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.

>

Creditasplants

 

Category: Credit, Federal Reserve, Fixed Income/Interest Rates, Real Estate

Please use the comments to demonstrate your own ignorance, unfamiliarity with empirical data and lack of respect for scientific knowledge. Be sure to create straw men and argue against things I have neither said nor implied. If you could repeat previously discredited memes or steer the conversation into irrelevant, off topic discussions, it would be appreciated. Lastly, kindly forgo all civility in your discourse . . . you are, after all, anonymous.

68 Responses to “How Lending Standard Changes Led to the Housing Boom/Bust”

  1. OhNoNotAgain says:

    But, but, but….CRA…Fannie Mae…..Clinton….Democrats….

    in one, two, three….

  2. leftback says:

    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.

  3. OhNoNotAgain says:

    “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.

  4. DANM says:

    #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.

  5. gary says:

    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.

  6. dad29 says:

    “…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.

  7. 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…

  8. leftback says:

    Today looks like a substantial pull-back. Crude is weak, we may see some profit taking after the run up in oil stocks.

  9. BrianVT says:

    “…created millions of mew potential home buyers.”

    Freudian slip?

  10. Snickers says:

    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?

  11. Don says:

    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.

  12. danf says:

    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”?

  13. wally says:

    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.

  14. dead hobo says:

    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”.

  15. charlie says:

    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.

  16. John Borchers says:

    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.

  17. John Borchers says:

    Another Fed program.

    These programs are going to start panics.

  18. leftback says:

    @ 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.

  19. DANM says:

    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!

  20. Spread the Wealth Baby says:

    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.

  21. Rathipon says:

    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.

  22. VoiceFromTheWilderness says:

    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.

  23. super-anon says:

    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.

  24. IAmEric says:

    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.

  25. Big J says:

    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.

  26. super-anon says:

    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.

    Greed is endemic to human nature. It’s not going away. The reason capitalism works is because it channels this greed in a way that leads to aggregate wealth and well being.

    To make the point I just made in the context of greed: I think to keep some rein on it, market participants have to have some fear of losses. And I think by protecting market participants from those losses in the name of economic growth and stability we encourage greed to get completely out of control and ironically create an economy that is far less stable.

  27. dead hobo says:

    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

    ———————————-

    Yeah, things are looking up again. When/if oil hits the low $60s or the $50s as more and more people are predicting, then the world will start to look very interesting again.

    All it will take for oil to remain low for several years will be for those with excess credit available (someday) and those with free cash to avoid the supplemental commodity markets (such as long only commodity index funds) and put that cash in the rest of the world.

    If you want commodity investments then bet on the actual commodity and risk delivery. Then, watch the stock markets go Varooom. It’s really that simple. Just say no to commodities and yes to everything else. Then watch your money multiply at an exponential rate … just hold back until oil bottoms. Then, off to the races.

    If oil rises out of control, again, then kiss your other investments goodbye, again. If you want oil to remain low then ignore it unless you are a genuine oil trader.

  28. Bob A says:

    Bingo!

    We should post this in the lobby of every bank and…

    pin in on the tail of many many donkeys.

  29. lurker says:

    I think a few posters missed the actual thesis of this blog entry. Hell I probably missed it too, but it seems to be that even though Greenspan, Wall Street and borrowers were involved, the mortgage industry was the central player. In order to generate short term profits a ton of basically “zero” interest + zero down” loans were originated and set up so that they would not fail until well after the mortgage company had washed its hands of each and every loan. This made it easy to buy – so everyone started swapping houses, taking credit lines out etc.

    I encountered these loans when I went to buy my third home a few years back – I’d been out of the market for a few years and when I applied for a loan the agent pushed very hard for me to get the “zero/zero” loan. I passed, and actually was a bit put off by the whole concept so I bailed on the buying a house idea. Good thing – it was in Miami. (and -no- I don’t have three homes, I was just renting at the time. Acutally I still am, and pondering the real estate marget again . . .)

  30. Eric says:

    “Your persistence in defining the change in lending standards as starting in 2002 is getting tired and worn out”

    Ding, ding, ding. Give this man a Ceegar!! Barry’s problem is that he just ain’t been around long enough!! Too young; damn whippersnapper!!

