In Mortgage Lending, it has always been said that the two largest purchases families will ever make are homes and cars. Since the 1900’s, those two items have not only revolutionized the way we live but also the way we spend. In 1901, the Oldsmobile sold for $650 which works out to be approximately $16,000 in today’s dollars. Home prices were on the average of $5000. In 2010, the average home price peaked to a historic high of $190,000. New car prices hit highs of $30,000 in 2012.
What helped the values soar so high?
The Housing Hour points to its own terminology, The Liquidity Factor. The Liquidity Factor is the ready availability of loanable funds made possible by the Federal Government, through varied techniques of government policies and created business entities, which help individuals and companies purchase goods and services that they otherwise would not be able to afford. Simply put, without liquidity in the marketplace buyers only options are to pay with cash. No liquidity means values stay at the levels of what consumers can afford to pay in cash.
The liquidity factor is the key to mortgage lending and home ownership.
The history of Mortgage Lending and The Liquidity Factor.
Mortgage Lending has several historic moments worth noting since the 1900’s. The most remarkable pieces of information revolve around long term financing options available in the 1900’s, there weren’t any. Mortgage Banks were formed in the 1870’s to help finance the expanding western territories, but they never offered ‘long term’ financing. It trended to be in the 5 to 10 year term range. But unsound underwriting guidelines caused a high default rates which led to the demise of these Mortgage Banks by the 1900’s, resulting in homes having to be purchased with cash.
It wasn’t until the roaring 20’s that expanding credit markets created enough liquidity to spur a mini real estate boom. Insurance Companies saw an opportunity to capitalize on the housing market bubble and got into the home lending field. But whatever a robust market giveth, a declining market taketh away. Black Tuesday struck, leading to The Great Depression. High unemployment and acute deflation caused high foreclosure rates, which collapsed the home lending market for a second time in 30 years. Facing a country wide crisis, the Federal Government created their own 1929 version of TARP, Troubled Asset Relief Program with the creation of The Home Owners’ Loan Corporation and Reconstruction Finance Corporation (RFC). These entities (like TARP) sole jobs were to liquidate non performing loans and remove them from the Banks ledgers keeping the banks from insolvency. They were toxic assets. Interestingly enough, home owners took advantage of this bailout opportunity and intentionally defaulted on their loan. These created government entities are estimated to have purchased over one million mortgages from banks.
The government buying toxic assets may keep the banks from insolvency but it doesn’t cure the lack of liquidity in the market place. No liquidity means no lending, so the Hoover administration started to form form (Roosevelt signed into law) the Federal Home Loan Bank. The main goal of the FHLB was to supply the needed liquidity to banks and Savings and Loans, as well as requiring specific lending guidelines, such as mortgage term limits of 10-15 years, as well as other stringent policies. The main lending institutions benefiting were the Savings and Loans. The S&L’s grew rapidly across the country, serving small community areas, creating a small town ‘good ole’ boy feel. Each S&L were owned and managed privately by individuals or groups, giving great control to the board of directors and president. But the expanding S&L’s demanded more flexibility from the government. The S&L’s were not full service banks. They could not offer checking accounts and other typical banking products. As a result of Banks and S&L’s waging a savings rate war, Congress, in 1966, regulated and limited the amount that banks and S&L’s could pay to customers. However, as a carrot to preserve their savings and lending, the S&L’s were given an award by the Federal Government with permission to increase the savings rate paid to customers in the amount 50 basis points over what traditional banks could offer their saving account customers. This regulation was known as Regulation Q. But the intentions of the regulation were more than just an award for the S&L’s; it also served as a back door liquidity technique. Regulation Q created a cash rich environment for the S&L’s and helped secure them as the leading mortgage lending institution in the nation, supplying the market with the necessary liquidity until the collapse of the S&L’s in the ‘80’s, paving the way for the expansion of FNMA and Freddie Mac.
At the peak of the Great Depression, the Hoover administration realized the importance of the liquidity factor. Their policies bolstered the S&L’s, securing them as the main channel to provide the necessary liquidity to the mortgage market. The Federal Home Loan Bank supplied millions of dollars to the local banks and Savings and Loans for lending.
The importance of the S&L’s was, unintentionally, immortalized in the holiday classic, It’s A Wonderful Life. George Bailey was struggling to save his father’s Building and Loan business (essentially a Savings and Loan) from being taken over by the evil Henry Potter. George Bailey’s father built the business around the principle that the common worker needed the ability to borrow money for a better home and quality of life rather than living in the horrid conditions of Henry Potter’s slumlord developments. Mr. Potter, being a significant shareholder in the Bailey family Building and Loan, admonishes the board for lending money to the ‘rabble’ types (or the lower classes; the common people) that live in Bedford Falls.
