HOUSING & THE CREDIT CRISIS - BUILDING A NATIONAL RAIL MANHATTAN'S OFFICE LEASING MARKET
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FEATURE
$5.99 | 2009: volume two
HOUSING &
THE CREDIT
CRISIS
MANHATTAN’S
OFFICE LEASING
MARKET
BUILDING A
NATIONAL RAIL
SYSTEM 1
2009: volume two
2 Contributors
4 editor’s notes
FEatures
6 Mortgages, Finance Markets, and the Imperative of Growth
The new mortgage-backed securities were supposed to have been low-risk investments.
By Hugh Kelly
12 Burning Down the House
First and foremost, trust, confidence, and stability must be restored
in the mortgage transaction.
By Sarah Gerecke
18 Fannie Mae and Freddie Mac
The mortgage agencies are best understood within the deposit insurance model.
We cannot avoid guarantees, and we probably should not want to, but we need to
control their costs.
By Robert Van Order
24 BUILDING A National Rail System
Incremental improvements, not high speed rail alone, are the best approach to
improving rail access.
By John V.N. Philip
conversations
30 Manhattan’s Office Leasing Market
Everything is available, at much lower rents and better terms.
A Panel Discussion
review
36 Eating at Jubilee
Traditional French cooking may be the best antidote to economics and public policy.
By Jasper Jones
edmonds sofa ROMAN THOMAS New York 2008 MAHOGANY, SPRINGS, HORSEHAIR, FEATHER, DOWN H 32 W 72 D 36
broken prose ROLY FENWICK Canada 2006 OIL ON LINEN H 48 W 72
chair JACOB KJAER Denmark 1930s OAK, COTTON, NIGERIAN LEATHER H 32 W 23 D 23
samuel table ROMAN THOMAS New York 2006 TEAK, STONE H 18 W 36 D 18
floor lamp G. SARFATTI Italy 1940s BRASS, MAHOGANY, MAPLE H 55 D 18CONTRIBUTORS FEATURE
editor’s notes
Sarah Sheon Gerecke has worked in the field of affordable Gail Shaffer is Associate Editor of The Stamford Review and
housing for 30 years, most recently as Chief Executive Officer a regular contributor. New York’s Secretary of State from 1983 to
of Neighborhood Housing Services of New York City. She has 1995, she managed the state’s coastline and chaired the Yonkers’
designed, launched and evaluated innovative housing programs financial control board during its desegregation battle. She also
for city and federal governments, and for non-profit and for-profit served as a member of the State Assembly, CEO of Business
organizations. She co-teaches a graduate seminar for New York and Professional Women/USA, and as president and CEO of the
University Law School and the NYU Wagner School of Public Policy Brooklyn Historical Society. Currently she is a board member of
on “Land Use, Housing and Community Development In New Dam Concerned Citizens, a non-profit organization which advo-
York City.” In the fall of 2009, she will join the New York University cates for dam safety and flood mitigation. Ms. Shaffer may be
Furman Center of Real Estate and Urban Policy full time and can reached at shaffergail@yahoo.com.
be reached at sarah.gerecke@nyu.edu.
Robert Van Order is Professor of Finance and Oliver Carr
Jasper Jones is a food writer and cookbook editor. He took Chair of Real Estate at George Washington University and is also
cooking courses in France and has written articles and restaurant a professor of property at the University of Aberdeen in Scotland.
reviews for numerous publications. He also developed one of He was the chief economist of Freddie Mac from 1987 to 2002
the first spiral-bound cookbooks with step-by-step illustrations, and, previously, Director of the Housing Finance Analysis Division
designed to sit on kitchen counters for quick reference. Mr. Jones of the U.S. Department of Housing and Urban Development. He
is also a textbook editor with specialties in reading and math. He has taught at the University of Michigan, UCLA, the University of
is presently working on an illustrated memoir about tenement Southern California, Queens University in Canada, the University
life in the Turtle Bay area of Manhattan. He may be reached at of Pennsylvania and the University of Michigan. He has also con-
jasperj15@hotmail.com. sulted on mortgage markets in Asia, eastern Europe and South
America. He may be reached at rvo@gwu.edu.
Hugh F. Kelly has a consulting practice and has been Associate
Clinical Professor of Real Estate at New York University for 25 years.
Prior to 2001, he was chief economist for Landauer Associates,
where he worked for 22 years. Hugh is also President of the Board
of the Brooklyn Catholic Charities’ affordable housing development
corporation and a member of the Counselors of Real Estate, the Editor & Publisher: Lawrence Sicular
National Association of Business Economists, and the American Associate Editor: Gail Shaffer
Art Director & PHOTOGRAPHER: Melissa Gorman (Company Standard)
Philosophical Association. He has written over 200 articles in in-
dustry journals and last year published a paper on contemporary The Stamford Review is published and edited in New York City
and Stamford, New York.
politics and economics in the philosophical journal Existenz. He
may be reached at hughkelly@hotmail.com. To contact the editor, please address all correspondence
to 360 Riverside Drive, 2C, New York, NY 10025.
John V.N. Philip is a lawyer, actor and writer in New York City To advertise in our next issue, please telephone 212-749-9525.
and has become a regular contributor to The Stamford Review. The Stamford Review is published twice annually. Subscriptions are $12.
(See “Crosstown Fabric: Building a Link Between Grand Central To subscribe please mail your check to 7 South Delaware Street, Stamford, NY
12167, or order on-line at www.stamfordreview.com.
Terminal and Pennsylvania Station” in our Fall 2007 issue.) He is
also a member of the Empire State Passengers Association, a ISSN 1949-2979 (print) / ISSN 1949-2987 (online)
citizens lobby for improved and expanded rail passenger service ©2009, The Stamford Review. All Rights Reserved.
in New York State. He may be reached at johnphilipnyc@aol.com.
