The house of cards

1 | P a g e in.linkedin.com/in/arisarkar
Note: This article is an output of research and does not bear any prejudice towards any organization or person living or
dead.
Contents
A Brief History ..............................................................................................2
What Cooked the Goose ................................................................................2
Bringing in the Winds of Change ...................................................................4
Beware of the House of Cards .......................................................................5
Summary .....................................................................................................7

dead.
A Brief History...
The mortgage industry has evolved dramatically over the last 100 years, yet the basics remain the
same. The high cost of real estate puts buying property out of reach for most people unless they
borrow the money. So it is today, as it was in England as far back as 1190.
It was English Common Law that included protections for the creditor by granting him an interest in
the debtor‟s property. Back then ownership rights extended from the center of the earth up to the
sky. Now, generally, they are limited to surface rights only.
As opposed to a “live pledge,” the word “mortgage” is from the Latin words, “mort” meaning death,
and “gage” meaning a pledge. To mortgage is to pledge to repay, or forfeit something of value, if
the debt is not repaid.
A mortgage was meant to relate a “dead pledge.” The pledge was dead under two circumstances:
1. The real property was lost or forfeited or dead to the debtor, if the loan was not repaid; or
2. The pledge itself expired, or was dead to the creditor upon repayment of the loan.
What Cooked the Goose...
The post depression boom (1929 economic depression) in housing along with return of many
soldiers to start families caused the rapid increase in homeownership between1940 and 1970.
Rising inflation in the 1970‟s and high interest rates in the early 1980‟s slowed the increase and
caused a short period of decrease in homeownership rates.
As rates dropped, people with higher rates refinanced into lower rates. The short spikes in rates
during the 1982-2003 periods served to make a market of homeowners who would again need to
refinance when rates returned to their downward trend. They were easily able to do this because of
the rapidly
appreciating property values at that time. Some of the key landmarks that led to the historical
nose dive were as follows;
2004 – 2006 Interest rates remained constant, leading to dramatic decline in interest rates based
refinance. The gap left by pure “Rate/Term” refinances was fulfilled by subprime and nontraditional
mortgage products;
 Subprime loans: The rates on these loans, though higher than rates on prime loans, began
to go down and these became more attractive to borrowers.
 Added to this the qualifying criteria eased, many borrowers did not have to verify income in
order to qualify.
 Also, Loan-to-Value ratios increased and in some cases, 100%.This brought millions of new
borrowers into homeownership, and allowed many others to refinance their current
residences and pull out the equity they had built.
 Alternative Documentation Loans – These loans were designed for self employed borrowers
with complex financials. While traditionally, these loans required borrowers to have strong
credit histories and low loan to value ratios. The standards relaxed significantly during this
period.
 These loans also allowed borrowers to avoid buying PMI (Private Mortgage Insurance) that
was usually required on any conventional loan with an LTV of above 80%. (80% through
first and 20% through 2nd
mortgage)

dead.
 ARM loan options increased with multiple permutations and combinations that allowed
borrowers a plethora of choices as per their needs (which were largely short term view to
the future).
 Often these loans came with “teaser rates” or rates as low as 1% for a very short period of
time
 Advertising often left gaps in communication especially while communicating lender charges
and interest rate methods
 Adding to this loan originators brought in their flair wherein new properties taxes and
interest were calculated only for the price of the land and not the structure leading to a
perceived payment which was far lower than the actual and attracted more borrowers
Volume of these products and gimmicks was extremely high during this period, and with the home
prices increasing rapidly it was a happy feel factor all around!
While these borrowers did have trouble paying their mortgage, they had the option of selling the
home for a profit and also the alternative of obtaining second mortgages against the new equity in
their homes.
“Predatory Lending”; Approval of mortgage loans regardless of whether borrowers can afford the
payments over the long term, was rampant, especially amongst mortgage brokers. The lenders
added fuel to the fire in their buying spree to increase profits.
Wall Street firms such as Bear Sterns and Lehman Brothers continued to securitize them as the
rating agencies like Standard & Poor‟s gave the securities good ratings.
And then.... The so called “Great Recession” set in. While the fire started in the housing market
it soon spread to lead to a broader economic event, where the key feature was a tidal wave of
unemployment rate. This added fuel to the fire leading to further mortgage loan delinquencies,
which remained at historically high levels.
In the initial stages, the delinquent loans were predominately subprime mortgages and non-
traditional mortgage products, however rising unemployment rates led to many borrowers losing
their jobs and default on traditional mortgage products that had been conservatively underwritten.
Some of the key landmarks during this point were as follows:
March 2007: As delinquencies began spiraling up many of the large subprime lenders failed and
this triggered a loss of confidence in the mortgage backed securities market (MBS).
August 2007: The market share of Fannie Mae and Freddie Mac rose sharply as alternative
sources of capital dried up. Even performing portfolios had difficulty in finding buyers.
September 2007: The credit market spiraled out of control with market for private label securities
dying a swift death and Fannie, Freddie and US government FHA program were the primary
mortgage outlets.
 Banks and financial institutions with moderate to high mortgage exposure saw their
stock prices plummet, even GSEs were not spared...Fannie Mae saw their stock
prices drop from USD77 to USD25...a whopping 67% drop!
 The largest mortgage company in the US, Countrywide Financials Mortgage was sold
to BOA after its stock prices dropped like a stone due to speculative origination in
subprime market and option ARM loans. And the list of mortgage companies that
failed grew in number almost daily.

