We hear about the mortgage crisis going on and see reports of families losing their homes, home prices plummeting, and huge lending institutions going belly up.
But what. has. truly. caused. this. problem?
It is a complicated situation, but the root cause is fundamentally simple, in my opinion. Between about 2000 and 2007, a once-conservative lending industry stepped over the line and turned predatory because it was easy and profitable to do so. Fiscal restraint was eroded by historically low interest rates, a reasonably sound economy and little oversight. Ravenous lenders lost their fear of bad loans the way bears lose their fear of humans when garbage is plentiful.
The tools that facilitated this travesty are not new to the lending industry; what is new is how irresponsibly these tools were used.
Adjustable Rate Mortgages Traditionally, ARMswere used to give qualified home buyers an initial respite from a fully-loaded mortgage payment for the first three to five years that they owned a home. Buyers were made to understand that the loan’s rate was adjustable and that it would eventually reset to a higher rate, at which time they’d be paying what everyone else was paying, or a little more. Such loans were used sparingly because they offered borrowers less security than a fixed-rate loan.
In the cash-induced haze of 2000 – 2006, though, lenders began to push ARM loans not as a way to save a little money early on with a mortgage, but as a way to squeeze buyers into homes they could not afford with a fixed-rate loan. Reasonable people with good credit were being put into loans they could barely afford at the outset, with little consideration being given to what the rate might adjust to three our five years later. Hope springing eternal as it always does, these otherwise reasonable, realistic borrowers allowed their desire for a new home to blind them to the likelihood that their barely affordable house payment in 2002 would become utterly unaffordable in 2007 when the adjustable nature of their mortgage kicked in.
Sub Prime LendingTraditionally, when considering who should be qualified for a loan, lenders took very seriously such key variables as income, employment history and credit score. As lending morays became more liberal over time, people with poor credit and little or no employment history ceased being seen by lenders as customers to avoid and became instead a desirable new customer base. Desperate borrowers with no justifiable reason to believe they should be allowed to borrow $200,000 with little or no cash in-hand and a disastrous credit history were suddenly being bombarded with promises that they too would be approved for a home loan. . . guaranteed! Lenders saw the opportunity to use their customers’ poor credit histories as a means to push them into loans that were more profitable up front for the lenders. These loans to sub prime cost the already disadvantaged borrowers a fortune in higher interest rates, shorter fixed periods (for ARMs), murderously high reset rates and embedded balloon payments that virtually guaranteed that the loans would be defaulted on in the long run. Yet some estimates are that more than 20% of all loans made in the early part of the 21st century were loans to sub prime borrowers.
Interest-Only and Negative or Reverse Amortization LoansAt the height of this lending inebriation, lending tools that had long been considered too risky for use by the general public had somehow come to be seen as additional tools that lenders could use to attract and sign new borrowers. Lenders had become skilled at convincing borrowers that an interest-only loan-- a loan that requires the borrower to only pay the interest on the loan each month-- would somehow save them money. They pushed these loan vehicles while underplaying the fact that the principle of a loan structured in this way remained undiminished month after month and would require payment in full eventually.
For others, an interest-only loan didn't go far enough to bring the monthly payment for the house of their dreams into range. For those seeking even lower monthly payments or more expensive homes, lenders began pushing
negative or reverse amortization loans. . . loans structured so that the borrower pays no principle and only a portion of the interest each month, with the principle owed continuing to increase over time. These loans of course can only allow such a free ride for a short period of time (typically five years) and reset or "recast" to a regular schedule if the principle amount exceeds a preset limit. Such pesky details held little interest for the folks selling and buying such loans when money was cheap and easy.
Again, the fact that the principle owed remains constant or continues to grow with such unconventionalloans was seen as an incidental nuisance. With home values rising by tens of thousands of dollars each year, no one had the time or inclination to worry about something as trivial as ever expanding debt loads.
