Scotsman Guide - December 2008 Residential Edition

How We Got from There to Here
Greed, fear and indifference all played roles in bringing the mortgage market to its current state
By Gregory J. Martin, executive vice president of corporate development, Lender Support Systems Inc.

When the government placed Fannie Mae and Freddie Mac under conservatorship, several critics balked against what they called a “bailout.” They characterized the government intervention with the backing of taxpayer funds as a negative occurrence.

On the other hand, proponents say that if our economic boat is sinking, we should be bailing it out as fast as we can.

Lost in the discussions of the government bailout of these companies and others in recent months, however, is what brought the economy to this point. Ultimately, market efficiency was reduced. Certainly, with loosened lending guidelines and lax products, mortgage brokers, lenders and others played a role in bringing the market to its current state.

It can be argued that certain human factors crept in — specifically greed, indifference and fear. When examining the current mortgage crisis, it is clear that all three factors were at work.

Greed

Greed played a critical role in pushing the mortgage market out of efficient bounds. To a greater extent than likely was prudent,

market participants pursued their own interests:

■ Home-builders built a majority of new homes priced well greater than local median home prices to maximize their profits;

■ Mortgage brokers and banks greatly boosted their revenue by relaxing lending standards at the front end of a capital conduit to homebuyers;

■ Investment bankers reaped profits creating the back-end source of the capital conduit through selling dubiously risk-adjusted mortgage bonds; and

■ Ratings agencies failed to exercise adequate diligence in monitoring the activities and risk profiles of the securities related to mortgage-backed debt and to the companies participating in the mortgage-banking market.

In addition, to varying degrees, homebuyers and homeowners refinancing their mortgages ignored simple truths about home values, affordability and excessive use of credit.

If you add the residential construction industry and the suppliers to the homebuilding and home-product industries, you would probably find more than half

of all U.S. households benefited in some way from the growth in the mortgage-finance market.

Indifference

Collectively, residents in this country knowingly participated in an increasingly dubious run-up in mortgage loans.

The risks were by no means a surprise. In fact, some members of the financial markets began betting against mortgage bonds as early as 2005.

“Fear is creating a
situation where the
continued unraveling of
home loans will create
substantial damage to
the economy that could
take decades to repair.”

Together, greed and indifference made the markets inefficient. They allowed huge profits to flow to residential finance, construction, manufacturing and related service companies, abetted by insatiable consumer demand financed with mortgage debt.

Fear

Fear did not really enter the picture until spring 2007, when the most-obvious lending errors became apparent. Although their volume was only a fraction of the larger prime- and Alt-A-loan pool, nonprime loans exposed the greed and indifference to risk of even some of the largest financial institutions.

Even the vaunted transparency of public firms that forms a key component of efficient markets was not evident during the nonprime run-up. Several public nonprime lenders declared bankruptcy, and the unraveling of the mortgage-banking conduits’ front end picked up pace.

By summer 2007, broader economic fear began to take hold. Rather than an efficient assessment of risk and reallocation of capital, the credit markets panicked as banks pulled critical credit lines from mortgage lenders across the board.

When August 2007 rolled in, the financial markets had almost seized up as financing was pulled even from business

loans. This choked the economy in a way that precluded an efficient correction to the problem in the mortgage-banking industry.

With the unwinding of nonprime loans marked by accelerating defaults and foreclosures, new decelerating forces buffeted the economy, and recessionary fears clouded effective decisionmaking.

What next?

Fear actually is creating a situation where the continued unraveling of home loans will create substantial damage to the economy that could take decades to repair.

If more than half of the U.S. population participated — whether directly or indirectly — in the run-up of the mortgage market, it’s possible to argue that taxpayers should participate in fixing an economy that is not capable of acting efficiently.

There is no financial institution large enough to affect the U.S. economy broadly and to break the cycle of the current market’s operation beyond its current boundary of efficiency.

With $2 trillion to $3 trillion in home equity at risk, bailout proponents have argued that quick and rational action was necessary. Acting decisively to provide solvency and adequate oversight may limit the damage to less than $1 trillion (hard costs plus decreased asset value) within another nine to 18 months of economic correction.

Collectively, players in the real estate and banking industries made a series of financial mistakes with open eyes.

Perhaps it is time to learn from our mistakes and act collectively to help push our economy back into the range where it can start operating more efficiently.

Gregory J. Martin is executive vice president of corporate development at Lender Support Systems Inc. (www.lendersupport. com), a 25-year-old mort-gage-technology enter-

prise. Martin has broad experience in corporate management, finance and marketing. He guides Lender Support Systems’ strategic partnership and investment activities, along with serving as interim CFO. Past roles include working as a mergers-and-acquisitions intermediary, managing director of a Hong Kong company and a Navy pilot. Reach Martin at gmartin@lendersupport. com or (858) 268-7100.