2 3EDITOR’S NOTES EDITOR’S NOTES
AprÈs le déLuge
rating agencies share culpability, for If there is an underlying thread con- evelt, and later by Franklin D. Roosevelt’s
assigning rosy ratings to increasingly ques- necting these essays, it is that economics New Deal, were met with cries of heresy,
tionable debt. As securitization became cannot be reduced to mere mathematical warning of capitalism’s demise. Instead,
progressively exotic, exquisite slicing and formulae. Judgment, moral values, and hu- corrective measures restabilized it. Today’s
dicing of the original loans camouflaged man nature have a role in how we construct crisis similarly demands visionary reform.
their true nature. The credibility of the rating and implement our economic system. The Adjustments are clearly needed to thwart
system depends upon better standards. reforms undertaken cannot be cosmetic; the downward spiral: to save it from itself,
recovery demands fundamental change. the current model of capitalism must be
Capitalism, to survive in the We are at a defining moment: a modified.
new century, must undergo a paradigm shift must occur, to re-engineer Neither laissez-faire capitalism in its
paradigm shift capitalism if it is to survive the new century. extreme, nor an overly intrusive regulatory
The economic meltdown was precipitated Our economy, and the public interest, de- scheme will foster a thriving economy for
by a perfect storm of systemic problems, mand greater protections against recurrent our future. Balanced reforms are needed,
plunging the housing market, the stock crises of this depth. American taxpayers with stronger intervention to ensure stability
market, financial institutions and other have assumed a heavy burden in bailing and accountability, without stifling the op-
major companies into an abyss, prompting out a private sector which lacked prudent portunity and individual drive which have
unprecedented public finance to the rescue. self-restraint. A multi-trillion-dollar bailout traditionally been the hallmark of America’s
Our authors’ analyses reveal that, through- makes the citizenry substantial sharehold- economic prowess.
out the system, despite all the talented ers, expecting a return on their investment. As the ancient Chinese curse cautions,
professionals, the essential ingredient of Therein lies the controversy: those re- “May you live in interesting times.”
The trajectory of our boom economy masked sys- The impact of foreclosures is profound for neighborhoods and judgment—that of consumers, investors, sistant to change perceive any checks on
temic weaknesses that led to a resounding crash, its magnitude families. The pernicious effect of widespread dislocation on the co- bankers, brokers, rating agencies and the private sector as abandonment of the
surpassing a mere cyclical problem. To regain some measure of hesion and character of communities can be wrenching. To restore even regulators—was put in escrow. This very capitalist system, the great economic – Gail Shaffer, Associate Editor
economic preeminence and credibility, America must chart a new the confidence of consumers and investors in the lending industry, suspension of disbelief was exacerbated by engine of American success. The reform
course. standards should be reset closer to the criteria typical of prime insufficient checks and balances. measures championed by Theodore Roos-
The economic terrain is far more complex than during the Great mortgages. Reforms must also unravel the maze of securitized debt,
Depression. When one sector of the economy—an overheated to clarify property ownership and help neighborhoods recover. Trust
home mortgage market—collapses, new financial vehicles, new and transparency are imperative.
technologies, and an intricate global economy now spread the pain.
The serendipitous dividend: envisioning
It worked, until it didn’t: Why the bubble burst a modern American railway system
In this issue, three authors illuminate various aspects of the sub- The stimulus package borne of economic chaos presents a new
48 HOMES SOLD EACH DAY
prime mortgage debacle, analyzing what went wrong and what opportunity to launch America into the twenty-first century in rail 2 HOMES EVERY HOUR
reforms are needed. Hugh Kelly, Sarah Gerecke and Robert Van transportation, a serendipitous dividend to a national trauma. Be-
Order unravel the complex factors that created the bubble and its cause of our love affair with the car, we have lagged behind other 365 DAYS A YEAR
subsequent burst. In addition, a panel of real estate experts dis- nations in public transit. The Obama administration’s new initiatives
cusses the impact of the financial crisis on the Manhattan office herald robust investment. In addition to high-speed rail, John Philip
market, discerning some hopeful signs amid the chaos. highlights the need for several lower-cost, near-term improvements Let yours be one of them
The securitization of sub-prime mortgage loans masked a risky to the basic rail system.
foundation. Seduced by high yields in an overheated market, inves-
tors ignored the escalating risk. Predatory lending misled borrowers, Economic reform must be comprehensive
rating agencies, and investors. Lack of transparency—and lacunae As Americans, we have taken for granted our miraculous economy,
in the regulatory framework—led to a disastrous void of judgment. trusting that, despite cyclical vicissitudes, the market would always
When the risk reached intolerable levels, the market imploded, lead- self-correct. The staggering meltdown of recent months has been P R U D E N T I A L E L L I M A N .CO M
ing to the current financial crisis, negative equity and an avalanche a sobering wake-up call.
of foreclosures. Effective reform must be comprehensive. Confidence cannot
Fannie Mae and Freddie Mac, hybrids of private ownership and be restored without ensuring accountability, transparency, higher
public responsibility, provide guarantees that are a double-edged fiduciary standards, appropriate capital reserves and meaningful
sword: imperative to the financial system, they also enable greater oversight throughout the financial industry.
risk taking. Their role in the sub-prime market problem was dwarfed All financial institutions must be brought under the regulatory
by that of the private institutions; effective reform must include tighter umbrella: new institutions created in recent decades competed with
regulation of these government-sponsored entities, as well as the banks, while escaping proper oversight. The reforms must extend
issue of moral hazard in the broader market. beyond the banks, Fannie Mae and Freddie Mac, and brokers;
4 5FEATURE FEATURE
Ten Commandments
for 21st Century Mortgages,
Real Estate Finance Finance Markets, and
I. Write upon thy heart the law that the Imperative of Growth
‘reward’ and ‘risk’ shalt always appear
in the same sentence. II. Make neither
markets nor regulators into idols, and
follow not false prophets of simplistic
bias. III. Be sober and watchful, lest the
enemy of massive loss approach like a
thief in the night. IV. Honor thy father HUGH F. KELLY
and thy mother’s ancient counsel: Keep
It Simple, Stupid! V. If thou wilt not do
thy own credit analysis, then vow to Originally I considered the sub-prime mortgage quality of these ‘private label’ securities was dropping, with the
invest not at all. VI. Thou shalt not defaults to be ‘product failure’ rather than
‘industry failure.’ In August 2007, sub-prime defaults were
high-risk sub-prime component growing 20% per year after 2003,
and sub-prime pools constituting 80% of non-agency RMBS issu-
adulterate thy portfolio with excessive a small percentage of the U.S. residential market. The total of
sub-prime mortgage loans outstanding was $1.5 trillion, even after
ance by 2006. Offshore holdings of U.S. mortgage debt increased
fourfold in the fifteen years beginning 1990, and were above $1
leverage. VII. Thou shalt not bear the several years of explosive growth, and delinquencies among sub- trillion at the middle of the present decade.
