Here's the narrative we've heard about the mortgage meltdown: miscalculation and unfounded optimism, clueless investors, cash-strapped home buyers clobbered by rate resets.
But there's one piece of the mortgage-meltdown tale that virtually every article or television program dances around without ever quite confronting. It's the simplest aspect of the crisis to understand and also the most troubling, because it's not about complicated financial dealings and can't be fixed with bailouts. It's about an astounding breakdown of social norms.
It's the story of the liar's loan.
The term is mortgage-industry slang for what's more formally called a "stated income" mortgage—a mortgage that a lender gives without checking tax returns, employment history, or pretty much anything else. Many of the loans that are in trouble now, or will be in trouble soon, fall into this category. But the term gives only the barest hint of the pervasive failure involved.
The original idea of the stated income mortgage was that it would benefit salespeople who work on commission, people who own their own businesses, and others for whom predicting next year's income isn't just a matter of looking at last year's.
At the height of the mortgage boom, however, especially in pricey markets, the liar's loan became a routine way of doing business; for some lenders—both smaller ones like IndyMac and WMC as well as big ones like Countrywide and Washington Mutual—it was the main way. In 2006 in some parts of the country, these loans made up as much as half of new mortgages, for both subprime borrowers and for homebuyers with high credit scores.
Under ordinary circumstances, we think of lying as something that a few people do. But the nickname "liar's loan" is stunningly apt. The vast majority of the people who took these loans out exaggerated at least a little. Most lied a lot. And it's likely that most of the liar's loans—including those given to people with excellent credit histories—will go bad.
Think about that for a second. Imagine a city center where running red lights isn't something that the occasional drunken driver or road-rage victim does, but where everybody does it all the time. That's a lot like the mortgage market in big swaths of the country one or two years ago.
Of all the problems in mortgage world, the liar's-loan crash was the most foreseeable. Knowledgeable observers were already sounding the alarm in 2005. But it wasn't until the next year—as lenders were furiously writing ever more such loans—that the hard data started coming in, confirming what everybody who'd stepped into a mortgage broker's office knew.
In 2006, a man named Steven Krystofiak gave a statement in a Federal Reserve hearing on mortgage regulation, representing an organization called the Mortgage Brokers Association for Responsible Lending. The organization had compared a sample of 100 stated income mortgage applications to IRS records.
More than 90 of the applications overstated the borrower's income at least a little. More strikingly, more than three out of five overstated it by at least 50 percent. This isn't a few people fibbing a little. This was the whole system breaking down.
If you lie about your income as much as most borrowers did, you'll wind up with payments that take half or more of your paycheck, a setup for quick foreclosure. Did this concern the lenders who were writing these loans? It boggles the mind to think that they could have been unaware. And yet they continued to write loans under the same terms,racking up supersize loans—and charging customers a little bit more in interest for what amounted to the privilege of lying.
How could they? If you've been following the mortgage story at all, you know the answer: They could take a few hundred or even several thousand of the loans, put them together into a "mortgage-backed security," sell them to investors, and, presto, they were no longer Countrywide's or Washington Mutual's or IndyMac's problem.
The consequences are predictably depressing. A blogger named Michael Shedlock has done some terrific work tracking the performance of these kinds of loans. Shedlock analyzed one particular bundle of loans from Washington Mutual consisting of 1,765 mortgages from around May 2007, a total of $519 million in loans.
These were not "subprime" loans. The borrowers' average credit score was 705, well within prime territory. This is a fairly typical package of loans for amortgage-backed security, but one thing that does make it stand out is the proportion of these loans that didn't ask for income documents: 88 percent.
Historically, a year into the life of a loan, well less than 1 percent of typical prime loans would be 30 days late or more. By the end of January, when Shedlock first looked at it, just eight months after the loans were made, almost one in five were at least 60 days overdue.
Shedlock looked at it again two months later, at the end of March. The results:
- Eighteen percent of the loans are already in foreclosure—or have already been seized by Washington Mutual.
- One in four of this bundle of liar loans is already 60 days past due.
Remember, these are folks with good credit histories—and one in four of them is well on his way to losing his home, or has already lost it.
Think about that city center again. All those cars speeding through those red lights. And crashing.
None of this could have happened without everyone's willing participation. If a car rental agency put up a huge sign saying, "We don't check your driver's license," you wouldn't imagine it really meant anything but "Come on in, we don't care if you have one." The word fraud really doesn't conjure up anything close to the real moral or financial reality.
Clearly, amazing degrees of stupidity and mendacity were involved. Some of the sob stories that have come out of the mortgage crisis, unhappy as they are, raise the question: "These folks earned $3,000 a month and had mortgage payments of $2,700. Was it so hard to see this was a mistake?"
But consider the position of borrowers in markets where close to half the people taking out mortgage loans were lying. Keep in mind that in some places (for instance, San Diego), half the people in the market were taking out stated income loans and so bidding up prices to points where almost any house became impossible to finance for someone who did not lie.
Then try to imagine the broker hovering over your shoulder, like the scientist in some mortgage-world version of the Milgram Experiment. In ordinary circumstances, the people and institutions you deal with reinforce social norms. They say it's not OK to lie. But what happens when the structures and institutions break down and start telling you the opposite?
In that case, the honor system that we take for granted goes out the door. You wind up with the situation in many countries—Russia, India, Italy—where, say, not paying taxes is not aberration; it's normal. What might be most worrisome is that once you get to that point, it's hard to get back. You don't just have to restore the structures. You need to restore the norms, too.