The Daily Reckoning by Bill Bonner

"The surest way to ruin a man who doesn't know how to handle money is to
give him some."
-George Bernard Shaw

Approximately two weeks ago, a group of regulatory agencies voiced their concern about what have become standard practices in the mortgage business. They released what amounted to a new set of standards, in a report entitled "Interagency Guidance on Nontraditional Mortgage Product Risks."

And now, cometh the Comptroller of the Currency, John C. Dugan, speaking about the innovations of the mortgage industry: "Lenders who originate these types of loans should follow sound underwriting practices that consider the borrower's repayment capacity."

Traditionally, the lender judged both his man and his market. If both were deemed solid, he would take a chance, lending the man a mortgage and hoping that the market was strong enough to allow him to recover his money if the man failed.

Nontraditionally, however, lenders wouldn't even bother with the man; instead, they would judge the market...and judge it foolproof. As long as house prices were rising at double-digit annual rates, non-traditional lenders considered mortgage lending a 'can't lose' enterprise; any fool could do it.

They were right. It was a no-brainer, in the sense that anyone with any brain at all would have avoided the new products. From reading the newspaper, we learned about the number and variety of non-traditional mortgages that flourished in the last six years. Adjustable rates, of course, became common. But so did mortgages with zero-down payments, alluringly low starter rates...including interest-only mortgages, flexible payments, and 'stated income' applications...in which the borrower is left
to use his own imagination in describing his financial circumstances.

From Grant's Interest Rate Observer, we learn also that as recently as 2000, only 25% of sub-prime mortgages were of the 'stated income' variety. Only one percent consisted of 'piggyback loans' - junior mortgages designed to eliminate the need for a real down payment. And none were I.O., or interest only.

Today, 44% of sub-prime loans have 'limited documentation,' 31% are piggyback loans, and 22% are I.O. And now that rising housing prices are no longer a sure bet, lenders are becoming more careful. They're beginning to do on their own, precisely what the feds are encouraging; that is, they're beginning to ask if the customer can really pay for what he is trying to buy.

Daily Reckoning readers will chuckle to themselves recalling that the stated purpose of both the federal government's housing policy and that of the lenders themselves was to 'help Americans buy their own homes' or words to that effect. Easy credit was meant to increase homeownership; renting was seen as a social disease awaiting a cure.

But the effect of 'EZ credit' was to turn Americans into a race of housing speculators, not of homeowners. At the margin - where renters were enticed to become homeowners - people did not actually buy houses...they merely paid for an option to buy them in the future. That's what an interest-only mortgage actually is, and as the I.O.'s, limited doc, flexible payment ARMs reached farther and farther into the general population of homeowners, fewer and fewer people really owned their homes at all. More and more of them became gamblers, betting that property values would rise
fast enough for them to keep on refinancing until they actually pulled in enough to afford to pay the principal down.

Meanwhile, we will all get an even bigger chuckle when we consider that the gullibility of the poor, sub-prime borrowers is at least matched by the gullibility of the great, super-prime lenders. Cheap suits, expensive suits - when you got down to it, they all fell for the same line of guff.

While the marginally lumped idiots took out ARMs, the hedge fund, pension fund, and insurance fund geniuses bought MBSs, mortgage-backed securities. The securities were backed by the mortgages, which were in turn backed by the imaginary incomes of the borrowers. Thus, the credit agencies rightly judged the quality of the mortgages as less than perfect, BBB. And then with the miraculous powers of modern finance, these same mortgages were put into MBSs and turned into triple-A credits!

This particular feat is attributed to the fact that the sliced and diced processed mortgages - the Spam of the lending industry - are less risky than the individual cuts. While this may be true for an individual 'can'of the stuff, it certainly cannot be true for the whole lot of it. The grease and fat that went in has to come out somewhere. In other words, one MBS buyer might get lucky, but they can't all do better than average. We don't know, but we suspect that when the tins are finally opened, the glop inside will not be very appealing.