John Preston's  Instablog

Mortgage Default and Skin-In-The-Game…and Why This Correlation is Wrong!

By John Preston

This is the first of a series that I will be posting to respond to inaccuracies, falsehoods and fabrications which permeate much of the discussion as it relates to housing and mortgage lending.

There is a significant amount of chatter, even on a strong site such as Seeking Alpha, regarding the issue of down payment…the skin-in-the-game concept…and the housing/foreclosure problem.  There are repeated attempts to correlate the crisis and leveraging on the part of borrowers and buyers…and, the evidence does not pass scrutiny.  It is simply kool-aid served to willing readers.  There is a lot of extrapolation…..a nice word for an educated guess…and a lot of “bobble-head” nodding….but no real evidence.

To understand the present, sometimes it helps go back and review the past.

By way of background, ver the years, beginning the mid 1980’s, I have attended mortgage underwriting training sessions.  I have, in the past, held signature authority as a mortgage lender.  At these sessions, discussions of the leading causes of default and foreclosure usually centered on what I will refer to as the “5 D’s”: Death; Disability; Discharge; Downturn; and Divorce.

The amazing fact is that these “5 D’s” are not observable prior to the fact.  There is no way to document them…they are beyond what can be reasonably quantified and guarded against in the underwriting process.   In other words, stuff happens, and some of it cannot be anticipated or prevented.

The missing “D” in the list is “DOWN PAYMENT”, mistakenly cited today as a prime cause for the mess in which we now find ourselves.

The “D’s” that truly affect the mortgage payment process are ALL related to monthly household income.  Quite simply, homeowners use monthly income to pay monthly obligations, and if the income declines or goes away entirely, problems begin and things can get bad, fast.

Death and disability are leading causes of bankruptcy, especially if the cause if a severe, long term medical problem, such as a form of cancer.  Both lead to loss of income, and they become a factor in default and foreclosure.

Discharge (layoff, fired, etc) and downturn relate to patterns and trends in the general economy.  Both lead to loss or reduction in income.

Divorce leads to a splitting of the household…and related incomes…and often emotional strife as well.

When I work with a client on a mortgage modification, I gather a lot of personal information, so I have real data in real time.  Part of the modification presentation is to illustrate the change in household income.  To date, 100% of the clients I work with, who are seeking help on their mortgage payments through modification, have experienced a severe downturn in their monthly incomes…35%-50%...some actually 100%.

Similarly, when I work with a client on a refinance, and they are not in payment trouble…their paperwork shows that 100% of these customers have maintained, or increased, their income during current recession. 

Notice, down payment is not part of the discussion.  It’s about the monthly income.

Years ago, in the 1980’s, as an underwriter at a Savings & Loan, working primarily with wealthy, complex borrowers, we used to look at “cash as king” and we would strongly consider down payment and liquid reserves as a sound reason for us to expand our underwriting vision for a particular borrower, along with our review of the projected stability of the sources of income.  In spite of the cash available for the deal, and to support the deal long term, everything always came back to income and how we felt about its stability and anticipated continuance.

The real problem in the housing market, that has lead us to the current crisis, was the distortion of underwriting…not necessarily the “no doc…state income” stuff, although they contributed…but the broader agency lending practices fueled by the automated underwriting systems at Fannie and Freddie.

 In the 1984/1985 time frame, I saw the first of the “no doc / stated income” type loans.  Keep in mind that fixed rates were still double digit at this time, and lenders were in the process of introducing adjustable loans and adding staff.  My gut feeling was that many lenders decided to avoid complicated paperwork, and chose to simplify the processing, and shift a great deal of the perceived risk to the borrower.  In essence…there wasn’t enough time or talent to deal effectively with the surge in mortgage demand, and, since the perceived risk was shifted to the homebuyer /borrower (through a large down payment), many lenders simply ignored the income/ qualifying issue. 

Back then, a 25% down payment got the customer into this special underwriting classification….and with a credit report (the mistake of relying on credit scores had not yet been made)and a big down payment (or lots of equity), everyone was an approved borrower.

Somehow, in spite the requirement for really big down payments, the supply-demand balance was screwed up…more borrower/buyers were enabled than actually existed, and they were chasing too few properties.  Asset values (property values) went through the roof. 

By 1989, or so, lenders were giving me feedback that upwards of 90% of the stated income loans were failing in audit review…results were pointing to the fact that the borrowers simply misstated income. 

Imagine that…with no real controls in place, the borrowers fudged...who would have thought.

In response to the audits, about this time, lenders began to shut off the ‘no doc/stated income” processing, the borrower pool was dramatically reduced, and in the late 1980’s housing crashed and we endured the S&L crisis.

Interesting to note that the “equity” that was lost during this time period was mostly real cash….lots of it.

Regardless, does any of this sound familiar? 

Twice now, in my 30 year career, the industry, which leads from the top…corporate leadership … government/agency leadership…and the money-men on wall street… has gone over the top and managed to take simple supply & demand mechanics and trash the dynamics by inflating the buyer/borrower pool through manipulation of the income/underwriting process…thereby eventually over-inflating asset values.  Then, at the point of the full realization of the error in their methodology, and the mess they had created, they reverse the process, and they impose drastic restrictions on the underwriting process, leading to a crash in the buyer/borrower/demand pool, and, eventually the reversal causes a severe downturn in asset values…they crush home prices.  Somewhere in here, the manipulation of how income is treated, lies the true heart of the problem.

This known history makes the current crisis all the unbelievable and unfathomable.  It’s not like we haven’t experienced this before.  We should have learned.  Unfortunately, not many industry participants have actual experience over this entire time frame of 1980 – 2009. 

I have read much of what is available on recent studies relating to the housing and mortgage crisis, and have traded thoughts with many of the authors.  When you strip away the fluff, you find that all of the studies are following false intuition to arrive at a predetermined end.  

There are simply more critical factors which need to be reviewed and understood, and the correlation between down payment and default, simply does not exist.

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