How the Real Estate Meltdown of 2008 Really Went Down

In a recent New York Times opinion piece, Times staffer Christopher Caldwell attempts to set the record straight about claims that Michael Bloomberg blamed the 2007 real estate meltdown on Congressional legislation that pressured banks “to make loans to everyone” but that’s not the whole story.

Michael Bloomberg was quite correct when he made that assertion in a 2008 interview, but he never specifically said that the intent was to broaden home ownership. He didn’t say that because Bloomberg probably knows better.

Caldwell, however, incorrectly claims that the real estate meltdown that triggered the Great Recession of 2008 was “result of a flawed attempt to use credit markets to broaden access to housing.”

Three presidents and their congresses did, in fact, modify lending policies to increase access to real estate loans for people who had been frozen out of the real estate game, but that’s not what caused the 2008 crash, which was brought about by a refinancing boom that began in 2000 in the wake of the bursting of the bubble.

Broadening access to housing isn’t the same thing as increasing access to home ownership, which is the objective that Caldwell attributes to the ill-conceived weakening of lending safeguards.

If you want to broaden access to housing, you build more multi-unit dwellings, not more single family dwellings, which often requires changing zoning regulations in a manner that depresses the values of adjacent single family homes, another omelet and egg situation, one of many that pertain to the real estate and mortgage businesses. If you want to increase actual home ownership, you increase funding for cooperative and condominium complexes, which combine multi-unit projects with the home ownership option.

What you don’t do is what several Republican and Democratic administrations actually did: opening the spigots of the lending system for unqualified borrowers.

Caldwell’s first mistake was to call the real estate melt down a “mortgage crisis” when the mortgage crisis was actually both a cause and an effect of the actual real estate meltdown. His second mistake – which was also Bloomberg’s mistake – was to attribute the mortgage crisis solely to an attempt to broaden home ownership among minorities. It was not.

I was in the mortgage industry from 1996 to 2012, after a twenty-five year stint managing nonprofit organizations (yes, I am old) while these things were going down, so I had a ringside seat from which I could observe what really happened.

It was, first of all, the snowballing effect of falling property values that burst the lending balloon, not the other way around. More importantly, the straw that broke the camel’s back was the “No 4506” mortgage adjustment. Of course, the falling property values were caused by increasing defaults and foreclosures which flooded the market with under-priced properties and those foreclosures resulted from increasing rates on adjustable rate mortgages, so it was something of a vicious cycle from the get-go.

In 2001, I noticed for the first time a new adjustment on Fannie Mae and Freddie Mac rate sheets. The adjustment charged 1/2 of one percent of the loan amount for “NO 4506.” (It may have been on the rate sheets even further back than that, but I had never noticed it until we started seeing an influx of less qualified borrowers. I have been unable to determine exactly when this adjustment was added to the rate sheets but I KNOW I was quite surprised when I saw it for the first time because it hadn’t been there the day before.)

Form 4506 is an Internal Revenue Service form, usually required in all mortgage packages, that gives the named party (the lender and the lender’s subsequent assigns) the right to access a borrower’s tax returns.

Lenders used this form to compare the tax returns the borrower was required to submit in their mortgage applications with the ones the borrower had submitted to the IRS in order to identify instances of fraud.

The 4506 waiver meant that a borrower could submit a completely false tax return, but the lender would have no way of verifying or rejecting the tax return. Since it is a felony to submit a false tax return with a mortgage application, something that is clearly stated on every mortgage application, the “No 4506” adjustment allowed borrowers to get away with committing a felony to obtain mortgages they were not qualified for on the basis of their actual income, assets and expenses. It was like renting a billboard in Times Square and posting a message encouraging borrowers to lie to lenders.

Millions of mortgages were written using the No 4506 adjustment from 2001 through 2007 when the melt-down began, and it was these mortgages that went into default FIRST as rates began to rise because borrowers weren’t qualified for those loans. (I wrote exactly one of those mortgages and then refused to allow any others to pass through my hands once I figured out what was going to happen. I didn’t want any of my borrowers to get caught in the switches.)

The “No 4506” was, however, a “rich person’s” adjustment. Low income borrowers were rarely in a position to pay either discount points or penalty points. (Discount points lower the rates. Penalty points lower qualification requirements and sometimes come along with rate increases.)

This adjustment was an invitation to borrowers to lie on their mortgage applications, and that was exactly what they did. This often necessitated submitting forged W2s and pay stubs as well as phony tax returns but, if you’re going to commit a felony in the first place, committing a second and third one is no big deal, and it isn’t very difficult to forge these documents. It was more difficult to get employers to verify false income statements but, since employers could not be penalized for doing so (especially if they verified income verbally), smaller employers in particular often did just that.

There were in fact other mortgage programs, often called Stated Income loans, that allowed borrowers to claim any annual income they chose to state with no legal risk, but those loans came with much higher interest rates and/or more upfront points, and usually much higher down payments or equity ratios. These “non-conforming” loans were also available in a No Document flavor, at even higher interest rates and points. (Remember: a point is one percent of the loan amount. Stated income loans could cost two percent of the loan amount. No Document loans could cost you up to four percent, if you could find a secondary lender willing to buy them.)

There were other contributing causes to the 2007 real estate collapse. The most important contributing cause was the near collapse of AIG, the secondary insurance carrier that underwrote the bulk of the conventional mortgages that were issued during this period, which proved to be unable to pay off on non-performing loans.

