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II. BACKGROUND
B. High Risk Mortgage Lending
The U.S. mortgage market reflected many of the trends affecting the U.S. financial system as a whole. Prior to the early 1970s, families wishing to buy a home typically went to a local bank or mortgage company, applied for a loan and, after providing detailed financial information and a down payment, qualified for a 30-year fixed rate mortgage. The local bank or mortgage company then typically kept that mortgage until the homeowner paid it off, earning its profit from the interest rates and fees paid by the borrower.
Lenders were required to keep a certain amount of capital for each loan they issued, which effectively limited the number of loans one bank could have on its books. To increase their capital, some lenders began selling the loans on their books to other financial institutions that wanted to service the loans over time, and then used the profits to make new loans to prospective borrowers. Lenders began to make money, not from holding onto the loans they originated and collecting mortgage payments over the years, but from the relatively short term fees associated with originating and selling the loans.
By 2003, many lenders began using higher risk lending strategies involving the origination and sale of complex mortgages that differed substantially from the traditional 30-year fixed rate home loan. The following describes some of the securitization practices and higher risk mortgage products that came to dominate the mortgage market in the years leading up to the financial crisis.
Securitization. To make home loans sales more efficient and profitable, banks began making increasing use of a mechanism now called "securitization." In a securitization, a financial institution bundles a large number of home loans into a loan pool, and calculates the amount of mortgage payments that will be paid into that pool by the borrowers. The securitizer then forms a shell corporation or trust, often offshore, to hold the loan pool and use the mortgage revenue stream to support the creation of bonds that make payments to investors over time. Those bonds, which are registered with the SEC, are called residential mortgage backed securities (RMBS) and are typically sold in a public offering to investors. Investors typically make a payment up front, and then hold onto the RMBS securities which repay the principal plus interest over time. The amount of money paid periodically to the RMBS holders is often referred to as the RMBS "coupon rate."
For years, securitization worked well. Borrowers paid their 30-year, fixed rate mortgages with few defaults, and mortgage backed securities built up a reputation as a safe investment. Lenders earned fees for bundling the home loans into pools and either selling the pools or securitizing them into mortgage backed securities. Investment banks also earned fees from working with the lenders to assemble the pools, design the mortgage backed securities, obtain credit ratings for them, and sell the resulting securities to investors. Investors like pension funds, insurance companies, municipalities, university endowments, and hedge funds earned a reasonable rate of return on the RMBS securities they purchased.
Due to the 2002 Treasury rule that reduced capital reserves for securitized mortgages, RMBS holdings also became increasingly attractive to banks, which could determine how much capital they needed to hold based on the credit ratings their RMBS securities received from the credit ratings agencies. According to economist Arnold Kling, among other problems, the 2002 rule "created opportunities for banks to lower their ratio of capital to assets through structured financing" and "created the incentive for rating agencies to provide overly optimistic assessment of the risk in mortgage pools." |15|
High Risk Mortgages. The resulting increased demand for mortgage backed securities,joined with Wall Street's growing appetite for securitization fees, prompted lenders to issuemortgages not only to well qualified borrowers, but also higher risk borrowers. Higher riskborrowers were often referred to as "subprime" borrowers to distinguish them from the morecreditworthy "prime" borrowers who traditionally qualified for home loans. Some lenders began to specialize in issuing loans to subprime borrowers and became known as subprime lenders. |16| Subprime loans provided new fuel for the securitization engines on Wall Street.
