The Mortgage Mess Explained (Sort of)

I get a lot of questions in class regarding the current mortgage mess and subsequent credit crisis. While I try my best to answer, I think the honest truth is that no one really knows what exactly has happened and whatever the truth is often distorted by pundits and ideologs. So here it goes—my best effort to explain this mess the best I can, and, as always, corrections and knowledge sharing is more than welcome.

One thing must be made clear—the mortgage market is not a free market—it is pricked and prodded at nearly every point by government activity that has distorted the process. True, there is much involvement by private entities, but we shall see how their actions merely responded to incentives offered by government manipulation of the market.

So it all begins with depositors leaving their money with the bank. Since deposits are insured by the Federal Deposit Insurance Corporation (FDIC), depositors need not do due diligence on the financial institution they leave their money with and don’t care if the latter make silly loans. Flush with cash from reassured depositors, the banks look to loan it out. Say Joe Schmo wants to buy a home, but Joe has lousy credit (we will avoid the usual credit points system and just give Joe a CCC rating). If Joes was a company looking to borrow money, then the bank may think twice, but there are no worries with the mortgage—Joe may not even have to put any money down—just pay the fees and Joe has his loan. Why would the bank do something so foolish? Because, it is not foolish. The bank doesn’t have to hold onto the mortgage and wait for Joe to default. In fact, the bank probably wants to get rid of Joe’s mortgage as fast as possible. Luckily for the bank, there is always a willing buyer for troublesome mortgages like Joe’s. Fannie Mae and Freddie Mac (two technically private entities chartered by the federal government) will buy the mortgage from the bank. The bank now has more money to lend out to the Joe Schmo’s of the world (who also may or not be real estate speculators) and also has the incentive to repeat this cycle over and over again.

However, Joe’s mortgage does not stop with Fannie and Freddie. Fannie and Freddie take Joe’s loan and combine it with other mortgages to create mortgage-backed securities, which they then sell to investors. Fannie and Freddie then use the money to buy more mortgages from banks who loan the money out again. So what self-respecting investor would buy a security backed by shaky mortgages? The answer is a conservative investor adverse to risk. “Huh?” you say, “why would a conservative investor buy something backed by a bunch of mortgages taken out by folks with lousy credit?” At this point the investor neither knows nor cares about Joe and his credit. When Fannie and Freddie sell a mortgage-backed security to an investor, they guarantee the mortgage payments. As far as the investor is concerned, the mortgage-backed security is sound as a pound. It was for this reason that mortgage-backed securities proved popular with traditionally risk adverse financial institutions such as insurers (like AIG) and hedge funds. Since a mortgage-backed security guaranteed a stream of interest payments, investors found all sorts of uses for them. A common use was as an interest rate swap, where a company looking to hedge against cash flow difficulties would swap its cash flow for the guaranteed stream of interest payments from the mortgage-backed securities. In short, mortgage-backed securities appeared to be a great way for companies and financial institutions to hedge against risk.

Unfortunately, what looked to be a firm foundation ended up being made of sand, because behind all those “good as gold” mortgage-backed securities lay Joe Schmos with rotten credit. The problem was that when credit rating agencies looked at mortgage backed securities, they didn’t see Joe and his CCC credit but guaranteed financial instruments which gleamed AAA and imparted this shine to the institutions holding them.

So what happened? Many of the loans had been made at adjustable, rather than fixed, rates. Since many folks had borrowed much more than they should of, even a small increase in interest rates meant big increases in mortgage payments. Not surprisingly, more and more people began defaulting on their mortgages as rates increased. Conventional wisdom had held that this would not be such a big deal for the holders of defaulted mortgages. After all, the house could always be sold to cover any losses. However, the prolonged slump in the housing market meant homes sold at greatly reduced prices or not at all. Entities such as Fannie and Freddie found themselves held to guarantees that they could not meet. Deprived of their guaranteed interest payments from mortgage-backed securities, investors (and the credit rating agencies) began to see what really backed the securities—homeowners with poor credit living in much depreciated housing.

This is when the house of cards fell down. No longer able to simply make dodgy loans and sell them to Freddy and Fannie, the banks started being more careful about who they leant to. The tightening of credit led to even less home buying and further depressed the market, which pushed the value of mortgage-backed securities even lower. Meanwhile, at the other end of the spectrum, investors discovered the real worth of the mortgage-backed securities they held. Many venerable institutions suddenly found themselves writing off billions of dollars in assets, and some, like Bear Stearns, simply imploded. To make matters worse, the use of interest rate swaps meant that companies with no real connection to the mortgage market saw their cash flow hedges dry up. In the meantime, consumers started worrying about paying their mortgages and fiercely reined in their spending, which caused the economy’s aggregate demand curve to shift back (or to the left). The subsequent evaporation of demand is now driving down prices, eroding profits, and producing layoffs, which are, in turn, leading to more defaults and further depressing consumption. To be blunt, we are in for a very rough tide. However, barring nuclear war, things always get better over the long-term. The good news about sharp recessions is that they are often over the fastest. Furthermore, as I blogged about earlier, the government’s reaction has been nowhere near as pigheaded as in the past, but will more government oversight stop this from happening again? Probably not, the chief culprit behind this mess has been the government’s thirty year drive to encourage homeownership in America. While this is a worthy goal, it depends on cheap credit given to those who may not be entirely credit-worthy. Somehow, I do not think this policy will change anytime soon, and it will only be a matter of time before those on Capitol Hill call again for easy lending, and then we start all over again.

Comments

[Lucas Pillman]

Great post. One of the best explanations I have read about the current financial crisis.

Question: One of the solutions we have seen to the economic recession we are now in is to push down interest rates for home loans to help out the housing market. If these loans are once again made with implicit or explicit government guarantees to home buyers with less than perfect credit are we setting ourselves up for another crash?

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I think it is a great blog.And I am happy to see such a brillant report that explains nicely current mortgage mess and subsequent credit crisis.