Dear Mr. Buffett: What an Investor Learns 1,269 Miles From Wall Street

by Janet M. Tavakoli

  Fortunately, a mortgage broker, who is completely objective, since his income depends solely on the fees he generates by making mortgage loans, is willing to overlook the absence of documentation. The Internet day trader can state his income, and that is good enough for the mortgage broker. The mortgage lender helpfully informs the day trader that there have been mortgages made to people who apparently cannot afford them other than the fact that they are willing to state an income which suggests they can make the payments—so climb on board.Warren Buffett would likely have asked whether or not the trader can pay him back. He would undoubtedly ask for documentation.

  After a few months, the mortgage broker calls the day trader with good news. The appraised value of homes in the day trader’s area has gone up, so the day trader has equity in his home. The mortgage broker asks if the day trader would like to take out a home equity line of credit, which can then be used to make the payments on the mortgage of another home, an investment property.Yes? Great! (In contrast, Warren Buffett avoids investing in any business [in this case the loan from a shaky borrower] that has excessive leverage, that is, no equity left in the home.)

  The way the loans were made was bad enough, but some of the new risky loan products made it difficult for homeowners to pay back the loan, even if their house increased in value, and if the value of the home stayed the same or declined, the homeowner would have a huge incentive to default.

  These dodgy loans were so laughable that the risk was an open secret. The market made up pet names with catchy tags for this trash. NINJA loan: no income, no credit, no job, no documentation, no down payment, no problem. Get a loan and get in over your head. Liar loans will let us take your homes.You will choke your credit trying to pay back strangulation loans. Vampire loans will suck your blood dry.

  In 2002, when Warren Buffett took losses due to Oakwood Homes’ bankruptcy and was coming to grips with the credit derivatives losses in his Gen Re unit, President George W. Bush announced his intention to increase minority homeownership by 5.5 million by 2010. It sounded like a great idea—who isn’t for home ownership? He lacked a sound plan to achieve it, and the regulatory policies of his administration enabled fraud fueled by greed. It sounded great to say in 2004 that homeownership had substantially increased. But by the beginning of 2008, homeownership was back down to 2002 levels, and minorities are most at risk for losing their homes—and their creditworthiness potentially ruined for years.4 Furthermore, the population is still growing as homeownership declined, so we have lost ground. Wealth transferred to the wealthy from the poor, and what cannot be wrung out of distressed borrowers is ultimately being subsidized by tax dollars as the Fed bails out investment banks, banks, and thrifts.

  The national tragedy is that the Bush administration apparently neither read Berkshire Hathaway’s shareholder letters nor sought Warren Buffett’s advice.

  In 2003, while Warren Buffett was acquiring ethically run Clayton Homes after having taken the lesson of Oakwood to heart, the Office of the Comptroller of the Currency, the OCC, subverted the states’ ability to defend the rights of mortgage borrowers against predatory lenders. The OCC examines national bank books and inquires about risk management practices in their capital markets areas. In an unprecedented move, it exercised an obscure power in the 1862 National Bank Act countermanding states’ predatory lending laws over the unanimous objection of all 50 states.5

  Ameriquest was alleged to be among the worst of predatory lending offenders. Forty-nine state regulators and the District of Columbia claimed it ran a boiler-room operation slamming borrowers with loans they could not pay back, hidden fees, and undisclosed escalating interest rates. The U.S. Senate delayed Ameriquest founder, Roland E. Arnall’s, confirmation to the post of U.S. Ambassador to the Netherlands, but approved it in February 2006, after Ameriquest paid a $325 million settlement.6

  Fair Isaac Corporation developed a scoring system (FICO) as a rough guideline of consumers’ ability to pay debts. Subprime borrowers have low credit scores; typically FICO scores are below 650. Lending problems were not limited to subprime borrowers, however. Risky mortgage products combined with overleveraging created problems for borrowers at all income levels, but subprime borrowers were hit the hardest. Subprime borrowers tend to be less sophisticated and include a higher percentage of minorities. Unscrupulous lenders prey on the relative naiveté of these borrowers.

