by Jack StrangeA quote widely attributed to the famous physicist Richard Feynman said, “No matter how complicated a subject, if you can't explain something to an average high school kid, you really don't understand it.” The recent cascade of events that has caused credit markets to freeze, the housing market to collapse, the stock markets to crash, and an instability in the global banking system have been in the making for decades and are well understood. What is less understood, even by some of the brightest economic and financial minds in the world, is what to do about it. It challenged me as a teacher of economics and mathematics to find a way to explain it to my students.
Let’s examine what happened in five plus steps that led us to the crisis we’re in today.
Step one. Historically, conventional home loans have required a reasonably significant down payment. 20%-25% was not unusual, with repayment schedules that run from 20-30 years. I remember scrimping and saving for years in order to accumulate enough cash for the down payment on my first house. In such an arrangement both the lender AND the borrower have significant equity (an ownership interest) in the property. This means that both the borrower and the lender have strong incentives to assure repayment of the loan in keeping with the terms of the agreement. That delivers stability and reduces default and foreclosure rates. Potential borrowers were evaluated by trained and experienced loan officers who frequently relied as much on intuition as on a checklist to evaluate the creditworthiness of borrowers. In other words, conforming loans protect EVERYONE when housing markets are rising as well as falling. Both the borrowers and the lenders have equity. But over the last two decades there was a change in how home loans were both offered and evaluated.
So now Congress gets into the act. There was a concerted push in the U.S. Congress to make home loans more “accessible” to a greater number of people; a populist political objective. “Everyone should own a home,” the politicians crowed, “a piece of the American Dream,” whether qualified or not. The prevailing attitude was that accessible mortgages were a positive externality and a public good. (As it turns out it’s not. It may be the world's biggest negative externality and still the government is subsidizing it.) Legislation was enacted that made it a stated regulatory objective of the two big GSE’s, the government sponsored enterprises Fannie Mae and Freddie Mac, to assure that as much as 40% of all the money (liquidity) that the GSE's made available to banks to lend to individual buyers went to buyers in the “affordable housing” markets. Many of these so-called sub-prime borrowers are those customers who could not possibly qualify for conventional conforming loans due to a lack of an adequate down payment, little credit experience, a history of delinquency or bankruptcy, insufficient income, or dubious legal residency. In other words, they were promoting and making risky loans to those who are far less likely to repay them.
Regardless, the banks and mortgage brokers pitched low down payment and no income/no asset (NINA) loans to less-than-qualified borrowers like there was no tomorrow. Sure, the risk of loan defaults was substantially higher with the sub-primes but so was the potential reward since the sub-primes yielded higher interest rates and profits. Institutional investors were hooked. Throughout the 90’s Fed Chairman Alan Greenspan kept the Federal Funds Rate so low that these alternative instruments looked more and more attractive. “If a few borrowers defaulted, so what? We repossess the house and it still keeps gaining in value,” they thought. Sweet!
Many of these loans would then be “repackaged” through process called securitization and re-sold as derivatives such as mortgage-backed securities and collateralized debt obligations to institutional investors who saw their value as high-return investments but who had little connection to the actual borrowers on which these securities were based or to the inherent risk that these mortgage pools carried. Derivatives are financial instruments whose values depend on the value of other underlying financial instruments. They are the house whose inherent stability depends on the quality of the foundation that it’s built upon. Now the trap was set and properly baited.
So there's the smell of money in the water and the feeding frenzy begins fueled by good old-fashioned greed. The banks and mortgage investors throw caution to the wind and try to make sure that they’re able to chomp and gobble as much green meat as they can. And why worry? The government and its GSE surrogates Fannie and Freddie were there to provide the safety cushion. Yes? Absolutely! And if not them... the American people.
