Foreclosure Nation

By Kristin Goff
The Ottawa Citizen
Oct 13, 2007

CLEVELAND - Mariah Crenshaw is not the least surprised when she leads a reporter around the back of a dilapidated house two doors down from her home and sees that thieves have been at work.

A board that was used to nail the back door shut has been pried off. Inside, there are holes smashed in walls where copper tubing has been ripped out, doors have been removed, light fixtures are gone and moisture in the walls has the paint weeping off in ugly chips that cover the worn rugs.

The thieves have even left the knife they used to pry open the door laying on the back stoop.

"Smart," says Ms. Crenshaw, an activist who is fighting foreclosure on inner city homes, including her own. "They even left their fingerprints."

Not that anyone would care. There are thousands of such homes in Cleveland where the subprime mortgage crisis is up-close, ugly and very personal.

Last year there was one foreclosure for every 98 households in Cleveland and surrounding suburbs, making it the worst hit city in Ohio, according to Policy Matters Ohio, a non-profit group. It is also one of the 10 hardest hit cities in the United States, according to RealtyTrac Inc., which reported foreclosures rose to a record rate of one per every 510 households in August nationally.

Officials expect 16,500 foreclosures in 2007 in Cuyahoga County, which includes Cleveland and surrounding suburbs, an area of 1.3 million people. The expected foreclosures are up 21 per cent from last year and almost one and a half times the number just six years ago.

The flood of foreclosures is compounding problems in this midwestern, blue-collar city, which was largely left behind in the economic boom that swept the U.S. in recent years. Although problems are now showing up in suburban and affluent neighbourhoods, the lion's share of foreclosures are in inner city neighbourhoods, populated largely by African-Americans. Subprime loans -- designed for people with a higher risk of default -- were heavily promoted there in recent years.

"The damages are so profound in Cleveland, we are not just returning properties that are in foreclosure (to lenders), we are creating huge empty neighbourhoods," says Mark Wiseman, director of the Foreclosure Prevention Program,

a county-backed program that co-ordinates help for people who face foreclosure or in danger of defaulting on their mortgage loans. "There are entire neighbourhoods in this city that will have to be bulldozed."

Within 72 hours of a house being vacated, it is looted for scrap metal. Copper piping is ripped

out of the inside, anything of value

is taken, aluminum siding is stripped from the outside. It is all carted off to scrap yards where the stuff is bought and no questions are asked, said Mr. Wiseman.

What is left is a shell that costs more to repair than the house is worth.

"It becomes a pile of rubble."

These boarded up shells are one visible legacy of the subprime mortgage crisis that rocked markets around the world, created tens of billions in financial losses in a global credit crunch and now threatens to throw the U.S. economy into recession, dragging down Canada's growth prospects with it.

RealtyTrac Inc., of Irvine, California, a company that maintains and sells information from a database of repossessions, expects two million foreclosures in the United States this year, up from 1.2 million last year and less than 850,000 in 2005.

The story of how troubled loans in Cleveland and elsewhere are tied to such far-flung financial events is not a straightforward tale. But greed, deceit and some clever ideas gone horribly wrong, all played a role.

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At the heart of the problem was the idea that you could manage risky mortgages if you pooled the debt with other less risky ones, then sliced and diced them into various investment vehicles, with predictable risk profiles. One popular product was the collateralized debt obligation (CDO) which created three types of securities -- all of which depended on payments from the mortgages to provide their income streams. The highest rated securities, it was thought, would be almost as safe as government bonds and for a long time they got the highest investment grade ratings from bond rating agencies.

Not only did the top rated securities reflect higher quality mortgages, the CDO was structured so that any problems caused by defaults on mortgage loans would first be written off against the medium and high risk securities created in the other two slices

of the CDO. Complex algorithms were used to calculate risks for the pool and its various component securities, which were designed for institutional investors, not individuals. But when loan defaults and foreclosures began to skyrocket at rates much higher than anticipated, it cast doubt on how safe any of the mortgage-backed securities were.