    Barry, when Freddie came out with something called, as I remember it, Freddie Mac Gold, it only required a 3% down payment (later to go to 0 as I understand it, or my company only chose the 3% option), I went into my manager’s office. Bill I sez, this is no good, this takes the cream away from FHA Bill tells me that it’s to help the little guy per Congress and the CRA.
    Matter of fact, I think I can dig through my memorabilia of old rate sheets for one that has CRA LOANS in Big letters from ’92-3 or so.
    I was a direct observer operating as a LO and RE agent in the DC area and else where for several decades. My take is that Phony and Fraudy helped lay the basis for our current trouble. They were the spark, kindling, and gallon of gas that got the banking system logs blazing. I hear now that those two were doing leverage of ONE HUNDRED FORTY TO ONE on their loan pools!!

    They lead the way. It was a case of monkey see, monkey do. The big banksd all lined up to do what those two started but on steroids.
    Want to really throw a monkey wrench into the system?? Require the buyer to choose his appraiser from a list provided by the bank. Appraisers can advertise the banks they do business with. Check gets made out to the appraiser; he now works for the buyer. Won’t be perfect; nothing is, but it might help.

  31. cloudy says:

    good stuff. I remember a friend, a single mom, getting a 100%,zero down, mortgage in 2004. People were camping out overnight to get in the first bid on new subdivision lots that they could flip for a quick $50,000. Prices were thought to be uni-directional, and if you didn’t buy a house now, you never would be able to.

    But we all know that. Mortgage lenders tried to outdo each other for competitive advantage. If X didn’t offer a product with, say, no income verification because they felt it was prudent not to do so, you can be that company Y would and eat their lunch. That was probably where we needed regulation to prevent the industry from self-immolation.

    How did these lenders, investment banks, et. al., book their mortgage sales? I know enough that the accounting got pretty arcane before the market went wild with derivatives, so I got to think that with derivatives, bundling, etc., etc., the back office accounting must been very, very creative, to say the least.

    thanks for a cool blog

  32. Moe Mortgage says:

    BR, you’ve got this issue pretty much cornered. I’d like to add a couple of additional points for context:

    1) Towards the tail end of the bust in credit standards (2006-2007) originators were aggressively pushing the early-pay default window down to 30 days from 90-180 as a term of sale, and succeeding.

    2)Almost all contracts have an unlimited “put-back” period for seller misrepresentation. However, Wall Street generally skimped on the back-office staff and procedures for identifying and processing repurchase requests. It was only after loans started to go bad that they started combing through the defaults and issuing put-backs en masse. I think it was the huge waves of put-backs all at once that contributed to the burst of dramatic failures seen on the Implode-O-Meter.

    I have to laugh when I see Goldman and MS calling themselves “banks” now……

  33. The 2/28 loan along with other exotic loans pushed during the 2000s are what really got us into this mess. Never before, have we had such wide spread real estate fraud. And yes, that is what it is. CNN is doing a nice piece on the “10 Most Wanted” for the current financial crisis right now. (Nice interview with Barry) You can see this was orchestrated by the CEOs at the top of the pyramid, including govt employees. Unfortunately, this mess will be hard to clean up.

    Affluent areas are just beginning to feel it, as toxic mortgages work their way up the Real Estate Food Chain.

    http://www.westsideremeltdown.blogspot.com

  34. IAM says:

    BR,

    “And, its why 293 mortgage lenders have imploded — all of these bad loans were put back to them.”

    This sentence appears to run contrary to the basic premise. The article suggests that the mortgage lenders were clear as long as there are no defaults within the 90/180 day period. So, how did these lenders got stuck with the mortgage put back. It will help if you can add some clarity in the article around that sentence. Thanks for the housing boom bust 101.

  35. Scott says:

    Rathipon,

    What is your basis for stating lending standards collapsing in 2006 ?

    My read of this was that by 2004, anyone who could fog a mirror could get a loan.

    We refinanced a house in 2003 (purchased in 2001) with a different lender — and all it took was a phone call, an appraisal, and that was it. No income check, no pay stubs, no credit check. (Not even a lawyer for the closing).

    By 2006 it was all over but the crying.

