What Caused the Mortgage Crisis?

So, “what caused the mortgage crisis” anyways?  In case you haven’t heard, we’re going through one of the worst housing busts in our lifetimes, if not ever.  And though that much is clear, the reason behind it is much less so.  In fact, there isn’t just one cause, but rather a combination of forces behind the current crisis.  I’ll attempt to list as many as I can think of here:

Originate-to-Distribute Model

In the old days, banks used to make mortgages in house and keep them on their books.  Because they held onto the loans they made, stringent guidelines were put in place to ensure quality loans were written.  After all, if something went wrong with the loans, they’d be accountable.  And they’d lose lots of money.

Recently, a new phenomenon came along where banks and mortgage lenders would originate home loans and quickly resell them to investors in the form of securities on the secondary market (Wall Street).  This method, known as the “originate to distribute model,” allowed banks and lenders to pass the risk onto investors, and thereby loosen guidelines.  The result was casual underwriting, less oversight, and more aggressive financing, which ultimately led to a lot of bad loans being made.

Banks and lenders also relied on distribution channels outside their own roof, via mortgage brokers and correspondents.  They incentivized bulk originating, pushing those who worked for them to close as many loans as possible, while forgetting about quality standards that ensured loans would actually be repaid.  Because the loans were being sliced and diced into securities and sold in bulk, it didn’t matter if you had a few bad ones here and there, at least not initially…

Fannie Mae and Freddie Mac

Of course, banks and lenders modeled their loan programs on what Fannie and Freddie were buying, so one could also argue that these two “government-sponsored enterprises” also did their fair share of harm.

In short, if the loan conformed to the high standards of Fannie and Freddie, it’d be easier to sell on the secondary market. And it has been alleged that the pair eased guidelines to stay relevant in the mortgage market, largely because they were publicly traded companies steadily losing market share to private-label securitizers.

At the same time, they also had lofty affordable housing goals, and were instructed to provide financing to more and more low- and moderate-income borrowers over time, which clearly came with more risk.

However, the private mortgage market took control during the lead up to the eventual crisis thanks to their bevy of high-risk mortgage products, so Fannie and Freddie had to ease their own guidelines to maintain market share.

As a result, bad loans appeared as higher-quality loans because they conformed to Fannie and Freddie.  And this is why quasi-public companies are bad news folks.

Bad Underwriting

That brings us to bad underwriting.  Now it wasn’t that underwriters didn’t know what they were doing, it was more a matter of influence from upstairs.  They were often told to make loans work, even if they seemed a bit dodgy at best.

Again, the incentive to approve the loan was much, much greater than declining it.  And if it wasn’t approved at one shop, another would be glad to come around and take the business.  After all, the loans weren’t being held for more than a month or so before they were the investors’ responsibility.

Faulty Appraisals

Going hand-in-hand with bad underwriting was faulty appraising, often by unscrupulous appraisers who had the same incentive as lenders and originators to make sure the loans closed.  If the value wasn’t there, it only took a little bit of tinkering to find the right comparables to get it right.  If one appraiser didn’t like the value, you could always get a second opinion somewhere else or have them take another look.

Home prices were on the up and up, so a stretch could be concealed after a few months of appreciation anyways.  And don’t forget, appraisers who found the right value every time were ensured of another deal, while those who couldn’t, or wouldn’t make it happen, were passed up on that next deal.

No Skin in the Game

Another big issue was the lack of a down payment in the most recent boom.  Back when, it was common to put down 10-20 percent when you purchased a home.  In the last few years, it was increasingly common to put down five percent or even nothing.  In fact, zero down financing was all the rage because banks and borrowers could rely on home price appreciation to keep the notion of a home as an investment viable.

However, it wasn’t long before prices began to peak and eventually fall, causing all types of problems for borrowers with little or no equity in their homes.  Those that purchased with zero down simply chose to walk away, as they really had no skin in the game, nothing to keep them there.  Sure they’ll get a big ding on their credit report, but it beats losing a whole lot of money.  Conversely, those with equity would certainly put up more of a fight to keep their home.

