How Lending Standard Changes Led to the Housing Boom/Bust
There is a general lack of understanding as to how the Housing boom and bust occurred, and why it led to the subsequent credit freeze. The situation is complex, and that is why we are still explaining this 3 years into the housing bust.
Let me take another shot at clarifying this:
Underlying EVERYTHING -- housing boom and bust, derivative explosion, credit crisis -- is the enormous change in lending standards. I am not sure many people understand the massive change that took place during the 2002-07 period. It was more than a subtle shift -- it was an abdication of the traditional lending standards that had existed for decades, if not centuries.
After the Greenspan Fed took rates down to ultra-low levels, home prices began to levitate. More and more mortgages were being securitized -- purchased by Wall Street, and repackaged into other forms of bond-like paper. The low rates spurred demand for this higher yielding, triple AAA rated, asset-backed paper.
In this ultra-low rate environment, where prices were appreciating, and most mortgages were being securitized, all that mattered to the mortgage originator was that a BORROWER NOT DEFAULT FOR 90 DAYS (some contracts were 6 Months). The contracts between the firms that originated mortgages and the Wall Street firms that securitized them had explicit warranties. The mortgage seller guaranteed to the mortgage bundle buyer (underwriter) that payments were current, the mortgage holders were valid, and that the loan would not default for 90 or 180 days.
So long as the mortgage did not default in that period of time, it could not be "put back" to the originator. A salesman or mortgage business would only lose their fee if the borrower defaulted within that 3 or 6 month contractually specified period. Indeed, a default gave the buyer the right to return the mortgage and charge back the lender the full purchase price.
What do rational, profit-maximizers do? They put people in houses that would not default in 90 days -- and the easiest way to do that were the 2/28 ARM mortgages. Cheap teaser rates for 24 months, then the big reset. Once the reset occurred 24 months later, it was long off the books of the mortgage originators -- by then, it was Wall Street's problem.
This was a monumental change in lending standards. It created millions of new potential home buyers. Why? Instead of making sure that borrowers could pay back a loan, and not default over the course of a 30 YEAR FIXED MORTGAGE, originators only had to find people who could afford the teaser rate for a few months.
This was a simply unprecedented shift in lending standards.
And, it is why 293 mortgage lenders have imploded -- all of these bad loans were put back to them.
Note that the fear of this occurring is what was supposed to keep the
lenders in line. The repercussions of this is why Greenspan believed the free market could self-regulate. (After all, people are rational, right?) One of the many odd lessons of this era is that, under
certain circumstances, companies and salespeople will pursue short term
profits to the point where it literally destroys the firm.
If you want to point to the single most important element of the Housing boom and bust, this is it. Ultimately, these defaulting mortgages underlie the entire credit freeze. And, it would not have been possible without the Greenspan ultra-low rates, which made the teaser portion (the "2" of the 2/28) of these mortgages so attractive.
Contrary to the cliche, failure is not an orphan in the current crisis -- it has 100s of fathers. But these four are the primary movers, the key to everything else. The perfect storm of ultra-low rates, securitization, lax lending standards and triple AAA ratings -- these are the key to how we ended up with the previous boom, followed by a bust, and ultimately, the credit freeze.
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Tuesday, October 21, 2008 | 07:21 AM | Permalink
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But, but, but....CRA...Fannie Mae.....Clinton....Democrats....
in one, two, three....
Posted by: OhNoNotAgain | Oct 21, 2008 7:42:58 AM
I don't want to minimize the role of Wall Street in enabling the rapid growth of unsound lending practices, and I think your analysis is largely correct. However, a substantial part of the growth of bubbles such as the US housing bubble is ultimately driven by the force of greed at the local level, where appraisers, mortgage originators and buyers all share part of the blame. Everyone knew someone who was doing it and everyone wanted a bigger house. The supply of greater fools is always a function of what is going on at the local level.
Posted by: leftback | Oct 21, 2008 7:43:45 AM
"One of the many odd lessons of this era is that, under certain circumstances, companies and salespeople will pursue short term profits to the point where it literally destroys the firm."