false witness of hidden assumptions in prime loans were 13%—indicating trouble with about $195 billion
of this risky debt. Losses appeared to be ‘containable’ within the
For investors, the attractions were yield and volume. The amount
of money seeking investment grew monumentally after 2000.
thy investment underwriting. VIII. Thou context of the $10 trillion residential mortgage system. I was not
alone in my judgment. The contagion of fear that traveled through
Anthony Downs, of the Urban Land Institute and the Brookings
Institution, identified several sources of increased capital: the eco-
shalt not covet for the short term, global financial markets arose with stunning speed and power was
initially transmitted by a limited amount of ill-advised U.S. housing
nomic expansion of China, India, and other Asian nations; changing
demographic patterns such as aging populations with impressive
yea, but shalt lay up thy treasures for debt. accumulated savings; sovereign wealth funds; the startling rise in
length of days. IX. In all things, yield metastasis
U.S. corporate profits; arbitrage of the low Japanese lending rate
of 1.5% into risk-free U.S. Treasuries at 4.5%; and the rising profits
not to the tempter’s snare of panic. Like higher-quality forms of residential debt, sub-prime mortgages
were packaged into Residential Mortgage-Backed Securities
of oil producing countries.
Huge levels of new demand caused rising asset prices and re-
X. Remember that, after thy exile in (RMBS). The prior history of RMBS gave investors some confidence
in the safety and soundness of such investments. But the new secu-
duced yields. Yet investors of all stripes—pension funds, insurance
companies, private equity funds, hedge funds, sovereign wealth
the wilderness, if thou heedest these rities depended on the repayment performance of ‘non-conforming’ funds, banks, mutual funds—clamored for enhanced returns. Se-
commandments, thou shalt once again loans not eligible for Fannie Mae and Freddie Mac guarantees. They
were therefore issued as ‘private label’ securities. Securitization of
curitization, through the bundling of sub-prime mortgages, offered
such yields, since the underlying sub-prime mortgages typically
return to the land of milk and honey. non-prime housing loans represented an important shift in risk,
since non-agency securities carried risks of both prepayment and
yielded 3% more than a prime mortgage loan. Regrettably, that
higher yield was not appreciated for its significantly higher risk.
default. Fannie Mae or Freddie Mac securities were guaranteed
against default. Disguising and Selling Risk
From 2000 to 2005 non-agency issuance rose from a 25% mar- Securitization disguised risk. The pooling of the mortgages afforded
Counselors of Real Estate ket share to approximately 56% of all RMBS. Moreover, the credit the illusion of diversification. Diversification, the foundation of mod-
Ethics Committee Panelists
October 2008
7FEATURE FEATURE
ern portfolio investment theory, is based on kets that the CDOs themselves helped to an agreement by one party to cover the The Imperative of Growth daunting task, so companies seek alterna- Financial institutions booked lucrative
the sound premise that the combination of cause. losses of a counterparty, in the event of One of the simple and powerful equations tive strategies for improving the growth fees, from origination of the home loan
diverse assets can reduce the level of risk. CDOs were commonly issued by an in- default or other ‘credit event’, in exchange underlying market pricing is the Gordon rate. A firm’s superior market penetration, (such as ‘points’ on the mortgage and
What remains however is ‘systematic risk,’ vestment bank, through a special purpose for an upfront payment. The first CDS Dividend Growth Model (GGM), which says vis-à-vis its peers, is taken to be evidence application fees) through the entire chain
that is, the risk that is common to all assets entity (SPE) created to acquire mortgage was fashioned by strategists at JPMorgan that the expected price of an asset is equal of better products, more skilled manage- of securitizations and derivatives (as each
in a marketplace. For sub-prime loans, sys- loans, auto loans, credit card receivables, Investments in 1995, and these swaps to its periodic yield, divided by its rate of ment, more effective advertising, or other step in the process involved ‘transaction
tematic risk is very high. And systematic risk or corporate loans. The SPE then issued grew to an estimated $43 trillion market in return minus the rate of growth.5 entrepreneurial attributes. But it may also costs’). These fees improved earnings in
was severely mispriced for RMBS. bonds, with a tranching structure 2 for cash 2007 and possibly as much as $62 trillion simply involve taking on more risk. the short run, while reducing the burden of
Also masking risk was the flawed per- flows and credit losses, similar to RMBS. in 2008. This is a multiple of the size of the E = DIV / r – g The track record of the largest firms— holding long-term mortgages in the longer
p i
formance of the major rating agencies. It Like the mortgage bonds, the CDO allowed world’s equity markets; world GDP in 2009 those successfully moving to the top of the term.
is computed to be $54.9 billion dollars by In other words, the higher the expected rate market size/share pyramid in recent years The ability to arbitrage risk in the sec-
the International Monetary Fund.3 of growth, the greater is the multiplier on —has been questionable. Countrywide ondary markets and in derivatives also
...mortgage brokers are a highly cost- With the spotlight on American Interna-
tional Group (AIG), where the CDS product
income. The marketplace thus favors public
and private companies with strong growth
Financial was the nation’s largest home
mortgage lender. Lehman Brothers and
lowered the cost of funds and improved
margins, especially since the total value of
effective field force for lenders. Brokers failed so spectacularly, it is now clear CDS potential, rewarding them with higher val- Bear Stearns were, respectively, the fourth the MBS issuance could be higher than the
were given incentives to originate a is an ‘insurance-like product’ that lacks two
key elements of ‘insurance.’ One is a sound
ues per unit of income. The imperative of
growth is that capital flows to assets with
and fifth largest investment banks. AIG is
still the world’s largest insurance company.
sum of the underlying mortgages. The very
existence of robust secondary securities
large number of deals and to push them actuarial basis for estimates of expected
loss. The second missing ingredient is cash
the brightest future.