dead.
July to September 2008: President Bush signed a housing bill that gave broader powers to FHA
and placed Freddie Mac and Fannie Mae under government stewardship, making the government
responsible for USD 6Trillion...almost 50% of the outstanding US mortgage.
But was this too little and too late....
 Lehmann Brothers, a 150 year old Wall Street investment filed for bankruptcy failing
solvency or a suitable buyer. US government declined to step in and bail them out of a near
impossible situation.
 Central Bank, large commercial investors, foreign countries such as Russia, China and
others informed US Treasury that they had lost faith in the GSEs.
 BOA agreed to buy Merrill Lynch for USD50 million, a significantly lower value than what it
was days before.
 American Insurance Group (AIG), the world‟s largest and most diversified insurance
company was close to bankruptcy. AIG had a liability of over USD400 billion in derivatives
tied to mortgage loans.
This was the crunch...
US Treasury announced appropriation of USD700 billion to buy back troubled assets of US financial
institutions thereby restoring confidence in the market and relieving balance sheet of private
institutions.
The Winds of Change brought in significant changes:
 Consolidation of many of the country‟s largest financial institutions along with vast majority
of the subprime market segment.
 It led to unprecedented policy initiatives, government interventions and tightening of
regulatory framework.
 CFPB (Consumer Financial Protection Bureau) an independent agency of US government
was formed in 2010, authorized by the Dodd–Frank Wall Street Reform and Consumer
Protection Act.
 Basel II and III led to building stronger resilience of financial institutions and enhanced
mitigation features such as leverage ratio to protect against perverse incentives to pile into
low risk assets.
 Fiscal and monetary stimulus in the form of near zero interest rates and
massive purchases of mortgage-backed securities and other assets.
 New government-sponsored loan modification programs in an attempt to keep millions of
defaulting homeowners in their respective homes.
 It also led to a steep decline in the price of homes, especially in the states of Florida,
California, Arizona and Nevada which had witnessed unprecedented price increases before
the „Great Recession‟ and non-traditional mortgage products emphasis.
Mortgage servicers had to scale up their hiring engine to hire and train additional collection and
foreclosure personnel and also develop the infrastructure, software and standard work practices to
roll out government HAMP loan modification programs and also revamp the proprietary loan
modification programs. Close to four and a half million homeowners were rescued from foreclosure
through HAMP and other modification programs.... And Sanity prevailed.
Despite these successes, the recent “robo-signing” and foreclosure-loss mitigation “dual run” issues
have put consumer and regulator concerns regarding the servicing process on the front page.
While regulatory oversight continues to catch the offenders like the recent alleged backdating of
thousands of foreclosures in the state of New York...

dead.
... Beware of the House of Cards...
Because the symptoms are still there...and it would be prudent to remember history repeats...
While most of the lenders are following a wait and watch policy see which way the cat jumps (read:
CFPB), and clear standards to emerge, however the rising costs may force them into a decision
sooner than they believe.
And also given the potential market size the temptation to forge ahead into the subprime market is
getting stronger day by day for the lenders.
While 2015 ushers in hope and optimism, it would be prudent to keep the eye on the ball and not
get into the spirit of „things‟ due to multiple reasons;
 Origination is at an all time low despite the low interest rates of 3.8%. And the lenders are
not happy; with the rising cost due to the stringent regulatory environment...origination
costs for lenders have gone through the roof (as high as USD 45000). This in turn is leading
to...
 ...Easing of credit conditions may lead pave the way for an increase in subprime origination
 Lenders are looking to widen the horizon of the types of borrowers they will accept
by reducing credit-score requirements and giving benefit of doubt to consumers
whose credit history may have suffered because of one-time events.
 With the new agreement on the cards with Fannie and Freddie, lenders may lift
most of their “overlays”. For example: The credit score overlay, while FHA guideline
allows a borrower with a minimum of 580 credit score to take advantage of the 3.5%
down payment, however in real life the borrowers with less than a pristine credit
rating is required to put more money on the table...as high as 10% or more down
payment due to lenders own policies.
 VA loans origination, especially refinance is at an all time high for the last 3 years.While
understandably these are government backed securities, what sense does it make to put
temptation in front of the borrowers providing lower rates with an increased term and
showering them with a short term financial benefit!
The similarities to 2004 boom are almost uncanny. While pundits may argue that the
delinquency rates are the lowest due to stringent underwriting conditions and other
factors...well so was 2004-2006 with loan performance at its best...here are some key
statistics

