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

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

This reaction of the appraisers causes a tightening of credit conditions. Say the buyer and seller decide on a price of $200,000 and the buyer puts down $20,000 and seeks a $180,000 mortgage. The buyer may think that he is asking for a fairly conventional 90 percent loan. But if the appraiser cautiously puts the "fair market value" of the house at just $185,000, the $180,000 mortgage the buyer is applying for actually looks like one of those high risk 97 percent loans with the buyer putting down just $5,000 more than the house is worth. With the banks already in the process of lowering the maximum loan-to-value ratios on which they are lending, the net effect of this is to make fewer mortgages available. With fewer mortgages, there are fewer sales. With fewer sales, the appraisers have even fewer comparable sales on which to base their appraisals, making them even more cautious.

Over time this effective tightening of credit has a big effect on prices. People who have moved to a new house before selling their original house face the burden of carrying two mortgages. At some point they get desperate and decide to cut their asking price for the house. This gives appraisers a "comparable price" for other houses in the neighborhood, but the comparable price is very low relative to the recent past. With prices obviously on a downtrend, further caution sets in. Everyone in the same neighborhood now is faced with the need to make huge price concessions in order to move their property. Prices begin a downward spiral. With relatively few sales--and those sales that occur happening at very deflated prices--a sort of contagion begins to effect the values of all houses in the area.

In the current credit cycle, this process is going to be exacerbated by the development of the mortgage-backed securities market. As discussed earlier, this financial development obviated the problems that caused the old S&L industry to fail. But it set in place a whole new set of pitfalls. Since the new system relied on a separation of mortgage originators who had some knowledge of both the borrowers and the collateral from the securitizers who packaged the mortgages and the actual lenders who bought the securities, there was a complete disconnect between the lender and the borrower. Investors who buy mortgages have no idea who the actual buyer of the home was and have never seen the houses that comprise the collateral behind the mortgages they are buying. They are relying on the statistical characteristics provided by those who did make the mortgage: a given loan-to-value ratio, a given set of homeowner characteristics with regard to creditworthiness, and a given maximum percentage of mortgage payment to monthly income.

When those mortgages were made, by and large the lenders met the statistical criteria. Some may have stretched the truth just a little in order to meet the criteria, claiming perhaps some additional income for the borrower that he really didn't have, or a more generous appraisal. The originators didn't care because they would still collect their fee for making the mortgage and the actual risks involved were small as long as house prices were going up. Now that house prices are going down, the statistical criteria on which the bundle of mortgages was sold no longer matches reality. So, if one of the borrowers just happens to default on his mortgage, the holder of the mortgage bundle finds that his actual losses are much higher than anything that his statistical model said they would be.