Income growth is actually achieved in
Citigroup and Bank of America are two of
the nation’s three largest banks.
markets reduced the illiquidity premium
embedded in the mortgage interest rate,
toward the highest possible loan amount. reserves set aside to fund such losses. CDS three critical ways, all of which played in lowering costs for everyone. Thus, if banks
This made them behave differently from contracts are negotiated instruments, not
established risk products where premiums
the housing finance market earlier in this
decade:
Growth on the Margin
Laser-keen attention to earnings provides
could depend on short-term capital for
mortgages with the expectation of selling
salaried loan officers. were calculated based upon hard, histori-
cal, statistically reliable evidence. Though
Increasing market size and share
Increasing margins
another avenue to growth. Mortgage
lenders effected a tremendous cost re-
into the secondary market quickly, they
could take advantage of the normal shape
‘sold’ as insurance, CDS are called ‘swaps’ Increasing price duction and improved profits by adopting of the yield curve, where short-term money
is common sense to question how 80% of the originators to transfer the risk to other precisely to avoid the statutory reserving automated underwriting. Not only was the is cheaper than long-term money. The
high-risk mortgages, bundled as a security, investors. Investment banks earned sub- requirements that traditional insurance Market Size and Share productivity of loan officers multiplied by ability to create off-balance-sheet special
were rated AAA, and 95% were rated A, AA, stantial fees while retaining (they thought) products must satisfy. Expanding market footprint is especially reducing the amount of interviewing and purpose vehicles meant that capital reserve
or AAA. A relatively new product, the sub- little residual liability. Their financial incen- Until the credit collapse, AIG was one of powerful when the market itself is getting credit investigation required, but also the requirements could be mitigated, again
prime RMBS had a thin and recent history tive was a function of volume, rather than the few companies in the U.S. that had an bigger. In housing finance, the increase primary reliance on FICO6 scores took out raising overall margins on measures such
of low defaults and rising home values, and the quality of the loans themselves. AAA rating, indicating a likely default rate in homeownership was a powerful force. that pesky element of personal subjectivity as return on assets, since capital freed from
the rating agencies modeled the assump- A primer issued by Nomura Securities in of virtually zero in the eyes of the ratings In 1988, 63.8% of American households known as ‘judgment.’ reserving obligations could be used to sup-
tion of a roughly 6% default rate. Investors 2004 was candid about the typical capital agencies. Credit default swaps covering owned their dwelling place; by 2004, that The number of mortgage brokers in the port additional lending.
could have resisted that assumption. But structure of a CDO: a pool of underlying securities backed by sub-prime mortgages, figure had increased to 69.0%, adding 6.1 United States increased from about 30,000 Consumers learned to play this game
the investors had significant incentives—in bonds with an average rating of single-B- were placed under the mantel of its AAA million housing units. The population of the in 1990 to 147,000 at its peak in early 2006 sharply, seeking mortgage credit and
compensation and management fees—to plus (by definition: speculative grade; poor rating—providing investors with the assur- United States had also continued to grow (The number is now back down to 73,000). shopping for the best available deal. They
accept a favorable rating for an investment credit quality) was ‘sliced and diced’, largely ance that these very weak-credit mortgage in absolute terms (by over 49 million per- As commission-based contractors, mort- refinanced frequently as interest rates and
that would boost their overall yield. to investments rated triple-B or higher, securities would be backed, in the case of sons); even with a stable homeownership gage brokers are a highly cost-effective housing prices shifted in their favor. They
At the end of 2007, an estimated $600 with the largest share in the AA and AAA default, by AIG’s enormous resources. After rate, there would have been demand for field force for lenders. Brokers were given learned that fees could simply be added
billion in sub-prime mortgage bonds were categories. This was financial alchemy of September 2008, many were surprised to approximately 12.5 million units. The num- incentives to originate a large number of to the principal amount of the loan and that
outstanding, worldwide. (The balance of the most mysterious kind. Nomura specifi- find that AIG’s primary financial products bers were solidly on the side of the housing deals and to push toward the highest pos- the required down payment was a nego-
total sub-prime mortgage indebtedness cally attributed the ratings transformation to regulator in the U.S. was the Office of Thrift industry: homebuilders, real estate agents, sible loan amount. This made them behave tiable figure.
was still being held on the books of financial ‘diversification,’ explaining that the ratings Supervision (OTS).4 mortgage brokers, bankers, furniture and differently from salaried loan officers. In On the business side, the improvement
institutions, and most of this was intended agencies attributed higher correlations of In all of this, there was insatiable appetite, appliance manufacturers, landscapers, 2001, an AARP consumer survey revealed in margins worked through the GGM as
for eventual securitization.) But this volume risk within a single asset sector (such as a ‘hunger for more’ that drove homebuyers, and retailers like Lowes and Home Depot. that mortgage brokers were twice as likely predicted. The S&P Financials Index rose
of weak RMBS was just the start. Sub-prime mortgages) than between asset sectors lenders, financial institutions and investors In the context of demographic growth, as bank lending officers to originate sub- from 372 in May of 2004 to 508 in Febru-
loans were then repackaged in Collateral- (such as mortgages and auto loans). well beyond the bounds of prudence. The increasing market share is an especially prime loans. “Churning” of refinancing 7, ary 2007, a 37% increase in 33 months. It
ized Debt Obligations (CDOs), described The growth of the Credit Default Swap result may well be called a mania, or a bub- difficult task. Competitive firms all respond high upfront fees, asset-based lending worked—until it didn’t: by March of 2009,
in financial engineering jargon as ‘asset- (CDS) market, which had critical interac- ble, euphoria, or irrational exuberance. To to the expansion in the customer base. An without regard to income-capacity to this index was down to 82.
