"With jacks and timbers they started back down
Then came that rumble way down in the ground
And smoke and gas belched out of that mine
And everybody knew it was the end of the line
For Big John"
Well, Big John's been gone a while now, but there's new rumbling down in the ground that may mean it will soon be the end of the line for a spectacular mortgage boom. Last year, according to the Federal Reserve, Americans bought 6.4 million homes. We refinanced 10 million mortgages. That's the good news. Now listen to the rumbling.
Rumble, rumble. In the first quarter of 2003 the percentage of mortgages in the foreclosure process climbed to a record level. As you might expect, foreclosure rates were higher among folks with lower incomes and lower credit ratings.
Rumble, rumble. Harvard University's Joint Center for Housing Studies found that about one in seven American households devotes more than half of its income to housing.
Rumble, rumble. Stories are starting to surface about how some unscrupulous appraisers have jacked up appraisals leaving borrowers vulnerable if the market slows and prices drop. The Mortgage Asset Research Institute says that 21 percent of the fraud cases it tracked in 2000 involved appraisal fraud. That's four times the rate just five years ago.
Rumble, rumble. Over at the Federal Home Loan Mortgage Association (Freddie Mac) there has been a bit of turmoil. The board fired the Chief Operating Officer for not cooperating with an internal investigation into the company's accounting. At about that same time the CEO retired and the Chief Financial Officer resigned.
A lot of us have a simple and inaccurate idea of how the mortgage industry works. We imagine that it's the way it was portrayed in the classic film, "It's a Wonderful Life". This is how George, played by Jimmy Stewart, describes the workings of the Bedford Falls Building and Loan.
"As if I had the money back in a safe. The money's not here. Your money's in Joe's house right next to yours. And in the Kennedy house, and Mrs. Macklin's house, and a hundred others. Why, you're lending them the money to build, and then, they're going to pay it back to you as best they can."
It was a simple picture and it was reasonably accurate for 1946. The bank had money it had taken in as deposits. It paid interest on the deposits. It took the money and loaned it to people in the community and charged them interest that was a little higher than what they paid out to depositors.
The banker knew everybody. He (they were always he's back then) knew the depositors and he knew the borrowers. The banker also figured that the bank would handle the loan until it was paid off. That was the integrated approach. It began to change in the 1950s.
First there was Fannie Mae (the Federal National Mortgage Association) and later there was Freddie Mac. Their mission was and is to help promote home ownership. They accomplish that mission by buying mortgages from primary lenders and then selling them to investors. That's called securitization.
Neither Fannie nor Freddie is a government agency. They're what's called Government Sponsored Enterprises (GSE). Being a GSE is a good thing.
While neither Freddie nor Fannie get any direct government support, they get $10 billion a year in indirect subsidies. That's the figure that the Congressional Budget Office (CBO) came up with.
Some indirect subsidies are tax exemptions and exemption from securities fees. Those are worth about $1 billion. And the other nine? It's what the CBO calls an "implicit subsidy." The GSEs get to borrow money cheaply because people think the federal government will cover any losses. But the federal government has no, repeat no, obligation to do that.
In the beginning Freddie and Fannie only dealt with government loans. But soon that changed. And a whole industry of mortgage bankers grew up. They originated the mortgage loan and serviced it, but they didn't carry the loan on their books, the way the Bedford Falls Building and Loan would have done.
In the last twenty years of the twentieth century the integrated model gave way, more and more, to the specialist model. Brokers arose to generate loans and nothing else. By the middle of the 1980s they were originating more than half of all mortgages.
Some banks and specialty service companies arose to service mortgages that others had written. In the old days it made sense for banks to keep both origination and servicing because they operate counter-cyclically, revenues from one increase as revenues from the other decline. It's called a natural hedge.
But more efficient servers found they could make money from service. They bought servicing rights for good prices and still made money. Banks figured they could take the good deals that the servicing companies offered on mortgage servicing rights because they didn't need that natural hedge. They figured they'd developed more sophisticated methods of hedging risk.
The old integrated model had worked, in part, because bankers knew everyone involved. In order for the specialist model to work, there had to be a way to know something about people who just showed up wanting a loan. The credit reporting system provided the information and computer and communication systems made it easily and quickly available.
Information alone wasn't enough to judge loan risk. But systems of credit scoring were developed, most notably by the firm Fair Isaac, that can, we're told, quickly and accurately determine the level of risk on a particular loan. That way loan makers, using their new sophisticated methods, can price the loan accordingly.
As a result we now have a system where, very often, no one is responsible for the entire process of a mortgage except the homeowner. The broker wants to get the deal done. The appraiser wants a fee. The banker wants efficient use of capital and a clean balance sheet. The investor wants a good deal. And the servicing company wants to operate at a profit.
To make matters worse, underwriting criteria have become standardized which means that there's less and less difference between lenders. That, increasingly, reduces competition to price. And the Net makes it possible for buyers to compare prices instantly. It's a recipe for really nasty competition.
This looks OK when things are going well and the market is up. It's easy to believe that the rising curve will go on rising forever. But it won't. It never has.
Back in the 1880s mortgage banks sprang up to generate loans to support the real estate boom in the Midwest. They funded their efforts by selling shares or bonds to investors. But the recession of the 1890s came and the specialized mortgage banks virtually disappeared.
As the Roaring Twenties roared along it wasn't just the stock market that was doing the roaring. Mortgage banks started selling bonds to generate loans to fund the construction boom of the time. The Great Depression destroyed this whole industry and forced the government to step in.
It can all happen again. The folks in the business say it won't. This time will be different. According to them it will be different because they now have more sophisticated methods of determining risk and pricing loans and hedging. As if they were smarter than the folks 100 years ago.
All the talk about sophisticated methods makes me nervous. Business, even the mortgage business, is not sophisticated. Good loans are made based on character and capacity and collateral. Good business is made by making good loans and servicing them. When we start to figure that computer programs and slick dealing will replace common sense, we get into trouble.
I think we're about to get in trouble again. Maybe that sound you hear isn't rumbling way down in the ground. Maybe it's the roaring sound of flapping wings as the chickens in this latest bubble come home to roost.
