Ask an Ex-Banker: Freelancer Homebuyer?

Editor’s Note: This post first appeared on the website Make Change as an advice column “It’s Complicated,” which is in the spirit of my occasional “Ask an Ex-Banker” posts. If you have personal finance questions for “It’s Complicated” or “Ask an Ex-Banker,” send me a note!

  homebuyer

Dear Its Complicated:

I’m a single fulltime freelancer looking to buy my first house. I’ve read a lot about how daunting the process can be for freelancers and now I’m worried and confused about what to expect.

While I don’t have a corporate gig, I do have nearly a decade freelancing in my industry with a steady income stream. I do have some debt I could pay off before applying for a home loan and am paying off last year’s taxes. Otherwise, I have a solid rental history and enough saved up to put 20 percent down on a modest home in my area.

Given that, what should I be doing now to secure a home loan in six to 12-months? When I’m ready to apply, what should I be prepared for when it comes to proving my income or work status? Finally, how worried should I be about the IRS payment plan and my small amount of debt?

Any guidance would be appreciated!

Dear Freelancer,

Congratulations on your imminent leap into homeownership.

You already anticipate that being a freelancer will make getting your mortgage a difficult process. Sadly, I agree. You should expect the worst. And then realize it will be even harder than that. By the end it will seem like they asked for everything except blood samples and your ability to count backwards from 100 by 7s. It’s super-annoying!

And so, may your home-buying mantra be borrowed from recent kerfuffles in the US Senate: #NeverthelessShePersisted.

Done right, homeownership can be the most powerful tool for building long-term wealth available to the middle class. (Emphasis on “done right.”)

In order of importance, your home purchase journey starts with spending a little bit of money this week to acquire your credit scores and reports. Those results will dictate what you do in step two, which is to get “financially fit” in the coming months. Third, I’ll describe how you can—and should—take proactive steps with a mortgage banker or broker, even before shopping for your house.

Step one: Credit report and score

Your first step is to order your credit reports and credit scores from each of the three credit bureaus, Experian, Equifax, and TransUnion. Each bureau offers a version of a 3-in-1 report combining all your information for about $45. You could also purchase your reports and scores separately for around $15 a pop. And while you could stick to one bureau’s credit report and score, keep in mind that reports can vary widely from each bureau. If you don’t check out all three, you could miss an error or negative information only reported by one bureau.

fico_scoreAlternatively, by law, you’re entitled to a free copy of your credit reports from all three credit bureaus once per year through AnnualCreditReports.com. But this only gives you the reports, and you’ll have to order your credit scores separately. Which is annoying. So skip it, and pay to get your score.

I’ll explain the importance of this step in a moment, but first, a few words of caution about buying your report and score. These three credit bureau’s websites seem to purposefully and maddeningly muddle your attempt to buy your report and score just once. Their websites steer you toward some “monthly credit monitoring,” at much more then $15 over time. #Resist all that nonsense. Also, steer clear of “free credit report” offers you see online because that does not include your actual numerical score. And finally, be leery of any site offering free credit scores or credit monitoring. Many of these sites simply estimate your score, and you need your true FICO score to move on to steps two and three. (For more on FICO scores, may I suggest Part 1 and Part 2 of an explainer by me?)

A big part of your future mortgage lender’s decision will ride on this information. You need to know how they will view you. Applying for a mortgage without knowing your score would be akin to applying to college without knowing your own SAT scores. You’d be flying blind and would probably apply to the wrong places. Like the SAT for college admissions offices, your FICO score is the sorting mechanism that mortgage lenders use to figure out how to treat your application.

Generally, if you score a 720 or above, every mortgage lender in the country will welcome your application with open arms and its best terms and rates. Your application will be directed to a “prime” mortgage. If you score in the mid-600s to 720, you can still qualify for a normal-ish mortgage, but expect the cost to borrow money to be higher, possibly even significantly higher. If you score a mid-600s or below, you will be relegated to a “sub-prime” mortgage with either a punitively high interest rate or a low teaser interest rate that will adjust upward and likely become unaffordable later.

Of course, all of the above is complicated somewhat by your freelancer status. Even if you have sterling credit, read step three carefully for information about income verification.

