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Generational Dynamics Web Log for 6-Feb-07
As housing collapses, subprime mortgage loan officers may be held accountable for fraud

Web Log - February, 2007

As housing collapses, subprime mortgage loan officers may be held accountable for fraud

The Realtors' economist David Lereah illustrates the Principle of Maximum Ruin.

While the housing market continues to slip, most investor attention is being focused on a particular aspect: The extremely high failure rate of subprime mortgage loans.

In the "old days," when financial managers were still people who had lived through the horrors of the 1930s Great Depression, you would buy a house by paying 30% of the purchase price (the "down payment") in cash (from your savings account), and you would pay the other 70% by obtaining a mortgage loan from a bank, to be repaid by means of monthly payments for 30 years. You would use the house as collateral, meaning that if you were unable to make the monthly payments, then you would lose the down payment and the house. The bank would take possession of the house, evict you, and then auction the house off to someone else for as much money as they could get.

When the Boomers started taking over leadership positions in the 1980s, credit became much easier to obtain. The amount of required down payment was reduced to 20%, sometimes as little as 10% or even 0%. This was justified by the fact that the homes were gaining in value, so the mortgage principal would (theoretically) equal 80% of the home's increased value within a year or two anyway. But lenders still verified that borrowers had enough income to make the monthly payments.

Another recent change was "no documentation loans," which permitted people, such as people who work on commission and can't prove their income, to qualify for a mortgage loan by paying a higher interest rate. That phrase isn't always entirely accurate though, because often the banker would require alternate documentation instead of no documentation. For example, even if a borrower isn't required to prove his income, he may still be required to list his assets and debts.

However, things have completely unraveled in the last three years, thanks to the housing bubble. With housing values increasing 10-20% per year, why worry about anything? The buyer could "flip" the house by holding it for a few months without even living in it, and then sell it for a lot more money. If the buyer didn't make his payments, the bank could "flip" the house in the same way. The result is that lending institutions have become even more careless about verifying buyer documentation, with the result that many subprime mortgage borrowers cannot afford the payments.

Now, at the beginning of 2007, it's been over a year since the housing bubble began to deflate. It was already fully apparent in August, 2006, that the housing market was collapsing faster than economists had expected.

Housing prices fell throughout most of 2006, obliterating the assumptions under which the careless lending rules were devised.

As a result, buyer defaults have been increasing, and a study by UBS Investment Bank of subprime mortgages made in 2006 found that the default rate is so high that subprime loans made in 2006 are on track to be the worst-performing class of loans ever issued.

In fact -- and this is really a killer issue -- many buyers are unable to make even the FIRST PAYMENT of the loan. From the buyer's point of view, the plan was to purchase the house with no investment at all, flip the house and sell it at a higher price. But if prices are falling, then the buyer realizes that any mortgage payments he makes are simply lost money, so rather than make even one payment, he defaults and lets the bank take posession.

"First payment defaults" are considered a special category of default because they may be a sign of fraud; that is, if a buyer never intended to make payments on the mortgage loan, then he's defrauded the mortgage lender.

Who makes money in this situation? An intermediary like a loan broker does. He brings the home buyer and mortgage lender together, and makes sure all the proper paperwork gets filed. By the time that the buyer has defaulted, the loan broker has already made his commission on the mortgage loan.

In fact, the amount of outright fraud is higher than most people think. In some regions, fraud may have been involved in as much as one-third of all subprime loans.

One type of fraud involves the use of "straw buyers," people who have no intention of living in the home they're buying or even "flipping" it and reselling. They collude with homebuilders to purchase the house at inflated rates, and then immediately default on the mortgage loan. The homebuilder and the straw buyer split the proceeds from the fraudulent sale, and the bank is stuck with the overpriced house.

Now, an article in National Mortgage News is beginning to ask the question: Should loan brokers be held accountable when the buyer defaults on an early payment? This could mean that he could be required to provide restitution to the lending institution of any money they've lost, and it could even mean criminal fraud charges against the loan broker for conspiring in the fraud.

I've already written several times that many hedge fund managers and investment advisers may be guilty of criminal fraud. These advisers have a fiduciary duty to their clients to provide the best advice. If however, an investment advisor or hedge fund manager protects himself while collecting commissions from clients whom he advises to invest more, and then a major international financial crisis occurs causing clients to lose their investments, the fact that the adviser protected himself can be considered evidence that he purposely misled his clients, and that would be criminal fraud.