In the famous scene, George Bailey rallies the board with the inspiring lines directed toward Mr. Potter, “You… you said… They had to wait and save their money before they even ought to think of a decent home. Wait? Wait for what? Until their children grow up and leave them? Until they’re so old and broken down that they… Do you know how long it takes a working man to save $5,000? Just remember this, Mr. Potter, that this rabble you’re talking about… they do most of the working and paying and living and dying in this community. Well, is it too much to have them work and pay and live and die in a couple of decent rooms and a bath?” Watch the full scene:
This scene typifies the great American dream that everyone should have the same opportunity to own their own home. George even points out what current research has verified when he asks the board a simple question “…doesn’t it make them better citizens?”Home ownership has social benefits and every president from Herbert Hoover to present has tried to further that sentiment.
But the scene also points out, inadvertently, the weakness of the Savings and Loan. That weakness was its localized business philosophy: meaning the small town, ‘good ol boy ‘ way of doing business. In every community across the country, S&L’s were the dominant player in the savings and lending business. Decisions were often based on who you knew or a set of standards and dynamics that was specific to a particular area or community.
When Roosevelt was elected in 1933, policies regarding how to supply the mortgage lending market with liquidity changed. Roosevelt saw the disadvantages of the small town, local S&L’s and opted for a national standardized way of supplying liquidity. In 1934, The National Housing Act was authorized which created three particularly significant changes to the housing market. First, the Federal Housing Administration (FHA) was formed to improve housing standards and to insure the mortgages against default to the lenders, bringing stability to the financing market. Fixed rate loans were introduced with terms in excess of 20 years and smaller down payment requirements. Lastly, a government sponsored enterprise (GSE) was authorized to purchase originated mortgages from lenders and securitization of those loans in the form of Mortgage Backed Securities (MBS).
In 1937, the Federal National Mortgage Association (FNMA or Fannie Mae, a GSE) was created to provide liquidity to the mortgage market by buying the newly originated FHA loans from lenders. This technique gave the lender the ability to replenish their cash assets so they could continue to provide additional FHA loans. FNMA, at that time, only bought FHA loans and did not enter the conventional financing market until 1970 when her younger brother, Federal Home Loan Mortgage Corporation (FHLMC or Freddie Mac), another GSE, was formed. As a result of the expansion of the GSE’s role in the liquidity market, Fannie Mae and Freddie Mac became the largest private mortgage companies in the country. Although the GSE’s are publicly traded and non-government owned, the US government gives its full backing to the loan products they purchase. The full backing of the US makes these mortgage bond investments one of the best investment choices in the domestic and foreign markets.
It is essential to note, the commercial banks were generally the only lending institution participating in the newly created FHA loans. The majority of the S&L’s continued with their long developed business practice of keeping originated mortgage products on their books. If they needed to create liquidity, they just sold their portfolio loans to other S&L’s across the country. This decision to not participate in government loans and the diversified liquidity it would provide them would play a future key role in the collapse of the S&L’s.
The strength of the S&L’s and their mortgage lending market share soared from post-World War II until 1965. The National Housing Act was a crucial first step to turning the Liquidity Factor from local markets to national markets, but the transition was extremely slow. When WWII ended, and millions of servicemen returned home, a housing boom ensued, caused mainly by a baby boom. The post war housing expansion was primarily funded by the S&L’s. S&L’s continued to grow in numbers and worth by offering saving rates that typically were higher than banks. By 1965, the S&L’s had over 26% of the savings customers and a historic high of 46% of the mortgage lending market. Banks and S&L’s were battling for savings account customers, but the S&L’s were winning the rate war. Customers took advantage of the fight until the government thought it necessary to step in and end the rate war in 1966. Regulation Q was passed to limit the rate of returns these institutions could pay to their customers. But, as stated in Part I, the government gave the S&L’s a 50 basis points rate advantage over the banks. This advantage enabled the S&L’s to maintain their dominance, particularly in the mortgage lending market. Yet, there was a deliberate limiting feature to Regulation Q and it had an effect on the number of S&L’s from 1965-1979, dropping the actual numbers of institutions from approximately 6000 to 4700. However, innovative business practices caused the assets of the S&L’s to grow.