Step two: Getting financially fit

Reasonable people could disagree on the following, but I would counsel most people with sub-prime scores to wait on buying a house. You specifically mentioned outstanding debt as well as an IRS agreement in your financial profile. A payment plan with the IRS generally won’t appear on your credit report unless you’ve defaulted on the monthly payments. If you have missed payments, or the IRS has placed a lien against you, this could push your credit score below prime. Carrying debt can also drag your score down, especially if you have late payments or have had any debt assigned to collection agencies in recent years.

subprimeBorrowing on a sub-prime mortgage will add 5 to 10 percentage points to the cost of your loan, or let’s say an initial $10,000 to $20,000 per year on even a small $200,000 mortgage. Just five years of that extra cost and you’re $50,000 to $100,000 poorer than you need to be. A better plan would be to settle all your outstanding debt problems in the next year. Later, with collections or tax liens in the rear-view mirror, the passage of time will heal your credit score. Waiting a year or two to build your FICO score up before buying the house will leave you wealthier in the long run.

If you’re already in the prime range, then you can accelerate your timeline. You mentioned worrying about your IRS payment plan and small amount of debt. If the IRS imposed penalties on you in the past, or you are subject to an IRS lien, certainly I’d recommend sorting that out before taking on the obligation of a large mortgage. If you have a good score, however, that indicates to me that you’re currently paying all tax plans and debts as agreed, without penalties. In that case, they are unlikely to inhibit getting a mortgage.

Mortgage lenders expect borrowers to already have some debts when they apply to a mortgage— whether student loans, car loans, or credit card debt—so a small amount of debt won’t deter them. You might feel better being debt-free, but it’s not necessary in order to get approved for most mortgages. The way the bank views your small amount of debt is like this: $10,000 in cash in the bank with $5,000 in debt gives you a net worth of $5,000. From the lender’s perspective that’s nearly the same exact position as if you had $5,000 in cash and zero debts. Banks won’t sweat the small debts.

Step three: Getting pro-active with a mortgage broker or lender

Before you shop for your house, every realtor will recommend you get pre-approved for a loan from a mortgage lender, for good reason. That pre-approval, including the maximum amount you can borrow, let’s you make an offer on a house with the confidence that you can actually buy it, and that makes you a much more attractive buyer. Without that pre-approval, you could expect realtors and sellers to take you less seriously when you make an offer to purchase a home. During the pre-approval process, you will present your assets, income, and employment, as well as debts. You will specifically want to explain your freelancer status to whoever works on getting your pre-approval.

preapprovedSince your income has been steady for a few years you should be able to get pre-approved. But expect that the lender, when it comes time to actually extend you a loan, will ask extremely invasive questions about your work and income . One to two years of federal tax returns will be the start of their inquiry. I can’t anticipate all of the ways a bank will try to vet your consistency of income, but be prepared to prove out anything you claimed as income.

Here’s an extreme example, courtesy of the editor of Make Change who bought a home with her freelancer husband in 2012, right after she’d transitioned from freelance work to a fulltime job: a few years’ worth of statements from every bank account they held individually and jointly, a letter from her new boss stating he anticipated her working there for the long-term (#awkward), verifying every check deposited for the past several months, including personal gifts in amounts of $50 or less. And that wasn’t everything, in total, she turned over two banker’s boxes worth of documents to her lender, and that was with a credit score in the prime range. Just remember to deep breathe your house buying mantra #NeverthelessShePersisted.”

Thankfully, the further out from the recession we get, the fewer of these burdensome verifications seem to be required. Still, it’s best to be over-prepared, even if it’s about as fun as a lumbar puncture. Hopefully it will all be worth it. Good luck!

 

A version of this “Ask an Ex-Banker” post appeared as a post for a semi-regular advice column “It’s Complicated” in the personal finance website Make Change.

Please see related posts:

FICO Scores explained Part 1

FICO Scores explained Part 2

Rent v. Buy – The Simplest Answer

Homebuying Part 1

Homebuying Part 2

Homebuying Part 3

 

 

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More on Subprime Lending Policies from the Feds

Editor’s Note: A (shorter and less conversational) version of this post appeared earlier today in the San Antonio Express News.

hud sealAn official from the Department of Housing and Urban Development (HUD) responded last week to disagree with my article two weeks ago in which I claimed that Secretary Julian Castro supported subprime lending, in his speech about HUD priorities September 16th.

We had a lovely chat.

What Castro said

What Castro actually said in his speech is the following:

“According to the Urban Institute, the average credit score for loans sold to GSEs [*which stands for ‘government sponsored entities,’ shorthand for Fannie Mae, Freddie Mac, and Federal home loan banks] this year is roughly 750. Currently, there are 13 million people with credit scores ranging from 580 to 680. Many of them are ready to own, but are being left out in the cold. The truth is that the dream of homeownership is out of reach for too many Americans. This has to change.”

I interpreted ‘this has to change’ to mean he advocated greater subprime lending. Castro specifically included credit scores that meet the ‘subprime’ definition, even though he did not use the phrase ‘subprime lending,’ probably because after the 2008 crisis ‘subprime‘ became a dirty word.