In the era of low interest rates, which started in the early part of this decade, there was a ready market for investments which promised higher returns than safe government bonds and treasury notes, which mortgage-back securities and their various spinoffs did.

The idea of passing the debt-backed investments from finance company to Wall Street banker to conservative pension funds and high-risk hedge funds and beyond, was also expected to provide a measure of safety, because it would diversify the risk among investors around the world.

Instead, the links provided channels that helped spread a financial contagion from the United States across the globe knocking hundreds of billions of dollars worth of value off global credit and stock markets, as questions belatedly arose over the true value of such asset-backed investments.

The system of selling and reselling the mortgages also created a yawning gap between those who wrote the loans for consumers at the street level and those who invested trillions of dollars in the securities that were spun out of them.

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The crisis has caused those in the investment and banking industry to rail against the "lack of transparency" about the level of risk contained in various mortgage-based securities. Those who borrowed to buy or refinance their homes, meanwhile, complain of fraud, lies and gouging.

Sylvia Walker, at 73, is caught in the middle of a situation she still doesn't fully understand. After getting one reprieve, her small bungalow is due to be sold at a sheriff's auction soon.

Things were tight after her husband went into a nursing home in 2005, so she was interested when a mortgage broker called to suggest he could solve her money problems by refinancing her mortgage.

He convinced her to increase the mortgage from $50,000 to $85,000 so she could pay off the car and other debts and take out $10,000 in cash for home repairs, as well.

Within days, repairmen who introduced themselves as friends of her mortgage broker began showing up at her door, uninvited. The first offered to fix her roof for $10,000. A second said he could do the windows for $7,000. It was a common ploy in Cleveland where the elderly have become targets in a home renovation scam with a new financing twist. Often, people would go door to door pointing out fictitious or real repair problems to elderly homeowners, then help them to refinance their mortgage to pay for the work.

Mrs. Walker didn't bite when one of the renovators offered to fix her roof. "I told him, I would choose who I wanted to do it," she recalls.

In the end she used the $10,000 from her refinanced loan to deal with other personal expenses when her husband passed away and her son ran into financial problems in 2006. Later that year, Mrs. Walker fell behind on the $694 monthly payment on her refinanced mortgage.

By then her loan had been sold to another company. They offered to refinance again, provided she paid a penalty of $543. She did, but the company started foreclosure procedures anyway. They told her the payment arrived too late, something Mrs. Walker disputes.

After the intervention of a consumer advocacy group, her current lender has made another offer. If she pays $1,500 up front, and $98 more per month for her mortgage, they'll let her keep her home.

On a fixed income of $1,100 a month, a monthly payment of almost $800 seems impossible, unless her grown son moves home to help.

"Right now, I feel kind of disgusted," she said. "I don't know if I want to keep it or not. Cause you got to pay your utilities or they cut them off."

Selling it is impossible, since what she could get in Cleveland's depressed market wouldn't come close to the value of her mortgage.

Ironically, the independent loan brokers who get paid a commission for mortgages and refinancing they write, are still calling.

Just two weeks earlier, a man who worked for the company that talked her into refinancing the first time telephoned, she said in an interview.

"He asked me, had I thought about refinancing again. I told him the house was in foreclosure," she said. "So, he wished me luck and hung up."

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Independent mortgage brokers don't work directly for banks or finance companies but write loans for them in return for a commission.

The bigger the loan, the bigger the commission, so they cram everything they can into them, including old car loans, home renovation funds, or cash for any reason, says Ms. Crenshaw, who describes herself as a "victim of predatory lending." She has become a vocal advocate of homeowner rights, as a member of ACORN (Association of Community Organizations for Reform Now), which is pushing for tougher treatment of bad lenders.

Some brokers can also earn a bonus if they manage to write a mortgage with a higher interest rate than would be necessary, based on their customer's credit rating score.

Mr. Wiseman calls it "a legal kickback" in which the borrower ends up paying more for getting ripped off by their loan officer.

Since there were no education or licensing requirements for national mortgage loan officers in Ohio, everyone from religious leaders to ex-drug dealers were writing mortgage loans at the height of the craze, officials said.

