Explaining
the Mortgage Meltdown
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There
will likely be more than 1 million foreclosures this year. In many places, home
prices have dropped significantly. Speculation fever has been replaced with
talk of a crisis. Even President Bush has stepped in with a plan to help some
troubled homeowners.
In
a way, though, this is a much-needed correction.
We
learn to swim by paddling around the wading pool — not by diving into the deep
end. Today’s situation isn’t much different: People caught in the “deep end” —
with loans they can’t afford and homes in peril of foreclosure — are often
those who jumped into homeownership before learning how to stay afloat
financially.
Here’s
how it happened. In the mid-1990s, the housing market grew dramatically. The
creation of a secondary market for sub-prime loans made credit available to
those who were historically underserved. At the same time, a roaring stock
market gave people the assets to purchase more expensive homes.
When
the dot-com bubble burst, investors sought refuge from volatile stocks by
pumping money into real estate. In short, the booming stock market that
launched the housing bubble inflated it even more when stocks plummeted. Also
during that time, to stem a crisis of consumer confidence, the Federal Reserve
began a series of interest rate cuts that cheapened credit.
Within
a few years, the homeownership rate hit an all-time high. Constant for more
than 20 years around 64 percent, homeownership soared from 1995 to 2006 —
hitting nearly 70 percent.
This
rise was mostly due to people who dove into the deep end. Before the
mass-merchandizing of sub-prime lending, and seemingly cheap credit, many of
these buyers would never have qualified for a conventional mortgage.
Some
took out oversized loans without understanding how much debt they were assuming
and how much their interest rates and payments could
change. Others dove in with full knowledge — gambling on a superheated market
to boost their home’s value, so that they’d be able to handle high-priced loans
by refinancing later at lower rates. Others hoped to make money by “flipping”
their properties.
For
a few years, it seemed to work. In much of the country, prices steadily
increased. Homes — traditionally viewed as places to live and long-term
financial commitments — became short-term investments.
Buyers
who were already deep in mortgage debt got in even deeper by using their homes
as ATMs, cashing out the equity created by the real-estate appreciation.
But
many of these borrowers weren’t in a position to keep up with their loans if
the housing market cooled. When it did, they faced the prospect of owing more
than their homes’ retail value, or of coping with a mortgage that would soon
reset to a much higher monthly payment.
Lenders
who offered zero-down home loans and low-cost, introductory rates to “cram”
buyers into homes that they couldn’t otherwise afford were irresponsible. But
so were the borrowers who cast caution to the wind and either overpaid for a house,
or bought into a house or locale beyond their means.
Further,
lenders should hold and manage the loans they create. When lenders sell off the
loans they write to investors, they have every incentive to “move as much
paper” as possible — as long as they’re not the ones holding worthless paper at
the end of the day.
Put
another way, the “mortgage meltdown” should teach both borrowers and lenders to
behave more rationally.
Bill
Higgins is the head of lending services for ING DIRECT.