Fear and greed: why the American housing credit crisis is worse than you think

International Economy, The, Spring, 2007 by Lawrence B. Lindsey

When credit standards ease, demand for the assets behind the loans increases, driving up the prices of those assets. In the case of housing, home prices rise faster than incomes and faster than rents on equivalent properties. Buyers, seeing these rising prices, jump on what they perceive to be an ever-upwardly spiraling market.

But when prices rise faster than incomes, borrowers run up against basic underwriting rules on the income they need to service the loan. For example, a standard rule is that the mortgage payment--which combines principal, interest, taxes, and insurance--be no more than 28 percent of the borrower's monthly income. These rules are designed to ensure that borrowers are able to make the monthly payment. To make loans and buy houses at ever-rising prices, both borrowers and lenders must look for ways to lower monthly payments. There are only two items under their negotiable control: principal and interest.

In the current credit cycle, ways were found to save on both principal and interest in order to qualify for a mortgage. First was the development of the "interest only" loan, in which the entire principal repayment was delayed. Second, the use of variable-rate mortgages that adjusted with market conditions also became widespread. To some extent these variable rate mortgages are quite prudent. Long-term interest rates on which fixed-rate mortgages are based are typically higher than short-term rates because the lender takes a risk that rates might go up. With a fixed-rate mortgage the lender carries this risk, with a variable rate mortgage, the borrower carries the risk. Indeed, no less an authority than Federal Reserve Chairman Alan Greenspan recommended that borrowers take out variable-rate mortgages in order to take advantage of this situation.

As the credit cycle got into its very late stages, even more exotic products were created. One was a negative amortization product where the interest rate was deliberately set below the market rate with the extra interest being rolled into the loan's principal. In a rising house price market this involved little risk to either borrower or lender. Another version of this was a very low qualifying rate with a drastically higher reset rate and a prepayment penalty attached. The lender essentially recouped the lost interest in the early stages of the loan either through payments made at the higher rate or through the prepayment penalty.

The most important point to make is that none of these loan product innovations are malicious in their intent. Their purpose was to help the borrower qualify for the mortgage. Increasing access to homeownership had the bipartisan support of the Congress and regulatory blessing and was coupled with both political and regulatory pressure. Families who never before had access to homeownership because their income, credit history, or neighborhood made them too risky to meet conventional standards now could attain that portion of the American dream. Of course, financial market participants were not doing this out of the goodness of their hearts, but to make money. So the currently fashionable term "predatory" should be used with care when considering the actual nature of this market. "High risk" is a better phrase. In moderation, these added risks were well worth it. But the self-reinforcing nature of this up cycle camouflaged the actual risks that were being undertaken. Inevitably, the dynamics created by the upward spiral create the conditions for a downcycle.