How Did the Mortgage Crisis Happen?

1. Introduction

digsThere is a branch of Physics called Catastrophe Theory. It deals with the way something that changes smoothly for a long time may get a sudden change, a catastrophe. The classical example is a pile of sand onto which you drop grain after grain: after a (long) while, the pile can’t sustain all the added sand and there will be an avalanche. How is it possible that something innocuous like adding a grain of sand will end up in an avalanche?

Catastrophe Theory explains that some systems have built-in inertia that can overcome a lot of pressure. In this case, the pile is composed of grains that have no desire to move, as they rub against each other and dislodging them would me overcoming the friction between them. Catastrophe Theory also explains that there is a crucial number for every system that says when the friction isn’t able to compensate for the excess pressure on the pile. Finally, catastrophe theory makes predictions about the likelihood at any point that the system collapse.

Catastrophe Theory, in other words, tells us all about the sudden change, except when it will happen. That’s too much to ask. It can, though, predict very accurately what will happen in the long run.

Catastrophe Theory also tells us that for a catastrophe to occur, there must be a cascading mechanism. That is, there must be a microscopic change that can trigger more microscopic change in a very short time frame. When that occurs, a chain reaction will cause the sudden change at the macroscopic level (the catastrophe). If there is no cascading mechanism, there is no catastrophe.

What does this all have to do with the mortgage crisis? Everything. You see, in the aftermath of the mortgage securities meltdown in 2007/08, we have found all sorts of culprits: from greedy banks to deregulation; from first-time home buyers to real estate investors; from CDOs to lax mortgage practices. Those are all wonderful explanations for a macroscopic change, but they don’t explain why the change was so sudden, so catastrophic.

2. The Lending Front

Let’s first start with a run-down of the situation on the mortgage front: after 9/11/2001, the Bush administration was desperate to jump start the economy – and rightly so. Low interest rates weren’t doing much for business, but they sure helped real estate jump along. Values were skyrocketing, had been for years. Since there was seemingly no downside to real estate, banks started to become less risk-averse. After all, even if a borrower defaulted, they’d have the collateral to sell for a nice profit!

Banks were trying to invent all sorts of ways to sell more mortgages. On the consumer front, this meant 0-down mortgages, and low-cost-short-term loans (ARMs). On the financial front, this meant bundling mortgages and reselling them.

The new markets for loans did something enormously important: they gave people who would have never before qualified for a loan the ability to buy a house. For those that fell into that category, it was a dream come true – the American Dream, in fact.

So far, so good. The logic was unassailable: even if some of the new buyers of mortgages default, their real estate is still worth a ton of money and there is no loss. To the institutions that wanted a piece of the mortgage pie, the banks sold the best chunk of mortgages at a lower interest rate. The crappier mortgages ended up with higher returns for the less risk-averse investors.

Financial models predicted how likely it was going to be that anything would go wrong, and the interest rates were chosen to match. Everything was perfectly in balance, and there was no reason to believe anything could go wrong. This was computed, after all, with all the prior mortgage crises factored in – how could there be anything worse than what had happened in the 80s, the 90s, or after 9/11?

3. The Friction

Imagine you live in a new neighborhood with 100 identical houses. Let’s say they all cost $100,000 when you moved in. You got yours at a 30-year fixed, the neighbor to your right has a 2-year ARM, etc. Everybody is happy, except for the usual disputes about dog poop and overhanging branches.

Then Mr. Smith across the street gets sick. Mr. Smith loses his income, and he starts having to pay medical bills. Not long after, Mr. Smith has to default on his loan, because he can’t find any buyer in time. It’s a real tragedy. Fortunately, Mr. Smith recovers and decides to piece his life together somewhere else.

What does the bank do with Mr. Smith’s house? it sells it, of course. All the bank wants to recover is its investment, which is the principal. Since Mr. Smith had the standard down payment of 20%, the bank doesn’t want more than the 80% it is owed (it would have to give the excess to Mr. Smith). So it sells the house for 80% of the value. It goes fast, since everybody wants to live in your neighborhood.

Now Ms. Miller wants to move in with her boyfriend out of town. She goes to a real estate agent and asks what her house is worth. The agent says, $110,000 (so she can make a commission), and the list it. There are interested parties, offers come in. When Ms. Miller has chosen a potential buyer, things get hectic. Inspections are scheduled, negotiations go on. Then comes the bank that has to fund the mortgage. The buyers are pre-qualified, there is no issue.

An appraiser is called. The appraiser does his job and looks at recent sales. What does he see? There is a property just like Ms. Miller’s that just sold for $80,000! That means that this property cannot be worth more than that. The bank says that the house is overpriced and Ms. Miller can’t sell. Worse than that, she cannot sell at all for more than $80,000, unless to some rich person that doesn’t need a mortgage. No bank will fund a sale higher than that.

Fortunately, appraisals have to be based on recent sales, so the ghost of Mr. Smith’s cheap house is eventually going to be gone. But it will typically take six months. That’s six months in which no house in the neighborhood can be sold for over $80,000. Worse, it cannot be sold for under that amount, either, since then the sale would not cover the principal and the seller would have to refund the bank.

Ms. Miller is lucky and can afford to pay the mortgage while she waits for things to settle. Under her breath, she curses Mr. Smith and his bad luck, but it’s mostly an inconvenience to her.

But then Mr. Baker needs to move out of town for a new job, and he can’t pay a mortgage here and another one (or rent) there. Being rational, he looks into his possibilities: he can continue paying the mortgage until he is ruined and default then; or he can default on the mortgage now. Rebuilding credit is based on when you defaulted, so he is much better off declaring bankruptcy now, restarting the credit clock now with some money left, instead of waiting until he’s got nothing and then restarting the credit clock a year later.

