The 2008 financial crisis occurred in part because the various financial instruments created from bundled subprime mortgages cratered when the risky mortgages went into default. Real estate values dipped before the crisis, but that alone does not explain why so many mortgages defaulted after the borrower had made payments for some time. The answer in part is that many of the mortgage loans had low introductory rates (so called ‘teaser’ rates) with relatively low payments, sometimes of interest only, followed by a sharp increase in the rate and higher payments. Lenders have been accused of failing to notify the borrower of the imminence of much higher payments. More than half of such mortgages were refinances, chosen for the low rates that were only temporary.
At the time, many lenders did not bother with the basic due diligence of verifying the underlying loan documents since the lender simply sold the mortgage and did not retain any risk. Wall Street bought the mortgages, bundled them into various securities and marketed and remarketed them. These securities plummeted when hundreds of thousands of mortgages failed.
One of the largest originators of these subprime loans was Countrywide Financial, a California mortgage bank whose accounts were eventually assumed by Bank of America. Countrywide’s COO, Stanford Kurland, cashed out in 2006, before the crisis, and left Countrywide with $200 million.
Kurland used that money and that of other investors to start the mortgage company Pennymac. In 2008-9, Pennymac bought failed mortgages from the government (which acquired them in the bailout) at 38 percent of the amount due on the mortgages. In a move the New York Times described as “like Jeffrey Dahmer selling body parts to a clinic,” Pennymac, having paid less than 40% of the loan value, including for loans originated by Countrywide, was able to renegotiate mortgages with homeowners or foreclose on the mortgages. This was a good deal for both Pennymac and some homeowners, but the taxpayers were stuck with 62% of the loan amount. John Lawrence, the company’s head of loan servicing described the business model as “off-the-charts good.” A more detailed description of this process is available here. Pennymac’s marketing of the program is here.
Ten years later, what are Kurland and Countrywide, oops, I mean Pennymac, up to now? Pennymac has joined Quickenloans as one of the largest nonbank, sometimes called ‘shadowbank’ lenders. These lenders originate over half of new mortgages but are free from the stricter regulations for banks enacted to avoid another mortgage crisis.
How do Pennymac, Quickenloans and others make risky loans and avoid risk? They, too, are the beneficiaries of the generous assistance of the taxpayers. Many of their mortgages are guaranteed by the Federal Housing Authority and at present, over 80% of FHA mortgages are issued by nonbanks. FHA mortgages require a down payment of only 3.5%, a credit score as low as 580 and must be for a primary residence (with limited exceptions). The rules are here. In a move predicted to affect 4-5% of FHA mortgages, the rules were amended in 2019 to make the loan standards slightly more difficult.
FHA mortgages, and bundled securities made up of FHA mortgages are guaranteed by the government agency Ginnie Mae. The agency has increasingly guaranteed more loans from non-bank lenders: 76 percent of new loans guaranteed by Ginnie Mae last year were issued by non-bank lenders, up from 18 percent in 2009.
There are signs that the non banks are up to the old pre- 2008 tricks. In a recently settled federal lawsuit, Quicken Loans was charged with misrepresenting borrower information and inflating appraisals in order to qualify for FHA insurance. As a result, when the loans soured, it was the taxpayers and not Quicken Loans that suffered the millions of dollars in losses.
Non-bank mortgage lenders are privately held and operate free of federal surveillance although they are regulated at the state level. The shadowbank industry claims they are watched closely by the states they do business in and by federal regulators such as the Consumer Financial Protection Bureau.
Banks have customer deposits to fund mortgage loans but non-banks have no depositors and issue mortgages using credit and then resell the mortgages. Since the shadow banks focus on the riskier end of the mortgage market, they may well be as the New York Times noted “revving up the same parts of the engine that resulted in defaults and foreclosures in 2008.”
The potential risk to the government is in the trillions. And this time, if the mortgages default en masse the government can’t choose whether to bail out the lenders, since the government has already guaranteed the loans.