backed synthetic securities.’1 Issuance of tions with the CDO and markets, was even understand this phenomenon more deeply, above-average rate of growth in an expand- repay, and ‘push marketing’ 8 were all
CDOs more than tripled from 2004 ($157 more astronomical than the swift rise of it helps to ask the underlying cause. There ing market means a sustained commitment margin-enhancing in the short run. In the Pricing
billion) to 2006 ($521 billion), before being sub-prime mortgage, private label RMBS, is such a fundamental driver, and it goes by to aggressive sales. Increasing the value of end, these tactics amounted to nothing less One of the classic definitions of inflation
caught in the shutdown of the credit mar- and CDO instruments. The ‘swap’ involves the ordinary and innocent name of ‘growth.’ the enterprise in such an environment is a than predatory lending. (attributed to Milton Friedman) is ‘too much
8 9FEATURE FEATURE
money chasing too few goods.” Inflation has often been viewed come to the same conclusion; insightful decisions should enable a
as favoring real estate assets. Housing prices reflect changes in person to break away from the herd.
household incomes as well as the impact of the cost of produc- Judgments also require standards. A panel of Counselors of
tion of new homes. The power of leverage, especially higher levels Real Estate prepared the ten rules which precede this article. I com-
of leverage, enables rather small changes in income or in interest mend them to you.
rates to be magnified into much greater changes in home prices.
Unfortunately, changes in a negative direction are also magnified by
NOTES
the same process of leverage.
1. The CDO has a suspect pedigree. The first collateralized debt obligation was
Nevertheless, the separation of asset values from underlying issued in 1987 by Drexel Burnham Lambert for the Imperial Savings Association.
economic fundamentals was identified relatively early, by Robert J. Drexel Burnham collapsed in 1990 in the wake of insider trading scandals that
Shiller in 2005, long before the bubble reached its maximum mag- sent financier Michael Milken to prison. Imperial Savings became insolvent in the
nitude.9 In the world of stocks, the ability to grow earnings based summer of 1990 and was taken over by the Resolution Trust Corporation.
on rising home prices affected a multitude of firms, in housing, in 2. “Tranching” (tranche means “slice” in French) is a financial structuring device
housing-related finance, in retailing, and even in manufacturing. All whereby a securities issue is divided into several classes, paying different interest
enjoyed the boom of growth, but all were subject to the conse- rates, having differing maturities, and bearing different risk levels, with a sequen-
quences of the subsequent bust. tial order of priority for payments and exposure to default.
3. International Monetary Fund, World Economic Outlook, (April 2009).
Conclusion
4. There has been a wealth of good reporting on AIG’s use of regulatory and rating
Having examined the metastasis of sub-prime mortgage lending, arbitrage, notably by The New York Times’ Joe Nocera (“Propping Up a House of
the disguising and selling of risk, and the bias toward growth, we Cards,” February 28, 2009), The Washington Post’s Dennis Brady (“Senators Call
have still not fully answered how we arrived at the present sorry AIG ‘Lost Cause’, March 6, 2009), and Daniel Wagner of the Insurance Journal
condition. (How AIG Fell Through the Regulatory Cracks, March 9, 2009). The Washington
The recurrence of bubbles over the course of history has been Post has also noted that the very compliant OTS was the regulator of Countrywide
Financial and Washington Mutual, two of the most aggressive of the sub-prime
the subject of instructive and entertaining narrative.10 But, as it turned
lenders. (Binyamin Appelbaum and Ellen Nakashima, “Banking Regulator Played
out, this was not merely of historical interest. Many recent events
Advocate Over Enforcer,” November 23, 2008).
should have been considered warning signs betraying weakness in
5 Named after Myron J. Gordon, and published in ““Dividends, Earnings and
our financial system. Since 1990, we have had the savings and loan
Stock Prices,” Review of Economics and Statistics, 41 (May l959), 99-105
crisis, a related bank capital crisis, and a series of ‘derivatives crises’
associated with the collapse of the Mexican peso in 1995, and of 6. FICO is an acronym derived from the Fair Isaac Corporation, which first devised
the Thai Baht in 1997, which led to the fall of Long Term Capital this credit measure in 1958. It is used by the major credit reporting companies
(Experian, Equifax, and TransUnion) to rate consumer credit histories, and
Management. Then there was the ‘dot-com’ collapse in 2000 and
widely relied upon by banks and credit card companies in evaluating customer
the shakeout in the telecom industry. creditworthiness.
The weakness was clearly not due to a lack of technical skills or
7. The practice of repeatedly returning to a client to reconfigure debt, often without
analytical capabilities. Nor was it for want of information (although
benefit to the borrower; HUD issued anti-churning regulations in 2004, in reaction
incomplete information did play a role in selling of sub-prime loans to widespread abuse.
to unsophisticated borrowers and the selling of AAA paper to inves-
8. Marketing where the message is controlled by the marketer and where the
tors). For at least two decades, the ‘best and brightest’ have flocked
customer is presumed to be relatively unknowledgeable about the product. Ag-
to our business schools, and the top graduates have disproportion-
gressive tactics such as frequent contact, excessive claims, and indications that
ately gone into the ‘investment industry’. the customer was ‘pre-qualified’ (even without any previously-indicated interest
Our shortcomings have been less due to the quantitative skills in the product) were used in push marketing of mortgages.
taught in our universities and deployed in finance than to our inat-
9. Shiller posted a ‘blog’ about this on April 12, 2005 on http://housingbubble-
tention to developing good judgment.11 Though there have been blogspot.com/2005/04/housing-bubble-will-pop.html.
failures in applying what is available in financial theory (e.g., an
10. See, for example, the classic John A. Mackay, Extraordinary Popular Delu-
understanding of systemic risk; the fundamental relationship be-
sions and the Madness of Crowds, Harmony Books (New York, 1980), originally
tween household income and housing affordability; the basics of published in 1841. See also John Kenneth Galbraith, A Short History of Financial
underwriting credit), these have not been failures of knowledge, but Euphoria, Penguin (New York, 1994). More recently, Charles P. Kindleberger and
of behavior. Robert Z. Aliber, Manias, Panics, and Crashes: A History of Financial Crises, John
Some of our choices could be better, were we to commit to Wiley & Sons (Hoboken, NJ, 2005).
a broader understanding of decision-making, good and bad. The 11. Previous writing on this subject have included, Hugh F. Kelly, “Can Universi-
case study method of learning is intended to promote this, but it ties Teach Real Estate Decision Making?”, Real Estate Review, v20, n.2, Summer
often devolves to mere calculation. Decisions should not be just the 1990; “Dimensions in Real Estate Research,” Real Estate Review, Fall 2001; and
application of mathematical formulae, but activities of a personal “Judgment: Imagination, Creativity, and Delusion,” Existenz. v.3, n.1, Spring 2008.
intelligence. In solving a mathematics problem, everyone should
10 11FEATURE
BURNING FEATURE
DOWN
THE HOUSE
– Talking Heads
Sarah Gerecke
Hold tight.
wait till the
party’s over.
