On August 14, 2007 the Fed released a statement announcing proposed illustrations of consumer information for certain adjustable-rate mortgage products (ARM) described in the Statement on Subprime Mortgage Lending.There is nothing Earth-shattering about any of these documents. The Fed is primarily pointing out the obvious, reaffirming existing legislation and providing a flavor-of-the-day take on issues that have been ready to boil over for quite some time.All the players in the economy are being given a time out and a bit of a talking to. The cyclical nature of life is evident in much more than the peaks and valleys of the economic cycle, but in the peaks and valleys of behavior and intelligence. These government actions always seem reactionary, but it is the nature of the human beast to get complacent and sluggish. Without a jolt to the system as a reminder of what the downside will be, the trend toward the "easy way" will continue.So what did the Fed have to say about subprime mortgage lending and the use of certain adjustable-rate mortgage products (ARMs)? First, I would like to point out that after the initial comment period, the Fed received 137 unique comments on the proposed Statement on Subprime Mortgage Lending. While these comments did serve to help refine the Statement, they served mainly to shine a light on the huge thought gap that exists between consumers and lenders.In short, the complexities of lending products have outpaced consumers' (and many lenders') learning curves. As a result, the Fed is highlighting the need for consumer's to be educated on these products, for lenders to do proper underwriting and risk mitigation, and for organizations to maintain proper compliance initiatives. The latest offering lists proposed examples of what should be communicated to consumers.How did we get here?Reactions. Reactions to the S&L collapse in the 1980s, the Asian financial crisis in the 1990s and the bursting of the tech stock bubble in 2000. - The Fed managed interest rates (keeping them at minimum levels) to avoid economic downturn. Anecdotal evidence suggests that even economic guru Alan Greenspan was aware of the potential for unanticipated damage resulting from these choices. However, choices must be made and it is yet to be determined if those choices were wrong.
- Low rates resulted in increased home prices, an increase in leveraged buyouts and overseas savings.
The result was typical shortsighted behavior and avarice fueled decision making from all parties. Consumers took full advantage of rates and leveraged themselves to the hilt. Consumers assumed debt well beyond their ability to shoulder in the event of a rate shock. Institutions took the opportunity to lower standards and bleed the subprime consumer while they could, while creating layer upon layer of financing that obscured the final investor from knowing what real values were. Attempts to push the long-term rates higher (and increase mortgage rates as a result) were foiled as investors' risk-return tolerance became suspect and foreign investment in U.S. Treasuries remained high. At the same time, non-regulated lenders became major players (banks were no longer the dominant lenders), loan-to-value ratios increased to untenable levels and borrowing requirements eased. In 2006, almost half (45%) of subprime loans were made to borrowers without fully documented incomes (and often, overstated credit worth). Bad loans were not in evidence, but mainly due to the ease of refinancing, and not due to any inherent strength in credit quality across the land.
Easy-money greed bled into the Leveraged Buyout business and down to the investors, including your next-door neighbor and your high school teachers' pension fund. With everything moving along at breakneck speed and high-risk investors raking cash, the disciplined, diversified investor was left wondering how they could justify staying out of the deep end. The con man needs a willing mark.
Lessons are always learned, but not often remembered.
