Financial Crisis Partly Caused by Reckless Mortgage Lending
TASA ID: 685
The financial crisis in the financial markets in the United States has been caused by a number of factors. This presentation will be limited to a discussion of the reckless mortgage lending that has been one of the primary causes of this financial crisis with the intent to review possible litigation opportunities.
When I first was involved in mortgage lending, I was employed as a senior officer with a savings and loan association in Houston, Texas, which was over thirty years ago. The underwriting for single-family mortgage loans was a very defined and standard practice in the industry with specific financial ratios that had to be met in order for families to qualify for a mortgage loan. Additionally, the primary financial information provided to the lender by the borrowers was verified for accuracy. Delinquency problems with properly underwritten mortgage loans were generally rare, except in times of economic downturns or other external conditions, like loss of jobs.
The two financial ratios widely used by mortgage lenders during that time frame related to gross monthly income of the borrower and the monthly debt service obligations. The first ratio is the ratio of the monthly mortgage payment, including taxes and insurance, compared to the borrower's gross monthly income. The maximum permitted ratio of monthly mortgage payment divided by gross monthly income was twenty-five percent. Thus, if a family had gross monthly income of $5,000, they could qualify for a mortgage loan, assuming all other requirements were met, with a total monthly payment of $1,250.00.
However, before the borrower could be judged as qualifying for a mortgage loan with a monthly payment of $1,250, a computation of the second financial ratio was required. That ratio added the monthly mortgage payment to the total of the borrower's other monthly debt service obligations. Thus, the second ratio was a computation of total monthly payments divided by gross monthly payments, and that ratio was limited to a maximum of thirty-five percent. Using the example of gross monthly income of $5,000, the total monthly payment obligations could not exceed thirty-five percent, or in this case $1,750.
Additionally, the borrower was required to complete a standard form residential mortgage application, which included financial information about the borrower's assets and liabilities. Verification of bank deposits, employment including salary, and tax returns to further verify income was required. A credit report was obtained and compared to the debt obligations listed on the loan application, as well as payment history.
The mortgage lender would obtain an appraisal of the property, using either internally employed appraisers, or outside appraisers who were on the lender's approved list of appraisers. The loan-to-appraised value generally would be limited to eighty percent, but could be higher percentages if private mortgage insurance was obtained to insure the amount at risk over eighty percent. Thus, the value of the home being financed was generally not an issue relative to defaults and foreclosures.
These lending principles were usually defined in loan policy and procedure manuals, which, in my experience, were standard throughout the mortgage lending industry. Thus, when mortgage lenders bought and sold mortgage loans in the secondary market, the lenders could be assured that the standard underwriting had been performed by the originating lender.
The current financial crisis on Wall Street, in other lending institutions, and experienced by investors and across the United States has in part been caused by reckless mortgage lending by many lenders who have originated mortgage loans and sold those loans, either directly to other lenders and investors, or sold those mortgage loans in the secondary market via securitizations. This reckless lending activity has caused Wall Street investment banks, commercial banks, insurance companies, mortgage companies and others to loss billions of dollars due to mortgage loan underwriting abuses.
What Caused the Large Financial Losses?
The questions are: what happened to cause these large financial losses, and who is to blame? First, what happened to cause these enormous financial losses was a near collapse of the standard underwriting practices described above. The evolution of the subprime mortgage market caused a feeding frenzy among lenders trying to originate and sell mortgages that did not conform to the standard lending practices.
A subprime mortgage loan, by definition, is a mortgage loan approved for a borrower whose credit background (payment history) and/or income does not meet the standards generally applied for prime mortgage borrowers, which means this is a much riskier loan relative to likelihood of defaults and/or foreclosure. Subprime lending began as far back as in the 1980s, but became a much more popular form of lending beginning in the 1990s.
As this form of lending increased in the late 1990's and early 2000's, lenders began to move away from the standard and prudent lending practices by approving loans to borrowers who did not meet the standard credit and income criteria. This type of loan has been branded a subprime loan, which has more risk of nonpayment, and generally will have a higher interest rate, which means the monthly payments are higher than for prime borrowers.
To entice subprime borrowers to accept higher interest rates, the lenders offer "teaser interest rates" on a floating rate basis, as compared to the standard fixed rate loan. The floating rate mortgage loans are referred to as adjustable rate mortgages ("ARMs"). Generally, an ARM initially has an interest rate below the market rate to tease or entice the borrower to accept the ARM. However, the interest rate on an ARM can be increased at defined time frames of up to several points, sometimes as much as six percent. Thus, an ARM that starts out with a four percent rate could be increased over time to a rate of ten percent. For a $100,000 mortgage the monthly payment, not including taxes and insurance, could increase from $477.42 per month to almost double at $877.42.
