The Bubble

How homeowners' missed mortgage payments set off widespread problems and woke up the Fed.

By Zachary A. Goldfarb and Alec Klein
The Washington Post
Monday, June 16, 2008

The mortgage executives who gathered in a blond-wood conference room in Southern California studied their internal reports with growing alarm.

More and more borrowers were falling behind on their monthly payments almost as soon as they moved into their new homes, indicating that some of them never really had the money to begin with. "Nobody had models for that," said David E. Zimmer, then one of the executives at People's Choice, a subprime lender based in Irvine. "Nobody had predicted people going into default in their first three mortgage payments."

The housing boom had powered the U.S. economy for five years. Now, in early 2006, signs of weakness within the subprime industry were harder to ignore. People with less-than-stellar credit who had bought homes with adjustable-rate mortgages saw sharp spikes in their monthly payments as their low initial teaser rates expired. As a result, more lost their homes; data showed that 70 percent more people faced foreclosure in 2005 than the year before. Housing developers who had raced to build with subprime borrowers in mind now had fewer takers, leaving tens of thousands of homes unsold.

People's Choice was feeling the slowdown, too. It had been generating about $500 million in loans each month, but profit fell by half in the first quarter of 2006, according to documents filed for an initial public offering that was later abandoned.

Zimmer saw the mounting problems as head of the department that worked with Wall Street to package mortgage loans into securities to be sold to investors. Such securities had fueled the housing boom by pumping trillions of dollars into the mortgage market.

Two decades earlier, Zimmer had been among the young salesmen pitching early versions of mortgage-backed securities. He had stayed in the field, becoming a top salesman at Prudential Securities before moving on to help run a big investment fund that specialized in those exotic products.

Now he was trying to make sure People's Choice could continue to raise money by pooling subprime loans. Zimmer and some other executives urged the company to tighten its lending standards. That could lower the rate of defaults. And the better the quality of the loans, the more investors would want them, he figured.

But "there was always push back" from sales executives when he advocated more conservative lending, Zimmer said. Like most big lenders, well over half of the loans made by People's Choice came not from its own employees but from independent mortgage brokers. If the company stopped taking the brokers' riskier loans, the brokers might take both those and their higher-quality loans elsewhere. What's more, People's Choice's own loan sales force -- at about 1,000 employees, the bulk of the company -- worked largely on commissions from loans they made.

"There were times when voices would get raised," Zimmer said. A colleague would pound the table, asking: Why don't you see this?"I was not," he said, "a popular person."

As his team analyzed the individual loan files, Zimmer said he was struck by evidence of fraud, such as doctored bank statements. "Fraudulent loans were a big part of the subprime mess," he said. Mortgage brokers forged borrowers' signatures and pumped up their income, he said. People seeking to buy and sell a home for a quick profit lied that they were going to live in the home -- qualifying for a lower interest rate. But People's Choice calculated that it would have been too complicated and expensive to go after fraud, Zimmer said.

Even as People's Choice sought to preserve its business, the housing climate continued to deteriorate. Many borrowers were defaulting so quickly that the company did not have time to pool those mortgages and sell them off as securities.

Feb. 7, 2007 . A few hours separate startling announcements. HSBC, a 142-year-old London-based bank that was one of the largest subprime lenders, says it must set aside $10.6 bi llion to cover expected losses. Then another industry giant, New Century Financial, says it will have to redo almost a year of accounting to reflect the depth of its losses.

In subsequent weeks, the stock values of many subprime lenders plunged, and others filed for bankruptcy protection. Construction of new homes hit its lowest point in nearly a decade. On Feb. 27, the Dow Jones industrial average fell 416.02 points, the seventh-largest point loss ever.

At the Federal Reserve, officials remained unruffled. They privately calculated that even if subprime losses were severe, the dollars involved would be no more than a blip in the overall economy. As late as June, Fed Chairman Ben S. Bernanke spoke via satellite to a conference of international economic officials in South Africa, predicting, "the troubles in the subprime sector seem unlikely to seriously spill over to the broader economy or the financial system."

But in financial circles, word circulated about trouble inside one big New York investment bank. Bear Stearns had two hedge funds that invested heavily in securities backed by subprime mortgages. Hedge funds, which handle the money of wealthy investors, are lightly regulated and don't have to report much about their operations to investors. So it was a surprise to Wall Street when the funds appeared on the brink of collapse, forcing Bear Stearns to lend one of them billions of dollars to keep it afloat.

The question in many boardrooms became: What else is at risk?

Debate among People's Choice executives gave way to questions about the subprime lender's own survival. The investment banks that had bought subprime mortgages to pool them were now demanding that lenders like People's Choice take back the mortgage loans that had gone into default, arguing that misrepresentations had been made about the borrowers. And lenders had to take them; they couldn't risk further damaging their relationship with the banks.

"Now the whole industry is starting to choke on the volume of loans put back to them," Zimmer said.

People's Choice turned around and tried to sell off the bad loans but took "a huge hit," he said. The company had been scrambling to further tighten its lending standards, getting rid of mortgages with no down payment and requiring borrowers to have stronger credit histories. But "by then, it was too late," Zimmer said. "This is a tidal wave."

Finally, banks that had been lending cash to keep People's Choice in business cut off the company. "When that happens, you're done," Zimmer said. "It's the kiss of death."

People's Choice filed for bankruptcy protection in March 2007. By June, Zimmer was laid off.

In Northern Virginia, things were also unraveling. Kevin Connelly, a mortgage broker at Pinnacle Financial's Vienna office, fielded calls from desperate homeowners. Some had been counting on disappearing sources of income -- family, renters -- to pay for mortgages. Many had been employed in the home-building industry, which was shedding workers in droves. Still others owed more on their mortgage than the home was now worth.

"There was a gross underestimation of the true cost of homeownership," Connelly said.

For most of these callers, he had nothing to offer. "What happened was the values had dropped, the credit scores had dropped, and the loan programs had gone away," Connelly said. "I would hang up the phone and be frustrated that I didn't have a solution."

Connelly's colleagues were fleeing even faster than they'd come on board in the boom years. At staff meetings, the gallows humor -- only half funny -- was, "We're having a sales contest, and the winner gets to keep his job," Connelly said.

By last summer, the atmosphere was motionless in his office. Each morning, Connelly visited a Web site called "the Mortgage Lender Implode-O-Meter," which chronicled lenders that were going under. His day "went from talking to 10 people and doing eight transactions to talking to 10 people and doing one transaction," he recalled.

By summer's end, he said, "I was working alone in that office."

July 19, 2007 . Fed Chairman Bernanke tells Congress: "Rising delinquencies and foreclosures are creating personal, economic, and social distress for many homeowners and communities -- problems that likely will get worse before they get better."

Bernanke and others at the Fed still did not see how severely the troubles would cascade through the economy.

washingtonpost.com