Definition of subprime

Banks sort mortgage borrowers according to their FICO scores, a personal-credit score based on past borrower behavior.

A 720 score and above is considered “Prime.” A 680 FICO and below is considered “Subprime.” To fill out the middle part of the scale, a 680 to 720 score is generally considered “Alt-A,” an in-between designation of credit worthiness.

Reasonable people can quibble on the exact FICO boundaries between Prime, Alt-A, and Sub-Prime, and banks can make their own determinations of the ranges for their own lending purposes, but 680 and 720 are the traditional boundaries separating the three segments of the mortgage market.

To make the definition completely clear: If you have a 680 FICO or below, to name one FICO score Castro mentioned in his speech, you have a history of not paying some of your debts on time. If you have a FICO score closer to 580, to name the other score Castro mentioned, you have a history of not paying most of your debts on time.

There’s no other way to have a 580 to 680 FICO than to have missed debt payments.

This doesn’t mean you’re a bad person. Nor does it mean you should never own a home. It just means that your past payment behavior suggests elevated future risks of not being able pay for your debts, such as a mortgage.

Most importantly, with a FICO of 680 or below, you will only qualify for a subprime mortgage from your bank.

So that’s why I think I made the reasonable inference from Castro’s speech that “This has to change” indicated a government preference for more subprime lending.

“Fair Access”

The HUD official did not agree with my description.

When I pointed out to the HUD official that historically 20% of subprime borrowers get into payment trouble on their mortgages, the official said I should focus instead on the 80% of borrowers who do not get into trouble, the ones who pay their mortgages on time.

HousingRow

Shouldn’t those 80%, he argued with me, have ‘fair access’ to the dream of homeownership?

Yes, of course. Nobody could ever disagree that people should have ‘fair access.’

He argued with me that the point of HUD policy is to ‘remove the barriers’ to the 80% of borrowers with bad credit who will pay their mortgages on time.

Removing barriers also seems great to me.

The much more difficult task is to figure out what ‘fair’ means, and what ‘access’ means. And what are the lending barriers that HUD wants to remove when it comes to borrowers with FICO scores below 680?

I would argue, and I did to Castro’s colleague at HUD, that the focus on positive outcomes for the 80 percent of subprime borrowers who pay their mortgage on time kind of finesses the point, by shifting the conversation away from the other 20 percent who will not be able to pay their mortgage.

And, in my opinion, the point is whether federal government policy should put its thumb on the scale to increase access to a market in which 20 percent of borrowers could lose their home due to non-payment on their mortgage.

In the end, however, I should not have worried too much because I don’t think the policies advocated by Castro will do much.

Actual Policy

House in Hand

It turns out, according to both the official and the follow-up materials his office sent me, that what Castro and HUD mean by “this has to change” is something pretty mild.

They mean a three-part program of
1. Encouraging borrower counseling
2. Clarifying lending standards (with an updated FHA Handbook!)
3. Analyzing additional data on mortgage lenders and sample mortgages

That all seems reasonable. In addition, this isn’t going to open the floodgates to increased subprime lending anytime soon.

Which leads to an interesting – albeit convoluted – ‘lets-agree-to-disagree’ point between myself and the HUD official.

Whereas I don’t think HUD should encourage more subprime borrowing and he does, I don’t think the federal government’s policies will have much effect, and he does.

So we’re both happy. I guess?

We all do this

Let me shift away from using the words “Castro” and “HUD” and “Federal Government” now to make this less personal, and frankly so it doesn’t seem like I’m politically attacking San Antonio’s golden child.

I’m going to make the decision-maker in the following sentences simply “We.”

Because I think we all do this.

As a society we are in the habit of wanting two contradictory things at the same time when it comes to banking policy, even though they are somewhat incompatible with each other.

For equality-of-access reasons we want banks to lend to more people, especially the neediest people, despite the fact that such lending is historically quite risky for both the bank and the borrower. The borrower, who we want to help, can wind up without a home, in bankruptcy, and with further wrecked credit. Banks can lose money, which – when this happens systemically – can crater an economy, as happened in 2008. In these indirect ways, therefore, increased subprime lending is quite risky for society.

subprime mortgagesAt the same time – or shortly thereafter, when 20% of these mortgage loans go bad, as expected – we want to punish banks for lending to the neediest people, “when the banks should have known better,” or when a loan to a needy person ends up looking predatory because either the rate is very high, or the collateral (the home) was seized in foreclosure, or both.

So we can all want these contradictory things at the same time, but I think we can also acknowledge that it’s all kind of hypocritical, no?