But change was coming. Inflation was on the rise, causing stress in the S&L’s by the mid 70′s. Inflation erodes the interest returns on fixed savings accounts and other fixed investments, like the below market fixed rate mortgages that the S&L’s were holding. Those savings customers, for whom the S&L’s had fought so hard for during the rate wars, were now looking for other methods of interest income. The locked in nature of the Certificates of Deposits which were the bread and butter of the S&L’s for the past 20 years were now prison cells to consumers, as high inflation rates stripped them of interest income and Regulation Q prevented the S&L’s to renegotiate the savings rates. The S&L’s found themselves, for the first time in their history, trapped by the very regulation that they had profited from in the past.
Additionally, there was more distressing news on the horizon for the S&L’s. As inflation started to appear, so did a new type of investment institution, the investment bank. A new investment product came to the attention of savings customers, the Money Market Mutual Funds (MMMF). The MMMF’s were highly liquid, paying current market rates with no early withdraw penalties and they were all outside the control of Regulation Q. The S&L’s were caught flat footed. The investment banks were now able to offer market rate returns to their customers by taking full advantage of the high interest rate market caused by inflation. When asked the question, ‘What, in your opinion, caused the collapse of the S&L’s?’ Stephen (Steve) R. Smith, CMB,Executive Vice President, Retail Sales & Production with Mortgage Investors Group and former top executive of an S&L in the ’80′s replied, “In a word, disintermediation.” Smith went on to explain what disintermediation meant, “….saving account customers poured out of the S&L’s and into the investment banks. The effects were devastating and in the end, insurmountable.”
The dominoes of the S&L’s slowly began to fall. In Part II, the point was made that the S&L’s did not participate in selling their mortgage loans to FNMA but chose to keep them, as assets, on their books. If they needed to free up money or liquidity, they sold to other S&L’s. But as a result of disintermediation, no S&L had any cash to buy, they were suffering the same fate: the threat of insolvency.
The only thing to stem the tide was deregulation, but it came too late and it came in pieces. There were numerous attempts by the government to help supply ballast for the listing S&L’s. In the early to mid-1970′s, the S&L’s were allowed to offer checking accounts, engage in commercial lending, make limited investments in land development and construction as well as educational type loans. These changes helped the S&L’s to develop diversified business practices, but Regulation Q was still the governing burden. The main source of their solvency continued to be the savings account customers and mortgage holdings, and by 1979, double digit inflation was wreaking havoc on these fixed rate investments.
Renewed hope appeared in March of 1980 with the first deregulation attempt to save the S&L’s, Deregulation and Money Control Act. The Act allowed the S&L’s to pay market interest rates to their savings customers in hopes to curb their moving to the investment banks. The act restored some confidence, but it only addressed half the issue, it did not address all those millions of dollars of under-performing fixed rate loans that were still on the S&L’s books. There was certainly no hurry for homeowners to pay off these low interest rate loans and there were no commercial buyers to purchase the mortgage paper from the S&L’s. Steve Smith supplies an anecdotal example of the dilemma the S&L’s faced, “…we used to joke that our business plan was based on 3-2-1, we loan money at a rate of 3, we pay savers at a rate of 2 and go play golf at 1, but when inflation hit and then deregulation, our model changed to 3-9-0, we were bleeding badly and couldn’t afford to play golf.”
It took 2 years for the government to deregulate the lending restrictions for the S&L’s. Reagan signed a new law giving the S&L’s additional flexibilities, namely the much needed adjustable rate mortgage. This type of mortgage allows the lender to move the interest rate to match market conditions, such as inflationary pressures, protecting the lender from a below market fixed rate investment. However, there was still no help for thousands of fixed rate loans that were trapped on the S&L’s books. But the new law gave the S&L’s ability to expand into more speculative business enterprises. By the mid 80′s, the speculative nature of the S&L’s along with poor business decisions and fraud sealed the inevitable collapse of the S&L’s. “The fraud was symptomatic of an existing systemic problem….” explains Smith, “…by the early to mid ’80′s we were trying to create revenue given the new advantages offered by deregulation. Certainly some didn’t play by the rules, but there was desperation throughout the industry. Inflation and the inability to react to it was an unintended consequence of government regulation and ultimately, in my opinion, the cause of the collapse. “
Although the S&L collapse caused great financial hardships, including the use of US taxpayer’s money for bailouts, it did not create liquidity void for mortgage lending markets. The expansion of the GSE’s, FNMA and the newly created Freddie Mac in 1970′s, allowed the vision of Roosevelt to finally be realized, the switch from local liquidity markets to a nationally controlled market.
