One of the biggest misconceptions of the whole sub-prime mess is that the problem was all of these bad loans products.  Yes, a lot of the loans that were done at that time were not your boring old 30-year fixed rate loans.  But that doesn’t mean that they were bad loan programs.  I can’t think of a single loan product that does not have some purpose, or some advantage for some circumstance. I’m not saying that every loan will work for every person.  In fact exactly the opposite is true.  The problems occur when the wrong borrowers get the wrong loan.  Blaming the loan is like blaming the gun when someone gets shot, or blaming the car when someone drives into a tree.

What we did have is a lot of bad lenders.  It’s not very hard to understand why – during this time just about everybody you spoke with was either getting into the mortgage business, or knew someone who was.  When I first got into the business (WOW that makes me sound like my dad!) it was pretty-much understood that it took about 6 months before you were considered marginally competent, and about two years before you really knew what you were doing.  In 2005 there were people managing mortgage companies with less than two years in the business!  But that was OK. The mortgage company itself probably wasn’t much older than that, they were selling to a wholesale lender with about the same level of experience, who’s loans were being packaged and sold by someone who probably didn’t even knew what a mortgage backed security was five years earlier. And they were selling these loans to investors who had no idea what they were buying, all blessed by rating companies who just assumed that any investment secured by residential real estate was solid gold.  But it was all OK, because business was growing and everybody was getting rich.

The other thing we had was a lot of bad borrowers.  Don’t misunderstand; this was not a new phenomenon.  We have always had plenty of lousy loan applicants.  People with bad credit, undocumentable income, too much debt and not enough cash have never been in short supply.  I believe that a big part of my job is to counsel these people on how to get their budgets under control, how to develop a more responsible attitude towards their obligations, and how to save money so that they could make that initial investment.  Frankly most people don’t change, but some would and be in a position to buy after working at it.  The problem occurred when the investors that establish underwriting guidelines lowered their standards to the point where we basically just gave loans to anyone who wanted to buy.  Eventually these borrowers preformed in a predictable fashion: badly.

It’s really not that complicated.  Loan performance (how well the borrower pays their obligation) is fairly predictable based on two factors:  Borrower quality and market performance.  Borrower quality is comprised of a combination of four factors:  Credit – how responsible a person is towards their obligations, Capacity – a measure of how much a person can afford to pay in comparison to their income, Cash – how much money a person is investing into the property and how much they will have after completing the purchase, and Collateral – a measure of the property value, condition and marketability.   Market performance is simply what is happening to the value of the real property.  Is it holding steady or appreciating at about the rate of inflation (normal market,) is it increasing at more than the rate of inflation (hot market,) or is it declining (bad market.)  This can be local, regional, state-wide, or even national – depending on what is happening.

  • Normal market:  Good borrowers will perform well.  Marginal borrowers will perform marginally.  Bad borrowers will perform badly.
  • Hot market:  Good borrowers will perform well.  Marginal borrowers will perform well.  Bad borrowers will perform well.
  • Bad market:  Good borrowers will perform well.  Marginal borrowers will perform badly.  Bad borrowers will perform very badly.

The proof is out there.  There are a lot of buyers that bought at the peak who still own homes, and are making all of their payments.  They’re not very happy about what happened to their home’s value, but they are still making their payments.  On the other hand, the borrowers who should have never been allowed to buy in the first place continue to default on their loans at very high rates – even after they have been modified into loan products with terms that are substantially better than even the most qualified buyers can get.

I know it’s not popular to think of borrowers as part of the problem because the media continues to paint the picture that all of the people loosing their homes are victims, and refuses to even consider their culpability in the whole mess.  There are people who paid $100,000 for a home and pulled out a bunch of cash – refinancing the home up to $250,000.  Since they are now underwater they just walk away.  The same thing goes for people who bought way more home than they ever could hope to afford – and put $0 down.  If the home’s value had gone up, they could have sold and pocked the cash; but now that the value is lower, they live rent free until the bank gets around to foreclosing – and then just walk away…

Please don’t misunderstand; I’m not saying that everyone who lost or who is in the process of loosing their home should never have bought or refinanced.  Even the most well-qualified borrowers can run into problems; life happens!  The problem is today you not only have a lot of people that have run into problems, you also have the people who were never really qualified in the first place, plus the people who can afford their payments, but just walk away anyway!

So now the government stepped in and is fixing he problem – not!  The fact is the problem fixed itself.  There are no investors out there buying stated-income 100% financed loans – and there will probably never be again!  Loosing a few trillion in wealth tends to make a permanent impression.  When was the last time you heard of someone rushing out to buy “junk bonds”, or invest in tulips?  (see: http://www.investopedia.com/features/crashes/crashes2.asp)  What the government IS doing (and has already done) is taking away the ability to do creative financing – even when it makes sense.  Most of the riff-raft is out of the lending profession, and mortgage licensing will probably drive even more out.  The pendulum was WAY OVER to one side, so logic would dictate that it’s going to go way over the other way – and it has.  The problem is the government seems intent on freezing it at the extreme position and that is making it harder for the market to recover.

In my next piece I will show how some seemingly “bad loans” and bad loan terms” do have (or in most cases now had) a function and a purpose.