How to Strangle What You Mean to Save

It’s almost never the big fellows that make the real leaps in technology and efficiency.

(TheNicheReport) -- Let me be as clear about this as I can: Spain and Greece are showing us what the U.S. future looks like in the real-estate and mortgage industry.  The road we are on leads us, lemming-like, to exactly the same outcomes we are seeing in Europe on the nightly news.  Meanwhile, Tim Geithner and the assorted gurus in Washington tell us they are doing the best they can to resurrect the housing market. I’m afraid they are.  But if so, it’s time for some new gurus.

I want to outline briefly what they’re missing, and why it’s going to get very, very black here before long, unless something drastic is done. Innovation is the lifeblood of industry.  There are countless examples, but we can go with just one: Apple Computer.  Some of us are old enough to remember the Apple IIe, precursor to the Macintosh (long before it became the Mac).  Apple, in its beginnings, was an innovative computer company.  Their computers weren’t fantastically versatile – my IBM 8088 was far more useful than my roommate’s Macintosh, when we were in college – but they were elegant and what they did they did brilliantly.

Apple, though, never seriously threatened IBM’s supremacy in the computer world until the Return of the Jedi (Steve Jobs), whereupon Apple produced another computer that was not very versatile, but that did one thing so well that within a few years there were hardly any competitors left in that space. We call that computer an iPod. Innovation followed on innovation.  The iPhone (do you realize that it debuted less than five years ago, in mid-2007?) revolutionized cell phones (and the phone/carrier interface as well); the iPad (2010) in only two years is starting to remake the computer industry altogether.

Apple is now the largest computer maker in the world.  Most people under the age of 30 don’t remember a time when IBM was a dominant player in the computer world.  Today’s IBM computers are not fundamentally different in function or design from what I had on my desk in college 25 years ago.  Apples?  So different they’d be unrecognizable as computers, if I went back and handed myself one.  The majority of people don’t even think of Apple as a computer company anymore, because Apple insinuated its products into life where nobody else thought of. The innovation of Apple has driven the entire industry to places it couldn’t have imagined going, and remade it into probably the most robust sector of the economy, spreading the wealth into everything from cell phone manufacturers to automobiles to Angry Birds.

Innovation made that happen – and it wasn’t innovation that came from the top.  It was a change in thinking that started at the bottom.  Steve Jobs’s greatest contribution to the revolution was that he gave it space to happen. Practically everyone has benefitted from it; we have all, in fact, become richer. That’s how innovation and productivity work. As I said at the beginning, this is just one example.  Every industry you can think of has been dramatically affected, even begun, by innovative products, things that came into existence almost exclusively from outside the big corporate giants.  Airplanes?  The Wrights were underfunded part-timers.  Cars? In 1863 a Belgian expatriate living in Paris built a three-wheeled version while actually trying to improve the telegraph – Daimler-Benz didn’t come along for another 25 years.

It’s almost never the big fellows that make the real leaps in technology and efficiency. I’ve been in mortgages for over ten years now.  That’s a relatively short time to some of you, and forever to others, but let me tell you what I see happening in mortgages that scares me.  There is no innovation.  If it’s true, and I believe it is, that innovation is most likely to come from the small operation, the part-time hobbyist, and the crossover from another industry, the mortgage industry is in real, serious trouble. It wasn’t this way a few years back.  I’m advancing an idea here that is going to get me labeled a dangerous lunatic, so before you decide I really am one, hear me out.

Remember the heady days of 2006, when there were something like sixteen thousand different mortgage products out there, everything under the sun from no-doc 100% loans to first-trust HELOCs with variable payments.  There was a new product every week.  Every few days, at one point.  That was a good thing. I don’t care what the New York Times says, it was a good thing.  It made loans available to a huge number of people, and, more importantly, it increased the number of players in the industry tenfold.  Mortgage lending, for so long that bastion of the 30-year fixed rate (why, on earth?), had a renaissance, a proliferation of programs and repayment options far beyond what anyone had thought possible.

It was a good thing. What was even better was the dilution of market share for the government.  At one point, the government’s share of mortgage loans – and I’m counting Fannie and Freddie here as well as FHA and VA – was about 40%.  Now it’s 95%. But this is because default rates were so high on those non-government loans, right?  Well, data here are sketchy.  It’s hard to know.  So-called “sub-prime” (now synonymous with Bernie Madoff) mortgage defaults were quite high during the crash of 2007.

There is a case to be made, however, that the rate of default on government-backed and -sponsored loans was not any lower, and the fact that all but a handful of lenders went bankrupt or were consolidated while the government lenders grew, means only that the private market did not have what Fannie and Freddie did – a gigantic, almost unlimited source of guaranteed liquidity, known as the U.S. Taxpayer. In fact, default rates were consistent across all mortgage types, when banded by credit score and equity position.  In other words, it didn’t make any difference whether you got your 100% loan conventional or subprime; if you got one at all, your default rate was higher than it would have been if you put 5%, 10%, or 20% down.  Additionally, where you got the down payment was a factor, with “gifted” down payments representing a higher risk than when the borrower used his own funds.