Federal law does not define subprime loans or subprime borrowers, but in 2001, guidance issued by federal banking regulators defined subprime borrowers as those with certain credit risk characteristics, including one or more of the following: (1) two or more 30-day delinquencies in the last 12 months, or one or more 60-day delinquencies in the last 24 months; (2) a judgment or foreclosure in the prior 24 months; (3) a bankruptcy in the last five years; (4) a relatively high default probability as evidenced by, for example, a credit score below 660 on the FICO scale; or (5) a debt service-to-income ratio of 50% or more. |17| Some financial institutions reduced that definition to any borrower with a credit score below 660 or even 620 on the FICO scale; |18| while still others failed to institute any explicit definition of a subprime borrower or loan. |19| Credit scores are an underwriting tool used by lenders to evaluate the likelihood that a particular individual will repay his or her debts. FICO credit scores, developed by the Fair Issacs Corporation, are the most widely used credit scores in U.S. financial markets and provide scores ranging from 300 to 850, with the higher scores indicating greater creditworthiness. |20|
High risk loans were not confined, however, to those issued to subprime borrowers. Some lenders engaged in a host of risky lending practices that allowed them to quickly generate a large volume of high risk loans to both subprime and prime borrowers. Those practices, for example, required little or no verification of borrower income, required borrowers to provide little or no down payments, and used loans in which the borrower was not required to pay down the loan amount, and instead incurred added debt over time, known as "negative amortization" loans. Some lenders offered a low initial "teaser rate," followed by a higher interest rate that took effect after a specified event or period of time, to enable borrowers with less income to make the initial, smaller loan payments. Some qualified borrowers according to whether they could afford to pay the lower initial rate, rather than the higher rate that took effect later, expanding the number of borrowers who could qualify for the loans. Some lenders deliberately issued loans that made economic sense for borrowers only if the borrowers could refinance the loan within a few years to retain the teaser rate, or sell the home to cover the loan costs. Some lenders also issued loans that depended upon the mortgaged home to increase in value over time, and cover the loan costs if the borrower defaulted. Still another risky practice engaged in by some lenders was to ignore signs of loan fraud and to issue and securitize loans suspected of containing fraudulent borrower information.
These practices were used to qualify borrowers for larger loans than they could have otherwise obtained. When borrowers took out larger loans, the mortgage broker typically profited from higher fees and commissions; the lender profited from higher fees and a better price for the loan on the secondary market; and Wall Street firms profited from a larger revenue stream to support bigger pools of mortgage backed securities.
The securitization of higher risk loans led to increased profits, but also injected greater risks into U.S. mortgage markets. Some U.S. lenders, like Washington Mutual and Countrywide, made wholesale shifts in their loan programs, reducing their sale of low risk, 30-year, fixed rate mortgages and increasing their sale of higher risk loans. |21| Because higher risk loans required borrowers to pay higher fees and a higher rate of interest, they produced greater initial profits for lenders than lower risk loans. In addition, Wall Street firms were willing to pay more for the higher risk loans, because once securitized, the AAA securities relying on those loans typically paid investors a higher rate of return than other AAA investments, due to the higher risk involved. As a result, investors were willing to pay more, and mortgaged backed securities relying on higher risk loans typically fetched a better price than those relying on lower risk loans. Lenders also incurred little risk from issuing the higher risk loans, since they quickly sold the loans and kept the risk off their books.
After 2000, the number of high risk loans increased rapidly, from about $125 billion in dollar value or 12% of all U.S. loan originations in 2000, to about $1 trillion in dollar value or 34% of all loan originations in 2006. |22| Altogether from 2000 to 2007, U.S. lenders originated about 14.5 million high risk loans. |23| The majority of those loans, 59%, were used to refinance an existing loan, rather than buy a new home. |24| In addition, according to research performed by GAO, many of these borrowers:
"refinanced their mortgages at a higher amount than the loan balance to convert their home equity into money for personal use (known as ‘cash-out refinancing'). Of the subprime mortgages originated from 2000 through 2007, 55 percent were for cash-out refinancing, 9 percent were for no-cash-out refinancing, and 36 percent were for a home purchase." |25|
Some lenders became known inside the industry for issuing high risk, poor quality loans, yet during the years leading up to the financial crisis were able to securitize and sell their home loans with few problems. Subprime lenders like Long Beach Mortgage Corporation, New Century Financial Corporation, and Fremont Loan & Investment, for example, were known for issuing poor quality subprime loans. |26| Despite their reputations for poor quality loans, leading investment banks continued to do business with them and helped them sell or securitize hundreds of billions of dollars in home mortgages.
