This is the second part of my series trying to answer peoples questions
about how mortgages work, and what went wrong. In the first part, I described
what a mortgage is, and how it works. In this part, I'm going to describe the
mortgage system - that is, the collection of people and organizations involved
in the business of mortgages, how they interact with one another, and how
that system has gotten into trouble. The next and final part will be
from the viewpoint of a homeowner who is taking or has taken out a mortgage to purchase a home, and what can go wrong from their side.
I'll reiterate my usual warning: I don't know much about economics. I come
at these things as a math geek who's spent entirely too much time reading
about the current situation.
One of the big failures in the mortgage system is that the system itself
is broken. Personally, I think it's deliberately broken - not in the sense of
a conspiracy between people to collude on creating a broken system - but by
the fact that each link in the chain is set up by the people in that role
trying to arrange things to maximize their benefit while avoiding
responsibility. When every link in a chain of responsibility sets things up so
that they have no responsibility, you end up with a thoroughly broken
system.
The Players
To understand how it's broken, you need to know what the pieces are, and
how they're connected. I've attempted to draw a rough flowchart of the various
people involved, which you can see to the right. In this chart, what basically
happens is that loans flow up the graph, and money flows down the graph. At
each link, there's an exchange of loans for money.
The way that it works is:
- Someone who wants to buy a home goes to a mortgage broker, and fills
out an application. - The mortgage broker takes the application, and brings it to a lender. The
mortgage broker is generally paid a commission by the lender for bringing them
the potential loan. - The lender gets applications, and decides whether or not to give the
loan. Once the loan is given, they sell the loans. They make money by
selling the loans. - Investors don't buy loans directly. So there's another intermediate - an
agent who buys mortgages, bundles them together into groups, and then sells
bonds based slices of collections of mortgages. The mortgage bond agent makes
money by selling mortgage bonds. - To supposedly manage risk, people like to buy bonds based on the best loans. That leaves a lot of leftover. Investors buy up bonds based on the best parts of the mortgage clumps. The remainder are sold to another kind of agent, who takes the leftover parts of the mortgage clumps, and combines those into a meta-bond, called a collateralized debt obligation. Those CDOs are then sold to investors. There's an elaborate system by which potentially risky
mortgages are repacked into supposedly high-quality investments. I spent
some time describing that system here.
There's a big problem with the structure of this system. Each intermediate
participant in the system makes money by selling the loans to someone else - so they make money not by earning interest on loans as they're repaid, but
by selling the loans before any payments are even received. So none
of them are personally at risk if the underlying loans can't be repaid.
Worse, each intermediate in the system can plausibly claim that they are not responsible for checking the information used to decide whether to approve the loan or not. The mortgage agent just fills out paperwork; he's just a facilitator. He's not really involved in the loan; even if he checked the information on the application, the lender should recheck it anyway, so why should he do it? The lender argues that they don't get to see the borrower, just the information that the mortgage broker gave them; he's their agent, he should have made sure that they got correct information. The investment agent that bundles loans into bonds argues that the lender was responsible for assessing the risk of the loans, and was supposed to give them valid,
checked information. Each participant knows what a farce this is; each one knows that the other parties aren't doing the checking that they should. But each one is making money, hand over fist, by not checking things,
and they've got a plausible excuse for denying their own responsibility.
What could possibly go wrong?
This system works pretty well, provided you assume some basic facts:
- Real estate always increases in value, at a rate higher
than the rate of inflation. - People tell the truth.
- People will always try to keep their homes - they'll default
on anything else before they let go of their home.
Unfortunately, all three of those assumptions have turned out to be completely
wrong.
Nothing can always increase in value faster than the rate of
inflation. Anyone who expects it to is an idiot. Money is, ultimately, a
finite resource - it's an abstract representation of the stuff we produce. And
we produce a finite amount of stuff. If something is increasing in value
faster than the rate of inflation, that means that a larger portion of the
total value of the stuff we produce is being spent on it. Eventually, it'll
reach a maximum: a point where no more of the total wealth we produce can be
spent on it. It can't go over 100% - because 100% is everything. It can't even
get to 100%, because there's a basic set of stuff that we can't eliminate:
energy, food, clothing. So ultimately, the value of homes has to stop
shooting up so quickly. But so many of the loans that were given could only
every be paid back by selling the property for significantly more than the
purchase price.
Second, the honesty assumption was broken in an incredibly systematic way.