  36. Peter says:

    I think that the damage of the low rates were not so much that the teasers got way low as it was that the prudent conservative savers/investors could no longer get above inflation rates on their normal conservative investments and looked around for some safe AAA stuff that could at least keep up with inflation.

  37. Barry,

    Couldn’t agree more with this post. However, I find it odd that another theme of yours is that Fannie and Freddie are not among the 20 top culprits in creating this mess. Fannie and Freddie were the elephants in the room in the mortgage business, even if they were not the ones buying up the really toxic paper or creating the alphabet soup of underfunded “insurance” products. Frannie and Freddie are definitely in my top ten.

  38. Kevin says:

    I think a few posters missed the actual thesis of this blog entry. Hell I probably missed it too, but it seems to be that even though Greenspan, Wall Street and borrowers were involved, the mortgage industry was the central player.

    I’m not sure that was the thesis of this blog post. If it is, I disagree. The terms of the loans being handed out on Main Street were very much dictated by the Wall Street firms that securitized them. The worse the terms of the loan were, the more Wall Street would pay for them, because they could be packaged into a more lucrative bond deal (or what looked to be more lucrative, back then).

    The mortgage industry was really just doing Wall Street’s bidding — doing the dirty work of folks like Blankfein, Mack, Thain, etc., who can pretend they didn’t know what was going on with this stuff, but they certainly did. This was insanely profitable for Wall Street (for a time) – mortgage-related desks were bringing in a huge portion of their profits.

  39. I-Man says:

    @BR:

    That was a good one…
    Now, can you get that down to a paragraph?
    5 sentences or less?

    :)

    -I-Man

  40. Peter says:

    Another thing I have been thinking about is that TBP previously showed some graphs where it was clear that from 2003 to 2004, agency MBS were cut in half, whereas the non-agency MBS more than doubbled. Is this because the 5 big investment banks were allowed to have more leverage – and used it to explode their business in mortgage bundling? And was it in response to loosing market share that Fannie and Freddy pushed to be allowed into the same type of loans?

  41. I-Man says:

    @Peter:

    “Is this because the 5 big investment banks were allowed to have more leverage – and used it to explode their business in mortgage bundling? ”

    AHA!!!

    Now you’re on to something.

  42. tyd says:

    I-Man is finishing the thought process here–
    the only reason the mortgage companies were offering/selling these loans is because the WALL STREET FIRMS allowed it—by setting the LAX UNDERWRITING rules as to what THEY would buy and SECURITIZE. A mortgage company will only close what they can SELL.

    As FAN/FRED lost market share (due to focusing on their acctg issues) the WALL ST FIRMS filled the market with EXOTIC UNDERWRITING to generate profit.

  43. Greg0658 says:

    lurker 9:35:01 AM – “mortgage industry was the central player. In order to generate short term profits a ton of basically “zero” interest + zero down”"

    for I=Man in 5 words or less … this is what I think (got it in 8)

    butter side or guns side
    both need juice

  44. Shnaps says:

    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.

    That would be odd, if it weren’t largely explained by the fact that every publicly-traded outfit is judged by their quarter-to-quarter results; including those (e.g. mortgage firms) which are engaged in a business that typically sees market cycles which are measured in years.

  45. curmudgeonly troll says:

    the drop in lending standards was driven by mortgage originators that were sponsored by investment banks.

    brokers said, we should we buy mortgages from banks with an actual underwriting culture, and let them profit? and sponsored originators like New Century, Ownit, etc.

  46. Alex H says:

    The new-fangled mortgage products were absolutely a cause of the current financial turmoil. But, let’s not confuse cause with blame (and I don’t think the column did so). Sure there was fraud and misrepresentation, which should be prosecuted, but the originators in general acted as “rational profit-maximizers.”

    The MBS markets would be clipping along just fine had accurate and reasonable loan loss / default reserves been used.

    If one wants to offer option ARMS, a 125% LTV, 8-year car loan and 8 credits cards to a subprime borrower that will has a high chance of default, no problem; but, assume default rates that coincide with the underlying assets when underwriting an ABS.