Not really a new thing. Over the past 20 years, the Big 3 auto companies have acted, with help from their own unions and reps in Congress, in the exact same way.
I would bet that you can find examples of this all over our economy, especially in publicly-held corporations. It is one of the unfortunate side-effects of having every Tom, Dick, and Harry investing their retirement money in the stock market and betting on the stock prices going up forever at a 7% rate. There is constant pressure on companies to think short-term instead of long-term. The incentives to make decisions that benefit the company in the long-term are all screwed up, starting with the compensation packages being given to CEOs.
Posted by: OhNoNotAgain | Oct 21, 2008 7:55:59 AM
#1 I'd still say it's the ultra low rate environment.
It's the thirst for yield that permitted the securitization. And it's the hugely attractive upfronting of EPS when securitizing that made it alluring to ease lending standards.
Posted by: DANM | Oct 21, 2008 8:00:13 AM
Where were the Boards of Directors of the mortgage lenders during this seachange to 2/28 ARMs. Do you think the BOD of, say, Ameriquest ought to have stepped up.
Posted by: gary | Oct 21, 2008 8:13:46 AM
"...companies and people will pursue short-term profits...until [destruction]..."
Not quite. They will pursue the incentives as offered (by Bear, FNMA, Goldman, etc.)
If the incentives were designed correctly, then destruction does not necessarily follow.
Posted by: dad29 | Oct 21, 2008 8:16:37 AM
Thank you...again. Will people finally stop trying to BLAME Fannie Mae on this?! I receive emails from colleagues of mine in the mortgage industry almost daily trying to pass the blame literally to the "corruption of Fannie Mae". Coincidentally, they are those who voted for Bush twice, so it makes sense to me...
Posted by: Joseph McCann | Oct 21, 2008 8:25:01 AM
Today looks like a substantial pull-back. Crude is weak, we may see some profit taking after the run up in oil stocks.
Posted by: leftback | Oct 21, 2008 8:25:22 AM
"...created millions of mew potential home buyers."
Freudian slip?
Posted by: BrianVT | Oct 21, 2008 8:26:57 AM
I think it's worth looking at the other side also -- so many poor quality mortgage loans would not have been made if there were no demand for securities created by aggregating them.
More fundamentally, I suspect that if it weren't US mortgages it would be something else, tulip bulbs or whatever... the real problem being poor risk management that was and is a consequence of financial institutions' perceiving themselves as too big to be allowed to fail.
Former Army general Eisenhower warned in his farewell address of the potential danger posed by a military-industrial complex. As he leaves office, will our first president with an MBA (from Harvard Business School, no less) sound a similar warning over the danger posed by giant financial firms?
Posted by: Snickers | Oct 21, 2008 8:27:35 AM
Your persistence in defining the change in lending standards as starting in 2002 is getting tired and worn out. It STARTED many years prior to that. For crying out loud, do you think lending standards were tight when Trump was going to borrow money against airport gates to buy American Airlines?
You could actually make the case that it started in the 1970s with Milken and junk bonds. This progressed to the Peso Crisis in the early 1980s, the S&L Crisis, then to LTCM. In EACH case, the Volcker/Greenspan Put convinced people that there was no risk, that the Fed would always be there. We've been bailing out bad lending decisions for three decades. It did NOT start in 2002. That just marks the point at which progressed to the housing market, which is where individuals had most of their net worth. That's when individuals got in on the action.
For a guy who says he wants to get at the root cause of the credit crisis, you're lack of long-term perspective means that any solution you come up with will not fully address the real problem.
Here's the real problem: people always believed that if a loan went bad, at least the asset backing the loan would go up in price so that the asset could be sold if payments were missed. That way, both the borrower and the lender would be made whole. That started a long time ago. Although I'll admit it went parabolic beginning in 2002.
~~~
BR: Don, it was the combination of factors. Yes, securitization existed for decades, and the ratings agencies have been corrupt for just as long.
But make no mistake about it
-- in the 1970s, or 80s or 90s, you could not get a no money down, no income verification, no credit check, interest only, 2/28 mortgage. They did not exist.THAT is the key difference.
