Saturday, July 14, 2012

California Subprime Mortgages: A Bad Dream Won't Go Away

The state that spawned the California Gold Rush and "fool's gold," was the center of the subprime mortgage industry,  Although there was a spike in subprime mortgage issuance beginning in 2004, academic researchers have found that some of the worst mortgage products (option ARMs, 80/20 mortgages, and subprime HELOCs) and the absence of documented underwriting standards combined to account for high volumes of toxic products in 2006. 

In the second quarter of 2006, 8 of the 10 top subprime mortgage originators were located in California.  The top 10 orginators issued a staggering $110 billion of mortgages in the quarter, of which 82% came from the California issuers.  Ironically, Wells Fargo Mortgage was the biggest issuer in Q2 2006, with $27 billion, followed by New Century Financial with $14 billion in the quarter; Countrywide was number four with $11 billion in the quarter.  These data are contained in Bankruptcy Examiner Michael Missal's report, which we have cited before as required reading for any serious student of the mortgage crisis. 

New Century Financial writes in its disclosures, that the company is focused on "lending to individuals whose borrowing needs are generally not fulfilled by traditional lending institutions because they do not satisfy the credit, documentation, or other underwriting standards prescribed by conventional mortgage lenders and loan buyers." 

Separately, Professors Mian and Sufi of the University of Chicago Booth School of Business write, "Homeowners with low credit scores in areas with high house price growth from 2002-2006 have seen mortgage default rates climb from almost 4% to almost 15% from 2006-2008." 

In June of 2006, Missal cites an internal finance department email at New Century Financial stating that their weighted average loan to value ratio in the borrower portfolio (combining mortgage and home equity lines of credit) had reached 87%!  Missal notes that there were three CPA's on the Audit Committee, including the Board Chair. CFO Cathy Dodge was a CPA. New Century had built it's model on a foundation of "originate and distribute."  By 2006, loan quality had clearly been falling apart since 2004, and growing "kickbacks" of bad loans from securitized pools by investors threatened the ability to raise cash by unloading the toxic assets to investors, declaring a gain on sale and pumping up earnings.  All of the normal processes and reporting were in place, and yet neither internal audit, the audit committee, nor the external auditor raised any red flags. Everything was fine until the company was near death: then nobody knew what hit them.

Were the borrowers all innocent victims?  I hardly think so.  Most of the mortgages originated by New Century were stated income loans, in other words the borrower gave an annual income number with no verification and the company's independent broker originators did no due diligence.  In addition, this kind of market with this kind of lending attracts the professional fraudsters, who plague credit card companies, rent-to-own companies and direct marketers like Fingerhut. It is a Faustian bargain, because why should the homeowner turn down free money, and why should brokers turn down cash commissions, and why should the management turn down bonuses for reported EPS which is economically fraudulent? 

Professors Mian, Sufi and Trebbi produced a startling and original scholarly research paper in 2009, "The Political Economy of the Mortgage Crisis."    The 2008 "American Homeowner Relief and Foreclosure Prevention Act" passed under President Bush had a "Hope for Homeowners" program which gave strapped mortgagees access to $300 billion in federal agency insurance.  The authors show that while defaults rose in both Democratic and Republican districts, support for the Act by Democrats were "near unanimous" whatever the default rates were in their districts, where Republicans tended to vote in favor where they represented high default rate districts. Mortgage defaults draw lots of bipartisan legislative sympathy, as opposed to credit card debt or student loans, at least historically.  There are a number of interesting trends in their data which are would take too long to discuss in a post.

Expect the full court press to stay on the Mortgage Resolution Partners California bailout plan for the bad actor homeowners in California.  If the executives at the subprime lenders got a free ride, why not them?  And now we have the massively incompetent (or worse)  managers of San Bernardino adding their two cents,
"We are intrigued," said Gregory Devereaux, chief executive of San Bernardino County, which is east of Los Angeles and has one of the highest unemployment rates in the state. "Our economy in this county can't be turned around until a large proportion of the mortgage crisis has been addressed."

No, Greg, the municapal finance crisis can't be turned around until San Bernardino gets control over its employee salaries and benefits and scales services at a level consistent with an economically sensitive tax base.

Be afraid, as this giveaway is not going away. 

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