extremely important and effective tool used by
Office of Federal Housing Enterprise Oversight
institutional investors who were bidding on large pools of REOs offered by some
of the larger financial institutions (and especially those in California who were in
the process of being acquired by Washington Mutual). More limited in scope than
an actual appraisal, but more detailed than the typical REALTOR's® property
market analysis, the BPO gave the bank or investor the essential information it
needed to accomplish its task. The results of the BPO include the following:
1. The estimated market value of the property in its "as is" condition.
2. The estimated repair and rehabilitation costs, if any, to improve the
property to a condition compatible with those properties in the
3. The estimated market value of the property "as repaired".
C. Lenders’ Marketing of REO Impacts Area Values
Area home prices became hostage to some banks' sales philosophy. Those
institutions which adopted a general policy of listing its properties for sale in their
"as is" condition, and having significant repairs that were not to be performed,
certainly caused a negative impact on neighborhood home values. Conversely,
REO properties which were repaired, rehabilitated and priced accordingly helped
restore and maintain attractive home values in those neighborhoods.
1. As lenders worked through their inventories of REOs, more than not
fortunately began improving their REOs as needed before placing them on
the market. They wisely realized not only could they demand a higher
sales price, recovering most or all of their foreclosure loss and repair costs,
but by doing so they protected the value of the collateral which secured
other loans they had originated for other homeowners in the
D. Dot-Com Bust Aids Real Estate Recovery.
By 1998 lenders had worked through most of their REO inventories with sales
and prices reflecting signs of recovery. Activity steadily increased aided by
the "dot.com" bust in 2001-2002 which saw investors fleeing the stock market for
real estate. By 2001, the market had not only recovered completely but was on its
way to an amazing five year boom in sales and rates of appreciation.
Key Points to Remember:
1. Foreclosures can both cause and be caused by declining home values.
Key Points to Remember, continued:
2. Foreclosures are typically one of the last things to occur in a recession, and
continue for some time afterward.
3. REO became a household word, with lending institutions using a variety of
marketing strategies to rid them from their books, including using REALTOR®
services in traditional listing arrangements, as well as using services of the
emerging third party asset management industry.
4. Broker Price Opinions appeared in a variety of forms. Fannie Mae BPO becomes
standard for many.
5. REO valuation policies held neighborhood home prices hostage.
6. Following the elimination of most REOs by 1998, the real estate market began a
rapid recovery, aided in part by the “dot-com” bust during the recession of 2000
to 2001 which witnessed small investors switching to real estate.
VIII. The Subprime Mortgage Market Explosion
A. Risk Assessment Models, Automated Underwriting Accelerate Lending
As we emerged from the 1990-1991 recession real estate sales activity accelerated
with the clean up of foreclosure sales in 1997 and 1998 and home prices started to
climb steadily. Home buyers adopted an attitude of "buy now before its too late",
and multiple offers on properties for sale became more common than not. During
all this a number of changes had occurred in lending practices. Over the past
decade lenders had introduced new programs in hopes of capturing a greater share
of the mortgage market place. Using new risk assessment guidelines to implement
so-called risk-based lending, aided by automated software and underwriting
models, they placed the loans they offer in the following categories, in order of
1. Prime conforming: The safest of all, these are loans which are sold to the
Government Sponsored Enterprises, Fannie Mae and Freddie Mac, and are
for the most part risk free to the lender.
2. Prime, non-conforming: Offered to borrowers with good credit who
can fully document income, assets and employment information.
3. Near prime, usually referred to as Alt-A: Offered to borrowers who have
superior credit and who are not usually required to document income and
4. Subprime: Extended to borrowers who are deemed the least creditworthy
and carry the highest risk to the lender. Potential borrowers of subprime
loans offered a relatively untapped profit source to the lending industry,
providing they could find a way to market volumes of them in the
secondary market place. To accomplish that would require packaging in a
manner which would reduce the impact of their high risk of default.
B. Wall Street Turns Junk into Jewels
In 1994 the lending community experienced a sharp rise in prime mortgage rates
with a resultant slowdown in origination. Mortgage companies and brokers went
looking for additional sources of business and focused on the subprime market.
The subprime industry happily responded, armed with new "financial
engineering" of products which accelerated the sale of subprime loans on Wall
Street facilitating the brisk pace of sales and the corresponding run up in prices.61
1. 1994 is generally credited as the year the subprime business took off with
origination volume growing from about $50 billion in 1994 to over $665
"What Caused the Housing Bust", Porter Stansberry, Daily Wealth, August 18, 2007
billion in 2005 representing over 20% of total loans originated, as shown
in Chart 2 below.62
Subprime Loan Volume
1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007
(Chart 2: Inside Mortgage Finance Statistic Annual, 2007 Edition,)
2. The expansion of Subprime lending allowed millions of Americans who
previously would have been denied credit to become home owners, and
more than half of the new households were minorities.63 Chart 3 below
reflects home ownership’s rise from 64% in 1994 to a record 69% in
1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008
(Chart 3: U. S. Census Bureau)
4. As the market gained speed and home values rose, growing competitive
pressure in the lending industry and the desire for increased profits led
Inside Mortgage Finance Statistic Annual, 2007 Edition; Freddie Mac historical loan origination
"Subprime Mortgage Lending: Benefits, Costs and Challenges", Edward Gramlich, Governor, Federal
Reserve Board (Financial Services Roundtable Annual Housing Policy Meeting; Chicago IL) May 21, 2004
U. S. Census Bureau
many mortgage lenders to deviate from standard underwriting principles,
offering a variety of new loan products. 65 Lenders and consumers were
aided by a number of new developments and regulations.66
a. Technological innovations, such as automated underwriting.
b. Changes and improvements in some government support
programs, such as the Community Reinvestment Act, amended in
1995, especially to make smaller institutions more competitive
with their larger counterparts.
The amendments aided lenders in increasing loan
origination activity to low and moderate income borrowers.
The CRA also allowed the securitization of subprime loans,
which in itself promoted the relaxation of underwriting
5. Near prime (Alt-A) and subprime loan products were introduced which
made it easier for millions of Americans who had been locked out of home
ownership to finally get their "piece of the rock".
a. Loan plans, such as piggybacks, reduced documentation, interest
only, 100% financing and loans which even exceeded the home's
value were rolled out.
6. Qualifying standards were revised, offering a variety of loan products to
borrowers with substandard credit and less qualifying income and cash
savings than typically required. Lenders evidently believed the then
current rapid appreciation in the market justified loosening their lending
C. Credit Scoring and Securitization: Keys to Subprime Success
In order to originate any significant numbers of these new and unique loan
programs, the lending community would have to secure new secondary mortgage
market resources. Two developments gave them the tools they needed and caused
the rapid growth of subprime lending.67
"Revisiting Traditional Paths to Ownership", Mark Olson, Governor, Federal Reserve Bank of Cleveland
(Community Development Policy Summit, Cleveland OH), June 23, 2005
"The Rise and Fall of Subprime Mortgages", Danielle DiMartino, economics writer, and John Duce, V.P.
and senior policy advisor, Federal Reserve Bank of Dallas, November
1. Mortgage lenders adopted credit-scoring to determine borrower eligibility
for non-conforming loans, including the riskier Alt-A and the even riskier
subprime loan products. Lenders, using established credit profile models,
could better determine which borrowers were suitable for appropriate risk-
based loans, and more importantly satisfy the secondary market
purchaser's risk assessment. But credit scoring by itself could not
accomplish the rapid growth of less than prime lending. Additional
sources of funding were necessary to accomplish the task.68
2. Before 1994, most lenders offering subprime loans were those which held
them in their own investment portfolio. They lacked the capital resources
to originate and hold large amounts of risky loans so they had to develop a
way to package them to be acceptable to secondary market investors and
insurance companies who they would submit for rating to make them
attractive as “safe” investments to their global investors.
a. The secondary market investor may either hold a loan it purchases
in its own portfolio, or package it as a residential mortgage backed
security (RMBS) and sell it off in shares. But with the additional
risk of subprime loans, it would be difficult for a secondary market
investor to attract buyers without some extra protection against
b. One innovative technique is a Collateralized Debt Obligation
(CDO), a unique form of RMBS derivative which divides it into
multiple risk grades, referred to as tranches, each grade
representing the level of risk to the investor purchasing that
particular part. A variety of techniques were employed, ranging
from CDOs consisting of only subprime loans to those blended
with prime loans, even auto and student loans of good quality. The
less risky tranches offers lower yields to the investor purchasing
them but greater security and protection from loss. Conversely,
greater yields are paid to buyers of the higher risk tranches. These
levels would incur the first of any losses.69
The lender originating the loan would be liable for early
defaults, and typically only those involving fraud.
