Banks, Bubbles and Blame

Greedy banks; not enough regulation; too much regulation; flippers; Wall Street greed; Republicans; brokers; Democrats; ratings agencies, developers; oil prices and foreigners.  These are all reasons, definitively claimed by those citing them, as the sole reason for the “mortgage crisis” currently in the headlines.  Anything garnering so much attention, particularly in an election year, is ripe for misunderstanding and poor presentation of the facts.  I can’t think of a more timely topic on which to apply financial skepticism and truly understand the crisis’ underpinnings.

To understand where we are today, we need to start by understanding how the mortgage market operates.  Historically, when one wanted to buy a house they went to their local banker, presumably one they knew, and asked for a loan.  The banker would assess the potential borrower’s credit, require a large down payment, check all their documentation and then decide if they were worthy of a loan.  In those days, banks earned money by borrowing cheap (deposits) and lending it out to worthy borrowers at a higher rate.  As long as the loan didn’t default, the bank kept the difference as profit, so making “good” loans to capable borrowers was the goal.  The bank’s greatest risk came if there was a regional downturn.  If the local plant closed, how were all those formerly good borrowers going to pay?  As a bank, you had risk concentrated geographically.

Over time, it was realized that someone could take loans from around the country with similar characteristics- say 1000 loans with similar interest rates, credit scores, loan-to-value ratios and pool them together into a security.  This pool of mortgages would spread the risk of single regional downturn.  So banks began to “securitize” their loans to gain diversification.  Over time, this proved to be remarkably effective and even newer products and services could be developed based on this principle.  For example, the mortgage broker was able to compare loans from different banks, presumably find you the best loan for you, and as long as you met certain required “underwriting” standards such as a minimum credit score, the bank would get the loan without having to have a loan officer get to know you.  This model became very successful because pools of American mortgages proved to be very low risk.  The default rate on mortgages turned out to be a fraction of defaults on other types of loans- 10 to 20 times less than other loans like auto, credit card or construction loans.  After all, even if you lose your job, the mortgage is the last bill not to be paid.  So, brokers get a commission for processing a loan while pools of these loans turn out to be high-yielding, low risk assets.  What’s not to like? 

This market developed very slowly over the decades (until the late 1990’s) and houses generally rose year after year in value with economic growth.  Then the real estate markets began to take off in popularity.  People saw day traders making money in dot com stocks and thought they could do it with houses too.  In fact, house flipping had even better advantages: you used borrowed money, it was tax advantaged, the web made searching for homes easier and faster- why not fix up a rental and sell it?  (It helped that home price appreciation had lagged other assets through the ‘90’s, so that by 2000, homes were relatively inexpensive and plenty of people were flush with cash from stock options and newly evolved creative loans).  Then came the old recycled arguments: “they don’t make any more land and the population keeps growing”; “homes never go down in value”; “you gotta live somewhere”; “I can always rent it”; “zoning laws prevent enough new development” and my favorite: “there is no real estate bubble because real estate is local” (hello non-sequitor!) 

Perhaps the biggest boost to the real estate bubble, was the invention of new mortgages such as extreme versions of sub-prime without documentation and interest-only loans.  Sub-prime is essentially lending to people who have less than adequate credit or not enough money to put down in exchange for a higher interest rate.  In other words, get paid more to take on the extra default risk.  For example, if you loaned someone $80,000 to buy a $100,000 house (20% “down”) and they defaulted, you would have take ownership of the house, put it on the market, price it to sell quickly, pay the agents commission all to recover your money.  Because the house was worth $100k, even after commissions, a low price, and administrative costs you would still walk away with roughly your original investment of $80k.  In fact, that 20% equity cushion is what made the mortgage pools so safe- there was a margin of error built in of 20%.  But most of the subprime lending of 2002-2007 had little to no money down, yet investors on Wall Street were still buying it and securitizing it into things called CDOs.  By adding a few financial features used for years elsewhere (over-collateralization, traunches, guarantees, etc) a pool of otherwise crappy credit could be transformed into something that even conservative banks could buy.  In the beginning, this was not deceptive.  Rather is was a true innovation, albeit unproved. The ratings agencies even blessed many of these securities with “AAA” or the safest rating available based on unproven and ultimately faulty assumptions. 

Here is why the bubble: despite warnings (and there are in every bubble, remember people saying dot-com stock prices were ridiculous and being ignored as too old fashioned?), everything worked out as long as house prices kept rising.  Even a loan with 0% down and hence no margin of error for the lender, had a big cushion if that home’s value rose 10%.  Whoala- a 10% cushion in just a few months!  And low interest rates courtesy of the dot-com recession encouraged borrowing too.

Of course, prices couldn’t rise forever, because all bubbles run out of buyers.  When the number of homes being built exceeds the number of people who could buy them or afford them, simple supply and demand takes over eventually.  In fact, at one point last year, the percent of American households who owned a home was near 70%- greater than the number of households with cable or satellite TV!  Now tell me, if you can’t afford cable, how can you afford to own a home?  (Skeptics who abhor TV are naturally excluded from this calculation).  When the music stops, the finger pointing begins as mortgage brokers say “buy you bought loans with no documentation, so why wouldn’t I sell them?” And banks saying “the ratings agencies gave it a AAA!” when they should have been doing their own due diligence.  And borrowers saying “I was told I qualified” while not understanding the papers they signed, while all of your neighbors delighted over the huge increases in the temporary value of their home, not realizing the value is only what buyers can afford and collectively everyone can’t afford ridiculous home prices forever.  There is a circular logic to bubbles: Joe borrows when he shouldn’t because someone tells him its ok;  they were told its ok because the loans are securitized and made safe for investors; investors know they ain’t making more land, so there is a cushion to the price and on and on.

So, who is to blame?  Was it the lack of regulation or greedy Wall St?  Was it the lying borrowers or the brokers who lent money to undeserving borrowers?  Was it Fannie and Freddie who pioneered securitization and made it safe?  Or was it the general bubble mentality of all the people trying to get rich in real estate?  I submit that it is the nature of bubbles to require a unique confluence of events to truly create a bubble.  This happened because all parties- the borrowers, builders, lender, banks, regulators, Wall St and human psyche lined up in just the right way to create a bubble.  If just a few of these players had acted differently, it would not have been a bubble.  So next time someone tries to easily explain such a wide ranging economic event as being the mortgage brokers fault, or the work of greedy banks or Joe, you’ll know the situation is a lot more complicated than most people realize and that the way to “fix” it is not simple either.