Dirty secrets of the real estate collapse

Sacramento News & Review, CA
By Madeline Zook

A local real estate broker offers her primer on how we got from a housing boom to a foreclosure crisis into a full-blown economic meltdown.

“Congress deregulated the banks.” “Clinton made banks loan to poor people.” “Bush fiddled while the system burned.”

There’s lots of blame going around for this economic crisis. Lots of experts are scrambling for the politically correct reason of the week—first for the real estate collapse, now for the global economic meltdown. How we got here was simple: too much credit and too much debt for too many years. But why are hard-working people, many Hispanic, losing their houses? The details are different from what the banking industry and the government want to admit. Here is one Reno real estate broker’s accounting.

How do people get mortgages?

Lenders, usually banks, have certain guidelines that they go by. Assets, liabilities, income must all be documented, verified, and stay within rational levels of debt-to-income, mortgage payment-to-income, and home-to-mortgage values. These safe practices allow the banks, the market, and even the homeowner to absorb a downturn in value or a loss of income. Foreclosure used to be rare.

The deregulated banking system of the ‘90s allowed banks to sell their loans (exactly like stocks) as soon as the ink was dry. This allowed the banks to make more loans with fewer assets. The government (both parties) decided that requirements should be loosened to allow more people to buy a house and live the American dream. New types of loans were offered to people with less financial discipline. One hundred percent financing, and even 103 percent became common for first time buyers so that no one had to save for a down payment or loan fees. Payment-to-income ratios soared, and documentation rules for income, assets, and debts were relaxed.

So called “low doc” or “no doc” prime loans were widely available. This was particularly prevalent in Reno because casino workers have mostly tip income, which is largely unreported. Finally, lenders offered lots of complex and quickly adjusting loans to marginal credit customers during the boom years of 2002-2006. Sub-prime loans (called “credit fix” loans in the trade) usually are fixed for the first year or two from origination, then they adjust—a lot. The idea was that a borrower with bad scores would build their credit by making payments for a few years, then refinance. Appreciation would create equity and a virtual “down payment.” These high-risk practices worked as hoped in a boom market but proved disastrous the second that home values fell.

It was the new millennium, why worry? The economy was booming, people had good jobs, more houses were sold, more loans were written, more and more people traded up to more house than they could really afford. As house values rose, more people took home equity loans out on their best asset and spent it on cars, clothes and eating out.

By 2005, the banking system of the ‘90s started to strain under all of this risky debt allowed by deregulation. Sub-prime products ceased being offered in February 2006 with the collapse of New Century, one of the biggest sub-prime lenders. The foreclosure wave had started.

Dirty Secret No. 1: The money’s gone.
Wait a minute, didn’t the lenders make homeowners take out mortgage insurance when they exceeded the gold standard 80 percent loan-to-value ratio? Who takes the hit when there’s a foreclosure? Besides the homeowner, of course.

The truth is that high-risk mortgages were “bundled” just like good mortgages and sold as iron-clad securities. Accounting practices allowed banks to “book” profit from these loans immediately and account for the risks later. The same practices were used on the infamous “credit default swaps.” These are insurance-like contracts that promise to cover losses on certain securities in case of a default—except they didn’t always work that way in the unregulated credit swaps market.

This created the short-term results that shareholders demanded. Could bank executives have booked less profit and held some reserve for the rainy day that was sure to come? Sure, and they would have been fired. The shareholders would have demanded they be replaced by their colleagues who were willing to show higher profit. So the money was taken as profit years ago, and there’s nothing left but debt.

Comdisco did this and collapsed. Enron did it. Now the entire United States banking system has done it. The Sarbanes-Oxley law was enacted to make CEOs and CFOs criminally liable for this level of fraud. Golden parachutes need to become iron shackles.

Dirty Secret No. 2: The Federal Reserve caused the bubble AND the meltdown.
From 2001 to 2005, interest rates were held low because there was no inflation. But the Fed’s inflation model—the consumer price index—didn’t include housing costs; only food, fuel, consumer and durable goods count. And a booming housing market meant skyrocketing housing costs. Simply put, people were paying more and more for housing, but the Fed didn’t count this as inflation. The higher housing costs eventually bled over into the broader economy, and the fuse was lit.

When Alan Greenspan and the Federal Reserve raised interest rates continuously over a period of a few months in 2005, the housing market stopped in its tracks. Prices started to fall, first slowly and then more rapidly as demand dried up, positioning everyone with a sub-prime loan for default. This started the wave of foreclosures, and we will not be done with subprime loan defaults until late 2009.

