On the Money Trail
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Predatory Lending: Observation of a Calamity
by Al Jacobs, author of Nobody's Fool
February 2008

Welcome to the aftermath.  With an estimated 2½ million American homeowners in danger of defaulting on their mortgage loans, to be followed by an unprecedented number of foreclosures, the possibility of real estate chaos looms.  Many of the people in danger used subprime loans to buy homes.  Subprime borrowers are typically people with poor credit, otherwise unable to afford a home. Those same people may now lose their homes because the subprime loan rates fluctuate, causing substantial increases in mortgage payments.

There’s no shortage of proposed solutions or self-proclaimed champions.  On Monday, December 5, 2007, New York Senator and presidential hopeful Hillary Clinton proposed a 90-day moratorium on home foreclosures, granting troubled homeowners additional time to work out difficulties with their lenders.  The following day President Bush announced a two-year hold on mortgage interest rates to help people in danger of losing their homes.  A scant nine days afterward, the Senate voted to make it easier for thousands of homeowners with ballooning interest rates to refinance into federally insured loans.  Not to be upstaged, on December 19th, Senator Charles E. Schumer, member of the Senate Finance Committee and the Senate Committee on Banking, Housing, and Urban Affairs, called for a more robust government role in responding to the subprime mortgage crisis, ridiculing the Bush administration's efforts to help homeowners at risk of foreclosure, while advocating tighter regulation of the mortgage industry.  And during the first week in January 2008, in keeping with the late comic Jimmy Durante’s assertion that “everyone wants to get into the act,” Rhode Island and Idaho, along with five other states, instituted a Registry for Lenders, designed to stop abusive lending practices by tracking unethical loan originators.  The landscape is just now beginning to churn.

How did we come to this?  What flaw in the mortgage industry enabled millions of borrowers to acquire unaffordable home loans?  This only makes sense if you understand how the modern lending industry functions.  The time is long past when home loan money came from a local bank whose depositors provided the necessary funds.  In that earlier era, the institution which approved and thereafter serviced each loan incurred an obligation that lasted the life of the obligation.  It served the interests of all participants that loans be soundly created and faithfully paid.  That’s no longer the case in this sophisticated world we occupy.  The changes that began during the Great Depression of the 1930s dramatically altered the relationship between borrower and lender.  Government involvement is today an integral part of the lending process, mandating a host of specialists to facilitate various functions.  These functions now take on a life of their own and the profits they generate dictate the viability of the loan.

Let’s analyze this carefully.  Who actually profits when an inherently worthless loan is created?  The first person to receive compensation is the appraiser who verifies the value of the property as adequate to secure the loan.  Next is the escrow company that earns a fee for simply processing documents.  A property inspector who certifies various mechanical and structural conditions will be assured of a portion of the earnings to be spread around.  If the loan is contingent upon sale of the property, at least one real estate agent will likely collect a commission.  A mortgage loan broker will share in any points assessed by the lender.  The company that issues a title policy will receive a portion of the closing charges.  Add to the list of potential beneficiaries many others: homeowner associations, local taxing agencies, loan service enterprises, county recorders, mortgage insurance companies—the list seems endless.

Of course you’ll contend that, despite a host of ancillary firms and individuals profiting from a piece of the action, the actual lender will, for pure self-protection, ensure that each loan is well-secured and that the borrower’s best interest is to honor the obligation.  You might think so, but you’d be ignoring how the mortgage market actually functions in the 21st Century.  To understand this, you must distinguish between a “mortgage lender” and a “mortgage holder.”  The lender creates the loan, and in doing so receives a fee along with the ability to market it.  In the absence of a contractual obligation in the event of later default, the lender is home free as soon as the loan is sold to another party.  For this reason, you may add the lender to the list of beneficiaries of a valueless mortgage loan, for it’s only the holder that eventually takes the hit.  Identifying the holder—the person or entity that actually loses when the loan goes bad—is a bit trickier.  For this, we must consider how the originating lenders dispose of the notes they create.  By and large they are packaged by the thousands and sold through Wall Street financial organizations such as Bear Stearns, Merrill Lynch, and Morgan Stanley, for inclusion in a pension fund, mutual fund, or hedge fund.

This finally gets us down to the actual holders at risk.  They are the millions of Americans whose IRA and 401(k) accounts are invested in the various funds that purchase these mortgage-backed securities.  When hundreds of thousands of sub-prime borrowers fail to make their monthly installment payments, it will adversely affect the value of these funds.  The losers, of course, are ordinary citizens with no involvement in the creation of these loan packages, and are largely unaware that their assets—often their life savings—are at risk.

As a final thought, I’ll offer this prediction as to the outcome of the efforts currently expended by the nation’s politicians to safeguard those victimized by predatory lending practices: Speeches will be delivered.  Legislation will be enacted.  Executive policies will be formulated.  And all the while it will be business as usual as the mortgage industry bobs and weaves its way, largely unscathed, through the fracas.

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Al Jacobs has been an entrepreneur for forty years. His business experience ranges from property management and securities investment to appraisal, civil engineering, and the operation of a private trust company. In his book, Nobody's Fool - A Skeptic's Guide to Prosperity, Al presents his Ten Ground Rules for Success for achieving wealth and a prosperous life by outlining a philosophy for spending, borrowing, making sound investments, and how to avoid being victimized by America's many intimidating institutions.