"WHY THE REAL ESTATE CRISIS HAD TO HAPPEN" By FRED CARACH

We cannot understand the present unless we understand the past. The first question to be asked is when did the real estate crisis become inevitable? The correct answer is in the time period between 1980 and 1982. It has been forgotten today but the last real estate crisis in this country were the twin real estate crises of the 1980s. In the early 1980s the first crisis was brought on by double-digit mortgage interest rates. Then in the late 1980s there was the savings and loan crisis, which in those days provided most of the nation's mortgage capital. In response to these twin crises congress passed two laws that made today's real estate crisis inevitable.
After these acts were passed it was only a question of time until the stars aligned correctly for the volcano to erupt.
In 1980, congress passed the DIDMCA Act. Prior to this time, it was illegal to charge less credit worthy customers a higher rate of interest on their mortgage. Then in 1982, congress passed the AMPT Act, which allowed adjustable rate mortgages or ARMs for the first time. Prior to this act adjustable rate mortgages had been illegal.
If you go back to 1896 when reliable housing records first began to be kept you will find that from 1896 to 1996 housing prices tracked the rate of inflation. Then suddenly from 1996 to 2006 housing prices doubled. The problem of course in that the income of the American people did not come anywhere near to doubling in that time period.
When you stop to think about it, you will realize that it is impossible for the price of housing to exceed the rise in the income of the American people for any sustained period of time. Unless there is an enabler, a speculator's tool that allows this to happen. What was the speculator's tool or device that enabled this process to occur? What was the enabler?
In the whole of American history there has only been one prior real estate bubble that resembles the real estate boom and bust that we are now witnessing. It was the great Florida land boom of the 1920s. Real estate has always been expensive. What has always held real estate prices in check was that people just did not have enough money to bull prices up for very long. The money is just not there. The device that enabled the Florida land boom to occur was the "binder." This is a real estate term that has gone out of use today. In the manner in which it was then used it was essentially an option payment on the down payment if you can conceive of such a thing.
What it boiled down to is that people thought they were speculating on real estate but in reality they were speculating on real estate options.
The stock market has long been the ultimate proving ground for speculative tools. Those of us who are stock market speculators are very familiar with stock options. The only thing that the reader has to know about options is that they are speculating tools that possess tremendous leverage. In other words, you can make a killing on a chump change investment.
Both the binder of the 1920s and the ARM are in reality real estate options. All options expire worthless if they are not exercised prior to their expiration date. Most ARMs were written to expire in two or three years, the fixed interest rate period. At that moment the option had to be exercised or rolled over because the option would become worthless. People were deluded into believing that they were buying real estate. When in reality they were speculating in real estate options. As we have seen, the tools for the bubble were in place by 1982. the only thing lacking now was the mania. The boom years from 1991 to 2007 provided the mania. Real estate prices rose relentlessly. It was a boom that seemed like it would never end. You couldn't lose in real estate because no matter how much you over paid because rising prices bailed out everyone.
Today in the aftermath of the boom, we are already discounting the impact on the human psych that manias and bubbles produce. To put it bluntly by the end of the boom almost no one could believe that real estate prices could fall. This nearly universal belief gradually eroded prudent behavior. The more risks you took the more you were rewarded. There was no down side.
In the early 90s the use of sub prime mortgages and ARMs were limited-since almost all sub prime mortgages were also ARMs they will be considered as a unit- but as the boom progressed their importance grew and grew.
Mortgage brokers just could not stay away from sub prime mortgages. They were three to five times more profitable than standard mortgages. Once they had sold one they didn't want to sell anything else. The caution that lenders had originally shown toward the new mortgage products was relentlessly ground away as the endless boom continued. Caution wasn't being rewarded, it was being punished. There was a Gresham's Law in effect- Gresham was an economist-in which bad or reckless behavior which was constantly being rewarded by lush profits drove out good or cautious behavior because the profits were inferior. In the final years of the boom, conservative firms could not even keep their mortgage brokers from bolting to subprime lenders.
Then around the year 2000 Minsky's Law kicked in. Hyman Minsky was a Noble Prize winning economist.

