Over the past eighteen months it's been nearly impossible to make it
through a week of news that does not include something about the terrible
state the housing and mortgage markets are in. We have heard a lot
about the troubles that Fannie, Freddie and many of the big banks are
having, often involving their failure or collapse into receivership.
As a banker this news cycle has been depressing to witness. However,
as depressing as it is for me, I can only wonder how dismaying it must
be for the average, hard working taxpayer who does not work in the
The questions that must be lingering are, "How could this have
happened? Should these companies have known better? How did it go on
for so long to turn into such a mess before being detected?"
In this spirit, I would like to take a stab at answering these
questions, from my vantage point. I began my career in the banking
industry as a mortgage loan officer at a small community bank sixteen
years ago. I learned about the fundamentals of making a mortgage loan.
It is pretty straightforward, there are three elements: income/debt
ratios, property/collateral and previous credit history. The mortgage
loan officer' job is to determine if an applicant can afford a house
payment based on their salary and existing debts. There were
generally accepted industry ratios that existed for maximum housing
debt to income and total debt to income. Decades ago borrowers were
required a long time ago to put twenty per cent down in cash. Over
time that number changed to a minimum of ten percent then five percent
then three percent with FHA. Finally, lenders believed that a
borrower's past credit history was likely a good predictor of future
credit behavior when it came to willingness to payback creditors. Part
of the application process involved verifying all of the information
that the borrower submitted. Fannie Mae and Freddie Mac bought loans
and subsequently sold them as mortgage backed securities to investors
that conformed to their standards.
Community banks often made the decision to hold loans in their own
portfolios rather than sell them into the secondary market to Fannie
or Freddie. They made this choice because they believed in the
quality of the loans that they were originating, as they knew their
borrowers, knew their markets and the properties that were being
purchased and had a cushion for error by requiring a down payment of
ten to twenty percent. Accordingly, if something went wrong for the
lender and the borrower defaulted, the bank could foreclose and not
take a large loss, in most cases.
The good news is that community banks still operate that way today!
Consequently, community banks have not seen the massive write-downs,
losses and failures that we have witnessed in the big bank and GSE
(Government Sponsored Enterprise) sector. This news begs the question,
what did community banks know that the big banks either did not know
or somehow miss in a really big way?
The big players started playing a different game in which they created
all new rules for making a mortgage loan. They were ambitious and they
wanted to make lots more loans and consequently a lot more money as
well. They created a new type of loan called the sub-prime loan aptly
named as this loan was considered to be of materially worse quality to
a conforming or prime loan. These loans later came to be known as
liars loans as the borrower could lie about their income because the
lender was not going to check, in some cases the lender lied about
their income for them so that they would qualify. The borrower was
often allowed to move in without any down payment. If their credit
history was poor, they were asked to pay a higher interest rate,
making a long-term payment trajectory less likely.
How could this happen? That part is pretty easy! Everyone in the
channel had something to gain by originating a sub prime loan. The
borrowers were able to purchase a home that they otherwise would never
have qualified for and with no money down. The mortgage broker working
for either a small or large brokerage was able to load up the loan
with large fees and points that were built into the loan. The broker
on this type of loan could make approximately ten times more money
than the community banker that was originating an old fashioned,
conforming loan. There are cases around the country where these
brokers where making tens of millions of dollars per year originating
these loans. Fannie and Freddie played a pivotal role as they
facilitated packaging and passing on billions of these types of loans.
In addition, they chose to hold hundreds of millions of these loans in
their respective portfolios, as well, with disastrous consequences.
Others in the mortgage channel also made a lot of money on these loans
as the volume grew over the years. Big banks liked the fact that they
could earn a much higher yield on these loans than conforming loans.
The result: higher earnings for shareholders and subsequently higher
bonuses to follow for the CEO's. Since the rating agencies rated pools
of these mortgages as triple A credit, investors, including foreign
countries felt comfortable buying them.
Investment bankers joined into the party by selling these sub prime
investments to their clients. It became easier to do when investment
bankers successfully lobbied for the overturn of the law that caused
the collapse of the stock market in 1907. In 2000, permission was
granted for investment bankers to sell credit default swaps. In many
cases, these products were sold to investors that were worried about
the inherent credit risk contained in these pools of subprime
mortgages. Presto-,the answer--the investment bankers could sell a
credit default swap to mitigate the risk. Investment bankers were
essentially selling an insurance product except they were not subject
to insurance regulation or bank regulation. Ultimately, they granted
way more insurance than their balance sheets could handle, (I believe
the number of credit default swaps sold was over $60 trillion of all
types) even though they were big balance sheets.
What was the motivation? I suppose you could point to greed. It is a
fundamental principal of capitalism, that businessmen will conduct
themselves with a basic morality and ethical responsibility.
How did it happen tactically? Everyone was willing to "stretch" to
ramp up sales and make more money or get bigger bonuses. This
stretching involved a very dangerous process: the layering of risks.
Bankers are risk managers and you cannot avoid risk if you want to
lend money to someone as there is always the risk that you will not
get paid back or you could lose money on a loan if the collateral is
damaged and the borrower defaults as well. Bankers learn early on
that is not wise to layer or combine risks in a deal. For instance, if
a borrower has a poor credit history then it is not a good idea to
also allow them to obtain a loan with no down payment. If something
happens, there is very little the banker can hang his proverbial hat
on to recover. This is precisely where the system broke down, as under
the new rules that were invented, a borrower could get a loan with
poor credit, put nothing down, pay lots of fees that were rolled into
the loan, pay a higher rate making the payment higher and the
affordability tougher. All of these layered combined risks made for a
loan that had a substantially greater risk of default.
Community banks did not make these types of loans as it seemed like a
terrible business decision to take on all these layers of risks with a
single borrower. Worse, community banks did not want millions of
dollars of these types of loans on their books because they knew they
could one day have the big losses to accompany the big risks that were
taken. Even the substantially better yields, sometimes up to 50%
better were still not adequate justification for all the additional
risk. You only collect the higher rate as long as the borrower is
How are community banks faring after the billions in announced losses?
I wish this was the unqualified happy ending. However, since so many
of these subprime loans were made throughout the country, real estate
values were driven higher over the years. Therefore, when a community
bank or big bank proceeds with a foreclosure, it is likely that all of
the home values in the area are inflated and the bank is more likely
to suffer a bigger loss than before. This means that most banks are
experiencing higher losses, but community banks are still in a much
better place since they did not engage in making the substantially
riskier sub prime loans. The bad news has been so consistent that it
has driven all investors to question the merit of buying any bank
stocks. However, the bargain hunters and value players have entered
the market and hopefully the darkest days are behind us.
Note: William A. Donius was elected CEO of Pulaski Bank in 1997. He
took the bank public in 1998 with Pulaski Financial Corp. NASDAQ
listed PULB as the holding company. Under his leadership the bank grew
from $168 million to $1.3 billion. Pulaski Bank is the largest
purchase market, mortgage originator in St. Louis and one of the top
three in Kansas City. Pulaski Bank was voted the Best Place to Work
in St. Louis in 2007, received a Torch Award from the Better Business
Bureau in 2008 and is ranked as one of the best performing smaller
banks/thrifts by industry publication SNL. Donius retired from the CEO
position in April of 2008 and remains Chairman of the bank. This essay
represents his personal view and may represent the view of the bank.
Donius was appointed to a two-year term on the U.S. Federal Reserve
Board TIAC Council in 2008. Donius served a four-year term on the
Board of Directors of America's Community Bankers ending in 2007. In
addition, he served as Chairman of for profit subsidiary, America's
Community Bankers-Partners for two years.