The Housing Crisis, What Caused It?


Was the Housing Crisis caused by mortgage brokers ?

At one time, when you obtained a mortgage on real estate, you did so at your local bank, or savings and loan.  They would lend you money, from their own deposits at a rate higher than what they paid to their depositers.  The difference between your mortgage rate, and their savings account rate was the bank's income.  That world disappeared some time ago.

The next method was one where, your local bank, approved you for your mortgage, but once the paperwork was all finalized, they sold off your mortgage to some other financial entity and only retained the "servicing" of the account.  That means, you still paid them, they took a percentage, but forwarded the bulk of the payment on to this other financial entity.

This went on for a while, but then these other financial entities got even cleverer.  Just choose an example entity, let's call them, just for illustration Lehman Brothers.  They collected each group of mortgages into packages and resold some characteristic of the entire package to various other financial entities.  So let's make up an example where they sold the "first ten payments" to Merrill Lynch, then sold "years two through five" to Fidelity Insurance and so on.  Or perhaps they sold "payments on properties worth more than one million" to Citigroup Investments, and "payments on mobile homes" to National Life Insurance Company.  Or maybe they sold every third payment, or 25% of each payment, or every late payment.  Whatever you can think is possible, probably some one of them was trying it.

Who knows all the possible bizarre combination of separation and layering that were going on, but however they divided up the characteristics of any collection that division is a derivative.  It's not the "mortgage" they are selling, they are selling some characteristic of the collection of mortgages, and that characteristic cannot be separated from the collection of which it's a part.  It derives from that collection, but no one object in the collection matches the derivative value.

Within the agreements for all this collection-selling, these financial entities also would have agreed to certain terms like "if ten percent of the collection defaults then the agreement can be canceled" or something of that sort.  And then everyone would also buy insurance on whether or not that would occur and pay for that and so on.  This sort of division and layering has been going on for a very long time in the insurance marketplace, but it had never been a part of the mortgage marketplace until the last ten to twenty years.

When insurance carriers buy and sell these layers, they use very smart actuaries and risk analysis to determine what they are buying and selling is really worth.  And of course insurance companies can fail in spectacular ways when they make big errors in judgment on that.  They go into receivership.  There are many tables of rates for various things, and a long history of comparison and so on in insurance.  But not so in the mortgage market.  So the question, "What is the possibility that this collection of mortgages will sour?" cannot really be answered with an adequate level of exactness and so the risk being taken on and the value of that risk cannot really be ascertained.  However the profits of this sort of buying and selling are too lucrative to ignore.

Home mortgages are usually a very safe investment which is why the interest rates are so incredibly low compared to other things like autos, boats, mobile homes, investments, businesses, credit cards, and so on.  People generally don't walk away from a home investment, especially if they've put a sizable amount into a down payment, or have a good amount of equity.  Home prices have risen steadily over many decades and the federal government has made it an issue to support home ownership as it helps stabilize and improve neighborhoods.

Mortgage-granting financial institutions are customer-facing, that is, you as a customer know who is granting you a mortgage and who will or can.  You don't know who is going to own that mortgage three months later.  Customer-facing institutions however very rarely hold any of the mortgages they grant.  When they hold a mortgage they are tying up that much capital that cannot be used for other purposes, over the life of your loan.  If they sell off this mortgage, they get that capital back into their hands to use for their next mortgage or some other product.  So it's in the best interest of this customer-facing institutions to sell off your loan as fast as they can.  This sort of activity was traditionally the provenance only of independent mortgage brokers.

The problem is that, the good name of the institution, allows them to sell off a mortgage that might have defects, to another financial institution, who will not re-check the mortgage details, but merely again repackages and layers the package selling off layers and chunks of the entire package to others.  So the risk of the bad mortgages gets spread across the entire landscape, instead of concentrated in the institutions perpetuating the problem.  The mortgage bankers have a vested interest then in covering up any issues that might exist, just as the mortgage brokers had been doing five years before them.

On the one hand you might say "they are lying", on the other hand they told themselves, "they are helping customers get a home."  The system of covering, concealing, and omitting just kept getting larger and larger the more the risk was spread away from those who were perpetuating the covering up.  Just like any pyramid scheme, it could only grow for so long until weakness started to appear.  That weakness was, more mortgages beginning to default than what the risk structure predicted.  Once the risk structure was perceived as being defective, more institutions started questioning their own portfolios, enforcing default agreements, and so on, which only caused the entire system to become even more unstable, as capital once available, was pulled back.

In other words, the institutions began to distrust each other's analysis, and to freeze the buying and selling of the mortgage derivatives.  Since this was the primary way in which the mortgage market worked, this level of distrust froze the market.  The only mortgage providers would then have been any institutions which still provided mortgages and held those same mortgages themselves.  They wouldn't have been affected, as they wouldn't care if they could find a buyer for their mortgages or not.  At this point in the game, the number of financial institutions holding their own mortgages was probably zero.