Riding the Sub
Ameriquest calls itself the "Proud Sponsor of the American Dream," but Mark Bomchill remembers his one-year stint processing loans at a branch outside Minneapolis as a nightmare.
Before joining Ameriquest Mortgage Co., Bomchill worked for Household Finance Co. There, he'd typically process two or three applications for home loans each month.
After he moved to his new job in suburban Plymouth, Minn., Bomchill was taken aback. Sure, annual interest rates for a 30-year fixed mortgage were below 5 percent, a 40-year low, so demand for new loans was high. But the demands to produce new business were even higher, Bomchill thought.
"It was so out of hand, I was juggling 10 to 15 new loans every month," says Bomchill, who now works as a loan consultant at Plymouth, Minn.-based Allstate Residential Mortgage. "And there were guys in my office doing two or three times as many as I was. No one ever thought to question whether [the loan] was right for the customer or for the lender. It was just do the deal and move on to the next."
Even though he and others in his office were closing more than 80 new loans every month, it wasn't enough to satiate upper management. "Every day my boss would scream and yell at us to make more calls, solicit more suckers," he says. "He was a tyrant. It never ended."
In the aftermath of the Internet-stock collapse and the Sept. 11 terrorist attacks, real estate became the go-to investment on Wall Street and Main Street.
But as the Federal Reserve Board continues to ratchet up interest rates and more and more buyers opt for high-risk, adjustable-rate mortgages, this safety net of the American economy in the past four years may not be that safe after all.
No mortgage loan gets made without a processor, and the processor's job is only as safe as the number of loans he or she can make in a month or a quarter. In theory, the software used to process and track each loan should be able to guide the processor through each loan's creation and immediately reject those borrowers who can't legitimately qualify for a loan.
But software is only as good as the people using it. And in the case of Ameriquest, safeguards appear to have been bypassed by an overriding desire to drive up volume of loanseven if it meant lending to less creditworthy customers who might lose their homes in the end.
Ameriquest has been paying the price, in court cases that have already cost it more than $100 million. And company officials have set aside another $325 million to settle other lawsuits on the horizon.
Former Ameriquest employees such as Bomchill; Joseph Khaliq, a former loan agent in the company's San Mateo, Calif., office; Lisa Taylor, a former loan agent at a Sacramento, Calif., branch; and Brien Hanley, who used to write loans at an Ameriquest branch in Kansas City, Kan., say heavy use of direct mail pitches, intensive cold-calling sessions from telephone banks, and even door-to-door canvassing for customers in minority and low-income neighborhoods helped vault Ameriquest to the top rank of home-loan originators.
According to Friedman Billings Ramsey & Co., an investment banking firm based in Arlington, Va., Ameriquest Mortgage last year accounted for almost a third of the $83 billion in loans generated by Ameriquest Capital Corp., its parent company.
Ameriquest is unusually profitable at it. According to the Mortgage Industry Directory, Ameriquest Capital earned $1 billion on $41 billion of loans it produced in 2003.
By comparison, Countrywide Financial Corp., based in Calabasas, Calif., generated $2.3 billion in the same periodon $434 billion in loans.
Ameriquest Mortgage's specialty? Focusing on the "sub-prime" borrowerAmericans with less than perfect credit ratings, but dreams of moving into a new or bigger home. The benefit? It can charge 2 or 3 percent more than normal rates. That bolsters profits, but stretches borrowers to their limits.
For example, a standard 30-year loan for a $250,000 home at an interest rate of 5.75 percent would leave the borrower with a monthly payment of $1,458.93. At the end, a typical borrower will have paid $525,216.75 for the home, of which $275,216.75 was interest.
The sub-prime borrower paying Ameriquest 7.75 percent, by contrast, would have a monthly payment of $1,791.03. By the time the loan was paid off, the borrower would have paid $394,771.19 in interestmore than $129,000 extra.
Managed well, lending to riskier customers can be a difficult but legitimate way of making more money than the next outfit in a booming business. And it gives more people chances to own homes.
