Wednesday, July 20, 2005

When 11 of 56 Leading Economists Agree, Something’s Wrong

A Mortgage Salesman’s Pitch

If you read one article in one newspaper all day, make it that one, by the excellent George Anders.

It’s hard to miss, being on the front page of the Wall Street Journal—although with all the earnings reports and the Yahoo-head-scratching going on, you might easily pass it up, thinking to yourself, “ho-hum, another real estate bubble story.”

But this one is the real deal.

It details in startling, awe-inspiring detail the workload of one Ben Ray III, a Northern California mortgage lender whose bread-and-butter is supplying “alluring and controversial mortgages that require unusually slim payments for a few years, before bigger sums fall due.” And there is so much over-the-top stuff packed into this article it’ll make your head hurt.

It’s kind of like the dinner I had last night here in San Francisco with some old, special pals—everything was good.

And if you think the bottom of the available-pool-of-buyers has been scraped, wait til you get to the part about the latest twist in mortgage lending.

No, I’m not talking about adjustable-rate mortgages—everybody, including my dog Lucy, knows about all the ARMs being sold. And I’m not talking about interest-only mortgages—the commotion over which has probably reached my cat Marvin, it’s so overblown. I’m not even talking about the so-called “Freedom Loan” ol’ Ben pushes—called the “Prison Loan” by his competitors.

I’m talking about “low documentation” loans:

“…including ones where lenders simply take borrowers' word about their income and don't ask for pay stubs.”

Now, the reason this “low documentation” idea rings a bell with me is because of a story I heard a few weeks ago from the straight-laced guys at Northern Trust, which handles a lot of family trust accounts.

Business is off-the-charts good at “The Northern” thanks to the bank consolidations in which faceless behemoths try to generate “synergies” by replacing “human beings” with “call centers” and “1-800 Numbers” and “ATM Machines,” causing old-line families who want to talk to a “human being” about a minor issue like, say, their inheritance—and can’t get past the recorded message—to pack up their money and move it to a bank stocked with “human beings.”

And one of the stories they told was of a family with several hundred million in assets that had done business with a bank for over 200 years—and couldn’t get a $4 million loan from the bank. So the family took their several hundred million to The Northern where they could actually discuss things without pressing “1” on the touch-tone keypad.

Thus, it has come to this: a family with several hundred million in assets and a 200-year credit history has a hard time borrowing from their family bank—but thanks to folks like Ben Ray III, Billy Bob can now get hisself a house without even digging out his Stuckey's pay stub from beneath the cushions of the couch he is paying through the nose for from the local Rent-A-Center.

No, I am not dumping on the Billy Bobs of the word. I do not think housing should be restricted to wealthy white families that bank at The Northern, and I particularly despise the inequities in lending costs between those wealthy white families that bank at The Northern and the Billy Bobs who get their pockets picked clean at the Rent-A-Center, a stock I would never own, placing it as I do on a par with tobacco companies.

But this is what it’s come to: low documentation lending. And there is much, much more in this excellent George Anders article. You really ought to read it start to finish.

The question this article raises, however—at least in my mind—is not how widespread these practices have become and whether low documentation loans signal The Top in the real estate mania. The question it raises is this: what is wrong with the real-estate-bubble-must-crash scenario?

I ask that question because of the following throwaway line in the story:

In a recent Wall Street Journal survey of 56 leading economists, 11 named a possible housing bust as their biggest worry for the economy.

We all know that anything widely anticipated—especially by 11 leading economists—will not happen the way those 11 leading economists expect.

Back in 1987, for example, it was generally accepted that stocks in Japan were highly overvalued—much like the dot-coms in 1999, and very much like real estate here today—and that if there was going to be a stock market crash it would start in Japan.

But the crash of 1987 did not start in Japan: it started in America, and it was triggered by a little-remembered device called “portfolio insurance.” I will deal with this device another day, but the gist of “portfolio insurance” was this: you sell when stocks are going down. Which is exactly what happened.

Thus, the Crash-That-Didn’t-Start-In-Japan came to mind when reading about Ben Ray III and the “low documentation” loans and all the other rotten loans that will surely come to grief.

