The Collapse of Lending Standards

Lending standards collapsed to an almost unimaginable degree during the great bubble, to the point that in some areas if you had a pulse, you could get a mortgage. The collapse manifested itself in many ways.

In 2001, the combined loan-to-value ratio for the average mortgage was 74 percent, meaning the buyer had put down 26 percent of the cost of the home (see Figure 1.7). When doing any kind of lending, it's critical that the borrower has meaningful skin in the game, so there is a strong incentive to repay the loan, even if the value of the asset falls.

Over the next five years, the average loan-to-value ratio rose to 84 percent, meaning that the average borrower was putting down only 16 percent, affording lenders much less protection in the event home prices tumbled. The situation was even more extreme for first-time home buyers, who were putting down only 2 percent on average by early 2007.

Not surprisingly, the percentage of mortgages for which the borrower put no money down—and was effectively getting a free call

2001 2002 2003 2004 2005 2006 2007

Figure 1.7 Combined Loan-to-Value Ratio

Source: Amherst Securities, LoanPerformance.

2001 2002 2003 2004 2005 2006 2007

Figure 1.7 Combined Loan-to-Value Ratio

Source: Amherst Securities, LoanPerformance.

Loan Value Ratio Images

2001 2002 2003 2004 2005 2006 2007

Figure 1.8 Mortgage Loans with 100 Percent Financing

Source: Amherst Securities, LoanPerformance.

2001 2002 2003 2004 2005 2006 2007

Figure 1.8 Mortgage Loans with 100 Percent Financing

Source: Amherst Securities, LoanPerformance.

option on home price appreciation—soared from virtually nil to one-sixth of all mortgages in 2006, as shown in Figure 1.8 .

Another change in lending practices compounded the problem. Historically, a lender was careful to verify a borrower's income and assets by asking to see pay stubs and tax returns—an obvious precaution to ensure that the borrower could afford the payments on the mortgage. There were exceptions made for certain self-employed borrowers like doctors, but this was not common. During the bubble, however, such requirements went out the window as low- and no-documentation mortgages rose to account for nearly two-thirds of all mortgages at the peak, as shown in Figure 1.9. More and more often, a lender simply looked at a borrower's credit score and the appraisal on the house and made the loan based on whatever the borrower stated as income.

Limited-documentation loans were an invitation for fraud, either by the borrower or by the mortgage broker (often both), and fraud is indeed what happened: One study shows that 90 percent of stated-income borrowers overstated their incomes, half of them by more than 50 percent. Another study found that "the average income for stated-income applicants

2001 2002 2003 2004 2005 2006 2007

Figure 1.9 Mortgage Loans with Low and No Documentation (aka "Liar's Loans")

Source: Amherst Securities, LoanPerformance.

2001 2002 2003 2004 2005 2006 2007

Figure 1.9 Mortgage Loans with Low and No Documentation (aka "Liar's Loans")

Source: Amherst Securities, LoanPerformance.

was 49% higher than the average for fully documented loans and the average income on loans with limited documentation was 92% higher."1 It's little wonder that these loans are now known as liar's loans.

The most dangerous loans of all are those for which the borrower puts no money down and the lender doesn 't bother to check income or assets. Such loans were unheard-of prior to the bubble, but they accounted for 11 percent of all mortgages in 2006, as shown in Figure 1.10 .

Historically, one of the most important factors to consider when making a loan was the credit history of the borrower. People who had previously defaulted on many of their loans or bills were rightly considered poor risks and were charged high rates for a mortgage—or, more likely, couldn 't get one at any rate.

The most common measurement of a person 's credit history is called a FICO score, which ranges from 350 to 850. The median score is 723, and 45 percent of people fall between 700 and 799.2 Roughly speaking (lenders and analysts use different cutoffs), a score under somewhere between 620 and 660 is called subprime, above 720 is o

2001

2002

2003

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2005

2006

2007

Figure 1.10 Mortgage Loans with 100 Percent Financing and Low/No Documentation

Source: Amherst Securities, LoanPerformance.

considered prime, and in between is called Alt-A, though this category is also defined by limited-documentation loans.3

As shown in Figure 1.11, prior to 2002 subprime mortgages were rare, never far exceeding $100 billion worth per year, but then the volume rose rapidly, peaking at roughly $600 billion per year in 2005 and 2006. Subprime had been a small industry generally characterized by reasonable lending standards, but it ballooned to the point that nearly anyone, no matter how poor or uncreditworthy, could get a mortgage, often with no money down and no requirement to document income or assets. Such mortgages were called NINJA loans: no income, no job or assets. True madness.

As much attention as subprime mortgages have garnered in the media lately, it is important to understand that they were just a small part of the marketplace—only 20 percent of the market at the peak of the bubble. Unfortunately, the bubble extended far beyond the subprime arena and, as we discuss later, losses among the other 80 percent of loans that were written during the peak years of the bubble will cause many problems going forward.

$700

$500

$500

Figure 1.11 Subprime Mortgage Volume and Percentage of Total Originations,

Figure 1.11 Subprime Mortgage Volume and Percentage of Total Originations,

Source: Inside Mortgage Finance, Inside Mortgage Finance Publications, Inc. Copyright 2009. Reprinted with permission.

To understand how far lending standards had fallen by the peak of the bubble, let 's hear from Mike Garner, who worked at the largest private mortgage bank in Nevada, Silver State Mortgage, who was interviewed by This American Life in early 2008:4

Alex Blumberg, This American Life: Mike noticed that every month, the guidelines were getting a little looser. Something called a stated income, verified asset loan came out, which meant you didn 't have to provide paycheck stubs and W-2 forms, as they had [required] in the past. You could simply state your income, as long as you showed that you had money in the bank. Mike Garner: The next guideline lower is just stated income, stated assets. Then you state what you make and state what 's in your bank account. They call and make sure you work where you say you work. Then an accountant has to say for your field it is possible to make what you said you make. But they don 't say what you make, just say it's possible that they could make that. Alex Blumberg: It 's just so funny that instead of just asking people to prove what they make there 's this theater in place of you having to

1994-2007

find an accountant sitting right in front of me who could very easily provide a W-2, but we 're not asking for a W-2 form, but we do want this accountant to say, "Yeah, what they 're saying is plausible in some universe."

Mike Garner: Yeah, and loan officers would have an accountant they could call up and say, "Can you write a statement saying a truck driver can make this much money?" Then the next one came along and it was no income, verified assets. So you don 't have to tell the people what you do for a living. You don 't have to tell the people what you do for work. All you have to do is state you have a certain amount of money in your bank account. And then the next one is just no income, no assets. You don 't have to state anything. Just have to have a credit score and a pulse.

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