Lending standards matter a great deal -- and they went to hell after 2002.
Posted by: Don | Oct 21, 2008 8:38:31 AM
I like to blame Greenspan as much as anyone but don't forget that Japan had super low interest rates all through the 90s and even today they are at .5%. Does anyone remember the "carry trade"?
Posted by: danf | Oct 21, 2008 8:42:17 AM
I'm not comfortable attributing the rising prices solely or even primarily to relaxed lending standards. Bubbles always seem to have a core of speculative greed and a delusion that prices will always rise. Looser standards for credit may enable that, but I still believe the price bubble is not identical with the credit bubble. The tech stock bubble was a speculative price bubble with not so much of a cheap credit factor, but it was a bubble non the less.
Posted by: wally | Oct 21, 2008 8:43:14 AM
BR said: One of the many odd lessons of this era is that, under certain circumstances, companies and salespeople will pursue short term profits to the point where it literally destroys the firm.
comment: This appears to be a controversial observation. You say "under some circumstances". I would argue "under every circumstance possible". This happens at the level of executive management and at the level of strawboss coworker or princess clerk.
People are smart. They will grab all they can if they can stick someone else with the bill. Bullies do this out of learned behavior and out of habit. Psychopaths do it out of their nature. Lobbyists do this as a common business practice.
This is a normal consequence of a lack of control by responsible people. It's the first stages of anarchy. It's simple entropy. If no energy is expended to maintain cohesion, you can expect things to fall apart and aggressive and exploitative self interest will appear.
This is what is so insidious about the modern Republican party. Their ideology would allow the world to disintegrate as a by product of their political philosophy. And a lot of people confuse this byproduct with "personal freedom".
Posted by: dead hobo | Oct 21, 2008 8:46:47 AM
Politicians have a short time horizon also. They only care about what happens between now and the next election. Even if they knew what would have happened in say 2003, they wouldn't have done anything about it. The problems would occur after the next election.
I think the actions of foreign central banks had a bigger role than the FED in this mess. The FED, acting by itself, couldn't have kept mortgage interest rates low. Foreign central banks recycling their pegging dollars back into the US at whatever yield they could get was the primary driver of low interest rates. That's why when the fed started raising interest rates, mortgage rates didn't budge. Remember Greenspan's conundrum.
I agree the republicans trying to blame the mess on the GSE's shows their true colors. The GSE's were and are middle men. For most of the housing runup, they were the only organization maintaining any sanity in the market. It wasn't until after congress had them act as the new subprime lender after all the subprime lenders went under, their troubles really started. If they had maintained their lending standards, it would have made the mess more manageable.
Posted by: charlie | Oct 21, 2008 8:49:03 AM
The low rate caused inflation to exist everywhere. That included house prices.
Since inflation was high for years the computer models figured it would continue on.
That was all fine and good until people couldn't afford things any more and began borrowing for normal lifestyle needs.
Posted by: John Borchers | Oct 21, 2008 8:58:53 AM
Another Fed program.
These programs are going to start panics.
Posted by: John Borchers | Oct 21, 2008 9:01:53 AM
@ dead hobo wrote:
"People are smart. They will grab all they can if they can stick someone else with the bill. Bullies do this out of learned behavior and out of habit. ...
This is a normal consequence of a lack of control by responsible people. It's the first stages of anarchy. It's simple entropy. If no energy is expended to maintain cohesion, you can expect things to fall apart and aggressive and exploitative self interest will appear."
Excellent stuff, dead on. I really couldn't have put it better, thanks for that post.
Oil is off $3, watch the $70 level it is critical. If it melts, we will get a meltdown in energy stocks later in the day/week.
Posted by: leftback | Oct 21, 2008 9:08:04 AM
It's simple entropy
---------------
Love it. That is exactly what is happening. And just because most people have absolutely no concept of what entropy is, doom will come even faster.
We are still in the era of the industrial revolution where growth has been made possible by millions of years of energy accumulated in each barrel of oil and burned in a single century.
Unless we can find a way to replace this source of energy which has permitted our current way of life, I don't know how anyone can expect it to continue for another century!