Mortgage brokers routinely advised their clients to lie about their finances;
in some cases, they even altered paperwork to lie about their clients'
finances without the clients knowledge. With the structure of the system set
up so that no one is responsible for verifying that information, brokers
routinely set up applications for people to buy houses that they couldn't
possibly afford. This didn't matter to the broker - they were paid on
commission by the lender, so finding a way to get people to take a bigger
mortgage was very much to their benefit. And numerous buyers were only too
happy to take advantage as well - they believed in the myth of the eternally
rising house price, so they weren't concerned about being left on the hook.
Informed buyers knew what was going on, and went along with it, because they
believed they'd come out ahead. Uninformed buyers got screwed, talked
into fancy mortgage schemes that were foolishly risky. And so it went,
up the chain: at each level, people lied, either through deliberate
deception or foolish ignorance.
Finally, the changing nature of loans changed the underlying facts that
drove people to desperately hang on to their houses. Not all that long ago,
you needed to have a minimum of 20% of the purchase price as a downpayment.
For people other than the very wealthy, 20% of the price of a house was a
huge investment; it was very nearly every penny they had saved in
their adult lives. For most people who owned homes, their home was
their wealth: the equity in their home was the vast majority of everything
they had in the world. In that situation, people would fight, tooth and nail,
to keep their home: if the bank takes it and sells it at foreclosure, they'd
lose everything.
But the modern loan system changed that. Now, you can easily get
a home loan with little or no downpayment. And with HELOCs, it's
very easy for an owner to treat a home as if it's an ATM - to "withdraw" every bit of equity that they've got in it. In fact, the ease of getting HELOCs
has mean that most homeowners in financial trouble have
withdrawn all of their equity already. So when they finally wind up not being able to make the payments, they have nothing to lose by foreclosure. In fact, many places now have a significant problem with people basically taking the keys to their home, putting them in an envelope, and mailing them to the bank - basically saying "Here you go". They've got nothing to lose - so they just move out, and hand the house to the bank.
Who's responsible?
The short answer to "Who's responsible?" is everyone.
The borrowers are responsible for either lying, or trying to buy
homes that they couldn't afford, or for being ignorant of just what they
were committing themselves to. A lot of people got screwed and lost
their homes, along with everything they put into them, and I do feel
bad for those people. But the fact remains that no one forces
you to take out a loan and buy a house; if you commit yourself to
a financial contract without understanding what it says, and what
obligations it places on you, you're setting yourself up for deep
trouble.
Mortgage agents are among the worst offenders in this picture. The number
of thoroughly dishonest mortgage brokers is astonishing, and almost every day,
there's new information on the kinds of scams that they participated in.
The lenders were almost as bad as the mortgage brokers - sometimes even worse. They knew that there was a lot of money to be made in re-selling
mortgages, and they were determined to get their share of it, by hook or by
crook.
The folks who packaged mortgages into bonds and CDOs set up
structures that took ridiculously risky loans, and by wrapping them
up in enough layers of dishonest paperwork transformed them into
supposedly high-quality investments.
It comes down to a broken structure. The breakage is caused by the fact
that there are so many links; each one has a short-term interest in
seeing loans granted; and each one has a plausible excuse for why
they aren't responsible for any problems. Each one can (dishonestly) argue
that they assumed that someone else had done the checking. Each
level's greatest immediate interest is in selling things to the level above;
if they can make the sale, they're raking in cash, and thus, they're happy.
The structure insulates them: if something goes wrong, they're not left
holding the bag: they've already sold the risk.
- Log in to post comments
You've hit the nail on the head. When everyone is responsible no one is responsible. Too many pointing fingers.
Excellent overview, and I've sent it off to many friends in the process of figuring out whether to buy or not.
The only point you might have overlooked is that many of us, myself included, refused to use a mortgage broker and applied only at banks, specifically at small or medium local banks (East "City" Savings Bank, "City" Savings and Loan, those sorts of banks), and have never had their mortgage sold. I think my interest rate might be 0.25 % higher than the local average as a result, but having the same loan officer for the forseeable future is a bonus that was worth the premium, in my estimation.
Not sure how that sort of mortgage shopping fits into your grand scheme of risk and responsibility.
"Worse, each intermediate in the system can plausibly claim that they are responsible for checking the information used to decide whether to approve the loan or not."
Do you mean "not responsible" or "can plausibly deny"?
>Now, you can easily get a home lone
spell check time....
gelf:
That's what my wife and I did. When we bought our house, we found a local bank that services its own mortgages, and doesn't sell the loans. Our loan is with them, directly. Like you, we're probably paying a bit more in interest than we could have by going to a broker, but we preferred to deal directly with the lender. (Working with a local bank has a lot of advantages; there's a specific person we can talk to if we need anything; we don't need to do escrow for insurance and property taxes, etc.)