 

Please see related posts:

HUD Policy – The Good And Bad So Far

Mortgages Part VIII – The Cause of the 2008 Crisis

Mortgages Part V – Good Debt or Dangerous Drug?

Book Review of Edward Conard’s Unintended Consequences

Audio Interview Podcast – Mortgage Originator Explains the Crisis

 

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New HUD Secretary – The Good and Bad So Far

Editor’s Note: A version of this post ran this morning in the San Antonio Express News.

I can’t remember any speech Mayor Julian Castro ever made to which I paid much attention.

julian_castro_sub_prime_mortgages
Shouldn’t be pushing Subprime Mortgages

Decade of Downtown?
Meh. I had just moved to San Antonio’s downtown and I didn’t have any context.
Democratic National Convention?
I missed it because I was recovering that day from a blowout wedding in the Yucatan.

But last Tuesday’s speech introducing his priorities at HUD?

Did somebody say mortgage and housing policy?

Now you’re in my wheelhouse, Secretary Castro. As a former mortgage bond salesman, I’ve got some strong opinions about federal mortgage and housing policy.

Two things stood out for me from his speech, one bad, and one good.

First, the bad:
HUD Secretary Castro named increasing access to mortgages for borrowers with low credit scores a top priority of HUD.
I cringed.

home_ownership_rates
Home Ownership Rate Comparison, 2011

Do you know another name for increasing access to mortgages for borrowers with low credit scores?
That’s called sub-prime mortgage lending.

Restricting mortgage loans from people with bad credit scores is not housing discrimination or lending discrimination.
Rather, restricting mortgage loans from people with bad credit is prudent practice for both borrowers and lenders.

People with low credit scores are people who have not previously paid their bills on time. That’s just the definition of bad credit.

People can fix their bad credit over time, and government can play a positive role in encouraging financial education, for example, or by regulating credit reporting and consumer protections.

But most importantly, people with bad credit are people who should probably wait a bit longer before taking on the largest loan generally available to them – a home mortgage.

Encouraging more people with low credit scores to take out mortgages is a bit like breaking out the champagne at the AA meeting to celebrate a month of sobriety. Bad things can and will follow.

 

Look, I get it, when you’re a hammer, everything looks like a nail. And when you’re HUD Secretary, more home ownership is always better.

I guess my larger problem with Castro’s stated HUD priority is that home ownership isn’t always better.

It’s fine with me if banks or private lenders want to take extraordinary risks and lend to people who won’t pay them back in the future, but I really don’t think the federal government should be encouraging more of that activity.

Back in the pre 2008-Crisis days, mortgage giant Fannie Mae used to run constant radio advertisements proudly proclaiming “We’re In The American Dream Business!” and at the time, who could argue with them?

Home ownership traditionally fell somewhere between Motherhood,
Baseball, and Apple Pie on the spectrum of unimpeachable good things.
Well, since 2008 we’ve gotten wiser:
Apple pie causes obesity.
Baseball is full of PED cheaters.
And Mothers are the direct catalyst for about 50 percent of all of the adults who seek psychotherapy. (Since you’re curious, scientific studies show that Fathers are responsible for the next 25 percent of all therapy-seekers, and scary, scary clowns make up the final 25 percent. In my case, it was the clowns.)

monopoly_housing
Housing as an investment tool

And home ownership? Well, it’s both an incredibly powerful tool for building middle class wealth, as well as the cause of the worst financial crisis since the Great Depression.

While I would advocate home ownership for many people, pushing home ownership to excess – like Apple Pie, Baseball, and Motherhood – also leads to terrible outcomes.

We don’t need more subprime lending, and we don’t need government agencies encouraging more subprime lending.

Speaking of Fannie Mae and the American Dream Business, I really liked a different part of Castro’s speech.

Castro advocated passage of a bi-partisan Senate bill (sponsored back in March 2014 by Tim Johnson D-South Dakota, and Mike Crapo R-Idaho) currently languishing indefinitely in the Senate purgatory between Banking committee passage and the Senate floor.

The GSEs worth killing
The GSEs worth killing

The bill would set broad guidelines for mortgage lending and securitization in the future. Most importantly – from my perspective – the bill would kill former mortgage monstrosities Fannie Mae and Freddie Mac, which themselves currently languish indefinitely in conservatorship purgatory.

Why were they monstrosities?

To me, the definition of a monstrosity is a company that enriches private investors and its executives, all the while enjoying a government guaranty, and therefore represents a massive public subsidy of private enrichment.

And yes, I understand that all of Wall Street briefly earned monstrosity status by that definition in 2008.

