Wednesday, May 19, 2010

Q1 - What Really Caused the Mortgage Crisis?

Brain surgery is not rocket science to a brain surgeon.

There are four questions I am being asked lately and they involve subjects that are described as "complicated", "confusing", "complex", you get the picture. I will address each question in separate blog posts over the next few days beginning with "what really caused the mortgage crisis"? The answer, you'll find, is quite simple.

The four questions I am been asked most often whether in committee meetings, networking functions or sitting at a bar. They are (in no particular order)

Q. Is there really a meaningful economic recovery underway?
A. No

Q. Is there still a risk of a double dip-recession?
A. Yes

Q. Why do I keep hearing that Social Security won't be there when I retire?
A. Because it probably won't.
Q. Why not?
A. Arithmetic

Q. What really caused the mortgage meltdown?
A. See below

Those of you who know me and have followed me know that I subscribe to the theory that no matter how you dress things up at their core nothing is really that complicated. This is the meaning of "brain surgery is not rocket science to a brain surgeon".

So, what really did cause the mortgage crisis? Some will tell you it was everyone who should have known better than to take a mortgage they couldn't pay, didn't understand or both. Some will say it was "greedy" brokers. Some will say it was "greedy" banks making bad loans and, of course, Wall Street was involved somehow. Each of the above did contribute but they are all just symptoms of the real cause.

Underwriting is the process used by banks, insurance companies and you to assess the level of risk involved in a transaction.

"Greedy" banks? Let's think about that for a minute. A bank is in the business of lending money. Its very survival depends on its clients' ability to pay them back. A bank requests a variety of information from a prospective borrower in order to analyze the financial health of the prospective borrower and, therefore, determines the likelihood that the borrower will be able to pay back the loan. In other words it underwrites the loan. Historically a borrower would be underwritten. If they fell short of qualifying for their requested amount the bank would tell them a) what they did qualify for and b) what they needed to do in order to qualify for what they requested in the first place. This was a valuable service.

During this crisis we continue to hear a great deal about the "greedy" banks engaging in "predatory" lending practices by giving loans to people who could not afford them. Ask yourself "how greedy is it to lend money to someone who CAN'T pay you back"? Again, a bank is in the business of lending money. Its very survival depends on its clients' ability to pay them back. The industry had done this successfully for hundreds of years. Why would they suddenly start lending to borrowers who could not pay them back? They certainly knew better. So, what is the only thing that could cause an entire industry to commit suicide? If you said "government" you'd be correct. Over time an attitude grew in government that the American Dream is to own a home. Therefore, everyone who wanted to buy a home should be given a mortgage for a home. In order to assure this was possible the government implemented new lending laws that made the standards for borrowing lower. In other words the government restricted the banking industry's ability to underwrite risk. Once banks were no longer free to assess risk based on each prospective borrower's merits but were instead compelled to follow arbitrary standards the effects were inevitable. Yes, we could talk for hours about "complex" issues like liquidity, derivatives, CMO's, GO's, A.R.M.'s, etc. But all of those things and their associated problems are just the inevitable symptoms of the original cause no different than a runny nose is an inevitable symptom of a cold. You can blow your nose to reduce the symptom but the cold has to run its course ending the cause before the running nose will stop.

There has been an extraordinary amount of nose blowing while standing naked in the rain on a cold day during the lead up and continuing well into this disaster but very little appropriate shelter or therapy has been sought to cure the problem!

See, it really isn't complicated at its core.

No comments:

Post a Comment