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Main Street for Dummies - Part 2

While I talked about the Wall St dummies yesterday, the financial cancer started on Main St.

The investment bankers in NY became addicted to their greedy behavior. Some of these actions even border on criminal.

While Washington D.C. was wrangling about the bailout bill, something else was going on in the other side of the country in Seattle. Washington Mutual (WAMu) became the biggest bank failure in US history. It might be representative of how this financial disease started.

Kerry Killinger rose up the ranks since 1982 until he became the CEO in 1990. He engineered WAMu’s numerous acquisitions, and was responsible for growing the bank into the largest savings and loan institution.

For the past 2 decades, WAMu adapted to the market and came up with innovative products and services. In the process, it transformed itself.

Their primary product turned out to be the home mortgage and the firm became the country’s top bank in servicing mortgages.

Target: Lower-Income Borrowers

Killinger came up with an innovative idea of “the only mortgage loan you’ll ever need”, and he focused on lower-income borrowers.

This loan mortgage, called the Option ARM provided flexibility and allowed the borrower to choose how to pay their mortgage, every month as follows:

1. minimum - during lean months, it allowed the borrower to keep more cash. However, this is not enough to pay for interest, so the total loan balance grows over time.
2. interest only payment - outstanding loan balance remains the same
3. regular payment - both interest and normal principal payments are covered
4. accelerated payment - allows the loan to paid off sooner; i.e. as in 15 years - saving the borrower from interest costs

Unfortunately, human nature takes over and most people tended to stick with option 1.

Perhaps the borrowers were hopeful that the value of their homes will keep on increasing to cover the growing balances in their mortgage.

Meanwhile, the loan officers, responsible for approving loan appliactions, were driven by the commissions and fees or other corporate business goals that Killinger had established.

Sure enough, mortgages started to default, especially after these Option ARMs adjusted their interest rates.

Irresponsible home buying? Probably.

I’m sure some people were having high hopes of buying more house than they can really afford. After all, It’s easy to “forget” that the low interest rates are temporary. Or was it that they were wishing that it would last forever?

Other people, who had extra money, were simply speculating. Some of them even pulled out their assets from the stock market, and bought 2nd or 3rd homes for investment purposes only.

Of course, there are the normal responsible folks who got caught in the tidal wave of mortgage defaults; they needed to:

• relocate for a job, or
• sell because of a death in the family, or
• downsize because of job loss
• pull the house equity in a divorce situation, etc.

These people paid their mortgages diligently, but they had a very legitimate need to sell their homes.

So it didn’t help with…

…The Rise of the Predators

Predatory lending? Most likely.

You see, loan officers should know better. They needed to be on the lookout for people who cannot really afford the homes they were buying.

They needed to watch out for market trends and assess the risk of speculative buying. They needed to assess the job stability of the home buyers.

Who came up with the “no documentation” loan anyway? It simply means that the loan officer can take the word of the applicant, with regard to his/her financial resources.

Wasn’t that a dummies idea or what!?

Unfortunately, there was too big of a carrot to pocket the loan fees, and not a big enough stick to be careful when approving loans.

So why this imbalance between the lender’s carrot and stick?

Watch out for part 3.