But according to former loan processors for Ameriquest, as well as Massachusetts Attorney General Thomas Reilly and Connecticut Attorney General Richard Blumenthal, Ameriquest's business practices indicate that individual loan agents routinely circumvented the company's loan processing system to approve loans and inflate the fees and interest rates charged.
One loan officer who worked from 2002 to 2004 at Ameriquest's branch in Lincoln, R.I., says large bonuses went to salespeople who pushed interest rates as high as possible. The loan origination system put few constraints on the games a salesperson could play, according to this loan officer. "To price a loan higher, you could tweak it literally all day," he says.
Documents, he adds, were altered to show higher incomes for applicants, and appraisers were encouraged to raise valuations on properties to make loans go through.
New safeguards, such as standardized pricing and automated checks of appraisals, were deployed by the end of 2004, according to the loan officerbut only because of the threat of lawsuits and regulatory action. "They did it, essentially, with a gun to their head," he says, a year later.
But it's not just former employees who have expressed concern with Ameriquest's aggressiveness. Attorneys general in 30 states and thousands of Ameriquest customers say volume often was a product of unethical and, they contend, illegal practices.
According to statements from a class-action lawsuit filed in U.S. District Court in San Francisco early this year, loan agents routinely witnessed or participated in falsifying data that was then entered into the Ameriquest loan processing system.
Joseph Khaliq, who worked in the San Mateo branch from late 2001 to late 2003, said in a sworn affidavit that some Ameriquest loan agents would "ask borrowers to sign blank documents. After the borrowers would leave, employees would fill out the loan documents as they saw fit ... I [also] witnessed employees at the San Mateo branch forge borrowers' signatures on loan documents."
Khaliq added that on several occasions, Ameriquest loan agents would tell borrowers to write a much higher income than they truly earned in the "stated income" field on the application to ensure the loan would be approved.
"Borrowers were not asked to be nor encouraged to be truthful in this," Khaliq said in his statement.
In one 2004 case, Idanel Bonaparte got a loan for $108,000 from an Ameriquest branch in Tampa, Fla. Her financial assets included a 401(k) account worth $25,456.53.
A month later, Linda Hubbard refinanced her home with a $211,000 loan from Ameriquest. Her application also included a 401(k) account with the exact same $25,456.53 balance. And two months later, Romy Hodge refinanced her house with a $75,000 loan and, much to her surprise, she, too, was credited with a 401(k) account that had a balance of exactly $25,456.53.
Hubbard and Hodge say they did not provide this information. According to attorneys representing the borrowers in a class-action suit filed in Florida, this was an example of how loan agents were recycling legitimate financial documents to get loans approved and processed through the Empower system, which Ameriquest installed in April 2001; software that is used by other mortgage companies as well.
In fact, Reilly and Blumenthal, as well as investigators in other states, say Ameriquest agents violated state and consumer laws by using bait-and-switch tactics, such as hiding prepayment penalties and falsifying borrowers' income.
In August, Ameriquest reached a tentative agreement to pay $325 million to borrowers in 30 states. In Massachusetts alone, more than 133 complaints had been filed with the attorney general's office since 2002.
Between 2000 and 2004, Ameriquest borrowers filed 134 complaints with the California Department of Corporations, compared to 39 complaints filed in the same period against competitor New Century Mortgage Corp.
A month earlier, Connecticut's Department of Banking reached a $7 million settlement with Ameriquest for exceeding loan fee limits established by the state.
Albert and Nona Knox of East Palo Alto, Calif., detailed their experience with an Ameriquest loan agent in a pending class-action lawsuit filed in San Francisco.
According to their testimony, Mr. and Mrs. Knox received an unsolicited telephone call from an Ameriquest loan agent in early 2002. Eager to refinance their home to pay off some credit card debt and remodel their bathroom, they agreed to meet with loan agent Richard Valle at their home.
Mrs. Knox says Valle filled out the entire loan application for the couple, not once having either borrower write down any information. Mrs. Knox then presented Valle with bank statements, Social Security check stubs and pension information that documented a monthly income of $4,000.