Now, it’s not disputable that a higher percentage of subprime loans went delinquent than prime/conventional loans.  The reason ordinarily given for this is that subprime loans were stupid, and prime loans were sane.  The data suggest, however, that when you compare apples-to-apples, the default rates are similar.[1]  The same borrower that defaulted on a prime loan would default on a subprime loan, and vice-versa.  The percentages are higher for subprime lending because a higher percentage of subprime loans went to riskier borrowers.  People forget this, but there were no-doc conventional loans, too.

The government competed for those borrowers right along with everyone else. There were many people that got subprime loans when their credit was good enough to get conventional financing.  I’m one of them.  Why would we do that?  Because subprime loans were better.  They required less hassle, less documentation, and had more flexible payment options.  For self-employed borrowers, as just one example, they were a Godsend.  Then the market tanked, and like all busts, there were a lot of people crushed under it.  If a lender didn’t have sufficient reserves, or hundreds of billions in backing from taxpayers, it failed.  Fannie and Freddie themselves were nationalized and became wholly owned and operated subsidiaries of the federal government. In short, the case can be made that government lending and warehousing grew not because Fannie and Freddie made smarter loans than others, it was because Fannie and Freddie could eat the losses, and others could not.

The death of the securitization of mortgages meant that there was just one source of liquidity in mortgage lending – and that’s you and me.  Fannie and Freddie, as branches of the government, became essentially the only game in town. But the bust in the housing market caused the baby to be thrown out with the bathwater.  Arguably, the culprit in the housing bust wasn’t subprime lenders (or not entirely), it was the securities market, and the insufficient scrutiny by the buyers of credit-default swaps of the product they were purchasing.  The government stepped in and bought up the dead assets, liquidated the failed companies (or forced their sale), and ran the other players out of town.  Then it propounded a blizzard of legislation and regulation that probably makes this particular type of crash impossible again, but in doing so chokes off the market to such a degree that no boom is possible, either.

We’re frozen in place.  If this were a good place, then maybe I wouldn’t carp.  But it isn’t.  It’s a slum.  And we can’t get out of it. Consider.  There is one category of loan that showed no increase in percentage of default from 2004 to 2011: portfolio products held by banks.  In other words, the institutions that were going to be on the hook for the loans they made, made good loans.  They also have and always did have innovative and somewhat quirky products, like bank-statement income qualifying and no-credit-history loans.  Since they were holding those loans, they made sure the compensating factors were there, and priced them in such a way that they represented a manageable risk.

This kind of small, community-based lending provides a look at what could and should happen in the broader market.  Only it won’t.  It’s probable now that it can’t. OFHEO, the Federal Reserve, FHFA, the newly-minted CFPB, all these organizations are set up to protect the industry that exists.  I know, they say they’re protecting us, the borrowers, but they don’t actually do that.  What they do is regulate the financial institutions, and they do that in such a way that the field of product in mortgage lending shrinks every month.  The institution of the “qualified mortgage” means one-size-fits-all effectively becomes the sole model for mortgage lending in the U.S.  Disruptive products cannot be introduced.  It’s as if the government had dictated what kind of phone was allowable.  There would never have been an iPhone.  It would have been illegal.  No doubt we would be sitting around with our Motorola RAZRs while Congressional testifiers pontificated about how we should be grateful things aren’t worse. The smaller banks, which still have some flexibility here, are not going to be able to save the day as things are headed.

One, there aren’t going to be any more of them than we already have.  The regulatory process for getting a new bank approved is spectacularly expensive and takes years to navigate.  Two, reserve requirements make it impossible for small banks to expand their lending without onerous depository requirements, so the ones in existence now cannot expand as fast as the market would allow.  And three, worst of all, they’re being out-competed by government subsidy.  Government loans can and do have cheaper interest rates, because ultimately, there isn’t really any risk on those loans.  In a pinch, the alphabet soup of regulators can always dial up Joe Taxpayer for more cash. I don’t get any pleasure out of painting this scenario.  I lend every day.  I work in the industry and I like it, and I want to keep doing it.

What I’ve seen from other industries I’ve been in, though (and one of those was the dotcom industry, back in the day), is that regulation strangles innovation and destroys growth.  Eventually, if the regulations get too severe, someone proposes that the industry just become a ward of the state.  Spain just floated the nationalization of its banks.  We are on the same path.  How far behind? We’re not seeing a recovery in housing because we’re not seeing innovation in housing. The market is there.  People are just as hungry to buy houses as they ever were.  What’s holding them back?  It could be the very people that speechify all day about getting things going again.  Washington wants a housing recovery?  It should take a hard look in the mirror to see where the problem is.  It might not be too late.

Chris Jones, branch manager with City First Mortgage Services, is a nine-year industry professional in brokering and banking, with a background in financial services, national politics and Main Street entrepreneurialism. He is the author of the forthcoming book, The Six Channels of Marketing, available in January. Chris lives in Lehi, Utah, with his wife, Jeanette, and their eight children, and can be found at, [email protected] or (801) 850-3781.

[1], compiled with data from three or four sources, with graphs and charts.  By far the greatest determining factor in default rates, in fact, is not credit, but equity.  The farther underwater a borrower is, the greater his risk of default, regardless of his credit score.