These three lenders and others issued a variety of nontraditional, high risk loans whose subsequent delinquencies and defaults later contributed to the financial crisis. They included hybrid adjustable rate mortgages, pick-a-payment or option ARM loans, interest-only loans, home equity loans, and Alt A and stated income loans. Although some of these loans had been in existence for years, they had previously been restricted to a relatively small group of borrowers who were generally able to repay their debts. In the years leading up to the financial crisis, however, lenders issued these higher risk loans to a wide variety of borrowers, including subprime borrowers, who often used them to purchase more expensive homes than they would have been able to buy using traditional fixed rate, 30-year loans.
Hybrid ARMs. One common high risk loan used by lenders in the years leading up to the financial crisis was the short term hybrid adjustable rate mortgage (Hybrid ARM), which was offered primarily to subprime borrowers. From 2000 to 2007, about 70% of subprime loans were Hybrid ARMs. |27| Hybrid ARMs were often referred to "2/28," "3/27," or "5/25" loans. These 30-year mortgages typically had a low fixed teaser rate, which then reset to a higher floating interest rate, after two years for the 2/28, three years for the 3/27, or five years for the 5/25. The initial loan payment was typically calculated by assuming the initial low, fixed interest rate would be used to pay down the loan. In some cases, the loan used payments that initially covered only the interest due on the loan and not any principal; these loans were called "interest only" loans. After the fixed period for the teaser rate expired, the monthly payment was typically recalculated using the higher floating rate to pay off the remaining principal and interest owing over the course of the remaining loan period. The resulting monthly payment was much larger and sometimes caused borrowers to experience "payment shock" and default on their loans. To avoid the higher interest rate and the larger loan payment, many of the borrowers routinely refinanced their loans; when those borrowers were unable to refinance, many were unable to afford the higher mortgage payment and defaulted.
Pick-A-Payment or Option ARMs. Another common high risk loan, offered to both prime and subprime borrowers during the years leading up to the financial crisis, was known as the "pick-a-payment" or "option adjustable rate mortgage" (Option ARM). According to a 2009 GAO report:
"[P]ayment-option ARMs were once specialized products for financially sophisticated borrowers but ultimately became more widespread. According to federal banking regulators and a range of industry participants, as home prices increased rapidly in some areas of the country, lenders began marketing payment-option ARMs as affordability products and made them available to less-creditworthy and lower-income borrowers." |28|
Option ARMs typically allowed the borrower to pay an initial low teaser rate, sometimes as low as a 1% annual rate for the first month, and then imposed a much higher interest rate linked to an index, while also giving the borrower a choice each month of how much to pay down the outstanding loan balance. These loans were called "pick-a-payment" or "option" ARMs, because borrowers were typically allowed to choose among four alternatives: (1) paying the fully amortizing amount needed to pay off the loan in 30 years; (2) paying an even higher amount to pay off the loan in 15 years; (3) paying only the interest owed that month and no principal; or (4) making a "minimum" payment that covered only a portion of the interest owed and none of the principal. If the minimum payment option were selected, the unpaid interest would be added to the loan principal. If, each month, the borrower made only the minimum payment, the loan principal would increase rather than decrease over time, creating a negatively amortizing loan.
Typically, after five years or when the loan principal reached a designated threshold, such as 110%, 115%, or 125% of the original loan amount, the loan would "recast." The borrower would then be required to make the fully amortizing payment needed to pay off the remaining loan amount within the remaining loan period. The new monthly payment amount was typically much greater, causing payment shock and increasing loan defaults. For example, a borrower taking out a $400,000 loan, with a teaser rate of 1.5% and subsequent interest rate of 6%, might have a minimum payment of $1,333. If the borrower then made only the minimum payments until the loan recast, the new payment using the 6% rate would be $2,786, an increase of more than 100%. What began as a 30-year loan for $400,000 became a 25-year loan for $432,000. To avoid having the loan recast, option ARM borrowers typically sought to refinance their loans. At some lenders, a significant portion of their option ARM business consisted of refinancing existing loans.