The bank now has a second home to sell. Even if the bank wanted, it wouldn’t be able to ask more than $80,000, since there is the prior sale of Mr. Smith’s house. Indeed, there is a good chance the bank won’t even get those $80,000 at this point, because people expect a better deal from a delinquency sale (mostly because delinquent borrowers don’t take a whole lot of good care of their home).

3. The Trigger

As you see, the appraiser’s interaction with delinquency sales causes a freeze in the market. As soon as the first delinquent property is sold, nobody else can sell until the delinquent sale is too old to work as a “comp.”

The problem is that a lot of the new mortgages were sold under the assumption of fluid markets. Buy as much house as you can, was the mantra, because you will sell it for a profit. A lot of borrowers were steered towards short-term ARMs, loans that start with one interest rate and reset to a much higher after a set period of time.

Banks love ARMs, because they feared that interest rates would eventually start to grow fast. In that case, they didn’t want to be locked into long-term contracts at low interest rates. Additionally, every time someone buys a new loan (refinances, in this case), the banks could make a neat profit.

But what if you have a 2-year ARM whose low-interest initial term expires just as Mr. Smith’s house sold? You can’t sell your house to anyone, because of the perverse appraisal situation. Worse, when you apply to refinance your loan, you realize that the bank treats refinancing as a new sale. If nobody else can buy your home, you cannot either. Even though you have a steady job with a good income, the bank won’t give you a new loan, because the house is not worth the money you paid for it.

This is where things collapsed. Suddenly there were all these short-term loans in frozen neighborhoods, and the borrowers had nowhere to go. They were faced with new interest rates that led to doubled mortgage payments, and they had been steered towards buying at the top of their abilities, anyway.

4. The Catastrophe

When banks started seeing mortgage defaults on the rise, they hit the panic button. They decided to choke mortgage loans, and nobody would get to buy a house as long as the situation wasn’t stable. Of course, that’s precisely what made the situation unstable.

Soon after, the high interest/high risk sections of the bundled mortgages were coming unglued, since the situation on the mortgage front was deteriorating much faster than it had historically. The result was that the institutions holding those sections (“tranches”) became saddled with debt they couldn’t possibly repay. Financial institutions, though, didn’t know how owned (or owed) what, and they stopped lending to each other, waiting for the fallout.

The result was that from a localized problem in one specific market (mortgages), the sickness spread to all money trading. Soon after, the financial economy seized up, revealing for the first time how big a portion trust had played in financial transaction, and how lack of trust translated into a dysfunctional market.

Venerable financial houses like Lehman Brothers died. Other gigantic financial institutions like AIG or Goldman-Sachs were rescued by government forces, and it’s never been clear why some institutions were rescued and others not. (One assumes political reasons more than economic.)

5. The Proof

How do we know if this scenario is correct? Well, if the trigger is the one described, then we should see a pattern in the meltdown: it should be triggered by neighborhood, since appraisals are only valid for a specific neighborhood; and it should focus on those neighborhoods that have lots of loans in need of reset.

What do you know, that’s exactly what happened. In the aftermath of the collapse, people pointed out how clustered the defaults were. They blamed home owners, who had taken on crazy loans out of ignorance of the market. First time home buyers in poor neighborhoods were blamed particularly harshly.

Fact is, though, that it wasn’t poor neighborhoods that were hit the worst. The collapse was spread over a vast number of locations, and the ones hit the worst were new developments with lots of investors. Places like Southern California, Nevada, Florida saw the largest drop in home values.

The issue was not poverty. The issue was not recklessness. The issue was the process banks used.

6. The Fix

If people had realized that the perverse cycle of appraisal and refinancing was the trigger of the catastrophe, they could have started any number of steps to prevent the meltdown, which was entirely man-made.

The first and most obvious fix would have been to require banks to refinance all mortgages without concern for the property or the borrower. If you financed it two years ago, you have to finance it now. End of story. You can change the terms, but you have to give the same terms to this buyer that you would extend to any other buyer with the same qualifications.

A second, and less impressive fix would have been to change appraisal rules to exclude bank-owned properties as comparables. The problem here is that when the situation is bad enough, a bank-owned property may need to be resold again in a short time frame, which in the example above means that Mr. Smith’s home, sold for $80,000, will then be resold by the bank for $64,000, dragging the price down again.

A third, and most definitive fix, would have been to regulate the fees that banks are allowed to charge on loan origination and financing. In particular, banks should not be able to make a profit out of simply selling a loan, but should be required to make their profits from the interest charged. Banking regulation requires disclosure of the up-front fees in the form of the APR. The problem of origination profit is not for the single buyer, though, but for the banking system as a whole.

Finally, a safety valve in the system should disallow banks from restricting loan origination. The meltdown was a consequence of suddenly tighter loan requirements: requiring banks to steady their lending would make them more conservative when things are good, and force them to be more liberal when things are bad.

7. Conclusion

Greed has been often named the main culprit of the financial meltdown of 2007/08. I think that’s wrong: greed is what drives our economy, and it’s worked just fine for centuries.

The problem was process. Banks follow a process in loan origination and real estate sales that has been established decades ago and that takes a long time to change. When conditions in the market changed faster than the loan origination process, the system was overwhelmed and seized up.

The meltdown was easily preventable. If anyone in the course of events had seen what was going on and had pushed the right buttons, the system would have been able to recover. That this was not the case shows how inefficient regulators have become at understanding the complex realities of markets – or how little interest they have in protecting it.

The meltdown is also easily repeatable. Since the culprit was misidentified, the same situation would currently lead to exactly the same result. Since real estate prices are rapidly growing again, it’s really important that someone realize what happened and take the steps required to prevent a reoccurrence.

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