Boston Mortgage Meltdown

Under the Surface #1

I just added a new category--"illusions." It is going to be an important one. The toughest but most important thing now is to see underneath the surface of what is going on in the mortgage and real estate market breakdown and understand the underlying structure and the primary forces at work that will determine what works to make things better and what doesn't work or makes things worse.

The Boston Globe reports today that the voluntary initiatives on the part of the mortgage industry to work out alternatives to foreclosure had reached 5.2% of the subprime borrowers. Some got renegotiated terms. Others got payment plans. They project numbers will rise.

The numbers are not going to rise high enough or fast enough. In the same issue, the Globe reports 7,563 foreclosures in Massachusetts last year.

This lender initiative is very nice, but it is never going to be enough help arriving soon enough, in spite of the best intentions of those companies. Why? Because that isn't the way they work. Although I would argue that rewriting these loans at a lower level and keeping the houses occupied and off the market IS the best way to maximize their return by keeping markets from completely collapsing, that requires taking the long view. Companies like the ones participating in this initiative work quarter-to-quarter. And in this world the way to maximize your return is to get your properties on the auction block before everyone else does.

Given this, expecting these companies to do widespread workouts and writedowns for troubled borrowers is asking them to work against the grain of what it means to be a for-profit business. It is asking the tiger or zebra or (pick your striped animal) to change its stripes. That is not something in its power to do.

The underlying structure of how these companies work has not changed. The forces they MUST be responsive to hasn't changed. Even if the desire to do the right thing here is genuine, the leaders of these companies cannot deliver it on the needed scale. This lender initiative is an illusion of a solution. The longer it takes to recognize this, the greater the irreparable damage to the local real estate market and every part of the economy that depends on it.

Choosing Trust

The New York Times reports today  that in Baltimore women are disproportionately being affected by the subprime foreclosure crisis. Even hair salons are emptying, as women funnel every dollar into trying to keep up with escalating interest rates and payments so they won't lose their houses, particularly in the Belair-Edison neighborhood, where there aren't a lot of banks. Data has not yet surfaced for Boston but anecdoctal information suggests that will be the case here, too.

These women took the loans that were available to them and trusted the lenders who made them. Both decisions, as it turns out, were mistakes. Lots of people got big fees from those transactions. All these women will end up having gotten is the illusion of ownership of a house for a few short years, if that. Trust will probably be in short supply from now on.

This kind of exploitation is probably what led to the creation of the mutually-owned savings banks, cooperative banks, and credit unions decades ago. Until legislation permitting the conversion of mutually-owned banks to stockholder-owned ones in the early 1980s (a precursor to the Massachusetts version of the S&L crisis later in that decade), Massachusetts had dozens of banks with names like the Workingman's Cooperative Bank and the Such-and-Such Five Cents Savings Bank, particularly in communities with large percentages of working class folks. Small and local, owned by their depositors, they were undoubtedly created as trustworthy alternatives to the loan sharks.

There is some irony that many of these savings banks and coops were among the worst "redliners", vastly reducing or even ceasing to make local mortgages at all when minorities, particularly African-Americans, began to move into those neighborhoods. In many ways, the Community Reinvestment Act was directed at them, not at the big commercial banks that didn't make residential mortgage loans at all. The concept, though, of a bank cooperatively owned by working people themselves being a trustworthy partner in the endeavor to build financial security and wealth, remains a sound one that survives today only in credit unions.

Some leaders in the Massachusetts mortgage industry are extremely concerned that consumers are losing choices as state regulators step up regulation. Last week Indymac Bank and Freedom Mortgage announced that they would no longer do business in the state because of concern about new regulations issued by the Attorney General's office limiting a practice known as "yield spread premiums" where brokers get paid by interest over and above what a borrower qualifies for--the higher the rate they can convince a borrower to accept, the more they get paid. "Consumer choice" hardly seems like the biggest problem here since no consumer who realized they qualified for lower rates (and lower monthly payments) would ever choose such a mortgage, any more than people 100 years ago would have ever "chosen" a loan from a loan shark if they had had other choices.