And it causes me to wonder: what’s going to make those 11 leading economists wrong about the real estate bubble?

Jeff Matthews
I Am Not Making This Up


Mad man on the water said...

Is it me or do the 'new breed' loan structures(actually they are the reintroduction of speculative loan structures from the '80's and '90's)look an awful lot like credit card loan structures? What with min. payments and no real maturity on the loan, it seems all the lenders care about is making the spread. Who can blame them when a large number merely flip the originated loans into the MBS market anyway.FWIW, Citibank got hammered in the early '90's on "No Doc" loans. It seems some "No Doc" borrowers had "No M-O-N-E-Y." Shocking.

black bart said...

"And it causes me to wonder: what’s going to make those 11 leading economists wrong about the real estate bubble?"

The one scenario that I can come up with is we are entering a period of hyperinflation with oil and housing leading the charge. So that it's not price of housing that comes down, but that most everything else rises to a new level. Point in fact: When my father was transfered from Los Angeles, CA to Newport Beach, CA in 1972, he was an executive earning about $12,000 a year. The four-bedroom he bought (two-blocks from the beach) cost $42,000. The value of that house, and a salary at his then executive level (I'm guessing), have both increased some twenty-fold plus.

dcm1023 said...

If these guys can put these loans together, take their cut and then pass along the risk immediately why wouldnt they do it???? What a business. Wow.

Jeff Matthews said...

Here's the best comment from my emails so far, from the always succinct and ever rational Helene Meisler of fame:


Here's my wonderment: why are ONLY 11 of 56 economists worried about housing? shouldn't it be more?


Gnanakan said...

It looks like less than 20% are worried about a housing bubble. Wouldn't that mean that this IS a big problem that will likely blow up soon since it's not the biggest worry of 80% of experts?

whydibuy said...

Much of this nonsense is born of differing interests among the mortgage industry. The front end only cares about getting the loan out-then they get their end and there're done with it. Ditto for inspectors. make the loan officer happy and then your gone with your loot. Let someone else worry about the mess created. Which leads me to think about what Charlie Munger wrote back in the S&L days that as standards fell, you either lowered your standards as well or lost the business to someone who will. That lead to a cascade effect in shaky, undercollarteralised loans. And it ruins those who try to maintain some discipline in their lending. He was right. Early 90's debacles proved his point. And here we go again.

DEN said...

What's wrong with this statement here...

"Lance Diener said, 'This is all about people improving the quality of their lives. If you can save $800 a month on your mortgage payments, maybe you can buy that brand-new Cadillac Escalade.' Larger loans also mean more revenue for Benchmark."

Since when is "improving" your life based on the Escalade you just bought from being leveraged to the hilt?

Barley_Dog said...

We are setting ourselves up for a national crisis...ever lower underwriting standards coupled with a clear housing bubble is going to ensure that many people will lose their homes. The rising real estate prices have saved many stretched mortgage borrowers because they are able to extract more and more cash from their home. Once house prices level off (or maybe even go down), the rate of foreclosures will increase dramatically and we will all be forced to deal with a credit quality crisis.

Its_strange said...

Do we have laws or regulations that cover the mortgage business or is it more like Wallstreet ?

Its_strange said...

The guy who using interest only loans for investment homes many does this guy get ? 1 ...3...5 ? ...Would a mortgage company know ? Care ?

dthorn said...

Given that forecasts of 5% 10 years have become regular annual events, rising interest rates are unlikely to be the event that end the current housing cycle.

I think an enforcement of lending standards could be. Of course, no one wants to take responsibility for such a course of action, but who thought Spitzer would do the SECs job? Enforcement may come from an unlikely place.

A second, and probably related event, could be a shift in investor interest to another asset class. Given the global flood of monetary liquidity, an end to rapidly appreciating housing would probably be associated with money sloshing somewhere else (from stocks to r/e 2000 - today).

I am not sure if this shift would be driven by the perception of poor returns in r/e or better returns somewhere else, but i do have several bulbous plants of the genus Tulipa for sale. I will even let you pay for them after you have flipped them for a tidy sum.

