I. The Classical Home Loan
At one time – sounds like a reference to the “olden days”, but it wasn’t so long ago – a borrower was expected to put 20% down as part of borrowing 80% of the purchase price of a home. The fixed monthly payment had two components: interest and principal. The interest was calculated as one-twelfth of the annual interest rate times the current principal balance. The principal was the difference between the monthly payment and the interest. Pretty simple. After thirty years of making the payments you owned the house. Things were a bit more complicated if the monthly payment included homeowner’s insurance and property taxes, but this was a minor adjustment to the basic idea.
II. The Community Reinvestment Act
The CRA was enacted in 1977. However, aggressive enforcement beginning in the mid-1990s sowed the seeds for the current financial problems. Why? It helps to know what the CRA requires. Yaron Brook of Forbes observed:
The CRA forces banks to make loans in poor communities, loans that banks may otherwise reject as financially unsound. Under the CRA, banks must convince a set of bureaucracies that they are not engaging in discrimination, a charge that the act encourages any CRA-recognized community group to bring forward. Otherwise, any merger or expansion the banks attempt will likely be denied. But what counts as discrimination? According to one enforcement agency, “discrimination exists when a lender’s underwriting policies contain arbitrary or outdated criteria that effectively disqualify many urban or lower-income minority applicants.” Note that these “arbitrary or outdated criteria” include most of the essentials of responsible lending: income level, income verification, credit history and savings history – the very factors lenders are now being criticized for ignoring.
Once the traditional lending criteria were jettisoned, banks started issuing mortgages to people who couldn’t put 20% down. These borrowers – we’ll call them CRA borrowers – had to borrow more than 80% of the purchase price. The larger loan meant a larger monthly payment, which was also a problem. The solution: option ARMs.
III. Option ARMs
An ARM is an adjustable rate mortgage, meaning that the interest rate varies from month-to-month rather than staying fixed for the life of the loan. ARMs have been around for a long time as a way to compensate lenders for the increased risk of lending to less than ideal borrowers. The new development was the option structure that had four repayment options:
- The borrower could make the fully amortized payment and pay the house off in thirty years;
- The aggressive borrower could make a larger payment and pay the loan off in fifteen years;
- The borrower could pay only the interest (this is almost indistinguishable from renting, except that renters have better mobility since they don’t have to find a buyer); and
- The borrower could pay less than the full interest – a negatively amortized structure.
The third and fourth options made it possible for the CRA borrowers to get into a home because of the reduced payments.
IV. The Housing Boom And Mortgage-Backed Securities
Once CRA borrowers got into the market, demand went up dramatically. This forced prices to increase, creating equity. This made U.S. real estate a very attractive investment.
What if you wanted to invest in real estate, but couldn’t afford to buy multiple houses? The brokerages had an answer: mortgage-backed securities (MBSs – maybe this should mean “More BS”). When a borrower took out a mortgage, the note was chopped up, and each piece was bundled with other pieces of mortgages. Shares in the resulting bundle were then publicly traded. As long as borrowers made their payments on time, these MBSs were good investments. And with real estate continuing to appreciate, what could go wrong? In fact, some of the issuers of MBSs promised to buy back any MBSs that didn’t pay a return.
As housing prices increased and borrowers used their homes as personal ATMs, taking out home equity loans that added to the ever-growing pool of MBSs.
V. The 115% Trigger And The Market Collapse
If the payment is negatively amortized, what happens to the unpaid interest? It gets added to the principal balance, meaning that instead of slowly decreasing to zero over the thirty-year loan, it grows. Meanwhile, the lender is not getting its principal back, and it isn’t even getting the full interest. No bank is willing to accept less than at least full interest payments indefinitely. Therefore, option ARMs have a trigger point. When the principal balance reaches 115% of the original loan amount the payment jumps to the fully amortized amount.
Borrowers got used to paying the reduced monthly payment. Therefore, when they reached the 115% trigger, they defaulted. This triggered the first wave of foreclosures, which increased the supply of housing on the market, which in turn lowered real estate values. The combination of loan defaults and real estate value decreases lowered the value of MBSs, and investors therefore wanted to use the buy-back promises. Unfortunately, the MBS issuers didn’t have the resources to buy back the MBSs. And with each new wave of defaults came further downward pressure on housing prices and MBS values.
As housing prices dropped, housing starts declined. Since housing is one of the key engines of prosperity, ripples of destruction expanded throughout the economy. Construction stalled, so companies making construction related products were hit. This led to layoffs. The laid-off workers no longer had the income to service their debts, which led to further defaults. And, of course, unemployed workers have less to spend, so demand for consumer goods decreased.