The next defaults would be taken out of what is referred to
as the "equity slice". This equity slice is usually sold at a
significant discount to the investment banker's hedge fund
as a cushion against expected defaults since it remains
uninsured. Therefore, even if the borrowers default the fund
DiMartino and Duce
"Investment Landfill: How Professional Investors Dump Their Toxic Waste on You", Paul Tustain,
Bullion Vault, July 2007
still wins as the discount is typically large enough to cover
anticipated losses in the CDO's value.70
After the equity tranche came the next highest risk rated
tranches, typically BB or BBB and offering somewhat
lower yields. Following these came the A to AAA rated
senior levels with the lowest yields. With the safety net of
first liabilities going to the originating lender and then to
the holder of the unrated equity slice, the insurance
companies declared the senior tranches secure and
relatively risk-free allowing them to be rated. Investors
world-wide snatched them up.
AAA+ Tranche receives
lowest yield but absorbs no
loss until all other tranches
AAA+ below are liquidated.
receives next lowest
AAA yield, and absorbs no
Tranche loss until tranches
(Absorbs next losses) below are liquidated.
Junior Mezzanine BBB Tranche earns next
Tranche lowest yield,
(Absorbs next losses. AAA Rated Tranches continue to absorbs loss after
receive earnings) equity is liquidated
Equity Tranche Equity tranche
Unrated receives highest
(Absorbs first losses in income stream. Rated yield, all losses
Tranches above continue to receive earnings) until liquidated
Losses Absorbed Ascending from Bottom to Top
(Chart 4: Example of Collateralized Debt Obligation)
3. Wall Street banks made a fortune packaging them. Hedge funds generated
what appeared to be risk free profits in the equity tranche for several years.
Fund managers kept putting pressure on loan originators to keep them
a. Before 1994, only 32% of subprime mortgages had been packaged
as mortgage backed securities. After 1994, with the help of this
new financial structuring from Wall Street, securitization of
Subprimes reached over 81% by 2005.
b. As a result subprime origination grew from an insignificant share
of the total mortgage market to about 9% of the market in 2001,
then to over 20% by 2006.71
D. Home Sales and Prices Skyrocket.
The real estate buying frenzy was aided by the "dot.com" bust and the short lived
2001 - 2002 recession, which saw investors leaving the stock market for real
1. The new and relaxed underwriting standards added to the accelerating
pace of the market. Mortgage denial rates, reported under the Home
Mortgage Disclosure Act, dropped significantly from 29% in 1997 to only
14% in 2003.73
2. The short lived recession of 2000-2001 only slightly slowed the market’s
growth, with aggressive increases from 2002 through 2005. See Chart 5
3. Interest rates at an all time low, well below 6% for most of
2003 through 2005, helped fuel the rush to buy and prompted further
speculation in housing.74
Number of Homes Sold
Units (000s) 4000
1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007
(Chart 5: U. S. Department of Housing and Urban Development; National Association of REALTORS®)
Inside Mortgage Finance Publications, Inc., The 2007 Mortgage Market Statistical Annual vol. I (IMF
2007 Mortgage Market)
"Federal Financial Institutions Examination Council Press Release", July 26, 2004
"Official Says Bad Data Fueled Rate Cuts, Housing Speculation", Wall Street Journal, March 6, 2006
4. California homes enjoyed seemingly unending appreciation through 2006
before declining in 2007. Not since the end of the 1973-1975 recession
had we seen such rapid rates of appreciation. See Chart 6 below.
California Median Home Prices
(Chart 6: Source, California Association of REALTORS)
5. Chart 7 below, based on the Case-Shiller U.S. Home Price Index study
which shows appreciation, inflation adjusted, from 1890 to present to be
about 66% (only .4% annually) and most of compressed into the last ten
U. S. Home Prices Inflation Adjusted 1890-2008
(Chart 7: Home Price Index, 1890 to 2008)
Key Points to Remember:
1. In 1994 rising home mortgage rates resulted in a significant slowing of loan
origination and real estate sales.
2. Searching for new sources of business, mortgage companies and their Wall Street
partners, using new “financial engineering” discovered an untapped inventory of
new borrowers in the subprime market.
3. Innovative, but risky, new loan products caused an explosion in subprime lending.
4. 1994 is generally credited, therefore, as the year subprime year exploded and was
the primary cause of the brisk pace of sales and rapid run-up in home
5. Many, including the Federal Reserve, at first praised subprime lending as making
home ownership available to millions of Americans who had previously been shut
out of the housing market.
6. Subprime lending accelerated due to a number of innovations, including
automated underwriting, credit scoring and new risk based underwriting in both
loan origination and the packaging and rating of their corresponding mortgage
backed securities as CDOs.
7. Subprime securitization jumped from 32% in 1994 to over 81% by the peak of the
market, 2005, and home ownership followed pace going from 64% in 1994 to
over 69% in 2005. Low prime rates also aided the market’s pace, especially
between 2003 and 2005.
8. Mortgage denial rates dropped during the period from 29% in 1997 to about 14%
in 2003, mostly attributed to subprime origination.
9. Home sales and prices continued to rise sharply, especially from 2001 through
most of 2006 before declining in 2007.
IX. The Mortgage Market Meltdown
A. Subprime + Stated Income = Default
In late 2005 the real estate market started its journey downward. A number of
factors contributed. Economists, the Fed, Fannie Mae and others pointed out that
there was indeed a housing bubble and it could no longer be sustained. One cause
was the Fed’s war on inflation, with sixteen rate hikes taking the fed funds rate
from 1% in June 2003 to 5.25% by June 2006. Mortgage rates followed the
upward climb. Then short term fixed rate loans which converted to adjustable
after two or three years, referred to as “2/28” and “3/27”, originated starting near
the end of 2003 began showing increasing delinquencies. Even before payment
resets took place, many borrowers found difficulty continuing to make the initial
payments which had rates considerably higher than prime rates and even higher
than Alt-A loan rates. (Although the media commonly reported payment resets
were the major cause of default a government study and report would contradict
1. Government research found the primary cause of default was the result of
the lender’s extension of credit on the basis of stated income without
verification. Low-doc loans, the study showed, accounted for over 40% of
all Subprime loans by 2006. The majority of subprime borrowers who
defaulted became delinquent even before payment resets occurred.75
a. The numbers may not be completely accurate since there is no one
system which tracks originations from all sources. For example,
economists for the Federal Reserve Bank of Dallas reported
originations of "low-doc" or "no-doc" loans accounted for 81
percent of Alt-A, 55 percent of jumbo, 50 percent of subprime and
36% of prime securitized loans.76
2. The rapid growth of these loans, with some 5 million originated between
2003 and mid-2007, can be singled out as one of the likely cause of the
crisis in the mortgage market and some say the primary cause.77
3. Adjustable rate subprime loans originated in late 2005 and in 2006
have performed the worst due to "the slippage in underwriting standards,
high loan-to-value ratios, and incomplete documentation", according to
Fed Chairman Ben Bernanke.78
U.S. Gov’t Accountability Office, GAO-08-78R, “Information on Recent Default and Foreclosure Trends
for Home Mortgages and Associated Economic and Market Developments” , 2007;Fannie Mae, “Weekly
Economic Commentary”, Mar. 26, 2007
DiMartino and Duce
"The Importance of Loss Mitigation Strategies for Keeping Families in Their Homes", Michael
Krimminger, Special Advisor for Policy, Office of the Chairman, FDIC, Los Angeles, CA Nov. 30, 2007
a. It is clear the relaxed underwriting standards which allowed for
reduced documentation loans certainly played a major role in the
increasing foreclosure activity.
