Sunday, August 26, 2007

Sub-prime mortgages, risk, and causes of financial crises

The sub-prime mortgage market is the current financial "crisis" in the United States. Comparing sub-prime mortgages today with the S&L crisis of 30 years ago provides interesting parallels and shows how the different mortgage market today has resulted in a different problem than 30 years ago.

Those under 45 or so won't remember Savings and Loans. Back in the 1960's and early 1970's there were several types of financial institutions. One which has not survived is the "Savings and Loan." A Savings and Loan could only accept money in savings accounts and only loaned money for house mortgages (perhaps also home improvement loans, I forget the exact rules). Savings and Loans could not provide checking accounts, auto loans, etc. which banks offered. On the other hand, S&Ls could have many branch locations, while banks were limited to a single office.

During this time most home mortgages were provided by S&Ls. The S&L would charge 6% and later 8% for mortgages, while offereing 3% (later 5%) for savings. Maximum interest rates were regulated by the government, limiting the rate charged for mortgages or paid for savings.

The S&L crisis started in the mid 1970's but hit its climax in the early 1980s with scandals about shady deals and bankrupt S&Ls. While many people remember the scandals of the 1980s, fewer remember the original causes in the 1970s.

To explain the S&L crisis, one needs to look at way the system worked and how it reacted to the high inflation and interest rates of the 1970s. Prior to about 1975 interest rates in the U.S. were fairly stable and regulated. As mentioned above, S&Ls loaned money at 6%-8% for home mortgages. Adjustable rate mortgages were illegal, and most mortgages were for 30 years. They were also "assumable", meaning that a buyer of the home could take over the payments (and balance) of the existing mortgage.

Another factor was that the secondary mortgage market did not exist. S&Ls and banks held their mortgages the full term of the loan, getting their monthly payments. Today's practice of bundling mortgages and selling them developed later in the 1980s and 1990s.

In the mid 1970s inflation started rising, peaking at over 13% in 1980. Prior to 1974 the inflation rate rarely exceeded 3-4%. With inflation rising, many people were not satisfied with the 5% paid on savings accounts (limited by law). They started moving money into higher yield investments and out of the traditional banking system. As money moved out of banks and S&Ls, they lobbied for higher interest rates, and the "certificate of deposit" was created. CDs could pay higher interest but had minimum balance and term restrictions. CDs stemmed the loss of money but increased the costs to banks and S&Ls. Remember that banks cannot create money out of thin air. If they loan money they need deposits to back up that money (yes, they sometimes only need deposits for a percentage of their loan balance, but they still need the deposits). The increased costs of higher interest paid on savings could only be made up by increasing loan rates. Banks were in fairly good shape -- most bank loans were for a few years (car loans were typically 3 year) so the bank could get income from increased rates fairly soon. Savings and Loans, however, were in a bind.

Savings and Loans had their money tied up in 30 year mortgages. While the typical American would move every 5-10 years, assumable mortgages meant that the low 6% of many mortgages had years and years to run. Savings and Loans could write new mortgages, but the new income could not make up for the higher interest paid for savings. Thus, by the late 1970s S&Ls were paying higher interest on savings than they received for mortgages. Since S&Ls held their loans until paid off, they were in a financial bind.

At this time S&Ls were given more freedom to do other things. They could offer checking accounts and begin to loan money and invest in other areas. However, this added flexibility couldn't solve the underlying problem and S&Ls proceeded to merge, fail, and in some cases commit fraud. By 1990, very few S&Ls remained, and those which did were called "Savings Banks" and were much closer to standard commercial banks.

Today we won't get an S&L crisis of this type. Since the S&L crisis the secondary mortgage market has evolved, and most mortgages are packaged and sold to investors. This avoids the S&L crisis because the buyers of mortgage backed investments pay up front and receive interest over the life of the mortgages. If mortgages are paid off early (due to falling rates) the mortgage backed investment is paid off early. If interest rates go up, the investor still gets the same amount from a mortgage backed investment (if backed by fixed rate loans). Assumable mortgages are also a thing of the past, so with the mobility of the US populations most mortgages probably exist less than 10 years, with the home owner moving or refinancing within that time.

With the changes in the market, the problem of long term loans financed by short term deposits no longer exists.

However, the new mortgage market has created its own distortions which reveal a new problem in the banking system. Today mortgages are originated by banks or mortgage brokers. These are then sold into the investment market after which the originating bank or broker has no part in rest of the life of the mortgage loan. Thus, mortgage originators are most concerned with getting a loan approved so they can receive their commission, a lump sum when the loan is sold.
This shows the source of the current sub-prime mortgage problem. Lenders have been becoming more and more lax over time. In the case of mortgages, there is intense competition to get a loan. I personally would receive several letters each WEEK offering to refinance my mortgage (I still average about 1 a day for a new credit card). Those who did not qualify for a fixed rate loan could get an adjustable loan at a lower rate. In addition, loan standards are lower. Traditional mortgage loans were for 80% of the home's value. FHA would allow up to 95% or 97% (with mortgage insurance). Today lenders offer up to 125% of a home's value, especially in shorter term home equity loans.

These new markets worked very well so long as home prices were rising and interest rates remained low. However, interest rates are rising. Because rates are rising, home prices are stalling (since part of the rise in home prices the last 15 years has been because a given mortgage payment could pay for more home as rates fell). With stalling prices and rising rates on adjustable mortgages, people who could barely afford their home are in trouble.

We now have a situation with rising default rates. This has severalcauses. One is people not realizing that their mortgage payment would rise and not being able to afford the rising rate.
Another cause is liberal lending practices by lenders who a more concerned with the immediate return of originating a loan than the long term prospects of repayment. A final cause is investors in mortgage backed securities not realizing how risky their investments are.

Tying this rather rambling discussion together, the S&L crisis of the 1980s was caused because S&Ls (by government regulation) had to make and hold onto long term loans based on short term deposits. This could not stand up to a rise in interest rates. Today's secondary mortgage market avoids the S&L type crisis but creates its own crisis -- liberal lending practices resulting in excessive foreclosures. In each case the "rules of the game" have created the environment. In the past, regulated rates that could not respond to high inflation. Today a system which allows excessively liberal lending along with a belief by many homeowners that housing prices would continue to rise indefinitely.

Unfortunately, the banking industry has adopted excessively liberal lending practices as a norm. Banks come close to forcing credit cards and credit card debt on consumers. The constant offers and credit line increases has been a minor problem for years and will become worse as time goes on, especially if interest rates continue to rise.