Mark P:
That was a typo; there was a missing "not". It's corrected now; thanks for catching it.
Stephen:
"Lone" for "loan" isn't the kind of thing that a spell-checker catches. "lone" is a correctly spelled word; it's just not the word that I meant.
>I've attempted to draw a rough flowchart of the various people involved, which you can see to the right.
uh, no. I can't see it :)
One of my favorite related funnies lately is The Subprime Primer.
Yeah, no flowchart, but excellent explanation, again. Sometimes an enthusiastic amateur can give a better high-level overview than a seasoned pro because one is not as concerned with the details. That doesn't mean I'll let you pick loans for me, but at least I feel like I understand the overall system a little better. Finance columns and blogs have too many acronyms and fancy-sounding doublespeak for me to follow well.
A couple of things, one substantive, I think, the other just commentary:
As I understand it, the process of creating the CDOs got really hosed up. In theory bundling loans should get you packages with risk that can be evaluated, like a fund that invests in a particular grade of bonds. The risks have turned out to be higher in practice, to the point that the big institutions that control the CDOs can't say just what the risk is. And if you can't evaluate the risk, you can't set the price, so the investors went from "Buy, buy, buy!" to "Stay the hell away!". That's where we see the transition from people losing their houses to the near-collapse of Bear Stearns and the like. The breakdown in the process of creating and evaluating the 'instruments' is part of what I think begs for a clear and jargon-reduced explanation.
Second: They've got nothing to lose - so they just move out, and hand the house to the bank. In some cases it's worse. They strip every valuable bit they can before moving out, right down to the light bulbs. The really angry ones actually vandalize the place, knocking holes in the walls and crap like that.
Lack of personal responsibility notwithstanding, I side with the borrowers, generally. We, as individuals, are not professional lenders, though I agree we MUST know what we're getting into. If a lending institution willingly sells me a mortgage they know I may not be able to repay, who's to blame? It's just wrong.
My beef is with the bailout of big business once again. They get caught with their hands in the cookie jar yet one more time, and our government would rather prop them up than help average Americans who got in over their heads. I guess the paperwork is less when it's just a few big lenders you have to help.
Why shouldn't they take the light bulbs? They probably put them in.
The personal property that confuses me are the attachments for built-in vacuums. The Realtors insist that they belong to the owner, so you should take them when you move. But so few homes have built in vacuuums, it doesn't make much sense. I had to contact the previous owner to get mine back! (And I left them when I moved out of that house.)
Before saying anything, I have to include some disclaimers. I work for a bank that sells mortgages. I'm intending to be as honest as possible here, but please remember this bias when evaluating what I say. Also, I am speaking only on my own and what I say does NOT represent my employer in any way.
I think Mark is quite accurate when he ascribes the problem to the avoidance of responsibility among a large number of different agents. I work as a programmer for the mortgage division of ING Direct, and I think that our bank's experience of the mortgage crisis provides some solid evidence of Mark's claim.
You see, ING Direct has handled mortgages a bit differently. As a bank, we fall into Mark's category 3: we're a lender. But unlike other lenders, we do NOT sell our mortages as securities. There are a few reasons for that -- one is that we just like being different, another is that we have lots of deposits that need to be invested someplace (in mortgages!). There's also the fact that we worked hard to simplify the application and as a result our data doesn't match what Fannie Mae and Freddie Mac buy. But whatever the reason, we're the end of the line -- historically we DO keep our mortgages instead of selling them.
That makes us a LOT more conservative than the rest of the market. If you're a marginal customer, there's no sense in applying with us... we're just not going to lend you as much as other banks (if you're really marginal we won't lend at all). We only want to hold mortgages that we are SURE will get paid back. The way we get customers is through our reputation for being consumer friendly (we work pretty hard at it, but it's difficult to tell how many mortgages that sells) and by having better rates than the other guys.
So in a way, our company is a "control group" against which we could test Mark's claim -- a bank that is still holding onto mortgages. (Some credit unions could also be used for this comparison, but I don't have numbers on them... maybe someone else does?) So it'd be interesting to find out how many of ING Direct's mortgages have had to foreclose.
The answer is FAR less than 1%. The last hard numbers I heard were a few months ago, but at that point we had foreclosed on 6 mortgages... yes, just 6 in the entire history of the bank (we're about 7 yrs old). Since we're so young, most of our mortgages were sold during the height of the troubled mortgage boom, yet somehow our mortgages are NOT being foreclosed on.
