From Your Wallets to Their Pockets

Pushing the Wrong Buttons At this same time, the government and regulators were marveling at the efficiency of the market and pressing hard, through the signals that they were giving, to increase homeownership. Public policy seemed well-suited to the new paradigm. Even if the signs were there, and some of them were, who’s going to stop this money train from heading down the track? Each player in the chain had expanded its operations and was competing intensively for billions of dollars in revenues. Signals in the market, even very strong signals, get pushed away in the frenzy of profit making and competition. In early 2005, the Fed began a 17-month run of interest rate increases. As the signals started to show, signals like widening spreads (basically, at the originator level, this means that people started paying less for the loans), companies had built out very large, expensive operations and frankly, from the author’s professional perspective, many (but not all) had a poor to limited understanding of whether these loans were even profitable as margins began going down or at what point the loans were unprofitable and they should act. In a unique confluence of market conditions, liquidity (the amount of money still trying to buy MBSs, CDOs, etc.) remained very strong even though margins were coming down significantly and quickly. In other words, companies could still sell most of the loans they could originate; they were just making less on each one. This was a direct result of the selling skills of the traders on Wall Street! Now the question for executives in these periods became, “Do we start reducing our expenses (i.e., cutting people, shuttering buildings ) or do we try to hang on because, based on the strength of liquidity, the margins might come back and we might not lose out to our competitors?” In late 2006 and 2007, the market literally took on the appearance of a game of chicken. The problem with this game of chicken was that, in order to keep up volume and to maintain a competitive position and stay in business, the players had to book a higher percentage of less qualified business at the same time profits on this business were in rapid decline. Getting more volume in the slowing market meant even more loosened underwriting guidelines, more “pushed” appraisals with a few more winks at compliance controls, and still, for every dollar of loan volume these companies booked, they were, in many cases, losing a nickel or a dime. Some knew they were losing money and hoped to outrun the problem with volume, and others didn’t know they were hemorrhaging money until it was too late. How could that be, you might ask. The very simple explanation is that these businesses were so profitable during the market heyday that they didn’t have to be very good at managing all of the aspects of the business to make a lot of money. They just needed to generate more loans. This mentality prevailed as they held on as long as they possibly could.