A Look Back at the Subprime Mess (or: Itzhak Ben-David Is a Prophet)

Back in June, 2007, we wrote a column about the research of Itzhak Ben-David, a Ph.D. candidate in finance at the University of Chicago (who has since accepted an assistant professor position at the Ohio State University). He had been studying the cash-back transaction — a real-estate sleight of hand in which cash-poor buyers received an unrecorded cash rebate from the seller in order to qualify for a loan.

This would result in the buyer sometimes borrowing 100 percent (or more) of the house’s value. That means that borrowers who were subprime to start with are taking on even more debt, creating a loan that’s just waiting to blow up.

Here’s my question: If an academic researcher like Ben-David knew as much as he did for as long as he did — while we wrote the article last summer, he’d been working on this research for a long time — why were so many people, including smart people at sophisticated institutions, caught off-guard by the subprime developments?

Take a look at a few key paragraphs of the article and tell me how much clearer the warnings could have been, and how lax the safeguards were:

[Ben-David] found that a small group of real estate agents were repeatedly involved, in particular when the seller was himself an agent or when there was no second agent in the deal. Ben-David also found that the suspect transactions were more likely to occur when the lending bank, rather than keeping the mortgage, bundled it up with thousands of others and sold them off as mortgage-backed securities. This suggests that the issuing banks treat suspect mortgages with roughly the same care as you might treat a rental car, knowing that you aren’t responsible for its long-term outcome once it is out of your possession.

At first glance, these cash-back transactions, while illegal, might seem a victim-less crime. After all, the seller gets his house sold and the buyer gets to move in with his family. The real estate agent, the mortgage broker, the attorney, and the appraiser are all paid their commissions or fees. Even the bank that made the loan comes out ahead, since it earned its fees on the transaction before passing along the mortgage to investors.

But Ben-David argues that there are at least two potential losers. The first is the honest buyer who won’t take a cash-back offer and therefore can’t buy a house — all while the illegal cash-back transactions are artificially driving up home prices in his neighborhood.

The second loser is the investor who bought the mortgage-backed securities. If a house purchased with a cash-back transaction goes into foreclosure, it is soon discovered that the home is worth less than the value of the loan. This, plainly, is not good for the shareholders of such assets. While people who hate rich people may get a thrill from the idea of wealthy shareholders being swindled by a bunch of small-time mortgage hustlers, keep in mind that mortgage-backed securities are the sort of conservative investment widely held by pensioners and other regular folks.


appreciative

Thanks for this post. Cleared up a lot of holes in what I read in the papers and flew a bit over my head

reddoorhomeloans.com

I'm skeptical about his guy's research. How exactly does the seller give the borrower the funds they need? Do they count it out in $20s? Also, how do you get the appraisal to come in where it needs to be?

Ryan

These "illegal" transactions are just the natural extension of the down payment assistance programs that have operated "legally" and in full view of FHA for the last 10 years. These programs use a non-profit to provide the down payment for the buyer, but the seller must agree to pay back the non-profit plus fees at closing. This has been going on for years with government backed loans. The greed of professionals, the complicity of banks, the entitlement American culture, and etc. all fed the current "crisis" and will assuredly do it again.

Marie

This mess goes back much further than 2007.

In 1999...
at an annual meeting, an activist group called the East Side Organizing Project (ESOP) noticed too many empty chairs. In looking into the reasons, they found a common denominator---foreclosures. Too many foreclosures.

"Years before the rest of the country was rocked by the fallout from aggressive lending, their neighborhoods were already home to the nation's highest concentration of foreclosures - and they were fed up."

In diving further into the situation they found a common lender who appeared to be most involved---none other than Countrywide Financial Corp., the nation's largest mortgage lender (which seems to be the "'Enron"' in this mess... but who knows).

ESOP mobilized to battle Cleveland's mortgage "loan sharks."

A very interesting story. They protested in a creative way. By showering their foe with plastic sharks to send their message.... :-)

Google COUNTRYWIDE SHARKS for a collection of the reports.

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HardyW

I had assumed the cash-back purchase was a scam to keep real estate prices inflated.

KK

Thank you, DJH, Justin, Mike logician, and Marie a big "DUH!" to everyone else!The same thing goes for the souped-up consumer credit industry and its insane under-regulated state. I hope the new legislation is entered before that economy tanks too: Imagine if they started calling in your credit card debt!

D

If he says "cash back is illegal then he is a patsy and being used by the real estate industry because he is naive about what is really going on. As the Dept. of Justice has indicated, real estate agents are allowed to give rebates or cash back from their commissions, but the real estate industry wants the consumers to be confused about cash back so they reinvented "mortgage fraud" as "cash back at closing". Many real estate agents will tell their buyers that "cash back" is not legal so they will not have to negotiate their inflated fees. This is a scam and the industry is duping the consumer into paying higher real estate costs. Cash back from the real estate broker is legal and protected by anti-trust laws.

"Mortgage fraud" or "illegal flipping" and has been around for years. In the 1990's Baltimore (for example) was a hotbed for such fraud. Somehow people think this is a new scam, it is not.

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