This article examines the synergistic effect unsound appraisal practices, sub-prime home loan originations and declining home values have had on the failure of mortgage-backed securities which triggered the Millennium Recession.

Making loans: from boom to bust

The shape of this Millennium Recession was formed in the housing boom of 2003 – 2005. During that three-year time span, many tenants bought homes due to the permissive mortgage environment brought on by historically low interest rates the Federal Reserve (Fed) maintained from mid-2001 until late-2004. Readily available financing and perceived property scarcity influenced tenants who would not have otherwise considered purchasing a home to seek out and secure purchase-assist financing, despite low credit scores or unfavorable debt-to-income (DTI) ratios.

This façade of urgency pushing consumers out onto the stage of homeownership was orchestrated and then appropriated by lenders, who were abetted by the inherently corrupt force of Wall Street, who in turn were indirectly funded by the Fed. Enter: mortgage-backed bonds. Conjured up by Wall Street with initial good intent, mortgage-backed bonds allowed lenders to shovel huge amounts of mortgage loans off their books, freeing up capital to make more loans. Eventually, these loans went disproportionately to subprime borrowers from 2004 – 2006.  Mortgage-backed bonds financed the business of lending, bringing about a boom in subprime mortgage originations.

In a study by the Federal Reserve Bank of New York (FRBNY) entitled “Below the Line: Estimates of Negative Equity Among Nonprime Mortgage Borrowers,” by Andrew F. Haughwout and Ebiere Okah, they report the loosened lending standards of yesteryear are not entirely to blame for the current plague of mortgage defaults. Rather, the study points to the increased prevalence of lackluster and deteriorating home prices as having the greatest economic impact on mortgage performance.  Home values did not appreciate forever as Wall Street rating agencies expected. The erroneous expectations led to excess lending originated with homebuyers who were qualified primarily to be tenants, creating an overabundance of mortgaged homes which eventually became saddled with negative equity.

Thus, we arrive at the paper’s central argument: negative equity (a phenomenon in which the loan balance is higher than the value of the home) influences homeowners to view their homes as worse than valueless; a detriment. The homeowner’s perspective of his home being an anchor around the neck affects the willingness of borrowers to continue paying their mortgages. Furthermore, Haughwout and Okah draw a distinct parallel between the arrested development of appreciating values experienced by millions of homeowners who purchased during the Millennium Housing Boom, and the resulting wave of negative equity during the predictable bust.

These events interacted to drastically reduce the value of the mortgage-backed bond market, triggering a collapse throughout the U.S. financial sector. The faulty mortgages exposed systemic financial irregularities throughout the banking system that gave rise to the Millennium Recession.

Market-inflicted defaults

What do the numbers tell us about the homeowners who defaulted? Were all of them unfit borrowers?  Surely, the commonly held belief is that all those subprime borrowers in default were just irresponsible and living beyond their means. But the Haughwout and Okah study points out that borrower quality (whether a borrower’s credit score was considered prime or subprime at the time of mortgage origination) did not affect the tendency of home values to drown in the deep waters of negative equity. Cited by the FRBNY study, findings by the Office of Federal Housing Enterprise Oversight show that the majority of borrowers whose loans sank into negative equity had higher credit scores than loans that maintained a positive equity. Thus, borrower qualification for a loan is not the real culprit.

Alternatively, the statistic that jumps out as predictive of default is the loan-to-value (LTV) ratio at the time the mortgage originated, an issue well known to real estate brokers and agents.

Traditionally, borrowers have financed far less than 100% of the value of the home, giving the homeowner some wiggle room in a housing market of fluctuating prices. For instance, if a home is valued at $300,000 and the buyer borrows 80% ($240,000), then the down payment and equity in the home is $60,000 (or 20%) on closing. But even the traditional ‘safe’ LTV ratio of 80% proved very unsafe for buyers in California. Consider, then, that during the Millennium Housing Boom (2002 – 2006) more than 25% of subprime originations had an initial LTV of 100% or more.

Why would a buyer, especially one with a fair-to-good credit score, tether himself to a loan with zero or less equity at origination? Keep in mind subprime mortgages during the boom time were originated on homes that were already overvalued by speculator pricing, and upward-biased appraisals. In other words, home values attached to mortgages were inflated and buttressed by future expectations held by both speculators and homebuyers. Appraisers were merely accomplices. In this light, an LTV ratio of 100% or more might not have bothered the borrowers or lenders in the period of 2003 – 2005, since nearly everyone expected homes to increase in value—investments were as “safe as a home.”

When expectations of increased value failed to materialize, California homebuyers and those who refinanced after 2002 were left with tens of thousands of dollars in negative equity. California alone racked up more than $21 billion in negative equity: a number reflective of the huge correction in housing prices now being experienced in the state. California’s negative equity bill is nearly double that of Florida’s, the state with the second highest amount of negative equity.

The word ‘correction’ aptly sums up the boom-bust cycle and explains the relationship of negative equity to massive defaults. Homeowners with negative equity will seek to correct their topsy-turvy finances by defaulting. As Haughwout and Okah point out, the likelihood a homeowner will default on his mortgage increases in tandem with the amount of negative equity present. Negative equity does not automatically lead to default, but negative equity is nearly always present when a homeowner does decide to default—whereas homeowners with positive equity rarely default.

The FRBNY article looks forward to future and likely incidences of default via negative equity and issues an implied warning to lenders to avoid high LTVs. The advice offered is sound and represents a return to real estate financing fundamentals. But the article fails to assert a direction or offer a resolution to alleviate the pandemic of negative equity and, by extension, default.

The best salve for curing the prevalence of negative equity must include an extension of judicial authority in bankruptcy to force a cramdown of the principal balance of a mortgage to below 100% LTV. Bankruptcy cramdowns would serve as a competitive impetus, diminishing the financial monopoly lenders hold and use as leverage to offer homeowners pseudo-modifications of their monthly payment amounts that nearly always increase negative equity. Thus, the rate of redefault on modifications now exceeds 65%. Mortgage principal must be reduced by lenders (voluntarily or involuntarily) to make homeowners buoyant enough to be above the high water mark of their home’s present value, stemming the tide of foreclosures, correcting the real estate market and making hundreds of thousands of California homeowners financially solvent to be consumers in the coming recovery.