"There are no ethics, there's no accountability, there is just nothing to keep these people from doing what they want," said Ms. Crenshaw.

She complains that enforcement action was slow in coming and that emboldened fraudsters.

A special task force, formed to crack down on predatory lending in Cuyahoga County two years ago, announced action in August on its first case against seven people, who are accused of filing forged and falsified documents to write subprime mortgages and pay themselves various fees associated with them. A 65-count indictment includes charges of racketeering and conspiracy of mortgage fraud.

Ms. Crenshaw's small two-storey house, in a tree-lined older neighbourhood on 119th Street is one of 38 in a one-block radius that has been foreclosed on. And those are only the ones she knows about because they are boarded up or marked for sale.

Like many in the United States, where mortgage loans are commonly written for terms of 20-to-30 years, Ms. Crenshaw, 41, had refinanced several times before her latest loan, which is now in default.

She got a small mortgage of around $20,000 about a dozen years ago, when she inherited the family home after her mother passed away.

Since then she has had two accidents, a divorce and illness. She refinanced four more times until her latest mortgage was $78,000.

"At the time, I was making these decisions, they seemed like very sound decisions," she said. "Now -- No. I was duped by charms and lollipop banking -- I was a sucker all the way."

Ms. Crenshaw is angry that the broker who wrote her last mortgage "inflated the property value and her income" to qualify her for a larger loan.

He promised to lower her payments from $735 in her previous mortgage to $584, including taxes and insurance, while extending the loan's term from 20 to 30 years.

It was important because she was living on disability at the time. Her income including child support was only $1,200 a month, said Ms. Crenshaw.

The paperwork was done in a rush before the U.S. Thanksgiving holiday weekend last year, she said. After the loan went through, Ms. Crenshaw found out taxes and insurance weren't included in the $584 payment. A promised cash-out of $7,000 was $2,000 short. Her lender filed to foreclose on the house after two months when she fell behind in her payments.

Unlike many who simply walk out the door or wait for the sheriff to evict them, Ms. Crenshaw hired an attorney to fight the foreclosure, using money from the mortgage payment she no longer makes.

Once she did, her lender offered to renegotiate the loan. But she has refused.

"Something is wrong with this process. I didn't want to go through it again," she says. "They did something wrong. In court, we got (the loan's) paperwork in discovery. I didn't sign half that paper."

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In the strange lingo of the subprime loan world, the type of mortgage Ms. Crenshaw got is sometimes called a Ninja loan -- for No INcome, Job or Asset verification. In other words, the loans were written up without any requirement that the borrower provide documents to prove that they had the ability to repay what they were borrowing. It was a common feature of subprime mortgages all across the country.

"When you offer a product that doesn't require any documentation, they are just liar loans," says Lou Tisler, executive director of Neighborhood Housing Services of Greater Cleveland. "You'll have people say I make $5,000 a month because I am going to run a daycare in this big house I'm going to buy."

At the same time, the finance industry and mortgage brokers participated in the fraud to an even greater degree, he says. Appraisals were routinely inflated and had more to do with how large a loan the broker, bank or finance company wanted to make, than the true property value, he said.

The industry aggressively pushed products designed to produce big loans so everyone could get their cut. Many were also designed to force people to refinance again and again, or lose their home if they couldn't, said Mr. Tisler.

The product that is designed to keep homeowners refinancing is aptly nicknamed "the exploding ARM." It is an adjustable rate mortgage with a hugely popular twist. In the first two years of what is usually a 30-year-loan, the mortgage offers a low fixed rate -- one that can get a new buyer into their house -- but the rate is reset starting in the third year. Exact terms vary by loan. But the monthly payment can quickly reach double its original amount in loans Mr. Tisler has seen.

An estimated $700 billion U.S. worth of ARMs, most issued in 2005-2006, will hit their rate reset dates by the end of 2008. Nearly three-quarters of those are subprime mortgages, according to industry estimates. With property values falling and finance terms tightening, the upcoming rate hikes represent a ticking time bomb that analysts suggest will make loan problems much worse next year.

