When I was a Marine recruit at Parris Island, when my platoon raised the ire of our drill instructors for whatever reason, the results would generally be most unpleasant. At least one of our four D.I.s (we were prohibited from calling them by that slang term) would charge through our barracks, Smokey the Bear hat cocked menacingly forward, scowl etched in place, ready to inflict pain upon us for the ineptitude we'd displayed. We knew from experience that we were in trouble.
These days, the mortgage industry and perhaps housing in general might as well be raw Marine Corps recruits. They're clearly in trouble. Last week, Sen. Chris Dodd (D-Conn.) oversaw hearings on the industry's lending practices, and he might as well have donned that infamous Smokey the Bear hat and well-practiced scowl.
My concern is that -- as with the Sarbanes-Oxley hoops through which corporate America must jump routinely, along with the counterproductive rules now governing much of securities analysis -- the regulators will almost certainly overcorrect as they seek to deal with the lenders' real or perceived transgressions. I believe that the results ultimately could be deleterious to the health of our nation's housing industry. And with hearings in the House set for this week, following the Senate's show, we may be about to watch the careful slamming of mortgage lending's barn door long after the cow has departed.
At the same time, many lenders' approach to their business may have spiraled so far from reality that some sort of tightening of standards is needed. Imagine making loans to customers with smudged credit histories and not requiring a down payment or the verification of income or employment. That, my friends, is precisely what has occurred on a not infrequent basis.
This cavalier approach to lending generally worked nicely in a climate of escalating house values. Borrowers were easily able to refinance and obtain new loans based on their homes' higher values when their payments on the initial loans -- which all too often were adjustable-rate mortgages, or ARMs -- necessitated higher monthly payments. However, when hikes in home prices stalled or, in some cases, were reversed, such refinancing became impossible, placing lots of strapped subprime mortgage holders in the soup.
Futuristic mortgage foibles
The phantasmagorical new adjustable-rate, nothing-down, interest-only, no-employment-verification-needed mortgages that have spawned the current crisis are generally relatively new. Until the1980s, most mortgages were of the conventional 30-year, fixed-rate variety and were written by conventional financial institutions, including the predecessors of what are now J.P. Morgan Chase (NYSE: JPM) and Wells Fargo (NYSE: WFC), along with a raft of thrift institutions.
In that decade, however, the phenomenon of "securitizations," wherein loans were taken off their lenders' books for packaging and sale to investors, began in earnest. There were a couple of indirect results from this new wrinkle. The first was the formation of a host of specialized mortgage lenders, including Countrywide (NYSE: CFC), the nation's largest mortgage lender. The second result, for which materially lower interest rates also served as a catalyst, was the emergence of the raft of space-age mortgages that are now weighing so heavily on borrowers and lenders alike.
When operated against a backdrop of spotty regulatory oversight, this new mortgage mosaic was, we now know, destined to run into difficulty. Some of the lending institutions are overseen by the individual states, and others are under the watch of such federal authorities as the Office of the Comptroller of the Currency (OCC) (which regulates the nationally chartered banks) and the Office of Thrift Supervision (which is, as the name implies, the overseer of the thrift institutions). The state-chartered banks are regulated by a combination of the Federal Reserve (which also monitors the bank-holding companies), the Federal Deposit Insurance Corporation, and the respective state regulators.
One difficulty is that many of the new standalone lenders, and those that are subsidiaries of larger companies like H&R Block (NYSE: HRB) and General Motors (NYSE: GM), frequently have slipped through the regulatory cracks. This basically precarious situation has been exacerbated by the OCC's policy of pre-emption, which has served to prevent the states from enacting regulatory requirements more stringent than the frequently loose standards in effect at the federal level.
Such a teaser
As a result, many lenders have been able to indulge in such patently questionable practices as offering "teaser" loans that bear unnaturally low rates for their first two or three years, before jumping to far higher rates -- and resulting payments. While that practice has been under attack, especially at the federal level, it has not yet been completely obliterated.
In the meantime, there are obviously more losers than winners in the expanding mortgage quagmire. To the affected borrowers and lenders, add the rating agencies, such as McGraw Hill's (NYSE: MHP) Standard & Poor's unit, which effectively appraises securities and transactions, including those mortgage-backed securities that are the end product of securitizations. Lately, those rating agencies have come under attack for placing their imprimatur on mortgage-backed packages that included subprime loans that later went into default.
The only apparent winners in all this, at least for the time being, have been those seeking prime mortgages. With funds exiting the subprime and intermediate, or Alt-A, credit levels, a greater percentage of available funds have been targeted to prime borrowers, making for some attractive packages for that most creditworthy tier of borrowers.
So what lies ahead for this oft-discussed and vitally important area of the U.S. economy? Obviously, nobody is certain, but it seems to me that there are some likely outcomes for the not-too-distant future:
- There will almost certainly be increased regulation of mortgage lending. But while there clearly have been lending excesses, increased regulation, a la Sarbanes-Oxley, is not always the best medicine for such a situation.
- Unlike the hit-or-miss pattern of lending regulation that has heretofore existed, whatever new rules spring forth almost certainly will reach all U.S. mortgage lenders. That is probably a good thing.
- But for anyone who believes that a spate of new regulations won't go too far and risk retarding the U.S. housing market's return to health, I have a bridge for sale at a very affordable price. Even with the obvious need for changes in subprime mortgage lending practices, I'm always skeptical when change is undertaken through spur-of-the-moment regulatory zeal, rather than through the effects of market forces.
- New regulation could make it even more difficult for those subprime borrowers groaning under escalating mortgage payments to obtain new loans through refinancing, thereby actually increasing the numbers of foreclosures.
For now, all we Fools can do is watch the regulatory reinforcements ride to the scene of the expanding housing carnage. For the present, it seems to me that the one homebuilding name that stands to remain somewhat above this fray is Toll Brothers (NYSE: TOL), whose position as the nation's largest luxury builder may be able to insulate it somewhat from the chaos on mortgage lending's lower rungs.
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Fool contributor David Lee Smith does not own shares in any of the companies mentioned. He welcomes your questions or comments. JPMorgan Chase is an
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