Personally, I think it's because Mark's analysis is dead on: when everyone shirks responsibility, loans are made which are no good for ANYONE: for the lender, the bondholder OR the borrower. And when one player in the game DOES take responsibility, the loans are far more reliable.
If anyone wants to discuss this further (or someone at ING wants to complain that I'm sharing information that shouldn't be public) you can reach me via mcherm@mcherm.com.
I'm as annoyed as anyone with the "real estate (gold, ...) always goes up" mentality, but when Mark says that "nothing can increase in value faster than inflation forever," he's wrong. This true if and only if your economy never grows, such that real economic output is a fixed, finite resource.
This is not true: new resources (physical or human), improved efficiency and technology can all create new value, which translates to money that wasn't there before. In the long run, real (inflation adjusted) economic output grows. (E.g., the world's real output growth in 2007 was around 5%.)
If we always spend n% of our pay on real estate then real estate will always, in the long run, outpace inflation. Our purchasing power increases over time.
Mark,
Thank you for a wonderful brief and to-the-point overview of the mortgage system. I do have a question based on gelf's and your own comments on borrowing money directly from a bank rather than using a mortgage broker. I don't see why one would need a personal connection with the lender if you have a fixed rate; pay on time; etc. 0.25% might not sound like much but over years it adds up dramatically! Is it really worth it? What exactly are the benefits of borrowing from a local bank?
Thanks!
Viktoria:
The advantages of getting a mortgage from a local bank are:
(1) The bank won't sell your mortgage - so you know who's servicing your
loan.
(2) You know the people servicing your loan at the bank.
(3) Because you know the people at the bank, you can work out all sorts of
terms for your benefit. For example, most mortgages require you to put money to pay
your property tax, mortgage insurance, and homeowners insurance in escrow. You
add a share of the those into each months payment, and at the appropriate intervals,
the premiums/takes are paid from the escrow fund. You don't get interest on your
escrow funds. But a local bank will often let you skip the escrow, and take care of the
insurance and taxes yourself.
The reliability of the local bank servicing your loan is worth a lot. i've watched friends get screwed in a variety of ways when their mortgage was sold to a rotten servicer.
The no-escrow can be a *huge* savings, too. For example, where I live, our property takes are huge. We pay $20,000/year in property takes. We get to hold on to our money until the takes are due. The interest on that money is ours.
I think that we ended up getting our mortgage for 1/8th percent above the lowest available. (I don't know why, but mortgage interest seems to be measured in 8ths of a percent.) The amount of extra payment is very small after considering the no-escrow benefits - and the fact that we know the people at the bank, and can call them anytime
we have a question or a problem is worth a lot. (For example - we got home yesterday
to find out that we accidentally used an old stamp to mail last months payment - so it was short postage. So we called the bank, and told them what happened. And it's no problem - we could talk to the person at the bank who processed the payments.
Mark: You don't get interest on your escrow funds.
Are you sure about this? I seem to recall that we get escrow statements each year showing our interest on that account. Our escrow is so small it only amounts to a few dollars a year anyway, but I wonder if this is something different about our bank?
Nice post, as usual, though. Very informative. You should consider writing a book or something. Really.
Not bad, but there's some history here as well, particularly step 4 (repackaging loans into bonds).
There was a time when no investor would touch mortgages, and so the lenders assumed the risk and carried the loan on their books until it matured or was repaid. Investor's wouldn't take on mortgages because of reinvestment risk. When interest rates fall a large number of loans are paid off, or start to pay off faster, which means the investor who was expecting (say) 7% over 30 years suddenly finds they're getting their money back faster. That is not a good thing, because now they have to find another investment and at a lower interest rate.
The CMO (collatoralized mortgage obligation) was created in the mid 80's to deal with this. It was a way for taking a set of payments and packaging them so they can support a fixed interest bond. Those bonds enabled investors to get into the mortgage market, which means that more funds are available for mortgages.
The system isn't broken up in order to avoid responsibility, the latter part of it at least is there to service a real need, which was not being fulfilled well as recently as 20-25 years ago.
If there is any one thing that is broken it is the incentives of brokers. They get paid up front with no downstream risk, so there is an incentive to lie about credit quality.
The big loop missing in that diagram is the one that shows how the guys at the top get the money to lend. They get it from the guys at the bottom, via enforced retirement savings.
Of course, it's not possible for the whole of society to "save for retirement". At the end of the day, the nonworking population are supported by the working population. What might seem to make sense for an individual cannot make sense for society as a whole, beacuse - as you point out - money is only a measure of what proportion of society's current output is owed to you.
Retirement investment - the whole idea of it - is simply an enormous scam that benefits no-one but the various boxes on your flowchart.