But the difference between Wall Street and the mortgage monstrosities Fannie Mae and Freddie Mac is that the latter companies always had this monstrosity status, from their very inception.

Technically, they were described as “Government-sponsored entities” and government officials occasionally tried to point out that their debt was not explicitly guaranteed by the Federal government.

In practice, Fannie and Freddie bond investors always assumed that when push came to shove Fannie and Freddie would be bailed out by the Federal government. Of course, push did come to shove in 2008, and bond investors were proved right.

Would you like an example of the kind of private enrichment and public liability I am talking about? Fannie Mae’s CEO Franklin Raines earned $90 million in compensation between 1999 and 2004. Their next CEO, Daniel Mudd, earned $80 million between 2004 and 2008. And then the federal government (that’s you and me, fellow-taxpayer) assumed all of the liabilities of Fannie Mae and Freddie Mac in 2008, up to $800 Billion.

I don’t know. That just seems like a lot of money to be paid to run a government sponsored (and guaranteed) entity. There’s no flies on that pair of Dickensian-named CEOs, Raines and Mudd, despite SEC investigations of both of them for securities and accounting fraud, and a paltry settlement with Raines.

The Senate bill supported by Castro would not eliminate federal government subsidies for the housing and mortgage markets, but it would greatly reduce the future taxpayer subsidies for the enrichment of quasi-private monstrosity entities like Fannie Mae and Freddie Mac, and their investors and executives.

The bill would replace them with a much more narrowly-functioning government entity – modeled on the banking deposit insurance agency FDIC – to provide mortgage insurance and a taxpayer-protection fund against mortgage losses.

That would lead to much less private enrichment with a public subsidy.

That would represent great progress.

 

Please see related posts

Mortgages Part I – I am a Golden God

Mortgages Part VIII – The Cause of the 2008 Crisis

Book Review – Edward Conard’s Unintended Consequences

On Housing Part II – The Risks

On Housing Part III – The Opportunity

 

 

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Interview: Mortgage Originator Explains the Crisis

Please click above to listen to full interview.

Mike sat down with David, a former mortgage originator during the boom times.  They discuss the move into Subprime lending, the causes of the crisis, and shockingly, whether it was all worth it.

David:  Hi my name is David and I used to be a mortgage underwriter and originator.

Mike: David, thanks very much for joining me.  Can you give me a little bit of background to what is a mortgage underwriter and originator doing. What does that mean?

David: I started out originating.  I was the one making phone calls.  My initial contact was with the customer directly.

Mike:  So, the customer comes in, and I think you said you started in the year 2000?

David:  Yeah it was in 2000 and it was right before, or right I guess right at the start of the whole refinance boom.  My territory was Northern and Middle California. So that’s kind of where everything starts.

As the Great Mortgage Crisis of 2008 slips into history, a consensus builds that the biggest breakdown of the system occurred because the different links in the mortgage production chain knew what they knew, and acted in their own self interest, but nobody knew enough of what the others knew.

I thought of this recently as I sat down with David.  He worked as a mortgage originator precisely the same time I worked as a mortgage bond salesman.  During that time, I never talked to a mortgage originator.  Nobody I ever worked with on Wall Street ever sat down with the guys originating mortgages to compare notes.  It never occurred to us.  An economist might call this breakdown in communication ‘informational friction.’  You might call it ‘stupid.’

Cogs during the Mortgage Boom Times

Mike: So [from] 2000 to 2001, I’m interested in part because it parallels where I was.  I joined the mortgage bond department in the end of 2001, which it sounds like you’d been at the job for a year. And what we were experiencing on the Wall Street side of things was an extraordinary boom in origination just the mortgage pipeline had never been bigger.  Everybody essentially who owned a home already would benefit from refinancing.  So everybody was refinancing at a breakneck pace.  I’m assuming from where you were sitting that your business was booming, and you have something to offer that everybody wants, right?

David: That’s exactly what it was, and that’s part of the reason that I got the job of there, was I didn’t have any financial experience previous to that, I was a salesman as I had done for years and years before that. And a friend of mine that worked in the personnel department at the bank knew that, and knew that they were coming up on this huge boom of refinancing.

Since we were mainly dealing with A and A+ paper, the most qualified borrowers, there was never a situation where we had to sell things that they didn’t need.  We just had an influx of people calling and an influx of business, and they needed people who could handle that.  The department that I worked for grew exponentially over the two years that was there.

The phones were literally ringing off the hook, in the end of 2001, to refinance homes or to take home equity out because the rates were so good.

But back in those days, at least in the beginning, business was booming and everybody made money.

