February 14, 2008
The brave new world of finance-7: The subprime mortgage debacle
(For previous posts in this series, see here.)
The current so-called subprime mortgage crisis is a result of a real estate boom fueled by a combination by ignorance, greed, lax standards and oversight, and outright criminality.
Unlike art or precious stones, in the case of a house, the value can be determined within a fairly narrow range. Knowing the neighborhood, the size and state of repair of the house, historical pricing patterns, etc., one can assess the value of a house fairly accurately. Barring sudden unforeseen events such as finding oil on the property or the discovery that some major new construction is going to occur nearby, or that the house has been built on a toxic waste site, the price of property tends to be fairly stable and predictable.
When it used to be the case that the banks that loaned you the money to buy a house held on to the mortgage themselves, there were built-in checks and balances to prevent the unrealistic pricing of homes. After all, foreclosing and selling a house is a costly and tedious business that banks would like to avoid, so it was in their own interest to ensure that the buyer could afford the house so that default was highly unlikely. It was also in the bank's interest that the house was being bought at a reasonable price, with a down payment, so that the bank was lending substantially less money than the house was worth so that they could sell it easily in the unlikely event of a default. That was indeed the case when we bought our own house nearly twenty years ago. There were careful checks of the title to make sure the ownership was not challenged, a valuation of the home by an independent appraiser to make sure we were not paying too much, and we had to demonstrate, using tax returns and the like, that we had the steady income that we claimed we had and that it was sufficient to pay the mortgage. The fixed-rate mortgage payments themselves were high enough so that they covered the interest and also part of the principal, so that the money we owed the bank steadily decreased over the time of the loan.
But those days are long gone. Now the banks that loan you the money to buy your house resell your mortgage within days in the secondary market. Since the banks that initially provide the money for the house purchase do not hold on to the mortgage but quickly sell them, this does not require them to look too carefully into what they are financing. Indeed it is better not to do so at all, since the banks make their money at the point of transaction, so that the more mortgages that pass through their hands, the more money they make. This lack of close scrutiny also encourages the emergence of unscrupulous mortgage brokers who make their living on the basis of the number and value of the mortgages they broker between buyer and bank. Hence it is in their interest to obtain as many mortgages as possible for as high a value as possible. This encourages them to inflate the prices of the houses being bought and sold (in which they are aided by appraiser accomplices) and to inflate the incomes of the buyers so that they become eligible.
In order to make even more buyers eligible, buyers with poor credit histories (i.e., those labeled 'subprime') were also offered adjustable rate mortgages with no down payment and low teaser interest rates for the first few years so that they could afford the payments, at least initially. Furthermore, they were offered mortgage deals in which the monthly payments were interest only (in which case the money owed never decreased) or, incredibly, did not cover even the interest, so that as time went by the borrower owed more money, not less. The net result of the latter practice was that the value of the mortgage often exceeded the value of the house by substantial amounts.
Why would buyers accept such terms? These practices enabled them to afford to live in a more expensive house than was otherwise possible for the few years during the initial low-interest period and they thought they could sell and move on before the higher rates kicked it. Those who hoped to make the house their permanent home could hope that they would be either earning more money in the future to make the higher payments affordable or were told that they could refinance to a fixed rate mortgage at better rates in a year or two, before the low initial interest rates ended.
As a result of all these dubious lending practices, more people became 'eligible' to buy more expensive homes and home prices naturally started going up as a result of the increased demand for them. As long as the real estate market was booming and prices were rising, overextended buyers felt they always had the option of selling the home at a higher price than what they bought it for, thus paying off the mortgage loan with a tidy profit left over. Everyone would be happy. As a result, no one was looking very closely at the underlying value of the properties. There was no incentive to do so, and in fact it was discouraged. Why do that and destroy the dream?
Next: The end of the dream
POST SCRIPT: Lewis Black gives TV executives some good advice