4. The vast majority of borrowers faced with high reset payments of loans
originated as late as 2004 had sufficient equity as rising home prices
allowed them to at least sell if not refinance and avoid foreclosure.79
5. The effect of home prices finally reaching an unsustainable level took its
toll on homeowners' equity. As more homeowners' payments reset at
levels beyond their ability to pay, the softening of values combined with
increasing interest rates impeded refinancing as a way out.80
6. An additional factor which contributed to the heavy default problem was
most did not require impound accounts for tax and insurance. A recent
study by the Home Ownership Preservation Initiative in Chicago found
that for as many as one in seven low-income borrowers facing difficulty in
managing their mortgage payments, the lack of escrow of tax and
insurance payments was a contributing factor.
7. Rising mortgage rates beginning in the summer of 2005 added to the
market's weakness. Loan quality problems started showing up in growing
numbers, and lenders began tightening underwriting standards.
a. As lenders continued cutting back, returning to traditional risk
assessment guidelines, eliminating subprime loan products and
tightening standards for both Alt-A and prime loans, housing
activity fell, followed by prices in mid-2006.
b. By spring 2007 the market witnessed increased delinquencies and
foreclosures,81 with most of the defaulting loans having been
originated between July 2005 and September 2006.82
c. Delinquency rates for subprime and Alt-A loans underwritten in
2006 greatly exceeded those originated in 2004.
d. By the end of the first quarter 2007, the rate at which subprime
loans entered foreclosure rose at its fastest pace since tracking of
the data began in 1970.83
"Housing, Housing Finance, and Monetary Policy", Ben Bernanke, Chairman Federal Reserve Bank,
Federal Reserve Bank of Kansas City's Economic Symposium, Jackson Hole Wyoming, August 31, 2007
DiMartino and Duce
8. With home prices continuing a slow downward adjustment and inventories
of both new and resale homes rising, increasing numbers of homeowners
were not able to sell their way out of trouble, and "the outlook suggests
foreclosures will increase for some time"84
B. Weakness in Financial Markets Cripples Mortgage Funds
The growing economic crisis was not to be confined to the housing market and
lending industry. Their weaknesses carried over into the financial markets on
Wall Street, causing a thinning in trading of subprime mortgage backed securities.
Downgraded by the rating agencies, market investors raised the yields they
required on risk premiums for nonprime mortgages. One result was a spike in
jumbo interest rates for even prime mortgages.85
1. Jumbo rates jumped an entire one percentage point between June and
August 2007, further impacting the already slowing real estate market.
2. Investors concerns about mortgage credit markets intensified, primarily
over the impending resets of 2/28 and 3/27 adjustable rate loans.
3. Losses began to cripple the financial markets, leading to the virtual
cessation of subprime lending. In June, 2007 two mega hedge funds
collapsed. On July 10, $12 billion of subprime backed securities were
downgraded, followed by another $1 billion on August 7.86
4. With billions of dollars in hedge funds liquidated or wiped out as a result
of the collapse of their equity slices, and the subsequent downgrading of
the rated tranches, fund managers had to sell the underlying residential
mortgage backed securities and CDOs.
5. As market conditions worsened, and more hedge funds suffered, they too
having to liquidate, fund values dropped. CDO buyers were few, and then
6. Since then, essentially no CDO or other subprime mortgage backed
securities have been issued. Investors abandoned not only subprime loans
but even jumbo and "Alt-A" issues have fallen sharply as well since July
2007.87 Subprime loan origination fell to 7.8% of total loans originated in
7. Subprime originators lost their secondary market place and their Wall
Street connection with its global investors’ CDO shares now valueless.
8. Most major lenders cancelled their subprime lending business. According
to a recent speech by Ben Bernanke, Chairman of the Federal Reserve
Bank, "a number of (lenders) that specialized in nontraditional mortgages
have been forced by funding pressures to scale back or close down".88
By October 2007, many nonbank lenders have imposed more rigid
standards or have left the business entirely.
10. 41% of banks tightened prime loan standards and 56% for subprime loans.
C. Pay-Option ARM Resets Possibly Next Wave of Foreclosures
Foreclosure fallout and its economic consequences from impending ARM resets
coming due between years end 2007 and December 2008, an anticipated $330
billion, if borrowers cannot meet the reset payments will be significant.89. The
next wave of potential defaults appearing on the horizon consists of the "pay-
option" ARMs which feature the possibility ("probability", more likely) of
negative amortization. These usually are not subprime loans but rather are prime
and Alt-A, originated for borrowers with good credit at the time. As seen in the
chart below, resets should begin in volume by late 2008 and peak by mid 2010,
following subprime ARM resets diminishing by mid to late 2008. (See Chart 8)
ARMS Forecast to Reset
$ Billion 25
Subprime Pay Option
(Chart 8: First American Loan Performance, ARM Resets Forecast)
1. The inherent risk of the pay-option ARMs is the negative amortization
which occurs when the borrower makes only the minimum monthly
payment based on the extremely low "teaser" or start rate, which can be as
little as one-third the amount of the actual full monthly payment.
2. Most of these loan plans allow the borrower to make this minimum
payment for up to five years or until the negative amortization reaches
115% of the original loan amount at which time the payment will reset.
a. The new payment is based on the actual note rate, likely to be at a
rate 5% to 6% over the start rate, with the accrued negative
principal added to the original principal, and then amortized over
the remaining term of the loan, 25 years in the case of an original
30 year term.
b. Over 75% of pay-option borrowers make only the minimum
3. Compounding the risk is the fact that most of these plans also allow for
reduced or stated-income documentation in which the borrower's income
is not verified. A recent survey revealed the following:91
a. Over 80% of pay-option ARMs are stated-income
b. Over 90% of borrowers exaggerated their income on stated-
income applications by at least 5%.
c. Over 60% of these borrowers exaggerated their income by
50% or more.
4. Borrowers who obtained pay-option ARMs under stated-income
plans, and who chose to exaggerate their income to qualify, will
likely become foreclosure casualties. Certainly if they couldn't
afford the payment based on the note rate to begin with they will
not be able to afford the much higher reset payment unless their
employment income has increased significantly.
5. As home values have declined, in some areas substantially over the past
two or three years, many home owners will find they have insufficient
equity to refinance and may even find selling impossible.
D. Market Forecast
The market's impact on new home sales and the building industry offers bleak
news. Sales cancellations have skyrocketed, new buyer traffic has slowed, and
"Straight Talk on the Mortgage Mess from an Insider", Herb Greenberg, DowJones Market Watch, News
and Commentary, Dec. 6, 2007
"IRS Tax Return Survey", Mortgage Asset Research Institute, Inc.
with the lending community's tightening of credit standards many builders have
offered large discounts and special incentives, resulting in prices plunging 8.6%
in October 2007. Analysts are looking for growing declines in both sales and new
construction, with the recovery extending a few months longer.92
1. California's housing slump and mortgage difficulties have spread to
related industries, primarily construction with employment down over
16% from the previous year.93
2. Job losses have also extended beyond housing, showing up in retail
businesses, especially building material and garden equipment stores.94
Continuing job losses will no doubt further increase delinquency and
foreclosure activity but by an amount which cannot be easily or accurately
Key Points to Remember:
1. The housing bubble, which many thought did not exist, finally burst in late 2005,
due in part to sixteen rate hikes by the Federal Reserve as it tried to fight inflation.
Mortgage rates began to climb, slowing the real estate and lending markets.
3. Defaults in 2 and 3 year fixed subprime loan plans began to appear in 2006 and
2007, especially those whose payments had reset at high adjustable rates. With
home values steadily declining many borrowers could not refinance or sell,
4. Foreclosures triggered severe losses among Wall Street investors who had
purchased MBS bonds. Hedge funds collapsed, losing billions of dollars.
5. Global investors, damaged and with CDO shares worthless, left the mortgage
market resulting in the virtual evaporation of loan liquidity.
6. Pay-option ARMs feared to be the next wave of foreclosures as payment resets
begin in great numbers by mid 2008, expected to peak by mid 2010.
7. Most of these borrowers made only the minimum payment causing negative
amortization, and with declining home values added to the negative amortization
most pay-option borrowers have difficulty refinancing or selling.