Mark,$20,000/year?
Sarah A. - good catch. Long term, real estate does increase faster than inflation, at least in growth areas, it is just that it does not do so uniformly due to momentum investing and some of the swings it can take as a result are sizable.
The other problem with the system was the incentives were to increase the number of risky loans to generate higher returns and lending standards were lowered in order to do so.
I love the discussion, but there is, actually, one significant missing link from the diagram. At some point, money has to flow from the home purchaser to the investor.
Why, it's almost as if a system in which everyone works for their own immediate advantage DOESN'T necessarily lead to the optimum, stable, long-term solution.
Rimpal:
Yes, $20,000/year. Westchester county property taxes are just out of control.
Great article, but I disagree that "Money is, ultimately, a finite resource - it's an abstract representation of the stuff we produce." At least in the sense that wealth is limited to how much "stuff" there is. Give Michaelangelo a $30 canvas and $10 worth of paint and he'll produce a million dollar painting. By doing that, he'll add $999,960 of value to the worlds weath.
Whether a bank will continue to service the loan they made you is almost entirely separate from whether they will sell the loan or not. Small banks often sell the mortages they make to an entity like FNMA, FHLMC or GNMA. However, those entities do not service loans. The bank who sold the loan retains the servicing rights, and gets a small percentage of the interest (on the close order of 0.5%), and passes the rest of the payment on to the owner of the loan. They also get to hold on to the payment for a short period of time, and can earn interest on the float.
If they hold the loan, they may still transfer the servicing. It's expensive to service a small number of loans, so it can be worth while to sell the servicing rights to an organization that can deal with then in large volume.
Why shouldn't they take the light bulbs? They probably put them in.
Because it is just so petty. Besides if everybody just left the lightbulbs, whatever you "lose" by leaving them behind, you "gain" back in your new house. And even if the new place was completely stripped of bulbs, what would it cost you, $100 to replace them, when you just plunked down $200k or more? And on the otherside, for those being foreclosed and not buying again, what are you gaining, 50 half dead bulbs when you just lost hundreds of thousands of dollars? Penny wise pound foolish.
It probably varies from state to state whether interest must be paied on escrow accounts. I got interest on mine here in Massachusetts. I think the requirement of an escrow account might also be by state. We had to have an escrow for homeowners insurance and property tax payments and we got our mortgage directly from a local bank (who did end up selling it a few years later). It also depends on the kind of escrow. Escrow accounts like for the deposit on a home purchase do not acrue interest. But these required accounts for insurance and taxes may not be considered real "escrow" accounts and so the state requires them to pay interest.
Mike (25), creating goods with more value does not increase the amount of money. Instead, it changes the demand of the available money. For instance, that painting you mention, does not create any more money. It has its value of $1M because people want it, and want to use money to purchase it. In effect, creating that painting adds $1M more of demand towards the available money. But, it does not change the supply of the money at all. That is accomplished by printing/minting - or destroying - actual money.
In summary, you are right that wealth is created, but that is not the same as creating money. It is, however, the same as creating more demand for money.
MarkCC,
Regarding the "jingle mail" issue -- do you have any pointers to stats on that? In particular, I'm looking at this post from Kevin Drum a while back (pointing to an LA Times article which no longer seems to be there, but the post has an excerpt):
http://www.washingtonmonthly.com/archives/individual/2008_05/013704.php
If there are any hard numbers on the phenomenon, I'd be curious. The story is out there, but actual data seem to be a bit thin on the ground.
In a strange way, I don't think it's fair to call the "system" broken. Human systems are always broken (by definition), and any economic system will always be subject to abuse and collapse. In a way, the imperfection of the system is part of it's evolution.
The premise "Nothing can always increase in value faster than the rate of inflation", is more or less incorrect. Increasing scarcity increases value. So if the population is growing rapidly (and there haven't been any good plagues for a while), and they all need places to live, the amount of available property is decreasing. If this is occurring faster than the normal rate of inflation (3%?) then the prices will consistently rise. Of course someone selling get-rich-quick-real-estate-schemes helps too.
Paul.
http://theprogrammersparadox.blogspot.com
BTW: Great blog!
When people are challenging the comment about the value of real estate versus inflation, notice that Mark's claim was "Nothing can always increase in value faster than the rate of inflation." This is true - because of the qualifier "always". Real estate, like anything else, can at times increase in value faster than inflation.
But, in many places right now, real-estate is actually decreasing in value, i.e. a negative increase, whereas inflation is still a positive amount. It is these times, where houses lose relative value, where the housing "system" that Mark mentions can fail.
