What Caused the Mortgage Meltdown?

The answer is simple. Like most financial crises, it was caused by greed and foolishness. The greed and foolishness of mortgage brokers, real estate appraisers, real estate brokers, hedge fund managers, and home buyers – with a little push over the ledge from the friendly folks at predatory credit card companies

Mortgage Brokers

The client’s perception of the mortgage brokers job is that they are to find the client the lowest interest rate on the best type of loan for their financial and lifestyle circumstances. Many of the mortgage brokers I’ve dealt with view their job as extracting the highest commission possible from the client and putting them into a loan product that will have them needing to refinance in two to five years. One heavily marketed loan product is one in which the homeowner makes interest only payments at a low interest rate like 6% for two or three years and then starts making regular payments at a rate around 10%. Payments on a $200,000 home can go from $1200 a month to over $2000 a month.

Real Estate Appraisers

Real estate appraisers take well deserved pride in the general honesy of their profession, but there a few bad apples who are referred to as “tame” appraisers, meaning they will appraise a home for whatever it is listed at so that the sale will go forward and the buyers’ and sellers’ real estate brokers will not lose a commission – even though the appraiser’s client is the homebuyer. This leads to homes selling for more than they are really worth and, depending on the percentage of the home’s value financed, may lead to homeowners being “upside down” (owing more than their home is worth).

Real Estate Brokers

The vast majority of brokers are honest, hardworking and take their duty to represent their clients’ interests very seriously. A few brokerages, however, engage in questionable practices. Some actively cultivate “tame” home appraisers. As mentioned above, this can lead to homes selling for more than they are worth and homeowners being “upside down.” Some brokerages offer larger commissions to brokers on properties listed by fellow franchisees, incenting brokers to push those properties over properties represented by brokers outside the franchise system. This can lead to brokers “steering” clients to properties on which they earn more money. Sometimes a broker will simply fail to inform a client that the home that they have fallen in love with is not a good buy for fear of losing a commission. Like I said, the vast majority of brokers are honest, hardworking and take their duty to represent their clients’ interests very seriously, but in any industry where large sums of money are at stake, some people will be less than honest.

Hedge Fund Managers

As previously mentioned, whenever there are large sums of money to be made, some people will, knowingly or unknowingly, make poor decisions based on greed. For an excellent description of hedge funds go here. If you’re really geeky you can follow the links from there to an explanation of the derivitaves market. For my stripped down version, read on.

A Hedge fund is a private fund with a very limited number of big money investors. These investors include banks, large corporations and other funds. Hedge funds are exempt from the regulatory safeguards that apply to mutual funds, brokerage firms and financial advisors. This leaves them free to put their money (more precisely, their investors’ money) into riskier investments. Originally a hedge fund would “hedge” its risky investments to offset potential losses. Not today. Hedge funds dominate the market for distressed debt, including sub-prime mortgages.

The positive sides of this are that there many homeowners today who would not be homeowners without hedge funds to buy their mortgages and that during good economic times everyone who participated in hedge funds made lots of money. The bad thing about hedge funds is that, being so heavily invested in distressed debt, they are especially sensitive to economic downturns. It doesn’t take very many people missing mortgage and credit card payments to turn a fund from a winner into a loser – especially if a lot of those people were already in over their heads. Over the last several years hedge fund managers have been taking on riskier and riskier debt.

Five years ago almost anyone who could fog a mirror could get a mortgage. Two years ago fogging a mirror was no longer required. Mortgage banks were selling these crappy loans off in lots to hedge funds. In the race for greater returns, hedge fund managers got greedy and stupid and bought way too many crappy investments. Just like the drunk at the craps table who keeps letting it all ride, they eventually crapped out. OOPS.

Buyers

There is a tendency to blame sellers and real estate brokers for the problem, based on the argument that they shouldn’t have been asking such high prices for real estate. Nonsense. Every seller is entitled to as much as he or she can possibly get for any property they sell, provided they have provided complete disclosure to the buyer. Real Estate Brokers are legally bound to get as much as they possibly can for a seller client. Failure to do so can result in criminal and civil penalties. In other words, if a real estate broker fails to price a seller clients’ properties at the absolute most the market will bear they can go to jail and get their ass sued off.

A lot of buyers made poor decisions and are now facing the consequences of those decisions. People who were not making ends meet as it was purchased homes they could not afford (with the complicity of mortgage brokers). Many people who should never have taken out adjustable rate mortgages did so (at the urging of mortgage brokers). As stated above, there are very few people who should ever get a variable rate mortgage. Think about it. If you get a fixed rate mortgage and interest rates rise, your payment remains the same. If rates fall, you can always refinance. With a variable rate mortgage, when interest rates rise, your payments rise and if even if you come to your senses and refinance, you will not be able to get the lower payment you would have if you had chosen a fixed rate initially. Personally, I would never get a variable rate mortgage (I have memories of the 23% interest rates of the late 70s), but the generally accepted rule is that you should only consider an adjustable rate mortgage if you know you will be moving in three years or less.

Credit Cards

When interest rates rise, credit card rates rise. Now, if you know a little about economics, you might expect that credit card rates would rise and fall at the same rate as the prime rate (the rate the Federal Reserve charges banks for the loan of money). No. If you know a little about unbridled greed (that would be everyone who’s ever had a credit card), you’ll know credit card companies will never miss a cance to raise cardholders’ rates by 2% (or more) every time the prime rises 1%, and they rarely fall. God have mercy on any cardholder who is one day late on their payment or one dollar over their credit limit, because the credit card companies will not. Add an interest rate increase due to a rise in the prime rate to an interest rate increase for being late or over the limit and a cardholder can have their minimum payment double. People with more than one credit card become victims of a domino effect as their other credit cards raise their minimum payment. Even people who carefully budgeted their home purchase can quickly become insolvent.

The Net Result

What we’re seeing in the real estate market and dependent segments of the economy are classic illustrations of the principle of supply and demand. Because hedge funds and their investors are losing money, there is not only less money available for risky borrowers, but for everyone. Fewer people qualifying for mortgages means lower demand for housing. Lower demand for housing means more homes on the market longer selling for less and fewer new houses being built. Fewer homes being sold means less money going into the pockets of home sellers for reinvestment in the economy. Fewer new homes being built and sold means less money for everyone who makes the stuff that makes houses (wood, gutters, appliances) or that makes the stuff that makes the stuff that makes houses (timber, metals, factory equipment) which means they don’t buy a new car this year and the car company lays off workers who don’t buy…and on and on.

Unfortunately, for the last twenty years or so, Oregon seems to always be one of the first states to suffer in an economic downturn and one of the last to recover. Even in good times our unemployment rate has been a full point above the national average. As the lady said, “get ready for a bumpy ride.”