The mortgage market - a retrospective

I'm going to weigh in with my two cents worth on ChiTom's post (below) about the mortgage market crisis.

Years and years and years ago, I worked for a mortgage banking institution. In those days, there were some pretty standard rules of thumb for mortgage lending. They were: 1) minimum down payment of 20%, sometimes 25%. 2) Price of the home no more than double the borrower's annual income. 3) Mortgage payments, including taxes and insurance, no more than one-quarter of the borrower's take-home pay.

Now, like all rules of thumb, these might not apply to every single circumstance, but they were pretty widely applied. And, they made sense. Not only did they protect the lenders from an excess of bad loans, but they protected the borrower's as well. How so? They prevented the borrowers from excessive debt that they couldn't handle.

Now, it's also true that those rules of thumb locked a large swath of the population out of the housing market because they couldn't meet the requirements -- the most difficult of which for most young couples seeking to buy their first home was the down payment.

An important element of the landscape in this period was the fact that the lender and the borrower tended to have a continuing relationship with each other. In many cases, the bank originating the mortgage loan intended to hold the loan in its own portfolio until it was fully repaid. Alternatively, even if there was a third-party originator, the third-party originator obtained advance approval from the ultimate lender (a life insurance company, for example) before originating the mortgage.

Occasionally, the lender would re-sell the loan to another lender, but these transactions were the exception rather than the rule.

But, then the financial "engineers" began to introduce new ideas to what had been a rather stogy industry. There were three principal innovations that changed the face of the mortgage markets in this country, and tellingly, two of those were pioneered by a group whose principle has since served hard time in Leavenworth.

The three innovations were 1) adjustable rate mortgages, 2) private mortgage insurance, and 3) securitization of mortgage debt.

Adjustable rates were introduced to make mortgage lending more attractive for commercial banks, whose sources of funds (deposits) tended to be tied to short-term changes in interest rates. If rates rose, banks would have to raise the rates they paid on their deposits in order to compete. But, if their investments were locked into low interest long-term mortgages, they might not have sufficient income to increase the rates paid on their deposits. Hence, for banks, adjustable rate mortgages reduced the risks to the banker. If rates rose, the bank's income from its mortgage portfolio would rise just as it had to pay higher interest to retain its deposits. And, if rates fell, even though its income from its mortgages would fall, it could reduce the rates paid on its deposits without risking large withdrawals.

Because of this, banks saw less risk in mortgage lending than they had before, and, hence were willing to lend at somewhat lower rates than would have otherwise been the case. Of course, the risks were shifted from the bank to the homeowner, whose income typically did not rise and fall automatically to compensate for the rising and falling costs of his mortgage. The lower rates did attract more people into the housing market, but they also exposed those who came to higher risk.

Still, however, there tended to be a direct link between the interests of the lender and the borrower that encouraged the lender to prevent borrowers from pigging out far beyond their means.

It was the next two innovations, pioneered by the now long-defunct Equity Programs Investment Company (EPIC), that tended to completely decouple lenders from borrowers and eventually led to the current debacle. One of those innovations was private mortgage insurance, which, for a fee, insured the top end of the mortgage loan, thereby allowing borrowers to reduce or even eliminate the down payment. Since the top end of the loan was insured, the lender no longer faced the risk of major loss if it foreclosed on a loan when housing prices had fallen. Even if the house could only be sold for 80% of the loan value, the insurance would cover the difference.

The second innovation was securitization of the loans. Instead of placing each individual loan with an individual lending institution, as had formerly been the case, the originator now pools the loans, issues securities against the pool, and sells those securities to a wide spectrum of individuals and institutions in an organized mortgage security market, just as a major company like IBM sells its shares on the stock market. The securities are widely traded to and from participants in the market, who never see details about the specific individual borrowers whose mortgages back up their securities.

At this point, the lenders and borrowers have become so decoupled from each other that lenders have no specific interest in keeping the borrowers within some limits of rationality. Nor does the originator have any interest in the long-term needs of the borrower. He originates the loan, sells it off as a package of securities and walks away with a fee. Underwriting became a forgotten art. The NINJA loan (no income, no job, no assets) had become a reality.

Add one further gimmick -- the teaser interest rate -- to really screw up the market. Originators noticed that you would really dupe the borrowers by offering an introductory below market rate to the ARM loan -- say 1% or maybe even 0% for the first year or so. Of course, to make that work for lenders, there had to be a catch. The rate had to adjust to an above market rate later to make up for the teaser rate in the early going. And, in order to make sure that the borrower paid the higher rate in the later years to re-coup the cost in the early years, there had to be a large prepayment penalty to prevent the borrower from refinancing the loan at market rates once the high rates kicked in. (Note: This gimmick doesn't work as well in the few states that outlaw prepayment penalties on mortgage loans).

Now, you might ask, why did the securities markets buy these securities at par? The securities and/or the mortgage insurers, after all, are going to lose if a large portion of the borrowers default. I suspect part of this is the bubble environment. As long as housing prices were rising rapidly, everybody remained happy. Borrowers could bail out at a profit if the mortgage servicing became too much of a burden, and lenders didn't face substantial losses on foreclosures because the housing markets were booming. The innovations in the mortgage market were almost certainly a major contributor to the rising housing prices. Hence, the "safety" of these securities became a self-fulfilling prophecy -- for awhile. But, bubbles tend to burst when there isn't economic substance to inflate them, and there was no economic substance here. Those old rules of thumb made pretty good economic sense, and still do.

These's lots more to this story -- ARMs that float on soy bean futures prices and the like, but the picture is clearly one of an unrestrained market gone completely bezerk. I'm reminded just a bit of the collapse of the Kuwaiti stock market back in the 1980s. There, there was no requirement that trades be settled within any fixed period. People went on buying sprees in the market without any capital whatsoever, based solely on their paper worth in securities they hadn't yet paid for. In many cases, checked were post-dated for a year later. The market exploded on the basis of all this "free" money until the bubble eventually burst.

These chaotic sprees are not the result of over regulation. They are the result of no regulation.