  47. fresno dan says:

    Nice, succint explanation that I agree with. Still, I find it hard to believe that no one in the bond raters and securitzers failed to see this… No, I think its “I can make a fortune for a few years and than get the hell out.”

  48. Wisdom Seeker says:

    I see many readers have hit the key point, but to add some clarity:

    In a nutshell: perverse incentives produce perverse outcomes. This is not a new lesson, nor an odd one, but the heart of the issue:

    “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. ”

    It’s not a new lesson. Corporations are not people; if the people in a corporation don’t mind it failing (because they get rich in the meantime and move on), then there’s nothing that will keep it alive.

    And then there are Corporations that are effectively “insured” (backstopped) because they are “too big to fail” — the individuals running them don’t even have to worry about the corporation failing. They’ll still get salary, and now it seems bonuses as well, regardless of the profitability – heck, regardless of the solvency – of the corporation.

  49. Truth08 says:

    Underlying EVERTHING – including the change in lending standards – are the ultra-low interest rates by Greenspan and the Fed. Manipulation of the interest rates creates distortions in the market, and the housing boom and easy lending standards are examples of this distortion. It made financial sense at the time because of the actions of the Fed.
    Self-Dealing and International Regulation

  50. tree says:

    also add in bold and underlined The National Association of Realtors.

  51. David says:

    Let me register my vote for 1) Barry’s observations and 2) the new capital gains rules for a primary residence that encouraged mass-scale “flipping” mentality and 3) perfect timing, in that investing in stocks after dot-com seemed more risky, and investing in real estate or MBSs *seemed* entirely risk-free.

  52. redriver says:

    psst, hey guys and gals, it started a little bit earlier than this. Time for School. Thanks to Jason R.

    Lest We Forget or, just plain continue to ignore hoping it will never re-surface again until after the election…..

    “Here is the article from the New York Times that was calling for Fannie Mae to open up the subprime market by order of the Clinton Administration. Maybe, all the democrats that have had power of the congress and have been led around by the nose by the lobbyist from Credit Suisse and UBS should stop saying that the Republican trickle down theory created this mess and take some ownership”.

    Here is the article:
    By STEVEN A. HOLMES

    Published: September 30, 1999

    In a move that could help increase home ownership rates among minorities and low-income consumers, the Fannie Mae Corporation is easing the credit requirements on loans that it will purchase from banks and other lenders.

    The action, which will begin as a pilot program involving 24 banks in 15 markets — including the New York metropolitan region — will encourage those banks to extend home mortgages to individuals whose credit is generally not good enough to qualify for conventional loans. Fannie Mae officials say they hope to make it a nationwide program by next spring.

    Fannie Mae, the nation’s biggest underwriter of home mortgages, has been under increasing pressure from the Clinton Administration to expand mortgage loans among low and moderate income people and felt pressure from stock holders to maintain its phenomenal growth in profits.

    In addition, banks, thrift institutions and mortgage companies have been pressing Fannie Mae to help them make more loans to so-called subprime borrowers. These borrowers whose incomes, credit ratings and savings are not good enough to qualify for conventional loans, can only get loans from finance companies that charge much higher interest rates –
    anywhere from three to four percentage points higher than conventional loans.

    ”Fannie Mae has expanded home ownership for millions of families in the 1990′s by reducing down payment requirements,” said Franklin D. Raines, Fannie Mae’s chairman and chief executive officer. ”Yet there remain too many borrowers whose credit is just a notch below what our underwriting has required who have been relegated to paying significantly higher mortgage rates in the so-called subprime market.”

    Demographic information on these borrowers is sketchy. But at least one study indicates that 18 percent of the loans in the subprime market went to black borrowers, compared to 5 per cent of loans in the conventional loan market.

    In moving, even tentatively, into this new area of lending, Fannie Mae is taking on significantly more risk, which may not pose any
    difficulties during flush economic times. But the government-subsidized corporation may run into trouble in an economic downturn, prompting a government rescue similar to that of the savings and loan industry in the 1980′s.

    ”From the perspective of many people, including me, this is another thrift industry growing up around us,” said Peter Wallison a resident fellow at the American Enterprise Institute. ”If they fail, the government will have to step up and bail them out the way it stepped up and bailed out the thrift industry.”

