Q&A: What started the meltdown?

Q:For once, can someone give me a straight answer? What caused the mortgage meltdown?

A: There have always been foreclosures. People lose their homes for various reasons, the most common of which have been such factors as the loss of a job, the death of a spouse, medical costs or divorce. Given that we have not seen a material increase in any of these events you have to ask: What changed that set off the current crisis?

The answer concerns the introduction of toxic loans and the increased use of stated-income mortgage applications during the past few years.

The problem is not centered on Wall Street, it's centered in your neighborhood and mine. Mortgage-backed securities issued by Wall Street would have unquestioned value -- as they have had for years -- if the underlying mortgages were sound. The problem is not with the securities bought and sold by investors, it is with the mortgages themselves.

Notice that the problem is not subprime lending or that the markets in several states have been especially impacted by foreclosures. If that were causing the mortgage meltdown then home values would not be falling in states with strong economies and foreclosure inventories would not be soaring nationwide.

The cause of the mortgage meltdown is different. Ask yourself: When did you first hear of an option ARM? When did you first hear of employed individuals applying for mortgages with stated-income loan applications -- applications where the borrowers estimate their income and the lender generally does not check?

In 1994, Congress passed the Home Ownership and Equity Protection Act, HOEPA. Under this law the Federal Reserve has the right to curb "unfair and deceptive acts or practices" or "UDAP" for short.

Using its authority, the Federal Reserve could have banned option ARMs; it didn't. It could have required fully documented loan applications for all mortgages; it didn't. It could have prohibited prepayment penalties; it didn't. It could have required lenders to escrow money for property taxes and insurance; it didn't.

If traditional underwriting standards had been maintained there would now be far fewer foreclosures. With better credit quality there would be better mortgage-backed securities. Simply put, we would not have the crisis we now face.

The Fed has now oozed into action. Beginning Oct. 1, 2009 -- after millions of families have lost their homes -- new mortgage rules will be in place, mostly for subprime borrowers.

Mortgage lenders have vehemently opposed the adoption of any UDAP standards. After all, adhering to decent standards would raise costs and lower profits. Need an example? A borrower financing with a stated-income loan application pays a higher rate then someone who provides full documentation.

The lack of real regulation associated with mortgage lending has been unconscionable. Consider this parallel: Surgeons could save money and earn more if they were not forced to sterilize their instruments. What's a few germs among patients? Such an argument is absurd and no medical regulator would adopt such a view, but a philosophy of lender deregulation was put ahead of borrower, investor and community interests.

It didn't have to be this way. Some lenders refused to offer toxic loans or drop their standards. Think of Hudson City Bancorp, ING Direct and maybe lenders in your community. These lenders maintained traditional underwriting standards and required borrower equity to protect their interests. But many lenders did not, nor did they have to because the Federal Reserve failed to adequately regulate national banks.

In 2004, I wrote that "with a growing number of stated-income loans on the books, financing with exaggerated numbers could quickly become a lender concern if home values dip, the economy slows and monthly payments don't show up. That's the point at which stated-income loans will come home to roost." I objected to toxic loans, as well.

Other people had similar concerns well in advance of today's troubles.. Unfortunately, such issues were ignored because homes were selling, prices were rising, bigger property taxes were being collected, quarterly profits were up, executive bonuses were being paid and mortgage-backed securities were being sold so why rock the boat?

Now we know why.

Q: Why do real-estate prices change so quickly?

A: At any moment there are different buyers and sellers in the marketplace, different properties are available and interest rates that are in motion. Change any of these factors and an endless number of new considerations and variations come into play. The price for a property is simply a reflection of the conditions which exist at one particular moment -- and which may or may not exist in the next.