“That’s Kim’s house. Hers was one of the last 100% financing loans I did. I guess she’s not here anymore.”
Mark Dziedzic stands outside a Spanish-style three-bedroom house in Maricopa, Ariz. Incorporated in 2003, Maricopa was a fast-growing subdivision outside Phoenix during America’s recent housing boom. But this day, the town has a deserted air. A sign in Kim’s window, posted by the local property management association three weeks earlier, indicated the house is vacant. It asked the owner to return to claim it.
Dziedzic was one of hundreds of thousands of people in the real estate business America-wide who helped arrange mortgages during the boom, using the exotic financing instruments that made credit so accessible to so many. Kim was one of his last clients. She decided to buy a house as an investment property in 2006, when prices were going up. But by 2007, she was having trouble finding renters, and the interest rate on her no-money-down option ARM (adjustable-rate mortgage) had reset, jacking her mortgage payments. By early 2008, she walked away. Mark Dziedzic has since changed jobs. And the bank was left with the liability.
A version of this story has been playing out across thousands of American municipalities and subdivisions since 2007. Borrowers with poor credit stopped making payments on their loans, and homes went into foreclosure — in record numbers. RealtyTrac Inc., an online organization that tallies foreclosures in the U.S., reported 272,171 such properties in July. That’s a 55% increase from July 2007; according to RealtyTrac, one in every 464 U.S. households is now in foreclosure.
At the same time, U.S. property values began to implode. In Phoenix alone this past June, they averaged US$153,000, down from a peak of US$227,000 in June 2006, according to the latest S&P/Case-Shiller home price report.
The legacy of those easy-money mortgages, combined with the crashing housing market, is a prolonged credit crunch. One year after the crisis first hit, it continues to wreak havoc on the U.S. financial system — not to mention the global economy.
At press time, U.S. Treasury Secretary Henry Paulson had just announced details of a federal bailout of the two U.S. government-sponsored mortgage lenders, Fannie Mae and Freddie Mac, which teeter under the weight of US$5.2 trillion worth of debt and guarantees on their books. (As of the end of December 2007, these debts were supported by US$83.2 billion in core capital — a gearing ratio of 65 to one.) Both lenders had seen their stock fall by an average of 85% this year.
The seeds of this bailout were sown earlier in the summer. On July 10, intense short-selling on the New York Stock Exchange drove Freddie’s shares down 22% to US$8 per share; Fannie’s fell 13.8% to US$13.20. A few days later, Paulson asked for — and eventually got — an unprecedented guarantee from Congress that it would provide financing to ensure Fannie and Freddie do not fail.
On September 7, Paulson used that guarantee, announcing that the Treasury would be taking control of both lenders and placing them into conservatorship. That, of course, means the U.S. taxpayer is now on the hook to bail out both government-sponsored enterprises — at a cost estimated anywhere up to US$200 billion.
How did the mighty U.S. economy fall this low? There are many answers, but the catalyst lies in events that took place in Phoenix and thousands of other municipalities in the south and southwestern United States, in a housing market where for too long, for too many, the pricing of risk was turned upside down.
It was a market where almost everyone involved bet on the notion that housing prices couldn’t fall. Lucrative incentives at each level of the financial food chain spurred banks to issue more and more mortgages, to borrowers who were required to show less and less proof they could make their payments. That, combined with a large dose of greed and opportunism, helped steer the runaway credit train over a cliff.
It’s a tale Mark Dziedzic knows all too well. Driving back from Maricopa to his office in northeast Phoenix, he says he quit his brother’s brokerage, RealCore Realty, in 2007, because he just wasn’t comfortable with the deals he was doing. “People were qualifying for financing who had no business doing so,” says Dziedzic. “Kids of 25 were coming in, telling me they were going to buy a house. People whose debt-to-income ratio was 55%. All people saw was free money. And the banks were willing to give it to them — so they went for it.”
A tall man in his early 40s with a taste for travel and adventure, Dziedzic toured the world as a gourmet chef before going into financial planning in Toronto. He moved down to Arizona in 2005 to work with his brother David in real estate at the height of the housing boom.