Working people now, as then, need a choice to be safe and a lender they can trust. Then, as now, that is most likely to be a lender that they own, in conjunction with others like themselves. Good riddance to Indymac and Freedom Mortgage. It would be an exciting development if, out of the rubble of the current subprime and foreclosure crisis, some new institutions would rise: Working Women's Cooperative Bank or, even better, Working People's Cooperative Bank, so working people could have access to lenders whose best interest is the same as theirs, and they could begin to build real--not illusory--financial stability and wealth.

When you don't know what to do, sue......

This past week, Baltimore sued Wells Fargo alleging discrimination against African-Americans, and Cleveland sued 21 lenders under the state's public nuisance law, both in an attempt to get damages to help them clean up the mess that has resulted from massive numbers of foreclosures. Cleveland's law director said it was looking for "at least hundreds of millions." Given the scale of the damage each city faces, with thousands of foreclosures and abandoned houses, it is not hard to understand why they are looking to those responsible for making the bad loans in the first place to help them cope. But does it make sense? Were local governments helpless victims?

The central facts in each case are hard to dispute. In Baltimore, subprime loans went overwhelmingly to people of color who live in places with concentrations of people of color. In Cleveland, entire city blocks of homes abandoned because of foreclosures make clear both the scale of the bad lending and the cost to the city. Whether African-American borrowers in Baltimore might have qualified and actually been able to pay for lower-interest loans than they got, and whether homes in Cleveland would still be occupied if loans had not been made, will be harder to establish.

But it would not be surprising if the lenders turned tables on the local governments and charge that they should have known exactly what was happening several years ago and that they failed to use the power they had to stop it, so are complicit themselves. And if they do that, they will, most probably, be right. The Woodstock Institute in Chicago, a research and advocacy organization focused on issues of lower-income neighborhoods and people, published some of the very first research on the disproportionate amount of subprime lending going to minority people and neighborhoods almost ten years ago. In Boston, U. Mass. Boston professor Jim Campen has been collecting and distributing similar Boston-area data for almost as long. So it would be a surprise if Baltimore and Cleveland had no clue how much subprime lending--by definition, risky loans to financially fragile people--was happening in their cities and to forsee that this would mean high levels of foreclosure.

But the facts are that neither borrowers nor their local governments are likely to ever put the smack on people handing out money by the bucket full, no matter what the consequences are likely to be tomorrow. Everyone--them included--got a pile of dough, either in loan proceeds or tax revenues, when the boom was booming. Only once the money was all gone, did it occur to them to use the power they had all along to move against the lenders, either through regulations or court suits, to halt the riskiest lending.

But, local and state governments would rightly protest, these huge lenders have enough power and money to overwhelm any local initiative taken to protect its communities against the fallout of bad lending. Glenn Simpson's terrific 1/31/07 story in the Wall Street Journal on the $20 million in political donations handed out by Ameriquest and the threats they made to quit doing business to insure that tougher subprime regs in New Jersey and Georgia were relaxed makes painfully clear just how tough protecting local markets is, particularly when times are good and ordinary folks have no idea that their communities are being placed at risk.

So what can a local government do against these 800-pound gorillas? Make very good information about asset-backed loans available in a computer-friendly format that analysts can download and crunch. Then let the analysts do the dirty work identifying the junk loans and rating them that way. If buyers choose to buy the junk anyway, at least they will get paid properly. But most would not and that would limit the instances of wide-scale damage like that now showing up in places like Cleveland and Baltimore.

 

Be Very Scared

Business Week's cover story this week, "Dirty Deeds," chronicles what Buffalo is doing to get foreclosed properties maintained and sold by foreclosing lenders. It brings back terrible memories of the 1970s in Boston's neighborhoods when more than 14,000 properties were abandoned in the wake of the failed BBURG program and the blockbusting that fueled. Some nights we could see 10 or 12 fires from the roof of my Dorchester house. Some of that was arson-for-profit but probably as much was desperate people just trying to get enough to pay off their mortgage and get out. People would come into the CDC where I worked and try to give us the deeds and keys to their houses. In the 70s, the lender was generally the Federal Housing Administration. Forget maintenance. It took them years and years to even figure out what they owned. Even today, acres of vacant lots remain, particularly in Dorchester and Roxbury.

So what is the same?

• homeowners deeply underwater, owing much more than they own
• disorganized or far-away lenders
• no buyers
• properties that now may be worth less on the market than the cost of maintenance
• the threat to the quality of life of the surrounding neighborhoods
• the threat of a declining tax assessments and collection

What appears not to be the same is that the pockets of potential distress are no longer just in low-income inner-city neighborhoods.

