The Solution to the Subprime Crisis

When it began, the financial engineering that got us into the current mortgage crisis actually made sense. On a purely mathematical basis, bundling mortgages together is a clever way for banks to reduce their risks while still earning the same expected returns on their investments.

Unfortunately, somewhere along the line, bankers, mortgage originators, and the investors who bought those loans forgot one crucial point: At the other end of a mortgage is a person, who used that money to buy a house. Unlike the stock market, where an incredible amount of information is available about the companies that trade, very little is available about what a home -- or borrower -- is really worth.

Whose skin is in the game?
As a result, banks had traditionally relied on substantial down payments to protect their investment. With a big down payment, a bank can be better assured that:

  • Buyers have their own money tied up in the house, not just the bank's.
  • Buyers really think their home is worth the money invested in it.
  • Buyers had enough financial savvy to save the cash in the first place.
  • If buyers got into hard times, they'd try to keep their houses to protect their own investments.
  • If the buyers paid too much, the bank's investment was protected by the down payment.

Ultimately, those down payments are as valuable to the bank for the information they provide about the borrower's intent and financial acumen as they are for the capital itself. When banks stopped requiring down payments, people with new mortgages stopped behaving the way people with mortgages had traditionally behaved. The rules of the game had changed, housing money had gotten exceptionally cheap, and that cheap money allowed the real estate bubble to form in the first place.

Bubble trouble
The market had been accustomed to people with skin in the game protecting their mortgages. As a result, it neglected to consider that people with nothing invested had nothing to lose by walking away. That enabled virtually anyone with a pulse to walk into a lender and walk out a "homeowner." Is it any wonder that home prices escalated, thanks to weak standards like that?

Not until property values stopped rising astronomically, leaving originators unable to recover their capital in forced sales, did the true risks become apparent. Contrary to popular rumor, even amid this crisis, houses are still selling, and banks are still writing mortgages. But lenders have wised up to the risks they created by handing out cash with no requirement for the borrower to invest one thin dime.

Pop goes the bubble
By tightening their standards, lenders have effectively priced some folks out of the market. Not everybody, mind you -- just the folks who had expected to buy a home with no money down. Unfortunately for people looking to sell their homes, prices aren't set in the market by the average buyer, but by the marginal buyers -- the people willing to pay the highest price.

Removing no-money-down buyers from the picture eliminates a huge chunk of marginal buyers. As a result, there's nothing left to prop up housing prices, which are now finally starting to retreat to more rational levels.

In fact, that's the solution to the subprime crisis. Tighter lending standards, lower housing prices, and homeowners with their own money invested in their homes. That's about the only way to get the dust to settle, entice banks to lend again, and convince investors to buy mortgage-backed securities once more.

Isn't that painful?
Of course, that doesn't sound much like help to the people and companies caught up in this mess. If you can't afford your house payment, the bank will foreclose. If the bank has a choice between holding on to an empty house or selling it for a loss because the buyer had negative equity, chances are it'll sell to recapture whatever cash it can.

And yes, that's painful for the banks, as well. In fact, it's a primary reason why so many banks and other lenders like these have fallen so far off their 52-week highs:

Company

52-Week High

Recent Price

Fall From Grace

IndyMac (NYSE: IMB  )

$35.5

$1.76

(95.1%)

Countrywide (NYSE: CFC  )

$39.4

$4.86

(87.7%)

National City (NYSE: NCC  )

$34.6

$4.5

(86.9%)

WashingtonMutual (NYSE: WM  )

$44.2

$6.6

(85.1%)

Corus Bancshares (Nasdaq: CORS  )

$18.5

$5.0

(72.9%)

Citigroup (NYSE: C  )

$54.5

20.0

(63.3%)

Bank of America (NYSE: BAC  )

$52.9

$30.4

(42.5%)

Data from Yahoo! Finance.

In addition, forced selling tends to depress prices even below what would be a rational level of affordability. That's where bargain hunters come in, profiting handsomely from panic in the housing market by buying properties at incredible bargain prices.

Be ahead of the curve
Those bargain hunters are often the first signal of the recovery of any market -- be it real estate, stocks, or artwork. They stand to be rewarded handsomely when the market finally finishes its swing back from the bargain bins toward rational levels. Given a choice, it's always better to be a buyer when times look tough and bargains abound.

Related Foolishness:

Only in times of panic do opportunities like these become available, and only those who see the opportunity amid the panic can profit. This very concept helps our Motley Fool Inside Value analysts select investment ideas each month. See all their picks with a free 30-day trial subscription.

Fool contributor Chuck Saletta hopes he has enough equity in his house that his bank would come out money ahead if it foreclosed, but he'd rather not test that theory. At the time of publication, Chuck owned shares of Bank of America and Washington Mutual. The Fool has a disclosure policy. Bank of America is an Income Investor recommendation.