"Housing Chartbook: December 2007", Mark Vitner, Senior Economist, Adam York, Economic Analyst,
Wachovia, Economics Group Special Commentary, Dec. 11 2007
X. Fraud in Lending
A. Extent of Fraud Not Completely Known
The extent to which fraud played a role in the collapse of the mortgage market is
not actually known since there is no single tracking source according to the
Federal Bureau of Investigation. The Mortgage Bankers’ Association estimates it
exceeds 10% to 15% of all loans, including prime and Alt-A. The relative fraud-
loss rate of Alt-A loans was more than three times higher than nonprime loans.
B. Fraud for Property vs. Fraud for Profit
The Federal Bureau of Investigation distinguishes between “fraud for property”
and “fraud for profit”. The former usually involves only the borrower whose sole
purpose is to buy and hold the property. Fraud for profit, however, typically
involves a real estate agent, mortgage broker, appraiser or some other industry
professional whose primary goal is income driven. A recent study by the FBI and
the U. S. Treasury revealed the following statistics regarding fraud.95 It was
refreshing to see the low percentage of REALTOR® participants!
1. Fraud for Property.
a. Represented up to 20% of all loan fraud
b. Involved a borrower obtaining a single loan.
c. The loan application had few misrepresentations.
c. The borrower intended to make the loan payments.
e. The borrower participated in 87.06% of cases with the mortgage
broker participating in 58.55% of cases.
2. Fraud for Profit.
a. Represented up to 80% of all loan fraud with at least one industry
professional being involved.
c. The FBI reported during a sting operation conducted between
March and June 2008 the Agency arrested 406 mortgage brokers
d. The borrower participated in 60.66% of cases and the mortgage
broker participated in 62.07% of cases
Federal Bureau of Investigation, Statistics on lending fraud, 2005
C. Fraud by Participant
The Department of U. S. Treasury Financial Crimes Enforcement Network
report of April 2008 identified the following level of participation in fraud as
shown in chart 9 below:96
Fraud Percent by Participant
Income Fraud Documents Occupancy Appraisal Straw Buyers Flipping
Appraiser 6.18 3.23 16.47 92.67 25 100
Borrow er 87.12 83.06 70.2 39.22 69 58.33
Mortgage Broker 64.13 68.15 61.96 48.71 66 68.75
Real Estate Agent 1.18 1 1.57 2.59 4 6.25
Seller 1.58 1.61 7.84 11.21 21 29.17
Investor 6.18 1 20 9.48 11 14.58
Appraiser Borrow er Mortgage Broker Real Estate Agent Seller Investor
(Chart 9: U. S. Dept. of Treasury, Financial Crimes Enforcement Network, April 2008)
D. Fraud by Activity
The Federal Bureau of Investigation has identified the following as the primary
types of loan falsifications in the fraud cases investigated by the agency.
1. Altered bank statements.
2. Altered or fraudulent income documents, such as pay-stubs, W2s and tax
a. Applications with misrepresentations were also five times as likely
to go into default. Many of the frauds were simple rather than
U. S. Dept. of Treasury Financial Crimes Enforcement Network, Mortgage Fraud Report April, 2008.
b. In some cases, borrowers who were asked to state their incomes
just lied, sometimes reporting five times actual income; other
borrowers falsified income documents by using computers.
3. Fraudulent letters of credit or gift.
4. Misrepresentation of employment.
5. Altered credit scores.
6. Invalid social security numbers.
7. Silent seconds.
8. Failure to disclose all debts or assets.
9. Mortgage brokers using identities of past clients to obtain loans for other
borrowers who could not qualify.
10. Fraudulent appraisals, especially in property flipping.
a. Appraisers failed to use comparable properties to establish
b. Appraisers failed to physically visit the property and based the
appraisal solely on comparable properties, i.e., the actual condition of
the property was not factored into the appraisal;
c. Appraisers participated in a fraud scheme such as flipping
d. A licensed appraiser’s name and seal were used by unauthorized
e. Ninety-percent of licensed appraisers, according to the 2007
National Appraisal Survey, indicated they had felt the pressure to
restate appraisals in order to “hit a certain property value”, up from
55% in 2003.97
11. Forged documents.
a. Borrowers forged co-owners’ signatures to loan documents (most
often one spouse forging the other spouse’s signature without prior
knowledge or permission);
October Research Corporation, 2007
b. Loan closing services forged applicants’ signatures on loan
documents (possibly to expedite the loan process); or
c. Builders forged borrowers’ names on loan draw documents.
12. Occupancy was the most common type of fraud activity regarding
intended use, with borrowers wanting to obtain the more attractive owner-
occupied interest rates.98
13. Other fraudulent activity reported by the FBI in its investigations:
a. Loan closing services failed to properly disburse loan proceeds or pay
off underlying property liens, including prior mortgage trusts.
b. Loan settlement officers were also reported for failure to pay
insurance premiums from funds collected at settlement.
c. Borrowers signed multiple mortgages on the same property from
multiple lenders. The mortgage settlements were held within a short
period of time to prevent the lenders from discovering the fraud.
d. Loan closing services failed to record the mortgage.
e. Prior lenders failed to release home equity loans in land record offices
after receiving mortgage pay-off, causing the new lender’s loans to
have a subordinate position. Homeowners continued to use the prior
lines of credit in addition to the new loan to obtain an extension of
credit that exceeded the property value
f. Violations of the Mortgage Broker Practices Act by mortgage brokers
who abused the terms of a power of attorney.
g. Mortgage brokers or correspondent lenders failed to ensure all loan
documentation was properly signed.
h. Real Estate Settlement Procedures Act (RESPA) violations by lenders
accepting kickbacks from mortgage brokers.
i. Non-arm’s-length sales occurred when parties to the real estate
transaction failed to disclose relationships between the buyers and
sellers. Knowledge of a non-arm’s-length sale would alert lenders to
scrutinize loan packages more carefully.
j. Elder exploitation where older individuals were persuaded to sign
loan documents without understanding borrower rights and
responsibilities under applicable federal and state law.
U. S. Department of Treasury, Financial Crimes Enforcement Network, Fraud Report, November 2006,
and April 2008.
k. Unofficial loan assumption occurred when property ownership was
transferred without the knowledge of lenders. This could indicate that
a straw buyer was used to obtain the loan, with the property title being
transferred to the actual owner after the loan disbursement.
l. Theft of debit card or convenience checks associated with home
equity lines of credit.
m. Fraudulent bankruptcy filings to stall or prevent foreclosure.
n. Suspected use of real estate purchases to launder criminal proceeds.
E. Number of Fraud Cases Reported.
The U. S. Treasury report indicated an increasing number of lenders are filing a
“suspicious activity report” (SAR) to the Department before funding loans. Chart
10 below reflects SAR filings since 1996.
1. SAR filings increased 454% since 2003, with 52,868 filed in 2007.
2. In California, SAR filings increased 71.3% between 2006 and 2008,
second only to Illinois which had a 75.8% increase.
Mortgage Fraud Reports Filed
1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007
(Chart 10: U. S. Treasury Department, Financial Crimes Enforcement Network)
3. The Treasury presently has 1,409 cases pending investigation.
4. The IRS independently has 223 cases pending, having prosecuted 881
5. The IRS average incarceration rate is 87.7%, with an average incarceration
time to serve of 43 months.
6. Mortgage brokers initiated the loans on 58% of the fraud filings.
F. The Role of Mortgage Brokers and Real Estate Professionals in Fraud
Not only does fraud for profit include at least one industry professional as
explained earlier, but according to the FBI’s research, mortgage fraud in a
depressed housing market often involves perpetrators who take advantage of
lending industry personnel attempting to generate loans to maintain current
standards of living. Those who succumb to the schemes sacrifice not only their
integrity, ethics and honesty, but if caught suffer the obvious consequences, loss
of licenses, possible imprisonment and fines, and the devastating effects on their
1. Paul Leonard, California Office Director for the Center for Responsible
Lending, in testifying before the California Senate Banking Committee,
March 26, 2007, stated “Brokers often determine whether subprime
borrowers receive a fair and helpful loan, or whether they end up with a
product that is unsuitable and unaffordable. Unfortunately, given the way
the current market operates, widespread abuses by mortgage brokers are
a. Leonard also said, “While brokers in California have a common-
law fiduciary duty to borrowers, the subprime mortgage market, as
it is structured today, gives brokers strong financial incentives to
sell excessively expensive loans to borrowers.”