    Under Fannie Mae’s pilot program, consumers who qualify can secure a mortgage with an interest rate one percentage point above that of a conventional, 30-year fixed rate mortgage of less than $240,000 — a rate that currently averages about 7.76 per cent. If the borrower makes his or her monthly payments on time for two years, the one percentage point premium is dropped.

    Fannie Mae, the nation’s biggest underwriter of home mortgages, does not lend money directly to consumers. Instead, it purchases loans that banks make on what is called the secondary market. By expanding the type of loans that it will buy, Fannie Mae is hoping to spur banks to make more loans to people with less-than-stellar credit ratings.

    Fannie Mae officials stress that the new mortgages will be extended to all potential borrowers who can qualify for a mortgage. But they add that the move is intended in part to increase the number of minority and low income home owners who tend to have worse credit ratings than non-Hispanic whites.

    Home ownership has, in fact, exploded among minorities during the economic boom of the 1990′s. The number of mortgages extended to Hispanic applicants jumped by 87.2 per cent from 1993 to 1998, according to Harvard University’s Joint Center for Housing Studies. During that same period the number of African Americans who got mortgages to buy a home increased by 71.9 per cent and the number of Asian Americans by 46.3 per cent.

    In contrast, the number of non-Hispanic whites who received loans for
    homes increased by 31.2 per cent.

    Despite these gains, home ownership rates for minorities continue to lag
    behind non-Hispanic whites, in part because blacks and Hispanics in particular tend to have on average worse credit ratings.

    In July, the Department of Housing and Urban Development proposed that by the year 2001, 50 percent of Fannie Mae’s and Freddie Mac’s portfolio be made up of loans to low and moderate-income borrowers. Last year, 44 percent of the loans Fannie Mae purchased were from these groups.

    The change in policy also comes at the same time that HUD is
    investigating allegations of racial discrimination in the automated underwriting systems used by Fannie Mae and Freddie Mac to determine the credit-worthiness of credit applicants.”

    Combine this with Pelosi’s speech on the steps so thankful that she was able, along with the leaders in Congress to “open up to all people the doors to the greatest equity creation the world has ever seen” and her recent video “Pre-Bailout” and you have it all.

    Welcome to the Raw Deal indeed. Now where is that rug?

  53. fgw says:

    Unfortunately, your post seems a bit off in implying that lax lending standards enabled waves of deadbeat borrowers, fueling the boom. Isn’t it true that in a period of stagnant income, the only way to support rapidly inflating house prices was to cheapen credit and loosen standards? The borrower had no choice, and as long as prices continued to climb the upside outweighed the risk.

  54. Quiddity says:

    While I agree with Barry’s points here, I still wonder why there were problems in other countries as well. Did they have the same change in lending standards and did they also promote 2/28 loans?

  55. oulous says:

    There seems to be a lot of indecision going on around here.

    If I put 10 kids on a merry go round and I spin it at a constant speed and there is much joy then the kids are fine.

    Now lets say my stronger brother comes along to keep the merry go round spinning only he spins it much faster, to the point at which kids start flying off everywhere and are impaled on various playground obstacles in the vicinity.

    Who is to blame? Me or my brother.

    So what do you want folks blame Bush et al or go all the way back and blame George Washington for being the first spinner… why not blame god, after all he supposedly got it all started didnt he?

    Make a decision and lay blame where it is deserved. The last 8 years has been disastrous.

    If I make a student loan so a poor person can go to school thats fine but if my cousin on wall street packages that loan in a weird investment and then comes to me and tells me to loan more money but to loan to F students instead of A students who is to blame when the F student who ends up being a janitor and cant pay back the loans.

    The honorable and fine idea of sending the less fortunate to school or the greed that saw it as an opportunity to make money. Point is these systems work until your idiot congress and executive branch allow it to be abused.

  56. flory says:

    If the contracts were for 90-180 days and that was all the time the mortgage securitizers had to be made whole by the originators, what’s led to all the mortgages being sent back to the originators long after that time period?

    Are the securitizers claiming fraud and the contracts were invalid from the start?

  57. sinful mistress says:

    Wasn’t private mortgage insurance(PMI) supposed to backstop this crap???