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 Close to 360 billion in loan amount generated through VA loans with 56% of the
loans getting refinanced
 Close to 25% of these loans have been taken by borrowers greater than 56 years of
age
 With an average loan amount of USD220K, over 85% of the borrowers have gone
100% LTV (loan to value ratio)...scary indeed!
 Emerging strategies for lending outside the “Qualified Mortgage” box is slowly starting to
take shape. While initially the criteria‟s are bound to be stringent; 680 and above credit
score and following Dodd-Frank act rule of verifying a borrower's income and ability to
repay based on eight underwriting factors, however...
 Auto loan hitting USD1 trillion ceiling representing 33.2% of the total outstanding non-
mortgage consumer debt with....
 ...New loans originated year-to-date through October for nonprime borrowers with
risk scores of 640 or lower, reaching 6.5 million, just under 31% of all auto loans
originated, according to the report. Similarly, the total balance of newly originated
nonprime auto loans in that same time is $119.0 billion, an eight-year high and
representing 27.4% of the total balance of new auto loans.
(Ref:Collectioncreditrisk.com)
 Payday loans, The Nine headed hydra: While 14 states and District of Columbia have capped
the payday loans APR at 36%, the same as for military loans. However the payday loans are
exploding across all other states with loopholes being exploited to the hilt and predatory
lending at its peak.
 And Last but not the least....the “Payment Shock”
 A series of temporary relief measures as well as legacy issues from the time of crisis
are looming in which may lead to home repossessions and cause economic
headwinds. The foreclosure crisis was never solved, it was only deferred till a later
date and it‟s here now...
 The first is the home equity line of credit – second mortgage that the borrowers took
out during the bubble years, to be brutally honest using homes as an ATM – which
will now start featuring higher payments due to principal kicking into the scheme of
things along with the interest. As per TransUnion estimates anywhere between USD
50-79 billion in home equity loans risk default because of increased payments which
will be quite steep.
 The government‟s HAMP which provided temporary interest rate relief to borrowers,
and after five years, that relief runs out. With interest rates gradually rising about 1
percent each year. Over 319,000 of these rate resets begin in 2015.
 Research firm Black Knight estimates that 2 million modifications will face interest
rate resets and 40% of those homes are underwater, where homeowners owe more
than the price of the property.
 As per Black Knight again, anywhere between 40%-80% of those loan modifications
have re-defaulted over the recent few years.
 Over and above, Mortgage Forgiveness Debt Relief Act expired in 2013, and may not ever
get renewed; all mortgage relief given to borrowers will get treated as earned income for
tax purposes, leaving the borrower with a huge tax bill they are unlikely to be able to
afford.
 And then there‟s more; Analysts like mortgage servicing veteran Lynn Effinger believe that
the foreclosure backlog, most prominent in states that require a court ruling to foreclose,
will finally unclog in the coming years. “Many of these loans and their associated properties
will emerge from the shadows late this year and early in the next,” Effinger writes.

dead.
 For all we know, this might already be happening. Despite the picture perfect
statistics, foreclosure activity did rise 2 percent from June to July after months of
reductions, not a happy state. Activity jumped 66 percent in Houston and 10 percent
in Los Angeles, and foreclosure starts jumped a massive 128 percent year-over-year in
Nevada.
Summary:
The intent here is not to paint a pensive picture or world catastrophe! But to identify
the levers that need to change. Dreaming of a better and secure future is a human
need and buying a property is a step towards it. But when this dream begins to get
smudged with a plethora of “Instant get rich” solutions, then the world turns into
macabre twisted reality which begins to haunt and hound the borrowers.
There is a limit to which a CFPB, CPA and Dodd-Frank acts of the world can regulate
and police the lenders and financial institutions, ultimately the ball is in the court of
the lenders and financial institutions to balance profitability against bondage of human
lives.
Till such time comes, let the “Watchers” (regulatory governing bodies) wield their clubs
and continue to promote conservative lending because the world‟s not ready for a
better future.

The house of cards

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