Only after the loan was approved did Mr. and Mrs. Knox discover Valle had recorded their monthly income as $6,800.
Lisa Taylor, a former Ameriquest loan agent in the Sacramento branch, says the atmosphere at her office was very similar to the environment portrayed in the 2000 movie Boiler Room, starring Giovanni Ribisi and Vin Diesel. In fact, one manager used the film as a teaching model.
"That was your homework. Watch Boiler Room," Taylor said in her statement.
According to Taylor, promoting the anything-to-get-the-deal mentality resulted in abuses. One time, she says, she walked in on co-workers using a brightly lit Coca-Cola vending machine as a tracing board where loan agents were copying borrowers' signatures onto blank documents.
Ameriquest executives say they will no longer "tolerate any of the bad apples" and have fired employees for these types of abuses. But Ameriquest would not provide any specifics on how it conducts this improved vigilance.
"The vast, overwhelming majority of our employees are out to do the right thing every day," says Adam Bass, the company's senior executive vice president and vice chairman.
Out of 17,000 employees, the possibility that someone could manipulate the system to make a sale can never be eliminated, he says, "but when we find those people, we terminate them, and we [try to] make right everything that was wrong."
Attorneys general Reilly and Blumenthal, the investigators in states such as Florida and California, former Ameriquest employees such as Bomchill, and complainants such as Albert and Nona Knox in the class-action lawsuit filed in San Francisco, blame the company's business processes and ethics for the behavior of its loan agents.
And Bomchill and other former loan officers say Ameriquest's loan processing software, which it deployed in 2002 to help its agents speed the processing of loans, facilitated their actions.
"Ameriquest agents would use the software to qualify people for loans they weren't qualified for in the first place and were always two or three percentage points higher than they would have paid elsewhere," says a former Ameriquest employee who worked at an Ameriquest branch in Florida but spoke on the condition of anonymity. "It was standard operating procedure."
As interest rates fell to a 40-year low in June 2003, large lenders such as Ameriquest began advertising loans for potential borrowers "regardless of their credit histories."
Ameriquest and other lenders offered interest-only loans, to entice borrowers to purchase second homes or to qualify for higher-priced homes they otherwise could not afford.
As one mortgage industry veteran in New York puts it, "Anyone who can fog a mirror can get a mortgage loan in today's environment."
Because these loan agents are relying on and, in some cases, abusing the information systems used to generate the loans that have made the real estate explosion possible, they also stand to share much of the blame if and when these risky loans begin to foreclose, says Richard Harmon, vice president of scoring analytics and software for San Francisco-based LoanPerformance, a firm that specializes in developing analytical software for the mortgage industry.
"It's always dangerous to paint issues of this type with a broad brush, but it's clear that more and more people are leveraging themselves to the breaking point," Harmon says. The danger is particularly great in overheated markets, such as California and Florida.
It doesn't have to be this way. The software systems that mortgage brokers use are capable of weeding out applicants with shaky financial backgrounds. But if the same software is used to fulfill sales quotas, these systems can simply make it faster to fill out unverified reports.
Empower, for instance, automates almost half of the steps needed to process a loan. Once the application has been filled out by the borrower, the data is keyed into the system. Loan agents can enter that data directly while talking to the borrower or, in some cases, without their consent, according to Bomchill.
At the underwriting stage, the loan is passed along for review by the underwriter to determine the viability of the borrower and recommend approval or denial of the loan.
In the past, the loan application and supporting documents such as W-2s, bank statements, 401(k) statements and other financial records were kept together in one file for review.
Now, all that documentation is entered electronically at the beginning of the process by the loan agent. In some cases, the underwriter is merely reviewing the data entered into the system by the loan agent and not double-checking the actual physical documents, Bomchill says.
These steps and processes, if done properly and with proper supervision and documentation, speed up the transactions for all parties. But in some of the cases detailed in the class-action suits Ameriquest recently settled, many of the appropriate checks and balances appear to have been ignored.
Ameriquest CIO Mark Sarago says the company's information systems are designed to ferret out abuses, but he declined to offer any specifics.