2. Federal Reserve Board Chairman Bernanke recently noted that placing
significant pricing discretion of mortgage loans in the hands of financially-
motivated mortgage brokers can be a prescription for trouble, as it can
lead to behavior that violates fair lending laws.99
3. Broker-originated loans, according to Harvard University’s Joint Center
for Housing, are also more likely to default than loans originated through a
direct lender’s retail store. Mortgage brokers, they said, “who are
responsible for originating over 70 percent of loans in the subprime
market, have strong incentives to make abusive loans that harm
consumers, and no one is stopping them.”100
Remarks by Federal Reserve Chairman, Ben Bernanke, Opportunity Finance Network Conference,
Washington D.C., November 1, 2006
Joint Center for Housing Studies, “Credit, Capital and Communities: The Implications of the Changing
Mortgage Industry for Community Based Organizations”, Harvard University.
a. The report concluded, “In recent years, brokers have flooded the
subprime market with unaffordable mortgages, and they have
priced these mortgages at their own discretion. Given the way
brokers operate today, the odds of successful homeownership are
stacked against families who get loans in the subprime market.”
4. With reports and articles expressing the foregoing, possibly without
supporting evidence, honest, reputable and ethical lenders, mortgage
brokers and REALTORs® are faced with growing mistrust by the public
and even regulatory agencies.
a. In his testimony before the California Senate Banking Committee,
Leonard cited that “California’s mortgage laws do not establish
even the most basic protections for underwriting and the
Department of Corporations has never examined the underwriting
criteria used by state-regulated mortgage originators.” Moreover,
he said, “the Department’s 25 mortgage licensee examiners could
not possibly be adequate to monitor the activities of some 4,800
licensees originating $150 billion in mortgages each year. Nor is
an examination schedule of once every four years likely to be
sufficient to evaluate the activities of an industry with a remarkable
capacity for product innovation.”
b. While it appears Leonard was referring to Department of
Corporation licensed mortgage brokers and not DRE
licensed, it is unfortunate he did not make that clear in his
report. He failed to report on the rigid and thorough
regulatory control by the California Department of Real
Estate and the Commissioner over licensed real estate
professionals, including examination, licensing and
continuing education standards to which real estate
licensees are subject.
5. Real estate professionals, REALTORs®, appraisers and mortgage brokers,
however, have indeed participated in instances of misrepresentation and
fraud, both with and independent of the borrower. It is true, unfortunately,
that not all real estate agents are concerned about fulfilling their fiduciary
responsibilities to their principals nor have they all adhered to what should
be their “principles”.
6. According to a June 2008 IRS Criminal Investigation Report, Federal
investigators have identified an increase in frauds and schemes in the real
estate business. These schemes victimize individuals and businesses,
including low-income families lured into home loans they cannot afford,
legitimate lenders saddled with over-inflated mortgages and honest real
estate investors fleeced out of their investment dollars.
7. As an example of the current fraud cases being prosecuted by the Dept. of
Justice, a joint investigation conducted by the Los Angeles FBI Office and
HUD-OIG illustrated an extensive scheme in which fraudulent
identification and employment documents were used to perpetrate
mortgage frauds. The scheme was largely assisted by an individual who
regularly manufactured false identity and income documents for a profit.
a. This document forger created W-2s, pay stubs, credit letters and
social security printouts over an eight-year period.
b. These documents were used by real estate professionals who
knowingly submitted the falsified information to lending
institutions. The loans were then insured by HUD and caused a
loss to that agency of more than $18 million.
c. A search warrant executed during the investigation revealed more
than 100 real estate professionals had ordered false documents in
d. To date, the document forger and six associates have been
convicted in the scheme, as well as 14 real estate professionals
G. Victims of Mortgage Fraud
According to the FBI, victims of mortgage fraud may include borrowers,
mortgage industry entities, and those living in the neighborhoods affected by
mortgage fraud. Lenders are plagued with high foreclosure costs, broker
commissions, reappraisals, attorney fees, rehabilitation costs, and other related
expenses when a mortgage fraud is committed. As properties affected by
mortgage fraud are sold at artificially inflated prices, properties in surrounding
neighborhoods also become artificially inflated. When property values increase,
property taxes increase as well. Legitimate homeowners also find it difficult to
sell their homes as surrounding properties affected by fraud deteriorate.
H. Emerging Schemes: Foreclosure Assistance Fraud
Foreclosure rescue scams continued to be problematic. Escalating foreclosures
provide criminals with the opportunity to exploit and defraud vulnerable
homeowners seeking financial guidance. The perpetrators convince homeowners
that they can save their homes from foreclosure through deed transfers and the
payment of up-front fees. This “foreclosure rescue” often involves a manipulated
deed process that results in the preparation of forged deeds. In extreme instances,
perpetrators may sell the home or secure a second loan without the homeowners’
knowledge, stripping the property’s equity for personal enrichment.
1. The “Foreclosure Consultant Law”, California Civil Code Section 2945-
2945.11, governs the practices of foreclosure consultants who work with
home owners in or nearing default. Licensees should familiarize
themselves with its provisions and gain a thorough understanding of what
they may and may not do in assisting the homeowner.
2. The “foreclosure consultant” may assist the homeowner by performing the
following services, for compensation:
a. Stop or postpone the foreclosure sale.
b. Obtain any forbearance from the beneficiary.
c. Assist the homeowner in reinstating the loan.
d. Obtain an extension for reinstatement.
e. Obtain a waiver of the acceleration clause.
f. Assist the homeowner in obtaining financing.
g. Assist the homeowner to avoid impairment of their credit resulting
from the notice of default.
h. Save the homeowner from foreclosure.
3. Among laws proposed to help homeowners is legislation introduced in the
California Senate, SB1054, passed and sent on to the Assembly where it
failed first committee vote but was approved for reconsideration. No
action has been taken since June. It is intended to protect homeowners in
default from foreclosure assistance fraud.
a. The law, if passed, would remove the incentive of any real estate
agent to derail a proposed or requested short sale in hopes of
getting the listing by prohibiting any licensee who gives an opinion
of value (broker price opinion) to the homeowner’s existing lender
from acting as a listing agent on that property for twelve months.
Key Points to Remember:
1. Although the extent of mortgage fraud is unknown, the Mortgage Bankers’
Association places it at 10% to 15% of all loans.
2. FBI identifies fraud in two categories: Fraud for Property and Fraud for Profit.
3. Fraud for Property accounts for 20% of all fraud, with the borrower actively
participating in 87% of cases investigated while a mortgage broker participated in
58.55% of cases.
5. Fraud for Profit, with 80% of all fraud, involved the borrower in 60% of all cases
and the mortgage broker in 69% of cases.
6. Real estate agents (not identified as being REALTORs® or not) participated in as
few as 1% of cases (involving assisting with fraudulent documents) up to 6.25%
of cases (involving flipping transactions).
7. Most common fraudulent activities included altered bank statements, income
documents or falsifications, gifts, employment and forgeries.
8. 99% of licensed appraisers in a 2007 survey indicated they were pressured by
industry professionals to “hit a certain” value, up from 55% in 2003.
9. Greatest percentage of fraud cases involved “occupancy” in which the borrowers
declared they would occupy the property.
10. Lenders, during the underwriting and approval process, report to the U.S.
Treasury what is referred to as “suspicious activity” of a loan applicant who is
suspected of fraud. These “SAR” report filings have increased in California by
71.3% between 2006 and 2008.
11. Foreclosure assistance fraud is one of several emerging scams REALTORs® need
to aware of, and to warn any home owner who is in default and who has been
discussing options with the REALTOR® to beware of anyone who proposes any
rescue plan that sounds “too good to be true”, and usually involve transfer of title.