Now, as to whether this was the result of an attempt by the government to broaden home ownership and increasing the number of minority homeowners, let’s remember that the “No 4506” deregulation bonanza took place during George Bush’s illegal reign as an unelected president of the United States. Since when is the Republican party in the business of attempting to increase the percentage of home ownership?

The real reason for the relaxation in the mortgage regulations exemplified by the “No 4506” adjustment was that we had just come through the collapse of the “ bubble” in 2000, which put a severe dent in the U.S. economy and threatened the future of the whole internet experiment. The relaxation in the mortgage regulations was intended to enable homeowners to withdraw equity from their homes and invest that equity in the depressed stock market.

Millions of Americans did just that, and a percentage of those millions of Americans made out very nicely by buying into a severely depressed stock market. Millions of others lost their shirts as some of those stocks just continued to collapse into bankruptcy. Some people bought Apple. Some people bought Compaq.

This isn’t mere speculation. Investment advisers across the country were advising their clients to do exactly this, take equity out of their real estate holdings and invest the proceeds in the market. There were even television commercials telling consumers to do just that.

The immediate net effect of this deregulation was to bolster the stock market and pull the IT sector of the market out of its collapse. It also insured George Bush’s second term as president because it was directly responsible for the surge in the economy that allowed an incompetent president to win re-election despite an unpopular war and a wholesale attack on the middle class.

The long term effect of the deregulation was to set the stage for the Great Recession of 2008, which really began in 2007, and which, in turn, was largely (though unadmittedly) responsible for Barack Obama’s seemingly miraculous election, since he appeared to have a clear plan for fixing the economy when John McCain clearly did not.

Michael Bloomberg was absolutely correct when he said that the mortgage meltdown was the result of congressional attempts to ease lending regulations. However, the goal wasn’t simply to increase home ownership among low income borrowers.

If THAT had been the goal, Congress could simply have limited the relaxed lending regulations solely to FIRST TIME HOME BUYERS. If they had done that, the mortgage collapse would never have happened because we wouldn’t have seen the orgasm of REFINANCE TRANSACTIONS, which is what really triggered the collapse. (This is where most of the academic apologists get it wrong. They never consider the ratio of refinances to first time homeowner purchases. It isn’t even mentioned in the cited article.)

On the basis of my personal recollections the ratio of refinances to first time purchases was running around three to one. Seventy-five percent of the mortgages written during this period were refinance transactions. In fact, in some cases, as property values escalated from 2000 through 2007, some homeowners were refinancing EVERY SIX MONTHS in order to pull more money out of their equity. In the first six months of 2003, 90 percent of the mortgages my company wrote were refinance transactions because much of our target market – the Greater Boston area – was already priced out of range for low-income borrowers looking for their first homes.

It is true that George H.W. Bush moved to lower the barriers to home ownership in the wake of the Los Angeles race riots, but the housing market didn’t collapse during his term. It is also true that Bill Clinton tried to increase minority home ownership on his watch, but that didn’t trigger the mortgage meltdown either.

It wasn’t until Fannie and Freddie made it possible to lie with impunity on mortgage applications (or the mortgage industry just starting using the No 4506 option) that the rotten apples began to fester in the mortgage market, and the collapse didn’t begin at the low end of the housing market. It began in the middle of the housing market, which is precisely where homeowners were refinancing in order to increase their stock portfolios.

This made a certain amount of sense since it was obvious to anyone with a good foundation in the real estate business that there was going to be a serious adjustment in real estate values when the real estate boom began. In some respects, middle-class homeowners didn’t have a choice. They had to pull the inflated value out of their homes because those values were going to disappear. The conventional wisdom was that they would make enough on the market to pay off their mortgages. That was where stupid took over the steering wheel.

There are a number of ridiculous statements in this article. One of the most amusing ones is that “the less likely you were to pay off a mortgage, the more likely you were to get one.” This is amusing because the underwriting criteria is EXACTLY the same for all borrowers. There aren’t any real separate criteria for low income borrowers. There aren’t even any real breaks for first time home buyers either.

Another whopper is the claim that all a borrower needed was 12 months worth of “reasonably
good” credit scores.

This one is ridiculous because no one underwrites credit scores on a month-to-month basis. Mortgage underwriters (and I was one) evaluate only current credit scores and do not retrospectively review credit score change over 12 or 24 months. The credit bureaus, which are private corporations not subject to government regulation, calculate consumer credit scores over a seven-year period (NOT 12 MONTHS) because that’s how long it takes for derogatories to fall off credit reports. (Some derogatories fall off a credit report after two years, but it takes seven to ten years – sometimes – to whitewash bankruptcies and foreclosures.)

Speaking of whitewashes, please note that, while the article mentions the 2001 recession, it does not mention that the recession was triggered by the collapse of the bulge in the stock market, which coincided with the biggest change in the mortgage regulations (the No 4506 adjustment,) which was the one that permitted so many unqualified borrowers to stick their beaks into the mortgage trough.

My summary conclusion about this article in the New York Times is that it was written specifically and deliberately to help Mike Bloomberg to explain away his blanket statement which really didn’t need much, if any, explanation since Bloomberg’s original, unembellished statement was a matter of fact not supposition. It does, however, give Bloomberg yet another coating of whitewash to reduce his perceived problem with minority voters.