by Eric Englund
is an immoral tax that leads to immoral values
South American banker
been in the credit profession for the past 23 years, I have
observed several cycles involving the loosening and then the
inevitable tightening of credit-underwriting standards. Of
course, the Federal Reserve stands at the epicenter of such
cycles. While money and credit are flowing like beer at an
Irish pub on St. Patrick’s Day, everyone ends up looking like
an attractive credit risk. When it appeared that the U.S.
economy was heading into a recession, after the collapse of
the dot.com and telecom bubbles, the Federal Reserve opened
up the taps and encouraged one and all to imbibe its tasty,
low-cost credit – with the most popular "flavor"
being the mortgage loan. At this point, mortgage lenders merely
became bartenders serving anyone who walked in the door. To
reach this nadir in mortgage-lending standards, it is inescapable
that the "Five Cs" of credit were ignored regardless
if a mortgage loan was deemed prime, Alt-A, or subprime. This
is exactly why the home-mortgage meltdown has just begun.
of my job entails analyzing personal financial statements.
Twenty years ago, without a doubt, households had much healthier
financial conditions. Back then, in proportion to household
net worth, savings were much higher and debt levels (especially
automobile, credit card, and mortgage debts) were dramatically
lower. It is alarmingly common, today, to see households with
well under ten thousand dollars in savings yet half-a-million
dollars in mortgage debt – not to mention thousands of dollars
in credit card debt and tens-of-thousands of dollars in automobile
debt. Such households are literally one or two missed paychecks
away from being destitute. Yet, amazingly, the heads of such
households are considered to be prime-level borrowers (as
long as there is adequate income to cover monthly debt service
and expenses). What has happened, in the sphere of personal-credit
underwriting, is that risk parameters have been redefined
with the word "prime" having been defined downwards.
unfolding mortgage-debt crisis did not emerge in a vacuum.
When Alan Greenspan’s Federal Reserve pounded the federal
funds rate down to 1%, in June of 2003, it is crucial to understand
that such a low rate materialized due to the Fed’s aggressive
creation of money and credit. In other words, America’s monetary
central planner "knew" that massive inflation was
needed to "rescue" the economy from the above-mentioned
dot.com and telecom implosions. Housing was specifically
targeted by the Federal Reserve to serve as "…a
key channel of monetary policy transmission." With
this colossal inflation of the money supply, I would argue
that a hyperreality surfaced in the housing market – with
corresponding bubbles emerging in consumer electronics and
automobiles. During such episodes of heavy inflation, people
tend to lose their sense of value including suspending any
fear of debt.
remarkable piece, Hyperinflation
and Hyperreality: Thomas Mann in Light of Austrian Economics,
Dr. Paul Cantor masterfully describes how central banking
brings about such a destructive hyperreality:
modernity is characterized by a loss of the sense of the
real, this fact is connected to what has happened to money
in the twentieth century. Everything threatens to become
unreal once money ceases to be real. I said that a strong
sense of counterfeit reality prevails in Disorder and
Early Sorrow. That fact is ultimately to be traced to
the biggest counterfeiter of them all – the government and
its printing presses. Hyperinflation occurs when a government
starts printing all the money it wants, that is to say,
when the government becomes a counterfeiter. Inflation is
that moment when as a result of government action the distinction
between real money and fake money begins to dissolve. That
is why inflation has such a corrosive effect on society.
Money is one of the primary measures of value in any society,
perhaps the primary one, the principal repository
of value. As such, money is a central source of stability,
continuity, and coherence in any community. Hence to tamper
with the basic money supply is to tamper with a community’s
sense of value. By making money worthless, inflation threatens
to undermine and dissolve all sense of value in a society.
be sure, when the federal funds rate declined to the surreal
level of 1%, lenders and borrowers behaved as if they were
transacting with Monopoly money.
to dealing with the psychologically corrosive affects of inflation,
mortgage lenders have become interwoven into what James
Grant deems "mortgage socialism." Since FDR’s
New Deal, a veritable alphabet soup of governmental and quasi-governmental
entities has served to intervene in America’s mortgage market
to slake Uncle Sam’s thirst for putting Americans into homes
regardless of creditworthiness. For example, in 2004, George
W. Bush clung to the coattails of the emerging housing bubble
credit for America’s increase in the rate of homeownership.
He saw fit to take such credit as he viewed newly minted homeowners
as a voting block to count on in the 2004 presidential election.
