What Caused the Mortgage Crisis?

It's amazing to sit here, see the economy tumble down at the pace it's going, and see the connection to the mortgage crisis. My friends and my family back in Europe ask about it, want to know how it happened, why it happened, and how to get out of it. I tell them that as soon as I am President… No, ok, I don't tell them that.

At the same time, I listen to their explanations, read those of the pundits here, and particularly check the solutions proposed by people either around me or in Washington. And all of that leaves me baffled, mostly because the situation seems so much simpler than described to me. So, here it goes, Marco's Theory of the Mortgage Crisis:

The whole conundrum started in 2001. George W. Bush had scored points in the election runup by telling everybody that the economy was going South, and certainly the stock market was not doing well. There was a real risk of recession, and incentives were needed. Tax rebates were the solution – one day I opened the mailbox and found a check for $300 from the U.S. government.

Then, the economy limping along unhappily, came 9/11. The economy didn't take a toll after that: it had a brain hemorrhage and there wasn't much anyone could do to revive it.

The real estate market was hit particularly deeply, along with everything related to travel. Nobody wanted to buy a house under the uncertain circumstances. No need for housing, no need for construction, no need for construction workers, and there you go, a whole economy is gone to the wayside, one that is not geographically contained.

The Fed decided to cut interest rates. They plunged at a screaming pace, getting down to 1% eventually. That was unheard of in many decades, but was certainly justified, given the situation and the critical juncture in the country's history.

At the same time, something happened within the banking and mortgage system. I don't know if this was prompted by the need to find more sources of revenue or whether the coincidence was serendipitous, but this change is the one that is costing us now.

Two main changes occurred at virtually the same time:

  • Mortgage companies started combining mortgage obligations into so-called Collateralized Debt Obligations (CDO); the mortgage originator would sell the debt to a second entity that would combine many mortgages into a single bond-like instrument that would be parceled up. The lowest yield would go to the parcel that had the best mortgages attached, and the worst parcel would have the highest risk, but also the highest yield.
  • Mortgage companies started inventing new ways to get consumers on board: no-down-payment loans, negative repayment loans, aggressive 2-year ARMs. The basic idea was to get more people interested in housing.

The two changes conspired in a sinister way: the first change removed the incentive for the bank to qualify the loan, since one originated it was quickly resold, and the problem went to someone else. The second change vastly increased the number of prospective customers, adding a lot of people to the equation that really had no experience buying real estate.

The whole theory behind this was a pyramid scheme: real estate prices go up, so if you buy something, you'll be able to resell it for profit in just a couple of years. So if you get a teaser rate for two years, you are fine, since you are just going to sell when the mortgage resets (justifying the aggressive ARMs and the negative repayment loans).  

Lots of people bought for investment (and all indicators are that those are the loans that are defaulting), hoping that areas like Phoenix or San Diego were going to grow without bounds forever. That's the people that caused the gigantic mortgage crisis. For reasons of political convenience, the media are focused on subprime mortgages, but I can't quite imagine that's the real problem.

So, there you have it: a pyramid scheme, political opportunism, and inappropriate risk assessment (with CDOs) are to blame. Better supervision of banks would have eliminated the problem. Easy solution. 

Interestingly enough, I have heard the strangest things proposed. I believe the weirdest suggestion was that of the pundit on NPR: the problem is the tax write-off of mortgage interest! Of course, taking it away now would force an additional HUGE number of foreclosures from home owners that can't afford their mortgages any more.