Peter Schiff Mortgage Bankers Speech 2006 – Transcript, part 4

Continuing with the transcription of Peter Schiff’s speech from 2006, here is part four.

You can view the second part of his speech on YouTube on the following link:

Read more for the transcript.

[But they didn’t bother to ask themselves, why should an asset that’s so overpriced] that it produces a negative return, why should that asset appreciate? It should collapse. But the people who were buying real-estate and are still buying real-estate were making the exact same mistakes that people were making in the stock-market. They were not basing their investment decision basing it [sic] on the fundamental value of the asset. They were basing it on the belief that prices would rise. On the belief that there would always be a greater fool willing to accept more losses – real-estate would always go up. It was a sure thing. Just buy it – it doesn’t matter what you pay for it, it doesn’t matter what the rent is ’cause it is always going to appreciate.

Well, people are now starting to find out that that’s not going to happen. And also you know, (one of the reasons [sic] ) people are saying – prices are just going to level off. That’s impossible. Prices can’t level off. It’s like, I can’t hold a balloon up in the air like this and take my hand away and expect the balloon to stay there.

Why did real-estate prices get so high in the first place? How did they get there? Well, they got there because of the artificially low interest rates that existed. Well, those artificially low interest rates are not there anymore. The rates are still not high, but they are not nearly as low as they were. And without those very low rates these prices are impossible because people can’t get payments that low.

They also were there because of the complete abolition of lending standards. Well, that process is starting to reverse itself – I’m going to talk about that in a minute. But standards are starting to tighten and they are going to be a lot tighter.

And number three, was the speculative mentality of the buyer. Now, one of the reasons people who were poor were buying real-estate, let’s say someone in California who believed that this house was going to appreciate by 20% a year. Let’s assume my income is 5000 dollars a month but I’m going to buy a house where the mortgage payment is 4000 dollars a month. Well, no sane person would commit 80% of his income to mortgage payment. But wait a minute, if I’m expecting that house to appreciate by 20% a year, my real income isn’t the 50 000 I earn as a police-man, it’s the 100 000 dollars a year, the 200 000 dollars I earn as a home owner. So they take a look at that money and they figure – that’s my real income. So they get one of these no doc loans, one of these liar loans that you guys came up with and say – my income is 150 000 a year. I qualify for that loan. And of course they pay a little bit higher interest penalty because they didn’t want to document their loan. And of course anyone who could document their loan would do it. Why would anybody who actually had the income not document it? I mean, they file a tax return. They are lying. But they don’t care.

And I wrote, I mentioned this as a paradox that even though real-estate prices were high, rising real-estate prices makes real-estate affordable. Because, if somebody believes that they are going to get paid 100 000 dollars a year for owning a house, right, that offsets the actual costs, of the mortgage, of the taxes, of the maintenance. But the minute a more realistic outlook for the future price is in the mind of the buyer, the minute he can’t anticipate that windfall, all of the sudden, the true cost of home-ownership becomes apparent to the buyer. And he’s not going to pay these prices. But more importantly then the buyers are the lenders who are not going to lend.

And a big part of this problem has been from the lenders perspective. Traditionally, the way people bought a house is that they went to the bank and the bank wrote them a mortgage. And the bank held that mortgage for 30 years. And so the bank had a big vested interest in the loan getting re-paid. So, how did the bank insure that that loan was re-paid? Well, it was very careful with who it lent money to and under what terms money was lent. Buyers needed a 20% down-payment. Why did they need a down-payment? Well, so that they wouldn’t cut and run at the first sign of trouble, number one. Number two, because the ability save a down-payment said something about an individual’s character and their ability to save and pay for the on-going expenses for home ownership. And number three, if the home went into foreclosure, the bank had a cushion. Right? There was something there.

Also, when the appraiser was hired it was hired by the bank and the bank wanted that appraiser to be accurate because that was what it needed if it had a default. It had to know – what is this asset worth, cause I’m going to carry this asset in my books for 30 years. If this guys doesn’t pay, what can I sell this property for.

