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How Lending Standard Changes Led to the Housing Boom/Bust

Tuesday, October 21, 2008 | 07:21 AM

in Credit | Federal Reserve | Fixed Income/Interest Rates | Real Estate

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.