Aggressive Financing

Playing off the lack of a down payment, aggressive loan programs like the pay option arm and other interest-only options also contributed to the mortgage mess.  As home prices marched higher and higher, lenders and builders had to come up with more creative financing options to bring in buyers.  Because home prices weren’t going to come down, they had to make things more affordable.  One method was lowering monthly mortgage payments, either with interest-only payments or negative amortization programs where borrowers actually paid less than the note rate on the loan.

Some banks, like now-defunct Bear Stearns, actually offered a pay option arm at 100% LTV, meaning you could come in with zero down and make a super low payment, often as low as one percent, for several years before the loan adjusted to a more realistic rate.

This of course resulted in scores of underwater borrowers who now owe more on their mortgages than their current property values.  As such, there is little to any incentive to stay in the home, so borrowers are increasingly defaulting on their loans or walking away.  Some by choice, and others because they could never afford the true terms of the loan, only the introductory teaser rates that were offered to get them in the door.

Limited Documentation

Home loans used to be underwritten full doc, meaning you would need to provide pay stubs or W-2’s, along with asset and employment information.  This would give the bank or lender plenty of reliable information to make an underwriting decision.  Then came limited documentation loans, such as stated loans, now known as “liar’s loans,” which were intended for people like doctors and the self-employed who had complicated tax structures.

Eventually, everyone seemed to be taking advantage of limited documentation underwriting, often because they couldn’t meet guidelines legitimately.  After all, your interest rate would only be another quarter-percent higher in many cases, so why provide real income if you can fudge the numbers a little and get approved?  More troubling were no-doc loans, where borrowers only provided a credit score.  No income, asset, or employment information was provided, allowing virtually anyone with a decent credit history to get their hands on a new home.

Over Reliance on Credit Score

That brings us to the now infamous credit score, which became the bank’s go-to risk indicator in recent history.  Instead of reading between the lines, lenders were happy enough to look at a three-digit credit score to determine risk.  If the applicant’s credit score was above a certain threshold, they were approved. Meanwhile, those with lower credit scores and perhaps more compelling borrower attributes would be denied.  This led to a lot of first-time homebuyers getting their hands on shiny new houses, even if their largest loan prior had been something as simple as a revolving credit card.

Low Interest Rates

And then there’s super low interest rates, which have been historically low for years now, and have just recently hit their lowest point ever.  During the boom, these low mortgage rates encouraged people to buy homes and serially refinance, with many taking large amounts of cash-out in the process.  Many of these borrowers had built up equity in their homes, but after pulling it out to pay everyday expenses, had little left and nowhere to turn when financing dried up.  At the same time, those who pulled cash out did so using appraised values that can no longer be supported.  So many of these borrowers now have loan amounts that far exceed the true value of their homes, and a larger monthly mortgage payment to boot.

Speculators

It’s not just families who have lost their homes.  Tons of real estate investors have also defaulted on their properties, adding to the foreclosure epidemic and pushing home prices lower.  Many of these speculators purchased handfuls of properties with little to no money down.  Yes, there was a time when you could purchase four-unit non-owner occupied properties with no money down and no documentation!  Why lenders ever thought that was a good idea is beyond me, but it happened.  Of course, the minute home prices turned, most got out of the game, either by selling or simply walking away, creating a further drag on home prices.

Home Builders

Everywhere you look, at least if you live in places like California, there are scores of new, sprawling housing developments.  It seems every corner has a sign spinner or a billboard advertising new luxury condos or single-family homes.  Unfortunately, many were built in the outskirts of metropolitan areas, often in places where most people don’t really want to reside.  And even in desirable areas, the pace at which new properties were built greatly exceeded the demand to purchase the homes, causing a glut of inventory.

The result is a ton of homebuilders going out of business or barely hanging on.  And guess who wants interest rates lowered?  You guessed it, the homebuilders.  Why?  So they can dump off more of their homes to unsuspecting families who think they’re getting a discount.  Of course, the builders don’t actually want to lower home prices.  They’d rather the government subsidize interest rates to keep their profit margins intact.