Accordingly, the alphabet soup of federally sanctioned housing-market
interventionists – Fannie Mae, Freddie Mac, Federal Housing
Administration, Ginnie Mae, Department of Veteran Affairs,
etc. – served the governing plutocracy’s political ends. What
many fail to comprehend is that socialization of mortgage
credit inherently means that mortgage-lending standards have
been systematically watered down.
Freddie Mac and Fannie Mae have been buying mortgage loans
from qualified lending institutions and then securitizing
bundles of such loans into mortgage-backed securities (MBS)
– which are typically sold to institutional investors. Ginnie
Mae, which is backed by the full faith and credit of the U.S.
Government, does not securitize mortgage loans but does guarantee
investors the timely payment of principal and interest on
mortgage-backed securities insured by the Federal Housing
Administration or guaranteed by the Department of Veteran
Affairs. Freddie and Fannie also guarantee the timely payment
of principal and interest on their securities but do not have
the full faith and credit of the U.S. Government backing them
– although the assumption is that Uncle Sam will not allow
Freddie or Fannie to fail.
housing bubble was expanding, the private sector aggressively
jumped into the mortgage-lending fray with an eye toward profiting
from securitizing and selling bundles of mortgage loans in
the form of mortgage-backed securities – think of companies
such as Countrywide Financial and Bear Stearns. A most important
aspect of these mortgage-backed securities is that they are
not backed by the full faith and credit of the U.S. Government.
However, and this is critical, these private brands of mortgage-backed
securities were created by bundling mortgage loans that were
originated using the same low underwriting standards as prescribed
by Uncle Sam’s socialized mortgage-credit hawkers. To compete
in this arena, it was essential to drop lending standards
down to the lowest common denominator. Yet, even if there
were a few "old-school" credit managers expressing
concern, top management – at the private firms producing these
MBS products – didn’t heed such apprehensions because most
of the mortgage loans weren’t being retained as they were
being securitized and sold for a profit. Hence, shoddy credit
underwriting became the problem of the MBS purchasers.
credit managers, undoubtedly, are still familiar with the
Five Cs of credit – which will be covered in depth below.
And when it comes to lending large sums of money related to
home mortgages, each and every one of these "Cs"
is important to the credit-underwriting process. Alas, such
old-fashioned underwriting isn’t conducive to rapid-paced
credit creation – beloved by the MBS peddlers – and most certainly
goes against the egalitarian spirit of mortgage socialism.
April 8, 2005 speech,
Alan Greenspan gushed about how technology has streamlined
credit underwriting and made credit more accessible to all
Americans. Here is what he stated at the Federal Reserve’s
"Fourth Annual Community Affairs Research Conference":
has every segment of our economy, the financial services
sector has been dramatically transformed by technology.
Technological advancements have significantly altered the
delivery and processing of nearly every consumer financial
transaction, from the most basic to the most complex. For
example, information processing technology has enabled creditors
to achieve significant efficiencies in collecting and assimilating
the data necessary to evaluate risk and make corresponding
decisions about credit pricing.
these advances in technology, lenders have taken advantage
of credit-scoring models and other techniques for efficiently
extending credit to a broader spectrum of consumers. The
widespread adoption of these models has reduced the costs
of evaluating the creditworthiness of borrowers, and in
competitive markets cost reductions tend to be passed through
to borrowers. Where once more-marginal applicants would
simply have been denied credit, lenders are now able to
quite efficiently judge the risk posed by individual applicants
and to price that risk appropriately. These improvements
have led to rapid growth in subprime mortgage lending; indeed,
today subprime mortgages account for roughly 10 percent
of the number of all mortgages outstanding, up from just
1 or 2 percent in the early 1990s.
a true socialist (really, what else is a monetary central
planner), Greenspan celebrated credit egalitarianism in this
speech – in which he concluded:
we reflect on the evolution of consumer credit in the United
States, we must conclude that innovation and structural
change in the financial services industry have been critical
in providing expanded access to credit for the vast majority
of consumers, including those of limited means. Without
these forces, it would have been impossible for lower-income
consumers to have the degree of access to credit markets
that they now have.
fact underscores the importance of our roles as policymakers,
researchers, bankers, and consumer advocates in fostering
constructive innovation that is both responsive to market
demand and beneficial to consumers.
Alan Greenspan certainly hasn’t been cheering about subprime
mortgages. I wonder why not?
Five Cs of Credit
long past, creditors actually underwrote their loans to such
a standard that default was unlikely. Consequently, the Five
Cs of credit were taken quite seriously by loan officers.