  In the United States in the last part of the twentieth century, an illegal practice called redlining denied sound mortgage products to eligible minorities. As we entered the twenty-first century, redlining was replaced with a perverse spin called reverse redlining. This was supposed to help minorities buy homes, but instead Reverse Robin Hoods stole from the poor and gave to the rich. Since many subprime loans do not meet the standards of Fannie Mae and Freddie Mac, mortgage lenders borrowed most of the money from a handful of investment banks that packaged the loans and sold them to investors around the world (banks, mutual funds, insurance companies and more). The subprime loan disaster would have been headed off if sophisticated investment banks had stopped supplying money (through packaging and selling the ridiculous loans) to shaky mortgage lenders.

  CNN’s personal finance editor, Gerri Willis, exposed despicable lending practices. She told The Daily Show’s Jon Stewart that in 2007, “two million people (in the United States) went into foreclosure,”7 and in a CNN segment in which she and I both appeared, she asserted “the cards were exactly stacked against [the borrowers].”8 I told her that some borrowers were “actively misled” and these loans on aggressively appraised homes: “were presented as gifts, but they were Trojan Horses you could ride to your financial ruin.”9 Many minorities are stuck with an insurmountable mountain of debt and many have declared bankruptcy.

  The net effect is a huge wealth transfer from minorities to builders, fee-earning mortgage lenders, and bonus seeking investment bankers.

  Warren Buffett promoted affordable housing and sound lending practices; he runs a well-managed corporation that has increased in value thus benefiting shareholders; he has bequeathed most of his wealth to benefit those less fortunate. Meanwhile, mortgage lenders and the investment banks that enabled them stole from naïve borrowers—and investors (such as municipal governments).

  Many people did not understand what they signed. Stretching funds to participate in what appears to be a rising housing market is merely speculation. No one is entitled to credit for speculation, and credit was pushed on people with the promise of refinancing before interest payments rose, and low-money-down loans were touted as a way to wealth in an unsustainable market in which housing prices were propped up by temporarily cheap borrowing rates. Sign here, you want to own your dream house and get rich, don’t you?

  The idea that minority homeownership would increase was used as a justification for a lot of bad lending. Predatory lending practices were cloaked in a mantle of moral self-righteousness, as if steering borrowers into risky mortgage products was a public service instead of an act of malicious mischief by savvy financiers.

  It is true that some borrowers knowingly overreached, but many were duped by confusing and risky loan products. More pain will come due to mortgage loans originated in 2005, 2006, and 2007. Mortgage brokers offered 40-year or 45-year adjustable rate mortgages (ARMs) in which homeowners built up virtually no equity in their homes in the early years of the mortgages. Approximately 80 percent of 2006 loan originations were ARMs of varying maturities with interest payments that reset sharply upward in two, three, or five years. For example, a 2/28 hybrid ARM has a fixed interest payment amount for the first two years, and then resets to an adjustable rate for the remaining 28 years. For a typical subprime 2/28 ARM, after low “teaser” rates of around 8 percent, many loans will reset to LIBOR plus 600 basis points, which as of summer 2008 would be around 8.46 percent.This borrowing rate, however, may be much higher by the time the actual reset occurs, particularly since the Fed will likely have to raise interest rates to head
off inflation to avoid further depression of the dollar. For example, using June 2007’s LIBOR rate, the interest payment would have been 11.32 percent. And here is the conundrum facing the Fed: If it raises rates, more bad loans will default and prolong a recession. But low rates fuel inflation, which leads to rising costs such as for gas and food, and the United States may slump into stagflation.

  Some mortgage loans are interest-only (IO), meaning that the homeowner does not accumulate equity by paying down principal; the only way the home owner can build equity is if housing prices rise, but as a result of profligate lending, housing prices are falling. Some of these loans were made with very low (or no) down payment, so the homeowner would now lose money if the house were to be sold.