In the January 3 www.BostonNOW.com issue, Adeline Enriquez of Community Housing Works, one of the nonprofits empowered by the initiative of Secretary of the Treasury Henry Paulson to modify loan terms for troubled homeowners, said: "You have to be very persistent and call again. They put on the music. They disconnect the phone call. I mean it is a mess."

This is what is standing between us and acres of abandoned houses. We need another plan.

Bad Actors

The Conference of State Bank Supervisors and the American Association of Residential Mortgage Regulators just announced the creation of a Nationwide Mortgage Licensing system intended to improve licensing, supervision, and consumer protection. Massachsuetts is one of the first seven states to join. By the end of 2008, well more than half of the states should be on board. Among other things, it is hoped that the system will identify and put "bad actors" out of the mortgage lending business. It is a start, but only a start.

Some lessons can be gleaned from a predecessor low-tech system--a"bad actors" index card file that examiners in the Mass. Division of Banks kept for years before I was appointed Deputy Commissioner of Banks in 1983. Its purpose was to keep track of the bankers who played fast and loose and who were thought to be responsible for an unusually high amount of bad lending. Examiners gave their banks extra attention. When they switched jobs, the examiner attention followed them. By keeping track of the job switching patterns of the bad actor bankers, examiners were also able to see who the "buddy banks" were that would daisy chain bad loans, for example, so would give loan files in those institutions extra attention, too.

The index card system had two big advantages on the system that was announced this week. First, it connected the lender and the loans. Since loans then still were held in portfolio, it was still possible to hold a lender accountable for the performance of the loans he made. Bankers got dubbed "bad actors" by Division examiners for the concrete reason that they wrote a suspiciously high level of bad loans. Second, by connecting the 'bad actors" with their networks of other bad actors, it gave regulators meaningful intelligence about weak links in the lending system so they could act to prevent losses on a scale that would cause bank failures.

The index card system would not work any longer, of course, since employees of regulated institutions are no longer the only ones lending money, loans are long gone when they go bad so accountability for performance is difficult, and no longer are all the parties local and the responsibility of one regulator. The newly announced system, by being computer-based and shared across regulators and localities, goes part of the way to addressing this problem. But one big problem remains: connecting the lenders to the loan and their networks.

A counterpart to the nationwide mortgage lender registration system has to be a nationwide mortgage registration system. The "fingerprint" of every lender has to stay with every loan, very much the way the payment of every bill shows up on every credit report. Identifying "bad actors" and taking away their licenses has to be automated and automatic if the system is going to be able to identify and stop bad actors before they do too much damage.

A Predictable Crisis

With apologies to Gail Sheehy, the current real estate and mortgage market crisis is nothing more or less than a predictable crisis in the adult life of these markets. It parallels almost exactly what happened in the stock market in the 1920s. Then, buying stock in local companies on local exchanges based on personal knowledge had been eclipsed by transactions on the Wall Street exchanges based on unverified claims and trust. In our day, local finance of local real estate was eclipsed by buying pieces of pools of mortgages assembled nationally and backed by mystery real estate based on unverified claims and trust. In each case, the development of information systems lagged the development of national trading mechanisms. As a result, all the players in these markets were pretty much operating in the dark. Bad things happen in the dark.

What kind of bad things happen?

First, people assume things to be true that, if they were, would create value. They bid on the basis of that assumed value. Unfortunately, the assumptions turn out to be false.

Second, some players in the market intentionally create illusions of value in order to fool prospective buyers into believing that something is more valuable than it really is and pricing on that basis. 

Third, information about the trading takes the place of the nonexistent information about the underlying asset. A claim to value is then supported by the fact that another occupant of the dark has paid such-and-such for it.

Every one of these situations sends the wrong signals to everyone else in the market which then does an increasingly bad job of setting prices on things that accurately reflect underlying value and risk.

If there is a lot of money floating around, this can keep up for quite some time before the-emperor-has-no-clothes moment when the lights go on for some reason and the claims to value are exposed as having no basis.

The correct response to the current crisis is to build an asset (in this case, real estate and mortgage) information system adequate to the demands of a globalizing mortgage market. As Louis Brandeis once said: "Sunlight is the best disinfectant."