Friday, January 14, 2011

The Mortgage Crisis

I am on the way home from Case Western. My colloquium went well and my visit with faculty members was stimulating and informative. Travel continues to be exhausting. My flight from Detroit to Cleveland three days ago was delayed for three hours due to a blizzard. Getting in late and having to get up early each day compounded my weariness. This morning I got up at 4:30 am EST, or 1:30 am in Pullman. The flight from Cleveland to Cincinnati went smoothly. As I ran the length of the terminal to make my tight connection, the gate clerk in Cincinnati informed me that my seat to Seattle was upgraded to business class; so, I enjoyed a good meal and a long snooze. Hopefully, I will be ready for my ice hockey game tonight in Moscow.

There must be some principle of nature that forbids air travel to go smoothly. Upon landing on time in Seattle, I learned that my flight to Pullman was delayed. So, I decided to pull out my laptop and complete a posting about my thoughts on the mortgage crisis, made poignant by my colleagues in Cleveland who told me a story of a friend who purchased an $800,000 home for about $250,000.

My thesis is that the sub-prime mortgage crisis, which has led the world into a great recession, was caused by both good intentions as well as opportunistic greed.

The simple fact is that homeowners will default on a mortgage if they can't afford to make payments. Conservatives blame the Community Reinvestment Act, which encouraged lending to a group of borrowers who did not qualify for traditional loans. Liberals blame greedily-exuberant mortgage brokers who approved unqualified borrowers. And what of the stupidity of people who borrow more than they can afford? I would also pin some of the blame on Ginnie and Fannie Mae, who provided a ready supply of cash to organizations that sold mortgages. When the housing bubble burst, Ginnie and Fannie Mae held almost 20% of the sub prime loans. Many parties were responsible.

Then came securitization of mortgages. Financial institutions bought mortgages and bundled them together in the same way that an equity fund bundles stocks and sells shares to investors. Under the assumption that housing prices would not drop, the rating agencies gave these bundled mortgage products their highest ratings. If a borrower defaulted, the bank owned the home, which it could sell to offset losses. What could be safer?

The consumer demanded high rates of money market interest in a low inflation economy that could not realistically meet these demands. The specialists responded by being highly creative. Exacerbated by the combination of the government's good intentions, exuberant sales of mortgages, and consumer greed, this led to an unsustainable and unstable state.

The whole game unraveled when housing prices started to drop. At this point, many mortgages went under water (the home is worth less than what the borrower owes the bank), making it impossible for banks to recover losses. But perhaps worst of all, the bundled mortgages combined both good and bad loans, so it was difficult to ascertain the risks of the whole package. This lack of information made it difficult to sort things out and made the banks overly cautious. This extreme caution brought lending to a trickle. That's when the government stepped in with the bailout.

Repercussions continue to propagate through the housing market. Homeowners with underwater mortgages find it more cost effective to default than to sell their home at a loss. Even homeowners that can afford to make payments choose strategic default. Mortgage Bankers Association of America president John Courson criticized homeowners for this practice. Ironically, the MBAA strategically defaulted on their $79 Million headquarters building, saving tons of cash by moving 5 blocks away to another building.

The direction of finger pointing depends on one's ideology. As another example of supreme irony, consider the Obama administration's criticism of predatory lending -- the idea that mortgages were given to people who could not afford the payments for a big profit to the lender. While making such accusations, the administration announced the first-time home buyers program that provides incentives to people who would not normally qualify for a loan to buy a home. While the intentions may be noble, the net result may be the same; borrowers who can not afford the monthly payment.

I would argue that even if all parties acted within the law (which they didn't), the net result would have been similar. The problem is that our society is highly complex. The answer is not in legislating detail. It is tempting to outlaw specific financial instruments; but, I claim that people will find new ways to make a buck with ever more dire consequences. Stifling creativity may prevent specific problems but could stifle true innovation that moves our civilization forward. The trick is to mitigate the downside without suppressing progress. Sadly, the world is too complex for any human or even collection of geniuses to take all factors into account and produce constraints without unintended consequences. We must accept the downs as a necessary consequence of progress.

My flight is scheduled to depart shortly, so I have to run. In my next post I will continue along these lines to speculate about the inevitable demise of our civilization. Have a good day...

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