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     Nov 8, 2008
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Subprime - an (im)morality tale
Confessions of a Subprime Lender by Richard Bitner

Reviewed by Julian Delasantellis

In 1949, the hard-boiled American crime writer Raymond Chandler observed that "Such is the brutalization of commercial ethics in this country that no one can feel anything more delicate than the velvet touch of a soft buck." It wasn't that "velvet touch of a soft buck" that the subprime mortgage business felt, and fell victim to, these past few years; it was the creamy caress of about 3 trillion of those soft bucks. It was the heady intoxication of this sensation that caused the industry to abandon all pre-existing standards of banking probity and morality, and this is the story


that Richard Bitner tells in his new book, Confessions of a Subprime Lender.

By 2006, Bitner, co-founder of subprime broker Kellner Mortgage, had seen so much of his industry's blatant balderdash, howling half truths, and malevolent mendacities that he could stand no more. Walking away from a business that had made him, and everyone in his business, insanely wealthy in an insanely brief amount of time, he pledged to write a book that would tell the truth about this business. Amazingly enough, considering the dross that winds up in the business sections of the bookstores these days (The Way of the Bushido Method to Sell Your Timeshare or, 12 Apostles=12 Successful Salescalls - The New Testament Sales, Commission and Wealth Plan) Bitner could not find a publisher for his work, so he self-published.

Buzz spread and word got around, John Wiley and Sons put out an edition in early summer. On Amazon.com, the book is now ranked number 4 in the "mortgages" sub-category of Business and Investing/Real Estate. In much the same way that epidemiologists traveled to Africa to investigate the origins of the AIDS virus, Bitner's book traces the current world financial crisis right back to its first bad loans.

What a strange embrace Americans have with the word, indeed, the very concept of, morality. Should you inform them that the first definition of the word in the Oxford English Dictionary is "ethical wisdom, knowledge of moral science", most of them will wonder how you've gotten rid of your French accent . Since at least the sexual revolutions of the 1960's and 1970's, and especially since Bill Clinton's fateful sibilations with Monica Lewinsky, Americans limit their conception of morality to the middle of the OED's third definition of the word, "Moral virtue; behavior conforming to moral law or accepted moral standards, esp in relation to sexual matters; personal qualities judged to be good."

In other words, morality is something that you do, or don't do, with your genitals, especially the proximity and frequency that they are placed in an unclothed close propinquity with those of others.

With references and notations the OED's definition of morality closes in on 3,000 words, but mine only involves one. Morality is denial; denial of pleasure, denial of some sort of personal advancement, denial of personal gain. If, in order to adhere to some abstract code of moral order, you deny yourself something that you would clearly enjoy, whether it be the readily available charms of your new administrative assistant, or maybe the $20 bill that fell out of the purse of the person in the checkout line in front of you, you are making a moral choice. Doing another 20 minutes in spinning class or forgoing your morning donut for a bran muffin may be good for you, but they're not moral choices; they're decisions made out of self-interest. Morality is having something that is a pleasure to you right at your fingertips and ready to be enjoyed and then pulling away, and this is what proved such a challenge to the US real estate and real estate finance industry these past few years.

After World War ll, the United States morphed from a place where people basically grew up and lived their lives where their parents had, on farms or in the closely packed cities of the industrial northeast, to a place of new suburbs outside the cities, and the whole new metropolises of the south and west.

The banking industry saw this as a problem. With the previous era's static, relatively immobile society, a banker could judge the credit risk of any prospective borrower simply; if the family tree was OK, the apple was judged to be unlikely to fall all that far from the tree. But in the new areas, this methodology would not work; their populations might be amalgamations of people from hundreds of other communities, from all corners of the country. No banker could be expected, basically, to make prudent educated guesses as to credit worthiness in this new, polyglot environment. A better way had to be found to make objective decisions as to who was and who was not a good credit risk.

Thus was born the credit score, the standardized mathematical tabulations that rolled credit history, employment and other factors into a single number that a banker could use to make the decision to reward or deny credit.

About five companies compute and report credit scores in the United States, but the most prominent of these is the so called "FICO" score, from the FICO Corporation, which in 1981 started selling to financial institutions the first FICO scores.

FICO scores can range from 300 to 850; the company reports the American median at 723. In the days before the subprime industry, and the subprime borrower, how this framework was applied to real estate was simple: if a borrower's score was above a certain number, maybe around 625, they'd get a mortgage, if not, they'd forever be renters.

Then, according to Bitner, somebody had a bright idea. Instead of making the decision whether or not to grant a mortgage a simple, yes/no judgment based on credit score, why not start to delve into the low FICO score market (borrowers with good FICO scores are called "prime" borrowers; that makes low FICO score mortgage applicants "subprime" borrowers) by making mortgage loans to this new class of prospective borrowers?

