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Accountability and the Mortgage bailout May 17, 2008

Posted by The Armchair Economist in Commentary, Economics, Politics.
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Five years ago, I was three years out of college and had just written the check for the final payment of my college loans (hurray). My thrifty ways had led to a slowly growing pile of cash in my money market account. I considered purchasing a home since I was gainfully employed, had little expenses and had enough cash for a nice down payment. A little more research into the housing market showed that many of the newest mortgage loans were Adjustable Rate Mortgages, mortgages that had low teaser rates that were to reset in a few years (usually 3-5 years) at the prevailing interest rates. The historically low interest rates, coupled with the stratospheric (not yet ionospheric, as I was soon to see) housing market, and number of ARM mortgages was enough to put a slight pause into my own dreams of owning a home. I reckoned that by the time the interest rates rose in the next few years,  many people who bought in hoping for a quick buck will head towards the exit – all expecting to  cash out before their loans reset, leading a possible downturn in the housing market possibly creating some buying opportunities. By the way, this was before mortgage lenders found a way to mediate the perfect storm of less knowledgeable (subprime) borrowers , increasingly greedy banks willing to accept an amazing new form of seemingly low risk, high return mortgage products , and an increasing number mortgage brokers with surprisingly absent scruples that finally caused the housing market to crash and burn.

Last week, the House has passed a $300 billion in federal insurance to refinance troubled mortgages. While I feel some sympathy for some families that will lose their homes, I question the wisdom of not letting the market work out the kinks of the housing bubble. In the true American (read litigous) fashion, we’ll likely be arguing about who lied to who, who knew what when, and who is truly a victim for the next decade, the truth is that everyone involved in the entire chain of events is partially responsible and should be held financially and criminally (if warranted) liable. Why should bystanders and taxpayers be held financially responsible for other peoples actions? 

Subprime borrowers were giddy at the prospect of finally owning a home, but did they ever wonder WHY even though they didn’t have enough credit to buy a used car, people were now giving them hundreds of thousands of dollars without even checking their income (or even requiring a down payment!)? Did borrowers using ARM mortgages ever consider what would happen if the interest rates ever increased from historic lows (did they really think rates would stay there, or even go lower?!?). While I can see the excitement of owning your own home, as well as the prospect of watching it go up in value 100% every 3 years, did these borrowers ever consider that housing prices might not continue appreciating exponentially in perpetuity? Sure, I understand that that some of these folks might claim that mortgage brokers lied to them or misrepresented some aspects of the loans, but didn’t these borrowers have a duty to try to figure out ‘whats missing’ in this picture rather than blindly sign on the dotted line and hope that they wouldn’t need to consider the ‘what ifs’ should things go sour? In the end, sure, it sucks to lose your home, but should you have been able to purchase this home in the first place (ie: did you really lose it if it was never meant to be yours?). I won’t even get into borrowers who can afford to pay their loans but decided to walk away because their loans are now upside down (ie: they owe more on the house than the house is worth).

Mortgage brokers represent another one of the responsible parties. Enticed by hefty commissions on subprime mortgages, brokers did everything and anything to write loans to innappropriate borrowers.  Mortgage brokers first lowered the credit standard of the borrowers (ie; subprime borrowers, who never should have been able to borrow in the first place),  they lent money without even proof of the borrowers income via ‘Stated Income’ loans, they lent money with ‘No Money Down’ removing the borrowers stake in the gamble, and they underwrote loans for amounts greater than the collateral was worth (ie: money for your house AND renovations).  All of these tactics served to increase the pool of borrowers and ensure that the hefty commissions kept on rolling in.  Brokers may argue that their managers told them to lend money via these standards, while managers may argue that the brokers acted on their own but one cannot deny that as professionals, both parties should have enough understanding that basic mortgage underwriting principles were being violated. 

What enabled the mortgage companies to underwrite such risky loans?  Weren’t they concerned about the fact that they wouldn’t be able to collect on their mortgage payments when the borrowers hit upon hard times?  The beauty of this scam lies in their ability to sell these mortgages to other investors, thus absolving them of the riskiness of these loans and yet keep the fees and commissions from writing these mortgages. 

