During this past month the nation learned of the collapse-in-progress of the sub-prime mortgage market, which it appears will be promoted as this season’s spectator sport. Each day we view another victim in this saga: a former sub-prime loan processor who lost her job, a condominium owner now six months behind in his mortgage payments and facing foreclosure, or a shareholder of Accredited Home Lenders whose stock value fell 65% in a single day. What are we to think? Who is to blame? What must be done?

First, a brief description of the sub-prime mortgage market
These are loans to homeowners with a history of poor credit, usually persons with FICO scores below 620. Normal characteristics of these loans are low or no down payment together with an adjustable interest rate following an introductory period of two or three years during which an artificial rate as low as 3% (known as a teaser rate) is used in qualifying the borrower. It’s customary that in those early years, no principal is paid on the loan, and in some cases the principal balance actually increases (referred to as negative amortization). So, what’s the problem? Remarkably simple! People with a history of not paying bills received inducements over the past several years to acquire homes they could not afford, encumbered by mortgage loans they cannot pay. Currently 2.1 million such loans, representing 13.3% of all sub-prime mortgages, are delinquent. If a substantial number of these homes fall to foreclosure, the residential housing market, and to a certain degree the nation’s economy, will be adversely affected.

In case you believe the problems we are witnessing come as a surprise to the financial world, you are mistaken. The principles of sound lending are well established, and those of us who participate in the world of legitimate mortgage brokerage and banking know a good loan from a bad one. Even officials of the federal government, not renowned for business acumen, foresaw the coming events. Several agencies, including the Federal Reserve and the Treasury Department, jointly issued a warning as early as 2005, cautioning lenders to refrain from granting loans to unworthy borrowers. Nonetheless, the unsound practices continued, and this deserves an explanation. The blunt fact is that an enterprise which will be generally unprofitable may be selectively profitable. For every dollar that one person loses, someone else will be a dollar richer. This is what the sub-prime mortgage business is really all about, with fortunes generated before the unraveling you now observe. Consider who are included among the co-conspirators. A fair income flowed to property appraisers, real estate brokers, mortgage loan processors, escrow officers and a host of others involved in the actual loan creation process. Persons who speculated in properties relied upon questionable financing to turn a quick profit.

I’ll provide details on a single transaction to give you a feel for how it works. In late November 2005 an investor purchased a 3-bedroom, 2 and a half bath condominium in Santa Ana, California, for $420,000. Following a little renovation, it sold in mid-April 2006 for $490,000. How a loan appraiser justified the selling price is a matter to be discussed at some other time. Terms of the sale: nothing down, $392,000 first mortgage @ 3.75% for two years, adjusting to market interest thereafter; $98,000 second mortgage @ 7%; seller crediting buyer $10,000 at close of escrow. Now that you know the terms, does the transaction seem unfavorable in any way? Actually it’s a win-win for everyone. The Realtor made a profit; the loan processor made a profit; the appraiser made a profit; the investor made a profit; the purchasers acquired a home without putting out a dime (actually they pocketed a few dollars) with occupancy for two years at a monthly payment less than rental value.

There are also a few other winners you might not even think about. The sub-prime lender, who made points and fees on the first mortgage loan, then packaged it with hundreds more and sold it to one of the Wall Street financial organizations such as Bear Stearns or Morgan Stanley for inclusion in a pension fund, mutual fund, or hedge fund, and all of them took a piece of the action. Until the loan goes bad—which it may never do—there are no losers. It’s true, of course, that when the foreclosures begin there will be persons who suffer. Most certainly, the buyers stand to lose their homes, though with nothing down and cheap payments for two years, perhaps it’s not all that bad. In addition, as we’re now witnessing, employees of the sub-prime mortgage lenders are out of a job. And the one group we mustn’t forget are the millions of Americans whose IRA and 401(k) accounts are invested in the various funds holding these mortgage-backed securities. Many of them will take a hit, even if most of them will never really know what hit them.

Now that we’ve determined what went wrong, and why, it’s traditional that we select a culprit to hold responsible for the calamity so he—on rare occasions, she—can be made an example of. In short, we must identify the snowflake on which to blame the blizzard. Perhaps we might pick out a single CEO of a major sub-prime lending company. Although Kenneth Lay, the late one-time CEO of Enron is no longer available, we’ll surely find someone we can sentence to 150 years in prison, thereby demonstrating our dedication to sound business practices.

A final word is in order: To conclude this episode, a new set of laws must be enacted. Already Chairman of the House Financial Services Committee Barney Frank and Senate Banking Committee Chairman Christopher Dodd are revving up “…to pass a bill that will diminish the likelihood of people being given loans they should not be given.” Whatever transpires will achieve the same result as the Sarbanes-Oxley act enacted in 2002 to deal with the financial scandals in the securities market several years ago—no meaningful effect whatever.


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