Nice article! The big log chain somehow diffuses responsibility to the point where it no longer exists.
A couple of points:
Escrow requirements vary by the lender and the down payment. The six times I've gotten a mortgage, I was very careful to have a 20% down payment, which each bank said was enough to skip the escrow. The escrow was never big enough to make me care about the interest, but I've heard enough horror stories about escrow agencies "forgetting" to pay the taxes or insurance, and I wasn't prepared to take that risk.
The other big advantage of having a real down payment was getting by without Private Mortgage Insurance (PMI). PMI is a nice scam where an insurance company purports to guarantee the lender against default. I say "scam" because while it helps against random default, it doesn't do a darn thing for broad market trends. When all the housing prices go down, and lots of buyers default, the insurance company simply goes bankrupt. Of course, soon the investors forget about the bankruptcy, and demand PMI anyway.
Mortgages are complicated, and that's one of the big allures of mortgage brokers. They make their money only by selling mortgages, so they do their best to make the mortgage. Contrast that with many banks, which often have only a part-timer making the mortgages, without any real effort. I once had a friend turned down by a bank for a mortgage because she was widowed and her daughter would be losing social security benefits soon. Well, after I re-directed her to a mortgage broker, the mortgage was a snap. And yes, she made the payments, even after the daughter moved out.
And with all of the mortgage brokers working away, it did get too easy to get a mortgage. People got one they never could afford ($500K on $25K salary???), thanks to all of the tricks that could be squeezed out to make the monthly and down payment smaller. The sad part is that drove up home prices and kept wise people from getting a house. Oh well, they are able to buy lots of houses cheap now! Gotta love foreclosure sales!
We had a slightly unusual requirement (wanted to lock in rates during the entire construction term plus 30-year-fixed, when all the banks we called would only do a 60-day lock-in), so we wound up going through a mortgage broker. The broker is a lifelong local resident, and the lender is not quite local but close enough to drive to (about 30 miles), or certainly contact by phone or e-mail. So we've sort of been able to have our cake (the broker finding the arrangement we wanted when we couldn't) and eat it, too (known people servicing the loan).
Another strange thing that is going on is Naked Shorting in the buying and selling of shares.
The link is to a rather long and detailed presentation on how some share brokers may be stealing and damaging, possibly even destroying, companies in the USA and I suspect in other share markets around the world.
The checks and balances along with honesty, openess and fair dealing seem to be long gone.
Mike wrote:
Sorry, but without putting too fine a point on it, that's bollocks.
The only reason a painting can ever be worth a million pounds, is if somebody who has a million pounds wants it badly enough. If nobody has a million pounds, or plenty of people have that much money but none of them want the painting, it's not worth a million pounds.
There's still the same amount of money in the economy: it's just been transferred from one rich idiot to another. Meanwhile, the poor idiots look on and say "Ah, well, if I'd only painted a painting, I could have had me a cool meg by now."
The same thing happens if you start magically manufacturing pound notes. If you double everyone's savings by giving everybody as much money again as they have already got, nobody really gets any richer: the price of goods doubles to compensate.
Or, consider what happens when workers in a factory making some essential goods for which there is a constant demand (let's say, light bulbs), ask for a pay rise. Management have to increase the price of goods to afford this. Now everybody else finds a higher proportion of their wages being spent on light bulbs; so they, too, want pay rises. So everything else gets more expensive -- including whatever it was that the light bulb makers wanted more money to be able to afford to buy in the first place.
This is a positive feedback loop and therefore inherently unstable (what happens when amplified sound from a loudspeaker gets back to the microphone?)
Thank you for this summary. Very interesting (and easy to understand!) for an outsider.
Now I need to find out what checks and balances are in place here in Denmark, since we don't seem to have a similar crisis on our hands even though houseprices are falling and foreclosures are up.
AJS, I don't think you are describing the feedback loop correctly for when more light bulbs are made. When more goods are made, there is more demand for the money to buy the goods, as you describe. But, just as you address, producing more goods does not produce more money. There still is not more money in the system, so it is not possible to simply pay all the workers more to meet their demand for more money to buy more goods. Instead, I'm suggesting, the feedback loop causes the value of the money to change.
Increasing the demand for money actually causes deflation, just the opposite of increasing the supply of money which causes inflation (like the Weimar Republic found). This deflation, a direct result of producing more goods of value, increases the buying power of the factory workers without any need for a pay raise. In effect, they are giving themselves a pay raise by producing those goods. That is how the feedback loop - the invisible hand of Adam Smith - works if more money is not produced.