Dziedzic ended up securing financing on mortgages for, well, pretty much anyone, because at the time, pretty much everyone was qualifying for loans. The mortgage products available featured new financing instruments designed to help more people cash in on the boom. These loans acquired funky acronyms like NINA (no income, no assets), NODOC (no documents) and NINJA (no income, no job, no assets). For a brief window — roughly 2004 to the end of 2006 — almost anyone could buy into the American dream of home ownership.
At the time, U.S. housing prices, which hadn’t seen significant depreciation since the Depression, were spiking — in some markets, by 50% or more in value. Many bought into the dream of buy-to-flip: buy a house, then sell it a few months later, pocket the appreciation, and go on to buy more properties. “People thought they would be able to make a quick buck, because prices were going up so quickly,” says Dziedzic.
Borrowers with terrible credit were able to access 100% financing from such lenders as IndyMac Bank and Countrywide Financial, which has since been taken over by Bank of America. The incentives for those arranging the loans were significant: cuts ranged anywhere from US$1,250 per loan — which Dziedzic says was his average rate — to a US$10,000 commission on new mortgages. Whether the people borrowing could afford their mortgages seemed to become a moot point.
Dziedzic started out selling insurance for his older brother, but he found it hard to make headway. “I was making US$50 to US$60 a deal,” he says. “So I got my real estate licence and started assisting my brother with the real estate business.” The two opened RealCore Realty in a Phoenix office on Feb. 1, 2006. But the plan to work together slowly unravelled, as the brothers clashed on everything from how to drum up business, to what kind of business to take on in the first place.
David Dziedzic is blunt as to why things went sour. “Mark wasn’t pulling his weight,” he says. “I’d bring in 29 real estate agents, he’d bring in one.” David claims Mark worked on “maybe three to five” real estate deals that David had passed on to him. As a result, David felt Mark didn’t deserve a percentage from the company’s sales. (At the height of the boom — summer 2005 to summer 2006 — the elder brother estimates he, individually, pulled in US$15 million in deal volume.)
Mark Dziedzic, meanwhile, maintains that David was running the show, leaving him little room to manoeuvre. “I had no influence on his business and the decisions he made there,” he says. Mark focused instead on earning commissions by arranging loan financing on deals David’s agents sent him.
As the boom heated up through 2006, however, Mark says he became increasingly uncomfortable with the terms of the deals he was doing. “Agents were screaming at me,” he says. “And I’d be saying, ‘Look, there’s no way this person should be getting this loan.’”
David disputes Mark’s version. “No one was holding a gun to his head,” he says. “And I certainly never told him that he had to do those loans in order to get business.” In fairness, David acknowledges Mark probably felt pressure to perform. “He may have felt that by not doing the loans, he might lose that particular agent’s business,” says the elder brother. “Back then it was so easy to get a loan. If the agent didn’t get loans from Mark, he could’ve easily got them from someone else.”
Mark Dziedzic ultimately left his brother’s brokerage in September 2007. With the credit crunch in full swing by August, he says he’d lost confidence in the business model. “A friend was saying, ‘This thing is going to be uglier than you can even imagine. This is going to make the tech bust look like a walk in the park.’”
Dziedzic knows he helped secure loans for people who couldn’t really afford them. Did his clients understand what they were buying? “Hard to say,” he answers. Dziedzic claims that only once did he put through a bona fide sub-prime loan, for a guy who, he says, “worked for US Airways and had inherited a whole ton of money,” but had “less than stellar credit.” The interest rate? An eye-popping 7.9%.
Dziedzic also did a few option ARMs. Those are adjustable rate mortgages, the ones with low, teaser interest rates that subsequently jumped — making it hard for many to keep up their payments. “One was for a realtor,” says Dziedzic. “I don’t remember the exact details. The start rate might be 2%, but that would go up. You would have to refinance and take whatever rates were available at the time. I told them, ‘Look, you need to be making at least the payments on your interest.’ But did they really truly understand it? Yeah. Maybe.”
The system worked on the assumption that the buyers and the bankers were the ones who should make the call on whether the loan should go through. Dziedzic says he stressed to people that they would need to be able to make their interest payments, and pointed out the clauses in the deal that showed the risk they were taking. “But all they saw was easy money,” he says.
