Connecting the Dots

The Fathers of a Crisis

In 1969, the 31 year old son of a Bronx butcher formed a partnership with another mortgage banker, David Loeb, to launch Countrywide Credit Industries. The company that Angelo Mozilo created was not initially successful, at least for its shareholders. In fact, the stock languished under $1 a share for a number of years and was de-listed until 1985.

The initial purpose of the company was to take a successful mortgage banking operation and make it a national brand. By advertising rates and fees, utilizing technology and making the home mortgage more accessible to the consumer, Countrywide grew to be the nation’s largest and most successful home mortgage lender.

The company thrived in the refinance boom in the last decade and the stock returned a whopping 23,000% between 1982 and 2003. Moreover, Countrywide helped launch a proliferation of mortgage brokers by giving them access to liquidity through various secondary market investment vehicles.

In the mid 1970’s, James Montgomery’s mission was to pioneer the variable rate mortgage. He had been unsuccessful when he tried it earlier as Chief Financial Officer with United Savings. But in 1975, as President of a much larger institution,Great Western Savings, Montgomery believed he then had the clout and capacity to make it work.

The reasons to do it were simple. Savings and Loans were getting killed by long-term fixed rate mortgages when interest rates rose on their sources of funding, deposits. By allowing the mortgage rate to vary with the bank’s cost of funds, Montgomery knew he could create a much stronger balance sheet for his institution. He also believed it would benefit the consumer as the lower introductory rates would allow for easier entry into homeownership.

In the late 1970’s, Lewis Ranieri, already at 31 known as a bond king, introduced a revolutionary new financial instrument called the mortgage backed security. This security allowed financial institutions to transfer the interest rate risk associated with mortgages to investors in these securities. These securities would act similar to other bonds and would be rated based on their risk by Moody’s and Standard and Poor’s. In turn, by shifting these mortgages off of the balance sheet and into the securities, the savings institutions would free up additional liquidity to make more loans.

With these and other innovations, the mortgage industry was off and running. Throughout the 80’s and 90’s, easy access to mortgages, variable or adjustable rate products, and plenty of liquidity supplied by the securitization market, made homeownership a reality for countless more Americans. It also fueled what seemed to be never-ending home appreciation and a healthy building industry.

All three innovations were good ideas at the time. In fact, all three innovations remain good ideas when administered correctly. However, time and greed often have a way of mutating fundamentally sound ideas. By the late 1990’s, those ideas were beginning to go terribly wrong.

Angelo Mozilo probably never envisioned that the mortgage brokerage offices that sold loans to and through his company would be more ubiquitous than 7-11’s. He also never imagined that many of the mortgage originators would have no more training than the clerks of those convenience stores or no more accountability than an aluminum siding salesman. But, as the market intensified and as Countrywide grew, Mr. Mozilo lost track. Even as he began to warn of an impending crisis in 2005, Mozilo also bragged that Countrywide was not in the business of making risky, sub-prime loans. Sadly, he was mistaken and he and his company have paid the price.

James Montgomery certainly never envisioned or condoned the use of variable or adjustable interest rate products in the manner in which they were used over the past few years. Pay option, interest only, hybrids with low teaser rates, were not part of the lexicon when Great Western was sold to Washington Mutual in 1997. Even during his tenure on the board of Freddie Mac until 2002, Mr. Montgomery would have protested if he knew the lender was to qualify the borrower’s ability to repay based on a teaser rate or on non-documented (now commonly referred to as LIAR) income. As interest rates declined in 2001 and beyond, banks were faced with a fiercely competitive market. It is in the face of this competition that mortgage originators began to throw underwriting criteria out the window. The traditional down payment required to buy a home was replaced by 105% financing. Borrowers too often were qualified by mortgage brokers who filled out application documents for the borrower based, not on reality, but what the investor wanted to see. All of sudden, it seemed almost overnight, the difference between A-paper, Alt-A paper and Sub-Prime paper was blurred. Everyone felt the bond rating agencies would know the difference. It turns out they did not.

Clearly, Mr. Ranieri knew something was wrong. He began warning of the impending disaster in the mortgage and housing markets a few years ago, but no one was listening by that point. Even the bank he founded and of which he still remains Chairman wasn’t listening. His message was clear and easy to follow; you throw out this much liquidity into the market and you throw out underwriting standards, you create an unsustainable bubble that is going to pop. The fathers were talking. The sons weren’t listening. The drum beats of profit and greed were too loud. The fear of the consequences could be pushed off another day. The wax in Icarus’s wings was destined to melt. The bubble simply popped. And, the consequences of a bubble popping, as opposed to the air being gradually let out, is that it can’t be easily re-inflated. The mortgage and housing market now needs to be rebuilt. As part of that rebuilding, we will need to restructure the mortgage banking industry, adjustable rate mortgage products and the underwriting of mortgage backed securities. All three elements will be an integral part of the rebuilding process. Ironically, the future mortgage industry will probably operate very much like Messrs. Mozilo, Montgomery and Ranieri envisioned in the first place.