Unsustainable Home Price Appreciation

As a result of many of the forces mentioned above, home prices increased rapidly.  Everyone thought they could get rich in real estate, either by flipping a property or refinancing over and over and investing the money.  The promise of never-ending home price appreciation hid the risk and kept the critics at bay.  Even those who knew it would all end in tears were silenced because rising home prices were the absolute solution to any problem.  Heck, even if you couldn’t make your monthly mortgage payments, you’d be able to sell your home for more than the purchase price.  Once that reality faded, big problems emerged.

There are likely many more reasons behind the mortgage crisis, and I’ll do my best to add more as they come to mind. But this gives us something to chew on.


12 Comments

  1. Lisa A. Payne August 26, 2012 at 12:01 pm -

    Good Article. The only thing I would add is; Loan Officers were real Loan Officers prior to 2001. The Loan Officer worked for the bank and had a degree in business/ finance or years of banking experience. In 2004, I started to notice that anyone could be a Loan Officer,- the loans were being originated in such large volume anyone could be a Loan Officer especially if you were a good sales person. The moral, ethical and trust values were lost and it was all about making money not the consumer.

    LP

  2. Larry hadley September 26, 2012 at 9:32 am -

    self regulation is the problem, it was so with the IPO and the morgage failure

  3. Scott M78 October 9, 2012 at 1:19 pm -

    The crisis was brought on by credit expansion on a massive scale. Bankers got bad habits and these were re-enforced :(

  4. Anthony October 10, 2012 at 3:40 pm -

    You for got the root cause of all this. Who allowed all those people to originate these loans? It was the Clinton and Bush administration. The government wanted more home ownership so they instructed HUD to instruct Fannie Mae to process more loans. The only way to process more loans was to lower the lending standards. Lending standards are set by Fannie Mae and they were compelled by the government to lower there standards to increase home ownership. So it was the government that actually caused the housing crisis. If they never lowered the requirements then the crisis would have never happened.

  5. Casey October 16, 2012 at 6:41 am -

    Thank you Anthony! I kept waiting to read about govt influence. How could that not be mentioned? No bank would make these bad loans if there wasn’t an insurance company that would insure the loan. Hello Fannie and freddie and hello Barney Frank

  6. Jim October 16, 2012 at 10:13 am -

    Frank /Dobb, Clinton, and a liberal lowering of mortgage requirements had everything to do with banks, without scruples, to make easy money on mortgage origination. Don’t ever be fooled by anyones spin!

  7. brian October 25, 2012 at 11:21 am -

    Actually this all started under Carter. The fair housing act, but it didn’t have big enough teeth. It was pushed heavily along under Clinton. Frank and Dodd gave it teeth and shoved it through. Bush actually tried to warn this was no good, but the Dem controlled house and congress got it done. Just about anyone with a paycheck from anywhere could buy a 300k home, gee wonder whats gonna happen. Get their Dem Pres elected and blame Bush, thats what. At the expense of the american people.

  8. Jeanne Johnson October 28, 2012 at 12:01 am -

    Blame the government BUT who was making all the money from these home loans? The builder, the mortgage broker, the appraiser, wall street, etc, not the homeowner. Nobody ever mentions that. The house price was set by the builder and they kept raising them beyond the worth of the home. SO who really got rich?

  9. Larry February 26, 2013 at 9:56 pm -

    Regardless of the price, the value is what one is willing to pay.

  10. Bonnie July 1, 2013 at 10:09 am -

    I blame the home builders, who as you mentioned, created tons of fake neighborhoods throughout the country, especially in random areas where housing demand wasn’t at all strong. And they were selling homes with all types of crazy incentives like zero down with all sorts of tax credits. I don’t think they actually checked to see if anyone could actually afford the homes.

  11. Antonietta February 5, 2014 at 9:52 am -

    Letting Taco Bell employees who made minimum wage buy $500,000 homes didn’t help…

  12. Robert "O" March 2, 2014 at 9:44 pm -

    The sad part is it’s all happening again once more…

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