The attention that the subprime mortgage problem is finally receiving has a bittersweet taste to Mr. Tisler, who says complaints about aggressive and predatory lending were met with indifference in the past.

"It was always seen as -- 'oh, it is some family in Cleveland that overextended themselves and they really shouldn't have been in that house...'" he said. "Once there was blood on the street --Wall Street -- it was 'oh, we're losing money. We'd better do something, we're past the point of acceptable losses'."

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Such loose lending practices were popular not only in "rust-belt" cities such as Cleveland and Detroit, but also in the U.S. sun belt states such as Florida, California, Nevada and Arizona. In those markets, house prices spiralled upward during the boom. Investors and speculators took out many mortgages with no money down and easy terms to start. So did existing homeowners, who were encouraged to use their mortgages as cash machines taking out money for everything from vacations to home renovations, by refinancing into larger mortgages. Interest on mortgages in the United States is tax deductible, so it wasn't always such a hard sell.

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In Canada, where the housing market continues to perform relatively well, subprime lending is a much smaller portion of the market, amounting to about five per cent of new mortgages, compared to nearly 25 per cent in the U.S., according to CIBC World Markets.

It was a niche market that was growing fast until the credit market meltdown this past summer. CIBC economist Benjamin Tal estimates subprime loans in Canada grew at 50 per cent last year and had been growing at around 40 per cent in the first half of this year until the freeze up in credit markets caused alternative lenders to either withdraw subprime loan offerings or crank up fees and financing costs, discouraging borrowers. Subprime lending may slow to only a fraction of its previous growth in the immediate future, said Mr. Tal.

Jim Murphy, president of the Canadian Association of Mortgage Professionals, says Canadian lenders are more conservative and cautious in qualifying borrowers for subprime mortgages so there's little chance Canada would experience American-style default problems, even if the housing market slows substantially.

Still there are signs that the more aggressive U.S.-style lending has jumped the border in some respects. The entry of more U.S. default insurers into the Canadian market, appears to have pushed the Canada Mortgage and Housing Corporation into liberalizing some of its rules, for example. CMHC's mortgage default insurance now covers no downpayment mortgages, interest-only payment loans and loans that stretch the amortization period to 40 years.

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In the United States, the housing market began to slow around 2003, but the demand for mortgage-backed investments did not. It was during this period, analysts say, that the seeds of the credit crisis were sewn.

As the volume of standard or "prime" mortgage loans dropped in half from $3 trillion in 2003 to $1.5 trillion in 2006, lending for subprime mortgages more than tripled from $400 billion to $1.4 trillion last year, according to TD Bank Financial Group (all figures in U.S. dollars).

Standards for supposedly more creditworthy mortgage lending loosened as well.

Richard Kelly, senior economist at TD Economics, says it was not just the growth in subprime lending, but the speed with which it happened that helps explain how sophisticated investment banks and funds were blindsided when things began to unwind.

"I think it was just this rapid pace over just a couple of years and no one was able to keep track of what was happening," says Mr. Kelly. "There was a bit of a lag about what's going on on the street corner, the fact that they were using these Ninja loans and liar loans to get mortgages to people that were maybe out of their price range. It wasn't quite clear what was going on and how widespread the practice had become until it was too late."

The dizzying complexities of the various mortgage-backed securities and the way various parties were separated into their own distinct worlds, also may have created a false sense of security among the players.

When investment banks packaged pools of mortgages into collateralized debt obligations (CDOs), they sliced it into three parts with different rates of return and risk.

Those who invested in the least risky, lowest return, slice of the CDO felt secure that potential loan problems, if they occurred, wouldn't reach them.

Specialized hedge funds, which sought higher returns from high-risk end of the CDO, had the biggest appetite for this debt security. They leveraged the investment in a several ways, amplifying gains, but also aggravating the crash when things got ugly.

There was another type of financial wizardry that used debt from 30-year mortgages as assets to back the sales of short-term commercial paper, which offered a higher paying alternative to short-term government notes and was in high demand.