As mortgage lenders began loosening underwriting requirements, and began accepting drive-by or windshield appraisals from unknown appraisers, the credit quality of the borrowers and the assurance of the value of the homes began to deteriorate.
"Liar loans" is a term of art that has been developed to describe a part of the subprime lending market. Mortgage lenders began to accept loan applications without the verification process to verify the financial information provided to the mortgage lenders by the borrowers. Thus, a borrower could state that his gross monthly income was $5,000, which was the number required to meet the underwriting guidelines in order to qualify for the mortgage loan amount being requested. The mortgage lender would accept that income number without verifying that it was a correct amount, when in fact the borrower had overstated his monthly income in order to qualify for the requested loan.
The second step in the development of the subprime mortgage lending crisis was the acceptance of appraisals that did not meet industry standards and requirements. These windshield appraisals were made by less-than-competent appraisers by driving by the house, but not making the generally required inspections and proper comparison to comparable house values.
Why would a mortgage lender originate a subprime mortgage loan when the lender did not know if the financial information being provided by the borrower was correct? The simple answer is greed and a system of checks and balances that was out of control.
First, greed. Mortgage lenders found that they could originate these liar loans and sell them in the secondary market, which provided these mortgage lenders with additional fee income and no exposure to delinquencies or foreclosures because the liar loans were sold in the secondary market. Thus, the more liar loans that would be originated and sold, the more money the mortgage lenders could make with no financial exposure, except in case of fraud.
Second, the system of checks and balances that had been in place for decades was circumvented. When a lender or mortgage broker originated a mortgage loan, the loan file would have all of the necessary financial information with verifications. With the liar loans, that information was not available to investors. Generally, there is a contract between the buyer and the seller of the package of mortgage loans that requires the seller to provide certain warranties, including to warrant that a proper credit underwriting standards had been done.
In the case where groups of mortgages are securitized and sold as bonds to investors, credit enhancement is provided by rating agencies, like Moody's or Standard & Poors. This credit rating in many cases overstated the quality of the potential stream of income from the individual borrowers' monthly payments, which is the end result of the financial meltdown experienced in the financial markets that represent front page bad news.
Who is to Blame for the Large Financial Losses?
Who is to blame for the large financial losses incurred by almost everyone involved in originating, selling, and purchasing of subprime mortgage loans, and what opportunities are there for litigation? The simple answer is everyone in the food chain who originated, sold, or provided credit enhancement for the subprime mortgage loan disaster may be a candidate for litigation.
Each group of mortgage loans that experienced heavy defaults and possible foreclosures followed a similar, or perhaps a different path to the ultimate occurrences of financial losses. The problem is to find entities along this food chain that are solvent and have sufficient net worth and/or insurance protection to ultimately pay judgments that may be awarded to plaintiffs by courts or through settlements. Class action opportunities may exist.
There are numerous financial institutions that originated these subprime mortgage loans that probably did not follow standard industry underwriting, and/or did not follow their own underwriting policies and guidelines. To the extent those lenders are still financially viable, those may be target entities ripe for litigation.
The second level of purchasers of these types of subprime mortgages, to the degree that they are financially solvent, are also potential targets for litigation. Likewise, this second level of financial institutions may be possible candidates to be plaintiffs looking back to the solvent sellers of the mortgage loans for financial restitution.
The financial entities that packaged the mortgage loans and sold them in the secondary market should be prime targets to the degree that they still are financially solvent. A review of their due diligence, or lack thereof, should provide evidence to use in litigation.
The credit rating agencies should bear responsibility for potential over-rating these securitizations of mortgage loans when a review of the underwriting and credit information available should prove that the rating agencies did not perform proper due diligence before assigning the high rating for the bonds.
The governmental agencies, Fannie Mae and Freddie Mack, may be possible targets, if permitted by law to be defendants. It is very probable that their files will show poor or inadequate underwriting of the mortgage loans they insured.
Finally, one other potential group of plaintiffs is the shareholders of the large financial institutions, whose stock value has been severely and adversely affected by the crash of the mortgage loan market.
In summary, subprime lending and the relaxing of prudent underwriting standards have led to needlessly large financial losses for a number of different types of financial institutions, investors, and others. Properly developed litigation may provide recourse to recover large financial losses.
This article discusses issues of general interest and does not give any specific legal, medical, or business advice pertaining to any specific circumstances. Before acting upon any of its information, you should obtain appropriate advice from a lawyer or other qualified professional.
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