Monday, January 28, 2008

The Mortgage Mess

Last night there was a good segment on 60 Minutes, the television news magazine, dealing with the mortgage mess in the United States, which is expanding to other countries. So how did we get into a situation with a trillion dollar loss?

It seems to have been a combination of cheap money on loan and a bubble in housing prices, and I suppose the cheap money helped fuel the housing bubble. However, there were institutional failures that seem fairly obvious in retrospect.

Banks made the housing loans. They offered loans with nothing down, because the bank officers got paid for making loans, and because they could argue that the rising prices would build equity in the homes quickly. They could offer low interest loans for a while (adjustable rate mortgages) because money was cheap at the moment, and because they could argue that the rates could and would be adjusted up in the future, and that the higher equity in the houses would cover the risk of people walking away from the houses later. Perhaps most important, the loan officers could argue that there was no long term risk for the banks because the mortgages were insured and that they were sold to others rather quickly before they could go bad. Thus there was an assured short term return that could be used to pay the money on loan to the bank, restore the bank's investment, pay the investors a profit, and pay the bank staff.

Why the supposedly independent appraisers got sucked into this chain is not clear, except possibly that appraisals are based on current market value, rather than on estimates of the real value of the property or its likely future value. The mortgage insurance companies are apparently in real trouble. Perhaps they too paid their staff on work performed and volume of business rather than on the prudent management of risk!

Apparently the key to all this was the new creation of mortgage-backed securities. The theory here, as I understand it, is similar to that which makes insurance work. While there is a risk in any mortgage that the borrower will not pay, there is in theory much less risk that all the borrowers for a bundle of mortgages assembled from different regions and different kinds of homes will not pay simultaneously. People are willing to pay more for an investment with lower risk, so the firms bundling mortgages into mortgage-backed securities could pay the bank what the mortgage was worth in its portfolio, pay the costs of the transaction, pay handsome salaries to its staff, and still sell the securities to investors.

Of course, the key to all this is that the probabilities of borrowers defaulting on their mortgages should be independent. As we have learned, when a housing bubble bursts and when money becomes more expensive, lots of borrowers default at the same time, nationwide! The risks in the mortgages are not independent.

It was interesting to hear the discussion of the psychology of the borrower. Once, apparently, the idea was that a local bank would loan a person money to buy a house, and the person accepted a personal responsibility to pay back the loan. Collateral was offered in case causes beyond the control of the individual -- illness, loss of a job, etc. -- made it impossible to pay the lender, in which case the collateral would be forfeited. Today, borrowers see the mortgage contract as saying either I make the payments or you take the house. The mortgage holder, not the borrower has the risk that the value of the collateral decreases to the point that it is not worth the payment stream.

That is not to say that people who bought houses cheap during the bubble and lost them when they could not make the payments in their adjustable rate mortgages did not lose in the process. Lenders will make them pay a price in their future borrowing.

Real losers were also the people whose pension plans invested in mortgage-backed securities, indeed those individuals who themselves made such investments, and the citizens in countries whose governments invested in these securities. (Especially those foreign countries that bought over-priced dollars to do so.)

Liberalization of markets, which is often a very good thing, should not be confused with lack of legitimate regulation. We look to the government to keep the system honest, and to keep people from making obscene profits by systematically mis-estimating risks when they work in insurance agencies, banks, securities firms, and brokers. Shame on the government regulators for letting this happen. This was not all the fault of the Bush administration, but the problem festered during its term in office and got worse.

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