"Are there ways for anyone to do anything to the software? Yes," he says. "If someone is entirely enterprising, they can find ways to beat the system. If someone really focuses on breaking something, I'm sure they can do it. But we think it's a very tight system."
The system, however, cuts out many of the verifications used to make sure the information on the loan applicationsuch as an applicant's salary or the description of the house being boughtis absolutely accurate.
With Empower, once an Ameriquest loan agent enters salary figures or other data into the system, there is no routine in the system that questions the entries to ensure there's supporting documentation, Bomchill says.
"They call it no-touch funding," says Al Bartello, vice president of sales for Fidelity National Information Solutions, the developer of the Empower system.
Which can mean no restraints as well. Khaliq and Taylor, in their statements for the class-action suit in San Francisco federal court, allege that income fields were changed by loan agents and processors to ensure that a loan would pass through the system without being rejected.
The result was that Ameriquest loan officers qualified borrowers for loans they otherwise wouldn't be approved for at annual interest rates at least 1 percent to 2 percent above the rate available to more creditworthy customers.
Bomchill says that what eventually led him to quit Ameriquest in 2003 was the unabashed joy his colleagues took in getting the highest possible rates from unsuspecting borrowers, many of whom were new to the mortgage lending industry and had less than perfect credit histories.
"These guys were cheering and high-fiving each other before the clients even got to their cars in the parking lot," he says. "They'd say things like 'I just [screwed] that couple for two [percentage] points.' It was just the atmosphere of the company. No one cared as long as the volume kept growing."
Ameriquest and other sub-prime lenders justify the higher interest rates charged to borrowers with less than stellar credit histories by the implied risk. Statistically, persons with lower credit scores are more likely to default on a loan.
Credit reports and scores used by mortgage lenders are generated by the three main credit bureaus: Equifax, TransUnion and Experian. In the 1980s, Fair Isaac Corp. developed the software used by each of the credit bureaus to give potential borrowers a rating known as a FICO score, essentially ranking the risk of a borrower defaulting on a loan.
This three-digit score ranges from 300 to 850. Those with scores of 850 have impeccable credit histories, low outstanding balances on credit cards and other loans, and have always made their payments on time and in full.
Depending on the mortgage lender and the specific FICO score selected (each credit bureau generates its own score based on slightly different criteria), lenders determine what class of loan a borrower is eligible to receive. Generally, scores in excess of 770 guarantee a borrower an "A" loan, with the lowest interest rates.
The lower the score, the higher the interest rate. Those scoring in the mid-600s might only get a loan from a sub-prime lender, usually at 1 to 2 percent above the rate available to the most creditworthy customers.
According to Bomchill, Ameriquest's boiler room-type atmosphere, where branch managers have been known to scream at, threaten and generally bully their loan agents around the clock, has pushed some agents to inflate credit scores and qualify risky borrowers for new loans.
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Brien Hanley, who worked as a loan agent in suburban Kansas City, Kan., said in his court statement that he witnessed Ameriquest employees fabricating borrowers' income and falsifying appraisals to make loans go through.
"Whatever you had to do to close a loan, that's what was done," he said in documents filed in the San Francisco court. "If you had to state somebody's income at $8,000 a month and they were a day-care provider, who's to say it wasn't?"
Hanley and Khaliq said loan agents took advantage of the company's "stated income" loan program, which required only a letter from the borrower declaring how much he or she earned.
According to these loan officers, borrowers were told what their income had to be to qualify and were often coached to invent fictitious side jobs, such as home-based computer consulting, to reach that number.
Nearly one of every six mortgages that Ameriquest brokered and then sold to Wall Street investors in 2004 was a stated income loan.
In a sworn statement filed in a recently resolved class-action suit in Redwood City, Calif., former loan officer Kenneth Kendall said Ameriquest managers encouraged employees to "promise certain interest rates and fees, only to change those rates at the time of the closing." And the Empower system made it easy to bypass these and other safeguards in favor of fulfilling Ameriquest's relentless sales quotas.
Ameriquest refuses to talk about the specifics of how its systems work.