Once mortgage default problems started rising, it turned out the "safe" and "risky" investors weren't as separated as it might seem.

Hedge funds borrowed from others to leverage their investments. Finance companies had complex deals with investment banks. Asset-backed commercial paper was in money markets everywhere, as a short-term parking place for cash from corporations and institutional investors.

Some of the early problems surfaced with companies that had large stakes in the subprime mortgage business. For example, Countrywide Financial Corp., the largest U.S. mortgage lender, had to be bailed out with an $11.5 billion loan from a group of 40 banks, in order to deal with its problems. Bear Stearns, a Wall Street investment firm, put two of its hedge funds into bankruptcy, after it lost $1.6 billion of investors' money in the subprime mess.

But the wall of worries that swept through select credit markets in the spring soon began to spread as investors and participants in the broader financial markets began to realize that even so-called safe mortgage-backed investments may not be as safe as they had believed.

And because of the financial engineering in these products, it was difficult to tell what the risk or worth of a given security might be.

The crisis spilled over into the global stock markets in an especially vicious way by mid-August when France's largest bank, BNP Paribas announced it would no longer accept orders to redeem the value of units in three institutional investment funds made up of asset-backed securities, because the market for such U.S. securities had grown so mistrustful it "has made it impossible to value certain assets fairly, regardless of their quality or credit rating."

The fear over the value of mortgage-based securities eventually spread to other asset-backed commercial paper in a $5 trillion market as investors sought to put their cash in safer government-backed treasury bills and other bonds.

The credit crisis pummelled global stock markets, cutting 12 per cent off the value of the Toronto Stock Exchange's key index in less than a month, to a low of 12,848 on Aug. 16. It has since recovered from much of those losses.

Action by the U.S. Federal Reserve, the Bank of Canada and other central banks have since helped to calm the waters. Not only did they lower interest rates to make it cheaper and more enticing for banks to lend to each other again, at times central banks also accepted asset-backed commercial paper in trades, restoring some market confidence.

Mr. Kelly of TD Bank Financial says credit markets are still unwinding, skittish about anything but the safest government backed debt.

Investment and commercial lenders, meanwhile, are starting to reveal their losses as they report their results for the latest financial quarter. Some are stunningly large.

Swiss banking giant UBS announced early this month that it would write down $3.4 billion U.S. worth of losses linked to the subprime mortgage mess in its third quarter. Wall Street brokerage Merrill Lynch & Co. wrote down $4.5 billion (U.S.) worth of CDOs and subprime mortgage holdings. There are continuing talks in Canada about problems valuing and trading billions of dollars worth of mortgage-backed commercial paper issued by non-bank financial companies.

Whether there will be a further price to pay in stock markets and in the economy in general could depend on whether there are further unexpected jolts, says Mr. Kelly.

Markets may have already priced in the further damage expected as loan default rates continue to rise when rate reset dates come up, he said.

At the same time, the subprime mortgage mess has left the U.S. economy more vulnerable to a recession, if it experiences another financial shock, he says. That in turn would slow growth in Canada's economy, which depends heavily on the U.S. for trade.

Mr. Kelly thinks there is a one-in-three chance that the U.S. economy may tip into a recession. More likely, "we'll see a bit of muddled growth for a year or so until we work our way out of this," he says.

It is a reasonably benign outlook that Mr. Tisler, who runs the Neighborhood Housing Services counselling office in Cleveland, wishes he could share.

He sees a wave of new foreclosures coming as rate resets for ARMS hit homeowners at a time when lenders are tightening their loan standards.

State and federal programs are offering some funds to people who may be able to stay in their homes with a modest amount of help, he says. But it is no panacea.

"It is going to get worse. We are going to take another hit very soon," says Mr. Tisler. "In Ohio there is $15 billion worth of ARMS that are going to reset in the next four or five years.

"We need to make sure people are aware -- if they have made timely payments -- that they need to try to get out of their ARMS. Then we are just going to have to sit in the boat and have the storm come through and see what happens."


© The Ottawa Citizen 2007