Step two. What ever happened to the steely-eyed loan officer with the trusty and well-worn rubber “NO LOAN” stamp whose job it is to protect the lender’s assets by carefully screening and qualifying loan applicants? Well, he was replaced by a statistical method of screening called credit scoring. Credit scoring had already proved itself an efficient and effective method of evaluating the creditworthiness of potential borrowers of other forms of debt like unsecured credit cards. So it should have worked with mortgages too. Or at least that's what everyone thought. Credit scoring had the other “advantage” of being less likely to be biased by factors that “human intuition” relies on such as, “What kind of neighborhood is the house in? Does the applicant have a steady job? Is his income verifiable and reasonable? Does he really have prospects of paying off the loan over the next twenty years? Does he seem like a solid citizen?” But credit scoring (instead of human intuition) as a predictor of credit risk failed to include a number of relevant variables. The statistical model relied on by lenders was broken so when housing prices declined credit scoring failed. Add that to the fact that, as we saw before, mortgage loans with low down payments are inherently destabilizing. Still 52% of Fannie Mae and Freddie Mac’s lending was to sub-prime borrowers. It was the enabler of the housing bubble… a bubble ready to pop!
OK, so where are we? Home loans are being offered to many new unqualified buyers. Risky? Sure. But as long as real estate values kept climbing you can afford to gamble. Everyone’s a winner! There’s no downside, right? Right?
Step three. With all this easy credit floating around to qualified and unqualified buyers alike it didn’t take long for the housing industry to get into the act. Houses and apartment dwellings were springing up everywhere like mushrooms after a spring rain. So much so that they got ahead of the market and that led to a classic problem of over-supply. According to some estimates, at the beginning of this year there were 18 million unoccupied housing units out of about 150 million households in the US. That leads to the free fall of prices as they seek market equilibrium. Pop! The housing bubble bursts! Add to this supply of housing the thousands upon thousands of new foreclosures coming on the market and things start to get really ugly!
Step four. You are a homeowner. Maybe you’re one of those sub-prime borrowers. You’ve got yourself a $400,000 adjustable rate mortgage (ARM) on a house with no money down. Sweet! But there's very little equity. Hey, when the mortgage broker pitched the financing package it seemed to be almost too-good-to-be-true! No money down, you didn’t need to prove your income, so you got fired twice last year but nobody checked, and the interest rate was really low so even the payments where do-able. Sure it’s an ARM but the rates don’t seem to adjust much and besides that’s two-years into the future. Go for it dude! And many did.
So here we are. The interest rates adjust. Actually, they skyrocket! You can't make the payments. You consider selling the house. But wait a minute! You discover that the house is now worth less than when you bought it. Whoa! That’s not supposed to happen. Real estate values always go up. Right? Worse still, you find out that you owe more than the house is worth. You’re upside down on your loan! So what do you do? You walk away. The bank will foreclose and take a bath. But not you. No sir. You'll only get dinged on your credit rating. A credit rating that wasn’t all that great in the first place. What about the ethics? I mean a contract is a contract. But hey, times are tough for everybody and sometimes you gotta do what you gotta do.
So the bank does indeed take a bath. Not just on this house but on thousands of similar houses. Now it’s in real trouble. And not just this bank but lots of banks.
Step five. The government gets into the act again. The goal of writing loans to unqualified sub-prime borrowers as a regulatory objective in part led to the unsustainable house of cards. In other words instead of allowing market forces to be the self-organizing system that drives the mortgage market, the calculated tampering by Senator Chris Dodd (D-Chairman, Senate Banking Committee) and Rep. Barney Frank (D-Chairman, House Financial Services Committee) to achieve their political objective (the regulatory mandate) of making housing “affordable” to bad-risk buyers has in-part led to a meltdown in global financial markets. Government’s role should have been to put a check on the derivatives and a check on credit scoring. It consciously did just the opposite.
Summing up... it's a tale of reckless behavior, of violation of fiduciary trust, of cynical political gamesmanship, of unbridled greed, of economic illiteracy, of no oversight, of no consequences. Lessons learned? None.
The fix? To close with another quote from Richard Feynman… "The real question of government versus private enterprise is argued on too philosophical and abstract a basis. Theoretically, planning may be good. But nobody has ever figured out the cause of government stupidity and until they do (and find the cure) all ideal plans will fall into quicksand.
No comments:
Post a Comment