  58. Wayne says:

    Has this country completely absolved itself of personal responsibility. Yes, a confluence of events occurred to allow for very lax financing but why doesn’t anybody call out the individuals who borrowed the money? Surely, not all of these people were idiots. Many of them knew exactly what they were getting into…they weren’t duped.

  59. Rathipon says:

    Scott,

    Admittedly my evidence is anectdotal. I’m an attorney in the NYC/LI area and I did quite a few residential transactions from 2003 through today. Before 2006 I never saw 100% LTV financing. Towards the middle of 2006, every single deal was 100%. So anectdotally, 2006 was when I saw lending standards get absolutely thrown out the window.

  60. readingcraplikethis says:

    hey David,

    The article you cited in NY Times, September 30, 1999 by Stephen A. Holmes does not exist in the NY Times archives. I’ve just queried the NY Times archives at the NY Times website: nytimes.com and there is no article on that date written by Stephen A. Homes.

    Nice try though.

  61. redriver says:

    Hey readingcraplikethis

    here’s the link which I got by googleing “Steven Holmes 1999 ny times article”

    http://query.nytimes.com/gst/fullpage.html?res=9C0DE7DB153EF933A0575AC0A96F958260

  62. khan says:

    Economic jurisprudence is based on interest and has always been so.. and interest is driven by greed and greed surpasses all regulations and institutional policies. hence the price is been paid , sadly back to the conglomerates to continue with thier greed.

  63. wunsacon says:

    oulous, nice analogy.

  64. BRIAN says:

    I hear alot of comments about how borrowers put themselves in homes they could not afford and that is true but also because of the lax underwriting standards there were many loans where there was no true borrower–they were created by the broker and others –the so called strawborrower deals-false borrowers and there were many of these.

  65. Wisdom Seeker says:

    @Flory “Are the securitizers claiming fraud and the contracts were invalid from the start?”

    Yes. The policemen and the regulators were instructed to look the other way, and a culture of fraud sprang up in some areas. Borrowers were invented, or their paperwork was modified without their permission (and in some cases understanding). People were pushed into loans they didn’t want (again, sometimes without their knowledge). The Federal Government told the states they couldn’t regulate most of this (some sort of override), and then the Federal Government sat on its a** and did nothing. Known criminals (former convicts) were handing out mortgage money, even though there should have been detailed background checks.

    Since there were no incentives to prevent this (and those that were there, were deliberately if mistakenly removed), Greed ran rampant and enlisted the aid of its pals Fraud and Falsehood (and Fannie and Freddie) and reduced the system to shambles.

    As to the broader question of why this happened here but the rest of the world suffers as well: the specifics are unique to each country but the whole world was in a competitive race-to-the-bottom in terms of leveraging, easy credit, and moral hazard / too-big-to-fail.

  66. downandout says:

    I think it all comes down to the human element that is called ” greed “.

  67. I think the cartoon at the end of your posts speaks volumes!

    It’s unfortunate that short term profit got in the way of long term value and stability, but I guess that’s what happens when we let the criminals run the assilum.

  68. Bill Carlson says:

    I guess I have a hard time accepting the argument that cheap credit and careless lending standards caused the current mortgage dilemma. I was under the impression these had little effect on lending practices. To begin with, didn’t bond insurers and subordinate investors keep lenders in check. When subprime mortgages were pooled they were done so in the form of asset backed securities and used bond insurance for credit enhancement. Thus, bond insurers were key in pricing credit risk. Weren’t they the main buyers of ABS along with subordinate investors who were meticulous to pricing risk and said no to overly risky securities. It seems they controled lending practices by saying no to risky loans. Instead, I would argue that increased demand by CDO’s caused the mortgage mess. When CDO’s came into the picture and began using subprime ABS as collateral they were less discerning in pricing risk and beat more experienced bond insurers and subordinate investors out of the market. This caused an increase in demand for risky loans since CDO’s were willing to buy them. Their had been little need for tight lending standards because the bond insurers and subordinate investors kept lenders in check. Lending standards didn’t cause the mortgage problem. Rather, a lack of experience by asset managers and investors when structuring and purchasing CDO’s combined with lack of experience in understanding default risks associated with underlying securities caused the current predicament.