BelowTheCrowd said...

Just to speculate on what possibly ends it, I think we have to look again at the use and abuse of derivatives and leverage throughout our financial structure.

I strongly believe that another LTCM-type event is possible. And with most of the big mortgage lenders being "black boxes" it's impossible to know where or when one of those might hit. The focus for quite some time was on FNM, but I suspect that whatever happens at FNM, and whatever FNM does in response (tightening standards?) will be collateral damage relating to a blow-up somewhere else.

Incidentally, mortgage brokers or all sorts have become the top advertisers on several of the local radio stations. In recent weeks the pitch has changed from "low introductory rate" to "none of that difficult paperwork."

Also noteworthy is that the various LA bimbos who regularly appear at the top of every phenomenon are now all mortgage brokers. In recent weeks they've even been assaulting me at my local farmers' market, telling me how much equity I could get out of my home. (That would be quite a feat, as I currently rent.) Last time I saw these characters in such great numbers, they were pitching me opportunities in day-trading or in startup dotcom investments, circa early 2000.


The Unknown Broker said...

"Low-doc" and "No-doc" mortgages have been around for a while and formerly served a valid and reasonable purpose:

Self-employed people -- small business owners, commissioned salespeople, etc. -- often show relatively low taxable incomes. And this doesn't mean they are tax cheats. No, their accountants advise them on any way in which they can take advantage of such deductions as are available. So they fund a retirement plan to the max, buy a 6000+ lb. vehicle for the special depreciation allowance, treat as many expenses as they can as business expenses, and so forth. So at tax time they have done the smart thing and pay a little in taxes as they legitimately can.

However, at mortgage time, when asked to show tax returns and such for income verification, their reported income is low enough that they don't qualify for the mortgage that they can easily take care of. So for them, the "low-doc" or "no-doc" option is a reasonable approach. It is based on creditworthiness -- which takes into account outstanding debts and payment history. The borrower pays a little more in interest to compensate the lender for having made a loan with less perceived security and everyone wins.

However, like many good ideas -- the internet, doughnuts, and the "Jaws" movies -- what starts off well can either result in perversion, overindulgance, or quality decline. "Low-doc" and "no-doc" loans are being misused to make people feel happy and believe that they are saving money. In reality they are financial swords of Damocles.

And the "Freedom Loan" mentioned in the article? That's what they're calling a "negative amortization" loan elsewhere. (I suppose "Freedom" sounds better than "negative." It's less, well...negative.) I know that mortgage brokers in Florida are pushing these for the 45% of condos (yes I said 45%) that are being purchased for investment (translation: flipping) purposes. The pitch given to a client of mine when he was buying recently: "All the 'smart' people are doing it this way. Hey, don't worry about what will be due later. Condo prices are going to go up 30% this year and at least 20% per year after that." That was the pitch of the real estate agent (who wanted him to buy a bigger place) and I'm sure it would have been echoed by the mortgage broker extolling the virtues of the negati...excuse me, the "Freedom" approach.

"You better think
Think about what you're tryin? to do to me
Yeah think
Let your mind go
Let yourself be free

Oh freedom
Let's have some freedom
Oh freedom
Yeah freedom"

-- Aretha Franklin "Think" (from "The Blues Brothers" (another movie that should not have had a sequel)

CanuckInTX said...

I find that talking about the housing market here in So Cal is now like discussing religion and politics. I just relocated from Long Beach, CA to TX to take advantage of what I think are ultra high prices and to buy somewhere that hasn't been going up. However, when I have discussions with my co-workers that live here in So Cal still we get into almost heated debates about the chances of housing prices declining. They seem to think demand for houses will never slow down just because of the popularity of this location. The argument that makes me laugh the most however is when the younger guy says 'Do you think banks would be lending to all these people if they thought the housing market was going to collapse?' I just laughed and asked him if he ever heard of the S&L loan scandal but of course he hadn't - too young. That must be why he thinks bankers and mortgage companies are so intelligent too!

Ed said...