Posted by: DANM | Oct 21, 2008 9:11:29 AM
Monetary policy was the obvious major cause of the housing bubble. But, I can't buy into the premise that a government campaign to pump liquidity into housing was just ancillary to the process. The GSE's may have been middle men, but they were middle men with government guarantees. Capital gains tax exemption? Mortgage interest deduction? Affordable housing? Its no wonder that we evolved into an economy where everyone built, sold, and financed each other's houses.
Posted by: Spread the Wealth Baby | Oct 21, 2008 9:14:42 AM
BR, you hit on the #1 reason without even realizing it. Greenspan's artificially low interest rate policy. Lending standards didn't loosen significantly until early 2006, by which time we already had a decent bubble. Don't get me wrong, it provided fuel to the fire, but the point is that nobody needed all sorts of crazy exotic mortgages until the prices ALREADY were too high.
Posted by: Rathipon | Oct 21, 2008 9:19:13 AM
People are rational, when they have enough information. However there was another level of disconnect: making crap loans, and selling them to wall st. was only a short term viable business, but if the CEO's, and other corporate officers and managers made enough money during that short term then the loss of the business is irrelevent.
Can you say the The Tan Man? I knew you could.
And of course it's not just managers at mortgage lenders or originators, but also managers at wall st. financial firms. Sure we're selling ludicrous investment products, and sure, sooner or later people are going to figure it out, but in the meantime we're making 9 figure bonuses. While I'm sure many of these folks figured the federal government would bail them out when they ran into trouble, I'm willing to bet that even these guys are at least slightly raised eyebrows over the ability to continue to draw bonuses as if the companies they operate were still generating returns like the did in 2004.
Posted by: VoiceFromTheWilderness | Oct 21, 2008 9:20:28 AM
I think the actions of foreign central banks had a bigger role than the FED in this mess. The FED, acting by itself, couldn't have kept mortgage interest rates low.
How much of an effect did these implied government guarantees on mortgage bonds have though?
In other words, would we have gotten the flood of foreign capital in to the mortgage markets if there wasn't this perception that there was no real risk to the mortgage bonds?
This seems to be the story of the notorious Greenspan Put.
I would observe once again that whenever some action is taken to remove the risk from markets and preserve the rewards for participants the markets have a history of going insane.
This seems perfectly rational to me - if you have the opportunity for immense profits and some outside entity is providing you with insurance against losses, why not go balls to the wall?
Furthermore what's the point of even having that kind of insurance besides encouraging risk taking?
Did we really need this implied or explicit backing of mortgage bonds when everybody and their dog is buying 10 houses?
What sense does that kind of policy make?
The hedge fund industry also played a similar role with the subprime mess - hedge fund managers who don't have to worry about losses basically buying all the subprime mortgage debt they can get their hands on.
But it's the same fundamental problem - separation of risk from reward.
Further I would argue this problem would have largely been averted if we hadn't rescued the financial system and cut rates in 1998.
Sure we might have had a painful recession, but we would have gotten all the leverage and garbage out of the system rather than having it pile up for another ten years.
Posted by: super-anon | Oct 21, 2008 9:22:32 AM
Hi Barry,
I'm generally a big fan of your blog and have learned a lot over the last couple of years. I think you've got the mechanism correct, i.e.
Ultra Low Rates -> Lax Credit Standard,
but I do not agree with your attributing it to mortgages alone. That same mechanism impacted ALL the fixed income spectrum from corporate bonds, to credit card and auto loan ABS.
As I've said before, when you have the flu and your running nose occurs before the soar throat, do you describe the soar throat as "runny nose contagion"? The entire fixed-income market was and is impacted by the mechanism you highlighted. That is why the credit crisis is no where near being over with. It hasn't even started.
Posted by: IAmEric | Oct 21, 2008 9:22:33 AM
Isn't today the Big, Bad Settlement of the Lehman bankruptcy and CDS swaps? If yes, when will it be done and cleared? End of the day???
Thanks.
Posted by: Big J | Oct 21, 2008 9:24:24 AM
