Fortunately, it didn’t take long to get up to speed. Both Ken and our third partner, Mike Elliott, who also worked for First Consolidated Mortgage, helped me understand the intricacies of this business. These two questions would ultimately serve as my personal reality check. Every time we doubted the logic of a specific loan, we used the questions as a litmus test. At the very least, being able to answer “yes” kept the moral compass pointing north and helped me sleep at night knowing we made the right decision.
Good Lending Gone Bad
I don’t know exactly when it happened, but a few years after we opened, the business started to change. Wall Street’s appetite for these loans increased at about the same time new subprime lenders entered the business. The increased competition and the red-hot real estate market led to the development of riskier products. As a lender who targeted brokers, our goal was to offer products that were similar to the competition. If we didn’t keep pace with the industry leaders, we’d quickly become an afterthought. But doing this created a bigger issue. The underlying principles that governed our thinking were slowly being compromised. Answering “yes” to our questions became more difficult with each passing month.
For me the turning point came in June 2005. Until that moment, I thought we still provided a valuable service to borrowers. For all the lunacy associated with this business, I wanted to believe that writing a mortgage for borrowers still meant the odds of them making their mortgage payment were greater than the likelihood of default. Violating this basic tenet was never supposed to be part of the equation.
It wasn’t until we wrote a loan for Johnny Cutter that I realized our business, the whole industry really, had lost sight of its purpose. The subprime industry, which once upon a time helped credit-challenged borrowers, was no longer contributing to the greater good. Johnny Cutter would serve as my wake-up call.
Just a good old boy from rural South Carolina, Johnny and his wife, Patti, wanted to grab a little piece of the American dream. Having picked out a newly built 1,800-square-foot house, they were relying on the same mortgage broker who worked with them in the past to secure financing.
Although we were looking at the deal for the first time, the Cutters had been down this road before. They had been turned down on two different occasions, both times as a result of bad credit. After the second decline, the broker advised them to start saving money for a down payment and work on their credit before trying again. Their credit never got better, but after three years of saving, they had enough to put 5 percent down.
The Cutters, however, bordered on deep subprime—few if any redeeming qualities. Their credit report showed they had almost no discipline when it came to managing money. With a credit score in the 500s, paying bills had never been a priority for them.
As with many subprime borrowers, the challenges didn’t stop there. Since Johnny worked at a gas station and Patti was a cashier, income was tight. They would need to use more than half of their combined gross monthly income just to cover the mortgage payment. If it weren’t for Patti’s sister, who let them live with her for the last three years, they never could have saved any money.
Fortunately, the Cutters had two things working for them. First, they had $5,000 toward a down payment. At a time when most borrowers were trying to finance with nothing out-of-pocket, someone with a down payment was a rarity. The more money a borrower was willing to put down, the more forgiving a lender would be when it came to past credit problems. Second, the industry had been getting more aggressive with product offerings. If this deal had come through our office three years earlier it would have been declined. A poor history of paying creditors, a large number of open collection accounts, and mediocre income meant too much risk.
By 2005, the industry had a different view of the Cutters. Because of more liberal underwriting standards, they were deemed an acceptable risk. The purchase was structured so the homebuilder would pay all closing costs. The Cutters brought a cashier’s check to the closing for $4,750, enough for the down payment. Three years of perseverance and some lucky timing finally paid off. Johnny and Patti achieved their dream of being homeowners. Little did they realize just how quickly it would become a nightmare.
Watching It Crumble
Shortly after moving in, Patti was hospitalized for several days because of an illness. After missing two weeks of work to recover, she lost her job. Since Patti contributed 40 percent of the combined household income, it took a toll on their finances. She found another job but lost six weeks of income in the process.
Their biggest problem was not having medical insurance. Without coverage, Johnny used what little money he had to pay the hospital, which only covered a fraction of the total bill. The lost income and medical expenses meant something else had to give, which turned out to be the mortgage. They quickly found themselves 90 days behind with no relief in sight.
It turned out they weren’t the only ones in a pickle. The investor who bought the mortgage from us issued a repurchase request. Since the Cutters didn’t make their first payment, we were contractually obligated to repurchase the loan. Sometimes we could negotiate our way out or buy some time before cutting the check, but not in this case. When a borrower missed the first three payments, the loan came right back to us. To complicate matters, the Cutter loan wasn’t the only deal we were being asked to repurchase. The loan repurchase requests usually came in waves, but lately they seemed to be getting worse. Depending on how hard Johnny wanted to dig in his heels, we could have been in for a long and expensive fight.
Once we bought the loan back, I called the borrowers to discuss their options. After listening to Johnny recount the events, it was hard not to feel sorry for them. They owed $25,000 in medical bills and Patti’s new job paid less than her previous one. With no one to lean on for financial support, they were in a world of hurt. This couple needed a miracle, and short of some divine intervention, they were going to lose the house. The only thing left to determine was how things would play out.
