What Was the Cause of the Mortgage Meltdown?

Great Debates
1

I think at this point we all have formed an answer to this question. Some of our answers are longer than others, some blame Republicans, some blame Democrats. Lots of people blame bankers, brokers, the home owners.

An article in the Wall Street Journal points to a much more specific cause: negative equity (aka no-money-down mortgages).

His research found that negative equity accounted for nearly 50% of foreclosures, but represent only 12% of mortgages.

So both looking back and looking forward, is there a case to be made for requiring larger down payments?

2

IMHO, absolutely. The worse your credit, the higher the percentage of down payment.

3

No, I think the problem of negative equity can hit people with good credit just as easy as it can hit people with low.

4

The follow up that should have been asked: Why did banks start making these negative equity loans?

The data look convincing, but presumably this negative equity lending is a recent phenomenon, or we would’ve seen this type of massive housing bubble before. What caused this change in lending practices? That’s the real answer to the “What caused it” question.

5

The cause of the meltdown was almost certainly a weakening of mortgage underwriting standards during the Aughties. The argument is over the cause of the cause; *why *were standards reduced. There was a This American Life segment that argued persuasively that it was due to international investors. The Giant Pool of Money

6

Were there ever standards to begin with?

One thing that I find odd is that before buying my house last year, I had just assumed you needed to put 20% down. It never occurred to me that you could get a mortgage without that. When I went to get a mortgage (in 2009) the broker thought I was crazy for putting 20% down, she said all I needed was 5% and that I “could use the rest for a trip.”

Who set the standards and who weakened them?

7

I had to cough up 15% when I bought my first house in San Jose in '92, but that was a very high priced market; my recollection is that 20% was more the usual down payment at that time.

Just a wild guess, but with prices doubling and tripling, perhaps after a while nobody could be found who could cough up 20% on $600k properties that used to be $100k properties, so they kept bending the requirements downward until there weren’t any.

Or perhaps there were standards that weren’t enforced.

8

Personally, my guess is that easier loans are what allowed the prices to go up.

The way I see it, the limiting factor in the housing market are available buyers. As I’ve said before, there was a point (about 10 years ago) where everyone that could buy a house had a house. At this point, house prices should have started to fall, or at least not gone up much faster than inflation.

Shifting the lending standard from 20% to 15% means a bunch of people could suddenly buy that couldn’t before. More demand, higher prices, everyone is happy.

Move it from 15% to 10% to 5%. to 0% Now look at the housing market, prices are doubling in a matter of months. Didn’t anyone bother to ask why suddenly an 80 year old $100,000 1.5 story house was selling for $250,000?

9

Its the culture.

Mortgages used to be part of the slo-mo capitalist culture, as compared with the go-go speculative variety, the kind that looks for the quick kill and run investment. Slo-mo is stodgy, responsible, and dull. Its where the investor goes who wants a solid but modest return on his money. For the slo-mo culture, boring was a positive virtue.

But more and more people got drawn into the casino, because thats where the action is. And mortgages didn’t fit that model, they were sedate and predictable. Perhaps more to the point, the person/bank that made the mortgage was responsible for it.

Once mortgages became “securitized”, bundled together and then sold as securities, they became part of the go-go culture. They became riskier the moment that so many mortgage creators no longer had to stick by their mortgages, they could pass them along. It was free money, they make the mortgage, they sell the mortgage, they take their cut and forget it. You couldn’t create a more likely scenario for chicanery. At first it was just the scoundrels, but when the responsible broker in his BMW saw the scoundrel zip by in his Jaguar, well, all over but the shouting.

The other part is the fact that so much of our housing is geared to the higher-end market, there is more money to be made building a $600,000 house than 4 $150,000 houses. Trouble is, sooner or later you start to run low on upper-middle class people to put in those houses. But hey! if its not your money, you don’t have much problem with “helping” a working class family buy something they can’t afford.