  Option ARMs allow negative amortization, meaning a homeowner’s principal balance—the amount you’d pay if you pay off your loan right away—can potentially rise. Borrowers may have initial payments so low that the payments do not even cover interest costs. Unpaid interest increases the principal amount, the loan balance, resulting in negative amortization. What if you bought a home with no money down (no down payment), and home prices fall? You are in an “upside-down” mortgage. You owe more than the house is worth, and the amount you owe grows bigger every day. As the song goes, you get “another day older and deeper in debt,” and if you sell the house, all you have left is debt. You never bought a home, you simply signed for a loan that you cannot pay off. You are much worse off than you started. These loans are vampire loans because mortgage lenders who keep these loans in their portfolio find that they look better dead than alive. The principal balance increases; the loan value appears higher; but the reality is that the borrower may be about to default on a payment (or may have already defaulted on one or more payments). Sophisticated investment bankers knew this, but they bought these loans from shaky mortgage lenders, packaged them up, and sold them anyway.

  As Warren Buffett points out, if you lend money to people who cannot pay you back, it will not end well (and it hasn’t).

  Homeowners with equity in their homes are encouraged to refinance with “no-cost” loans. In my opinion, this term should be made illegal. There is no such thing as a no-cost loan, albeit this type of loan may make sense for homeowners planning to move in a year or two. Fees are buried deep in the mortgage documents as a yield spread premium. Usually a borrower pays around 2 percent of the loan amount in closing costs. On a $100,000 loan there are about $2,000 in closing costs. With a no-cost loan, the mortgage lender builds fees into the interest rate, and the borrower pays the fees over time. Since the lender sells the loan to an investment bank, the lender makes money because the loan paying a higher interest rate sells for a higher price, so the lender gets his money right away. Lenders are not required to tell a borrower how much this is worth, and most borrowers—even educated, intelligent, otherwise savvy homeowners—do not know where to find the yield spread premium in their loan documents, which seems like pages of boring jargon, much less calculate what it is worth. Warren counsels that you should not invest in something you do not understand, and that would also apply when taking out a loan to “invest” in a home.

  The borrower may be getting a loan with a higher interest rate than he or she could get through another broker or through a traditional bank. Brokers doing this often raise the rate by 0.5 percent over and above the closing costs and what the borrower would otherwise pay elsewhere. For a $100,000 30-year fixed-rate loan, the extra charges mean additional interest payments of $11,500 above the closing costs already built into the interest rates. Honest brokers will run the math for a homeowner, show the borrower all of the fees, and calculate the breakeven ownership time period where the borrower will be indifferent between paying the closing costs upfront or paying the closing costs over time embedded in the monthly payments. Honest brokers will not fee slam by stuffing an extra 0.5 percent into the yield spread premium above and beyond the closing costs. There is no such thing as a no-cost loan.

  Some brokers of no-cost mortgages will only pay appraisers at closing (when borrowers sign documents to buy the home).They claim the appraiser will otherwise not work as hard to fairly value the property, but the opposite is more likely. A higher appraisal makes it more likely the deal will close, and the appraiser only gets paid at closing. It creates a conflict of interest for the appraiser.The appraiser has an incentive to come up with a higher number to ensure there is additional value for the seller or for a homeowner refinancing a loan.

  Mortgage brokers are responsible for about 70 percent of subprime loans. Many brokers make prudent loans, but a lot did not. According to Aaron Krowne’s Internet-based Implode-o-Meter, from late 2006 to June 2008, 262 major U.S. mortgage lenders had gone “kaput.”10 The number continues to climb.This is an unprecedented failure rate.

  The Alt-A mortgage market includes borrowers that have higher credit scores, but not high enough to qualify as “prime” borrowers. In both the Alt-A and prime markets, borrowers have purchased multiple dwellings with little or no money down. As housing prices drop, these borrowers find they have to sell property at a loss if the debt burden becomes too much for them.

  Fraud on borrowers is a problem, but so is fraud on lenders. Borrowers, often in collusion with unscrupulous brokers, supplied phony documentation or engage in identity theft. Lenders have a right to complain about this type of fraud, but their own due diligence standards should certainly be tightened.