The Five Cs of credit are character, capacity, capital, collateral,
and conditions. What follows is a brief description of each
of the Five Cs – as tailored to making personal and home-mortgage
This is the general impression you make on the lender.
The prospective borrower’s educational background and professional
experience will be reviewed, along with his credit score.
It is important to manage one’s personal credit carefully.
There is a strong correlation between past credit history
and the propensity to take care of present and future debt
obligations. Ultimately, the creditor is seeking to gauge
the honesty and reliability of the borrower. In days past,
a banker would have had a long-term business relationship
with each customer and would have come to know each customer’s
reputation within the community.
Honesty alone does not pay the bills. Here again, educational
background and professional experience enter the equation.
A loan officer will look at a borrower’s current employment,
job history, and skill-sets to discern stability, earnings
power, and responsibility. Most certainly, the applicant’s
current income and monthly expenses will be key factors considered
in the loan-underwriting process. Nonetheless, just because
a loan applicant may have adequate current income, to make
the monthly mortgage payment, does not necessarily mean he
is a good risk for a long-term loan. A spotty employment history,
perhaps indicating instability and irresponsibility, certainly
does not mesh well with granting a mortgage loan. If such
a person is also looking to purchase a house for the first
time, he may not even understand the personal and financial
commitments associated with homeownership.
A personal financial statement provides a critical snapshot
as to a loan applicant’s financial condition. Within the balance
sheet, the individual will list assets and liabilities. After
making underwriting adjustments (mostly to the valuation of
assets), the applicant’s net worth can be derived by subtracting
total liabilities from "as allowed" assets.
at this point that a lender will determine if the loan applicant
has the financial strength to qualify for the loan. A few
key questions will come to the underwriter’s mind. For example,
is the applicant too leveraged to qualify for the mortgage
loan – as indicated by a high debt-to-net-worth ratio? Does
the applicant, moreover, have sufficient liquidity (e.g.,
cash and securities) to make a 20% down payment? After making
the down payment, will there remain an adequate "rainy-day"
fund for the mortgagor to survive several months of unemployment
which entails supporting all household expenses and debt service?
In home-mortgage lending, the house is the collateral. It
is crucial to understand that a house, in most cases, is a
non-income producing asset. A house, typically, is purchased
for the utility it provides as a family’s primary shelter.
The lender will maintain a security interest (i.e., a lien)
in the house until the debt is fully repaid. Should the borrower
fail to make the monthly payments, foreclosure and liquidation
would ensue to help repay the loan.
Lending decisions are partially based upon the conditions
of the local, regional, and national economy. For instance,
would you want to be originating long-term home loans to Detroit
autoworkers? Some lenders may answer in the affirmative, while
structuring the loans to factor in applicable economic risks,
while others would deem such a proposition as too risky.
condition to consider pertains to the neighborhood in which
a house is located. Some lenders may prefer to make home loans
related to newer houses in more affluent neighborhoods. Thus,
the value of the collateral is more likely to remain unimpaired.
Should foreclosure come to pass, the lender may stand a better
chance of fully recouping the value of the loan.
loan officer does not feel comfortable with the risk profile
of a loan applicant, then it is his responsibility to say
"no" to the prospective borrower. Although this
may come as unwelcome news, the loan applicant eventually
may realize that the loan officer kept him out of financial
danger. Declining to make a poor loan, additionally, meshes
with the objective of underwriting sound and profitable loans.
The Five Cs of credit are invaluable when it comes to originating
when the Federal Reserve targeted housing to reflate the U.S.
economy with enormous doses of money and credit, America’s
creeping credit socialism was given fertile ground to grow
into a monstrous housing bubble. Mortgage lenders irresponsibly
said "yes" to just about any borrower while Alan
Greenspan cheered them on. It is no wonder why I have seen
the most debt-laden, maladjusted personal financial statements
in my entire career. In fact, the Federal Reserve’s data
support my observations as domestic household debt has increased
from approximately $2.5 trillion in 1986, to $7.7 trillion
in 2001, to $12.9 trillion in 2006 (with 76% of the 2006 figure
being mortgage debt). The toxic combination of mind-numbing
inflation and credit socialism has crippled household finances
from coast to coast. Therefore, do not believe the talking
heads who claim that the mortgage mess is limited to the subprime
stratum. As the housing bubble continues to implode, the financial
fallout will result in nothing short of an international economic
disaster. The Federal Reserve’s September 18, 2007 one-half
percent cut in the fed funds rate will not do anything to
head off America’s looming household-insolvency crisis.