Banks and Investors, in blind pursuit of ever increasing returns,  was the likely party that enabled the house of cards framework of the mortgage crises.  Companies such as Fannie Mae existed that bought mortgages from the primary mortgage market and bundled these mortgages together to sell as a portfolio product that promised high returns with limited risk (with favorable ratings by credit rating agencies).   The basic rule of finance and investment is high returns come with high risk, and there are VERY little opportunity to get high returns with low risk (free market economics states that there are no free lunches).  Securitidized mortgage products (a portfolio of thousands of mortgages bundled together reduces the risk of individual defaults much like the protection you receive when you buy a mutual fund and one of these companies goes bankrupt) have always held a dear place in investors hearts due to their predictable (and relatively safe) income stream.  With the increasing number of subprime loans, loans offered to risky borrowers and thus had higher interest rates, the rate of return of these packaged mortgage products rose accordingly.  For some reason that I don’t understand, credit rating agencies failed to see the risk inherent in these loans and gave them credit worthy scores.  These credit ratings encouraged investment banks to blindly invest in these products creating a cycle of more demand for risky mortgages.  At some point, why didn’t someone at the investment banks question WHAT had fundamentally changed to enable the once modest mortgage market to offer such an increased rate of return in exchange for minimal change in risk? 

One can argue how borrowers were coerced to borrow money by mortgage brokers; Mortgage brokers are just writing the loans that ‘help people own homes’ and to fulfill the demand of the securitidized mortgage products, and Investors were misled about the riskiness of the mortgage products. However each party likes to play victim, each should be responsible for their actions and the resulting consequences without burdening the rest of the population. 

Disclosure: I still don’t own a home.. maybe in a few years. digg story

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Comments»

1. matt - May 19, 2008

It has happened before, several times in the past and it will happen again.Namely, BBCI, Savings and Loans Scandals, LTCM, Enron, and Wall Cooking of the Books. Taxpayers are paying for it all. I bet any bailout is to help the investors who have political clout. It just legalized crime. What’ new.

2. matt - May 19, 2008

It is just legalized crime. Some private banks take paper and loan the paper to consumers at outrageous interest rates and the consumer has to work night and day to pay for the worthless paper they were loaned. If the consumer cannot repay the paper he or she losses any and all tangible asset they may own. Try to print your own paper and you will be locked away for many years in jail. Got me.

3. John - May 19, 2008

It seems that nobody is responsible for their actions anymore. I agree with the article in that everybody should have done their homework but apparently nobody wanted to rock the boat. Fine but I do not want one penny of tax dollars to bail anybody out. This rewards irresponsible behavior. I also think that all a bailout will do is delay the end result not cure anything.
I do not think we are even close to how low this will drag down the economy. For years people have been buying things they could not afford with money they did not have and now the bill must be paid.
J O’K

4. Wizard Prang - May 19, 2008

Brilliantly put. In many cases it was a combination of stupid borrowers and/or stupid lenders.

In other cases – the one situation I have genuine sympathy for – there has been a change of circumstance, such as a lost job or ill health. However, most Americans are totally unprepared for even a month out of work. I find the average American’s lack of rainy-day savings deplorable.

Methinks that a lot of Mortgage lenders will soon find themselves involuntarily in the Real Estate business. And a lot of people will come to hard realization that they have no business buying a house; at least, not yet.

5. croixian1 - May 19, 2008

It is frustrating to be sure. Whatever happened to personal responsibility? I feel bad for those in New Orleans, except those who did not have insurance on their homes and are crying to the government to bail them out. I feel bad for those today losing their homes because of the subprime mortgage crises, but there WERE presented with a document to read before signing. We Americans are addicted to instant gratification.

Here is an interesting, but disturbing view on the failure of Democracy:

http://www.apatheticvoter.com/Article_DownfallDemocracies.htm

6. Fed bailout of Wall Street: Reverse Redistribution of Wealth « Armchair Economics - September 19, 2008

[…] Edit: For a more detailed framework of the subprime lending crisis, read my old post. […]


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