Sheila Bair, former FDIC chair and author of The bullies of Wall Street, joined Joe and guest co-host Josh Dorkin from the Bigger Pockets podcast to talk about the mortgage crisis and the events that led up to it. She also told the guys what the future holds for young adults and teens because of the mortgage fallout.
Joe: Welcome, Sheila!
Sheila: Thank you. Happy to be remotely in the basement. (laughs)
Joe: Less than 2% of mortgages were foreclosed on previous to 2007. If the mortgage crisis was a long time coming how was that number so low?
Sheila: That is historical data. Traditionally, the 30 year fixed-rate mortgage came with a lot of underwriting. For the most part, lenders retained the risk. They required down payments, they required income documentation, and they kept the mortgage payment relatively low as a percentage of the borrower’s income. Originally it was between 30 – 35%.
With secularization the people who were making the decision to originate the loan were different from the people who were retaining the risk if the loan defaulted. You had a change of incentives from lenders who would keep the risk themselves to originators who would pass on the risk through secularization to investors.
When that happened, the person convincing someone to take out a new mortgage didn’t care anymore about whether the person could afford to make the mortgage payment, because the risk was being passed on. It became a volume driven business. That’s why when you had lenders retaining risk you had very low historical default rates. As secularization picked up steam in the early 2000’s that’s when you saw deterioration of mortgage lending standards.
Joe: A lot of people still don’t understand the concept of secularization. The rise of these mortgage lenders that aren’t attached to your local bank is really the problem. They don’t care if your loan fails or not.
Sheila: In a nutshell, that’s it. Unfortunately, as these non-bank sub-prime originators started making it so easy to get a loan, they started undermining the competitive position of a lot of the regulated institutions, particularly in the thrift industry. In the thrift industry, WaMu and Countrywide…and some others of the bigger names got into this business as well. It was their ultimate demise. It started in the non-bank, non-regulated sector. Wall Street investment banks were packaging these loans and secularizations and selling them off to investors. That started driving down lending standards.
Then some of the regulated institutions, especially the thrifts, started getting involved as well. We ended up with a very big problem. One of the big questions I still have is why investors buying these mortgage-backed securities didn’t look hard at them. They will say the rating agencies were giving this debt high ratings… Investors should have done more due diligence themselves. You did not have to look too hard to see what was going on.
Joe: What does the future look like for kids in their late teens/ early 20’s?
Sheila: The final section (of my book) focuses on the legacy of the crisis.
In terms of stretching out government, the national debt has ballooned. That will have to get paid down at some point. It is part of our stressed physical finances. Both the social security and medicare trust funds are going to be falling short in the next 15 years or so. If we started getting on top of that problem now we could accumulate savings gradually to mitigate any harsh sudden impact on taxpayers. Young people will be paying payroll taxes as recipients. But we are not doing that. We are kicking the can down the road. Which I think is unfortunate. Also, it’s a bad labor market. Older people were hit financially.. They are staying in the workforce longer. Monetary policy has also depressed their returns on their fixed income investments. You are seeing old people staying in the workforce longer, which is hurting job opportunities for younger people.
We did not do what we needed to in the housing markets to confront and meaningfully deal with all these troubled mortgages. Only now you are seeing the housing market come back. It’s the wealthier neighborhoods that are coming back, whereas the lower income neighborhoods are still struggling. It’s a bad legacy. We were not good stewards of the economy, the baby boomer generation. We still have a big obligation to kids to get this fixed.
I want kids to understand the kinds of challenges that will confront them. I want to make sure as they become voting adults that they are more aware of these issues and demand accountability form their elected officials to deal with these issues.
Joe: Are student loans the same we saw with what happened with mortgages? Are they going to be the next wave?
Sheila: It is the same in the sense that loans are being made to kids without the kids fully understanding the kind of accumulated debt they are taking on, and what kind of repayment burden they will suffer once they graduate. Borrowing money to go to school may be a very good investment, as long as you understand what you are borrowing and that you are going to a school that is going to give you a degree that is going to help you be successful once you enter the workplace.
I do think it is a problem. The for profit schools have recruited kids very aggressively without really paying attention to the degree they will get. Is it going to land them a job that they can service the loan? It is the same kind of skewed incentives you saw in sub-prime. With the government guaranteeing the lions share of the student debt, it is in the interest of the for profit schools to bring the kids in and get the money without regard to whether they graduate or get good jobs. The government will pay for it if they default. There are similarities to some of the upside down incentives we provided for sub-prime mortgages.
Some very hard hitting topics in our interview with Sheila Bair. If you would like to hear her go into more detail about many of the ugly types of loans people used right before the bubble, the law of unintended consequences from the secularization for mortgages, the Hank Paulson meeting with the bailed out bankers, or how she feels the Dodd/Frank act helped the situation, please listen to the full interview here.
You can also buy Sheila’s book The bullies of Wall Street here.