The enhanced prospect of default implied by the low FICO scores of these borrowers would be compensated by having the borrowers pay higher interest rates than standard borrowers, and, especially, by charging much higher fees to the borrowers just for the privilege of advancing these loans.

To me, how this industry worked in the recent past reminded me a bit of a passenger's experience upon arrival at an airport. If you're going first class, if, that is, your FICO and down payment details are sufficiently standard that your mortgage will eventually be eligible for purchase by Government Sponsored Enterprises Fannie Mae and Freddie Mac, then you probably wouldn't be dealing with a mortgage broker such as Mr Bitner and his ilk. You could walk right into a standard bank, and, once your financial bona fides had been checked, be greenlighted right into your mortgage.

But, if your FICO score was too low, or, if you didn't have much of a downpayment, or if you were seeking to borrow more than the GSE's statutory limits of around US$420,000, the standard banking system might very well turn you down. Off you would go to the world of the mortgage brokers, those small, three- or four-person bucket shops that suddenly appeared on the sides of the roads like weeds in spring, and now, as the winds of the current financial crisis blow hard and cold, have basically died and disappeared from the landscape.

You submit your subprime mortgage application to the mortgage broker, and, as it leaves your hand, it, like our air traveler, begins its tortuous journey through the system. Like the passenger transiting from one moving walkway to another, the loan moves through and up the system, from one mortgage broker to another, then to another after that, until it reached its "gate", the actual lender, what Bitner would call the "investor", who would actually fund the loan. For Bitner, this might be Countrywide, Citigroup, or the Household Bank subsidiary of HSBC - it was the reporting of bad quarterly results from Household by HSBC, which served as an early-warning flare marking the existence of the monster that is now devouring the financial system (see Rocking the subprime house of cards, March 6, 2007, Asia Times Online.)

Once in the hands of one of the big banks, the mortgages would be rolled up and made into the mortgage backed security (MBS) bonds that we now know so well. These would get sold into the markets (now they are soon to be bought by the US Government as part of the $500 billion mortgage security purchase plan initiated by US Treasury Secretary Henry Paulson), freeing up the banks' capital, so that the process could ramp up again for another round.

Since these mortgages carried such high interest rates, they were massively profitable, and so popular with banks such as Countrywide, and with the investors who bought their securities. They wanted as many of them as the brokers could write, and mortgage brokers like Bitner were more than happy to oblige them. As Bitner described it:
As the appetite grew for these securities, so did the price to purchase the mortgages. By 1994, investors were paying upwards of 700 basis points per loan, or 7 percent of the loan amount. Even a small company had enormous profit potential; a total monthly volume of $10 million, multiplied by 7% (700 bps) would result in a gross profit of $700,000 … a subprime could earn in monthly revenue $400,000 in monthly net revenue. To be able to produce this income with fewer than 50 employees was phenomenal.
Of course, it was this, the insanely profitable fee structure and investor demand for the final product, that caused all those boarded up ice-cream stands and shoe-repair shops to re-open as mortgage brokers. Why didn't the market work its magic and force down the fee and interest rate structure through competition? Well, one thing that became obvious was the difference in outlook between the prime and subprime borrowers. The prime borrowers knew they had the system by the short hairs; if they didn't like the offered terms from one bank they could walk down the street and get a half dozen others. The subprime borrowers were grateful for, and accepted, the terms on any mortgage they were offered; community organizers are only now learning how many less-educated and minority borrowers were offered, and accepted, subprime loans when they would have otherwise qualified for prime.

Bitner specifies three government policy changes that stoked the subprime fire. Interestingly enough, not included in his list is the current Republican Party talking point that the whole crisis is solely attributable to liberals and African-Americans at Fannie and Freddie having the unmitigated gall to attempt to put poor Americans in their own homes.
  • The Depository Institutions Deregulation and Money Control Act (DIDMCA) of 1980 made the subprime business legal by allowing lenders to charge higher rates and fees to borrowers.
  • The Alternative Mortgage Transaction Parity Act (AMPTA) of 1982 allowed the use of variable interest rates (ARMs) and balloon payments.

    Continued 1 2

  • Gambling, economic growth and imagination (Oct 15,'08)

    The liquidation trap
    (Sep 19,'08)

    Lehman and the end of the era of leverage (Sep 16,'08)

    Yellow-brick road

    2. Abu Hussein's invitation to Damascus

    3. An Indian hymn to Obama

    4. Big names jostle for top posts 

    5. What Obama means to Bangkok

    6. Now it's 'Cool America'

    7. Barack Obama rules

    8. Europe looks on in wonder

    9. Kazakhstan reins in oil majors

    10. Bernanke's unenviable legacy

    11. Change, and change, in the Middle East

    (24 hours to 11:59pm ET, Nov 6, 2008)



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