Take an actual example from one of my clients in Sparks: A $435,000 Kiley Ranch house was purchased in 2005 with about $87,000 down. The house is now valued at $225,000. A bank won’t refinance the mortgage because the $343,000 loan is worth more than the house.

My clients wanted to sell the home, but with foreclosed properties at 55 percent of the market, houses sell at a huge discount—$225,000 vs. $435,000. And my clients have to pay the difference: $118,000 cash. Since monetary troubles are the reason they are selling, it is impossible to expect people to come up with tens of thousands of dollars to sell their home. They consider renting out the house, but the mortgage payment is much higher than the rent they can get. So, they need $500-1200 per month to keep the house, even with renting it—and of course, they also have to pay rent to live somewhere else. It just isn’t feasible.

Dirty Secret No. 3: The bank doesn’t care if you go broke trying to save your home.
Now that the low interest “teaser” period on the sub-primes is up, the payments adjust to the new interest rate. With no regulations on subprime loans, this can be 4-6 percent. For the average Reno home, the new payment is $500-700 per month more.

Most people who bought their home 24 months ago have not seen an increase in their income of $700 a month! Subprime loan payments are normally more than 40 percent of household income before the adjustment. So, people struggle, burn up their savings and cash out their retirement funds, get second jobs, and it’s only when they are in default that they finally seek help from me.

Owners attempt to negotiate with the bank, but that leads nowhere. Banks do not accept partial payments, and after 60 days in arrears, they stop allowing the homeowner to make any payments at all on the loan. The loan is sent to another department to start the foreclosure process, and $10,000-plus in legal fees is tacked on to the late fees and overdue payments.

When you fall behind in your payments, the system is set up to extort as much money out of you as it can before foreclosure. People will try anything to stay in their homes, and the banks use that emotion to their advantage. Remember, the loan contract states that the only remedy that the bank has in case of default is foreclosure. It doesn’t say a thing about lowering your interest rate, forgiving payments, or renegotiating the note—and banks absolutely will not do so. They can’t—it’s not their loan.

Dirty Secret No. 4: Banks rarely hold mortgages.
The bank you write your check to doesn’t hold the loan, they just collect a service fee for administering it. Most loans are resold as soon as escrow closes. This frees up more capital to sell more loans. Even sub-prime loans were resold immediately to investors—often at a substantial profit. The only limits were how much debt the international markets could handle, and how creative the banks were.

Once the boom hit, and the credit started flowing ever faster, banks looked for ways to get more people into homes, even with marginal credit. Congress and the Federal Reserve have finally disclosed that oversight was negligible for years, perhaps decades. As far back as 2005, it was known that Fanny Mae and Freddie Mac were in deep trouble, yet Congress refused to regulate them. It appears that Bill Clinton and his Attorney General Janet Reno were largely responsible for creating the sub-prime debacle. Bi-partisan legislation undid Depression-era regulations that prohibited banks from entering into the stock market. Reno forced banks to lend to minorities with poor credit by threatening prosecution for “red lining” properties in areas of high risk.

Naturally, the banks complied with their new guidelines. To mitigate the risk, the banks fell over themselves to provide subprime loans to less qualified borrowers.

Why did they do that? Because selling the loan yields tens of thousands in instant profit from the yield spread—the difference between the interest the bank borrows money for and what they charge. And the worse the credit of the borrower, the more profit there was.

Consider this: On a subprime loan of $200,000 with an interest rate of 8.5 percent, the bank’s profit would be about $19,000. Pure profit, taken as soon as the note was recorded. Then the note was sold, likely for face value or even more, and the money reused to close yet another subprime loan, to make another $19,000. But that’s conservative—often banks made $25,000 originating subprime loans, or more.

The consumer never saw any of this. Complex loan terms are hidden in reams of fine print. People who don’t, or can’t, read and understand all of it are vulnerable. Vulnerable to anyone who wants to profit off of that incomprehension. It’s like a language barrier.

Dirty secret No. 5: Hispanics are the hardest hit demographic group in the subprime debacle.
Ironic isn’t it? The very minority group that the Clinton Administration wanted to court by making them homeowners is the group hardest hit in the foreclosure crisis. I estimate that 35-45 percent of the Notices of Default recorded against homes in our area are against Hispanic homeowners.

Notices of Default are lists from the title industry that some realtors purchase as a service—I do. Gathering complete statistics is hard: These lists aren’t available to the public. Newspapers publish auction notices (the last step in the foreclosure process), but these lists are less than 10 percent of all foreclosures. Even so, the percentage of Hispanic names is there for anyone to see. I apologize if this sounds like profiling.