Worst of all were the guys making loans on margin, Dziedzic says — something he emphatically denies doing. “Some would sell a client an adjustable rate mortgage with a 3.5% margin. The consumers had no clue what that meant. They didn’t truly understand.” Loans with a 1.75% margin could make the broker US$500 or US$600 on the deal; loans with a 3.5% margin meant the broker could make US$6,000 to US$10,000 on the same deal, depending on the size of the mortgage taken out. “On a sub-prime deal,” says Dziedzic, “that could go up to US$12,000.”
Of course, buying property on margin meant both the interest rate and any losses on the investment would be similarly amplified, once the rate reset — with a larger proportion of the buyer’s capital going back to the lender in the case of a loss. But there weren’t supposed to be any losses, remember, because housing prices would never go down.
Unfortunately for the rest of the world, the alchemy that turned bad mortgages into good business didn’t end at the point of sale. That golden opportunity to make money off the considerable risk these instruments represented was then sold on up the financial food chain, sliced and diced into the now-famous collateralized debt obligations, or CDOs, and other securities backed by sub-prime mortgage debt.
Supposedly neutralized through diversification, the risk these mortgages represented spread globally. And at each transaction, the fees these instruments could earn their traders mushroomed, in keeping with their level of risk and leverage.
But just like those buying the mortgages in places like Maricopa, few of the traders buying and selling securities backed by that debt really understood the risk they took on. (The president and CEO of TD Bank, Ed Clark, has since gone on record saying he ran numbers on these various exotic instruments, decided they were too complicated for traders or investors to understand, and steered clear of them.) It was a potent equation: ignorance plus cheap credit plus greed plus opportunism plus herd mentality equalled global financial disaster.
Some, including Mark Dziedzic, have expressed fears that the Canadian mortgage market is in for its own sub-prime shock in places out west and in Toronto, where house prices have spiked recently. If that were to happen, the Canadian taxpayer — bound by law to back up 90% of the insurance taken out through private insurers against the risk of mortgage default — might be in for a rough ride. (The total value of the mortgage market in Canada is now $900 billion; by 2010, it is projected to rise to $1 trillion.)
It’s a thought that clearly occurred to those making policy on the mortgage file at the Department of Finance in Ottawa. Mindful of taxpayer exposure, the federal government announced in July that it would no longer back mortgage default insurance on a raft of relatively new mortgage products. These included mortgages in which the bank was lending more than 95% of the money; mortgages that would be amortized over 35 years; and successful loan applications where the credit score of borrowers was less than 620.
Still, fundamental differences in the way Canadian and U.S. mortgage markets are run make a sub-prime-style meltdown here all but impossible, according to Jim Murphy, president of the Toronto-based Canadian Association of Accredited Mortgage Professionals. “In the U.S., the vast majority of mortgages are securitized,” explains Murphy. “That means they are sold on to a third party. In Canada, by contrast, 60% of mortgages are kept on the lenders’ balance sheets. We do have a securitization market, but it is much smaller than the one in the U.S.” (According to Nancy Hughes Anthony, president and CEO of the Canadian Bankers Association, about 20% of all Canadian mortgages are securitized.)
There are also important differences in the way that Canadians and Americans insure their mortgages. In the U.S., many of the more exotic loans didn’t require insurance, reducing borrowers’ costs — but exacerbating the risk of default. “By contrast, in Canada, by law, home buyers have to take out mortgage insurance on any mortgage in which the borrower puts less than 20% down,” says Murphy. That adds a premium to the cost of the mortgages, reducing the risk that banks could issue mortgages to those who cannot afford them, and insuring the mortgage against default.
Back in Arizona, Mark Dziedzic has decided Canada is where it’s at — at least when it comes to selling real estate from the ashes of the Phoenix market’s meltdown. After leaving his brother’s business, Dziedzic started Arizona for Canadians, a full-service real estate brokerage that sells discounted U.S. properties in Phoenix, Scottsdale and Tempe to Canadians looking for a second home in the sun. “When I look back on what I did, do I have regrets? No, I never did anything wrong. But the lessons I learned are significant. When things seem like they are too good to be true — they probably are.”
Few guessed just how expensive the myth of free money would turn out to be. And the craziest part is, the crisis isn’t over yet.