Banks

Back in the 50’s there were strict requirements on qualifying for a home mortgage. In those days the vast majority of mortgages were issued by Savings and Loans (S&L’s) and banks only issued a mortgage to a wealthy person so they could get his checking and savings accounts. If you wanted a loan you had to have a down payment of 5% for FHA loans and 20% for commercial loans. In addition there were income requirements. The principal and interest payment on your house plus the cost of home owners insurance plus taxes could not exceed 28% of your gross income. If you earned $500 per month you could only pay out $140 which means that if loans were at 5% you only qualified for a $25,000 loan assuming you put 5% down.

In 1959 I bought my first house which cost $10,000 and after 5% down and getting a 30 year loan at 4.75% my principal and interest payment was $50 per month. My insurance and taxes brought this up to $90 per month which meant that my income had to be at least $320 per month and that is exactly what I was making not counting overtime.

In Springfield at that time the town like many others was segregated, meaning that the blacks all lived in one part of town. Many of these people could not qualify for loans because of the above mentioned requirements so there was a whole section of our town that was denied the American dream of home ownership.

There were some in that area that could have qualified but the loan officers were told not to bother thinking it a waste of time. In their offices they had a map and they circled the black areas with a red pencil and this process was known as redlining. For those of you who saw the movie, A Raison In The Sun, you know this story was about one family who came into an inheritance and tried to move into an all white neighborhood.

As we moved into the 60’s the process of redlining came under scrutiny and the government wanted to do something about this perceived injustice. It took many years but in 1977 the community reinvestment act was passed.



The Community Reinvestment Act (or CRA, Pub.L. 95-128, title VIII of the Housing and Community Development Act of 1977, 91 Stat. 1147, 12 U.S.C. § 2901 et seq.) is a United States federal law designed to encourage commercial banks and savings associationsto meet the needs of borrowers in all segments of their communities, including low- and moderate-income neighborhoods.[1][2][3] Congress passed the Act in 1977 to reduce discriminatory credit practices against low-income neighborhoods, a practice known as redlining.[4



Loan officers began to interview potential buyers from the red line areas but most failed to meet the requirement and very few loans were issued. It was about this time that community organizers began to form, groups like the now infamous “Acorn”. They would go into the black areas and take people down to the loan office but still very few qualified.



When Bill Clinton became president, he wanted to make it possible for more people to qualify for home ownership, so he changed Fannie Mae to lower the requirements on home loans. In a second move he told the mortgage companies that the bank examiners would be checking to see how many loans were made to minorities and there would be penalties for failure to meet certain loan standards. This still didn’t have the desired effect so Clinton told Henry Cisneros Secretary of HUD to use, “creative financing” which he proceeded to do.

This lead to an amazing display of mortgage loans that boggles the mind. First, the down payment was eliminated. Then came the question of qualifying for the monthly payment rule, called the 28% ratio. If a person wanted a $100,000 loan at 6% for 30 years the monthly principal and interest payment would be about $600. If that was too high they were offered and interest only loan for $500 and if that was too high they could get a negative amortization loan at $400. This loan would add to the principal so by the end of the first year you owed $102,000 on your loan but since your house would increase in value to $105,000 you were sill ahead. Even with these less stringent requirements many still did not qualify so the industry came up with a NINA loan. This was a no income no asset loan sometimes called NODOC for no documentation. Now you could walk into the bank and get a loan with no proof that you had any income or any assets so now every warm body qualified. This subsequently led to giving loans to non existent people, that is, dead people.

So who was providing the money for all of these loans. The banks no longer kept loans in the local bank but immediately sold them to another entity and so they were not all that concerned about the quality of the loan but where was the money coming from and what caused the demand for these additional mortgages. To understand this we need to understand derivatives. A derivative is a piece of paper that gets its value from some other source. If you buy a CD at the bank, the CD is a derivative since it is a piece of paper that “derives” its value from some other source, in this case, your money in the bank. If you have a home mortgage the deed is a derivative that “derives” its value from the house it represents. Why are investment derivatives necessary? Suppose you are a farmer and it is planting time and you know that you must get a least $3 per bushel for your wheat in order to make a living. You do not know what the price will be next October so you purchase a derivative. You look at the futures market and see that you can buy an agreement to sell your wheat for $3. These agreements are derivatives since they are paper representing your wheat.

Certain large investment type banks decided to take home mortgages and bundle them together and sell them as investments. At a time when CD’s were paying one percent these bundles would pay 6 percent since they were home mortgages so they were very popular. These bundles contained 5,000 home mortgages and sold for millions of dollars so the man on the street didn’t buy them but they were sold to large investors like pension funds. The original price was set by adding up the value of all the 5,000 loans but as time passed these values changes since appraised values of real estate changed. So now we have mortgages that are derivatives and these are combined into bundles which are derivatives of derivatives. The demand to purchase these products was greater than the supply and so a new product was created and it was called virtual mortgage derivatives and these were sold based on virtual mortgages. On top of all these mortgages you had a company like AIG that was selling insurance policies to guarantee companies against any loss they might incur while trading in derivatives.

So let’s recap the derivative story. You start with a home mortgage deed which is a derivative of a brick and mortar home. Then you bundle these into derivatives of a derivative. Then these become virtual derivatives of a derivative of a derivative. Next we purchase an option on these and now we have a derivative on a derivative on a derivative on a derivative. Now we buy an insurance policy to protect us against loss and we have a derivative on a derivative on a derivative on a derivative on a derivative. Next we hold the SEC responsible to make sure that all of these transactions are legal and I say to them, Good Luck.

The point of this whole scenario is to show once again the folly than ensues when the government intervenes to promote a social good what some refer to as the unexpected consequences of good intentions. All of this mess was started by trying to help people to achieve the American Dream of home ownership.

There is a need for government involvement but is must be carefully evaluated before enacting laws. We are this day faced with new regulations on the financial industry and congress is trying to force it to a vote before most members have even read the bill. This will someday come back to haunt us but those responsible will have long since retired.

We went through a similar disaster in the 1980’s with the Savings and Loan fiasco and we will likely experience the down side of this new legislation in about 20 or 30 years.



John/Jack