What Caused the Mortgage Crisis?

mortgage crisis

So, “what caused the mortgage crisis” anyway?  In case you haven’t heard, we went through one of the worst housing busts in our lifetimes, if not ever.  And though that much is clear, the reason behind it is much less so.

There has been a lot of finger pointing. In reality, there wasn’t just one cause, but rather a combination of forces behind the housing crisis.  I’ll attempt to list as many as I can think of here.

Originate-to-Distribute Model

  • Banks weren’t keeping the loans they made
  • Instead they’re were selling them to investors on the secondary market
  • Who were slicing and dicing them into securities
  • The transfer of risk allowed more risky loans to be made

In the old days, banks used to make mortgages in-house and keep them on their books.  Because they held onto the loans they made, stringent underwriting guidelines were put in place to ensure quality loans were made.  After all, if something went wrong with the loans, they’d be accountable.  And they’d lose lots of money.

Recently, a new phenomenon came along where banks and mortgage lenders would originate home loans and quickly resell them to investors in the form of mortgage-backed securities (MBS) on the secondary market (Wall Street).

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This method, known as the “originate to distribute model,” allowed banks and lenders to pass the risk onto investors, and thereby loosen guidelines.  The result was casual underwriting, less oversight, and more aggressive financing, which ultimately led to a lot of bad loans being made.

Banks and lenders also relied on distribution channels outside their own roof, via mortgage brokers and correspondents.  They incentivized bulk originating, pushing those who worked for them to close as many loans as possible, while forgetting about quality standards that ensured loans would actually be repaid.

Because the loans were being sliced and diced into securities and sold in bulk, it didn’t matter if you had a few bad ones here and there, at least not initially…

Fannie Mae and Freddie Mac

  • This pair wasn’t free from blame either
  • They were quasi-public companies
  • That were trying to keep private investors happy
  • By easing underwriting guidelines to stay relevant

Of course, banks and lenders modeled their loan programs on what Fannie and Freddie were buying, so one could also argue that these two “government-sponsored enterprises” also did their fair share of harm.

In short, if the loan conformed to the high standards of Fannie and Freddie, it’d be easier to sell on the secondary market. And it has been alleged that the pair eased guidelines to stay relevant in the mortgage market, largely because they were publicly traded companies steadily losing market share to private-label securitizers.

At the same time, they also had lofty affordable housing goals, and were instructed to provide financing to more and more low- and moderate-income borrowers over time, which clearly came with more risk.

However, the private mortgage market took control during the lead up to the eventual crisis thanks to their bevy of high-risk mortgage products, so Fannie and Freddie had to ease their own guidelines to maintain market share.

As a result, bad loans appeared as higher-quality loans because they conformed to Fannie and Freddie.  And this is why quasi-public companies are bad news folks.

Bad Underwriting

  • The underwriting, if you could even call it that
  • Was atrocious at the time leading up to the crisis
  • Basically anyone who applied for a home loan
  • Could get approved back then

That brings us to bad underwriting.  Now it wasn’t that underwriters didn’t know what they were doing, it was more a matter of influence from upstairs.  They were often told to make loans work, even if they seemed a bit dodgy at best.

Again, the incentive to approve the loan was much, much greater than declining it.  And if it wasn’t approved at one shop, another would be glad to come along and take the business.

After all, the loans weren’t being held for more than a month or so before they were the investors’ responsibility.  So you could get away with it.

Faulty Appraisals

  • The appraisals were also highly suspect
  • Emphasis on “high”
  • Since the values were often grossly inflated
  • To make the loan work, which further propped up prices

Going hand-in-hand with bad underwriting was faulty appraising, often by unscrupulous home appraisers who had the same incentive as lenders and originators to make sure the loans closed.

If the value wasn’t there, it only took a little bit of tinkering to find the right sales comparables to get it right.  If one appraiser didn’t like the value, you could always get a second opinion somewhere else or have them take another look.

Home prices were on the up and up, so a stretch in value could be concealed after a few months of appreciation anyway.  And don’t forget, appraisers who found the right value every time were ensured of another deal, while those who couldn’t, or wouldn’t make it happen, were passed up on that next one.