David: There was no risk involved at the time.  If you got a borrower in from Northern California, from Carmel, who – say he made, you know, $3 million per year, and he’s got an 820 FICO, what do I care?  He’s going to put 20% down, even if, for some reason, he falls off the face of the earth and he goes 6 months and he defaults, we get the house back into our portfolio because we paid for it, it’s our money.  We sell the house again through our real estate side. Or through a realtor that we know, we make money on that, and we’ve got this 20% down, his $250,000 initially.  There was absolutely no risk involved in lending to those types of borrowers.

Mike: There was just so much volume going through the system and everybody qualified essentially and everybody had home equity.

David: Yeah it was a flood.  And our big territory was California, and that was like the beginning of like the tech boom.  All the software guys were out there.  And Google hadn’t even started yet, it was Yahoo and Microsoft and these guys were just collecting money and their bank accounts were huge and they really couldn’t account for all of it because they didn’t get normal paychecks or they got bonuses, or this and that, but they had perfect credit and they had a lot of money and we sold them houses.

Mike: So we know now, in the macro picture, 9/11 happens, the Fed lowers interest rates, there’s extraordinary amounts of money looking for some return, all the models say that mortgage are a great place to get a return, so on the investor side everybody wants mortgages, and on the retail side, everybody wants to refinance their house, which has gone up in value, so its just this awesome machine, and I was also a cog in the machine, in doing my bit.  When you’re a cog in the machine it’s not always, it’s not obvious to us what this is all going to lead to.

The Move to Subprime and Alt-A Lending

And then two great new types of mortgage origination came along.  Alt-A, which meant you could provide much less information than on a traditional mortgage application, and Subprime, which meant you could get a mortgage even though you did not have a history of actually paying your bills.  We started to dive into that where I worked, and David’s two employers during that time period also entered the exciting new world of people with marginal credit and minimal screening of their applications.   Again, so much money was being made.

I joined the Goldman mortgage desk in the end of 2001, beginning of 2002.  and at that time Goldman had, pretty much that month, there was a guy named Kevin Gasvoda, he’s a Vice President and he’s got this mandate to get Goldman into this business because we’d realized that Bear Stearns and Lehman Brothers were taking/stealing our market share in the mortgage department and we didn’t have a subprime or Alt-A program.  And Goldman had basically not gotten into that business because of reputation risk, and we didn’t quite trust that these people would pay the money back, but suddenly in 2002 we were going to invest in that, and the models say that looking back over the last five years everybody does pay their subprime mortgages back. And Alt-A is a perfectly safe product if you structure it correctly, and by the way Lehman and Bear are making tons of money doing this, they are just printing money.

I distinctly remember this kind of back and forth from, internally at Goldman of ‘Should we be in this market?’

In the ‘90s they’d decided not to be, but by 2002, kind of just as I was joining, they were saying ‘We cannot NOT be in this market, we have to be there.  We’ve not trusted it in the past but we’ve got to be there and it/s growing so fast.  That’s my side of the subprime thing, so what’s going on, on your side, while that’s happening?

David: That’s pretty much, actually that’s exactly, almost exactly parallel to what was happening at my bank.    It went from a kind of normal application process, so a normal application form, we’d call their bank for verification, they’d submit income, assets, they’d submit pay stubs that kind of thing, like you would nowadays if you went to get any mortgage, anybody.

Six or seven months into my stay there, so middle of 2001, we didn’t care anymore.  I was literally getting applications with a social security number, a name, a job description, and a bank account statement, and that was it, and we’d write them a check for a million dollars.  And that was happening all day long because it didn’t matter.

Six or seven months into my stay there, so middle of 2001, we didn’t care anymore.  I was literally getting applications with a social security number, a name, a job description, and a bank account statement, and that was it, and we’d write them a check for a million dollars.  And that was happening all day long because it didn’t matter.

Mike: The process of just social security number, job, that was for A-Paper, that’s high quality borrowers, that’s 2001

David: Those would be our no income, no asset borrowers,

In other words, Alt-A paper

David: they come in, we run their credit, and they’ve got an 820 FICO

Mike: Perfect credit, we’ll cut you the check

David: Yeah, we’ll give you what, it’s not a big deal.

David then moved over to USAA Bank, but did not enjoy the subprime market as much.

David: Um, I was there really briefy because I don’t, I didn’t think they were going in the direction that I wanted to go in, as far as that’s concerned…the jumped immediately into the, uh, mid-level and subprime lending because what’s they wanted to get into.

Mike: All the models said, sub-prime people actually paid back, if you looked the previous four years, they all refinanced and paid their money.