Home Equity Loans. A third type of high risk loan that became popular during the years leading up to the financial crisis was the home equity loan (HEL). HELs provided loans secured by the borrower's equity in his or her home, which served as the loan collateral. HELs typically provided a lump sum loan amount that had to be repaid over a fixed period of time, such as 5, 10, or 30 years, using a fixed interest rate, although adjustable rates could also be used. A related loan, the Home Equity Line of Credit (HELOC), created a revolving line of credit, secured by the borrower's home, that the borrower could use at will, to take out and repay various levels of debt over time, typically using an adjustable rate of interest. Both HELs and HELOCs created liens against the borrower's house which, in the event of a default, could be sold to repay any outstanding loan amounts.
During the years leading up to the financial crisis, lenders provided HELs and HELOCs to both prime and subprime borrowers. They were typically high risk loans, because most were issued to borrowers who already had a mortgage on their homes and held only a limited amount of equity. The HEL or HELOC was typically able to establish only a "second lien" or "second mortgage" on the property. If the borrower later defaulted and the home sold, the sale proceeds would be used to pay off the primary mortgage first, and only then the HEL or HELOC. Often, the sale proceeds were insufficient to repay the HEL or HELOC loan. In addition, some lenders created home loan programs in which a HEL was issued as a "piggyback loan" to the primary home mortgage to finance all or part of the borrower's down payment. |29| Taken together, the HEL and the mortgage often provided the borrower with financing equal to 85%, 90%, or even 100% of the property's value. |30| The resulting high loan-to-value ratio, and the lack of borrower equity in the home, meant that, if the borrower defaulted and the home had to be sold, the sale proceeds were unlikely to be sufficient to repay both loans.
Alt A Loans. Another type of common loan during the years leading up to the financial crisis was the "Alt A" loan. Alt A loans were issued to borrowers with relatively good credit histories, but with aggressive underwriting that increased the risk of the loan. |31| For example, Alt A loans often allowed borrowers to obtain 100% financing of their homes, to have an unusually high debt-to-income ratio, or submit limited or even no documentation to establish their income levels. Alt A loans were sometimes referred to as "low doc" or "no doc" loans. They were originally developed for self employed individuals who could not easily establish their income by producing traditional W-2 tax return forms or pay stubs, and so were allowed to submit "alternative" documentation to establish their income or assets, such as bank statements. |32| The reasoning was that other underwriting criteria could be used to ensure that Alt A loans would be repaid, such as selecting only borrowers with a high credit score or with a property appraisal showing the home had substantial value in excess of the loan amount. According to GAO, from 2000 to 2006, the percentage of Alt A loans with less than full documentation of the borrower's income or assets rose from about 60% to 80%. |33|
Stated Income Loans. Stated income loans were a more extreme form of low doc Alt A loans, in that they imposed no documentation requirements and required little effort by the lender to verify the borrower's income. These loans allowed borrowers simply to "state" their income, with no verification by the lender of the borrower's income or assets other than to consider the income's "reasonableness." They were sometimes called "NINA" loans, because "No Income" and "No Assets" of the borrower were verified by the lender. They were also referred to as "liar loans," since borrowers could lie about their incomes, and the lender would make little effort to substantiate the claimed income. Many lenders believed they could simply rely on the other underwriting tools, such as the borrower's credit score and the property appraisal, to ensure the loans would be repaid. Once rare and reserved only for wealthier borrowers, stated income loans became commonplace in the years leading up to the financial crisis. For example, at Washington Mutual Bank, one of the case studies in this Report, by the end of 2007, stated income loans made up 50% of its subprime loans, 73% of its Option ARMs, and 90% of its home equity loans. |34|
Nationwide, the percentage of high risk loans issued with low or no documentation of borrower income or assets was less dramatic. According to GAO, for example, from 2000 to 2006, the nationwide percentage of subprime loans with low or no documentation of borrower income or assets grew from about 20% to 38%. |35|
Volume and Speed. When lenders kept on their books the loans they issued, the creditworthiness of those loans determined whether the lender would turn a profit. Once lenders began to sell or securitize most of their loans, volume and speed, as opposed to creditworthiness, became the keys to a profitable securitization business.
