A big topic of discussion today is how the real estate industry got to the point it is in. Phillip C. Querin, a Partner with Davis Wright Tremaine (and Legal Counsel to PMAR-Portland Metropolitan Association of Realtors®), was asked to give a succinct and realistic evaluation of what he thinks happened.

Here is Phil’s response in the February 2009 edition of the REALTOR®, the official publication of PMAR:

While I believe the following evaluation is realistic, you must remember it’s my opinion alone.  As for “succinct” that’s a word that I can’t seem to find in my “Lawyer’s Lexicon.”  But here it goes…

For the past couple of years, perhaps commencing the Fall of 2007 in Oregon, we started to see significant indications of what has now blossomed into a full-blown mortgage and foreclosure crises. Initially, it was the sub-prime market, where many of us learned that when lenders and mortgage brokers said, “We offer financing to anyone…” they really meant it.  At first blush, most people thought the problem would remain there, since it consisted primarily of borrowers with marginal—or less than marginal – credit.

Next, as the defaults spread, we learned that the subprime mortgages had been packaged and sold all over the world, and bought by respectable banks and others because of the high returns. Then it was the Alt-A and Alt-B loans that started to falter. These were primarily the “no-Doc” or “liar loans” that were given to borrowers with good to “almost-good” credit. These folks oftentimes had no records to establish a regular and predictable source of income, such as salespeople, solo builders, etc., and investors.  In many cases, lenders did not require them to provide a tax return, or show proof of W-2 or 1099 income –as long as they had good credit scores.

When the rest of us (i.e. with regular employment histories) applied for loans from institutional lenders, we had to run the gamut of filling out standard documentation. We were the “prime” borrowers, with decent FICOs and work histories, who received loans that conformed to the FNMA and Freddie Mac requirements, and therefore could be purchased by these two government sponsored enterprises (“GSEs”), then securitized and sold into Wall Street. For years, while the economy hummed along, default rates were relatively low and Wall Street investors received good returns. FNMA and Freddie Mac were the darlings of Wall Street—consistently meeting projected goals.*1 The higher up the food chain one went usually meant the lower the interest rate and/or points paid for the conforming loan.

Then Wall Street, investment banks, and private investors decided to get into the act too, by creating complicated financial vehicles known by various acronyms and names such as CDOs (collateralized debt obligations), structured credit products, default swaps, etc. too difficult to understand by most investors, but they continued to buy.

Lastly, banks and mortgage lenders began to create imaginative loan products, such as adjustable rate and negatively amortizing loans, which permitted borrowers with little or no credit to qualify for loans with little regard for what might happen when the interest rates got reset—which sometimes occurred within a month or two. And, mortgage brokers found themselves making a lot more money through the little understood (nor clearly disclosed) use of yield spread premiums (“YSPs”) on higher interest rate loans to riskier borrowers ( a fact that may change slightly if RESPA reform ever actually occurs).*2 All combined, this was the perfect recipe for disaster when the economy started to overheat and slow down.*3

With the help of Alan Greenspan and the Federal Reserve, the result was a credit bubble that seemed to have no limits and no end. The “irrational exuberance” kept getting more irrational—with some residential loans exceeding 100% of appraised value. The Federal Government had previously gotten into the act much earlier during the Carter administration with the 1977 passing of the Community Reinvestment Act (CRA), which encouraged banks to make loans to low-income borrowers—many of whom the lenders might not otherwise have lent to, using standard income and credit criteria. *4 With activist pressure on many lenders in the 2000s, the subprime market began to proliferate. *5

For Realtors® and most home sellers and buyers, these background facts were barely noticed. The credit bubble soon blossomed and morphed into a housing bubble, and those criticizing the trend were regarded as naysayers and cynics. It was business as usual for the rest of the country, and most politicians—even those who should have appreciated the risks being created—bragged that they were making it possible for everyone to realize the “American Dream.”

Unfortunately, in hindsight, we’ve learned, albeit too late, that many loans simply should never have been made, and some borrowers were not altogether honest on their applications. Add to this the flippers, who drove prices to unrealistic heights. These problems were exacerbated by crooked—or inattentive—appraisers, mortgage brokers, lenders, and others, who had a hand in creating and approving loans that should never have been made in the first place. This was because once the bad loan was made, it was sold off into secondary mortgage market, repackaged and marketed worldwide. The buyers included investors, hedge funds, REITs, investment banks, and even FNMA and Freddie Mac (who perhaps should have known better), but couldn’t resist the attractive returns of these collateralized debt obligations.

This process continued uninterrupted until the economy contracted, financing and re-financing dried up, and the default rates on homes skyrocketed, resulting in foreclosures, short sales, walk-aways, deeds-in-lieu of foreclosure, and similar activities that resulted in the evaporation of residential values and home equity. Today, even though many steps are being taken to rectify the situation (with questionable success) and interest rates remain low, there exists a crisis of confidence among the banks and buyers, the two primary players if homeowners are to sell their homes.

Footnotes:
*1) We didn’t learn until 2004 exactly how they did it with their “Cookie Jar Accounting.” FNMA’s stock has plummeted ever since. In 2004 FNMA’s stock sold for $77 a share. Today (Feb 17) it is selling for .57 a share and is controlled by the federal government. *2) I am excluding a discussion of the role of politicians such as Chris Dodd, Barney Frank, Charlie Rangel, and other “Friends of Anthony.” That’s whole ‘nuther story and space doesn’t permit. *3) Interestingly, author Peter Schiff, of Euro-Pacific Capital, Inc., a broker-dealer firm, was an early predictor of the housing crash and financial collapse in hi 1007 book “Crash Proof: How to Profit from the Coming Economic Collapse.” The accuracy of his predictions brought him fame and attention. Unfortunately, although he may have been right, his solutions may not have been. The current market has placed his investment strategy into question, and many of those who put their money into his company saw losses of 50% or more. See, “Right Forecast by Schiff, Wrong Plan?” Wall Street Journal, January 31, 2009. *4) This in not to say the CRA “caused” the subprime crisis. It certainly had several aspirational goals. However, from a pure credit/risk analysis, there is little question that these types of loans were likely to be the first to fail—and they did. But this was just the tip of the credit iceberg and the Titanic had just set sail.  *5) To be clear, the subprime market had existed before 2004, but the default rate, which was a known quantity, had already been factored into the cost of these types of loans. It wasn’t until late 2006 that some experts began to realize that default rates were skyrocketing—even for prime loans—and upon foreclosure, there was no sure way to value the loans or the property they secured.

©Copyright, 2009, by Phillip C Querin, Partner, Davis Wright Tremaine, PMAR Legal Counsel.  Reprinted with permission.

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