XI. Tough New Laws for Predatory Lending Practices
A. Praise by the Fed for Subprime Lending: Hindsight is Always 20-20.
A few years ago the Federal Reserve Bank of Dallas claimed, “(subprime)
practices opened the housing market to millions of Americans” and “the
expansion of nonprime mortgages clearly played a role in the surge of home
ownership.” In 2004, Federal Reserve Bank Governor Edward Gramlich
commented, “the increased availability of subprime mortgage credit has created
new opportunities of homeownership and has allowed previously credit-
constrained homeowners to borrow against the equity in their homes to meet a
variety of needs”. He did, however, caution increased subprime lending has been
associated with higher levels of delinquency, foreclosure and “in some cases,
abusive lending practices”.101
1. Despite the caveats of default and the predatory practices of some lenders,
Gramlich indicated that because of subprime lending, “credit and
ownership markets are democratizing. Millions of lower-income and
minority households have a chance to own homes”. While rates of serious
delinquencies raise red flags and call for efforts on the part of industry and
government to prevent foreclosures, he pointed out that the vast majority
of these new homeowners do not seem to be having problems.
a. As of May, 2008 Subprime loans which were delinquent 90 days
or more represented only 18% of all Subprime loans, and 27% of
Subprime ARMS. While the number is significant, Gramlich was
correct in stating the “majority” had no problems.
B. Subprime Defaults Reveal Extent of Predatory Lending
Such practices, however, “may have been at the expense of later sales, further
dampening the market going forward” due to high foreclosures and the
devaluation of the real estate market,102 according to Dallas Federal Reserve
economists DiMartino and Duca. Foreclosures do not affect just the homeowner
who loses the family home, as Fed. Governor Mark Olson warned, commenting
“multiple foreclosures in one neighborhood will bring down the property value
for all homeowners in the neighborhood”.103 Furthermore, Governor Gramlich
said that pushing home ownership to the extent that the benefit is offset by
foreclosures does no good. He called for the development of systems capable of
identifying lenders and brokers whose practices facilitate foreclosures.
DiMartino and Duca
“Remarks by Governor Mark W. Olson”, Community Development Policy Summit, Federal Reserve
Bank of Cleveland, Cleveland OH, June 23, 2005
1. In a speech in April 2005, former Fed Chairman Alan Greenspan praised
the rise of the subprime mortgage industry and encouraged the use of
adjustable rate loans,104 which turned out to account for most subprime
foreclosures, but later indicated he had missed the mark, saying “I really
didn’t get it until very late in 2005 and 2006”.105
2. Borrowers who were sold a loan plan which carried an inherently
unaffordable payment at time of reset probably are the victims of
predatory lending. Karl Case, an economics professor at Wellesley
College and co-author of the Case-Shiller Home Price Index, says “we had
an aggressive home-mortgage industry trying to get people into homes
they couldn’t afford at a time when home prices were very high. It turned
out to be a house of cards”,106
3. Subprime loans were originally intended for borrowers with lower income
and spotty credit. Fed. Governor Olson commented “(although) data show
record high homeownership rates among low-income and minority
borrowers, reports of lending abuses and increased foreclosure rates
loom as dark clouds”.107
4. Research shows the subprime market wasn’t restricted to just lower
income borrowers. As home prices accelerated, more affluent home
buyers sought high-rate loans to buy homes costing more than they could
afford under conventional lending guidelines.
a. High rate loans are defined as those carrying interest rates 1.5 and
3.5 percentage points higher than market rates for 1st and 2nd loans
respectively under new Fed TILA amendments.
C. Responsible Subprime Lending Recommended by Fed Governor Olson
Predatory lending is a serious problem according to Fed. Governor Olson. But it
must be dealt with in a way, according to him, that allows “responsible” subprime
lenders to offer loan programs to worthy borrowers having imperfect credit,
giving them the opportunity to become homeowners.108 He cautioned that
returning to the days when some borrowers have very limited credit is not an ideal
solution to the problem.
1. The goal is to encourage, not limit, mortgage lending by responsible
(non-predatory) lenders in low and moderate income markets.
“Remarks by Chairman Alan Greenspan, Fed Reserve 4th Annual Community Affairs Research
Conference”, Washington D.C., April 4, 2005
“Greenspan says didn’t see subprime storm brewing”, Reuters, September 13, 2007
“The Unites States of Subprime Loans”, Rick Brooks, The Wall Street Journal, October 12, 2007
2. Instead of eliminating subprime lending from the marketplace, Olson is
among those whose position is to offer objective, reasonable guidelines for
the lender to follow which allows borrowers meeting risk-based qualifying
standards to become homeowners in a way which protects them from
D. Federal Agencies Implement Tough New Standards
In mid 2007, the federal government took its first steps to regulate subprime
lending practices, especially involving adjustable rate mortgages, and on June 29,
2007, the federal banking agencies issued supervisory guidance to address the
underwriting and marketing of subprime adjustable mortgages. They focused on
two primary consumer protection principles:109
1. A loan should be approved on the borrower’s ability to repay based on the
complete terms of the loan, which includes qualifying at the reset note rate
and not simply the fictitious low initial or teaser rate.
2. A borrower must be provided with the information necessary to
understand all the terms of the transaction, including the risks inherent in
it, and in a manner which gives them time to decide if the loan is actually
appropriate for them.
3. The FDIC and federal and state banking agencies believe clear and
common sense standards of underwriting and marketing of subprime
adjustable rate mortgages are necessary to protect the consumer, reinforce
mortgage market discipline and preserve a flow of capital to fund
4. Non-traditional loan products can be appropriate for the borrower who is
both a low credit risk and financially savvy, according to the FDIC. What
is not appropriate is to target those borrowers who do not fully understand
the “embedded” risks of the subprime product being offered and who are
not presented with potential risks associated with them in clearly written
language. The challenges to today’s complex mortgage market, says the
FDIC, call for an approach that encourages sound underwriting without
inhibiting innovation, which regulators recognize has created
opportunities for millions of homeowners”.111
“FDIC Outlook: Breaking Ground in U.S. Mortgage Lending”, Cynthia Angell and Clare Rowley, FDIC
Economists, Summer 2006
E. Federal Reserve Board Amends and Tightens Reg. Z
In December 2007, the Federal Reserve Board proposed amendments to
Regulation Z, Truth in Lending, under the Home Ownership and Equity
Protection Act (HOEPA), which were finalized and approved July 2008. Not
restricted to only adjustable rate mortgages) these amendments address and
strengthen consumer protection in certain mortgages, identifying prohibited
abusive practices and become effective October 1, 2009:112 The Board’s
amendments include the formal inclusion of a new category of “higher-priced
mortgages”, those mortgages whose annual percentage rate (APR) exceeds the
“average prime offer rate” (average market rate) by at least 1.5% for 1st loans and
3.5% for subordinate loans.
F. “Higher Priced Mortgage” Amendments for Reg. Z
The amendments for these higher-priced, which include not only Subprime loans
but some of the Alt-A mortgages as well, include:
1. Prohibit a lender from engaging in a pattern or practice of lending without
considering borrowers’ ability to repay the loan from sources other than
the home’s value.
2. Prohibit a lender from making a loan by relying on income or assets that it
does not verify.
3. Prohibits prepayment penalties on loans having payments which adjust
within the first four years. On all other loans a prepay penalty may not last
longer than two years.
4. Require the lender to establish an escrow account for the payment of
property taxes and homeowners insurance for the first year of the loan, at
which time the borrower could opt out of the escrow account. (This
provision becomes phased in April 1, 2010).
G. Amendments for All Mortgages Under Reg. Z
Amendments for all mortgages, including higher-priced, include:
1. Prohibit certain lending practices, such as failing to credit a payment to a
consumer’s account when the servicer receives it, failing to provide a
payoff statement within a reasonable period of time, and “pyramiding”
late fees (the practice of charging late fees to a borrower who has not paid
a prior late fee).
“Proposed Amendments to Reg. Z (Truth in Lending)”, Board of Governors of the Federal Reserve
System, Division of Consumer and Community Affairs, December 12, 2007
2. Prohibit a creditor or broker from coercing or encouraging an appraiser to
misrepresent the value of a home.
3. Prohibit specifically seven misleading or deceptive advertising practices
for closed end loans, including:
a. Advertising “fixed” rates or payments without adequately
disclosing that the rate or payment amounts are fixed only for a
limited period of time rather than for the full term of the loan.
b. Comparing an actual or hypothetical consumer’s current rate or
payment obligations and the rates or payments that would apply if
the consumer obtains the advertised product, unless the
advertisement states the (actual) rates or payments that will apply
over the full term of the loan.
c. Advertisements that characterize the products offered as
“government loan programs”, “government supported loans”, or
otherwise endorsed or sponsored by a federal or state government
entity, unless the loans are government supported or sponsored
loans such as FHA or VA loans.
d. Advertisements that prominently display the name of the
consumer’s current mortgage lender, unless the advertisement also
discloses the fact that the advertisement is from a mortgage lender
that is not affiliated with the consumer’s current lender.
e. Advertising claims of debt elimination if the product advertised
would merely replace one debt obligation with another.
f. Advertisements that falsely create the impression that the mortgage
broker or lender has a fiduciary relationship with the consumer.
g. Foreign-language advertisements in which certain information,
such as a low introductory “teaser” rate is provided in a foreign
language, while required disclosures are provided only in English.
