At a recent doctor’s appointment I told my physician about a story I’m working on that involves the securitization of loans in which the underlying collateral is housing, evoking the dreaded term “mortgage-backed securities.”
My doctor’s reaction was something I’ve heard several times from friends and family lately: “They’re doing the same things that caused the financial crisis!”
In a lot ways that is true; much of the financial machinery that produced mortgage-backed securities and their derivatives are still in place, churning out the same products that wreaked havoc on the global economy.
But there a few key differences between the housing market then and the housing market today that make another global financial calamity, or at least one that mirrors the previous one, unlikely.
While highly complex debt instruments such as mortgage-back securities, collateralized debt obligations, and credit-default swaps are what turned the housing crash into a financial crash, the underlying problem was ultimately quite simple: Low- and moderate-income people were given mortgages on which default wasn’t just possible or even probable, but inevitable.
In the early 2000s, the construction sector churned out houses at a dizzying pace,leading to an oversupply of single-family homes. To get people into these homes, lenders extended credit to people who shouldn’t have gotten it, and the terms of the mortgages were such that the interest rates would “reset” after a couple years.
The process was egged on by Wall Street, which catered to intense global demand for mortgage-backed securities from investors both foreign and domestic. The explosion of these securities created demand from hedge funds and insurance companies for credit-default swaps and other derivatives, which served as insurance policies against their mortgage-backed securities.
The frenzy pushed home prices up, and everyone in the chain was getting rich on transaction fees without regard for whether the mortgage payments actually came in. When the interest rates on subprime mortgages began to “reset” to higher rates in 2007, defaults sky-rocketed, the securities failed, and the whole system came crashing down.
Today, all this financial machinery still exists, with one key difference—subprime mortgage loans with adjustable ratesaren’t being written at anywhere close to the same volume. This isn’t necessarily the result of newfound restraint by mortgage lenders and Wall Street bankers; it’s more a reflection of a housing market that’s the inverse of the one that existed in the run-up to the collapse.
Instead of a housing oversupply that required creative lending to attract buyers, today we have a housing shortage that’s creating an affordability crisis. Homes for sale in some of the hotter markets in the U.S. spark intense bidding wars usually won by the person with the most cash or the best credit. What realtor is going to sell a home to someone who needs a subprime mortgage when they can pick and choose between multiple offers that are more than likely going to include someone with good credit?
Most mortgage lenders don’t hold the loans the write; they sell them to Fannie Mae or Freddie Mac so they can redeploy that money into a new loan. They make money off the transaction, not on the incoming mortgage payment. But they can’t sell the mortgages to Fannie or Freddie if they don’t conform to Fannie or Freddie’s rules. For the most part, this forces banks and mortgage lenders into better lending practices.
While it looks like things are stable now, that doesn’t mean it can’t change in a hurry. One of the remarkable things about the financial crisis is how quickly the bubble was inflated. Bad, adjustable-rate loans started seeping into the market in 2005, and three years later the economy was in free fall.
Already we’re seeing an uptick in subprime mortgage bonds produced by private lenders, although it’s grown from barely a tiny blip into a slightly larger tiny blip. In 2014, $100 million in mortgage-backed securities was issued. In just the first half of 2017, $2.6 billion in subprime mortgage-backed securities were issued in the $53.5 billion mortgage-backed securities market. Even if all the new subprime mortgage bonds failed, financial markets would hardly notice. In 2006, there was almost $1.5 trillion in outstanding subprime mortgage debt.
In the run up to the crisis, easy credit created an artificial demand for housing that pushed prices up, creating a bubble that ultimately burst. Today, millennials looking to become first-time home buyers are flooding a housing market that’s starved for supply. Low supply and high demand means high prices. One could argue that today’s housing bubble isn’t a bubble at all, but a reflection of an incredible supply and demand imbalance.
There are so many institutions and industries that depend on home prices going up that there are intense institutional and policy forces causing just that. If they haven’t already, those forces may push prices beyond the real value of the asset. Wall Street being Wall Street, it’s found new ways to squeeze every last dollar out of the housing market by leveraging big data and national online investorplatforms such as those for home flipper loans and so-called iBuyers.
The financialization of housing by institutional capital has negative consequences, like inflating home values at a time when affordable housing is scarce to nonexistent. And as housing is such a bedrock of the U.S. economy, the well-being of housing and the economy are tethered such that if one goes down, the other goes down with it.
It may over the next few years turn out that these forces inflate a housing bubble—and that bubble might burst, causing an economic down turn. The inverse could happen, too. But given changes to lending practices and the mortgage securitization chain, the bubble probably won’t burst in the same way it did last time around.