Minsky's Law

Over periods of prolonged prosperity the economy evolves from financial

relationships that engender a stable financial system to financial relationships

that produce economic instability. The longer the trend persists the more

violent the correction when the trend reverses.

As the boom rolled on the most important factor was that almost everyone was a winner. This was true in spite of the fact that subprime mortgages were constantly defaulting at the higher rates that had been predicted. Not only was the higher default rate not a problem but everyone was making out like a bandit with subprime mortgages. This included the subprime borrower. As soon as he fell behind his friendly subprime mortgage broker would be there to write him a new subprime mortgage. In fact he often got to take out new money when he refinanced the mortgage. It was not unusual to have subprime borrowers take out new mortgages every two or three years during the boom.

If there wasn't enough equity to suit the lenders, real estate speculators would be pounding at his door offering to take the property off his hands as soon as the notice of default had been published. Often at a profit over his purchase price.

The banks were the greatest winners of all. They were making a killing. It is obscene how much money a bank can make during the foreclosure process as long as someone buys the foreclosed property. Not only do they receive all the back payments but the brutal penalty fees as well. Indeed the most profitable scenario that can be imagined for a mortgage lender is to make nothing but high profit subprime loans and then to have them all default. Their profits would be enormous. That is, so long as the lender never has to take back the property.

When the boom ended, things became incredibly ugly for the banks with amazing speed. One of the most important favors that real estate speculators did for the banks when they bought a foreclosed properly was that in addition to paying the obscene penalty fees they also paid the nearly as obscene attorney foreclosure fees. Not to mention repairing the often seriously vandalized property. An angry homeowner can easily do $20,000-$30,000 in damages.

When the boom ended all these expenses landed on the banks head like a falling safe. The banks never knew what hit them. I am sure that they still think that they were run over by a Mack truck.

Fred Carach is the author of the book, " Forty Years A Speculator." His blog is fortyyearsaspeculator.blogspot.com

"WHY THE BANK WILL NOT MODIFY YOUR MORTGAGE" BY FRED CARACH

We cannot understand the present unless we understand the past. To understand today's banking and real estate crisis you have to go back to the last banking crisis. The savings and loan crisis of the late 1980s resulted in a new banking paradigm. Under the old paradigm almost all banks were "full service banks." In other words all real estate lending functions were handled in-house. By the time the crisis was over with the typical bank had been transformed beyond recognition. Banks went from being full service institutions to limited service institutions that had farmed out to others many banking functions that had hitherto been regarded as being important core functions.

However,none of these dramatic changes were visible to the typical bank customer. It looked like the same old bank to them.

This transformation was part of a much broader transformation that was taking America by storm. This new business philosophy held that every business had a core competency and that the way to maximize your profits was to concentrate on your core, high profit skills and to farm out to other institutions your low profit, non-competency functions. It was taken for granted that the activities that were earning you the greatest profits were your core competencies and that anything that was low profit was a low competency skill that was bested farmed out to others. The flaw in this system was that in times of crisis you no longer had the in-house skills to cope with the crisis because the skills had been farmed out to others.

It has to be admitted that in normal times the new paradigm delivered on its promise of lowering costs and increasing profits. This is why today when you make a call to complain about a product or service you end up talking to a speaker who lives in Calcutta, India.

The Old Bank Model

In-house staff real estate appraisers

In-house mortgage originators

In-house servicing of mortgage payments

In-house warehousing of mortgages

The New Bank Model

No in-house staff appraisers

Very limited amount of in-house mortgage originating

No in-house mortgage servicing

Almost no warehousing of mortgages

(mortgages were sold off rather than kept)

Under the old banking model when a mortgage got into trouble the bank had all the expertise needed to solve the problem in-house. Under the new banking model not only was the bank clueless but it was enshrouded in total darkness as well.

