New Century Illegally Limited Loan Rejections in Contracts with Investment Banks
As the fallout from the subprime lending mess continues, many fingers have been pointed-and many more will surely be pointed-at those allegedly to blame for the severity and massive scale of the crisis.
Of course, banks point to greedy consumers who took out loans they did not have the means to repay; consumers point to banks who tossed lending standards into the wastebasket along with their scruples; and both blame speculators, shady mortgage brokers, investment banks who bought securities on subprime mortgages, and generally everyone up and down the mortgage industry who built, sold, bought, flipped, bought again or possibly even looked at a house within the past five years.
Yet in the interests of learning as many of the lessons as can be learned from the current apocalyptic state of the mortgage industry and so many bankruptcy filings, it is always helpful to lay out specific industry problems as they are identified.
Take, for example, the recent revelation that New Century-one of the country's largest lenders and therefore also largest lenders to subprime borrowers--wrote a 2.5% cap on total loan rejections into its contracts with investment banks.
Mortgage companies bundle thousands of securities backed by mortgages and sell them to investment banks, and during a time of widespread optimism about the housing industry, these mortgage-backed securities sold like hotcakes.
Why?
Housing prices were on the rise at exponentially-increasing levels, meaning that investments in these securities were massively successful, even in the short run.
Investment banks employ auditors to keep tabs on the credit qualifications of borrowers; an NPR story on former auditor Tracy Warren relates how she would routinely reject the qualifications of a borrower only to see the application rescued from the rejection pile and approved.
Only later did Warren find out that the reason was that New Century had contract provisions that limited the amount of mortgages that could be rejected. Capped at 2.5%, auditors like Warren were essentially useless beyond that point, since investment banks were contractually obligated to take the bad with the good after the 2.5% margin.
Consumers may be confused as to why it would make business sense for an investment bank to take on mortgage securities that it knew were bad. After all, poorly-qualified borrowers are greater risks for loan default than highly-qualified (or "prime") borrowers-once defaulted, a mortgage security is just a giant loan with no one obligated to pay for it.
Again, we have to turn to the idea of "risk" to explain the approach. By bundling in the good with the bad, the investment banks were hedging against losses by purchasing huge volumes of mortgage securities. A law professor quoted in the NPR story used an agricultural analogy to help explain: "They put the bad apples back in the barrel because they knew that they could sell the bad apples along with the good apples and, at least in the short term, nobody would know the difference."
Then, if borrowers defaulted, the profits would have been boosted so high by the tremendous volume of securities changing hands in such a positive-trending market that they hoped the losses would be negligible. Some studies showed that investment banks were making as much as a 40% return every two months on these mortgage securities. That's almost unbelievable!
Of course, there is the little fact that rigging the rejection process in the way that New Century did is illegal; it's consumer fraud, because it establishes arbitrary criteria for accepting or denying a loan request that may have nothing to do with the consumer's financial information.
Currently, the New York state attorney general is investigating the allegations. Rest assured, it won't be the only chance state or federal prosecutors have to examine questionable lending practices connected with the subprime loan industry.