No Skin in the Game

  • Lots of borrowers walked away from their homes
  • Because they weren’t at all invested financially
  • When you put nothing down
  • It doesn’t take much to walk when prices go south

Another big issue was the lack of a down payment in the most recent boom.  Back when, it was common to put down 20 percent when you purchased a home.  In the last few years, it was increasingly common to put down five percent or even nothing.

In fact, zero down home loan financing was all the rage because banks and borrowers could rely on home price appreciation to keep the notion of a home as an investment viable.

However, it wasn’t long before prices began to peak and eventually fall, causing all types of problems for borrowers with little or no equity in their homes.  Those who purchased with zero down simply chose to walk away, as they really had no skin in the game, nothing to keep them there.

Sure, they’ll get a big ding on their credit report, but it beats losing a whole lot of money.  Conversely, those with equity would certainly put up more of a fight to keep their home.

Aggressive Financing

  • Zero down financing was prevalent
  • As were negative amortization loans
  • That allowed borrowers to pay less than the amount of interest due
  • With the expectation that home prices would make up the difference

Playing off the lack of a down payment, aggressive loan programs like the pay option arm and other interest-only options also contributed to the mortgage mess.

As home prices marched higher and higher, lenders and home builders had to come up with more creative financing options to bring in buyers.  Because home prices weren’t going to come down, they had to make things more affordable.

One method was lowering monthly mortgage payments, either with interest-only payments or negative amortization programs where borrowers actually paid less than the note rate on the loan.

Some banks, like now-defunct Bear Stearns, actually offered a pay option arm at 100% LTV, meaning you could come in with zero down and make a super low payment, often as low as one percent, for several years before the loan adjusted to a more realistic rate.

This of course resulted in scores of underwater borrowers who now owe more on their mortgages than their current property values.  As such, there is little to any incentive to stay in the home, so borrowers are increasingly defaulting on their loans or walking away.

Some by choice, and others because they could never afford the true terms of the loan, only the introductory teaser rates that were offered to get them in the door.

 

It was so bad that some homeowners never ever made their first mortgage payment.

Limited Documentation

  • It started with stated income
  • Which was only intended for select borrowers with complicated finances
  • Then moved on to no doc
  • Where all you needed was a credit score to get approved!

Home loans used to be underwritten full doc, meaning you would need to provide pay stubs or W-2’s, along with asset and employment information.  This would give the bank or lender plenty of reliable information to make an underwriting decision.

Then came limited documentation loans, such as stated loans, now known as “liar’s loans,” which were intended for people like doctors and the self-employed who had complicated tax structures.

Eventually, everyone seemed to be taking advantage of limited documentation underwriting, often because they couldn’t meet guidelines legitimately.

After all, your interest rate would only be another quarter-percent higher in many cases, so why provide real income if you can fudge the numbers a little and get approved?

More troubling were no-doc loans, where borrowers only provided a credit score.  No income, asset, or employment information was provided, allowing virtually anyone with a decent credit history to get their hands on a new home.

Over Reliance on Credit Score

  • Some argue that we relied too much on credit scores
  • Which are automated and easily manipulated
  • And not at all foolproof
  • Borrowers also didn’t care about destroying their credit if it meant losing less money

That brings us to the now infamous credit score, which became the bank’s go-to risk indicator in recent history.

Instead of reading between the lines, lenders were happy enough to look at an automatically populated three-digit credit score to determine risk.  If the applicant’s credit score was above a certain threshold, they were approved.

Meanwhile, those with lower credit scores and perhaps more compelling borrower attributes would be denied.  This led to a lot of first-time homebuyers getting their hands on shiny new houses, even if their largest loan prior had been something as simple as a revolving credit card.

Low Interest Rates

  • They were a double-edged sword
  • While they allowed borrowers to save money
  • The low rates also fostered a refinance frenzy
  • And encouraged individuals to buy overpriced homes

And then there’s super low interest rates, which have been historically low for years now, and have just recently hit their lowest point ever.