“Johnny, I’m sorry to hear about your situation,” I started. “As difficult as it is, we need to talk about what’s going to happen next. As you know, the mortgage on your property is currently 90 days past due, which means you’re $2,800 behind and your next payment is due in a week. Given your situation do you see any way possible to catch up?” I asked him.
“Well sir, I wish I could, but right now, I don’t see how,” he said.
From this point, one of three things could happen. First, we could start foreclosure proceedings once they were 120 days delinquent. It usually takes three to four months to complete this process. Second, the Cutters could file for bankruptcy protection. Since they were in over their heads, it would at best buy them some time and postpone the inevitable. With no money to pay the bankruptcy attorney, it was an unlikely scenario. Third, the Cutters could agree to a deed-in-lieu, which would allow them to sign the property back to us. It was the easiest way to resolve the issue, but most borrowers refuse because it requires them to move out in short order.
Johnny struck me as a straight shooter. He appeared genuine in his desire to fix the problem but he was in no position to make payments. He wouldn’t say it directly, but I was sensing he just wanted a way out. If I was right, he might be willing to give us back the house.
“Johnny, if you agree to sign the deed-in-lieu, I’ll do two things for you. First, I won’t report it on your credit report, so no one ever has to know you gave up the property. Second, I’ll let you stay in the house until the end of next month, which gives you time to find a new place to live,” I said.
Considering his limited options, it was a decent offer. He would walk away from a bad situation with minimal damage, having only lost his down payment. After taking the night to think it over, he called me the next day and agreed to the offer. In the midst of his sadness, he almost sounded relieved. Faced with an impossible situation, we gave him an out and he decided to take it. He was definitely the exception. Most borrowers in th
is situation take the opposite approach. They’ll do everything possible to avoid losing the home, right up to the point when the sheriff evicts them.
Considering we’d tied up $90,000 to repurchase the note, it felt like we had dodged a bullet. If the Cutters had filed for bankruptcy, it could have been months, maybe years, until we saw the money. We had just finished foreclosing on a property in North Carolina and it took two years to remove the borrower from that home. If a person knows how to work the system he can buy himself a lot of time.
I hated this part of the job. Being a lender is supposed to be about putting people into homes, not taking them out. I rationalized that it’s just a part of the business, something every subprime lender has to go through. If only I had been able to do a better job convincing myself of that.
What Were We Thinking?
The next day I started reviewing the Cutter file. For any deal that went bad, we thoroughly reviewed the loan to find out what went wrong. Perhaps we made a mistake, or maybe the broker committed fraud. Whatever the reason, it was important to understand why the loan defaulted. Looking through the income and credit sections of the file, I wondered how the loan got approved in the first place. Here are the facts:• The borrowers had a combined gross monthly income of $2,800.
• After paying the mortgage, they had $700 left for the month. This had to cover all their expenses—food, clothing, and everything else.
• After closing on the purchase, they had $250 left in their checking account. They had no savings or retirement accounts to fall back on. They were living paycheck to paycheck.
• Their credit was abysmal. They had no history of paying any creditor except Sears, and that account was delinquent at the time of closing. The rest of their credit report was filled with pages of old collection and charge-off accounts.
• They had no proof of making any housing payments in the last year, since they lived with Patti’s sister. We didn’t know if they’d ever made a rental payment in their lives.
• In the last three years, neither of them had held a job for more than nine months at a time. Both of them had experienced significant gaps in employment.
As I went down the list, my thought was someone must have made a mistake. Aside from a good property value, there was not one redeeming factor to this loan. The credit stank, income was light, employment was spotty, and there was no rental history or savings to fall back on. Put all this together and it was a foreclosure waiting to happen. What the hell were we thinking when we closed this loan?
I checked everything in the file against the investor’s guidelines, trying to figure out the mistake. Then it hit me. We did nothing wrong. Our underwriter approved the deal, we funded it, and the investor purchased it from us because it fit their guidelines. There was nothing manipulative or fraudulent about the loan. Everything from the income to the appraisal was accurate.
I was pissed off but I didn’t know whom to blame. It’s not as if the guidelines suddenly appeared. We’d been closing loans with similar borrower profiles for over a year. In fact, the 5 percent down payment product was a niche we’d been promoting to our brokers. For the first time I was seeing this product pushed to the extreme, and from a risk standpoint, it made no sense at all.
We’d written some pretty rough deals in the past. A few of them even made me scratch my head and wonder whether we had made a mistake. As for the Cutters, there was nothing to question. This loan didn’t provide value to anyone—not to them, my company, or the investor. The Cutters caught a bad break, but for them any hiccup was going to be disastrous. With no savings and nothing to fall back on, they had no margin for error.