* There doesn't need to be a "crash" and there probably won't be - it could just be no appreciation, or a downward drift. Any investment class widely believed to be a "good investment" is bound to disappoint over a 5-10 year horizon.

* In the last two months, I had a belhop at a Miami hotel give me advice to invest in local real estate, and I heard the doorman at my girlfriend's building tell the gardener that it is much better to own than rent.

As a tribute to Jeff's idea of "outliers" that could cause this to end, I've compiled some of my own outlier cases:

jay-b says said...

The biggest annoyance for me about the potential "housing bubble" is reading and listening to all the journalists that think they know everything there is to know about the mortgage and real estate market. They buy a house or do a little research and now "kaboom" they are instantly a real estate pro!

If you believe that lenders are purposely using Low Doc and Reduced Doc loans to put un-creditworthy buyers into homes then you are very misinformed. Think about it....that makes no sense.

And since when is it the banks responsibility to tell someone that they shouldn't borrow money?? Have we lost all personal responsibility? Think of the "McDonalds made me fat" lawsuit. Banks evaluate risk and then price it accordingly.

In full disclosure I am a mortgage consultant in my 10th year. I am successful without selling a single neg-am loan. Myself and nearly all of my co-workers do not sell these types of loans. We are wise enough to know that it will ultimately be bad for our business. We live off of referrals.

There are many unscroupulous lenders in the market and because of this and the tremendous amount of poor information out in the media I spend a good portion of my day educating my clients on what is fact and what is fiction.

So don't get down on my industry as a whole because there are many, many of us who truly put our clients best interest as a first priority. I have a very rewarding career and I am reminded of this quite often when someone who has actually been saving money to buy their first home is handed the keys at closing. It's a nice feeling.

I've been wondering...What does a contrarian do when faced with this real estate market?

CanuckInTX said...

jay-b...I commend you for being one of the 'long termers' in the mortgage sales business, but I don't think you can say that there are only a few unscrupulous people in your business now. I would venture to guess that the majority of people that have started to do what you do in the last 5 years or so don't have the same level of commitment or moral standards to help out their clients.

Any business that starts making easy money (for instance formerly daytrading) is going to attract a lot of people that look for the quick easy buck. And as a recent article in the LA Times showed the number of sub prime loans that are now being written by the likes of Ameriquest and Countrywide has had parabolic growth since the early 2000's.

It makes PERFECT sense to think that a mortgage broker with no scruples is putting people into homes with no or low doc - he knows he won't be around in 1-3 years to pay the piper when those people lose everything they have. And if you believe the lending institutions don't have any responsibility to tell someone whether they should borrow some amount or not I highly doubt you are all that well informed about the business yourself. Do you think the years of lending standards that have been established and now tossed aside is a good idea??

If a janitor walks in and asks for you to shoehorn him into a $1m home because he can afford the payments for the next year, does that strike you as 'not your responsibility' to educate him on the risks? Or do you heed the siren call of so many others that 'This time it's different?'

As for what to do as a contrarian in this market? Do what I did and sell California and move somewhere more affordable. There are jobs all over this country.

the management said...

Unknown broker has it right. If you want to see how this pans out from a market that's about two or three years down the track on this one (the UK), the search term is "self-certification", because that's what we call a low-doc mortgage on this side of the pond.

It's like UB said. It's in principle a sensible product for the self-employed. And low-doc doesn't mean "no credit checks"; the fact is that once you've been through the credit bureaux and pulled the Experian file on someone, just having a look at their pay stub doesn't actually give you all that much marginal information

except ...

the self-cert/low-doc loan to an employee is the teflon-coated bullet or knuckleduster of the mortgage industry. It's not that it's the most evil thing in the world, it's just that it doesn't have any readily apparent innocent uses. Why the hell would it be a good idea to use "not doing the paperwork properly" as a marketing point? Anyway, our FSA recently had a word with the biggest mortgage lenders and told them to turn it in. House prices here are flatlining and beginning to fall, so we'll find out what happens pretty soon.

Praying for the "Irish solution" (property prices in the right parts of Dublin went up 200% in five years, but then just gracefully returned to more normal growth).

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