David: Absolutely all the math worked.  But the thing is if you look back four years on anything it’s going to work.  If you look eight years or ten years or sixteen years…you’d have to look as far back as the Great Depression – recently – to find where the curve was.  It’s so big it’s hard to see the whole thing especially when you’re focusing on making money like everybody else was.

The reason I didn’t like it so much was they were gearing more toward sub-prime people, and I could obviously see they were starting to lend to borrowers who were not going to be able to pay stuff back.

I’m not saying anything about about USAA bank, obviously everybody was starting to do it at the same time. Because you’re right everybody said “They’re going to pay us back” even though we knew if you give somebody with a 40% debt ratio and you mitigate that by a credit score they still don’t have enough money to pay the loan back, no matter what their credit says and that credit might say that now I mean six months from now and eight months from now it’s going to drop 100 points because they just defaulted on the mortgage you sold them that was, that was out of their means.  And that’s why I said I’m not gonna kind of do this anymore.

David moved back to a customer service job at a private mortgage broker, something he enjoyed immensely, in contrast to the previous work with Subprime and Alt-A borrowers.

The American Dream Business, Gone Bad

David: That was the opposite side of what I was doing before, where we were just handing out checks to people, you know, four or five years previous to that.  And didn’t care about anybody or anything, just making money, this was helping people get into houses.  And actually, like, making their dream come true. It’s not that trite a sentiment when you’re actually doing it.   When you actually are able to call somebody and say we’ve got your loan approved, you’re going to get this house.  It’s much more satisfying than just signing your name on a piece of paper that’s worth a million dollars.

Mike: So you, but you enjoyed that part of it?

David: Absolutely

Mike: It was satisfying to be originating and brokering mortgages for folks.

David: Yeah, and that’s kind of the, that was the fun part, was doing that, versus trying to sell products that probably weren’t suited for somebody to them, and thinking always in the back of your head, is this person going to lose their house, are we going to lose money, is everybody.  Like, this is starting to kind of not, not be agreeable anymore.

 

David: Yeah, and that’s kind of the, that was the fun part, was doing that, versus trying to sell products that probably weren’t suited for somebody to them, and thinking always in the back of your head, is this person going to lose their house, are we going to lose money, is everybody.  Like, this is starting to kind of not, not be agreeable anymore.

Small Mortgage Errors Compounded With Great Leverage

So, back to the economists, and the information frictions.  One of the things I really liked talking to David about was bridging that information gap.  What is it he knew, that Wall Street should have known.  Its too late of course, but still, what if mortgage originators, mortgage bond salesmen, and mortgage investors had actually spoken to each other in the run up years to 2008?

Mike:  With the benefit of hindsight lots of people have pointed out that all along the mortgage chain each person was doing their job more or less properly as they saw fit, and each person was acting in their own self interest and yet somehow there was information lost.  Somewhere between either the models don’t take into account enough past information on the investor or bank structuring side, homeowners aren’t taking into account the idea that real estate values don’t always go up, they also go flat and they also go down.  On the mortgage origination side lots and lots of banks went under because they sold wholesale packages to Wall Street, which then stopped taking them and putting them back and it just bankrupted the mortgage originators who couldn’t take back the, at that point, unsaleable mortgages.

So everybody got hurt, and yet it’s interesting because every one of us was trying to do the best we could.  In the back of our minds “Huh, something’s not quite going right.”  Do you have any anecdotes of having talked to homeowners about something being not quite right.

David: What I look back now and think about were all the times where we…we you stretch it a little bit.  And if I’m stretching this person’s income by $1,000, or if they’re telling me they make you know $3,500/month, versus $3,200/month and I see their pay statements and it kind of makes sense and I’m just cursorily looking over it and signing off on it, well, that $300 has to come from somewhere, theoretically.  That’s kind of what happened, and I’m that one person.  And there’s one hundred of me.  And there’s a thousand of my departments, and there’s a thousand of my banks.  If you take all those little stretches and flubs and oversights that don’t mean anything at the time because you’re either caught up in writing a loan or making a deadline or a quota

Mike: Keep your volume up, make your monthly number.

David: Or even at the best, helping somebody get a house.

Mike: Right

David: All those things have to come from somewhere, that’s not just…they don’t just go away.  So if you approve this person, or don’t approve this person, or you approve too many of these people, or a hundred of your compatriots are doing the same thing at exactly the same time then the numbers start to skew from the model to actuality and it’s like gaining weight or getting fat, you don’t notice it

Mike: it’s only a half pound per month, but a year later…you’re a lot fatter

David: Exactly, you don’t notice it until you’re 50 pounds overweight a year later, and then you start thinking about all the times you had an extra serving of ice cream, or you didn’t stop at, you know, two pieces of cheese, or whatever it is.