In addition, in the years leading up to the financial crisis, investors that might normally insist on purchasing only high quality securities, purchased billions of dollars in RMBS securities containing poor quality, high risk loans, in part because those securities bore AAA ratings from the credit rating agencies, and in part because the securities offered higher returns compared to other AAA rated investments. Banks also bought investment grade RMBS securities to take advantage of their lower capital requirements. Increasingly, the buyers of RMBS securities began to forego detailed due diligence of the RMBS securities they purchased. Instead, they, like the lenders issuing the mortgages, operated in a mortgage market that came to be dominated by volume and speed, as opposed to credit risk.
Lenders that produced a high volume of loans could sell pools of the loans to Wall Street or to government sponsored entities like Fannie Mae and Freddie Mac. Likewise, they could securitize the loans and work with Wall Street investment banks to sell the securities to investors. These lenders passed on the risk of nonpayment to third parties, and so lost interest in whether the sold loans would, in fact, be repaid. Investment banks that securitized the loans garnered fees for their services and also typically passed on the risk of nonpayment to the investors who bought the mortgage backed securities. The investment banks were typically interested in loan repayment rates only to the extent needed to ensure defaulting loans did not cause losses to the mortgage backed securities they sold. Even some of the investors who purchased the mortgage backed securities lost interest in their creditworthiness, so long as they could buy "insurance" in the form of credit default swaps that paid off if a mortgage backed security defaulted.
To ensure an ongoing supply of loans for sale, lenders created compensation incentives that encouraged their personnel to quickly produce a high volume of loans. They also encouraged their staffs to issue or purchase higher risk loans, because those loans produced higher sale prices on Wall Street. Loan officers, for example, received more money per loan for originating higher risk loans and for exceeding established loan targets. Loan processing personnel were compensated according to the speed and number of the loans they processed. Loan officers and their sales associates received still more compensation, often called yield spread premiums, if they charged borrowers higher interest rates or points than required in the lender's rate sheets specifying loan prices, or included prepayment penalties in the loan agreements. The Subcommittee's investigation found that lenders employed few compensation incentives to encourage loan officers or loan processors to produce high quality, creditworthy loans in line with the lender's credit requirements.
As long as home prices kept rising, the high risk loans fueling the securitization markets produced few problems. Borrowers who could not make their loan payments could refinance their loans or sell their homes and use the sale proceeds to pay off their mortgages. As this chart shows, over the ten years before the crisis hit, housing prices shot up faster than they had in decades, allowing price increases to mask problems with the high risk loans being issued. |36|
Borrowers were able to pay for the increasingly expensive homes, in part, because of the exotic, high risk loans and lax loan underwriting practices that allowed them to buy more house than they could really afford.
Notes
15. "Not What They Had In Mind: A History of Policies that Produced the Financial Crisis of 2008," September 2009, Mercatus Center, http://mercatus.org/sites/default/files/publication/NotWhatTheyHadInMind(1).pdf. [Back]
16. A Federal Reserve Bank of New York research paper identifies the top ten subprime loan originators in 2006 as HSBC, New Century, Countrywide, Citigroup, WMC Mortgage, Fremont, Ameriquest Mortgage, Option One, Wells Fargo, and First Franklin. It identifies the top ten originators of subprime mortgage backed securities as Countrywide, New Century, Option One, Fremont, Washington Mutual, First Franklin, Residential Funding Corp., Lehman Brothers, WMC Mortgage, and Ameriquest. "Understanding the Securitization of Subprime Mortgage Credit," by Adam Ashcraft and Til Schuermann, Federal Reserve Bank of New York Staff Report No. 318, (3/2008) at 4. [Back]