And you can be sure that furious clients will be only too delighted to see all such people get skewered as painfully as possible.

Now we see where these charges can also extend to loan officers. If, for example, a buyer lied on his application in order to qualify for a loan, but the loan officer didn't check that the application was valid, then the lending institution can claim that the loan officer purposely avoiding checking in order to collect a commission. Once again, that's criminal fraud.

In fact, the mortgage lending industry is getting hit very hard. A new web site, "The Morgage Lender Implode-O-Meter," has been tracking the collapse of mortgage lending firms as they occur, and as of this writing, 18 lenders have gone out of business since December, 2006.

That lenders are going bankrupt won't be surprising when you realize that the number of foreclosures in 2006 is up 42% from 2005. Much of this is caused by incompetence by loan brokers, and complicity in fraud by buyers.

And we can't end this article without talking a moment about Mr. David Lereah, the chief economist at the National Association of Realtors.

Each month, when the Realtors' housing report comes out, Lereah provides commentary on the real estate market. He's become the butt of a number of jokes because his commentary is always the same: The housing market is getting better. He's been wrong almost every month for over a year.

A recent article by MarketWatch has tracked some of the unrealistic statements made by Lereah in the past year: "The market is in the process of normalization" in January; "Home sales will move up and down somewhat over the remainder of the year but stay at a high plateau" in April; "The market should even out just below present levels" and "The market is stabilizing" in July; and finally, "The good news is that the steady improvement in sales will support price appreciation moving forward" and "It appears we have established a bottom" last month. Each month's statement has turned out to be overly optimistic and wrong.

But David Lereah hasn't just become famous now. One person has been tracking his optimistic statements in a David Lereah Watch blog since August, 2005.

Will David Lereah be charged with criminal fraud after a housing bubble crash? I don't know the answer to that question; it probably depends on whether he's lying or incompetent.

What we're seeing here are examples of what I've been calling "The Principle of Maximum Ruin." This principle states that the maximum number of people will suffer the maximum amount of ruin in a crash. That's because people like David Lereah will convince people to continue to make unwise investments.

I devised this principle after reading what happened in the 1929 stock market crash, as described by economist John Kenneth Galbraith in his 1954 book The Great Crash - 1929:

"A common feature of all these earlier troubles [previous panics] was that having happened they were over. The worst was reasonably recognizable as such. The singular feature of the great crash of 1929 was that the worst continued to worsen. What looked one day like the end proved on the next day to have been only the beginning. Nothing could have been more ingeniously designed to maximize the suffering, and also to insure that as few as possible escaped the common misfortune." (p. 108)

Galbraith shows what happened after the initial crash on October 24, 1929: "In the first week the slaughter had been of the innocents," in the second week it was "the well-to-do and the wealthy" who were slaughtered (p. 113), and then more and more people were sucked into ruin during the years that followed.

People like David Lereah and overly optimistic financial advisers convince more and more people to invest more and more money, especially when buying stocks on margin (credit):

"The fortunate speculator who had funds to answer the first margin call presently got another and equally urgent one, and if he met that there would still be another. In the end all the money he had was extracted from him and lost. The man with the smart money, who was safely out of the market when the first crash came, naturally went back in to pick up bargains. ... The bargains then suffered a ruinous fall. Even the man who waited out all of October and all of November, who saw the volume of trading return to normal and saw Wall Street become as placid as a produce market, and who then bought common stocks would see their value drop to a third or fourth of the purchase price in the next twenty-four months. ... The ruthlessness of [the stock market was] remarkable." (p. 109)

From the point of view of Generational Dynamics, we're in the first stages of this same process. Advisers who stand to make commissions by providing overly optimistic advice draw more and more people into the bubble market, whether it's the housing bubble market or the stock bubble market. No matter what happens, these advisers always say that everything is OK, and they draw in more money and more investors, until the maximum number of investors suffer the maximum amount of ruin. The Principle of Maximum Ruin. (6-Feb-07) Permanent Link
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Generational Dynamics Web Log for 6-Feb-07 As housing collapses, subprime mortgage loan officers may be held accountable for fraud

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Generational Dynamics Web Log for 6-Feb-07
As housing collapses, subprime mortgage loan officers may be held accountable for fraud