FEI (NYC Chapter) Professional Development session November 18, 2008 By Eileen Xethalis
When Al Clapp, a leader for professional development seminars for Financial Executives International’s New York Chapter, first asked me to speak at a forum on ethics and to spike the speech with my view from the trenches as the former CFO of a Mortgage Bank & brokerage firm, I thought we have traveled so far from ethical behavior that the best course of action was to revisit the definition of Ethics.
The American Heritage dictionary defines Ethics as a set of principles of right conduct. For our lawyers in the room the very definition is fodder for discussion! I also discovered a cynical quote from Mason Cooley, a U.S. Aphorist, “In ethics, prudence is not an important virtue, but in the world it is almost everything”
And we don’t want to go down the path of defining a prudent man, that’s a 108 page legal definition! Let’s suffice it to say that Ethics is the balancing act that tempers greed in the prudent man. And, when that doesn’t work we have regulation.
During the inflation of the mortgage bubble, we had neither Ethics nor regulation. The codification of regulations was well known within the industry, but the recognition of why the regulations were necessary started to slip away. Soon we found that the due diligence normally done on appraisers by a staid banking system slipped away. Many real estate appraisers maintained their standard of conduct but, where there is opportunity to make extra money, the dishonest prevail. The loan processing departments of the past would not accept appraisal from appraisers with shoddy reputations. As the market heated up, many firms including Country wide, Indy MAC and to a lesser extent, WAMU did not reject questionable appraisals or appraisers. Hugh loan volume also contributed to lesser scrutiny. You may recall Indy MAC lost 80 million dollars on a group of loans that had a two tier fraud; inflated appraisals and owners (straw buyers) that were duped into signing mortgage documents for homes outside their state.
Add to this process the misuse of products, such as Stated Income, the “liar’s loan”, or Stated Stated, now you get to embellish both income and assets! A stated income loan requires only that you declare how much income you earn. Reputable lenders asked that you sign an IRS form 4506 for verification; but even reputable lenders rarely checked. Stated Stated loan is no verification on assets or income. The really problematic loan, in my opinion, is the Interest only loan ( IO). Many borrowers were sold this type of loan in conjunction with 80/20 loan, and many IO were ARMS. An 80/20 loan is actually a first and second mortgage, the second being a HELOC with a sustainably higher interest rate. With an 80/20 loan the property is 100% financed! From day one the buyer is in a negative equity position of roughly 5%.
However, with rapidly appreciating values in the 20% appreciation range, within a year they were no longer in a negative position. Borrowers were encouraged to take an IO because the rates were falling. While many people could qualify for a 5% fixed 30 year mortgage, they were routinely advised to take the IO, the rates will go down some more, or use the IO Loan on an 80/20 and use what would have been a principal payment to pay down the HELOC, the 20% loan. (The reasoning went, you could invest the down payment at higher rates or instead of buying the traditional starter house, skip starter and buy the second house) The IO was the favored loan in a rapidly appreciating housing market. Many speculators entered the market with an IO loan. Many a family, whose house is their biggest asset missed the opportunity of their life time to lock in a 5 or 6% fixed rate for thirty years. Prudence did not prevail!
It was not uncommon to see the same borrowers from the same branches cashing out the equity in their homes on the dual premise that the house would continue to appreciate and the rates would continue lower. The practice created a constant income stream for lenders, just as the IO’s were creating another constant income stream. In the pre- hot market, multiple refinancing within short periods of time would have been viewed as not only as a questionable practice, but also a red flag for the banking department auditor.
The sub-prime market, because of all of these lending practices, enveloped more than people with credit scores lower than 620; when the market stopped appreciating borrowers with IO’s & 100% financing were also caught in the sub-prime net. In late 2004 early 2005, I estimated that somewhere between 25 – 28% of the loans written by the small mortgage bank I was associated with fell into this precarious category. During this same period, the press was touting Sub-Prime at only 5%. That was true if you defined Sub-Prime as loans with borrower’s credit scores of 620.
Many a consumer was playing Russian roulette with the cash value in their homes, constantly refinancing, mostly to pay down credit card debit in the range of 25,000 to 45,000, each refinancing increasing the amount of money borrowed. The press liked to refer to this as the piggy bank. (You may remember the front page of the business section of the NY times with a house, a slit in its roof to swipe the credit card the credit card sticking out of the roof.) The press had, in a back handed way, made this practice look chic. And not unlike the Dot.com Bubble, the press is equally culpable in inviting the speculators to the block party!
Where homeowners duped? Some, however many went down the yellow brick road with their eyes wide open unable to understand their own money psychology. Where financial institutions blindsided by greed? Yes. And the practice of securitization left no one interested in the long term value of paying the loan off. The originator had the loan off their books and would most likely generate more fees from the same borrower within the next 13 months. No one was responsible.