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Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On June 09, 2008, at 4:43 PM, jczinki wrote:

    Greedy lenders forgot the five Cs of creditworthiness:

    Character (good citizens repay loans)

    Capacity (cash flow to service debt)

    Collateral (no explanation needed)

    Capital (for down payment)

    Conditions (economic and downside vulnerabilty)

    Lending bubbles go in cycles and are self-correcting. The current one has been painful and costly for all participants. Lenders are getting back to basics and perhaps they will learn this time but don't bet on it!

    Joe Sinkey

    Emeritus Professor of Banking & Finance

    Terry College of Business

    The Unversity of Georgia

  • Report this Comment On June 09, 2008, at 10:38 PM, hifibri wrote:

    There were many factors that contributed to the present state of the housing market. Sub-prime foreclosures are not the cause but a symptom and only made up about 15% of the entire market. Please understand the primary cause of the boom and bust. When you keep asking why long enough you will find ultimately it was our own FED who kept rates too low for too long, creating a huge frenzied groundswell of demand. For almost 3 years from about Oct. 2002 until Aug. 2004 when the FED started raising rates, mortgage rates were some of the lowest in 40 years. Tremendous appreciation, low credit score-no down payment loans, rating agency issues, complex secondary market bundling, - everything that followed would not have happened. Low, low rates fueled the frenzy and created the bubble - artificial manipulation to stimulate the economy. Then as appreciation continued to soar our FED, in attempts to prevent inflation, raised rates which brought mortgage rates from the low 5’s to almost 7% in June of 2006. This raised the cost of borrowing so the average borrower could not afford the inflated home prices and appreciation stopped. Then the foreclosures started. When people started treating housing as an investment vehicle it started acting like one and since they had no skin in, they were out, and broke their promise to pay. Sub-prime loans by their very nature are risky. That’s why these foreclose first. Underwriting then tightened, exacerbating the problem.

    Anyone alive during the last 7 years could not escape the incessant 'housing bubble' and ‘housing frenzy’ news stories. Even the FED warned of ‘froth’ in the housing market. Everyone knew the housing market could not continue in the direction it was headed but no one knew when or how to stop it. New home purchases and cash-out refinances were the only thing keeping the economy going and now we don't have that. All the inherent problems with the economy in 2000 when the stock market crashed (the last bubble, then 9/11), which prompted the FED to lower rates are still with us except now we have higher fuel costs.

    Everyone likes a simple explanation and someone to blame. “Greedy Lenders” are ultimately the same people trying to maximize your 401K returns and reduce your insurance premiums – we in essence are lending to ourselves by investing our money in the secondary mortgage market which had an insatiable demand for ‘highly rated’ mortgages. Financial engineering, or economic engineering, yes, but it wasn’t started by the banks, mortgage originators, or investors.

    There is pending legislation that may put mortgage brokering companies out of business by changing the way these companies derive income. Mortgage brokering companies did not capture 70% of the mortgage market by being less competitive than banks, but apparently through political and media rhetoric they have become the scapegoat. There are areas in the system that can be improved to mitigate the risk of this happening again but it is very important that we do not let knee jerk reactions put inappropriate controls in place that will do more harm than good. If this happens banks will become very profitable, at our expense.

    The solution to fixing the housing market is to provide incentives to those who will buy foreclosed properties, not by keeping people in houses they can’t afford. Only by getting rid of excess housing inventory will the market find its balance. If this does not happen prices will continue to deteriorate and foreclosures will continue to rise.

    Hifibri

    Just a guy wonderin' why.

  • Report this Comment On June 10, 2008, at 2:40 AM, Irishangel3d wrote:

    This does not describe the very ethical Real Estate Brokers who try to serve their clients truthfully However I do know people who have been involved in the following and contributed to the housing bubble.

    1) The Real Estate Brokers whose main concern is their commission., taking people to homes that are above their ability to pay or their comfort level.

    . 2) They usually set the value of the house for listing (set the value for the seller), 1 month later they inform the seller the price is too high and have them reduce the price giving the impression there is a defect in the home. also giving the impression to a buyer there is a bargain to be had..

    3) They help the borrower find financing (I can get you into the house of your dreams by taking out two mortgages no money down) sometimes the broker gets a commission for the referral.

    4) Telling the seller this is the only person bidding or who has shown interest in your house. The person interested needs a buyers assistance program. However their commission is based on the higher price and costs both the seller and the buyer

    5) Tell the buyer 2-3 other people are bidding on the same property, thereby increasing the buyers offer. Many times this is well above the asking price. In one case the buyer found this out after signing the paperwork there were no other bidders.

    6) Changing the terms of the contract without explaining those changes to the buyer.

    7) Buyers who do not understand the terms of the contacts they are signing in many cases due to lack of knowledge in that field. Not because they are stupid.