5. Require truth-in-lending disclosures to borrowers early enough for them to
use while shopping for a mortgage. Lenders could not change fees until
after the consumer receives the disclosure, except for a fee to obtain a
6. These changes apply only to advertisements for closed-end loans and not
for home equity lines of credit (the Board indicated they didn’t observe
predatory practices in the origination of open-end home equity lines of
7. The new regulations also extend early disclosure of good faith estimate
disclosures to both purchase money and non-purchase money (refinance)
closed-end transactions (current regulations provide only for the disclosure
on purchase money loans).
8. Effective January 1, 2010 a new “consumer friendly” Good Faith Estimate
of Settlement Costs” and revised HUD-1 will be required of all lenders. It
uses plain language including simple “yes” or “no” answers to questions
such as “Does your loan have a prepayment penalty?”, “Can your interest
rate rise?”, as well as simple statements as “Your interest rate is”.
9. The Federal Reserve Bank has said, “the goal of these changes and of the
Federal Reserve Bank is to ensure they are likely to protect consumers
from unfair practices “without shutting off access to responsible
credit”.113Fed Chairman Ben Bernanke said the Board responded to
deceptive lending problems with rules that were carefully crafted with an
eye toward deterring improper lending and advertising practices without
unduly restricting mortgage credit availability.114
H. Income Verification Guidelines Left to the Industry to Define
The Fed, in response to its request for input, comments and recommendations
from industry participants, especially regarding stated income issues, published
the following in its announcement of the new Reg. Z. amendments.
1. Salaried Employees: The Fed specified that for most consumers who are
salaried employees, incomes can easily be documented by W2s and pay stubs
since most consumers can, or should be able to, produce one of these kinds of
documents with little difficulty. For other consumers, the Fed’s rule is quite
flexible. It permits a creditor to rely on any third-party document that provides
reasonably reliable evidence of the income or assets relied on to determine
repayment ability. Examples include check-cashing or remittance receipts or a
written statement from the consumer’s employer.
a. The rule is also flexible as to consumers who depend heavily on bonuses and
commissions. If an employed applicant stated that he was likely to receive an
annual bonus of a certain amount from the employer, the creditor could verify
the statement with third-party documents showing a consumer’s past annual
bonuses. The same would be true with commissions.
2. Self-employed borrowers: The Board’s rule about self-employed borrowers
income verification allows considerable flexibility. The rule allows creditors to
adapt their underwriting processes to the needs of self-employed borrowers. For
Press Release, Federal Reserve System, December 18, 2007
“Statement by Chairman Ben S. Bernanke”, Federal Reserve Bank, Federal Reserve System Press
Release, December 18, 2007
example the rule does not dictate how many years of tax returns a creditor must
review to determine a self-employed applicant’s repayment ability. Nor does the
rule dictate which income figure on the tax returns the creditor must use. The tax
code may permit deductions from gross income, such as depreciation, that a
creditor reasonably would regard as not relevant to repayment ability.
I. Secure and Fair Enforcement (S.A.F.E.) for Mortgage Licensing Act of 2008
The Housing and Economic Recovery Act of 2008 establishes rigid education,
examination and licensing requirements for loan originators. It is designed to
provide consumers with a higher degree of protection from a loan originator’s
negligence, misrepresentation or fraud. It implements the following:
1. Loan originators, which include mortgage brokers and real estate agents,
and anyone who assists a loan applicant or prospective borrower in
obtaining financing, must register with the Nationwide Mortgage
Licensing System and Registry and be licensed by the state in which they
live and work. Persons who perform only administrative tasks are exempt
from the licensing and registry requirements unless they are independent
2. Loan originators must submit to background and credit checks and be
3. Prior to successfully passing a federally prepared examination with a score
of 75% or higher originators must complete a total of 20 hours course
instruction including the following;
a. 3 hours of federal law and regulations.
b. 3 hours of ethics, including instruction on fraud, consumer
protection and fair lending.
c. 2 hours of instruction related to lending standards for non-
traditional mortgage products.
4. Each year the loan originator’s license must be renewed, requiring
completion of 8 hours of continuing education as follows:
a. 3 hours of federal law and regulations.
b. 2 hours of ethics, including instruction on fraud, consumer
protection and fair lending.
c. 2 hours of instruction related to lending standards for non-
traditional mortgage products.
Key Points to Remember:
1. Effective Oct. 1 2009 new regulations become effective under Reg. Z, Truth in
Lending, which establish a new category of loan: higher priced, which for 1st
loans would be any rate which exceeds market rate by 1.5% or more, and for 2nd
loans a rate which exceeds market by 3.5% or more.
2. Under the new higher-priced loan guidelines, a borrower must have income
documented and verified, and it must be considered in the approval process.
Relying on the home’s equity to offer repayment ability is not allowed.
3. Prepay penalties are prohibited on loans having payments which adjust within the
first four years. For all other loans prepay penalties may not last longer than two
3. Additionally the borrower must agree to have property taxes and hazard insurance
impounded with monthly payments for the first twelve months (effective April 1,
4. Other new laws apply to all loans, not just subprime, and include the prohibition
of not clearly advertising loan terms, such as rate advertised as “fixed” is actually
fixed for a few years after which it becomes adjustable.
5. Also, the new regulations prohibit solicitation to a borrower which implies it is
from the existing lender when in fact it is not, and advertising “debt elimination”
if the debt is merely to be replaced by another obligation.
6. The Housing and Economic Recovery Act of 2008 established a rigid
examination, licensing and continuing education program for loan originators,
including mortgage brokers and real estate agents.
XII. Help for Home Owners in Default
A. FHA Secure
Borrowers who currently find themselves in default may have help available
through one of two programs. The first, administered by HUD, is FHA Secure.
1. FHA Secure, designed for borrowers with satisfactory credit histories who
have not been delinquent on mortgage payments before an adjustable rate
loan interest rate hike at reset caused them to default, offers a possible
solution to avoid foreclosure. Eligibility requirements include:115
a. The loan being refinanced must be a non-FHA ARM and the
interest rate has reset or will by the end of 2009.
Reset must have occurred between 2005 and 2009.
b. The home owner must now be delinquent in making payments
after reset, with the following exception.
If the homeowner's payment has not yet reset, they must
demonstrate they will not be able to make the new payment
after it does.
c. Prior to reset, the homeowner's payment history must reflect on-
time payments during the six months before reset.
d. The homeowner must have 3.5% equity in the home.
e. The homeowner must be able to document adequate income to
make the new monthly payment.
2. If the homeowner has adequate equity in the home, FHA will allow the
delinquent payments to be added to the new loan.
3. If the loan being refinanced exceeds the FHA maximum loan amount for
the region, the borrower is allowed to obtain a second loan from the
refinancing lender providing the lender's guidelines allow, of course
providing the borrower can afford both payments.
B. HOPE for Homeowners
In 1933, as discussed in Chapter III, to help homeowners in foreclosure the
administration of Franklin Delano Roosevelt established a government program to
Department of Housing and Urban Development
refinance loans of homeowners in default. It was in operation for three years,
from 1933 to 1936. The plan is reborn with “HOPE for Homeowners”, an FHA
refinance program established by the Housing and Economic Recovery Act of
2008, signed into law by President George W. Bush July 30, 2008. It offers the
hope of assistance for homeowners who are presently in default or may default in
the near future (they must document that their current financial situation is such
that they soon will no longer be able to afford the current monthly mortgage
payment). It is anticipated that up to four hundred thousand homeowners not
eligible for FHA Secure will benefit from HOPE for Homeowners. However, the
program is voluntary on the part of homeowners’ existing lenders who will be
asked to write down a portion of the unpaid loan balance and pay some costs
involved. Its success will depend entirely on their cooperation. FHA has $300
billion available for the program. HOPE for Homeowners will operate from
October 1, 2008 until September 30, 2011, three years just like its predecessor,
the HOLC. The guidelines are as follows.