So there was a lot of scrutiny and a lot of soundness in the lending practices. And of course the lenders would say – well, I’m not going to lend to any more than 30%. I’m not going to let anyone commit to a loan where payments are more than 30% of their income. Because they know what can be reasonably handled.

And of course they wanted the borrower to fully document that loan. Yes, we want proof. I’m not just going to your word for what you make. Prove it!

Now, how does the lending industry work today? Well, you’ve got this huge moral hazard built in and a lot of it was created by government and guaranteed mortgages of Fannie Mae and Freddy Mac. But what happens is that you got a whole bunch of people in this room that are lending money. But when you lend the money, does anybody in this room keep that loan? No it gets sold. It gets re-packaged, and these other companies buy them and then they re-package them again. And they get sold to Goldman Sachs and Morgan Stanley who creates these collateralized mortgage obligations or they sell them to Fannie Mae and Freddy Mac that just buy them if they are conforming loans.

So what happens is that lenders just want to make loans, they don’t care if they are ever re-paid because they are not going to own the loan. Now, all of the sudden, when they hire an appraiser, do they want an appraiser who is going to give an accurate appraisal? No, they want an appraiser who is going to appraise the property high enough to fund this loan. The appraisers know that. The appraisers want to get jobs, they want to get hired – who hires them? The mortgage lenders. If a guy keeps coming in with low appraisals – he’s not going to get any work. So the appraisers have an incentive to inflate the value of the home. Of course, the buyers, they don’t care they just think it’s all going to go up, so they just want to close on this thing.

In fact, back in California, when I was living there, the house would go on the market and there would be a hundred offers. People would write in with sob-stories you know: Please sell me your house, I go to church every week. You know, it was like a gravy train, all you had to do was to own this house and you were home free. Done, you were rich. You didn’t have to work anymore. So all they wanted to do was to buy this home.

Now, when people used to buy home with a 30 year mortgage, the reason it made sense to buy a home, the reason it was an investment was because you paid off the house. After thirty years, you lived rent-free. Now you can retire, burn your mortgage, because you longer had any debt. And the return on home ownership was that rent you paid to yourself and that you are now out of debt. Well, today people aren’t buying homes, they are renting them from the banks. They have interest only loans, or worse yet negative amortization loans when they go deeper into debt every year. All they are doing is that they are hoping that the appreciation value bales them out. That they build equity not by paying off the loan but by the house just magically appreciating in value. That doesn’t happen. I mean it can happen for a short period of time but it doesn’t happen for the long-run.

Let me tell you about the subprime market which I am actively involved in shorting right now. But to show you what is going to happen. The way the subprime market works – and I didn’t even realize this until I did the research to start shorting stuff. 65% of the subprime mortgage market, were where a guy [sic] stated income, no doc, negative am, risky loans, 65% of those things are re-packaged by Wall Street and rated AAA. AAA, the equivalent of sovereign debt of the best credit quality governments of the world. How can it possibly be that 65% of the subprime mortgages that are issued get a rating at AAA? How can that be? Well, the reason is that Wall Street creates these tranches of CMO‘s, a billion dollar’s worth of mortgages. The way they structure it is they insulate the top 65% from losses by saying all the losses from interest in principal are going to go to these riskier tranches. The riskiest tranche represents one percent of the market, ten million face [?]. That risky tranche gets all the losses first. So, that tranche has to be wiped out before any other tranche looses one dime of interest, let alone principal . Now, that particular piece of paper is rated triple B minus and yields about seven and three quarters percent right now. That piece of paper should be rated F and it will go to zero as will several tranches above it. Right now, one of the big trades that is starting on Wall Street and which I’m participating in is shorting that tranche. A lot of the brokerage firms are creating derivative instruments where you can do these credit the fall swaps [?] and you can bet on those things, the fall things.

Now, what’s going to happen as more and more people put this trade on, the price of those bonds are going to start to fall. As the price of those bonds, those risky tranche bonds falls, the yields are going to shoot up. When that happens, it’s going to make it impossible for Wall Street to collateralize this debt. [Because it’s going to be too expensive, rates are going to rise and the bottom is going to drop out of the subprime market].