Mike: You’re making me feel guilty

David: Yeah, me too.

Mike: I like your explanation that the income has to be $3,500 [per month] but it’s actually $3,200 and there’s this missing $300/month, that where it’s close enough so we’ll just pass it on

David: Yeah

Mike: And yet, $300/month, you know, it gets put on the credit card and then eventually you’re talking about…

David: And that’s what it is

Mike: …You’re $20,000 in the hole and your house is in foreclosure.

David: It doesn’t seem like a lot to me.  Because I’m thinking, “Yeah, no, this is fine.”  Its only $20/month on their payments to give them this versus this, but 20 times a year, times thirty years, your asking this person to repay back thirty thousand dollars more than they are currently able to.  And that’s assuming that their position is going to get better, instead of assuming their position is going to stay the same or get worse which is what actually happened.

Mike: It gets pretty geared up, pretty leveraged.

David: Yeah.

Mike: Small mistakes get amplified.  On the Wall Street structuring side, where we knew to the Nth degree how to exactly satisfy the letter of the law with respect to how the rating agencies needed bonds to be structured – not the spirit of it, not we’re going to make some safe AAA-rated bonds and some A-rated bonds then BBB-rated bonds, but precisely the letter and not a single iota of wiggle room is you take those $300/month off income and then you gear that to the Nth degree of what the rating agencys will let Wall Street get away with.

All of the mortgage business was entirely a, what we would call a rating agency arbitrage, where you’re just doing precisely the thing that will get you the rating you need to sell it to your investors, but with the no wiggle room, and then as the origination is happening that way, even if you have a slight hiccup it’s all going to come down.

Was It All Worth It?  David Says Yes

Towards the end of our conversation David and I were getting a little bit philosophical and then he surprised me, by saying the entire mortgage debacle might have been worth it.  I had never met anyone who would say that outloud.  But David did.

David: Yeah. That’s something I think about too.  If it wouldn’t have worked out so well for everybody – yeah it went to something bad but – if that money wouldn’t have been made would everything still have kept rolling or would have just been kind of steady or stagnant.  Let’s say you win the lottery, and you go out and you spend all your money in a year. Who’s to say that wasn’t the best year of your life?  And it wasn’t worth spending all of that money on?

Mike: Were the gains in the lead up from say, 2000 to 2007, bigger than the ultimate loss of a steady-state of just steady growth?

David: and that’s coming from someone who isn’t rich, who isn’t wealthy.  I didn’t make, you know, tremendous gains.  I was just a regular employee.  I made a good paycheck, a regular salary but it wasn’t, it wasn’t anything I could retire on.  It wasn’t anything or it wasn’t going to have to work the rest of the, the rest of my life. So, just to be clear about who is actually saying this. It’s not someone who has, who has profited from that big wave, and I’m sitting on a big pile of money giving, giving an interview saying how good it was. This is someone who will has to work a job everyday for the rest of my life because the industry now probably couldn’t support what it did back then.  And I still think that that might have been worth it to get where we are now to know what we know.

Mike: yeah it’s an interesting thing that most people are not saying, which is, the boom might’ve been worth the bust. Is that in a sense what you’re saying?

David: Yeah

Mike: both from a knowledge as well as from a wealth standpoint?

David: Yeah

Mike: That’s a really unusual statement.

David: It’s the position of someone who’s watched it from the inside and then the extreme outside. Someone who gas prices matter to, who knows what a gallon of milk costs.  And, it still seems to me that the experience and that the situation is okay now, it’s not as dire I don’t think as people are making – it was – in like 2007 and 2008 when we almost actually literally lost everything.

Mike: we were staring at the financial abyss, living in caves

David: Yeah it was really close.  It was a financial Holocaust. It was going to happen. Everybody was going to lose everything, at the same time. And banking was going to stop. But it didn’t.  The fact is it didn’t, because we took everything that we had learned from the previous seven or eight years and said “Okay, this isn’t going to work.  We’re seeing it not work.”

If that wouldn’t have happened, would we have even seen that.  Would the curve have been shallower and longer, and had more detrimental effect, if the spike wouldn’t have been so great when it was.

Mike: I think that’s really interesting.  Most people don’t have your philosophical approach to it. I don’t know either way.

David: As I said, it’s not to mitigate or to rationalize, you know, the millions of dollars that I made, because I haven’t.  And it’s not positive just to be positive about it, to kind of negate others things or to ignore it.  I’m by nature a very pragmatic person.  But even that.  You have to at least accept that the experience was worth it.

 

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