Housing PricesWith the influx of this cheap money into the real estate market during the boom around 2000, real estate prices inevitably began to inflate. It soon came to be expected that a new home buyer of a $150,000 home could sell his home two or three years later for $30,000 more than he had paid. Across the country, home values increased on average somewhere near $800 per month. . . month after month, year after year. This, coupled with extremely low interest rates, made the temptation for homeowners to buy, sell, and upgrade nearly irresistible.
Home Equity LendingAnother byproduct of inflated home values and low interest rates was the explosion of home equity lending. At its height, seemingly every other radio commercial showed lenders telling listeners how easily they could get the equity out of their homes for vacations, college tuition, home improvements, or credit card debt consolidation. And Americans ate it up, trading equity in their homes for vacations, luxury spending and the consolidation of credit card debt. This conversion of unsecured credit card debt to secured loans against their homes is perhaps more responsible than any other single dynamic for the spiraling debt load that Americans carry today.
SummaryWhen things were good, they were very good for home buyers. The rules of the game were simple; get into as much house as you can finagleand tread water for a few years. After just a few years, you'll have a ton of found equity that you wouldn't otherwise have. And instead of throwing money away on rent, you'll pay the same money in interest on mortgage and get 30 percent of it back on your taxes at year-end via the Mortgage Interest Deduction.
So what has happened now to bring all of this to a head? These loans and practices have been going on for years now. Why is this blowing up now? While there are many dynamics at play here, these are what I believe to be the most important and influential contributing factors to the current state of the industry.
Cause 1: Interest rates are trending upward. While still relatively low, rates are considerably higher than they were in 2003 at the height (or depth) of the bacchanalia, when a reasonably-qualified applicant could secure a 30 year fixed rate mortgage for 5.25% with no points. The adjustable rate mortgages made throughout the first half of this decade are now adjusting upward and driving some owners to default.
Cause 2: Sub prime borrowers, who were known by all to be poor credit risks from the outset, are now defaulting on loans of all types (not just ARMs) as everyone knew—our should have known—that they would. Bad loans go bad, to no one’s surprise.
Cause 3: Lenders are becoming more cautious with their lending. Higher lending standards necessarily increase the scarcity of money available for home purchases, which subsequently drives down home prices nation-wide and (eventually) crashes new home sales and construction starts as sellers and builders compete for fewer buyers.
Cause 4: Corrections in home pricing, combined with the trend in home equity spending are resulting in people becoming equity-poor in their homes. Owners who spent most or all of their home’s equity on consumer debt and vacations are now finding that their houses aren’t nearly as much as they once were. Even as their payments rise to a point where borrowers find it difficult or impossible to make the payments each month, these same borrowers are finding that their lack of equity makes it that much more difficult to refinance or sell their home. And this in turn drives up defaults and reduces the turnover rate of existing homes, depleting the buyer base and driving home costs down even further.
Okay. It's well and good to point the finger at lenders and blame them for this crisis. But isn’t the borrower responsible for this mess too? After all, they’re the ones who can’t pay their bills, right?
Absolutely. A significant portion of the blame rests squarely in the laps of the borrowers. The American dream has evolved in the twenty first century to demand a level of luxury that is effectively unattainable for most. Americans, by and large, save nothing and spend more than they earn. We are inherently unwilling to settle for less than our peers, and the abstract nature of monetary dynamics are such that a little denial goes a long way in enabling people to get into trouble. After all, next month will always be better than this month, right? And the credit card bill won’t be that high, really.
So the borrowers are at fault. But I argue that lenders and investors bear the lion’s share of the blame for this current debacle. Highly sophisticated lending and investment firms with all of the marketing power that money can buy have targeted an industry that is challenging for even the most sophisticated customers to navigate. These lenders have directed much of their influence toward selling harmful and destructive loans to the members of our communities who are least well equipped to see the danger inherent in those loans or understand the long-term implications of the agreements they were signing. Hard-working people of limited means were misled to believe that the loans they were agreeing to would better secure their future.
Instead, the bubble burst and those who were most at risk are now being destroyed. And the irresponsible lenders are already seeking a bail out by the government that could make the
Savings and Loan debacle of the 1980s look trivial by comparison.
