Residential mortgage lending was previously a very staid business. Lenders meticulously considered the merits of making loans: They obtained careful appraisals, required sizable down payments, and made sure each borrower had a stable job and reliable income. Lenders knew their institutions would take substantial financial hits if borrowers failed to make good on their loans. They also knew regulators were watching, checking to make sure each loan was sound.
Staid was the last thing you could call mortgage lending during the housing boom. Frenzied might be a better term; and as the boom became a bubble, out of control would be even more appropriate. The mortgage business had been completely transformed.
Lenders now made their money solely on volume; the more loans they originated, the greater their profits. Whether borrowers would be reliable payers was, at best, a secondary concern; Wall Street was buying the loans and, it was thought, using its financial alchemy to ensure that everyone made out. Regulators still cared, but they took comfort in the fact that the lenders they oversaw weren't on the hook if things turned out badly. The institutions most exposed were nonregulated private mortgage lenders and investment banks, ranging from New Century Financial to Bear Stearns. And although they were growing in size and number, they weren't the regulators' responsibility.
Wall Street drove the changes in the mortgage lending business. Making a loan and maintaining ownership of it was no longer as profitable as making the loan and selling it to an investment bank. The investment banks had connections to yield-hungry investors all over the world who were willing to pay fat premiums for anything lenders could originate.
Lenders obliged en masse. They had been making subprime loans for some time, but these originally required large down payments and careful scrutiny of subprime borrowers' income and savings. Lenders also demanded compensation for the extra risk of making a subprime loan; under the so-called "risk-based pricing" model, the greater the chance of default, the higher the interest rate and the bigger the fees a borrower would need to pay. However, as the market heated up, down payment requirements shrank and documenting a borrower's income slid from a requirement to a recommendation. Risks were rising, but in the hypercompetitive environment, interest rates and fees could not.
Lenders let their standards slip because if they didn't make a loan, their competitors would. No industry had more avidly embraced the Internet than mortgage lending, and the effect had been intoxicating for both consumers and lenders. Borrowers previously had few choices; if they needed a loan to buy a house, they could apply at their neighborhood bank branch.
Now a horde of eager prospective lenders was only a mouse click or two away. The Internet was a boon for lenders as well, offering any storefront or basement-based operation access to customers across the country, and dramatically cutting the overhead costs involved in making loans. But the net effect was a competitive frenzy, with lenders furiously undercutting each other to gain customers. Everyone, it seemed, was in the mortgage business. Alongside traditional banks and thrifts were largely unregulated real estate investment trusts, Wall Street investment banks, and even home builders trying to move their unsold units. In this atmosphere, a lender demanding strict, old-fashioned credit standards would soon be out of business.
A few old-time mortgage lenders worried that the tried-and-true rules were being abandoned, but most were swept up in the hubris of the time. The housing boom was built on a solid foundation, or so they reasoned. Loans with no down payment were a problem only if housing prices weren't rising, and prices were rising rapidly. Certainly, they would eventually slow down and level off, but no one expected prices to actually decline. And the lenders' math-whiz consultants had devised new, sophisticated models of borrower behavior. Applying their algorithms and formulas to past performance, they were confident they could separate the good borrowers from the deadbeats.
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