Bank of America announced this morning that virtually all of its quarterly profit was wiped out by write-offs of Collateralized Debt Obligations and related mortgage securities. The bank set aside reserves for further losses in its consumer mortgage and credit card portfolio, in line with large increases in defaults and delayed payments in the fourth quarter of last year.
Several weeks ago the bank had alerted markets to the charge-offs, but the amount written down in the CDO portfolio of $5.28 billion was $2.0 billion more than anticipated. At that time, CEO and Chairman Kenneth Lewis said “There’s been a change in social attitudes toward default …. We’re seeing people who are current on their credit cards but are defaulting on their mortgages….I’m astonished that people would walk away from their homes.”
It’s even more astonishing that an executive of a U.S. bank would expect Americans to continue paying on their mortgages after the way the banking industry has treated borrowers. Let’s review the tape:
* Banks invent a product in the 1990s called the home equity line of credit. Consumers can now borrow money against the equity built up in their home. The home becomes “liquified” or “commoditized” – a veritable cash machine for consumers.
* Banks continue to sell first mortgages to Fannie Mae and Freddie Mac, or get guaranties from these agencies for the mortgages they keep on their books. When Congress suggests reining in these mortgage agencies, banks set their lobbying machine in motion and Congress backs off.
* To book even more mortgages, and escape the impediments that their own capital imposes on growth in their balance sheets, banks invent third-party conduits called Structured Investment Vehicles, which they don’t own but do control. These SIVs package the bank mortgages into securities and sell them into the market to investors around the globe.
* Bank mortgage lending takes off in the late 1990s. Mortgages and consumer loans exceed 50% of bank assets by the end of the decade, for the first time ever.
* The mortgage market, and home equity lines of credit kick into high gear in 2002 when the Fed engineers ultra-low interest rates of 1%.
* When Fannie and Freddie run into accounting difficulties with their mortgage hedges in 2002, the banks team up with Wall Street to replace these agencies with a securitization process that uses SIVs and Wall Street brokerages to peddle mortgage securities as fast as the banks can process them.
* Credit standards collapse after 2002 in the mortgage business since banks no longer own the mortgages they are booking. Consumers with no income, no job, no assets, no credit experience, and no business borrowing money are handed mortgages for half a million dollars or more.
* Home owners with equity in their home are encouraged to “cash it out”. No mention is ever made that the “cash” is only paper profit not earned by the consumer unless they sell their home and move into a smaller one. No mention is ever made of the total amount of new debt the consumer will be taking on. The only thing mentioned is the low monthly payment, made possible by historically low interest rates. Mortgage loan advertisements take over as the largest form of advertising on radio, daytime television, and the internet.
* Traditional loan to value ratios are abandoned; loans in excess of the property value become the norm. Loans are predicated solely on FICO scores, but “no score is too low” to qualify a borrower, according to many advertisements. Appraisers are put under pressure to “meet the number” necessary to give loans to the increasing list of deadbeats who quality for jumbo mortgages. Massive amounts of fraud creep into the process, but the banks don’t care to look because they don’t own the loans.
* Banks successfully petition Congress to change the bankruptcy laws to make it much more difficult for consumers to keep their homes in bankruptcy.
* By 2005, housing values are increasing at double digit annual rates in most parts of the country, and two standard deviations beyond the historic growth rate. Warnings are issued regarding a bubble in housing, but banks deny or ignore them. Consumers have no problem taking out five or six consecutive refinancings, and withdrawing all equity built up in the frenzied market appreciation. Mortgages for second homes are easy to get, as are mortgages for investment purposes. In some states nearly 50% of all new mortgages are for borrowers who will not live in the homes, but banks turn a blind eye to this phenomenon.
* Like the real estate industry in general, banks believe and tell their customers that home values never go down. Their internal models are predicated on this assumption. Everything communicated to the consumer tells them that their home is a piggy bank of ever-increasing value. Withdrawing cash from the piggy bank is made as easy as possible. Consumers are given loans allowing them not to pay any interest at all and build up a balloon balance, which will assuredly be taken care of down the road by market appreciation. These option characteristics allow the banks to charge even higher points up front and stick penalty clauses into mortgages forbidding the homeowner from paying off the loan until the bank receives all fees due them.
Given this chronicle, why should Mr. Lewis be “astonished” that people who can pay their mortgage refuse to do so when the home value is less than the mortgage? This behavior is nothing more than the same behavior during the bubble, only in reverse. During the bubble consumers were encouraged not to pay down their mortgage. They were sold products specifically for this purpose. The bank loans officers were marketing mortgages on the premise that future appreciation in the home would pay off the debt – the consumer could refinance in two or three years.
It worked for awhile, but now it doesn’t. Now home values are declining and millions of homeowners are underwater. If they weren’t expected to pay down their mortgage when values were appreciating, why should they suddenly be expected to do so now that values are going down? Their home is a commodity and can be walked away from like any bad investment. The underwater mortgage is the bank problem; there are other homes of similar size now much cheaper to buy anyway, or rent is an option as long as the consumer has a job.
Mr. Lewis’s obtuseness is the only astonishing thing here. He trained his customers to behave this way and he should at least have the sense not to imply that there is some moral failing when consumers walk away from their mortgages. A moral failing has occurred, to be sure, but it was ten or so years ago, in the executive suites of banks all around the country.