At last, the point when go-go and slow=mo became indistinguishable, when the real estate market was so hot people were buying houses to sell them, just like stocks, make a killing and run for the border. Each time one of those houses sold, the price went up as the cut was taken. Absolutely inevitable that, sooner or later, someone would buy that house for more than it could ever be worth if the next fool does not materialize.

We used to have rules that said that stodgy old bankers couldn’t be go-go, up to the second financial hipsters. This was found to limit creativity and vital, vital entrepreneurship. Well, we got creativity, we got entrepreneurship, then we got boned.

10

Aren’t we ignoring why lending standards were lowered to start with? The federal government pressured banks to lend to “underserved populations” who traditionally have poorer credit and are unable to produce a 20% down payment. The Bush administration considered down payments to be a hassle that got in the way of home ownership. FHA loans only require 3.5% down, even today, and are backed by the full faith and credit of our government.

Lending institutions were more than happy to provide no doc and no down payment loans that they would just sell to Fannie and Freddie. Profits were privatized while losses were socialized. If the lender were on the hook for bad loans they would require larger down payments and very good credit.

The bad guys in all of this are the politicians who, I believe, had the best of intentions. Everyone on Capitol Hill was pushing home ownership as part of the American dream. Unfortunately, politicians very often don’t think of the consequences of their well intentioned policies.

11

**yorick73 **That “why” ignores that the same or worse took place in commercial real estate.

I still think that “why” was a factor, but not the main one. It seems to me that when financial institutions created the “financial weapons of mass destruction” the clock began to tick.

12

I 'm surprised only 50% are caused by negative equity. This is what I see in my area:

Remember all the ads “Borrow 125% of your home equity!” ? So many people used home equity to buy boats, cars, vacations and the like. That got a lot of homeowners in trouble who would have been all right otherwise. All of a sudden they had to move for a job or had an income drop and they couldn’t make their payments or sell their house to cover the mortgage.

The other big factor is zero down loans from the government. These loans are still available and I predict another round of foreclosures for a lot of these buyers. Especially during the tax credit. I saw people who didn’t even want a house pushed into it by their parents. They would barely even be able to scrape up $200.00 earnest money and they’re buying a whole house. The minute the fridge breaks they’re going under.

I also see people letting their houses go to foreclosure just because it’s financially better for them. A lot of them are Realtors working the system. They buy a new property at a good price, move, then let their old property go into default. I live in an area where people move a lot in the area so it’s easy to follow what people are doing.

Our first house, purchased in 1987, required 10% down and you could not borrow any of it.

13

Greed.

Greed on the part of lenders who lent money to those who did not pass the smell test.

Greed on the part of buyers who smelled too much and were lent money by lenders with stuffed up noses.

14

Jeff Rubin, the author of Why Your World is About to Get A Whole Lot Smaller says that the mortgage meltdown was caused by $100 per barrel oil. Just sayin’. :slight_smile:

15

My recollection is that the pebble which started the avalanche that burst the real estate bubble in October 2007 was a reset by half-a-point in the ARM component of low and no down payment mortgages. This meant that a whole lot of folks (millions) who had financed at the very limit of their ability to pay suddenly found themselves overextended and having to default. Just as suddenly, mortgage lenders decided sub-par borrowers weren’t a good thing and tightened credit underwriting standards. Almost overnight, we went from easy credit to almost none.

How did this happen? In the halcyon days, the assumption was that real estate had a stable value, could only go up, not down. What was missed was that this cycle, which had continued for many years, was dependent on easy credit. Take that away and the assumption crumbled. In effect, the change in perception by the credit markets created the very thing they most feared.

16

The key point is being missed. I’m too lazy and inept to articulate it properly, but let me try a summary.

