Tuesday, August 19, 2008

Motivations Behind Bad Loans

I’ve written columns for the Baltimore Sun on the mortgage crisis and the emails I received from readers included these comments:

“It is hard to feel sorry for folks who got in over there heads, knew it and now what us to bail them out.”

“You are omitting the fact that the majority of subprime borrowers are in their current situation due to fiscal irresponsibility or carelessness.”

My response to these comments is that the goal of my writing is to educate consumers so that they are able to make better decisions. Markets do not work as intended if the consumers do not understand the contracts they sign.

But, for the people who write these comments, their underlying assumption is that homebuyers do know or at least should know what they are doing when they sign a loan agreement. The mortgage crisis is the result of character defects—greed, irresponsibility, over consumption, and so on. Pick one or several character flaws from a list and that explains the problem.

Of course, attributing misfortune and/or good fortune, on one’s character is as old as the Bible. Outcomes do depend on character, although not always. More personal failures and successes result from chance than most people would like to believe.

But the issue of character is an interesting one and I’ve been pondering it after recently reading two profiles of homebuyers facing foreclosure. In both cases the numbers involved in the loan agreements were so outrageous, it’s hard to believe any reasonable person would be party to such a contract.

A July 30, 2008 article in the Baltimore Sun profiled Veronica Peterson, a single mother of four who operates a home daycare in Columbia, Maryland. She is loosing her $545,000 home to foreclosure after the rate adjusted from 8.25% to 11.25%. The article provides few other details on her income and mortgage payments. However, if I work with the numbers provided and assume a 30-year loan, such an increase would mean monthly payments changing from $4094 to $5293 per month, an increase of $1199 per month. This does not include taxes and insurance that must add an additional $500 to each monthly payment.

I cannot image how a home daycare operator could generate the kind of income needed to support monthly payments that high; especially since the State of Maryland limits the number of children home daycare providers can care for to no more than eight. The average cost of daycare in Columbia, Maryland is about $1000 per month. That means by law she cannot gross more than $8000 per month and she must still pay income taxes. Living in a half-million dollar home while paying no taxes is sure to raise questions from the IRS. She said her mortgage broker inflated her income. I wonder what number was stated for her income on the loan application and how it compared to her tax return.

Another profile I read was in Jay Hancock’s August 8 column on Kimberly Thomas who showed up at a closing to find the interest rate on her mortgage from Wells Fargo Bank changed from 7.13% to 10.65%. The change resulted in the monthly payment going from $3000 to $4667. Her monthly take-home pay is $5000. The title company agent conducting the settlement told her to sign the documents anyway. It was 6 PM and no one else was present or available to contact. He assured her the bank would correct the “mistake” the next day.

But the next day Wells Fargo insisted that there was no mistake and that she was bound by the terms of the agreement. Because she couldn’t afford the terms, she ended up not taking possession of the house or making a single payment. The mortgage went into foreclosure immediately. She sold the house for which she paid $505,000 for a $95,000 loss and spent tens of thousands on legal fees. Eventually a jury agreed that Wells Fargo had acted fraudulently and awarded her $1.25 million in damages. Wells Fargo maintains they did nothing wrong and are appealing the verdict.

So what is it about the character of these people that results in situations where the numbers in the agreements are so ridiculous as to be unbelievable? My own take is that it is a combination of optimism bordering on wishful thinking, wanting to please others, and willingness to trust people presenting themselves as “professionals.” Homebuyers want to believe what the agents and brokers are telling them. And, the agents and brokers are very good at telling people what they want to believe. The fake friendships that develop allow the brokers and agents to take advantage of people who want to please others. Homebuyers do not want to anger people by scuttling deals at the last minute and willingly believe that everyone is acting their best interest.

Brian Paul, the lawyer for Kimberly Thomas, said: "She honestly believed there was a mistake in the terms that could be fixed after the fact."

I remember my own experiences with home buying. The real estate agent told me: “It’s impossible to overpay for a house because it has to be appraised. The bank will not allow you to pay more than the appraised price.” I’m sure all the homebuyers he works with get that same line and many believe it.

I remember a refinance of my house where the day of closing, a settlement sheet was faxed to me with a completely different set of numbers than previously agreed to. I took a hard line telling the broker the deal would not happen unless the numbers were changed back. Within an hour a new settlement sheet appeared with the original numbers. But many people are reluctant to “cause problems” at the last minute. It is also easier to walk away from a refinance than a home sale.

So, is believing the best about ourselves and others a character flaw? It can be when it allows us to be taken advantage of and enter into agreements not in our best interest. As I warn in my book The Two Headed Quarter, the lender and realtor profit from immediate sales, not the long-term financial health of the borrower. If the government, or some other investor backs the loan the lender is at no risk. That means homebuyers must look out for their own interests. Don’t believe the agent when he or she tells you that a bank would never loan you money if you couldn’t repay it.

In fact the real crux of the mortgage problem is the ability for agents, brokers, and executives to profit by gambling with money that is not their own. That is the point I made in my previous post. Wells Fargo and its agents don’t care if a loan is paid back because they will collect commissions and fees while selling the loan to other investors. The loan would become somebody else’s problem, not theirs. The homebuyers might have character flaws but the behavior of the lenders in these cases is criminal.

Joseph Ganem is a physicist and author of the award-winning The Two Headed Quarter: How to See Through Deceptive Numbers and Save Money on Everything You Buy

No comments: