I had a front-row seat to watch thousands of companies jump off of a cliff.
One by one, they lept until there were none left standing. The path they took was so destructive that hindsight observation is comical.
In 2004, I took an executive role with a residential home builder. I was responsible for a profit center and had zero experience working in this industry before accepting the position.
My background was in engineering and sales. In this role, I was responsible for 100 employees and nearly $1B in closed revenue in a space I knew little about.
I was 28 years old and my experience with real estate was exclusive to a townhome I purchased with my wife a few years earlier. The housing market was already overheated. My immediate challenge was merely keeping up.
I had three focuses when I got to the office every day.
- Don’t forget 1 and 2
We couldn’t hire people fast enough to keep up with demand. New employees outpaced our ability to find new office space. We shoved new trainees into conference rooms, boiler-room style.
They didn’t seem to care. Anything to be close to the hottest market in the economy.
What Is Everyone Else Doing?
As home prices soared, loans performed perfectly. In other words, borrowers made timely mortgage payments.
If a borrower got into trouble, they could sell their property at a steep gain or take another loan out on the rising equity in their property.
Cab drivers bought and flipped $500,000 homes. I recall one waitress telling me about how she made $70,000 flipping one of our company’s spec homes in just 90 days.
Lenders with zero experience in a downturn churned out ever more ridiculous programs to entice new borrowers.
Small players started to eat into the market share of large banks and Fannie Mae. Rather than behaving like grown-ups, these reputable organizations ignored decades of data and sold out.
- Down payments moved from 20% to 10% to 3% to nothing
- Credit score requirements went from 640 to 600 to 560 to no requirement
- Borrowers went from providing full documentation to partial documentation to none at all
Monkey See, Monkey Do
These underwriting changes happened piecemeal. Each incremental tweak was quickly copied by the entire industry.
In 18 months, lending standards went from aggressive to downright moronic. You could imagine a sign in front of a bank:
“Eat Shit. Twenty billion flies can’t be wrong.”
Lenders flooded our offices with aggressive marketing, making promises that anyone could get a loan from their company. They weren’t lying.
Countrywide Financial convinced itself that a program marketed as “Fast and Easy” was a full-documentation loan. This program required a credit report and let borrowers “state” their income and assets.
“Sir, to qualify for a $600,000 loan, you must have an income of $10,000/month and total personal assets of $30,000. Can you please state your monthly income and assets?”
“Uh, $10,000 and $30,000?”
“Great! You’re approved.”
The “Fast and Easy” program was so profitable that every lender in the country adopted the guidelines.
As an executive new to the industry, it was a confusing time to learn a business model. Imagine trying to understand how a lender underwrites risk at a time when it is virtually impossible to get denied for a home loan.
The credit crisis of 2008 may have shocked the nation, but not those of us who worked in real estate.
It was like riding a train headed for a cliff. You wanted to jump off but the train was moving just a little too fast. Instead, you hoped that the engineer might stop the train in time.
Except, no one was driving this train.
In December of 2006, I had a moment of clarity when I got personally involved with a customer.
He purchased a $700,000 townhome with intentions of flipping for a profit. It took us seven months to build the home. By the time it was finished, the price of new homes in that community was closer to $730,000.
His closing date was set but a routine employment verification identified that he lost his job.
This poses a serious roadblock when you apply for a loan that carries a $7,500 monthly payment. It is even more absurd when this is your second mortgage.
In a sane world, both parties chalk it up to bad luck. The home builder has to remarket the property, likely at a loss. The borrower is relieved not to have this burden and can focus on finding employment.
This was not a sane world.
This customer was apoplectic. How could we not give him a loan? It was just a short term blip in his career and he could find another job. This guy reeked of entitlement.
He planned to immediately flip the property and wanted to keep the profit accrued from the sales price increase. He demanded to talk to a manager.
I listened to his case and called our head of underwriting. Without missing a beat, he said we could switch him to a different product.
“Didn’t you hear me? He doesn’t have a job.”
“Yep. We have a program for that. No income, asset or job verification.”
The world has since learned the term used for this nonsensical loan – the NINJA loan. It felt like I was the butt of a joke for a bad TV series.
The NINJA loan was slightly more expensive to account for the risk. The customer paid an extra 1% fee of $7,000 and closed on the loan that night.
No job? No problem.
Stories Are More Powerful Than Data
That borrower immediately listed the house and sold it 30 days later. He made one mortgage payment before claiming his profit.
I couldn’t stop thinking about what would have happened if sales prices were falling. I looked at our backlog of homes under construction in that community and I was shocked.
28 out of 30 homes under construction were sold to investors using similar mortgage programs.
I shared this story with our CEO and the President of our mortgage company the next week. Our CEO was shocked that such a mortgage program existed. He was equally shocked that 95% of the buyers in that community had a similar story.
I relayed every detail of that customer’s situation. A CEO often makes decisions based on hard data but the details behind this loan were critical to warn of the high-speed crash the industry was hurtling toward.
I made it clear that when prices plateaued, every investor would walk from their contract. The same greed that was pushing them to fight for garbage loan approvals would turn to fear when they realized the cost of carrying two mortgage payments.
Our mortgage President pushed the CEO to cut off investor sales or risk getting stuck with thousands of built homes with no buyers.
The next week, our CEO took the extraordinary step of banning new sales to investors who could not put at least 25% down. Effectively, this ended all sales to speculators and angered every sales rep in our company.
We missed our sales plan by 30% that month. The investor gravy train was over. But the program madness was just heating up.
A Dire Prediction
In the summer of 2007, a new lender presented to our executive team.
At this point, mortgage programs were bananas. Halfway through this presentation on subprime loans, our President snapped.
Bill was a veteran of 40 years and lived through some ugly downturns. He faced down a bankruptcy after the Savings and Loan crisis in the late 80’s and he had a knack for moving before the crowd.
He was also intimidating as hell. Bill was a Vietnam veteran who ran his business like a platoon sergeant in the bush.
He didn’t so much as yell but growl when he was displeased. Bill was an old-school lender who believed in practical underwriting. This world made no sense to him.
The sales rep boasted about his bank’s willingness to ignore a recent bankruptcy and foreclose on a credit report. Bill lost his mind.
“This is garbage! You people never learn. This paper is going to ruin people’s lives. Your company is going out of business!”
The presenter awkwardly pointed out that these programs were ubiquitous.
“And that makes it right? If that’s the case, you’ll all be out of business!”
With that, he stormed out of the meeting. Those of us remaining weren’t sure what to do, so we let the poor schmuck finish his slide show. Talk about uncomfortable.
“We’re Shutting This Down”
What I didn’t know was that our President marched right down to our Chairman’s office. In no uncertain terms, he demanded that the company immediately stop selling to any buyer who required an exotic mortgage of any kind.
He made it clear that a reckoning was coming. It would be uglier than any downturn they had managed through in the past.
Our CEO was called down and briefed on Bill’s concerns. He was initially skeptical, knowing that our President had a tendency to overreact. Our CEO wasn’t sure a move this dramatic was necessary.
Our financial analysts dug into our backlog of sales to assess the risk. Nearly 35% of our company’s sales under construction were tied to marginal mortgage programs.
Bill was not moving from his stance, “This whole thing is going to crash. We’re shutting this down now.”
He argued that we had six to twelve months to get ahead of the problem. If we quit selling homes that required subprime mortgage programs before our competitors, we could work through our backlog before the exotic products disappeared.
Our Chairman sided with Bill and the three executives made a decision that still impresses me ten years later.
A Short-Term Sacrifice For Long-Term Gains
Our CEO convened his top executives and walked through the risk the company was undertaking. He shared the startling data and then announced a bombshell.
Our company would close out any remaining backlog of homes with these mortgages but would not write another new sale tied to one.
Some executives lost their minds.
- This meant annual bonuses were out the window.
- Many communities would fail. They were purchased and priced to only work with insane mortgages.
- Sales reps would leave the company in droves as they would now face competitors armed with programs they couldn’t use.
All of these things happened over the next year.
- Sales took a big hit as we stopped selling to speculators whose only interest was flipping a new home for a quick profit.
- Sales reps left. They joined competitors who were still pushing these programs.
- Most managers in the company missed their bonus, and we lost good people who felt burned by the decision. They were recruited away by competitors who offered large signing bonuses and guarantees.
- Our stock fell from $900 to a low of $400.
- We reduced our staff dramatically as many of our active communities were no longer viable. This was an emotionally gut-wrenching time as many in the company saw it as voluntary.
We closed most of the homes in our backlog while we still had the programs to do so. Every loan closed under an exotic mortgage was personally reviewed by our President.
To put this into perspective, we had a team of 40 underwriters to handle the risk of our backlog of loans. Over a period of six months, Bill personally reviewed thousands of loans.
I remember this period vividly due to the process. Bill reviewed each loan with the executive responsible for the office. I ran a region that was half of the company’s volume and because of our high sales prices, we had 75% of the exotic mortgages.
On a daily basis, I sat down with Bill and reviewed ugly loans with sparse documentation. For several weeks, he kicked my ass out of his office because I had little evidence to support a borrower’s ability to repay.
“You want me to say yes to someone with a 600 credit score and you can’t even show me a paystub and bank statement?”
Loan by loan, our offices got the point. Treat the exotic loans just like traditional mortgages and don’t send loans to me without documentation.
Loan by loan, we closed out our backlog of subprime loans while making sure not to sell any new homes unless buyers qualified with traditional financing.
Our risk dropped every month and our book of business shrunk. But the buyers we had were well qualified. This meant that the homes that we were building had a great chance of closing with a paying buyer.
Our competitors were not so lucky.
The Shit Hits The Fan
In early 2008, banks started announcing major problems.
As quickly as the programs showed up, they started to disappear. Actually, much quicker. Every day, we received multiple emails announcing adjustments to mortgage programs.
Credit score requirements rose, documentation was required and people needed to prove that they had a job. What a novel concept.
The market forced our competitors to do what we did the previous year but with one important difference.
When we decided to stop selling these programs to new customers, we still had access to the mortgages. This allowed us to honor our commitments to customers with homes under construction.
Now, builders had hundreds of millions of dollars tied up in homes under construction with no way of recouping their money. Their customers had no method of qualifying for the houses.
They built thousands of homes and had no buyers.
Home prices dropped between 40–70% and hundreds of small home builders went bankrupt. Even large builders went through turmoil and several went out of business.
When the spigot turned off, we were ahead of the game and started playing offense. We took the painful steps to reorganize and remained profitable as the worst of the downturn hit.
When prices on land plummeted, we had little competition for valuable communities. Over the next ten years, our stock price went from $400 to $4,000.
As every company in the industry lined up to jump off the cliff, our executives decided to step out of line and watch.
It was a lesson in herd mentality that I will never forget.
Pay Attention To Experienced Voices
Two days after we decided to shut down new sales with exotic mortgages, Bill stopped by my office.
He had a calm confidence that I had not seen in months. He was content that the company was avoiding a major disaster but there was something else.
“How much cash do you have?”
“In my wallet?”
“In your retirement account, dumbass.”
“A good bit.” [That was a lie, I was 100% invested.]
“Good. This stock market is going to crash. I sold everything.”
“Well, no. I bought some Treasuries.”
Treasuries? The only person I knew who bought Treasuries was my grandpa. I used to get a $25 Treasury certificate for my birthday every year. Gee, thanks Pops. I look forward to the returns over the next 25 years.
I thought Bill was nuts for selling all of his stock. I adored this man but he tended to overreact. He had scars from decades of battling in this industry.
I ignored his warning.
Twelve months later, my holdings were down 40% and Bill’s cash was doing just fine. In a crisis, experience matters. When leaders go through challenging periods, they develop a gut sense for how to behave.
Let History Guide Your Decisions
While others diminish the severity of a downturn, leaders with battle scars can’t act decisively enough. When our executive team made the decision to sabotage sales in 2007, they pissed off most of the company. Our stock was crushed in the short term but rewarded over the coming decade.
The world is attempting to figure out who moved our cheese. Many voices will shout that we have hit the bottom and that everything will be back to normal in no time.
But small businesses have no choice. Get this wrong – react too slowly – and you won’t be around to second-guess yourself.
Having run businesses through the tech bubble recession, 9/11 and the credit crisis, I can’t recall any decision that proved to be “too drastic” when viewed in hindsight.
Act decisively, face your new reality and be bold when your competitors are waffling. Let history be a guide for your actions today and respect those with scars from previous crises.
Do it well and your business will dominate when this crisis subsides.
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