  Investment banks funneled money to mortgage lenders by purchasing the mortgage loans and storing them in special purpose companies known as warehouses. Once there were enough loans, thousands of loans, in the warehouse, they packaged up the loans into residential mortgage-backed securities (RMBS) and sold them to investors. As long as the banks could keep stuffing the loans into securitization packages and selling them, they did not have to keep the risk themselves. If you are ethically challenged and have reason to know you are building airplanes with defective parts, you will sell the airplanes as quickly as possible. That way, when the parts give out, someone else will fall out of the sky. Unfortunately for investment banks (and mortgage lenders that sold them the loans), they got stuck, and their earnings crashed.

  Mortgage lenders were obliged to take back loans that did not meet certain standards. Some of the loans made in 2006 and 2007 were so bad that they began defaulting before an investment bank could get rid of the risk (by selling packaged loans to investors like mutual funds and others). Shaky mortgage lenders could not buy back the bad loans without borrowing money from another investment bank. When things got bad enough, investment banks stopped lending and the shaky mortgage lenders went bankrupt. Many investment banks were stuck with mortgage lenders’ unpaid loans and with a warehouse full of bad subprime loans.

  One really can’t say this enough: Warren advises that you shouldn’t lend money to people who cannot pay you back. Investment banks—acting as indirect mortgage lenders, bought up the mortgage loans and supplied money to shaky mortgage lenders.They kept the “party” going.

  Before the party ended, mortgage lenders siphoned off fees and dividends. When everything unraveled, many mortgage lenders had no value to their shareholders and could not pay back their loans from investment banks (“old investors”), without the money provided by the “new investors,” to whom investment banks sold the packaged dodgy loans. Perhaps your mutual fund. The only thing that kept the money train moving was the fact that money from “new investors” was used to generate the illusion of high returns for “old investors.” That is a Ponzi scheme. A Ponzi scheme raises money from “new investors” so “old investors” can be paid a return on their money even though the business model is a failure. When Ponzi schemes unravel, even “old investors” lose some of their money, and the “new investors” lose much more. Only “old investors,” who get out very early, escape unscathed.

  In late 2006, I saw a prospectus for RMBS that took hundreds of mortgage loans, put them into a portfolio, and sold the risk to i
nvestors. The deal seemed targeted for foreign investors and showed a portfolio including first and second lien (piggyback) mortgages. Some were adjustable rate, some not. The portfolio included negative amortizing product and interest-only product.The loans were purchased from various mortgage lenders. More than 60 percent of the loans were purchased from New Century Capital, which in turn acquired them from New Century Mortgage Corporation, a subsidiary of New Century Financial Corporation, which filed a news release in February 200711 that it would have to restate its financials and filed for bankruptcy on April 2, 2007, under a cloud of fraud allegations.12 Investment banks had a responsibility to perform rigorous investigations into the quality of loans coming from mortgage lenders.

  One would expect investment banks that are obliged to perform due diligence appropriate to the circumstances to yell: Stop the money printing presses!

  For example, Merrill Lynch (the previously mentioned deal was not a Merrill Lynch deal) was a part owner of California-based Ownit Mortgage Solutions. Mike Blum, Merrill Lynch’s head of global asset-backed finance, sat on the board of Ownit Mortgage Solutions. Revenue was up around 33 percent in the first three quarters of 2006, but Ownit was losing money. In November 2006, JPMorgan Chase told Ownit that its $500 million credit line would disappear on December 13. When Ownit imploded, Blum faxed in his resignation. Ownit made second-lien mortgages, issued 45-year ARMs, and originated no-income-verification loans. In the words of William D. Dallas, its founder and CEO: “The market is paying me to do a no-income-verification loan more than it is paying me to do the full documentation loans.”13 In this post Sarbanes-Oxley world, one might have expected Merrill’s Mike Blum to insist on a fraud audit of Ownit instead of faxing in his resignation. Warren Buffett points out, “[T]here are worse things than Sarbanes Oxley.”14 This is one of them.