Before 1999, if homeowners faced foreclosure it was typically in recent years, they lost market share to private label securities
due to a life event—medical bills, divorce or unemployment. In the and their stock prices dropped. According to American Banker, the
past decade, millions of homeowners have been unable to pay GSE share of residential mortgage bond issuance fell to a low of
back their mortgage debt because of the terms of the mortgage 44% in 2007; from 1995 through 2003, their share was in the high
Hold tight.
itself—little or no money down, negative amortization, or rapidly 70s and low 80s.
increasing payments. To prevent the fire of exotic loans from burning During the decades when the traditional prime mortgage flour-
down the house, we must restore the traditional mortgage to its ished, the typical young family saved for the 20% down payment
central role in the housing market. and closing costs. By their mid-30s, they were ready to buy a house;
we’re in
I work for Neighborhood Housing Services of New York City, part their family size and income were stable, and they did not expect
of a national network of 235 nonprofit housing groups chartered by to move. The bank examined their application using the “5 C’s”
NeighborWorks® America. NHS was founded in 1982 partly as a of underwriting: credit history, collateral (the value of the home),
response to redlining by banks. Our eight offices throughout New cash (income), capital (savings in the bank for downpayment) and
for nasty
York City invested $185 million last year in affordable loans for low- character (This could be a basis for discrimination, but the banker
income New Yorkers and educated over 11,000 residents in home or broker actually knew the borrower). Purchasers made the same
buying, home repair, foreclosure prevention, and basic saving and monthly payment for thirty years, providing certainty and stability.
budgeting. Housing costs were fixed and incomes rose over time, increasing
weather.
Foreclosure prevention is our fastest growing activity, and the the ability to save. At about age 65, the home was paid off and
most disheartening. The threat created by aggressive mortgage household expenses dropped just as the family transitioned to a
lending is the greatest NHS has faced since its creation. fixed-income retirement.
This was the model for working class neighborhoods around
There has got
The Good Old Days of the Prime Mortgage the country. Owners lived in their homes until they passed away.
The traditional 30-year, fixed-rate, self-amortizing mortgage is a Turnover was rare; often the estate sold the home, or it was left to a
beautiful thing. Invented during the Great Depression, these loans family member. One street block, in a working class Bronx neighbor-
were generally underwritten to standards set by Fannie Mae and hood, tells this story. Of its 16 homes built in the 1960s, thirteen had
to be a way—
later Freddie Mac, government sponsored enterprises (GSEs) that the same ownership from 1966–1986. Four of the owners died in
purchased or guaranteed the loans from lenders. While GSEs their homes and passed their homes to the children. The affordable
provided capital to the mortgage market at low cost, they did not fixed payments and high transaction costs associated with moving
generally participate in the exotic mortgage market. Consequently, minimized the turnover of families on the block. Homeownership
12 13FEATURE FEATURE
under these conditions contributed to calls, infomercials) targeted to minorities vided by the 30-year mortgage evaporated, Parallel Hazards eligible for up to $500,000 from the Securi- a legal obligation to act in the borrower’s
happiness, wealth-building, high school who distrusted traditional banks with their hurting property values, quality of life and The attributes of homeowners who are fac- ties Investors Protection Corp; no similar interest. Participants in these counseling
graduation rates, economic growth, and reputation for saying “no.” I have met many the tax base. ing foreclosure are surprisingly similar to fund exists for mortgage victims). Loan programs have a 34% lower risk of mortgage
lower incidents of teen pregnancy.1 families who were told that they were get- At the other end of the financial food the attributes of investors and lenders who terms and documentation should be clear default. Yet “[m]ost counseling agencies
ting a traditional loan when in fact on page chain, investors eagerly bought collateral- made the loans. Both exhibited ignorance, and accessible. The borrower, originator, struggle to support homeownership coun-
Exotic Loans 20 of the mortgage document it disclosed ized debt obligations (CDOs) made up lacked due diligence and were peppered packager and investor should all retain seling services with funding from a variety
In the 1990s, lenders began offering loans an adjustable, negative-amortizing rider. of pools of mortgage-backed securities, with those taking advantage of a lax regula- some responsibility for nonperformance for of sources, primarily public sources. This
that required little or no money down, used But even this disclosure was opaque; the bundling thousands of Bronx-type loans tory environment. Look at the parallels of the entire term of the mortgage. Meaningful unstable and sporadic funding rarely cov-
a variable interest rate, and were subject mortgages typically refer to obscure indi- from all over the country. These investments homeowners and investors: relief for victims of fraudulent transactions is ers the true cost of providing sustainable
to less underwriting (usually only 2 C’s, ces and points, instead of laying out the were much riskier than the investors ever needed. Some argue that these steps will counseling services. Thus, salaries for
credit and collateral). Some had negative best- and worst-case payment schedule in expected. • Didn’t read the fine print make mortgages more difficult to obtain counselors are low, hours are long and
amortization, where the loan balance grew simple language. • ( Were) overpaid for the value of the and more expensive. That would be a turnover is frequent.” 3
over time. These loans were sold dispro- The need to refinance and take money Is Helping Out a Bailout? asset good thing for the most part: of the 9 mil- Financial education should begin in
portionately to minorities concentrated in out of the home often coincided with an Imagine that a homeowner calls 911. Her • Misjudged the risks involved in owning lion at-risk homeowners, many should not childhood, and homeownership education
large metropolitan areas. Beginning in the unexpected illness, divorce, or job loss— stove caught fire and she needs help. In- the asset have received the loans in the first place. should be a routine part of the home pur-
