Why is everyone apparently so surprised with the current housing crisis in the United States, and what brought it about? The short answer is collective stupidity, but I suppose that’s not nearly as entertaining as understanding the pieces of the puzzle.
One important catalyst is securitization. Securitization, as defined in wikipedia, is the process of homogenizing and packaging financial instruments into a new fungible one. Acquisition, classification, collateralization, composition, pooling and distribution are functions within this process. Simply put, some financial alchemists found a way to sell stuff on Wall Street that couldn’t easily be sold there before.
The way mortgages used to work was Joe Blow would walk into his local bank and talk with his banker, with whom he’d had a relationship since he first opened his savings account at age 12. Joe would explain to Mr. Banker that he needed a loan for his house. Mr. Banker could borrow the money at 6% so, taking in his cut (the spread), he loaned the money to Joe Blow at 7%. Everybody happy. The problem was that traders couldn’t really get in on the action. The overhead to handle such petty loans made it unmanageable. BSDs don’t care about Joe Blow’s pathetic $125,000 30-year 7% loan. In order to make their fat bonuses to buy a new yacht, they need to handle lots and lots of loans but they don’t want to deal with individual accounts. They trade stuff. That’s what they do. So how can they get in on the action?
Well, in the US we have the perfect tool for this job… the FICO score! This magic number tells you all about a person’s credit worthiness. So you can bucket mortgages by FICO score, mortgage type and maturity… 750+ 30-year fixed maturing August 2035 all go into one bucket. That’s a whole bunch of assets right there… Now the mortgage lender creates a subsidiary, probably offshore, that becomes the rightful “owner” of all these assets. This subsidiary issues some bonds based on expected cashflows coming in every month from all the people in that bucket. Let’s say, for simplicity, that there’s 10,000 mortgages in that bucket bringing in an expected $2.5 million a month in payments. Now, statistically, you’re dealing with 750+ FICO scores, so these people are extremely creditworthy… Still, assume that $100K won’t get paid every month… that leaves $2.4M. Of course, there’s operational costs, vacations, hookers,… so that leaves maybe $1.5 million per month. Now whatever bonds you issued pays $1.5 million per month over 30 years… Voila! Bonds is the kind of thing traders understand.
So that’s the first piece of the puzzle. The geeks on Wall Street found a way to let traders in on the game of mortgage. So far, so good.
Let’s go back to FICO scores… It’s easy enough to bucket 750+, 700-750, 650-700 mortgages. Those are some pretty solid credit scores. The odds are pretty good that those homeowners will make sure to pay their mortgage every month. But what about some poor shmuck with no income and a credit score of 525? How can you get him to play the housing bubble game? The geeks on Wall Street thought long and hard and decided that maybe you could slice the buckets horizontally.
They call it tranching in structured finance. The idea in so doing is to provide more reward for more risk taken. So the lower tranches will still get securitized and make their way onto the Street… but those are serious junk bonds. They may bring in 18% annually but they’re backed by a bunch of mortgages that were handed out to homeless trolls living in shopping carts in Berkeley. Let’s say that the risk of default is high… Aha! But not quite… because a shopping cart in Berkeley will cost you $500,000 and you can probably sell it tomorrow for $600,000, so at that point in time you’ll have built up some equity and you can refinance… No no…you don’t need any income. In fact, you don’t even need to give us any money at all. We’ll just tack on the interest at the end of your loan. Actually I diverge… we’ll discuss mortgages further below. For now, back to tranching. So basically, the top tranche is given a grade of AAA because, despite the fact that it only pays 5% annually, it is the first tranche to get paid. So the top tranche of the 500-550 bucket (read: serious subprime) still manages to get a AAA rating… As long as it’s BBB+ or above, it’s investment grade so the traders can happily tap into it… Ok, look let me get graphic for a minute… Yo, Einstein…If you fill a bucket with shit, does the cream rise to the top? Investment grade? Sheesssh
So now you have the big mortgage lenders who have a way to offload their mortgages onto Wall Street…. Sah-weet! The way to make a lot of money is to take in as many loans as you can, grab your cut, “securitize” them, and send them off to Wall Street. Thus, the creative mortgages were born: No points. No fees. 3/1 ARM. Negative Amortization. Hybrid Interest Only. HELOCs… “Come one, come all!!! Get your loan right here!!! Get ‘em now while they’re hot!”
So now we have it… Wall Street and large mortgage lenders have created a very large need for lots and lots of loans, which means we need lots and lots of new houses for people to buy. No income? No problem… Come and get your house and you can ‘flip it’ in a year or two and make $200K. See? Now you got income!
In places like Vegas, build houses they did like there was no tomorrow. Here in California, they pushed well into the central valley and, of course, prices in large metropolitan areas skyrocketed. “Build it, and they will come?” Damn straight they did!!!! Everybody was buying and demand was far outpacing supply.
Interest rates were low, too, making it much easier to borrow money for cheap. Traders, too, borrowed money to trade these bonds… They borrowed Yen at 0% and traded them into dollars so they could buy these bonds. They even have a name for this, the Carry Trade.
Well, we’re now in the days of reckoning… Ultimately the people who are paying today are those greedy bastards on Wall Street and those who bought a house without following the fundamentals. I’m fairly certain that those of us who bought in the last 3 or 4 years at 3 times annual income, like the rule-of-thumb suggests, aren’t really sweating it right now. Those with a $75,000 household income who bought a place in SF for $850,000? Well, good luck to you. I hope you make it out of this mess unscathed, but I wouldn’t hold your breath.