The 1% Was The Culprit

Posted: May 07, 2008 9:53 PM

I always have to laugh when I hear commentators present a label for a problem that simply proves to be incorrect. What started the subprime credit crisis and who deserves the biggest blame will be argued for years. As one of the combatants in this crisis (not by choice), I have my own opinion which will never be shared by today’s financial reporters. It is shame that pundits never take the time to get things right, as it is easier to learn from mistakes than to misunderstand the problems and try to get everyone to accept an incorrect hypothesis.

First and foremost, the subprime crisis only really concerned itself with one aspect of the subprime market: stated wage-earner loans. There were a myriad of different loans that were underwritten and funded by the subprime industry that made eminent sense and were successful, or as successful as most prime loans. But we made sure to throw the baby out with the bath water so we wouldn’t have to distinguish the good loan programs from the bad. They are all gone. The majority of the subprime borrowers took a subprime ARM for a short period of time—two, three or five years. They cleaned up their mess: late payments, too much debt or judgments and charge-offs. After the fixed period of the loan was up, they refinanced to prime loans at good interest rates. That is how the subprime industry was designed to work. And for the most part it worked very well.

Then many in the industry set their eyes on an untapped market: stated wage-earners. Nobody stopped to ask why we should put people in “stated income” loans with the borrower stating his/her income and not having to prove it, when these people had pay stubs, W-2s, and verifications of employment available for review. Stated loans were designed for the self employed who lack such income documentation, and if they had left it that way we most likely wouldn't have this crisis. Many lenders couldn’t resist the stated income loan market with its higher profit products, and the rest is history. When you allow someone to state income that can’t be checked (and wasn't) it is a license to lie, and boy did they!

Once the ball started downhill, it quickly picked up speed and many of the bad loans that the prime market had also brought forth joined the fray and were labeled “subprime.” In fact everything that happened thereafter was a “subprime problem,” or so the reporters told us. Here is where they and I parted company. The Wall Street brokerage houses had launched a number of different investments known as derivatives. These magic creations fulfilled insatiable demand for high returns and were based on smoke and mirrors, akin to the emperor’s new clothes. It probably would have worked if the subprime demise hadn't started, but once it did, key investors implemented reality checks and we had a new group of worthless investments. So derivatives quickly joined the subprime crisis as a distant relative of the same name.

Prior to the unraveling, the lenders were creating product and Wall Street was not only gobbling it up, they were encouraging the lenders to bring them more. What made it all change? The tremendous losses the Wall Street firms realized as the various pools, loans and derivatives were marked down to reflect their worth: zero. Which gets me back to the title of this article. I was listening to a well-known financial reporter talking about a new culprit to blame for the mess: the option ARM or pay-option ARM. I guess it is new as I’ve only known of it since the early 1980s when I actually had one.

Option ARMs were the bedrock of the old savings and loan business and the main product of Coast Federal Savings, Home Savings and Loan, American Savings, and Great Western Savings. In case you haven’t heard of these companies of late, they were all taken over by Washington Mutual. Countrywide and Washington Mutual were the two big banks that led the mortgage industry in the 2000s in the sales of option arms. They weren’t alone.

What was different this time was the real culprit: the teaser rate of 1%. Although nobody paid 1% for anything, everyone today swears they thought the interest rate was 1%. How could that be? When you are driving in an area you have never been before and you are stopped by a policeman for speeding, the fact you hadn’t been there before and didn't know the speed limit doesn’t cut it. If you pick something up in a store and walk out without paying, the fact that you didn’t see a checkout line doesn’t get you out of your new problem: shoplifting. Why did everyone believe that 1% was the interest and not the payment rate and why didn’t they read their loan papers? Even if they didn’t understand a word, they could have sought help. Even though they saw their balance on their home loan increase, they claimed they didn’t notice.

For the preceding 20 years, I don’t recall the option ARM ever being lower than 3.95%, and nobody seemed to have a problem distinguishing that rate from the true interest rate. Is 1% a more confusing number? Whether it is or not, people went for this loan by the thousands. They never checked anything about the loan. It seems that the worse the deal, the more people took it. The higher the margin, the longer the prepay, the better it obviously appeared. I have given up asking myself why. Why? Because it was the ultimate fantasy backing the greatest greed. Not only would the real estate prices continue up, but the payments would remain negligible. We Americans love tall tales!

Fannie Mae has just announced two important programs: (1) Those who have existing Fannie Mae loans can refinance them up to 120% of the value, not to exceed $417,000 as long as they are not delinquent. (2) Jumbo loans (maximum $729,750) will be priced at the same prices as the current conforming loans. This could change the mood of the potential buyers as well as the lenders immediately. Because unfortunately too many potential buyers are too scared to venture out until they are satisfied that the problems have ceased and order has been restored. It is too bad that few will learn and fewer still will benefit from all the good that will come from all of the pain. The opportunity to buy houses at prices that we haven’t seen in a decade and finance them with rates that are still historically low will just go to the few courageous people who understand value and the laws of supply and demand. I guess we can chalk it up to human nature and move on.