"We're a very, very successful organization," Sarago says. "We're very comfortable with what we're doing as an organization. There are a lot of misconceptions out there. It's not up to me to clarify these misconceptions. We're a privately held company and we just don't talk about these [information-technology] issues publicly."
"Ameriquest is very tight-lipped about how they use the [Empower] system," Bartello says.
But Bartello recalls the implementation vividly because Ameriquest was the first major sub-prime lender to install the system, which "put us [Fidelity National] on the map."
Bartello says that after implementing the system for 2,500 employees at Ameriquest, the project's success helped Fidelity National became a leading vendor of loan origination software systems.
He says that 24 of the top 100 lenders in the U.S. are using some version of Empower, including Accredited Home Lenders Holding Co. in San Diego; Fieldstone Investment Corp. in Columbia, Md.; and National City Corp. in Cleveland.
"Ameriquest originally identified about 50 steps in the process, from the beginning to the end, where actual people had to handle documents and verify information," Bartello explains.
"They wanted to speed up the rate that they process these loans. The Empower system allowed them to automate about 30 of those steps."
But along with the automation came a lack of queries by the system for supporting documentation, which increased the possibility of faulty business practices.
Before software programs came along, manual processing of loans would typically require a sheaf of key financial documents to be attached to the loan application all the way from the initial prequalification stage to the underwriting phase.
At each stop, different employees in different departments would have the physical copies of W-2 reports and paycheck stubs staring them in the face, Bartello says.
Even if employees weren't inclined to make substantial inquiry into each of the thousands of loans processed at any Ameriquest branch in a given month, there was ample opportunity to even accidentally notice discrepancies in the financial paperwork provided, Bomchill says.
Now, all of this data is managed electronically, leaving employees at each stage of the loan process to rely solely on the authenticity of the information displayed on the screen.
Indeed, the quality and integrity of the financial data entered by the loan agent into the initial application is rarely if ever verified as the loan winds its way through the system.
"The idea is that once the data is entered, it can be used again and again electronically without being touched or reviewed by others as the loan is processed," Bartello says.
But now Ameriquest is seeking greater control over how it configures and manages loan data in its system.
Ameriquest says it implemented a new software system in 2002 called SNAP, for Sales Navigation and Accelerated Production.
The program was to help enforce fair and uniform loan pricing, validate appraisals and enforce the distribution of legally required disclosure documents to consumers.
By coding rules for loan pricing into software, Ameriquest says it has limited the ability of sales representatives to raise interest rates or points arbitrarily, or to engage in what could be construed as bait-and-switch schemes.
In most cases, Ameriquest officials say, the loan pricing is set by the software, not the salesperson.
Executives describe these changes as part of a "continuous improvement" process at the company, but the new systems also helped address some of the fraudulent or unfair lending practices Ameriquest has been accused of in the past.
Bartello says the Empower system was originally configured with the minimum amount of constraints on the application and pricing portion, the fields that allow agents to input the fees and rates for a specific loan.
Then Ameriquest replaced a hodgepodge of lead and contact management applications with SNAP, which operates through a Web browser.
SNAP was created with help from Tavant Technologies, a software development consulting firm with offices in Santa Clara, Calif., and Bangalore, India, that Ameriquest uses partly for its offshore development resources.
Although Tavant is an independent private company, Ameriquest chairman Roland Arnall owns a majority of its shares and Sarago was Tavant's chief technology officer before Ameriquest hired him as CIO in 2003.
SNAP overlaps with Empower at the front end of the loan origination process and includes a complete product and pricing engine that allows agents to adjust rates and fees at their discretion, Bartello says.
Sub-prime lenders typically add a 1 percent fee to the cost of a loan because of the higher risks in extending loans to these applicants. But the original Empower system was configured to allow loan agents at Ameriquest considerable freedom in pricing loans for their clients.
"We can make it completely restrictive if a client wants, or leave it open and apply the basics to allow adjustments," Bartello says. "Ameriquest left it open to the loan officer. Our view is that once they buy the car, they can do what they want with it. They have the tools themselves."