There are structural problems in the modern economy, some related to a breakdown in an expected cause/effect relationship, some related to a futile quest for “hyperefficiency.” These are the real culprits in many modern problems. Two examples of this which affected mortgages:

(1) There was often little relationship between the writer of a mortgage and the risktaker. Mortgages were sliced, diced, traded, and treated like commodities. Often the banks or brokers that wrote a mortgage had no risk (except to their reputations*), and were motivated just by the immediate fees. Much of the worst mortgage paper ultimately ended in the hands of naive investors (or, in some cases, taxpayer-financed government entities). The less-naive holders of bad mortgage sometimes relieved themselves of risk by hedging with fancy-shmancy forms of credit risk insurance. (*-and reputations are often irrelevant, see next point.)

(2) The link between executive decision-making and corporate well-being is too often severed. A Rothschild banker wanted to do homage to his Rothschild grandfather, and pass a sound bank on to his Rothschild grandson. A modern banker, instead, is ready to flee to a competitor whenever the conditions are right. They have no interest in long-term safety; only this quarter’s numbers interest them. And, while a few Wall Street giants were allowed to fail (out of spite?), long-term safety was proved not to be an issue: Washington D.C. is happy to prop up Wall Street firms, moral hazard be damned!

One of the most absurd examples proving my point was the credit derivatives trading at AIG. Unlike Lloyd’s of London’s ship insurance, these credit risks were very highly correlated, but AIG management seemed unable to grasp that simple fact and awarded the derivatives traders huge bonuses based on quarterly results. This was ridiculous, though acclaimed at the time as a hyperefficiency ultimately helping those who couldn’t afford homes to buy homes. (What is the current estimate of taxpayer loss just in AIG?)

17

Negative equity? That sounds like an excuse. A bigger factor was probably that securitization allowed lenders to sell a mortgage in two directions & walk away, leaving one side with a debt they couldn’t pay & the other side with a debt they couldn’t collect, while the broker stayed in the black. And the securitized instruments were less traceable back to specific fraudsters. Yes, I said fraudsters.

Yeah, negative equity may have contributed. But the meltdown required the lack of responsibility on the part of lenders that the securitization process enabled.

18

Based on the research in the article, that change in the ARM didn’t have the affect people thought it did:

“What about upward resets in mortgage interest rates? I found that interest rate resets did not measurably increase foreclosures until the reset was greater than four percentage points. Only 8% of foreclosures had an interest rate increase of that much. Thus the overall impact of upward interest rate resets is much smaller than the impact from equity.”

19

Unfortunately, most of this is just jargon. And a sad result of how our news media is set up to repeat simple concepts until they become fact.

Sub-prime mortgages didn’t make up the majority, 51% of foreclosures were prime.

Just so we’re all on the same page here: the beauty of a mortgage is that it is a fully collateralized loan. At least traditionally there was no need for the foreclosure process, because the house could always be sold to cover the debt. That’s why for so long the foreclosure rate was steady, and investing in mortgage back securities was a nice safe investment. Bundling mortgages made those investments even safer.

So even IF the toxic securities never got issued, the no money down mortgages would have still caused a massive economic failure. When house prices stopped going up, every one of those low equity loans would have been underwater.

Just think about that for a second: putting 0% down means you have zero equity (duh), but it also means that you need the house value to go up faster than inflation+interest before you’ll have any equity at all. Foreclosure is inevitable! The amount of principal paid each month is almost negligible, so the house will never have equity.

The mortgage backed securities didn’t become toxic until the buyers failed to realize that break in tradition. Once people stopped putting down significant capital, the foreclosure rate was destined to go up. Increased foreclosures will necessarily cause house prices to either fall or not go up as fast.

In the end, there is no point blaming politicians. It’s an entire culture including regulators, lenders, buyers, and investors that expected house prices to continue to rise at unheard of levels, never bothering to consider what happens when they stop rising.

20

Liebowitz admits that number is conservatively low. The data he has can’t account for secondary loans–where the buyer will borrow to pay the 20%. But that’s still a case of negative equity, even though on paper the mortgage is valued less than the house.

What I don’t understand in all this is at what point mortgage insurance was supposed to kick in.