For all its complexity, subprime lending still comes back to our two fundamental questions. Somewhere along the way we have to believe a borrower can make the payment. The decision to lend money should require us to find something to hang our hat on, some aspect of the borrower’s profile to justify the loan. It doesn’t take much—income, credit, cash reserves—but something has to confirm the decision. In the end, the Cutters had nothing. This loan was indicative of an industry that had lost its way.
Time to Get Out
If the Cutters served as my wake-up call, the final alarm didn’t go off until a few months later. In what I now view as more than coincidence, the same week our profit margins took a nose dive, my house, the same custom home that subprime lending helped build, caught fire. It’s hard to say how the two were related, but watching the fire department battle the blaze made me realize I’d had enough. A friend reminded me it’s often the dramatic events in life that provide us with clarity when we need it most. Whether it was fate or the work of a higher power, it served as the impetus I needed to make a change. The time had come to get out.
Looking back on these events made me realize just how lucky I was. No one was hurt. The fire started in the garage during the early evening, while everyone was home and awake. Since we reported it just minutes after it started, the fire department was able to get on top of it quickly, which contained the damage.
I was also fortunate to have great business partners. In the five years we owned Kellner, it was the most harmonious business relationship a person could ask for. I didn’t have to tell my partners I was ready to leave, they saw it on my face. They approached me with an equitable buyout and I felt a little like Johnny Cutter. When I was stuck in a situation with no easy answers, they provided me the way out I was looking for. Like other subprime lenders, Ken and Mike hoped that order would eventually be restored to the industry. As it turned out, things would only get worse.
Friends have commented that my decision to get out before the subprime implosion took great foresight. As easy as it would be to claim that I possessed some profound wisdom and saw the implosion coming, my desire to leave was driven by the fear of losing what we had built. Looking back, I now believe my departure was a combination of luck, a desire for self-preservation, and perhaps some divine intervention.
Moving Forward
I have two reasons for writing this book. First, unless you’ve been totally cut off from civilization, you’ve read something about the subprime industry over the last year. Even with all the media coverage, there’s still a more in-depth story to be told. My objective is to pull the curtain back on the subprime mortgage industry and expose it from the insider’s perspective. This view will show that the niche business was built on a defective foundation.
The demise of subprime lending is a result of multiple failures. Understanding the motivations of the industry’s players and how they acted in concert with each other is the key to telling this story. By exploring the brokers who originated the loans, the lenders that funded the mortgages, the investment firms that packaged them into mortgage-backed securities, and the agencies that rated the deals, we can fully understand how and where the process failed. Examining each piece in detail will show how the entire industry, from one end to the other, was at best, flawed, and at worst, negligent. The findings will also reveal the problems the housing market is currently facing are much greater than most people realize.
This book will discuss a wide variety of people and companies that operated in the world of subprime lending. As you can imagine, many of the stories don’t portray them in a positive light. Real names have been used whenever possible, but in many cases they’ve been changed. Some of the case studies in Chapter 4 are composites drawn from dozens of typical deals. They represent the kind of activity that happened daily.
My second reason for writing this book is to develop solutions. For all its negatives and enormous imperfections, subprime lending, when used appropriately, provides value to credit-challenged borrowers. Unfortunately, industry greed has put hundreds of thousands of borrowers in jeopardy of losing their homes. Only by understanding the root cause of each problem can effective solutions be developed. When the issues are properly addressed, it’s possible to have the best of both worlds—one that creates significant consumer protections but doesn’t reduce t
he availability of credit to the marketplace.
The mortgage industry desperately needs to be fixed. The lack of investor appetite for all nonagency mortgage-backed securities has led to a massive reduction in the availability of credit. The current product offerings resemble those from 15 to 20 years ago. Until investors believe the problem has bottomed out and the issues that triggered the collapse are sufficiently addressed, borrowers will continue to suffer from reduced credit options. If we don’t restore confidence in the entire lending process, from origination to securitization, the crisis will continue to grow and wreak havoc on the housing market as well as the entire economy.
CHAPTER 2
The Gunslinging Business of Subprime Lending
If you hang around the subprime lending business long enough, you’ll meet your share of interesting borrowers: strippers, cons, pimps, thugs, and various other upstanding citizens of the community. These were not our typical customers. But if a borrower has credit problems and a checkered past, employment gaps, or income from unverifiable sources, he usually ends up talking with a subprime lender. Strangely enough during my five years at Kellner Mortgage, loans to borrowers who worked as ministers had one of the highest fraud rates of any profession.
Since my company, Kellner Mortgage Investments, was a wholesale mortgage company, we didn’t deal directly with borrowers. We funded loans to subprime borrowers who were brought to us by mortgage brokers. The broker’s job was to convince us to fund their client’s loan. Inevitably, the brokers seemed to start the conversation with us by always using the same four words, “I got a guy . . .” Listening to their lengthy explanations of why their borrowers were not responsible for their current predicament, and thus somehow worthy of financing, made for an interesting case study in the art of persuasion.
Confessions of a Subprime Lender Page 2