late 1990s, 21 different mortgage compa- traditional reasons for mortgage default. stead of getting the address, the dispatcher • Tempted by above-market returns and At the same time, underwriting should not chase process along with an independent
nies originated loans on the Bronx block. And greed certainly played a part by both asks a series of questions: “How did the fire appreciation be unreasonably restrictive; qualified pur- inspection and appraisal. Housing counsel-
By 2008 only three of the original sixteen borrowers taking cash out of their homes start?” “Was there negligence involved?” • Faced contractual barriers to negotiating chasers should have access to affordable ing could be required by legislation and by
owners remained. Eleven of the homes had and brokers who earned commissions Fortunately, the fire company does not as- an optimal solution mortgages or the housing market will not be the GSEs for riskier loans as it was prior
nontraditional or sub-prime loans, seven for from loan churning. However, the mortgage sess blame before it dispatches a truck. Its • Couldn’t liquidate as there is no market able to recover. Thoughtful regulation can to 2006. It should also be required for all
more than the home was worth; five were terms now magnified the impact. The cash first mission is to put out the fire. for asset create the level playing field that will allow loan modifications of nontraditional loans in
owned by investors rather than owner- received was often much less than prom- Why is the mortgage crisis so differ- • Often involved innocent victims (univer- the market to better price risk by setting order to ensure that borrowers understand
occupants. One of the two-family homes ised, after commissions and fees were ent? The Center for Responsible Lending sity students and retirees for investors; basic ground rules. what went wrong. Payment of counseling
had five mailboxes on the door.2 deducted, and the refinanced mortgage projects that between 2009 and 2012 more children, tenants and neighbors for fees should be part of the mortgage trans-
Families on blocks like this now risk rarely had terms as favorable as the original than 9 million families will face foreclosure homeowners) Regulate the modification action, like the lender’s legal fee or the title
losing their homes, their savings and one. Parents took on additional jobs to try in addition to 2 million who already lost their • Unwilling to lend or unable to borrow Even the minimal regulations governing company fee. Lenders should be required
their credit. At NHS we now are flooded to keep up with the rising payments. Other homes in 2007 and 2008. Were they all to • Too big to fail (The biggest institutions mortgage origination (Truth In Lending Act; to provide performance data on different
with these families, providing foreclosure household needs—food, medical care, blame for their difficulties? Is moral indigna- and nine million homeowners) Real Estate Settlement Procedures Act) do types of counseled loans, allowing pricing
prevention assistance to 2,500 families in school—were skirted in order to pay the tion really appropriate? not apply to the process used to modify ex- advantages to be linked to borrowers who
2008 alone. The overwhelming majority did mortgage. It defies reason and experience that Policy Recommendations isting loans when a borrower seeks to avoid have obtained effective counseling.
not obtain homeownership education from Eventually many families like those on eleven million families knowingly gambled In a few short months, the Obama Admin- foreclosure by calling his or her lender or
a lawyer or a HUD-certified housing agency this Bronx block were forced into distress their homes, their children’s stability and istration has created many new initiatives to a third party agency. Homeowners are Make Trustworthy Loans
prior to signing the mortgage. How can it sales. Some couldn’t escape the debt their financial security only out of pure address the mortgage crisis by creating a frequently victims of foreclosure rescue Redlining was the norm in the mid-twentieth
be possible that so many did not have the through sale and were forced to decide greed. Fraud was rampant in the mortgage market for toxic assets, giving new mortgage scams or of modifications that are worse century. Banks and government wouldn’t
good sense to take the time to read and between foreclosure or bankruptcy. (Bank- process, escalating rapidly with the housing options to homeowners and by increasing than the original loans. The Administration’s lend in inner cities because they did not be-
understand their mortgage? ruptcy does not eliminate the debt due on a boom. Many borrowers did not understand liquidity in the markets. We are beginning Making Home Affordable plan starts from lieve that low-income, minority homeowners
to see signs of success with each program, the premise of affordability: it cannot result would pay them back. The Community
but public and private policy makers need in housing costs exceeding more than 31% Reinvestment Act (CRA) mandated lending
Sub-prime and exotic mortgages of the past ten years are to keep an eye on the big picture as they de-
sign each piece of the economic recovery
of the borrower’s income. But many hom-
eowners won’t qualify for this government
in communities where banks took deposits.
CRA coincided with the creation of our
not your parents’ mortgages...basic underwriting no longer toolkit. In other words, they should make
sure the fire is extinguished for good; even
program and, unless they have taken the
initiative to find a qualified housing coun-
NeighborWorks® America (NWA) network
of 235 nonprofit housing organizations
protected the borrower or the lender from over-reaching. as they order more fire trucks and design selor or attorney, they are on their own in to act as links between bank capital and
better equipment. the negotiations with the servicer. “riskier” borrowers and neighborhoods.
These organizations and other nonprofit
Sub-prime and exotic mortgages of the mortgage; it just modifies other debts). The the terms of their loans, and they trusted Regulate the Mortgage Create Trustworthy housing groups worked with government
last ten years are not your parents’ mort- family had to relocate quickly—with ruined brokers to find them the best deal. Even First and foremost, trust, confidence and Borrowers and lenders to educate borrowers, trans-
gages. First and foremost, the mortgages credit, exhausted savings, and children the banks and Wall Street funded loans stability must be restored in the mortgage You need a Ph.D. in mortgage finance to form their savings and credit profiles, and
did not conform to GSE standards, so basic forced to change schools mid-year. Rental where they trusted the originator or the transaction. The borrower needs to know understand today’s loan terms, and most mitigate the risk.