It is actually a very stable feedback loop, barring any exceptional demands from the workers.
One piece of the puzzle that nobody has covered but NPR's "This American Life" is what they called "the global pool of money," that is, the $70T in fixed income securities that doubled in the course of a few years as places like China, India, and the middle east built up giant account balances.
This global pool of money didn't have anywhere to go, and the money managers found a potential resting place in American mortgages.
"This American's Life" coverage ("The Giant Pool of Money," aired on 11 May '08) was well worth listening to.
kieran
I've been in the business 20 years, and this is a really good explanation of the recent madness.
I mean really good.
Jonathan:
Please stop reposting comments from other people. If they want to participate in the discussion here, they're absolutely welcome to come on over and comment for themselves. But I consider it unacceptably rude to have a discussion off somewhere out of site, and then post excerpts from it publicly. Feel free to invite them to come join the discussion here themselves; but I don't want their stuff posted here by a third party.
Sorry for the misunderstanding. There is no off-site discussion that I know about. There are a bunch of smart guys to whom I've been emailing stuff from your blog, sometimes including my comments, for a couple of years.
For whatever reason, they don't blog. So I take their emails entire and, with their permission, submit them to you. They're kind of old-school, willing to post papers on the web and papers on arXiv and papers winning awards in journals and proceedings, but biased against the addictions of blogging.
But if they don't want to comment to you directly, and you don't want to accept their wise comments, with attribution, from me, then everyone loses.
I could not get my father to ever email, in the decade before he died. He insisted on old fashioned handwritten letters.
Sorry that my attempt to market your blog has failed. No offense intended.
Mark,
Thank you for such a detailed answer. So what can happen if one's loan is sold to a "rotten servicer"? The terms of the mortgage wouldn't change, would they? And if they don't why should I care who owns my loan?
Viktoria:
The servicer determines a lot of stuff that affects you.
For example, whoever is servicing your loan is in control of it. One of the rights of the mortgage servicer is to "call" the mortgage - that is, they're effectively able to foreclose the loan at any time, and for any reason on short notice. So a lousy servicer can foreclose your loan if you're late with one payment.
Less severe, but still serious: most mortgages require you to pay into an escrow account to pay your property taxes and homeowners insurance. Lousy servicers aren't careful about paying those on time. And if they screw up and forget to pay the taxes, who's stuck with the late fee? you. And if they screw up and forget to pay the insurance,
and it lapses, who get's stuck paying for damage? You.
There are lots of little things like that.
Mark,
I had an ARM during a time when ARMs worked well for most people that had them, because mortgage rates were declining from historic highs. Yes, I knew the risk I was taking.
In Part 1, you say that a change of "only" 2% in the rate caused a jump of 17% in the payment. You should have said that a drastic 40% change (from 5 to 7) had caused the 17% change in payments.
I think you also conflate wealth and its measure. Inflation relates to the measure of wealth. So real estate prices could always beat inflation, but their rate of increase would rapidly approach the inflation rate as they came to dominate all other forms of assets.
The lack of transparency in the data models as a key part of the rise in riskiness of these mortgage backed securities - a "no income verification" mortgage should be radioactive in an MBS since the additional risk premium did not cover the risk of default. That greed was allowed to overrule clear risk guidelines for investment was an absolute failure of fiduciary responsibiity, IMHO, in those that valued and invested in these securities.
But that is for players that should have known better because of their responsibilities. The sheer innumeracy of those bamboozled by fast talking salesmen at the other end of the pipeline fed their own version of greed - living beyond their means. This shows that basic living skills does include understanding compound interest - and it needs to be taught that way in American high schools to everyone.
And you leave out one large responsible party in all this mess. Home mortgages are a tax privileged choice of investment in the US. This alone can tip the scales of price appreciation, and create the myth of prices growing to the sky, which was additonally fueled by speculation, but primarily fueled by the tax code. Home ownership is not an absolute good that should be baked into the tax system.
We need a term to describe absolute changes in percentage vs percentage changes in percentage!
In my field, RF Engineering, we measure the efficiency of our power devices in %. How do you describe a change from 40 to 50 %? I like to say that it is a change of 10 points or a change of 25% depending on what I am trying to say. Of course, "points" has another meaning in mortgage transactions that Mark didn't even mention!
Doubtless you know it Mark, but for other readers, Tanta's "Ubernerd" posts at calculatedrisk are probably the best source of (occasionally mind-numbingly) complete details on how the mortgage deals are structured, and what can go wrong.
(Apparently, there's another Stephen who comments here.)
