Let's Raise the Hood on Mortgage Lending
Like it or not, we've become a nation fixated on investigations. Congress in particular, taking its oversight role perhaps a little too seriously, has all manner of inquiries going at any given time. The most recent -- and perhaps the most questionable -- involves a look-see by a Senate committee into potentially self-serving activities by a group of half a dozen televangelists.
Fine, investigate the TV preachers if you must -- although targeting that group in hopes of unconvering some sort of income-tax or truth-in-sermonizing violations appears a little absurd for members of this purportedly august group. But what about mortgage brokers and lenders? This crew is appearing more culpable by the day for the subprime mortgage wounds that have bled over too much of our economy. That, it seems to me, is where the senators might better expend their efforts.
Until recently, my conclusion was that the subprime infestation was simply a circumstance of cyclicality: The system had been working as it should -- that is, until home prices stopped increasing linearly, catching all manner of borrowers in bad positions when the music stopped. But a Wall Street Journal article published last week has led me to believe that there really are identifiable culprits in the subprime rot.
At this juncture, I'd be hard-pressed to state precisely where the bodies are buried in this mess. But I think we should start with an analysis of the practices of the major lenders, including, of course, Countrywide (NYSE: CFC), Washington Mutual (NYSE: WM), Wells Fargo (NYSE: WFC), and JPMorgan Chase (NYSE: JPM). And let's not forget that army of brokers who worked with the individual mortgagees. Beyond that, we should clearly take a gander at those who securitized the mortgages, including the likes of Goldman Sachs (NYSE: GS), Merrill Lynch (NYSE: MER), etc.
According to the Journal, in 2005, fully 55% of subprime mortgages that were ultimately packaged into securities to feed the voracious appetites of investors went to borrowers with scores that could have qualified them for cheaper conventional loans. In 2006, that proportion moved to 61%, nearly half again higher than it had been in the first year of the decade.
Further, the article also contains a number of other sobering revelations:
- Brokers frequently operated under compensation schemes that rewarded them for pushing borrowers toward loans carrying higher interest rates than they should have been charged.
- An analysis by Fitch Ratings of 45 subprime loans that lurched into default, despite the borrowers' having credit scores that theoretically should have put them into conforming loans, indicated a prevalence of misrepresentation in the origination process.
- A New Century rate sheet from last March (that was not intended for public disclosure) promised brokers a "yield spread premium" for putting borrowers into loans with interest rates above the lender's listed rates.
- In an era when we're prone to regulate almost any transaction of any type between two or more parties, in most states, mortgage brokers or lenders have no obligation to steer lenders toward the mortgage that's most appropriate for them.
So, I'm admittedly in a quandary, Fools. On the one hand, I'm opposed to regulatory oversight of almost any industry. My experience has been that, when government at any level begins meddling in an area of commerce, that area is soon on the way to higher prices, lower quality, or both.
Control tower to lender
But in this case, I believe that the various sectors of the mortgage business have demonstrated in spades that they're generally unsuited for flying without control-tower supervision. Of course, although it's been conveniently forgotten, the industry was pushed by members of the administration and the preacher-investigating Congress to participate in raising home ownership toward what was considered a magic 70% level.
Beyond that, the system of subprime adjustable-rate mortgages, with the down payment often tied to piggyback loans -- such that borrowers frequently waltzed into their new homes with nary a dime of their own cash forked over -- worked well as long as home prices headed steadily higher. But as they say, all good things must come to an end, and they've clearly done so for housing.
With the idea that the system must be fixed, we first have to establish who or what went wrong. We will clearly be able to do that best by raising the investigative hood on all segments of the mortgage industry and attempting to repair what's broken. But until that's accomplished, I'd recommend that Fools give a wide berth to investments in the lenders, the homebuilders, and perhaps most areas of financial services that haven't been thoroughly fumigated.
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