When the smoke finally cleared from the destruction of the S&L’s in the late 80′s early 90′s, FNMA and Freddie Mac were solidly in place. It took 36 years for Roosevelt’s national liquidity vision to be realized. The 90′s brought hope of a new mortgage lending era with cutting edge technologies and an internet system that connected the world. FNMA and Freddie Mac incorporated the national credit scoring system along with property valuation models into their automated underwriting systems (AUS) to produce a streamlined approval process. This total automated system was intended to take all the guess work out of analyzing risk, which in turn, would reduce costs of originating and selling loans. These cost savings could be passed through to the consumer in the form of cheaper interest rates and closing costs, as well as eventually finding their way into the profits of lenders, FNMA/Freddie Mac, bond traders and ultimately the end investor. The other important feature was the complete automated nature of the system with its ability to expand or contract its guideline through simple tweaking of the computer models. In the early 90′s, pressure from the Clinton administration for a National Home Ownership Strategy was developed. This complete housing overhaul consisted of over 100 action items and over 50 industry wide corporate partnerships signing their support. The new initiative was known as the American Dream Commitment. By 2004, continued expansion of the commitment was evident in FNMA mission statement, “We at Fannie Mae are in the American Dream business. Our mission is to tear down barriers, lower costs, and increase the opportunities for home ownership and affordable rental housing for all Americans”. With this new mantra and fresh momentum, backed by policy makers and trillions of dollars, the housing bubble years were inflating. The most aggressive part of the mission statement from FNMA was, ‘…tear down barriers…’ and ‘…for all Americans.’. The barriers could be easily torn down by simple manipulation of the automated systems resulting in achieving the second point, more Americans becoming eligible for mortgage loans almost overnight.
In the past, FNMA/Freddie Mac were always known as the world supplier of ‘AAA rated’ Mortgage Backed Securities meaning the best loans available for securitization, the cream of the crop. They were referred to in the vernacular as: ‘A’ paper or prime paper. By Y2K, FNMA/Freddie Mac entered the less than prime business called Alt-A or A minus. Alt-A is defined as not A paper but better than C through D paper. There were private lenders who did specialize in loans referred to as: non-traditional, ‘C/D’ paper or the popular term, sub-prime, but these loans were consider high risk, niche products. The sub-prime market could charge higher interest rates and more closing costs depending on the degree of risk to the lender. However, by the late ’90′s, credit scoring models gave the sub-prime lenders an easier ability to analyze risk. These lenders were able to expand their origination numbers by creating automated underwriting systems, similar to FNMA/Freddie Mac, based on their own sub-prime risk criteria.
The sub-prime loans were traded much like the prime loans but through Private-Label Mortgage-backed securities (PL-MBS) as created by the 1984 Secondary Mortgage Market Security Act(SMMSA). The SMMSA was a loosely government created policy allowing private institutional investors more freedom to compete in the Government dominated MBS markets. The SMMSA was basically an attempt to supply private liquidity to investors for the national liquidity markets. In a similar sense, the Private-Label -MBS were what the S&Ls were to the liquidity market before their fall, except for the fact the Private -Label MBS were securitized and traded worldwide. Investors with large appetites for higher interest returns flocked to the sub-prime markets. In 2001, the Private-Label MBS market had a small 20% market share but by 2006 their market share soared to 56%, suggesting the sub-prime primordial world was strongly competing for investment dollars with the conforming loan markets. Pressure for profits and from government policies propelled FNMA/Freddie Mac to review its policy on purchase of Private-Label MBS bonds.
As early as 2001, FNMA/Freddie Mac were purchasing sub-prime mortgages from the Private-Label MBS pools. But according to The Financial Crisis Inquiry Report, FNMA’s purchase of sub-prime loans only represented a relatively small 10.5% of total sub-prime loans originated. By 2004, FNMA exposure rose to a 40% high before dropping back to 28% by 2008. However, between 2001 and 2008 FNMA/Freddie Mac significantly dropped their guidelines to allow riskier loans to be purchased and securitized by the GSEs. In a 2 year span between 2005 and 2007, FNMA/Freddie Mac had purchased close to a trillion dollars in Alt A and sub-prime loans; a level that could not be sustained. Private-Label MBS had decreased to less than 10% market share in 2008 but by that time, the worlds financial markets were flooded with assets that would soon turn toxic.
As reported in the Inquiry, FNMA and Freddie Mac were motivated by a need, “to meet stock market analysts’ and investors’ expectations for growth, to regain market share, and to ensure generous compensation for their executives and employees—justifying their activities on the broad and sustained public policy support for home ownership.”
By 2008, the GSEs and the Private-Labels MBS were collapsing.
Click: The Liquidity Factor Series