So, ten years ago, i got a fixed rate mortgage, but with less than 20% down. So i had "PMI" payments. We didn't buy more house than we could afford, but then one of us lost their job, and the other changed jobs to one paying less. Five years ago, we refinanced, which helped enormously. We got over the 20% bit because the value of the house was appraised higher. Still fixed rate.
We'd used a local bank, but this bank has merged twice since then. And the mortgage has been sold to a large New York outfit that i think of as the scum of the Earth. They've already used our "relationship" to get a high pressure salesman to try to ram some additional insurance down our throats. I tried to be polite, but had to hang up on him. When he kept reading from the script, only louder, after i said that "we're not interested", he was telling me, and in no uncertain terms, that i should look for a way to transfer the mortgage somewhere else.
At least it's still a fixed rate mortgage. And, it's one i can afford. At least until i get laid off. But the idea that i can suck my equity out of the house then walk away from it is good news. Selling a house in the Detroit area isn't pretty. But my current equity will buy a house outright here. That's unexpected. Especially as it comes from short term greed in the system.
You are touching on the symptoms but not the real cause. Someone has already seen this coming five years ago and his name is Ron Paul.
Have a read:
http://www.lewrockwell.com/paul/paul128.html
Re #48: Much of what Ron Paul wrote in that mini-essay was true. My son registered Republican to vote for him in the Primary. But my son renounced Ron Paul once his Creationist views became known to us. Good Math on the real estate bubble; Bad Math about Evolution. That's 1 for 2. Which is better than Sarah Palin's 0 for 2. So, since you follow Ron Paul's advice, which of the minor party candidates do you support for President (i.e. those not of the one-party Incumbency)?
I think it's a little silly (I say this in a friendly way) that you would write off the best candidate to ever emerge in American politics based on his religious belief. :) Since this site deals with math, I would say you have to give different weight to different things. Giving the same weight to a religious belief (as a person's understanding of the economy) which has no relevance in a man's ability in carrying out his job as a president is wrong math. :)
If people on the other side of the fence use the same math, RP will not be elected if there are more people believing in Creationism in this country, so I would say that's a wrong approach for either side to take. Religious belief simply should not enter into politics.
We should look at his overall voting records and whether he is consistent and truthful and uphold the Constitution.
RP believes in liberty, which means that we are all allow to believe in what we want, do what we want as long as we don't harm others. That's why liberty brings people together. All the decisions that I have seen him made in the congress is based on the Constitution, not religion. That alone makes his belief irrelevant to getting the job done right for America. His deep understanding of the Austrian economics (which predicted many of these crisis), his honesty, integrity, his fiscal conservatism and his strict adherence to Constitution are enough to make him stand out amongst the clowns out there. So in the end whether he believes in God or not is as irrelevant as whether he believes what he should have for breakfast, because he most definitely will not impose that belief on you through anything he does on your behalf. That's the way I see it.
I brought up the article RP wrote not so much to get politics into this blog but because I think the current analysis the blog owner makes is like one of the many I have read - it has a whole host of correct arguments but it's missing out on the larger picture and mistake the symptoms as the root cause of the problems we are facing today. This is dangerous because when we do that, we might end up with more regulations, and therefore bigger government, and loss of liberty and freedom in the process.
BetterLateThanNever: I think it's a little silly (I say this in a friendly way) for you to conflate my son's voting preferences with my own. My son is an intelligent man -- he tested completely out of high school, and went straight from 8th grade to university at age 13. He earned a double B.S. in Math and Computer Science. He, at 19, is in his 2nd year of USC Law School, where he still admires Ron Paul's understanding of Constitutional and economic issues. Evolution, however, is established science, based on hundreds of thousands of researchers over centuries analyzing and interpreting billions of data. Anyone who lets religious beliefs and bad math replace those facts with myths and parables is indeed subject to scrutiny as to fitness for higher office.
I am not discussing my own political beliefs. My father and his his father were old-school Wall Street Conservative Republicans, deserted by their dysfunctional party. My mother was a left-liberal Democrat, deserted by her dysfunctional party. I have been an elected town councilman in two communities of two states, and written speeches for a presidential candidate.
This is a Good Math/Bad Math blog. Creationism, and its fraudulent repackaging of Intelligent Design is part of the discourse here.
A few points:
1. The rating agencies invented these computer models that were a joke. But, there was another layer of corruption that slapped the AAA ratings on the securities.
2. Many of the investment banks that packaged the loans kept the high risk (high interest) tranches.
3. The Credit Default Swap market went nuts on this stuff. I could buy multiple insurance policies (CDS) on one of these securities and not even own it.
Most of the damage came from the last two points.