    The buyer must learn not be emotionally attached to a property.. Be prepared to walk away if the price keeps escalating.Even when the broker says you have to get it now before its gone or this opportunity will not present itself again.

    8) The Real Estate Firms that are seeing the lower prices, buying up the best properties before other buyers have a chance to view them, and plan to hold on to them until the market RECOVERS. In the mean time renting these properties back to the former owners at half what their mortgage payment was before the foreclosure.After choosing the best deals , the only homes left are almost striped but still offered at inflated prices to the general public.

    9) This in turn starts the process all over again,by keeping prices higher. Not really allowing the prices to return to the true value of the property, because they will also make a commission on the property when it is sold once again

  • Report this Comment On June 10, 2008, at 9:27 AM, MrHankie wrote:

    I worked for a subprime mortgage lender. They were always checking credit history, LTV and other factors. (You wouldn't believe some of the stuff that shows up in a credit check and how many liars were caught out by this) They always made sure to have a wide risk spread across different postcode areas, different loan amounts, different types of product and so on. They had a whole bunch of reports to make sure this was always kept in check. Hardly irresponsible.

    It is the idiots who think they have a god given right to own a house that caused the problem.

  • Report this Comment On June 10, 2008, at 10:32 AM, hifibri wrote:

    Correction to my post above; The FED began agressively lowering rates at the end of 2000. It was around Oct. 2001 (not 2002 as written above) where rates were at record lows which lasted almost 3 years, fuelling the housing bubble.

  • Report this Comment On June 10, 2008, at 10:50 AM, moon32 wrote:

    There are some underlying issues not addressed such as theCommunity Reinvestment Act imposed upon banks to correct their preceived prejudicial lending practices (if you couldn't meet their lending criteria you didn't get the loan); FHA's abandonment of their rule of thumb on the amount of insurable mortgage to income; the First Time Home Buyer program; interest only ARM mortgages to name a few. The people who should have known better were placed in a position of participating or being "politically incorrect" or were following the guidelines from people suffering from the Peter Principle. The bundling problem is the lip stick on the pig and rest with the investment market.

  • Report this Comment On June 10, 2008, at 11:57 AM, hifibri wrote:

    Moon, good point. Consumer groups are responible for pressuring lenders to create of many of these generous mortgage programs for the 'underserved non-traditional' borrower. We now see the result and it's the lenders that are blamed. To pile insult onto injury when looking at the poorer neighborhoods with these loans and the higher default rates these same consumer groups blame lenders for prejudicial lending practices and red lining! As is typical to justify a position the data is correct but the conclusion is wrong. There were a myriad of issues that contributed to the housing crisis. It is a very complex issue which is not fully explained in a media article. Because the whole story is never told most citizens have the wrong percetion of the issue.

  • Report this Comment On June 10, 2008, at 1:04 PM, shooter326 wrote:

    I don't think I feel sorry for the mortgage lenders. If we look back lenders were always careful who they loaned money to demanding income statements, tax returns and a reasonable down payment. Then along came the GO GO years of low interest rates and excalating property prices. Suddenly lenders were doing "stated income" with no proof, and little or no down payments and "interest only loans" which many people did not fully understand could and would come back to bite them. If you made such a loan and bought at the peak of the bubble you now find yourself upside down in your property. But if, in an attempt to be responsible you go to your very same lender and say "I need relief here. Can I refinance at the low low rate your advertising" you will be told "sorry Charlie, you don't have adequate income or down payment". Remember, this is the same lender that pushed you out the door with a no down payment interest only adjustable on a "stated income", perhaps only one or two years ago. Sure the lenders are suffering but what about all those borrowers? Who weeps for them. No one wants foreclosure. No one intentionally chooses to destroy their credit. No, I do not feel sorry for the overly agressive lenders. They wandered from good practice and everyone lost.

  • Report this Comment On June 10, 2008, at 1:39 PM, jbhowe100 wrote:

    I am a Nissan Dealer; I battle with banks all day long. I was going to tell more but I better leave it at that. Although I do have a hand full of banks Plus Nissan Finance and GMAC That we finance thru that are Good Lenders.

  • Report this Comment On June 12, 2008, at 5:43 PM, bgpr wrote:

    I agree with all points in the article in particular the "down payment" i.e. the buyer needs to have some skin in the game.

    FHA stated that when the seller puts up the down payment the foreclosure rates are double and thus wanted to stop allowing the practice. Congress insisted that the practice be allowed to continue as it provided a chance for those with no money to buy a house.

    We do not learn from our mistakes!!!

  • Report this Comment On June 13, 2008, at 6:07 AM, douggieboy wrote:

    MY THREE WORD SOLUTION TO THIS WHOLE DAMN MESS:---

    ERADICATE FICO SCORING!

    Check out my site, FICOVICTIMS.COM. I predicted exactly what's happening today, ten years ago.

    FICO has destroyed my life.

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