During the boom, these low mortgage rates encouraged people to buy homes and serially refinance, with many taking large amounts of cash-out in the process, often every six months as home prices surged higher.

Many of these borrowers had built up equity in their homes, but after pulling it out to pay everyday expenses, had little left and nowhere to turn when financing dried up.

At the same time, those who pulled cash out did so using appraised values that can no longer be supported.  So many of these borrowers now have loan amounts that far exceed the true value of their homes, and a larger monthly mortgage payment to boot.

Real Estate Speculators

  • Many of the homes lost during the crisis
  • Were actually investment properties
  • Ironically a lot of mortgage and real estate industry workers
  • Got in on the fun too and lost their hats

It’s not just families who have lost their homes.  Tons of real estate investors have also defaulted on their properties, adding to the foreclosure epidemic and pushing home prices lower.

Many of these speculators purchased handfuls of properties with little to no money down.  Yes, there was a time when you could purchase four-unit non-owner occupied properties with no money down and no documentation! Amazing isn’t it?

Why lenders ever thought that was a good idea is beyond me, but it happened.  Of course, the minute home prices turned, most got out of the game, either by selling or simply walking away, creating a further drag on home prices.

Home Builders

  • There was definitely a supply and demand imbalance
  • Just too many homes and not enough buyers
  • Especially once homes became too expensive
  • And many properties were built in the outskirts

Everywhere you look, at least if you live in places like California, there are scores of new, sprawling housing developments.  It seems every corner has a sign spinner or a billboard advertising new luxury condos or single-family homes.

Unfortunately, many were built in the outskirts of metropolitan areas, often in places where most people don’t really want to reside.  And even in desirable areas, the pace at which new properties were built greatly exceeded the demand to purchase the homes, causing a glut of inventory.

The result was a ton of home builders going out of business or barely hanging on.  And guess who wants interest rates lowered?  You guessed it, the home builders.  Why?  So they can dump off more of their homes to unsuspecting families who think they’re getting a discount.

Of course, the builders don’t actually want to lower home prices.  They’d rather the government subsidize interest rates to keep their profit margins intact.

Unsustainable Home Price Appreciation

  • Everything worked because home prices kept rising
  • But they couldn’t sustain forever
  • And once prices stalled and began to drop
  • The flawed financing backing the properties was exposed

As a result of many of the forces mentioned above, home prices increased rapidly.  Everyone thought they could get rich in real estate, either by flipping a property or refinancing over and over and investing the money.

The promise of never-ending home price appreciation hid the risk and kept the critics at bay.  Even those who knew it would all end in tears were silenced because rising home prices were the absolute solution to any problem.

Heck, even if you couldn’t make your monthly mortgage payments, you’d be able to sell your home for more than the purchase price.  Once that reality faded, big problems emerged.

Greedy Borrowers

  • No one was forced to buy or refinance
  • It’s entirely voluntary
  • What happened to all the money that was extracted from these homes?
  • Ultimately everyone has to take accountability for their actions

Finally, the homeowners themselves should take some accountability for what happened.  After all, no one was forced to buy a home, or forced to refinance and pull hundreds of thousands of dollars out of their home.

And where exactly did all this money go?  When you tap your equity, you get cash backed by a home loan.  But what was all that money spent on?  Were these equity-rich borrowers buying brand new cars, going on fancy vacations, and buying even more real estate?

The answer is YES, they were.  Everyone got a little caught up in the excitement and forgot that you actually had to pay the money back.  They were loans, not free money, yet many borrowers never paid the money back.

They just walked away from their homes, but may have kept the many things they bought with the proceeds.  You’ll never hear anyone admit that though.

Ultimately, each borrower was responsible for paying their own mortgage, though there were certainly some bad players out there that may have manipulated some of these folks.

Still, a home purchase is a major decision and one everyone should fully understand and be comfortable with before proceeding.  And while you can blame others for financial missteps, it’s your problem at the end of the day so take it seriously.

There are likely many more reasons behind the mortgage crisis, and I’ll do my best to add more as they come to mind. But this gives us something to chew on.

Read more: When will the next housing crash take place?

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