underwriting no longer protected the bor- tenants in two-family homes were evicted rating agency. Is misplaced trust a moral that the mortgage will be suitable for his Americans are woefully uneducated about The success of CRA lending is now,
rower or the lender from over-reaching. by the lender during foreclosure, even if hazard, or was it also poor controls, dimin- or her situation. Mortgage brokers should financing, budgeting and credit. But there unfairly, blamed for the mortgage crisis. The
Second, the mortgage broker used they had been paying rent. The financial ished business ethics, and faulty or absent be held at least to the same standard as are HUD-certified housing agencies and Federal Reserve Board has recently studied
push-marketing tactics (flyers, phone security and social stability that were pro- regulation? stock brokers. (Bernie Madoff’s clients are counselors that work with borrowers with the performance of loans to low-income,
14 15FEATURE
underserved borrowers under the Community Reinvestment Act, We are presently in a crisis that is prompting a dislocation far Resources
often made in partnership with nonprofit community development larger than Hurricane Katrina or the devastation of the South Bronx.
institutions. The Federal Reserve study concluded: “Thus, the Just as a firefighter puts out the fire first and then assesses the Nonprofit Organizations
long-term evidence shows that the CRA has not pushed banks cause and the blame, so should our policy makers give us tools to Center for Responsible Lending
into extending loans that perform out of line with their traditional put out the urgent fire, keep families in their homes and resume the www.crl.org
businesses. Rather, the law has encouraged banks to be aware of flow of responsible credit. There will be time, after the family and the
lending opportunities in all segments of their local communities as loan are stable, to address the underlying causes of default. The Center for NYC Neighborhoods
well as to learn how to undertake such lending in a safe and sound most important ingredients in fire prevention are public education, www.cnycn.org
manner.” It also “found that loans originated under the NWA program safety rules in building construction, and a shared commitment to
had a lower delinquency rate than sub-prime loans. Surprisingly, the the goal of reducing deaths by fire. Here too, we should unite in our Neighborhood Housing Services of New York City
loans in the NWA affordable lending portfolio had an even lower rate commitment to preventing ansother mortgage crisis by increasing www.nhsnyc.org
of foreclosure than prime loans.” 4 public education, imposing safety rules, and achieving the goal of
Today we have widespread networks of sophisticated nonprofit a reliable mortgage process. NeighborWorks® America
lenders who use all five C’s of underwriting in their programs. They www.nw.org
are hurt hard by today’s recession, losing access to flexible and NOTES Foreclosure prevention best practices are available at the
affordable capital and charitable support they need to make re- 1. William M. Rohe, Shannon Van Zandt and George McCarthy, “The Social NeighborWorks® Center for Foreclosure Solutions:
sponsible loans. Both banks and government should invest in these Benefits and Costs of Homeownership: A Critical Assessment of the Research” http://nw.org/network/neighborworksprogs/foreclosuresolutions/default.asp
networks to deploy capital responsibly in the neighborhoods that (Harvard Joint Center for Housing Studies, Low Income Homeownership Work-
are hardest hit by the mortgage crisis—because it’s a sound busi- ing Papers, October 2001); Donald R. Haurin; T. Parcel; R. Jean Haurin “Does New York State Coalition for Excellence
Homeownership Affect Child Outcomes?” (Real Estate Economics, Volume 30,
ness decision to do so. in Homeownership Education
Issue 4, 2002). “We find that owning a home compared with renting leads to a 13
http://cxhe.wordpress.com
to 23 percent higher quality home environment, greater cognitive ability, and fewer
Create a meaningful safety net child behavior problems. For children living in owned homes, math achievement
While it is estimated that the Obama Administration’s Making Homes is up to nine percent higher, reading achievement is up to seven percent higher, A website devoted entirely to the neighborhood impact
Affordable program will help 4 million families avoid foreclosure, the and children’s behavioral problems are one to three percent lower.” of the mortgage crisis is www.stablecommunities.org
program may help less than 50% of the families at risk. During the 2. Author research using New York City Department of Finance Automated
Great Depression, we wove a strong social safety net for the families Citywide Records Information System, May 2009. Government Resources
that became the Greatest Generation, without calling Social Security New York City Department of Housing Preservation
3. Abdighani Harad, Peter M. Zorn; “A Little Knowledge is a Good Thing: Empiri-
or the Home Owners Loan Corporation a bailout. A good model cal Evidence of the Effectiveness of Pre-Purchase Homeownership Counseling”
and Development
might begin with the New York Times Neediest Subprime Cases (Harvard Joint Center for Housing Studies, October 2003); Doug Dylla, “The www.nyc.gov/html/hpd
Fund, launched last year, which provides basic financial assistance Current State of Homeownership Education and Counseling Services in New
to those who need to move because of mortgage default. York State” (NeighborWorks® America: September 2007). New York State Halt Abusive Lending
4. Randall Krozner, “The Community Reinvestment Act and the Recent Mortgage Transactions (HALT) Task Force
Encourage neighborhood-based strategies Crisis,” in Revisiting the CRA: Perspectives on the Future of the Community Rein- http://www.banking.state.ny.us/cshalt.htm
Securitization has complicated efforts to deal with concentrated vestment Act (Joint Publication of the Federal Reserve Banks of Boston and San
foreclosures and to stabilize neighborhoods. It is difficult to establish Francisco: February 2009). US Department of Housing and Urban Development
ownership of the loans and of the foreclosed homes, which are scat- 5. Corinne Gentilesco, Annie Myers and Abigail Westbrook, “Mitigating the Neigh- Find HUD-Certified housing counseling at
tered through different investment pools and asset management borhood Effects of Lender Homeownership in Eastern Queens” (The Wagner http://www.hud.gov/offices/hsg/sfh/hcc/hccprof14.cfm
companies. Some investors don’t foreclose, and some borrowers Review, Volume XVI 2008-2009).
move before foreclosure is completed, leaving ghost properties with Housing counselors who have adopted National Industry Standards for
titles held in limbo by zombie banks. At a minimum, states need to Homeownership Education and Counseling, including a code of ethics, can be found at
bring transparency and accuracy to the process of recording lien http://www.homeownershipstandards.com/index.shtml
and foreclosure data, and make public the identities of the manag-
ers of foreclosed property and the owners of the mortgage.5 Various Federal initiatives relating to the mortgage crisis can be found at the following sites:
http://www.whitehouse.gov/issues/economy
www.makinghomeaffordable.gov
http://www.financialstability.gov
http://www.hud.gov/offices/cpd/communitydevelopment/programs/neighborhoodspg
16 17You can also read