Interpret the data however you choose. My professional experience leads me to believe that Hispanics as a group were preyed upon—mostly by Spanish-speaking loan officers and realtors—to buy homes that were absolutely unaffordable, and to use subprime loans to purchase them. I know this because I get called into play at the 11th hour, when every other resource has been exhausted, and people are finally desperate enough to trust an outsider. Only then do I get to review their credit, income and the loan.

A number of factors explain why so many Hispanics are defaulting. A cash-based economy, lack of financial experience, English as a second language, an inability to read and understand the fine print; and a “trust only our own” mentality all led to Hispanics with poor credit getting loans they never understood until it was too late. Even informed and savvy buyers with good credit fell victim to unscrupulous brokers simply because they spoke the right language.

We all have a healthy skepticism when the news reports that borrowers “didn’t understand” or “weren’t informed” about their loan products, but in the case of Hispanic borrowers, it was too often true. Readers can draw their own conclusions: Spanish-speaking buyers, Spanish-speaking agents, contracts written in English. I’ve seen children as young as 12 years old interpreting these documents for their parents. Often it was a “just sign here” situation.

I had a client whose Hispanic loan officer tried to put them into a loan where just the loan fees were $12,000 more than the loan I ended up getting them, not to mention an obscene interest rate. That’s $12,000 in pure profit to the loan officer and even more to the bank. It’s always the same explanation—so and so was a friend, they recommended we do this, etc.

During the red hot years, I lost a lot of business because I refused to keep my mouth shut when buyers told me they wanted to take interest-only loans to get that big house they wanted, or to cash out and refinance their home with pay-option adjustable rate mortgages (ARMs) and buy a bunch of rentals. I’m a fiscal conservative, and although your home is worth money, it’s also your home, not a credit card.

I have personally lost my shirt to unload a property rather than face foreclosure. Yep, I lost $75,000 on my own house when Congress changed the tax laws and enacted the passive activity loss act in 1978, and no one could convince me that home values would never come down. Well, they have, and there is no end in sight. There is no “law” that says that homes have to appreciate at all. So to those who believe that home prices will recover and begin to appreciate again, don’t bet on it. Right now foreclosures are here to stay.

Dirty secret No. 6: The banks make money on foreclosures
So, why are the banks so quick to foreclose on homeowners? Why won’t they negotiate? How can they possibly be absorbing the losses?

The answer is that banks make money on foreclosures. How is that possible? Because they didn’t hold the debt. Remember, they sold that mortgage immediately upon closing the loan and got the money back. The debt is long gone. All they are doing is getting a small percentage of that money for collecting payments. It’s not much money for one loan, but with millions of loans it adds up nicely.

Many times, it costs banks nothing to repossess a house. It doesn’t even matter how little they get when they sell it, because the loss goes to Argentina or Iceland which bought the original debt. Many banks don’t even pay the taxes on the properties. So, when you stop making payments on your mortgage, the bank is strongly motivated to get you out of the house, originate another high-profit mortgage, sell the new debt, make money, and start collecting that small percentage again.

Most bank-owned-properties require loan approval from that particular bank. Since it’s a real pain to get loan approval these days, I’d estimate that 90 percent of all borrowers will go with the foreclosure bank’s loan when they buy.

You may not believe that banks make money on foreclosures. But then you would have to believe that Bank of America is a charity, and they bought Countrywide and their sub-primes because they wanted to lose money. In return, they got all of those mortgages. Some will pay off, others will default, and BofA will make money no matter what, on each and every one of them.

Where do we go from here?

Well, the $700 billion bailout of investment banks is simply not going to help any homeowner facing foreclosure. There is no requirement for the banks to use taxpayer’s billions to refinance home loans. A bottom-up bailout of homeowners could stop the foreclosure crisis in its tracks, and it might even be cheaper. But what about those homeowners who are not in default? What kind of fair policy would make those who practiced sound fiscal management and made large down payments pay for those who didn’t? And individual homeowners don’t have lobbyists, so there’s no political clout to make it happen. I think it’s more likely that there will simply be a lot less credit available for the foreseeable future, and we’ll probably see a return to the historical home buyer requirements: 20 percent down and excellent credit history.

It is time for America and Americans to live within their means. That means on an everyday level living without that new big-screen, touch cell phone, and eating out every night. On a bigger level, we need to drive our cars less, keep our cars longer, and live in smaller houses. Along with our carbon footprint, it’s time to start living with less of a credit footprint.

Does the average middle class family really need a 3,000-square-foot house, 3 cars, and all that debt?