1. Eligible loans are those originated on or before to January 1, 2008.
2. The homeowner’s current home payment debt ratio must be 31% or higher
to qualify for the maximum loan-to-value of 96.5% for the new loan.
3. The homeowner may not deliberately default on their current loan merely
to obtain lower housing payments or better financing.
4. With the assistance of the existing 1st lender, the homeowner must
eliminate any existing second loan, such as a home equity line of credit.
The 2nd lender, however, will receive a portion of the government’s shared
appreciation as described below.
5. The homeowner may not obtain another second loan or home equity line
of credit for five years following the origination of the new FHA loan,
unless it is for the upkeep of the home. The maximum combined loans to
value may not exceed 96.5% providing the borrower’s housing debt ration
does not exceed 31%, otherwise the combined loans may not exceed 90%
and allowing for a housing ratio up to 38% and 50% for total debts.
6. The new maximum FHA loan under the program is 96.5% LTV.
7. The maximum loan for the program is $550,440.
8. The homeowner’s existing lender must write down their loan to 90% of
the value of the home as determined by the new FHA loan appraisal.
9. They must also write off all penalties, fees and legal costs. Furthermore,
they must accept the proceeds at closing as being “paid in full”.
10. The Act doesn’t clearly specify if that means they are restricted from
reporting to a credit repository that it was “settled for less”.
11. The borrower must pay a 3 percent upfront mortgage insurance fee.
12. The homeowner must pay a 1.5 percent annual mortgage insurance fee.
13. The refinancing lender may pay all borrower’s costs through premium
14. After obtaining the new FHA loan if the home is sold or refinanced the
homeowner must pay an “exit fee” of 3% of the remaining mortgage
principal to the FHA.
15. FHA will also receive a portion of the homeowner’s profit at time of resell
or refinancing as follows, and will share a portion of the proceeds with a
former 2nd lien holder to the extent of the borrower’s unpaid balance
which was extinguished upon refinancing.
a. 100% of profits if homeowner sells or refinances in one year or
b. The amount payable to FHA will be reduced by 10% for each
additional year which passes before selling or refinancing.
For example, 90% of profit will be paid to FHA if sold or
refinanced during year two, 80% if sold or refinanced
during year three, etc, until the fifth year at which time
FHA will receive 50% of the profits if sold or refinanced at
any time thereafter.
C. Hope Now
An alliance of home lenders plus The U. S. Department of the Treasury and HUD,
Hope Now offers the hope of assistance to an approximate 80,000 home owners
to save them from foreclosure.116
1. This voluntary program, targets home owners with subprime loans with
rates which will reset between January 2008 and July 2010. Qualified
borrowers will have their interest rates frozen at the original rate for five
years. Basic eligibility requirements include:
a. The borrower must be current on their present mortgage payment.
b. They must not have been more than 60 days late in the past year.
Hope Now, Press Release, Washington D.C., December 6, 2007
c. They must demonstrate they will not be able to afford the new
mortgage payment after it resets.
d. The borrower's FICO score cannot be higher than 660, and cannot
have improved more than 10% since applying for the original loan.
e. The borrower must have less than 3% equity in the home.
f. The borrower must be occupying the home.
g. The reset monthly payment must increase by more than 10%.
h. The original loan must have been originated between January 1,
2005 and July 31, 2007.
D. Help for Others
Borrowers who fail to meet the requirements for either FHA Secure, HOPE for
Homeowners or Hope Now plans may still have relief available. Most alliance
members have indicated they are prepared to work with home owners in or
1. Homeowners in need of assistance may call 1-800-995-HOPE.
2. Options which may be offered to the homeowner include:
a. Modifying the loan payment or amount.
c. Accepting a "short pay".
Key Points to Remember:
1. FHA Secure: FHA refinancing help for borrowers having subprime adjustable rate
loans in default. Default must be due to payment reset and borrower must have
been current for six months before reset. Maximum loan-to-value is 96.5%.
2. Hope for Homeowners: FHA refinancing help for borrowers in default on any
loan. Allows up to 96.5% loan-to-value new loan providing the existing lender
accepts proceeds as payment-in-full. Second lien holder must release their debt.
a. Borrower’s housing debt ratio may not exceed 31%.
b. Borrower must pay upfront MI of 3% and annual MI of 1.5%.
c. Refinancing lender may pay all borrowers’ costs through premium pricing.
d. Hope for Homeowners will operate program for three years.
3. Hope Now: Voluntary organization of conventional lenders offering help for
borrowers in default through modification or refinancing.
A. It Was a Market Destined to Collapse
The run-up in value of Americans’ homes beginning in the late ‘90s was possible
due to the explosion of sub-prime lending, easy credit allowing millions of
Americans who did not meet the more rigid standards of conventional loan
programs to become home owners. Home owners tapped into increasingly high
equities available due to the runaway rates of appreciation to finance more real
estate, autos, SUVs, recreational vehicles, vacations and all sorts of big ticket
consumer goods. In 2006 alone, over 58% of all loans originated, including prime
and Alt A, were refinances.
1. Lenders and Wall Street investors relaxed lending and risk assessment
guidelines. Using creative financing engineered to make subprime loans
and securities which they backed less risky then they appeared, they
generated income streams and profits which both drove and were driven
by the rapidly rising home sales and prices. They all appeared to have no
ceiling in sight, just like the 1929 stock market.
2. And like the 1929 stock market it was a house of cards, with home sales
and values destined to reach an unsustainable level, practically
guaranteeing widespread foreclosures.
3. The collapse of home values has affected not only subprime borrowers but
creditworthy borrowers who had refinanced into mostly Alt-A loan
products and even standard prime loans.
4. Escalating food and fuel prices, until recently, along with increasing
joblessness have taken their toll on the American consumer. Growing
numbers of borrowers who refinanced into high mortgages with high
payments and now with evaporating home equities have become victims
of default and foreclosure.
B. Innovative Change
Changes to lending industry regulations by the federal agencies as well as those
voluntarily implemented by the industry along with new programs offer hope.
1. With guidelines which require borrowers to document adequate income
and reasonable liquid reserves, home owners acquiring loans under the
new standards should have less risk of default than in the past.
2. The emerging “covered bond” market and the additional regulatory
oversight of and liquidity protection for Fannie Mae and Freddie Mac as a
result of the government taking interim direct control as conservator could
help return absent secondary market investors necessary to steadily
advance home sales and prices.
C. Strengthened Regulation of Mortgage and Real Estate Industry
Mortgage brokers, real estate agents, appraisers, escrow companies and other
industry professionals are more closely regulated and controlled by new laws
which have been implemented recently. Those in the business who have always
conducted themselves in accordance with the National Association of
REALTORS® Code of Ethics surely welcome any regulation which helps cleanse
its ranks of those who would conduct their business practices contrary to NAR’s
and CAR’s policies and the law.
D. The Recovery
The continuing liquidity problems in the markets, the collapse and bankruptcy of
yet more financial institutions, the uncertainty of the future for Fannie Mae and
Freddie Mac, the threat of inflation and growing unemployment offer little
optimism for a robust housing market anytime soon. As lenders continue to
reduce the loan products available to prospective borrowers, tighten lending
standards and themselves become victims of the market, the tools available to
those who make their living in the housing and finance industries to serve
America’s home buyers and sellers in achieving their goals and dreams become
But tough times and challenging markets don’t last forever. Things always get
better, eventually. This market is no exception. I was recently trying to return
home from San Francisco but the weather just wouldn't cooperate, with my flight
continuing to be delayed later and later. After finally being able to take off, a few
minutes into the flight we hit heavy turbulence. This was real heavy turbulence.
I'm used to flying, having accumulated many hours over the years, including a lot
of bumpy ones, so I usually don’t get real nervous about bumps in the air. But this
was real heavy, don't try to take a drink, and try to act nonchalant, turbulence. We
got through it, just as I knew we would (well, hoped we would I guess).
The same is true of real estate down cycles. It may seem as if a recovery will
never take off, and things may get bumpy along the way with some real heavy
turbulence, but we get through them. This one is no exception.
George W. Lawrence