17. Interagency "Expanded Guidance for Subprime Lending Programs, (1/31/2001) at 3. See also "Understanding the Securitization of Subprime Mortgage Credit," by Adam Ashcraft and Til Schuermann, Federal Reserve Bank of New York Staff Report No. 318, (3/2008) at 14. [Back]
18. See, e.g., 1/2005 "Definition of Higher Risk Lending," chart from Washington Mutual Board of Directors Finance Committee Discussion, JPM_WM00302979, Hearing Exhibit 4/13-2a; 4/2010 "Evaluation of Federal Regulatory Oversight of Washington Mutual Bank," report prepared by the Offices of Inspector General at the Department of the Treasury and Federal Deposit Insurance Corporation, at 8, Hearing Exhibit 4/16-82. [Back]
19. See, e.g., Countrywide Financial Corporation, as described in SEC v. Mozilo, Case No. CV09-03994 (USDC CD Calif.), Complaint (June 4, 2009), at ¶¶ 20-21. [Back]
20. To develop FICO scores, Fair Isaac uses proprietary mathematical models that draw upon databases of actual credit information to identify factors that can reliably be used to predict whether an individual will repay outstanding debt. Key factors in the FICO score include an individual's overall level of debt, payment history, types of credit extensions, and use of available credit lines. See "What's in Your FICO Score," Fair Isaac Corporation, http://www.myfico.com/CreditEducation/WhatsInYourScore.aspx. Other types of credit scores have also been developed, including the VantageScore developed jointly by the three major credit bureaus, Equifax Inc., Experian Group Ltd., and TransUnion LLC, but the FICO score remains the most widely used credit score in U.S. financial markets. [Back]
21. See, e.g., "Shift to Higher Margin Products," chart from Washington Mutual Board of Directors meeting, at JPM_WM00690894, Hearing Exhibit 4/13-3 (featuring discussion of the larger "gain on sale" produced by higher risk home loans); "WaMu Product Originations and Purchases By Percentage - 2003-2007," chart prepared by the Subcommittee, Hearing Exhibit 4/13-1i (showing how higher risk loans grew from about 19% to about 55% of WaMu's loan originations); SEC v. Mozilo, Case No. CV09-03994 (USDC CD Calif.), Complaint (June 4, 2009), at ¶¶ 17-19 (alleging that higher risk loans doubled at Countrywide, increasing from about 31% to about 64% of its loan originations). [Back]
22. 8/2010 "Nonprime Mortgages: Analysis of Loan Performance, Factors Associated with Defaults, and Data Sources," Government Accountability Office (GAO), Report No. GAO-10-805 at 1. These figures include subprime loans, Alt A, and option payment loans, but not home equity loans, which means the totals for high risk loans are understated. [Back]
24. 7/28/2009 "Characteristics and Performance of Nonprime Mortgages," GAO, Report No. GAO-09-848R at 24, Table 3. [Back]
26. For more information about Long Beach, see Chapter III of this Report. For more information about New Century and Fremont, see section (D)(2)(c)-(d) of Chapter IV. [Back]
27. 8/2010 "Nonprime Mortgages: Analysis of Loan Performance, Factors Associated with Defaults, and Data Sources," GAO, Report No. GAO-10-805 at 5, 11. [Back]
28. 7/28/2009 "Characteristics and Performance of Nonprime Mortgages," GAO, Report No. GAO-09-848R at 12-13. [Back]
29. 7/28/2009 "Characteristics and Performance of Nonprime Mortgages," GAO, Report No. GAO-09-848R at 9. [Back]
30. Id. GAO determined that, in 2000, only about 2.4% of subprime loans had a combined loan-to-value ratio, including both first and second home liens, of 100%, but by 2006, the percentage had climbed tenfold to 29.3%. [Back]
31. Id. at 1. GAO treated both low documentation loans and Option ARMs as Alt A loans. This Report considers Option ARMs as a separate loan category. [Back]
34. 4/2010 "Evaluation of Federal Regulatory Oversight of Washington Mutual Bank," prepared by the Offices of Inspector General at the Department of the Treasury and Federal Deposit Insurance Corporation, at 10, Hearing Exhibit 4/16-82. [Back]
35. 7/28/2009 "Characteristics and Performance of Nonprime Mortgages," GAO, Report No. GAO-09-848R at 14. [Back]
36. See "Estimation of Housing Bubble: Comparison of Recent Appreciation vs. Historical Trends," chart prepared by Paulson & Co. Inc., Hearing Exhibit 4/13-1j. [Back]
Back to Contents A. Rise of Too-Big-To-Fail U.S. Financial Institutions C. Credit Ratings and Structured Finance
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