Under the old system when a mortgage problem arose the bank knew exactly what to do. Under the new system it sits around and sucks its thumb. Under the old system the first thing the bank would do was send out one of its in-house staff appraisers to do a complete inspection of the home and a complete professional appraisal. Under the new system they call up a real estate broker and ask for a BPO, a broker's price opinion. No doubt you are wondering why they don't hire an appraiser? The answer the bank will give you is that they are way too smart to pay the $275-$350 a complete appraisal would cost. This standard appraisal also includes a complete interior and exterior inspection of the property.

A BPO they craftily inform you will only cost them about $75. That's because the broker never leaves the office. He spends fifteen minutes scanning comparable sale listings on the MLS system. Eyeballs what seems to him to be an appropriate number and another fifteen minutes writing up the one or two page BPO. As the bankers will proudly tell you they are way too smart to get the job done right. Guessing is so much cheaper.

I speak with an insiders knowledge on this point. You see I was one of the in-house appraisers that were thrown out on the streets like a dog.

Let's step back in time and continue our analysis. In the old days when a client asked for a mortgage The in-house appraiser and loan officer would carefully scrutinize the deal. Due diligence was taken seriously because the mortgage was going to be warehoused by the bank until maturity and not sold off. If the mortgage blew up the bank took the loss. In this case the appraiser and the loan officer give the deal a thumbs down. The appraised value is below the sale price and there are problems with the buyer's earnings and credit. The bank turns the deal down.

A month later, an independent mortgage broker shows up at the bank with the same deal. Only this time as if by magic the appraised value hits the purchase price and the earnings and credit problems have disappeared from the mortgage application. Now you know why the banks fired all their staff appraisers and most of their in-house loan officers. Prior to this time the banks originated about 90% of all mortgages. By the bull market peak independent mortgage brokers originated over 70% of all mortgages.

Of course, if the banker has a brain in his poor,stupid head he has suspicions. However his hot, little hands are now holding an appraisal done by a licensed appraiser and a mortgage application that has been done by a licensed mortgage broker. The bank accepts the deal but there is no way he is going to warehouse this mortgage or the ever growing number of dubious mortgages that the bank is accepting from outside mortgage brokers. These mortgages are going to be pooled and securitized into various types of mortgage-backed securities ( MBS and CDO) as quickly as possible.

Let's now return to the present. The bank now realizes that the outside appraisal was dubious and the mortgage application was even more dubious. It has probably sold off the mortgage servicing rights and kept the mortgage or it may have sold the mortgage and kept the mortgage servicing rights. Do not underestimate the importance of mortgage servicing rights. This is what gives you control of the mortgage. Others may own the mortgage but the mortgage servicers control the mortgage. There are about 8,500 banks in this country. The vast majority of which do not service their own loans. The 27 largest mortgage servicers dominate the service industry.

You now know why the banks are responding so poorly to urgent requests to modify mortgages even when it is in their overwhelming interest to do so. It is the common assumption that the reason why banks will not help out their clients is because they are just being mean or greedy. The reality is that in today's brutal real estate market it is almost never in the bank's interest to foreclose. Yet, the foreclosures continue because they are on automatic pilot. It is often the case today that the mortgage servicers start and often finish foreclosure proceedings without prior approval from the bank.

You see mortgage servicers are paid for foreclosing on the mortgages that they are servicing but until a recent change in federal regulations, they were never paid to modify a mortgage.

You now know why the banks and troubled mortgage payers are in such trouble. The reason why banks appear to be wandering around in a stupor, is because they are in a stupor. To a shocking extent they have lost control of the ability to manage this crisis. They are in trouble because they are as blind and dumb as a fence post. The expertize that they once had is gone with the wind.

Fred Carach is the author of "Forty Years A Speculator. His blog is fortyyearsaspeculator.blogspot.com