"SNAP does everything that Empower doesn't," Sarago says. In particular, it goes beyond merely recording loan applications to helping mortgage salespeople close more business by making it easier for them to track contacts and sales leads, and then select the loan products most likely to appeal to each customer. Previously, different branches used different sales software systems.
"The goal is to have consistency throughout all the branches," Sarago says.
Former Ameriquest loan agents and mortgage software vendors who are familiar with Ameriquest's systems see SNAP as a step toward replacing Empower with a custom, Web-based system with more safeguards, such as standardized pricing. For now, Empower remains the dominant system in Ameriquest's underwriting department, while sales offices primarily use SNAP.
But Sarago says Empower could remain in place at Ameriquest for years to come. Even so, Ameriquest says it has deployed other new software systems that it maintains will cut down on problems with loans.
In interviews, Sarago confirmed or clarified information gleaned about its system by Baseline. He also denied the software was responsible for any allegations made in the class-action suits.
For example, he says Ameriquest has implemented fraud prevention systems, but would not say either what those prevention techniques are or even whether the company is working with any of the antifraud software or information services vendors that focus on the mortgage industry.
Customers, however, do care about the details.
More than 1,800 borrowers in California, Texas, Alabama and Alaska claimed in a suit originally filed in 2000 in San Mateo County, Calif., that Ameriquest agents misled them about the cost and terms of their loans and, in some cases, fraudulently misrepresented their financial information, including their annual salaries and the value of their investment portfolios and other assets. In March 2005, Ameriquest agreed to settle the San Mateo suit.
The company finalized the settlement in June, agreeing to pay up to $50 million to borrowers who allegedly were victimized by bait-and-switch tactics, such as adding prepayment fees to loans after the initial loan terms were determined.
If this keeps up, according to the American Banker, a trade publication, "a potential settlement [of class-action lawsuits by borrowers] could top the record $484 million that Household International paid in 2002 to settle predatory lending allegations by regulators from all 50 states."
Ameriquest denies any wrongdoing, but noted in court that it was looking to its systems to curb any abuse.
In the June class-action settlement, for instance, the lender said in court papers that the potential for such abuses was eliminated by a switch to a benchmarked loan pricing software system, implemented in 2003, "which substantially eliminates discretion from branch personnel to change loan terms in a pattern of bait and switch."
The software was designed, according to the statement, "to ensure systemwide use of risk-related criteria in loan pricing, and reduce the possibility of discriminatory or discretionary loan pricing at the branch level."
(Ameriquest limited the settlement offer primarily to consumers who claimed to have been misled about the terms on loans issued prior to 2003, when the pricing software was introduced.)
Ameriquest officials say this is a reference to a software "engine" for enforcing pricing rules that is integrated with both its loan origination system and its newer mortgage sales portal, SNAP.
Because the pricing rules are based on objective factors for determining risk, such as the applicant's income or the ratio of the loan amount compared with the value of the property, the software helps prevent discriminatory pricing or arbitrary price changes.
A former systems consultant to Ameriquest reviewed the pricing system while it was in development and found it to be well designed and fair.
According to the consultant, the system uses more than 80 factors to determine the risk and price of a loan, such as the ratio of the loan amount to the appraised value of the home.
It was still possible to alter the pricing recommended by the software, the consultant says, but the salesperson would need to get approval "from two levels up in management" to make that change.
While Ameriquest prefers to paint the addition of this pricing system and other antifraud measures as part of its "continuous improvement" processes, it's also easy to see it as a reaction to lawsuits and regulatory scrutiny, says Craig Focardi, a TowerGroup analyst who studies technologies for consumer lending businesses.
Meanwhile, the financial crimes unit of the Federal Bureau of Investigation told Baseline that it is investigating allegations of fraud in the mortgage industry, but the agency would not elaborate.
"We cannot identify any specific companies in our investigations," says an FBI special agent who spoke on the condition of anonymity. But, he said, "we're taking a close look at mortgage lenders throughout the country."
That itself could improve systems. "When you start thinking in terms of being caught by the FBI, it goes from a cost of doing business to being put out of business," Focardi says.
Ameriquest is not the only mortgage firm scrambling to improve its underwriting standards and fraud prevention processes, Focardi says, "but they do have a big target on their back" because they are the largest sub-prime lender.
Although systems changes did make it harder for Ameriquest agents to play games with loan terms, some of the abuses continued, according to the former Rhode Island loan officer.
For example, to comply with the Real Estate Settlement Procedures Act of 1974, Ameriquest devised a system that would trigger the automatic printing and mailing of new disclosure documents, as well as notification of a mandatory delay in the closing date if a loan was changed, for example, from a 30-year fixed-rate mortgage to an adjustable-rate mortgage.
But some salespeople discovered that they could avoid the delay by making the change in Empower rather than SNAP, according to the former Rhode Island loan officer.
Arthur Prieston, a mortgage lawyer who offers lenders insurance against fraud-related losses through his Prieston Group in Novato, Calif., doubts that there is a technological solution to mortgage fraud.
Software products can flag suspect loans, but ferreting out fraud still requires a large dose of human understanding and investigation, says Prieston, who co-authored the book Mortgage Fraud: The Impact of Mortgage Fraud on Your Company's Bottom Line for the Mortgage Bankers Association.
"Those tools, although effective to some extent, have their limitations," he says. "We estimate they can reduce less than 20% of the fraud experienced."
Ameriquest and the rest of the mortgage industry are now at the front lines of what many economists call the greatest threat to the U.S. economy since the technology stock implosion.
"In my mind, it probably doesn't take a rocket scientist or Warren Buffett to figure out how serious this problem has become," says an analyst at JP Morgan Chase & Co. in New York.
In July, Federal Reserve Chairman Alan Greenspan repeated warnings about the increase in exotic mortgagesespecially interest-only lendingand referred to the "speculative fervor" that has driven up prices in some markets.
One month later, on Aug. 9, the Federal Reserve Board raised its benchmark overnight lending rate to 3.5 percent, the tenth increase in the past 14 months. In June 2004, the overnight lending rate had been 1 percent, a 46-year low.
Whether Greenspan's moves prick this bubble or whether surging oil prices push the economy into recession, the risk is this: Those sub-prime borrowers may run out of rope. If times get tough and they have to sell their homes, they could lose them if they can't sell. And if they don't want to sell, they still may lose them, if they can't make the payments.
"There are lots of people out there who have stretched themselves to their credit limit," LoanPerformance's Harmon says. "Those are the people who are at the greatest risk."
In fact, the amount of lending to sub-prime borrowers has more than quintupled in the last 10 years, from $91 billion in 1995 to an estimated $516 billion last year, according to SMR Research Corp., a Hackettstown, N.J.-based market research firm. SMR studies show that sub-prime lending accounted for more than 22 percent of all mortgage lending in 2004, up from just 9.4 percent in 1995.
The stretch can be seen this way: the U.S. Department of Housing and Urban Development recommends homeowners spend no more than 30% of their annual income on paying off mortgages.
A study by the Joint Center for Housing Studies at Harvard University, however, shows nearly one in three American households now spends more than 30 percent, and one in eight spends nearly 50 percent. In California, one in five households spends more than half its income on housing, according to the Public Policy Institute in that state.
And borrowers are increasingly being encouraged to take on as much debt as they possibly can to live in a home. According to the National Association of Realtors, 42 percent of all first-time buyers and 25 percent of all buyers made no down payment on their home purchases last year.
But it's one thing for people to stretch themselves to their credit limit. It's another for them to be misled into debt they can't afford.
Gartner analyst Richard DeLotto, who studies banking industry technologies, says the most serious problems of the mortgage sector are based on self-deception, both by mortgage lenders and by consumers.
"It's not a technology problem, it's a business case problem," DeLotto says. "Businesses have been willing to price in the risk of loans going bad based on the idea that property values always go up and no matter how bad their loans are, equity is going to increase faster than their risk."
While the mortgage industry likes to talk about problems of quality control rather than fraud, DeLotto says the errors "tend to be skewed toward anything that makes the loan happen."